Pir Sahib on Wall Street (Part –1)

Gold and Economic Freedom

By ALAN GREENSPAN

An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense-perhaps more clearly and subtly than many consistent defenders of laissez-faire-that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other.

In order to understand the source of their antagonism, it is necessary first to understand the specific role of gold in a free society.

Money is the common denominator of all economic transactions. It is that commodity which serves as a medium of exchange, is universally acceptable to all participants in an exchange economy as payment for their goods or services, and can, therefore, be used as a standard of market value and as a store of value, i.e., as a means of saving.

The existence of such a commodity is a precondition of a division of labor economy. If men did not have some commodity of objective value which was generally acceptable as money, they would have to resort to primitive barter or be forced to live on self-sufficient farms and forgo the inestimable advantages of specialization. If men had no means to store value, i.e., to save, neither long-range planning nor exchange would be possible.

What medium of exchange will be acceptable to all participants in an economy is not determined arbitrarily. First, the medium of exchange should be durable. In a primitive society of meager wealth, wheat might be sufficiently durable to serve as a medium, since all exchanges would occur only during and immediately after the harvest, leaving no value-surplus to store. But where store-of-value considerations are important, as they are in richer, more civilized societies, the medium of exchange must be a durable commodity, usually a metal. A metal is generally chosen because it is homogeneous and divisible: every unit is the same as every other and it can be blended or formed in any quantity. Precious jewels, for example, are neither homogeneous nor divisible.

More important, the commodity chosen as a medium must be a luxury. Human desires for luxuries are unlimited and, therefore, luxury goods are always in demand and will always be acceptable. Wheat is a luxury in underfed civilizations, but not in a prosperous society. Cigarettes ordinarily would not serve as money, but they did in post-World War II Europe where they were considered a luxury. The term ``luxury good`` implies scarcity and high unit value. Having a high unit value, such a good is easily portable; for instance, an ounce of gold is worth a half-ton of pig iron.

In the early stages of a developing money economy, several media of exchange might be used, since a wide variety of commodities would fulfill the foregoing conditions. However, one of the commodities will gradually displace all others, by being more widely acceptable. Preferences on what to hold as a store of value, will shift to the most widely acceptable commodity, which, in turn, will make it still more acceptable. The shift is progressive until that commodity becomes the sole medium of exchange. The use of a single medium is highly advantageous for the same reasons that a money economy is superior to a barter economy: it makes exchanges possible on an incalculably wider scale.

Whether the single medium is gold, silver, sea shells, cattle, or tobacco is optional, depending on the context and development of a given economy. In fact, all have been employed, at various times, as media of exchange. Even in the present century, two major commodities, gold and silver, have been used as international media of exchange, with gold becoming the predominant one. Gold, having both artistic and functional uses and being relatively scarce, has always been considered a luxury good. It is durable, portable, homogeneous, divisible, and, therefore, has significant advantages over all other media of exchange. Since the beginning of Would War I, it has been virtually the sole international standard of exchange.

If all goods and services were to be paid for in gold, large payments would be difficult to execute, and this would tend to limit the extent of a society`s division of labor and specialization. Thus a logical extension of the creation of a medium of exchange, is the development of a banking system and credit instruments (bank notes and deposits) which act as a substitute for, but are convertible into, gold.

A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security for his deposits). But the amount of loans which he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments.

When banks loan money to finance productive and profitable endeavors, the loans are paid off rapidly and bank credit continues to be generally available. But when the business ventures financed by bank credit are less profitable and slow to pay off, bankers soon find that their loans outstanding are excessive relative to their gold reserves, and they begin to curtail new lending, usually by charging higher interest rates. This tends to restrict the financing of new ventures and requires the existing borrowers to improve their profitability before they can obtain credit for further expansion. Thus, under the gold standard, a free banking system stands as the protector of an economy`s stability and balanced growth.

When gold is accepted as the medium of exchange by most or all nations, an unhampered free international gold standard serves to foster a world-wide division of labor and the broadest international trade. Even though the units of exchange (the dollar, the pound, the franc, etc.) differ from country to country, when all are defined in terms of gold the economies of the different countries act as one--so long as there are no restraints on trade or on the movement of capital. Credit, interest rates, and prices tend to follow similar patterns in all countries. For example, if banks in one country extend credit too liberally, interest rates in that country will tend to fall, inducing depositors to shift their gold to higher-interest paying banks in other countries. This will immediately cause a shortage of bank reserves in the ``easy money`` country, inducing tighter credit standards and a return to competitively higher interest rates again.

A fully free banking system and fully consistent gold standard have not as yet been achieved. But prior to World War I, the banking system in the United States (and in most of the world) was based on gold, and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post- World War I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion.

But the process of cure was misdiagnosed as the disease: if shortage of bank reserves was causing a business decline- argued economic interventionists-why not find a way of supplying increased reserves to the banks so they never need be short! If banks can continue to loan money indefinitely--it was claimed--there need never be any slumps in business. And so the Federal Reserve System was organized in 1913. It consisted of twelve regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled, and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. Technically, we remained on the gold standard; individuals were still free to own gold, and gold continued to be used as bank reserves. But now, in addition to gold, credit extended by the Federal Reserve banks (paper reserves) could serve as legal tender to pay depositors.

When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve`s attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain`s gold loss and avoid the political embarrassment of having to raise interest rates.

The ``Fed`` succeeded: it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930`s.

With a logic reminiscent of a generation earlier, statists argued that the gold standard was largely to blame for the credit debacle which led to the Great Depression. If the gold standard had not existed, they argued, Britain`s abandonment of gold payments in 1931 would not have caused the failure of banks all over the world. (The irony was that since 1913, we had been, not on a gold standard, but on what may be termed ``a mixed gold standard``; yet it is gold that took the blame.)

But the opposition to the gold standard in any form-from a growing number of welfare-state advocates-was prompted by a much subtler insight: the realization that the gold standard is incompatible with chronic deficit spending (the hallmark of the welfare state). Stripped of its academic jargon, the welfare state is nothing more than a mechanism by which governments confiscate the wealth of the productive members of a society to support a wide variety of welfare schemes. A substantial part of the confiscation is effected by taxation. But the welfare statists were quick to recognize that if they wished to retain political power, the amount of taxation had to be limited and they had to resort to programs of massive deficit spending, i.e., they had to borrow money, by issuing government bonds, to finance welfare expenditures on a large scale.

Under a gold standard, the amount of credit that an economy can support is determined by the economy`s tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government`s promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets. A large volume of new government bonds can be sold to the public only at progressively higher interest rates. Thus, government deficit spending under a gold standard is severely limited.

The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which-through a complex series of steps-the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets.

The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy`s books are finally balanced, one finds that loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion.

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists` tirades against gold. Deficit spending is simply a scheme for the ``hidden`` confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists` antagonism toward the gold standard.


(As reprinted from the book ``Capitalism, the Unknown Ideal``
by Ayn Rand with additional articles by Alan Greenspan - 1967

Following is a verbatim article as it was published in the Wall Street Journal ... back before he was the Fed chairman ... (more below)




CAN THE U.S. RETURN TO A GOLD STANDARD?


By Alan Greenspan


The growing disillusionment with politically controlled monetary policies has produced an increasing number of advocates for a return to the GOLD STANDARD - including at times president Reagan.

In years past a desire to return to a monetary system based on gold was perceived as nostalgia for an era when times were simpler, problems less complex and the world not threatened with nuclear annihilation. But after a decade of destabilizing inflation and economic stagnation, the restoration of a GOLD STANDARD has become an issue that is clearly rising on the economic policy agenda. A commission to study the issue, with strong support from President Reagan, is in place.

The increasingly numerous proponents of a GOLD STANDARD persuasively argue that budget deficits and large federal borrowings would be difficult to finance under such a standard. Heavy claims against paper dollars cause few technical problems, for the Treasury can legally borrow as many dollars as Congress authorizes.

But with unlimited dollar conversion into gold, the ability to issue dollar claims would be severely limited. Obviously if you cannot finance federal deficits, you cannot create them. Either taxes would then have to be raised and expenditures lowered. The restrictions of gold convertibility would therefore profoundly alter the politics of fiscal policy that have prevailed for half a century.


Disturbed by Alternatives

Even some of those who conclude a return to gold is infeasible remain deeply disturbed by the current alternatives. For example, William Fellner of the American Enterprise Institute in a forthcoming publication remarks ``...I find it difficult not to be greatly impressed by the very large damage done to the economies of the industrialized world... by the monetary management that has followed the era of (gold) convertibility... It has placed the Western economies in acute danger.``

Yet even those of us who are attracted to the prospect of gold convertibility are confronted with a seemingly impossible obstacle: the latest claims to gold represented by the huge world overhang of fiat currency, many dollars.

The immediate problem of restoring a GOLD STANDARD is fixing a gold price that is consistent with market forces. Obviously if the offering price by the Treasury is too low, or subsequently proves to be too low, heavy demand at the offering price could quickly deplete the total U.S. government stock of gold, as well as any gold borrowed to thwart the assault. At that point, with no additional gold available, the U.S. would be off the GOLD STANDARD and likely to remain off for decades.

Alternatively, if the gold price is initially set too high, or subsequently becomes too high, the Treasury would be inundated with gold offerings. The payments the gold drawn on the Treasury`s account at the Federal Reserve would add substantially to commercial bank reserves and probably act, at least temporarily, to expand the money supply with all the inflationary implications thereof.

Monetary offsets to neutralize or ``earmark`` gold are, of course, possible in the short run. But as the West Germany authorities soon learned from their past endeavors to support the dollar, there are limits to monetary countermeasures.

The only seeming solution is for the U.S. to create a fiscal and monetary environment which in effect makes the dollar as good as gold, i.e., stabilizes the general price level and by inference the dollar price of gold bullion itself. Then a modest reserve of bullion could reduce the narrow gold price fluctuations effectively to zero, allowing any changes in gold supply and demand to be absorbed in fluctuations in the Treasury`s inventory.

What the above suggests is that a necessary condition of returning to a GOLD STANDARD is the financial environment which the GOLD STANDARD itself is presumed to create. But, if we restored financial stability, what purpose is then served by return to a GOLD STANDARD?

Certainly a gold-based monetary system will necessarily prevent fiscal imprudence, as 20th Century history clearly demonstrates. Nonetheless, once achieved, the discipline of the GOLD STANDARD would surely reinforce anti-inflation policies, and make it far more difficult to resume financial profligacy. The redemption of dollars for gold in response to excess federal government-induced credit creation would be a strong political signal. Even after inflation is brought under control the extraordinary political sensitivity to inflation will remain.

Concrete actions to install a GOLD STANDARD are premature. Nonetheless, there are certain preparatory policy actions that could test the eventual feasibility of returning to a GOLD STANDARD, that would have positive short-term anti-inflation benefits and little cost if they fail.

The major roadblock to restoring the GOLD STANDARD is the problem of re-entry. With the vast quantity of dollars worldwide laying claims to the U.S. Treasury`s 264 million ounces of gold, an overnight transition to gold convertibility would create a major discontinuity for the U.S. financial system. But there is no need for the whole block of current dollar obligations to become an immediate claim.

Convertibility can be instituted gradually by, in effect, creating a dual currency with a limited issue of dollars convertible into gold. Initially they could be deferred claims to gold, for example, five-year Treasury Notes with interest and principal payable in grams or ounces of gold.

With the passage of time and several issues of these notes we would have a series of ``new monies`` in terms of gold and eventually, demand claims on gold. The degree of success of restoring long-term fiscal confidence will show up clearly in the yield spreads between gold and fiat dollar obligations of the same maturities. Full convertibility would require that the yield spread for all maturities virtually disappear. If they do not, convertibility will be very difficult, probably impossible, to implement.

A second advantage of gold notes is that they are likely to reduce current budget deficits. Treasury gold notes in today`s markets could be sold at interest rates at approximately 2% or less. In fact from today`s markets one can construct the equivalent of a 22-month gold note yielding 1%, by arbitraging regular Treasury note yields for June 1983 maturities (17%) and the forward delivery premiums of gold (16% annual rate) inferred from June 1983 futures contracts. Presumably five-year note issues would reflect a similar relationship.


A Risk of Exchange Loss

The exchange risk of the Treasury gold notes, of course, is the same as that associated with our foreign currency Treasury note series. The U.S. Treasury has, over the years, sold significant quantities of both German mark - and Swiss franc denominated issues, and both made and lost money in terms of dollars as exchange rates have fluctuated. And indeed there is a risk of exchange rate loss with gold notes.

However, unless the price of gold doubles over a five-year period (16% compounded annually), interest payments on the gold notes in terms of dollars will be less than conventional financing requires. The run-up to $875 per ounce in early 1980 was surely an aberration, reflecting certain circumstances in the Middle East which are unlikely to be repeated in the near future. Hence, anything close to doubling of gold prices in the next five years appears improbable. On the other hand, if gold prices remain stable or rise moderately, the savings could be large: Each $10 billion in equivalent gold notes outstanding would, under stable gold prices, save $1.5 billion per year in interest outlays.

A possible further side benefit of the existence of gold notes is that they could set a standard in terms of prices and interest rates that could put additional political pressure on the administration and Congress to move expeditiously toward non-inflationary policies. Gold notes could be a case of reversing Gresham`s Law. Good money would drive out bad.

Those who advocate a return to a GOLD STANDARD should be aware that returning our monetary system to gold convertibility is no mere technical, financial restructuring. It is a basic change in our economic processes. However, considering where the policies of the last 50 years have eventually led us, perhaps there are lessons to be learned from our more distant GOLD STANDARD past.


( The above appeared in print on September 1, 1981. Its author, Alan Greenspan, was then a partner in Townsend-Greenspan & Co. - an economic consulting firm. It is relevant and very significant to also know that Greenspan was the Chairman of the Council of Economic Advisors from 1974 to 1977, a period witnessing dramatic changes in the price of gold.)

#61 by SR on November 23, 2002 Re: Zeemax Notional value of derivatives

[Let`s all repeat that number so it sinks in: $128 Trillion]

Yes the growth of derivatives has been as follows:

1994: $50.94 Trillion
1998: $ 83.23 Trillion
1999: $ 90.99 Trillion
2000: $ 97.90 Trillion
2001: $ 121.74 Trillion

As of Semptember 2002 it may well be $128 Trillion. I can believe that. There`s a big jump from 2000 onwards.

As from above, it`s obvious there`s a major trend towards leveraged financial instruments. $ Libor is at 1.48% p.a. so where does one go to get a return ? The most popular instruments in the Arab Capital Market now are inverse/reverse floaters and ridiculous stuff like that. Thus the growth in derivatives. It`s total madness.

Yes I agree. The bubble will burst. I also agree risk cannot be eliminated, only distributed. When the bubble bursts, only the people holding intrinsic value will survive.

Rgds

Re: Zeemax Notional value of derivatives

Good to see your post. My figuers were old when I quoted the $72 Trillion figuer. The situation today, in fact, has gone far worse then even I had imagined. Your figuer is also a bit old. The latest figuer that I`ve seen (as of September 2002) is a wapping $128 Trillion.

Let`s all repeat that number so it sinks in: $128 Trillion

Derivatives trading outside exchanges grew 15 percent to a record $128 trillion in the first half of the year, driven by contracts pegged to interest rates, the Bank for International Settlements said earlier this month. The market is more than four times global gross domestic product as measured by the World Bank.


[Derivatives] have become ``central`` to global growth because they make it easier to take risks, Greenspan recently told the Council on Foreign Relations.

At the same time, derivatives` reliance on leverage creates the ``remote`` possibility of a chain reaction of failure, ``a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked,`` Greenspan said.

Fed feared that could happen following the September 1998 collapse of Long Term Capital Management, in 1998, when the world economic picture was far healthier than it is today. I don`t think the possibility of a disaster is all that ``remote`` as officals claim. A cursory glance at the financial history of just the recent decade shows so many of these ``remotely possible`` events that one begins to wonder if they are really ``remote`` or if their mathametical models are flawed. Let`s see: Asian currency crisis, Russian collapse, LTMC, Mexican peso, Turkish Lira, Argentina, ... knock, knock,... hello? Any body home???

No, they`ve all gone to the casino to spend their worthless paper money to buy even more wothless paper, called ``shares`` of Novellus, eBay, Qualcom, etc, etc, at ``low`` (nod, nod, wink, wink), reeeeally low bargain prices.

...SR

Re: #58 by wm [``... I believe that a decently run small business beats any mutual fund any day of the week. If you want return on investment you gotta work at it and raise it yourself, no one else is going to do it for you and don`t be taken in by the `fake` market and don`t be suckered into coke snorting armani wearing crooks ...``]

There is no question about it on average.

However, if you were to go about two standard diviations off, the picture changes.

I`m glad you`ve particularly singled out `mutual funds` because that is the true average.

Most people do not get rich, only few do. It therefore follows that doing what most people do is a sure way of staying right at or around the mean. Most people (of those who think of themselves as investors) `invest` in mutual funds. Its a no-brainer, and that`s the reason why most people do it.

...SR

#51 by sac on November 15, re tahmed32 #50:

[SR may have been (un)knowingly disingenous about the $72 trillion derivatives figure. ]

Let me make a correction here. The derivatives outstanding at end 2001 were as follows:

Over-the Counter (OTC) Foreign Exchange + Interest Rate + Credit + Commodity + Equity-Linked + Debt-Linked + Exchange-Traded Derivatives : $ 121.74 Trillion.

(Source: Bank of International Settlements, British Bankers Association)

Rgds

RE: SR

My two cents, I don`t have time for the commodities yet, and I have held my simple and naive view that Wall Street is a rigged market for quite some time now, so I don`t sweat the ticker, I believe that a decently run small business beats any mutual fund any day of the week. If you want return on investment you gotta work at it and raise it yourself, no one else is going to do it for you and don`t be taken in by the `fake` market and don`t be suckered into coke snorting armani wearing crooks at the street. Someone recalled a funny story, the ticker would jump points while the sleaze ball ``analyst`` had commented how good a company it was, not revealing the fine print that they were on its payroll and now they talk about laterling...isn`t that a shocker...;-)

Re: #56 by Pardesi [“… there are so many contributing variables, some … manipulated by governments and others not, that it makes it very hard … to determine this probability with any certainty. Therefore, … medicine … would be proportional to one’s own judgement…

Are you going to discuss this in your next article? …”]

Thank you for your input. I completely agree with you. It is only the differences in opinions that make up a market. If we all agreed on everything, no one would buy or sell anything, and I would be without an occupation.

The coming pieces under the Chowk FOMC column should contain several different themes. It should take many months of regular writings before a range of important subjects is touched upon. I hope that time and energy allow me to keep pace with the readers. I feel greatly honored and at once humbled that many readers have paid attention to my ramblings and have opted to give feedback and expressed valuable insights.

Re: #55 by bharatvaasi The whole point of SR`s article and his replies has been that big bad fed led by Alan Greenspan is the bad ole wolf and the govt needs to come to the aid of the money changers

Stop trying to set up a long apologia for these guys by passing the buck onto the fed and greenspan.

Thank you very much for your views of the article and my responses.

I hope that you didn’t read all of what I wrote. Because if you did read what I wrote, then I have miserably failed as a writer and have bot clearly stated my views. In that case, please accept my apology for the lack of clarity in writing prose.

…SR

Rabbani Sahib, scary scenarios that you have laid out can happen. Point however is, what’s the probability of this possibility. Obviously, if someone is totally invested in gold, he/she believes that probability is one. Those who are totally in stocks, knowingly or unknowingly, they are in the camp that believes the probability is zero.
I believe that there are so many contributing variables, some of which can be manipulated by governments and others not, that it makes it very hard for any human being to determine this probability with any certainty. Therefore, the amount of gold, or whatever other medicine that can be bought for this plague, would be proportional to one’s own judgement of that probability.
Are you going to discuss this in your next article?
Regards and thanks for the great article and facilitating the discussion.

The whole point of SR`s article and his replies has been that big bad fed led by Alan Greenspan is the bad ole wolf and the govt needs to come to the aid of the money changers other the people are going to lynch these poor fatherless people.

Now what I cannot understand is that these same moneychangers and grabbers asked the govt to bat an eyelid when the hardworking people were loosing their jobs and industries as a whole were going to the wall. That is tough these moneygrabbers and money changers said. Now it time that the govts left these fatherless people wallow in the sty they created.

Stop trying to set up a long apologia for these guys by passing the buck onto the fed and greenspan.

Re: tahmed32

Ahmed sahib the point you`ve raised about pension benefits deserves a more detailed treatment than is possible here. So if you bear with me, I want to write something about it in one of the coming columns.

As for blaming the guy(s) who came up with the idea of changing the pension systems, its of course the whole corrupt ruling class that has engineered a huge macro scale transfer of wealth from a very large segment of the population to a much smaller one (my dormant Marxist is screaming to come out, even in my `republican` days -- gosh, don`t tell my wife I referred to myself as a republican or we`ll have a divorce).

The two men most responsible for most of the ills are Sir Printsalotspan and former Tres. Sec. Ruben. They engineered this free credit orgy that led to the bubbles that prompted everyone to follow suit.

Re: faiseluno

You`ve raised several good points and since they are along the lines of matters I plan to write about (hopefully soon), I`ll keep this response short. There is one particular I wish to retort to below.

You wrote: [``...measuring fund managers against a benchmark is an effective evaluation tool. would you pay fees to a manager investing in utilities stock if his portfolio rose 15% while the broad utility index was up by 20%? ...``]

I wouldn`t pay any manager even a penny. But seriously, unless you look at absolute returns how can you judge success?

We invest to make money, not lose it. If you start with a hundred and end up with ninety nine, you`ve lost one. I don`t care how many more Tom, Dick or Harry may have lost, but I cannot keep a straight face and say that I was successful. If you beleive that I was successful because I didn`t lose as much as someone else and for that you are willing to pay me, boy, then you are just the kind of a person I`d love to have as my first client. :)

I`m sorry, you can;t sell me this relative success party line. This is only for the ``faithful`` that I`ve referred to in the article.

Maybe my eyes are bad, but I don`t see the invisible fabric. As far as yours truly is concerned, this emperor is butt naked...

...SR

#51 by sac [“…Notionals ae meaningless as far as risk levels are concerned. … most of these contracts are equal and offsetting the risk is actually pretty small. … derivatives curtail risk not enhance it. …”]

Again, this is a typical line of argument given by the trio of academics, market ‘pros’ and government bureaucrats. This trio has led us down a path of rosy dreams. This path leads into heavy fog and somewhere further along it could abruptly end at the edge of an abyss. The world is in the financial trouble that it is today because of all those Ivy League MBAs who studied just a little too much math and got carried away in their application of those equations to economics that should have been reserved only for physics.

In theory what you say about the offsetting risk in derivatives is correct, but unfortunately the real world is not always accurately predicted by models.

The harsh reality of our world is that risk cannot be eliminated, it can only be managed, transferred and distributed. This is a very critical point to understand. I shall repeat: risk cannot be eliminated.

Now, let us look at how, as you say, “derivatives curtail risk?”

Take the case of XYZ Corporation that has an open ended financial risk exposure to certain future possibilities that, if they happen, will be unfavorable to the company’s assets. The number crunchers have quantified a ‘tolerance limit’ beyond which they want to “curtail” their risk. What they will do is to employ a derivative and transfer that excess risk to someone else. But the risk still remains in the system. The bank that accepted that risk from XYZ for a fee, wants the fee but doesn’t really want all the risk. So it finds another party (or several parties) to whom it can further transfer that risk for a smaller fee (hopefully) and thus the chain goes on and on. In the end that big blob of risk, like the hot potato which no one wants to hold, has moved through several hands.

To be a bit specific lets take the safest type of derivative: the long option. Be it a call option or a put option, the buyer of the option has certain rights but no obligations, so, supposedly his risk has been curtailed and all he has lost is the premium he paid. Any market loss he experiences in the underlying asset (against which he purchased the option as an insurance), he should be able to recover by exercising his rights conferred by the option. But there is a potential problem: counter-party risk.

If every body was buying these options from God there would be no problem at all. God’s balance sheet, after all, is Almighty. Not so with mere mortals, be they JP Morgan or even Sir Allen Prints-a-lot-span.

The option seller, who assumed the market risk of the underlying asset in exchange for the premium he charged the buyer, has to be able to deliver. In the event of a loss he shall have to perform his obligations under the contract and make the buyer whole by assuming his losses. This seller, in turn, may have done the same with someone else like the insurance companies do all the time. The guarantees behind most of these contracts are backed by nothing more than the strength of the issuer’s balance sheet. In other words, a song and a dance, backed by very little else.

Under normal circumstances this all works well, but what would happen in a major crisis? If just one of the links in the chain of the multiple counter-parties breaks down, there could be a domino effect and the whole house of cards could come crashing down. The original hot potato could burn the hands of all those who passed it around.

Laugh all you may at these “doom and gloom predictions,” but they are real possibilities. These possibilities are the ‘Black Swans’ mentioned by Nasim Taleb in his excellent book Fooled by Randomness (recommended reading).

The college professors will smile, the bureaucrats will shake their heads and the market ‘pros’ will wave their hands impatiently and tell you that such pessimistic rubbish has no place in modern finance. They will say that in this new and improved age of reformed church of world finance such things cannot happen.

Yet George Soros, no stranger to derivatives himself, makes a pretty good case of the vast systemic risks in his Crisis of World Capitalism.

Warren Buffet says that this is a “ticking time bomb”.

And the eternally optimistic Sir John Templeton, whom I had the pleasure of listening to earlier this month, told the audience that he was “deeply worried” about the “great systemic risks” that we face today.

Now I don’t know about anyone else, but I vote with Soros, Buffet and Tempelton and against Uncle Greenie and his toddies. They claim they didn’t know that there was an equities bubble, and that even if they had known they couldn’t have done anything about it. They’ve also been telling us for now almost three years that the boom is coming “next quarter” or “next year” blah, blah, blah….


[“…Long term Capital fiasco is the closest the global financial system came to … a cascading chain of disastrous scenarios. Since that time financial institutions have strengthened their risk controls and legislation in the form of the infamous FAS 133 has worked wonders in reining in the machinations of the treasury departments…”]

You must be pulling my leg… An edict issued by a bureaucracy “worked wonders”…???

All Financial Accounting Statement 133, issued by the Financial Accounting Standards Board (FASB) accomplished was to add an extra layer of bureaucracy and increased paper work by mandating new filings and reporting procedures.

FAS 133 was issued sometime in 1998 or 1999 and went into effect in 2000, to my great amusement, on the same day that Magna Carta was signed by King John, 785 years earlier.

Ira Kawaller, who used to be a member of FASB’s Derivatives Implementation Group headed a detail study to measure the impact of FAS 133 implementation on risk management practices. I read that report and though the details escape me now, I recall that, in conclusion, FAS 133 was deemed ineffectual at best, and maybe even harmful at worst. Anyone who is interested can go to the AFP archives (Association of Financial Professionals) and find the report themselves.

Gawd...I really hope we are making some folks think by these discussions, because it is exhausting. Its making my head hurt too much, and here I thought we were just going to have some fun. :)

...SR

re sac post 51

want to avoid getting into a `take it or leave situation`. paki passport limits the choices i have in terms of career options. at this point in time, i really dont want to go back and work for nbp. but perhaps, you are a better person than than i am.

re tahmed32 #50:

SR may have been (un)knowingly disingenous about the $72 trillion derivatives figure. Notionals ae meaningless as far as risk levels are concerned. Its just like saying Pakistani missiles have a range of 2500 kms versus India`s 1800. What is of more importance is the payload they can carry and accuracy in hitting the target. Considering that most of these contracts are equal and offsettting the risk is actually pretty small. Contrary to popular opinion, derivatives curtail risk not enhance it. The Long term Capital fiasco is the closest the global financial system came to in terms of a cascading chain of disastrous scenarios. Since that time financial institutions have strengthened their risk controls and legislation in the form of the infamous FAS 133 has worked wonders in reining in the machinations of the treasury departments.

re faisaluno #47:

I have no idea what your point is. I must be dense.....or maybe I can attribute that to my Pakistani passport too.

later
-sac

DrDr #44 I stand corrected. I checked and you are right - Japan`s unemployment rate in September was under 6 percent. And the US unemployment rate isnt much lower than that nowadays. So I assume that the problem with Japan is not the level of unemployment but the extended time period (over a decade) that it has been there. And that is why Japan has an economic malaise while the US has a mild recession (since the latter has been around for just over an year).