Where did all that debt come from?, Part 3

In the first article in this three-part series, we examined the concept of leverage and how consumers' use of credit expanded.  In the second article, we looked at how banks extended credit to consumers, how this market grew, and its effects on banks and economies worldwide.  Tonight, in the final article in this series, I'd like to look at money supply and how its growth has enabled the 'credit boom';  then I'd like to look at the derivatives market, which is perhaps the ultimate extension of the credit boom - and is so unstable that it may destroy economies all around the world.

Once again, I'd like to emphasize that in three short, relatively simple blog articles, I can't possibly discuss or account for all the factors and variables involved.  Inevitably, this series will appear over-simplified to an expert in the field.  That's OK.  I'm not writing this for experts in the field, but for ordinary folks, to convey the essentials of the issues involved as simply as possible.

First, money supply.  Wikipedia defines it thus:

In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits (depositors' easily accessed assets on the books of financial institutions).

Where does this money come from?  In times past, individual banks might issue their own banknotes, backed up by their deposits and holdings of hard assets such as gold.  Over time, this function was taken over by government, usually delegated to a finance ministry or a central bank, which would oversee the national currency and produce and issue banknotes and coins as required.  However, the quantity of currency that could be issued depended on the value of the asset(s) supporting it.  It might not be issued on a one-to-one value basis, but a government would normally allow its currency to be exchanged for gold, and would maintain sufficient gold reserves to allow this in normal use.  (Those reserves might be worth only, say, 10% of the banknotes in circulation:  but governments could get away with this, because they relied on the fact that relatively few people would want to exchange their banknotes for gold at any one time.)  This became known as the 'gold standard'.  The United States followed it to a greater or lesser extent until 1970.

During national emergencies, when more money was needed than could be supported by reserve assets, governments might issue banknotes 'guaranteed' by other types of 'assets', such as future tax revenues (e.g. the so-called 'Continental currency' issued by the fledgling United States in the earliest years of its existence).  They were usually issued 'at par' with (i.e. at an officially equivalent value to) hard-asset-backed currency;  however, they were usually regarded with suspicion by the markets, and typically traded at a discount to hard-asset-backed currency.  This was evident, for example, during the US Civil War, when 'United States Notes' (popularly known as 'greenbacks') were authorized.  One commentator points out:

The value of the greenback bounced around continuously as the public digested and interpreted news and events that might impact the probability that they would be able to redeem greenbacks for gold (eventually). Of great importance during this time, as one might imagine, was the success or failure of the Northern armies during the Civil War.

For example, the Battle of Chickamauga in the fall of 1863 produced a Confederate victory when the Army of Tennessee drove the Army of Cumberland from the field. News of the battle caused the greenbacks to drop 4 percent. Since the greenbacks were issued by the North to pay for the war, Confederate progress was inimical to redeemable greenbacks.

However, as the Northern Armies achieved victories at Gettysburg, Vicksburg and Port Hudson, the greenback grew progressively stronger. A stunning reversal occurred in the summer of 1864, when the greenback would fall dramatically to only 35 cents ...

The passage of the Resumption Act in 1875 mandated that greenbacks would be redeemable in specie beginning in January of 1879. As the date neared, the discount grew smaller and completely disappeared in late 1878 as gold payments resumed, as scheduled, in 1879.

As the population grew and economic activity expanded, more currency was needed to circulate among banks, businesses and consumers;  but, as noted above, unless their reserves of hard assets increased, governments could not allow the production of more coins or paper money whose value was denominated in terms of those assets.  To get around this problem, governments sometimes authorized banks that met (nominally) stringent standards in terms of their reserves and assets to issue their own banknotes;  but this depended on the honesty of banks in reporting the true value of their reserves and assets, and on the honesty of officials designated to investigate and certify those values.  Needless to say, such honesty was sometimes conspicuous by its absence.

Furthermore, the relatively inelastic supply of money led to problems in its circulation.  At harvest time, for example, large sums of money were needed to buy crops from farmers;  but after sending their banknotes and coins to farming regions, banks in cities might find themselves short of cash to issue to consumers, who were thus less able to buy the goods they needed, thereby affecting local businesses.  Clearly, something had to be done to make sure that enough money was available to meet the demands of the market in all areas.  This was achieved by the establishment of central banks (such as the Federal Reserve in the USA), whose job was to regulate the money supply.  A central bank might accept part of the reserves of a commercial bank, as well as commercial notes (e.g. so-called 'bankers acceptances'), as security.  It would issue currency against this security, rather than against hard assets.  In that way, temporary shortages could be alleviated and sufficient money kept in circulation to satisfy the needs of the economy.  However, it represented a further movement away from asset-backed currencies.

Despite these measures, the demand for money in circulation continued to increase much faster than the assets backing it could be built up.  Indeed, so much value was sequestrated from the market (by being 'locked up', literally and figuratively, in national hard-asset reserves) that it began to disrupt the world's economic system.  (Don't forget that a monetized asset has value primarily when it's in circulation - i.e. able to be used to buy something.  If it's locked away in a bank vault, it's not being used, and therefore not contributing to day-to-day commerce and industry.)  This is what led to the slow but inexorable movement away from the gold standard, culminating (in the USA) in the 'Nixon Shock' of 1971.  Since then, the US dollar has not been linked to any asset at all.  It became a 'fiat currency', as have the currencies of almost every other nation.

Fiat currencies can be issued at the discretion of the central bank.  There are no assets underlying them, so they can be - and are - printed almost at will (or created as numbers on a computer screen).  For example, look at this graph of the US money supply from 1970 to date, including money in circulation (the M3 measurement of money supply) and credit extended to business and consumers (which is effectively the same as money, in that it can be spent - we examined this in the first two articles in this series).

The USA wasn't alone in drastically expanding its money supply during this period.  Every major economy did likewise.  Of course, since this was all fiat currency, with no underlying value whatsoever, inflation became a major problem;  but in a short blog article like this, I don't have space to go into that subject.  If you'd like to read more about it, here are a few interesting perspectives (an Internet search on the topic will provide many more, most disagreeing with each other!).

Inflation
Is Inflation Harmless or Even Good?
Sound Money and Deflation

OK, we've discussed money supply.  Let's look now at the derivatives market, which is perhaps the single most dangerous element of the present financial crisis.

A derivative can be very simply defined as a bet.  Wikipedia defines it thus:

A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties.

. . .

Hedging:  Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk.

Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.

There's more at the link.

The important thing to remember about a derivative is that the contract isn't only for the asset itself;  it's predicated on the behavior of some aspect of that asset in the future.  In the contract between the farmer and the miller referenced above, if the future price of wheat doesn't reach the agreed level on the open market, the farmer is still guaranteed the fixed price for which he contracted.  If it exceeds that level on the open market, the miller is still guaranteed the wheat at a lower-than-market price.  Both sides have 'hedged their bets', so to speak.

Trouble is, neither side has to pay the full cost of the bet 'up front'.  A derivative contract typically attracts a payment of anywhere from 1% to 10% of the total contract value at the time of fulfilment.  If one or the other party can't meet their obligation to pay the balance, or supply the goods, at the time of fulfilment, they can (and frequently do) default on their contractual obligations.  To offset this risk, derivative insurance is offered by many firms, and many traders will refuse to enter into derivative contracts without such insurance being attached.  However, such insurance can be for astronomical sums of money - far too much for any insurer to actually pay on demand.  This is one reason why AIG went bankrupt and had to be bailed out at vast expense by the US government in 2008 - it had issued credit default swaps (i.e. insurance) on credit derivatives worth tens of billions of dollars, that it could not afford to pay.

Furthermore, because so little money is required 'up front' to trade in derivatives, traders can amass huge positions in them that are realistically far too large to ever be paid.  Instead, the trader will buy and sell them, making sure that his portfolio is never in danger of falling due for payment.  (If it does, or if the market moves strongly in a direction that puts a major derivatives portfolio at risk, it can mean catastrophe - witness the Barings bankruptcy of 1995.)  As a result, trillions of dollars in derivatives are changing hands in an endless chain of transactions, with myriad middlemen taking their cut of each transaction, but never dealing in 'real' money or assets.  It's a financial fantasyland.  As the Milken Institute Review points out:

When derivative contracts lead to large financial losses, they can make headlines. In recent years, derivatives have been associated with a few truly notable events, including the collapses of Barings Bank (the Queen of England’s primary bank) and Long-Term Capital Management (a hedge fund whose partners included an economist with a Nobel Prize awarded for breakthrough research in pricing derivatives). Derivatives even had a role in the fall of Enron. Indeed, just two years ago, Warren Buffett concluded that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

But there are two sides to this coin. Although some serious dangers are associated with derivatives, handled with care they have proved to be immensely valuable to modern economies, and will surely remain so.

There's more at the link.

How big is the derivatives market?  Mind-bogglingly big.  According to AOL Daily Finance:

A quadrillion is a big number: 1,000 times a trillion. Yet according to one of the world's leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon's), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world's annual gross domestic product is between $50 trillion and $60 trillion.

None of us can wrap our minds about a figure so huge.  It's at least twenty times larger than the annual gross domestic product of the entire world . . . and it's all being traded right now.  It's not real money - no-one's ever printed that number of banknotes or minted that quantity of coinage - it's just numbers on a computer screen.  Yet, if those derivative contracts are ever forced to maturity and payment is demanded, they'll wipe out the value of the world's economies overnight.

How could this situation have arisen?  It did so because the derivative market, from the beginning, was largely unregulated - and kept that way by those running it.  They bribed 'persuaded' politicians to let them get away with it, as we discussed here last year.  In 2009, Robert Borosage wrote:

The reforms call for standardizing derivatives, trading them on a public exchange, with transparency, so prices can be compared and holdings regulated. Common sense, one would think.

But the five largest American banks -- in rough order of declining solvency: Goldman Sachs, Morgan Stanley, JP Morgan Chase, Bank of America and Citigroup -- hold fully 95% of derivatives -- with a notional value of over $290 trillion. In the first six months of the year, they made about $15 billion trading in these things. Not surprisingly, they have leveled their guns at the very notion of a public exchange. They enlisted companies that use derivatives to hedge against foreign exchange risks and the like, arguing that the reforms would raise costs all around. They have largely succeeded in the congressional cloakrooms.

. . .

How do the banks fend off needed reform? Follow the money. A recent report by Paul Blumenthal of the Sunlight Foundation shows that the 27 members of the House Financial Services Committee have received over one-fourth of their contributions from the FIRE (Finance, insurance and real estate sector). Ranking Republican Spencer Baucus from Alabama opposes the CFPA, arguing that we don't need "more regulation," we just need "smart regulation." He received a staggering 71% of his contributions from the finance sector over the first six months of this year (and 45% of his total contributions over his career). Democrat Melissa Bean who leads the effort to gut state regulatory authority over the banks has received fully 42% of her contributions for the first six months from the banking sector. Not surprisingly, the champions of reform like Rep. Alan Grayson, Maxine Waters, Keith Ellison, Adam Putman, and Carolyn McCarthy all pull in the lowest percentage from the sector.

Historically, the banks, as Senator Dick Durbin decried in disgust, "own the place." And they've succeeded thus far in frustrating reform, even while pocketing literally hundreds of billions in support from taxpayers.

Again, more at the link.

I don't have space or time to go into more detail now.  I hope what I've given you is sufficient information for you to investigate further on your own, if you're interested;  and I hope it's shown you why we're drowning in debt, as individuals, as a nation, and as a world.

I don't believe there's any easy answer to this mess.  It took us decades to get into it, and it'll probably take us decades to get out of it.  They're going to be lean, hard decades, and many of us who relied on State subsidies and/or pensions for our old age are going to find them far less than we anticipated.  Some may not be there at all.

Peter