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The Predicted Financial
Storm Has Arrived
By Gabriel Kolko
09/02/07 "ZMag" -- -- Contradictions now wrack the world's
financial system, and a growing consensus exists between
those who endorse it and those who argue the status quo is
both crisis-prone as well as immoral. If we are to believe
the institutions and personalities who have been in the
forefront of the defense of capitalism, we are on the verge
of a serious crisis-if not now, then in the near future.
The International Monetary Fund (IMF), the Bank for
International Settlements, the British Financial Services
Authority, the Financial Times, and innumerable mainstream
commentators were increasingly worried and publicly warned
against many of the financial innovations that have now
imploded. Warren Buffett, whom Forbes ranks the second
richest man in the world, last year called credit
derivatives-only one of the many new banking
inventions-"financial weapons of mass destruction." Very
conservative institutions and people predicted the upheaval
in global finances we are today experiencing.
The IMF has taken the lead in criticizing the new
international financial structure, and over the past three
years it has published numerous detailed reasons why it has
become so dangerous to the world's economic stability.
Events have confirmed its prognostication that complexity
and lack of transparency, the obscurity of risks and
universal uncertainty, especially regarding collateralized
debt and loan obligations, will cause a flight to security
that will dry up much of the liquidity of banking.
"…Financial innovation itself," as a Financial Times
columnist put it, "is the problem". The ultra-creative
system is seizing up because no one understands where risks
are located or how it works. It began to do so this summer
and fixing it is not very likely.
It is impossible to measure the extent of the losses. The
final results of this deluge have yet to be calculated. Even
many of the players who have stakes in the countless arcane
investment instruments are utterly ignorant. The sums are
enormous.
Only a few of the many measures give us a rough estimate:
The present crisis began-it has scarcely ended there--with
subprime mortgage loans in the U.S., which were valued at
over $1.3 trillion at the beginning of 2007 but are, for
practical purposes, worth far, far less today. We can ignore
the impact of this crisis on U.S. housing prices, but some
projections are of a 10 percent decline-another trillion or
so. Indirectly, of course, the mortgage crisis has also
brought many millions of people into the larger financial
world and they will get badly hurt.
What the subprime market did was unleash a far greater
maelstrom involving banks in Germany, France, Asia, and
throughout the world, calling into question much of the
world financial system as it has developed over the past
decade.
Investment banks hold about $300 billion in private equity
debts they planned to place-mainly in leveraged buy-outs.
They will be forced to sell them at discounts or keep them
on their balance sheets-either way they will lose.
The near-failure of the German Sachsen LB bank, which had to
be saved from bankruptcy with 17.3 billion euros in credit,
revealed that European banks hold over half-trillion dollars
in so-called asset backed commercial paper, much of it in
the U. S. and subprime mortgages. A failure in America
caused Europe too to face a crisis. The problem is scarcely
isolated.
The leading victim of this upheaval are the hedge funds.
What are hedge funds? There are about 10,000 and, all told,
they do everything. Some hedge funds, however, provided
companies with capital and successfully competed with
commercial banks because they took much greater risks. A
substantial proportion is simple gamblers; some even bet on
the weather--hunches. Many look to their computers and
mathematics for models to guide their investments, and these
have lost the most money, but funds based on other
strategies also lost during August. The spectacular
Long-term Capital Management 1998 failure was also due to
its reliance on ingenious mathematical propositions, yet no
one learned any lessons from it, proving that appeals to
reason as well as experience fall on deaf ears if there is
money to be made.
Some gained during the August crisis but more lost, and in
the aggregate the hedge funds lost a great deal-their allure
of rapid riches gone. There have been some spectacular
bankruptcies and bailouts, including some of the biggest
investment firms. Investors who got cold feet found that
withdrawing money from hedge funds was nigh on impossible.
The real worth of their holdings is hotly contested, and
valuations vary wildly. In reality, there is no way to
appraise them realistically-they all depend largely on what
people want to believe and will take, or the market.
We are at an end of an era, living through the worst
financial panic in many decades. Now begins global financial
instability. It is impossible to speculate how long today's
turmoil will last-but there now exists an uncertainty and
lack of confidence that has been unparalleled since the
1930s-and this ignorance and fear is itself a crucial
factor. The moment of reckoning for bankers and bosses has
arrived. What is very clear is that losses are massive and
the entire developed world is now experiencing the worst
economic crisis since 1945, one in which troubles in one
nation compound those in others.
All central banks are wracked by dilemmas. They have neither
the resources nor the knowledge, including legal powers, to
remedy the present maelstrom. Although there is clamor from
financiers and assorted operators to bail them out, the
Federal Reserve must also weigh the consequences of its
moves, above all for inflation. Then there is the question
of "moral hazards." Is the Federal Reserve's responsibility
to save financial adventurers from their own follies?
Throughout August the American and European central banks
plunged about a half-trillion dollars into the banking
system in an attempt to unfreeze blocked credit and loans
that followed the subprime crisis-an event which triggered a
"flight to safety" which greatly reduced banks' willingness
to loan. In effect, the Federal Reserve relied on banks to
restore confidence in the financial system, subsidizing
their efforts.
Central banks' efforts succeeded only very partially but, in
the aggregate, they failed: banks and investors now seek
security rather than risk, and they will sit on their money.
The Federal Reserve privately acknowledges its inability to
cope with an inordinately complex financial structure.
European central bankers are in exactly the same dilemma:
they simply don't know what to do.
But this scarcely touches the real problem, which is
structural and impinges wholly on the way the world
financial structure has evolved over the past two decades.
As in the past, there is a critical split in the banking and
finance world and each has political leverage along with
clashing interests. More important, central banks were not
designed to cope with today's realities and have neither the
legal powers nor knowledge to control them.
In this context, central banks will have increasing problems
and the solutions they propose, as in the past, will be
utterly inadequate, not because their intentions are wrong
but because it is impossible to regulate such a vast,
complex economy-even less today than in the past because
there is no international mechanism to do so.
Internationalization of finance has meant less regulation
than ever, and regulation was scarcely very effective even
at the national level.
Not only leftists are naïve but so too are those
conservatives who think they can speak truth to power and
change the course of events. Greed's only bounds are what
makes money. Existing international institutions-of which
the IMF is the most important--or well-intentioned advice
will not change this reality.
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