Century of Enslavement: The History of The Federal Reserve
Money As Debt - Full Length Documentary
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The Financialization of Big Business - Costas Lapavitsas on Reality Asserts Itself (4/8)
xxxxxxxxxxxxxxxxxxxxxxxxxxMr. Lapavitsas says that capitalists have learned how to make huge profits without producing anything useful -
Bio
Costas Lapavitsas is a professor in economics at the University of London School of Oriental and African Studies. He teaches the political economy of finance, and he's a regular columnist for The Guardian.
Transcript
The Financialization of Big Business - Costas Lapavitsas on Reality Asserts Itself (4/8)PAUL JAY, SENIOR EDITOR, TRNN: Welcome back to The Real News Network. I'm Paul Jay in Baltimore. And this is Reality Asserts Itself with our guest Costas Lapavitsas, who now joins us in the studio.
Thanks for joining us again.
COSTAS LAPAVITSAS, ECONOMICS PROFESSOR, UNIV. OF LONDON: Pleasure.
JAY: So, just quickly one more time, Costas is a professor of economics at the School of Oriental and African Studies, University of London. And his most recent book that just hit the shelves is Profiting without Producing: How Finance Exploits Us All.
This graph shows the percentage of GDP, American GDP, and the percentage which is finance. And you can see in the graph that it goes--from the time of industrialization it goes up, up, up, and then just before the crash of '29-30 it's at this enormous peak. In the Depression it comes down some, and then in World War II it comes down significantly, it's about the '70s and about 1980 that that percentage of finance of overall GDP reaches the same level as it was in 1929-30, just before the crash, except instead of it going down or being mitigated, it actually takes off like a rocket ship.
LAPAVITSAS: And that's when I would say the second bout of the rise of finance takes place, the financialization of capitalism really happens in full earnest, because what happens from the '70s onwards, I would argue, for about four decades, is that big business itself is now transformed. It becomes financialized. Big business begins to find--has the capacity to finance its investment increasingly from retained profits. It has a lot of liquidity and cash. It begins to play financial games itself for financial profit, acquires financial capacity, and begins to draw financial profits.
JAY: General Motors has its own way to lend money to buy cars and so on.
LAPAVITSAS: Yeah.
JAY: Everybody's got their own credit card these days.
LAPAVITSAS: Yeah, that kind of thing. So we have a process of financialization of, certainly, U.S. big business, but also other countries' big business. And that transforms the way in which large enterprises operate. It changes the hierarchy, the way in which command works within big business. It changes their outlook. It changes their investment practices. It changes the horizons that they use for organizing their production. It changes everything. Big U.S. business has become financialized in a very profound way because it looks at the stock market all the time and it looks to financial transactions and--.
JAY: Its own bond issues and so on.
LAPAVITSAS: And all that.
JAY: Yeah. But even though big business is perhaps less reliant on the old-style just go to the banks and get a loan (although certainly that still happens, but the biggest monopolies are less reliant), that sure doesn't mean that the financial sector's getting any smaller.
LAPAVITSAS: Far from it.
JAY: In fact, as you said, like you point out in your book--you'll have to remind me of the year, but it wasn't very long ago. Was it '09 or '10 the number comes from? Forty percent of all profits are actually in the finance sector.
LAPAVITSAS: Oh-three, actually, 2003.
JAY: Two thousand and three.
LAPAVITSAS: What--I mean, as this happens in the real sector (let's call it that), as this happens in the real economy, finance then enters a period of extraordinary growth, extraordinary growth.
JAY: Well, let's just quickly say, when we say finance, what are we talking about? Which institutions are we talking about?
LAPAVITSAS: What's the world of finance? The world of finance is in a sense hard to pin down, because it's like--it's a world that changes all the time.
JAY: I mean, most people think of Wall Street.
LAPAVITSAS: Yeah, but Wall Street is just one aspect of it. Obviously we're talking about big banks. We're also talking about big investment banks, not necessarily--.
JAY: Goldman Sachs.
LAPAVITSAS: Yeah, these kind of banks. We're also talking about institutions that, you know, to some extent they can do commodity trading. [crosstalk]
JAY: Yeah, I mean, the Koch brothers, which are one of the richest corporate entities in the world, mostly in oil, but they're also one of the biggest finance companies,--
LAPAVITSAS: That's right.
JAY: --they're very involved in lending money and all kinds of derivative plays and such.
LAPAVITSAS: That's right.
And then there's a whole--I mean, if you look at banks, there's the whole--there's a raft of other types of banks going down, all the way down to, you know, what used to be called thrifts and so on in this country. And these are all parts of the world of finance. Finance is a huge structure, and we put it all in there when we discuss about the growth of finance. So there's obviously high finance, the big barons and the great buccaneers of the global market, the ones that we like to see in the newspapers and we read about their speculations.
JAY: The Jamie Dimons [incompr.]
LAPAVITSAS: And so on. But it goes all the way down to smaller financial institutions in local areas.
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LAPAVITSAS: It goes down to smaller financial institutions in local areas and neighborhoods, you know, which wouldn't be able to compete with the Goldman Sachs of this world, but they belong to the world of finance.
So finance itself begins to change. And we can talk about financialization and transformation of banks. It rises very powerfully, becomes, again, an incredibly powerful part of the capitalist economy, the mature capitalist economy. And it does so by relating to the economy in a different way to before, because big business has financialized itself. Banks do other things. Banks now begin to play games and to draw profits out of financial transaction, out of trading financial instruments, out of intervening in big markets. Fees, commissions, and profit made on [an account] from trading becomes a very, very important part of what banks do, banks remaining the biggest part of the financial system. So the banking firm is changed. The banking firm is not a static thing. Banks today are very different to banks 150 years ago, and the change is partly in the way in which I've indicated.
JAY: I mean, one of the changes is the development of the whole derivatives markets,--
LAPAVITSAS: Absolutely.
JAY: --where they--. So explain that, because my understanding is the global derivative market is something like six times the global GDP or some crazy number like this.
LAPAVITSAS: Those markets, derivatives markets in particular, are very much a product of the financialization period. But we've got to be careful when we look at them. Why do we have them? Because financial markets explode during this period, not just derivatives markets or financial markets. Why the derivatives markets? Because basically that period of financialization is a period of unstable interest rates and unstable exchange rates. The derivatives markets pivot on these two key prices. You can have a derivative on anything, but interest rates and exchange rates are key areas for derivatives. So these 40 years have been years of highly unstable interest rates, highly unstable exchange rates, and therefore growth of derivatives.
Derivatives, then, are basically bets; essentially they're bets through which you can take positions on these highly changeable magnitudes, interest rates.
JAY: Yeah, you can bet a certain certain currency will go up, someone else is going to bid it's going to go down. There's going to be a winner and a loser.
LAPAVITSAS: That's it, and what's going to happen on interest rates and so on, and there's going to be a winner and a loser.
JAY: I mean, it gets crazy. There's a derivatives exchange in Chicago just, I think, about a year ago had an application: there's a group wanted to do bets on whether movies would make money or not--not investments in the movie; they just want to gamble. And, of course, the movie industry was outraged, because some of the people betting controlled media. So now you could have people give bad reviews to a movie, and they're betting your movie's going to lose money. But they accepted it. There is now a derivatives play on whether a movie's going to make money or not. I mean, this is craziness. This is where it gets--.
LAPAVITSAS: But think about it. You see, a derivative is a bet. So, therefore, you can have a derivative on anything. There are derivatives on the weather, there are derivatives on whatever you care to think.
JAY: But isn't part of this--I guess there's two parts to this. One is there is a need, you could say, within a capitalist economy to mitigate risk. So you could say, if you want to have affordable mortgages, and not subprime but affordable, it's easier for banks to give more affordable mortgages if it can spread the risk out amongst seven other banks and package them and share the risk.
But there's another part of it, which is these things which are just pure bets. It's 'cause there's not enough good productive places to put your money. So you gamble with it.
LAPAVITSAS: Let's think about that a little bit more, because obviously there's an element of that in it. The first thing you've got to say is that these instruments which are characteristic of financialization grow because of the instability of these key variables. Now, if you really want to do something about the risk that comes from that, you try and create some stability in the variables rather than play with derivatives. If you really want to do something about it, you do something about more stable interest rates.
JAY: But then you have to change capitalism.
LAPAVITSAS: I know. But if we're going to argue about stability and so on, let's start from where the instability comes from. But let's suppose you don't have that. Let's suppose you got unstable interest rates.
JAY: Okay. Now, let's just make this really clear, what you're saying, 'cause I think it's very important. Part of the growth of this mitigation of risk is 'cause the system itself is so fragile, so volatile, that you have to do these risk-mitigation plays 'cause nobody actually believes that the economy can do--banks don't even believe each other's books anymore.
LAPAVITSAS: That's correct. And why didn't you have derivatives in the '50s and the '60s on the same scale? Because during that time of controlling finance and different type of capitalism, as we discussed it, exchange rates were fixed, or certainly they were more stable, and interest rates were under control. And therefore the scope of derivatives was much, much less. When you decontrol the system and you go into financialization, you create automatically the need and the scope for that.
JAY: And here's where you get this relationship between sort of the spontaneous processes and policy. There's kind of inherently spontaneously unstable processes in capitalism. But when you change the policies to deregulate, it makes it way more volatile. But that's in the interests of the financial institutions, 'cause they make a killing out of volatility.
LAPAVITSAS: That's it. That's it. Then they move into that and they begin to make a profit out of the volatility.
Now, let's push that a little bit further on the derivatives front now. So you get derivatives that do that kind of thing, and some people come out and say, that's a good thing, because derivatives are basically a hedge--they allow you to handle risk. And you read the textbooks and you get all these essentially fairy stories about farmers that might protect their crops because of the weather and they'll buy derivatives, forwards, futures, and so on, and they're very happy because they've locked in the value of their stock, and it's a very nice story. And then you look at these figures that you just outlined and mentioned, because the figure is actually a bit misleading, because these sums are vast, because it's the size of the bet rather than the money you actually pay. You look at these figures more closely and you look at what proportion of those vast volumes actually involve producers, it's less than 10 percent. The rest is basically finance. In other words, these--has finance somewhere. In other words, these derivatives markets are actually markets that the financial system has created, and it plays itself in there.
Now, who runs the derivatives markets and how? Each derivative that you get, each so-called over-the-counter derivative (in other words, a derivative between two specific parties, but even some of the exchange rate derivatives), if you look at who trades mostly them--these are derivatives traded in open markets, but certainly for over-the-counter derivatives, each one of those must have a bank there. So there is a bank in each transaction. Who is behind the bulk of this stuff, then? About 65, 70 dealer banks across the world. How many of these banks are the biggest and therefore pretty much control it? Fifteen to 20. The derivatives markets is essentially 15 to 20 banks. That's basically what it is.
JAY: And I'm not far off from my six times global GDP on the size [crosstalk]
LAPAVITSAS: In terms of the size of the bet.
JAY: The size, the whole size of the global derivatives market.
LAPAVITSAS: Yeah, it's misleading, because it's the size of the bet rather than the money that actually changes hands.
JAY: Right. That's right.
LAPAVITSAS: You've got to bear that in mind. But nonetheless, it's a huge market. Right?
But who is behind it? Fifteen to 20 dealer banks control the bulk of this over-the-counter derivatives market.
JAY: Okay. In the next segment of the interview, we're going to talk a little bit about, well, what's wrong with that? Because, I mean, frankly, if you didn't have some of this, you wouldn't be able to buy a house. You do need mortgages.
So, in the next segment of the interview, I'm going to ask, well, okay, so finance is big, a few banks control it. Well, so what's wrong with that? Please join us for the next segment of our interview on Reality Asserts Itself on The Real News Network.
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Big Risk: $1.2 Quadrillion Derivatives Market Dwarfs World GDP
One of the biggest risks to the world's financial health is the $1.2 quadrillion derivatives market. It's complex, it's unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost -- and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so.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.
To understand the concept of "notional value," it's useful to have an example. Let's say you borrow $1 million to buy an apartment and the interest rate on that loan gets reset every six months. Meanwhile, you turn around and rent that apartment out at a monthly fixed rate. If all your expenses including interest are less than the rent, you make money. But if the interest and expenses get bigger than the rent, you lose.
You might be able to hedge this risk of a spike in interest rates by swapping that variable rate of interest for a fixed one. To do that you'd need to find a counterparty who has an asset with a fixed rate of return who believed that interest rates were going to fall and was willing to swap his fixed rate for your variable one.
The actual cash amount of the interest rates swaps might be 1% of the $1 million debt, while that $1 million is the "notional" amount. Applying that same 1% to the $1.2 quadrillion derivatives market would leave a cash amount of the derivatives market of $12 trillion -- far smaller, but still 20% of the world economy.
Getting a Handle on Derivatives Risk
How big is the risk to the world economy from these derivatives? According to Wilmott, it's impossible to know unless you understand the details of the derivatives contracts. But since they're unregulated and likely to remain so, it is hard to gauge the risk.
But Wilmott gives an example of an over-the-counter "customized" derivative that could be very risky indeed, and could also put its practitioners in a position of what he called "moral hazard." Suppose Bank 1 (B1) and Bank 2 (B2) decide to hedge against the risk that Bank 3 (B3) and Bank 4 (B4) might fail to repay their debt to B1 and B2. To guard against that, B1 and B2 might hedge the risk through derivatives.
In so doing, B1 and B2 might buy a credit default swap (CDS) on B3 and B4 debt. The CDS would pay B1 and B2 if B3 and B4 failed to repay their loan. B1 and B2 might also bet on the decline in shares of B3 and B4 through a short sale.
At that point, any action that B1 and B2 might take to boost the odds that B3 and B4 might default would increase the value of their derivatives. That possibility might tempt B1 and B2 to take actions that would boost the odds of failure for B3 and B4. As I wrote back in September 2008 on DailyFinance's sister site, BloggingStocks, this kind of behavior -- in which hedge funds pulled their money out of banks whose stock they were shorting -- may have contributed to the failures of Bear Stearns and Lehman Brothers.
It's also the sort of conduct that makes it extremely difficult to estimate the risk of the derivatives market.
How Positive Feedback Loops Crash Markets
Another kind of market conduct that makes markets volatile is what Wilmott calls positive and negative feedback loops. These relatively bland-sounding terms mask some really scary behavior for investors who are not clued into it. Wilmott argues that a positive feedback loop contributed to the 22.6% crash in the Dow back in October 1987.
In the 1980s, a firm run by some former academics came up with the idea of portfolio insurance.
Their idea was that if investors are worried about their assets losing value, they can buy puts -- the option to sell their investments at pre-determined prices. They can sell everything -- which would be embarrassing if the market then started to rise -- or they could sell a fixed proportion of their portfolio depending on the percentage decline in a particular stock market index.
This latter idea is portfolio insurance. If the Dow, for example, fell 3%; it might suggest that investors should sell 20% of their portfolio. And if the Dow fell 20%, it would indicate that investors should sell 100% of their portfolio.
That positive feedback loop -- in which a stock price decline leads to more selling -- boosts market volatility. Portfolio insurance causes more investors to sell as the market declines by, say 3%, which causes an even deeper plunge in the value of investors' holdings. And that deeper decline leads to more selling. Before you know it, many investors are selling everything.
The portfolio insurance firm started off with $5 billion, but as its reputation spread, it ended up managing $50 billion. In 1987, that was a lot of money. So when that positive feedback loop got going, it took the Dow down 22.6% in a day.
The big problem back then was the absence of a sufficient number of traders using a negative feedback loop strategy. With a negative feedback loop, a trader would sell stocks as they rose and buy them as they declined. With a negative feedback loop strategy, volatility would be far lower.
Unfortunately, data on how much money has been going into negative and positive feedback loop strategies is not available. Therefore, it's hard to know how the positive feedback loops have gained such a hold on the market.
But it is not hard to imagine that if a particular investor made huge amounts of money following a positive feedback loop strategy, other investors would hear about it and copy it. Moreover, the way traders get compensated suggests that it's better for them to take more and more risk to replicate what their peers are doing.
Traders Make More Money By Following the Pack
There is a clear economic incentive for traders to follow what their peers are doing. According to Wilmott, to understand why, it helps to imagine a simplified example of a trading floor. Picture yourself as a new college graduate joining a bank's trading floor with 100 traders. Those 100 traders each trade $10 million: They "win" if a coin toss lands on heads and "lose" if it lands on tails. But now imagine you've come up with a magic coin that has a 75% chance of landing on heads -- you can make a better bet than the other 100 traders with their 50-50 coin.
You might think that the best strategy for you would be to bet your $10 million on that magic coin. But you'd be wrong. According to Wilmott, if the magic coin lands on a head but the other 100 traders flip tails, the bank loses $1 billion while you get a relatively paltry $10 million.
The best possible outcome for you is a 37.5% chance that everyone makes money (the 75% chance of you tossing heads multiplied by the 50% chance of the other traders getting a head). If instead, you use the same coin as everyone else on the floor, the probability of everyone getting a bonus rises to 50%.
When Traders Say 'Jump,' Risk Managers Ask 'How High?'
Traders are a huge source of profit on Wall Street these days and they have an incentive to bet together and to bet big. According to Wilmott, traders get a bonus based on the one-year profits of those on their trading floor. If the trading floor makes big money, all the traders get a big bonus. And if it loses money, they get no bonus -- but at least they don't have to repay their capital providers for the losses.
Given that bonus structure, a trader is always better off risking $1 billion than $1 million. So if the trader, who is the king of the hill at the bank, asks a lowly risk manager to analyze how much risk the trader is taking, that risk manager is on the spot. If the risk manager comes back with a risk level that limits how big a bet the trader can take, the trader will demand that the risk manager recalculate the risk level lower so the trader can take the bigger bet.
Traders also manipulate their bonuses by assuming the existence of trading profits before they are actually realized. This happens when traders get involved with derivatives that will not unwind for 20 years.
Although the profits or losses on that trade have not been realized at the end of the first year, the bank will make an assumption about whether that trade made or lost money each year. Given the power traders wield, they can make the number come out positive so they can receive a hefty bonus -- even though it is too early to tell what the real outcome of the trade will be.
How Trader Incentives Caused the CDO Bubble
Wilmott imagines that this greater incentive to follow the pack is what happened when many traders were piling into collateralized debt obligations. In Wilmott's view, CDO risk managers who had analyzed a future scenario in which housing prices fell and interest rates rose would have concluded that the CDOs would become worthless under that scenario. He imagines that when notified of that possible outcome, CDO traders would have demanded that the risk managers shred that nasty scenario so they could keep trading more CDOs.
Incidentally, the traders who profited by going against the CDO crowd were lone wolves whose compensation did not depend on following the trading floor pack. This reinforces the idea that big bank compensation policies drive dangerous behavior that boosts market volatility.
What You Don't Understand, You Can't Properly Regulate
Wilmott believes that derivatives represent a risk of unknown proportions. But unless there is a change to trader compensation policies -- one which would force traders to put their compensation at risk for the life of the derivative -- then this risk could remain difficult to manage.
Unfortunately, he thinks that regulators aren't in a good position to assess the risks of derivatives because they don't understand them. Wilmott offers training in risk management. While traders and risk managers at banks and hedge funds have taken his course, regulators so far have not.
And if regulators don't understand the risks in derivatives, chances are great that Congress does not understand them either
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