Two Forms of Cultural Bias:

Stop-gap "Cures" for Volatility

A recent and most remarkable development has been the escalation of indebtedness in Britain and the USA and the simultaneous growth of derivative financial products including swaps, options and hedge funds. But these are largely aimed at a single purpose, damping down volatility and its attendant risks. For example, a currency swap allows you to swap one currency for another before a specified date, so that the adverse movement of the pound sterling against the euro, or vice versa can be forestalled by moving your funds into the stronger currency. Similarly an option to buy or sell a stock at its current price, at some future date can save you making a serious loss. A Financial Officer who had omitted to take such precautions would be open to criticism. The more volatile the market the more attractive such derivatives become.

But perhaps the commonest refuge from volatility is debt. You go into debt if you need to make an unusually large purchase like a house or new factory or if your income is irregular. Credit can smooth the bumps. But these are all technical interventions and do nothing to address the underlying malaise that debtors increasingly outnumber savers and that debt and volatility go hand in hand exciting each other to excess. Derivative products can be very complex needing algebraic formulae to understand. It requires very clever people to handle these. Whether they are also wise is another question. Persons calculating for personal advantage within a system too rarely ask if the system taken as a whole creates wealth or destroys it.

One obvious thing to note about hedging against volatility is that the financial system producing that volatility is now selling you the supposed antidote. There is a passing resemblance to a protection racket in the sense that those offering to alleviate the threat have occasioned it. But the analogy should not be pushed too far because there is no criminal intent in this case. The volatility is not the result of a conspiracy but a phenomenon that no one really understands, arising from the interaction of many players with no one party to blame.

That said, financial agents benefit twice over and investors lose twice. High volatility drives investors to put their money in the charge of competent agents, who charge for their skills. The activity of these agents is increased by the volatility because many threats and opportunities arise in turbulent oceans. This same volatility drives the sale of swaps and options and the resort to hedge funds - all of which the investor must pay for if he seeks to survive.

Another serious question is whether these instruments, while smoothing out minor disturbances in the short run, do not contribute to major disturbances in the longer run. Persons who sell you swaps, options, other derivatives and credit, need to protect themselves by hedging that risk with other institutions. In other words the risk is passed on. Most usually, over 95% of the time, the risks people seek to avoid can be balanced out. "A" wants to swap dollars for yen. "B" wants to swap yen for dollars. What arises is a dynamic equilibrium, not far from the laissez-faire ideal of the free market. But on some occasions everyone is moving in the same direction, out of dotcoms or away from East Asia following its 1997 financial collapse, just as now everyone is running from sub prime mortgages and other "toxic assets". Such mass flights cause a chain reaction and a contagious panic, in which hedge funds are also caught up so that these increase not decrease the mad momentum. These are now part of the problem.

The sharpness of decline is further exacerbated by "stop-loss orders", under which a falling stock is automatically sold if it loses - say 10% of its value. There is no human intervention in this process. One sell-order precipitates another in the manner of falling dominoes, so that slides are self-perpetuating. When a crisis occurs one on side of the market i.e. US real-estate, then everyone wants out and stampedes in the same direction away from the disturbance. Everyone seeks to operate the same swap, the same option and discovers that their high indebtedness cannot now be repaid. They default on mortgage payments. Their houses are repossessed but in a depressed market do not repay the initial loan so the bank loses too and seeks to repossess faster, before markets decline even more.

In the cusp catastrophe graphic Increasing Volatility has driven both Indebtedness and Derivatives to ever higher levels. This is not because the investor gains from this but because he seeks precaution against loss. What is missing is the Calm and confidence instilled a high Savings Rate. Domestic savings have dwindled to be replaced by those of Asian economies buying our Treasury notes. Can debtor economies be anything but jittery? What we have on the cusp of catastrophe is a Debt and Derivatives Mountain, from which we slide into the abyss of Financial Crisis. The derivatives which once saved us are now part of the land-slide as are those to whom our debts were passed.

Note the speed and violence by which we fall, jumping from one side of the Bifurcation Set to the other with no chance to pause. Note also that the ideal state where borrowers and savers serve each other at the furthest right hand edge of the upper graph is barred by a steep ravine, because indebtedness now looms over thrift and savings. With interest rates savagely cut to stimulate the economy, who would want to save anyhow?



(please come back tomorrow for Charles' next briefing)