An Economy of Buccaneers and Fantasists

by Gabriel Kolko Le Monde diplomatique 10/16/2006

Last month a major US hedge fund, Amaranth Advisors, lost more than half its assets in a week, speculating on natural gas prices. The company proved correct the chief worry of such major financial institutions as the World Bank and the International Monetary Fund: that financial reality is now out of control.

GLOBAL financial structure is far less transparent now than it has ever been. A few decades ago daily payments for foreign exchange transactions were roughly equivalent to the capital stock of a major United States bank; today they exceed the combined capital of the top 100 US banks. Financial adventurers constantly create new products that defy nation states and international banks. This May the International Monetary Fund’s (IMF) managing director, Rodrigo de Rato, deplored these new risks, which the weakness of the US dollar and the US’s mounting trade deficits have greatly magnified.

His fears reflect the fact that the IMF has been in both structural and intellectual crisis. Structurally, its outstanding credit and loans have declined sharply since 2003, from over $70bn to a little over $20bn, leaving it with far less leverage over the economic policies of developing nations, and a smaller income than its expensive operations require. The IMF admits it has been “quantitatively marginalised” (1). Many of its problems are due to the doubling since 2003 of world prices for all the commodities (oil, copper, silver, zinc, nickel, etc) which are traditionally exported by developing nations. So developing nations have been able to bring forward repayment of their debts, further reducing IMF resources.

Higher prices for raw materials are likely to continue because rapid economic growth in China, India and elsewhere has created burgeoning demand that did not exist before, when the balance of trade systematic- ally favoured rich nations. The US has seen its net foreign asset position fall, whereas Japan, emerging Asia and oil-exporting nations have become far more powerful over the past decade and have become creditors to the US. As US deficits mount, with imports far greater than exports, the value of the dollar has declined, falling by 28% against the euro between 2001 and 2005.

The IMF and World Bank were also severely chastened by the 1997-2000 financial meltdowns in East Asia, Russia and elsewhere. Many of their leaders lost faith in the anarchic premises, inherited from classical laissez-faire economic thought, which had guided their policy advice until then. Intellectually both institutions are now far more defensive and concede that the premises that led to their creation in 1944 are hardly relevant to the way the real world now operates. Our “knowledge of economic growth is extremely incomplete,” many in the IMF now admit, and it now needs “more humility”. The IMF concedes that the international economy has been transformed dramatically since then and, as Stephen Roach of bankers Morgan Stanley has warned, the world “has done little to prepare itself for what could well be the next crisis” (2).

The nature of the global financial system has changed radically in ways that have nothing to do with virtuous national economic policies that follow IMF advice. The investment managers of private equity funds and major banks have displaced national banks and international bodies such as the IMF. In many investment banks, buccaneering traders have taken over from more cautious and traditional bankers and owners. Buying and selling shares, bonds and derivatives now generate higher profits, and taking far greater risks is now the rule among what was once a fairly conservative branch of finance.

Profits, real or not

Such traders are rewarded on the basis of profits, fictitious or real, and routinely bet with house money. Low interest rates, and banks eager to lend money to hedge funds and firms that arrange mergers and acquisitions, have given such traders and others in the US, Japan and elsewhere, a mandate to play financial games, including making dubious mergers that would once have been deemed foolhardy. In some cases, leveraged recapitalisations allow the traders to pay themselves enormous fees and dividends immediately, by adding to a company’s debt burden. What happens later is someone else’s problem.

Since the beginning of 2006 investment banks have vastly expanded their loans to leveraged buy-outs, pushing commercial banks out of a market they once dominated. To win a greater share of the market, they are making riskier deals and increasing the likelihood of defaults among highly leveraged firms — “living dangerously” as the head of Standard & Poor’s bank loan ratings section put it. “Observers are predicting a sharp increase in defaults among highly leveraged companies,” the Financial Times noted in July (3).

But there are fewer legal clauses to protect investors, so lenders are less likely than ever to compel mismanaged firms to default. Hedge funds, aware that their bets are more and more risky, are making it much more difficult to withdraw the money with which they play. Traders have “reintermediated” themselves between traditional borrowers (national and individual) and markets, further deregulating the world financial structure and making it far more susceptible to crises. They seek to generate high investment returns and take mounting risks to do so.

This March the IMF released Garry J Schinasi’s well-documented book Safeguarding Financial Stability (4), giving it unusual prominence. The book is alarming, and reveals and documents the IMF’s deep anxieties in disturbing detail. Deregulation and liberalisation, which the IMF and proponents of the Washington consensus (5) have advocated for decades, have become a nightmare: they have created “tremendous private and social benefits” (6) but also hold “the potential for fragility, instability, systemic risk, and adverse economic consequences”.

Schinasi concludes that the irrational development of global finance, combined with deregulation and liberalisation, has “created scope for financial innovation and enhanced the mobility of risks”. Schinasi and the IMF advocate a radical new framework to monitor and prevent the problems that are now enabled to emerge, but any success “may have as much to do with good luck” as with policy design and market surveillance. Leaving the future to luck is not at all what economics originally promised.

Even more alarming is a study, also publicised by the IMF and produced at the same time by establishment specialists, analysing the problems that deregulation of the world financial structure has created. The authors believe that deregulation has caused “national financial systems [to] become increasingly vulnerable to increased systemic risk and to a growing number of financial crises” (7). The IMF shares the growing consensus among conservative banking experts that the world financial structure has now become far more precarious.

As the financial meltdown of Argentina in 1998 proved, countries that do not succumb to IMF and banker pressures can play on divisions within the IMF membership to avoid many, though not all, foreign demands. About $140bn in sovereign bonds to private creditors and the IMF were at stake in Argentina, terminating in 2001 with the largest national default in history. Banks in the 1990s had been eager to lend Argentina money and they ultimately paid for their eagerness.

Full article: Le Monde diplomatique

Gabriel Kolko is a historian and author of The Age of War and After Socialism: Reconstructing Critical Social Thought.


(1) IMF Survey, New York, 29 May 2006; IMF in Focus, New York, September 2006. (.pdf files) See also : IMF Survey index 2006 page.

(2) Roberto Zagha, “Rethinking Growth”, Finance & Development, Washington DC, March 2006; Stephen Roach, Global Economic Forum, Morgan Stanley, New York, 16 June 2006.

(3) Financial Times, London, 17 July and 14 August 2006.

(4) Garry J Schinasi, Safeguarding Financial Stability: Theory and Practice, IMF, New York, 2006. (.pdf file).

(5) The term was coined by the economist John Williamson in 1989 and summarises the recommendations made to states, including tax reductions, free markets, privatisation and financial deregulation. To qualify for IMF loans, governments
must implement such measures.

(6) This and following quotes are from Schinasi, op cit.

(7) Kern Alexander, Rahul Dhumale and John Eatwell, Global Governance of Financial Systems: The International Regulation of Systemic Risk, Oxford University Press, 2005.