Here’s the way it worked from the end of WW2 until 1971,and the fatal flaw involved. Each of the participating nations Central Banks had to exchange their currency for Gold on demand,the fatal flaw was that the price of Gold was frozen at $35 an oz. By 1971,gold was trading at over $100 Oz due to the aggressive expansion of America’s debt to cover the expenses of the Vietnam War and the Great Society. A run on gold was imminent,(even I’m smart enough to buy something worth $115 for $35),so we changed the system,and things get interesting. The new system disconnected Gold from currency,and created an international “Floating” currency system. This system also had a fatal flaw. In fact, the first generation of Derivatives were formulated to add stability to the Dollar,in other words,to hedge, the system. What nobody had noticed was that the world currencies themselves had become derivatives. All a derivative is,is an instrument whose value is found in something else,”the underlying”. Under the new system,the value of the Dollar is expressed in ratios with the Pound,the Franc etc etc. Gold backed dollars are also derivatives,Gold being the underlying,but Gold is not a Derivative,it has value without reference to any “underlying” entity. So now our currency has become a derivative whose underlying value is a derivative whose underlying value is a derivative ad nauseum,and that was the fatal flaw. As the world’s money supplies expanded exponentially from 1971-2007,creating the enormous credit Bubbles that have burst everywhere,the world Derivative volume grew exponentially along with it,they were feeding each other. When the derivative markets crashed due to their underlying value(The value of homes)collapsing due to the credit bubbles bursting. ,the connection becomes clear.
A couple of sidebars,it is an irony of history that the change of systems in 1971 allowed the Soviet Union an extra ten years of life before its financial collapse. The way this worked is that there was a flood of dollars that flew to Europe in the seventies as a result of the new arrangements,eventually these were called Euro-Dollars. Anyway,the official main banking system for the billions of the Eurodollars was a subsidiary of the USSR,so.in effect, we financed the last gasp of our favorite cold war evil empire.
I became fascinated with Derivatives after one of the wealthiest counties in the US,Orange County Calif,went bankrupt in the 1990s. Enron’s use of Ds was also fascinating ,as was the case of Jefferson County Alabama,but today,the power of Derivatives to destabilise and deconstruct should be obvious,but,instead, I am reading about “Resecuritization”. Goldman Sachs is recombining its “failed” CDOs into new configurations,backing them with other failed instruments,getting a AAA rating and selling them(sound familiar),and the customers are buying them with Government money. I guess the yolk’s on us.
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I think by your own thesis, until and unless a decision is made to “re-assetize” currencies, re-securitization is inevitable. In the immortal words of William Burroughs, “Wouldn’t you?” As long as the financial players have motives – discern their self-interest to include hedging and trading profits – they’ll enter into derivative contracts. No one can say that there isn’t a lot of risk to be hedged in the world, a lot of money theoretically to be made (and lost). The problem, of course, is that when you multiply this by several zillion times over and run it through a thousand PhDs, you end up with “systemic risk” and the Big Nobodaddy government called to the rescue – not merely introducing moral hazard, but exposing the entire socio-economic construct as the United States of Extreme Moral Hazard.
July 14th, 2009 at 11:09 am
CK,you are right on the target. Geithner,Summers,Bernanke,are trying to recreate the lost world(1980-2007),it’s a little bit like the Utopian Idealists who over the centuries tried to recreate the Edenic experience only to end up with Concentration Camps.
Think about 37 years witin a big picture historical perspective. We traded in our financial stability for 37 years of “high on the hog” lifestyle,this was the rope we sold ourselves that we used to hang ourselves,(paraphrase of Lenin).
July 14th, 2009 at 11:22 am
David Weidner today in Market Watch Asks the “Five Most Important Questions”. Actually question #1 is the key.
How much are toxic assets worth?
“For all of the good feeling generated since the financial industry stabilized in the first half, the core problem remains: no one still knows how to value all of that junk on bank’s books. Getting a marketable value, though painful in the short run, will eventually help banks and the economy because institutions will have a place to go to buy or sell troubled securities.
This isn’t a problem washed away by some accounting rule trickery. About $4 trillion remains to be written down by the world’s banks, including $550 billion in the U.S. banking market alone, according to an International Monetary Fund estimate in April.* And those losses are mounting, the IMF said.
The Treasury Department is trying to help by creating a government-sponsored auction, the Public-Private Investment Program. PIPP is moving forward, but at a glacial pace. The nine custodian banks were named last week, but that’s more than three months after the program was first announced. The sluggish pace of the program and fear among banks that their assets may be not be worth much are combining to sandbag PPIP.
New accounting rules may allow banks to mark up assets, but at some point there needs to be a marketplace so buyers of distressed debt can have an opportunity and banks can create capital.”
*This is a lowball #,too low to be credible. The assumptions on which this is based is 80% of face value,smarter estimates believe it should be 20% of face value or less. Also,this doesn’t count the Assets not on the books which some believe to be a greater amount than what is counted. Anyway,we still haven’t taken Step 1,which in any “Turnaround” is to have the facts with complete and honest data which will determine the best Turnaround Tactics and Strategy. It’s been almost Three years,and we aren’t at Step 1,it’s very discouraging,to say the least. I thought Americans were when the going gets tough kind of gritty realist go getters,Ostrichlike is closer to the truth.
http://www.marketwatch.com/story/the-big-5-questions-facing-wall-street
July 14th, 2009 at 12:14 pm
OMG, The unexposed core of our problems,in a short paragraph. This is the one we all need to comprehend,
“Time to tackle the real evil: too much debt”
By Nassim Nicholas Taleb and Mark Spitznagel
Published: July 13 2009 19:11 | Last updated: July 13 2009 19:11
“The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about TRIPLE the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.”
The writers are with Universa Investments; Prof Taleb is author of ‘The Black Swan: The Impact of the Highly Improbable’
http://www.ft.com/cms/s/0/4e02aeba-6fd8-11de-b835-00144feabdc0.html
July 14th, 2009 at 1:04 pm
RCAR,
The problem with your analysis, and that of many many others who agree that our fiat currency cannot hold is that people and institutions continue to snap up 10 year treasuries with 2.x% interest rates and 30 year treasuries with 4.x% rates, and the price of silver is at a historical low. Everybody says they expect inflation; but nobody is acting on that expectation.
Inflation will apparently be a “black swan” event that everybody expected, as the housing price stall and then drop was widely expected.
July 14th, 2009 at 1:51 pm
“Everybody says they expect inflation; but nobody is acting on that expectation.”
In my opinion,the “Smart” money is on deflation in the short term(Up to a decade) unless we address the debt bomb. I am enclosing a pretty standard “Smart” Deflation analysis.*
http://www.counterpunch.org/whitney07132009.html
*Don’t be concerned that this is in Counterpunch,MW is a super bright analyst
July 14th, 2009 at 2:00 pm
Here is the best explanation of The vShadow Banking System/Derivatives that I’ve seen.
http://business.theatlantic.com/2009/07/exclusive_interview_what_is_shadow_banking_and_how_did_it_fail.php
July 14th, 2009 at 2:37 pm
No the actual problem is that gold couldn’t maintain its link over time ($35 – $115). This the trouble with pegging to anything. Pick your measure. The gold standard created its own set of problems, and it has been replaced with another set. Gold is a metal whose price moves on what basis? The expectations and thoughts of what people are willing to pay for it. Gold in and of itself is not as rare as initially thought and has limited industrial uses. We assess a value wildly beyond any of its physical properties. We need to quit fixating on gold and instead watching to see that currency is not manipulated for the purposes of our political overlords. When the fed quit worrying about the task of keeping an honest dollar and instead worried about fighting this and that malady, our troubles began. Gold would have provided no better solution. It failed to stop the meltdown of the great depression. Governments create this problem, not gold or the lack thereof.
July 14th, 2009 at 4:08 pm
Jem,”No the actual problem is that gold couldn’t maintain its link over time ($35 – $115).”
You can’t fix a price for a commodity,that was just stupid,but the reason Gold went up(35-115) is because of Dollar inflation,not a change in the value of gold.
The Gold Standard would have stopped the expansion of the money supply,but the best argument for it is that all Governments reject it. All governments want to print their money without the restriction of any standards.
July 14th, 2009 at 4:30 pm
Indeed – I agree with you, governments do and will, regardless of what they try to peg it to. I guess you could argue that gold makes it more difficult to do so, but I really have a difficult time believing that modern government can’t find a way around anything. I still believe firmly that your currency should provide a stable value for trading a unit of your labor for something else. As long as any government is willing to follow some other goal, problems ensue.
July 15th, 2009 at 8:35 am