What is that reality? It includes a number of factors. Alone they would be exceedingly serious; combined, they are very likely to be lethal.
First of all, the International Monetary Fund (IMF) has been undergoing both a structural and intellectual crisis. Structurally, its outstanding credit and loans have declined dramatically since 2003, from over $70 billion to a little over $20 billion today, leaving it with far less leverage over the economic policies of developing nations--and even less income than its expensive operations require. It is now in deficit.1
A large part of the IMF's problems are due to the doubling in world prices for all commodities since 2003 -- especially petroleum, copper, silver, zinc, nickel, and the like -- that the developing nations traditionally export. While there will be fluctuations in this upsurge, there is also reason to think it may endure because rapid economic growth in China, India, and elsewhere has created a burgeoning demand that did not exist before, when the balance-of-trade systematically favored the rich nations.
The U.S. has seen its net foreign asset position fall as Japan, emerging Asia, and oil exporting nations have become far more powerful over the past decade, and have increasingly become creditors to the U.S.2 As the U.S. deficits mount, with its imports being far greater than its exports, the value of the dollar has been declining -- 28 per cent against the euro from 2001 to 2005 alone.
Equally important, the IMF and World Bank were severely chastened by the 1997-2000 financial meltdowns in East Asia, Russia, and elsewhere, and many of the two institutions' key leaders lost faith in the anarchic premises, descended from classical laisser-faire economic thought, which guided policy advice until then. "{O]ur knowledge of economic growth is extremely incomplete," many in the IMF now admit, and "more humility" on its part is now warranted.3
Worse yet, the whole nature of the global financial system has changed radically in ways that have nothing whatsoever to do with "virtuous" national economic policies that follow IMF advic. These are ways the IMF cannot control. The investment managers of private equity funds and major banks have displaced national banks and international bodies such as the IMF, moving well beyond the existing regulatory structures and they have "reintermediated" themselves between the traditional borrowers, both national and individual, and markets. They have deregulated the world financial structure, making it far more unpredictable and susceptible to crises. They seek to generate high investment returns, which is the key to their compensation, and they take mounting risks to do so.
A "brave new world" has emerged in the global financial structure, one that is far less transparent because there are fewer reporting demands imposed on those who operate in it. Financial adventurers are constantly creating new "products" that defy both states and international banks. The IMF's managing director, Rodrigo de Rato, at the end of May, 2005, deplored these new risks -- risks the weakness of the U.S. dollar and its mounting trade deficits have magnified greatly.4
In March of this year the IMF released Garry J. Schinasi's book, Safeguarding Financial Stability, giving it unusual prominence then and thereafter. In essence, Schinasi's book is alarmist, and it both reveals and documents in great and disturbing detail the IMF's deep anxieties. Essentially, "deregulation and liberalization", which the IMF and proponents of the "Washington consensus" advocated for decades, have become a nightmare, creating "tremendous private and social benefits" but also holding "the potential (although not necessarily a high likelihood) for fragility, instability, systemic risk, and adverse economic consequences."
Anyone who reads the data in Schinasi's superbly documented book will share his real conclusion that the irrational development of global finance, combined with deregulation and liberalization, 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 now able to emerge, but success "may have as much to do with good luck" as policy design and market surveillance.5 Leaving the future to luck is not what economics originally promised. The IMF is desperate, and not alone.
As the Argentina financial meltdown proved, countries that do not succumb to IMF and banker pressures can play on divisions within the IMF membership, particularly the U.S., comprising bankers and others to avoid many, although scarcely all, foreign demands. About $140 billion in sovereign bonds to private creditors and the IMF were at stake, terminating at the end of 2001 as the largest national default in history. Banks in the 1990s were eager to loan Argentina money and they ultimately paid for it. Since then, however, commodity prices have soared and the growth rate of developing nations in 2004 and 2005 was over double that of high income nation, a pattern projected to continue through 2008.
As early as 2003 developing countries were already the source of 37 percent of the foreign direct investment in other developing nations. China accounts for a great part of this growth, but it also means that the IMF and rich bankers of New York, Tokyo, and London have far less leverage than ever. Growing complexity is the order of the world economy that has emerged in the past decade, and with it has come the potential for far greater instability, and dangers for the rich.
High-speed Global Economics
The global financial problem that is emerging is entwined with an American fiscal and trade deficit that is rising quickly. Since Bush entered office in 2001 he had added over $3 trillion to federal borrowing limits, which are now almost $9 trillion. So long as there is a continued devaluation of the U.S. dollar, banks and financiers will seek to protect their money and risky financial adventures will appear increasingly worthwhile. This is the context, but Washington advocated greater financial liberalization well before the dollar weakened. The world now has a conjunction of factors that have created a far greater risk than the proponents of the "Washington consensus" ever believed possible.
There are now many hedge funds, with which we are familiar, but they now deal in credit derivatives and numerous other financial instruments. Markets for credit derivative futures are in the offing. The credit derivative market was almost nonexistent in 2001, grew fairly slowly until 2004 and then went into the stratosphere, reaching $17.3 trillion by the end of 2005.
What are credit derivatives? The Financial Times' chief capital markets writer, Gillian Tett, tried to find out. She failed. About ten years ago some J. P. Morgan bankers were in Boca Raton, Florida, drinking, throwing each other into the swimming pool, and the like, and they came up with a notion of a new financial instrument that was too complex to be easily copied (financial ideas cannot be copyrighted) and which was sure to make them money. But she was highly critical of its potential for causing a chain reaction of losses that will engulf the hedge funds that have leaped into this market.6 It for reasons such as these, as well as others, even more opaque, such as split capital trusts, collateralized debt obligations, and market credit default swaps, that the IMF and financial authorities are so worried.
Banks simply do not understand the chain of exposure and who owns what. Senior financial regulators and bankers now admit as much. The Long-Term Capital Management hedge fund meltdown in 1998, which involved only about $5 billion in equity, revealed this. The financial structure is now infinitely more complex and far larger. The top ten hedge funds alone in March 2006 had $157 billion in assets. Hedge funds claim to be honest but those who guide them are compensated for the profits they make, which means taking risks. But there are thousands of hedge funds and many collect inside information, which is technically illegal but it occurs anyway. The system is fraught with dangers, starting with the compensation structure, but it also assumes a constantly rising stock market and much, much else. Many fund managers are incompetent. But the 26 leading hedge fund managers earned an average of $363 million each in 2005; James Simons of Renaissance Technologies earned $1.5 billion.
There is now a consensus that all this, and much else, has created growing dangers. We can put aside the persistence of imbalanced budgets based on spending increases or tax cuts for the wealthy, much less the world's volatile stock and commodity markets which caused hedge funds in May to show far lower returns than they have in at least a year. It is anyone's guess which way the markets will go, and some will gain while others lose. Hedge funds still make lots of profits, and by the spring of 2006 they were worth about $1.2 trillion worldwide, but they are increasingly dangerous.
A great deal of money went from investors in rich nations into emerging market stocks, which have been especially hard-hit in the past weeks, and if they leave them the financial shock will be great. The dangers of a meltdown exist there too.
Problems are structural, such as the greatly increasing ratio of corporate debt loads to core earnings, which have grown substantially from four to six times over the past year because there are fewer legal clauses to protect investors from loss, and to keep companies from going bankrupt when they should. So long as interest rates have been low, leveraged loans have been the solution. With hedge funds and other financial instruments, there is now a market for incompetent, debt-ridden firms. The rules some once erroneously associated with capitalism -- probity and the like--no longer hold even on paper.
Problems are also inherent in speed and complexity, and these are very diverse and almost surreal. Credit derivatives are precarious enough, but at the end of May the International Swaps and Derivatives Association revealed that one in every five deals, many of them involving billions of dollars, involved major errors. As the volume of trade increased so did errors. They doubled in the period after 2004. Many deals were scribbled on scraps of paper and not properly recorded. "Unconscionable" was outgoing Fed chairman, Alan Greenspan's, description. He was "frankly shocked." Other trading, however, is determined by mathematical algorithm ("volume-weighted average price" it is called) for which PhDs trained in quantitative methods are hired.7 Efforts to remedy this mess only began in June of this year and they are very far from resolving a major and accumulated problem that involves stupendous sums.
Stephen Roach, Morgan Stanley's chief economist, on April 24 of this year wrote that a major financial crisis was in the offing and that the ability of global institutions to forestall it -- ranging from the IMF and World Bank to other mechanisms of the international financial architecture are utterly inadequate. Hong Kong's chief secretary in early June deplored the hedge funds' risks and dangers. The IMF's iconoclastic chief economist, Raghuram Rajan, at the same time warned that the hedge funds' compensation structure encouraged those in charge of them to increasingly take risks, thereby endangering the whole financial system.
* * *
The entire global financial structure is becoming uncontrollable in crucial ways its nominal leaders never expected. Instability is increasingly its hallmark. Financial liberalization has produced a monster, and resolving the many problems that have emerged is scarcely possible for those who deplore controls on those who seek to make money, whatever means it takes to do so. Contradictions now wrack the world's financial system, and if we are to believe the institutions and personalities who have been in the forefront of the defense of capitalism, it may very well be on the verge of serious crises.
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