The Preposterous Notion of ‘Fixing’ the Derivatives Market and Other Follies.

Abstract: Our current government believes, or so they say, that they can fix financial and economic problems with policy and oversight, mostly using taxation. Some eight centuries of research show that this is actually a proposal that flies in the face of veracity. Government decisions hatched in the Obama administration  appear to be based almost entirely on partisan policies where the entire political game is contingent  upon searching for new ways to restrain capitalism while  acquiring as much of the wealth from this source as possible. The general thrust is to equalize income for the masses even if it requires a total destruction of the capitalist structure of a given economy. This is based on the old, tired Marxist notion of redistribution of wealth. This essay investigates the methods used to nationalize General Motors and the current political attack on Goldman Sachs and then concludes with the stark financial realities of the existing derivatives market.  The notion that some government can control a $600 trillion derivatives market is so far divorced  from realism that we must be both amused and fearful that they will attempt something in the near future toward this objective. Government meddling into markets always yields the same result: higher taxes or prices and less efficiency.  Shortages almost always follow an episode of government perturbation of the free markets. We need to realize that the derivatives market is comprised of millions of willing buyers and sellers. Buyers think they are buying something of value. Who is our government to question that? Whenever we build something there suddenly appears a pack of howling populist or Marxist radicals clustering around to tax it or destroy the process and replace it with government. I don’t see any important exceptions to this rule in our current government officials.  Our elected officials, speaking for the most part now to those in power, are incompetent and greedy radicals that will say or do anything to get at our money.

Our society seems to tolerate politicos who dominate certain sectors of our society and generally attempt, in their words, to offer a stable system of laws, the running and regulation of banks, currency and other benefits. Most of the success in politics is grounded by some form of naiveté, and like-minded misplaced trust from the politically uneducated masses and is based on broad promises to the lower classes. Most governments tend to be of the authoritarian type where orders are handed out by some central committee or a close ensemble of trusted cadres that surrounds some dictator or satrap and the citizens are expected to eagerly comply with orders. It is apparently a sorry attribute in human behavior to wish for somebody to hold tightly to your collar and guide you through the rough elements of life. Governments can grow in size and power according to several mechanisms such as protracted war, famine, regulation of commerce, imperialism, religious conflicts, conquests and other factors and resist truncation at all costs. The new recompense for unreasonable expansion in the size of government will be debt and defaults.[1] Singular events that perturb the society such as financial crises are particularly interesting in that they seem to be easily converted into dynamic wellsprings of new and bigger government. The public grovels and twists their hats in the presence of their devoted leaders while begging for relief from some problem; they get only promises. The general observation is that when a financial crisis occurs and the currency or other important  economic vector turns down then such events signal a change in political direction from left to right [or the converse] is indicated by the votes from angry and disappointed people who respond to this effect. George Bush was chased out of office and his party decimated from the 2007 financial crisis which he handled very poorly. As for the voters, “prosperity is right around the corner” they are promised. Or in our current political maelstrom the notion that “I have a plan to fix the economy” encourages change from either or both contestants.  When times turn hard the voters tend to vote for the opposition in frustration and ignorance, two attributes which characterize most of our citizens.

The voters tend to bend according to personalities and not fact-based realities of the economy; they are easily controlled and their views strongly influenced if we watch the approval rating polls after some speech. Peasant societies, in which the bottom level people in that system have much in common with our current voters, are universal in our long recorded histories and are seemingly best controlled by feudal or authoritarian systems. The necessary jobs are simple and fairly easily regulated in peasant societies and are not skill intensive. Unemployment was rarely a problem. Those who couldn’t cope merely starved and were no longer a problem. Feudal lords and overseers could control vast amounts of land, water and food with little force. The workforce was mostly immobile and tended to regenerate itself limited only by the food supply and certain diseases. The feudal system of Europe lasted more than a millennium and was very stable in terms of the resident populations being controlled by their lords and ladies. That control and stability has faded away. Some of our biggest nations, such as the US and U.K. posses an intrinsic and major peasant mentality deeply rooted in the broad voter’s psychological composition. Translated, this means that many of our voters are political morons and, as such, are valued assets in any political contest and parallel the Soviet’s notion of the ‘useful idiot.’ The ignoranti can be mounded into convenient lumps like Silly Putty.

The advent of the Industrial Revolution, which eliminated the feudal system, placed the new powers in the hands of individuals who could generate wealth from business operations in stark contrast to the earlier wealth-transfer systems that used inheritance and land control to pass along power structures, land and wealth to the next generation. Here, capitalism[2] advanced rather abruptly, as measured in social time units such as generations, and became the dominant creator of power and influence because the ability to make money transitioned from a small collection of heirs to a broad segment of the society who produced a few entrepreneurs. Thus, a new pyramid was created with entrepreneurs seated a the very top of the pyramid.[3] The first offspring, the main vector in continuing on with wealth and power of many nobles, were not able to compete in the free markets with others of lower birth in an arena where cognitive skills were worth more than mere family tartans and standards. Much of their workforce migrated to the cities in quest of money, fun and drink and left landed nobles to their own fate. Thus power in the form of money and capital displaced the previous leadership and land models and pushed the emphasis in new directions.  Clever individuals no longer need authoritarian overseers. They could now do their best without constraints.  There was, then, virtually no limit to how much wealth and power could be accumulated by those individuals with industry, essential cognitive skills and some luck. The system had changed forever.

The accumulation of wealth in the hands of a few is always an economic, military and political problem, but reasonably no more of a problem that was extant in the feudal system.  It is currently more of a problem when those few are the politicians who ostensible replaced the nobility.[4] Sometimes this balance appeared to get out of hand and certain governments needed to control business and extract taxes to spread around the profits and address some needs of society that could not be fixed in the feudal system.  After all, there was new and abundant wealth being created from capitalism. Socialism in some form or another was an attempt to control the distribution of the wealth of capitalism and make it more equitable or to pretend to provide the nonexistent ‘equality’ to all.[5]  This effort failed, as we should have expected,  and the politicians shifted the political emphasis to equal ‘outcomes’ rather than the pure ‘equality’ theorem that is rendered impossible by the natural distribution of cognitive skills. People are clearly not equal. The process of controlling the capitalists led to some fateful interactions frequently resulting in the disintegration of whole business sectors or portions of governments. It is fair to say that there must be some level of cooperation between the capitalists, usually few in number, and politicians with even fewer attributes in advanced business skills, and this interaction is both necessary and sufficient to stabilize the society. Capitalism is what drives our world economy. Attempts to stamp out capitalism have summarily failed[6] and resulted in famine and economic disasters wherever attempted. The hybrid forms of capitalism—socialism controlling businesses such as Nazism, Peronism,[7]  and Marxism in the form of modern Communism as practiced in the People’s Republic and elsewhere have produced somewhat satisfactory results as long as government does not interfere too much in the practice of commerce. China is a stunning example of how capitalism [more accurately mercantilism in their case] can produce nearly unlimited wealth and prosperity along side a totalitarian government. Cuba and North Korea are examples where the citizens have a zero chance of rising above poverty levels. We have some 190 countries on the planet and counting changes in” leadership” this sums to about some 1000 or more governments since 1900 alone and most of them do not function well if you analyze and rank the wellbeing of their citizens as a metric. Government is essentially a failure when the history is analyzed in full context and politicians are mostly the root cause of such failure. The chief complaint here is that governments will not share power with individuals for long and will attempt to confiscate wealth derived from capitalism. There is no other source. The political quest for wealth frequently destroys capitalism in local sectors. Note that capitalists vanish from the scene if their business adventures fail for any reason but politicians seem to be firmly cemented in place.  Their propensity to fail does not diminish their status or position in political parties and many times such conduct only facilitates and enhances their stature and frequently only elevates them in the eyes of their adoring chorus.  We would be intellectually closer to the bugs and rodents in cognitive terms if we failed to realize that politicians never offer themselves as the failing component of some disastrous social program or war. They have more excuses that there are grains of sand in Arabia. Thus a criminal, loser or racist might attain a higher station in the political world even though he or she may have the California[8][9][10][11][12][13] disease [Our National Leper], or be tacitly comfortable with drug abuse, financial chaos or even the progressive sodomizing of children or other perversions.  We have more to fear from the soon-to-be second hand marijuana smoke rising and falling in the Assembly in California than from guns in private hands. When corporate leaders fail they are demoted from their position by the sterile arithmetic facts stated clearly in their balance sheets; when political leaders really botch a job they are frequently praised. Corporations constantly reassemble and overcome problems and are thus self-refining and efficiency driven while political parties remain stagnant and their leaders sometimes resemble painted statuary dutifully[14] studying the ancient history of political theory.

Suffice it to say that governments and capitalists interact in complex ways and those ways frequently determine the economic fate of a given society. This topic of complex ways must sooner or later be defined in terms of the stability of the economy and more particularly in terms of financial crises. Governments cannot seem to properly balance tax revenues and spending.[15] There is apparently no potential political power in a balanced budget. A reading of two recent books: Ascent of Money[16] by Niall Ferguson’ and the newer book This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth Rogoff show, very clearly, that the vast majority of governments cannot manage finances with any long term competence. They make enormous mistakes as outlined by 1957 book: War and Aftermath 1914-1929 by Pierre Renouvin[17] that offers us a critical but objective scrutiny of the political and military actions of various government agencies starting in the 1890s and leading up to August 1914 where most world stock markets suddenly shut down for months; this history is enlightening. By 1916 most governments had spent all they had and were wildly printing money to fund the Great War.[18] We achieved 51 million deaths out of that adventure and enough hate and discontent to set up the next world war for 31 million more to pay the ultimate price. This is government operating in full bloom and proves that diplomacy can recurrently solve no problems. Failed governments have no discernable history in the political sense.

We can talk about peace and such, but every year we find military action and economic pressures being applied in many places on this globe. Even Obama bombs villages in two places in the Middle East despite his seeming aversion to war. The ethic that should prevent wars proposed by many is absent in nearly all governments. We must finally admit that we are never going to agree on what peace and stability means on this planet and be content to dealing with lesser crises. War is expensive and  this relevant fact brings us back to the perpetual occurrences of financial crises:

We had a depression in 2007 that was, in my view[19], temporarily stalled from its downward plunge by massive interaction by the US Federal Reserve and Treasury that resulted in essentially doubling our money supply [M2] in a few weeks.  We wasted a trillion dollars on war for no apparent gain and much more in worthless social programs and the legacy of these efforts surged directly into our debt. Our government now prints unbelievable amounts of money and all of that pile slithers directly into the national debt now approaching 14 trillion dollars.  Our soaring debt will rekindle this depressionary fire in the next few years.[20] We are bankrupt.

Several things must be made clear about this attempted salvage of our economy in the 2007 Depression: [1] It was an experiment never attempted on such a massive scale and [2] much of it was guess work at the time as the politicians had scant time to analyze what was happening and [3] the aftermath of this process generated new political opportunities to expand government and control over certain markets.  We are now hopelessly mired in debt and trying to spend our way to prosperity using more debt.[21] There is no way we can grow out of 14 trillion in debt with deficits exceeding a trillion dollar every year on a GDP of only 14 trillion unless we debase our currency.  We are on the path to economic destruction.

The first thrust after any catastrophe is to put new laws into place that will ‘fix’ the problem and ‘prevent’ it from happing again. World War 1 was the Great War that would end all wars. This nostrum has never worked in the past because we continue to have such financial catastrophes and government has been in place with ostensibly their fingers on the levers of the money machines for the last 5000 years without any convincing evidence that they are doing anything other than grabbing power or guessing what to do next. They are incompetent.

A recent and noisy example of how government can ‘fix’ a problem is the nationalization of General Motors.[22] What happened was actually very simple: the unions forced concessions on job security, pay, benefits and retirement from the company over many decades that brought its labor costs up to unacceptable and noncompetitive levels and the company then lost money on every car they made on average so the corporation failed. This attracted political attention and the Obama organization decided to fix the problem by nationalizing the company. This conforms to my theory of ‘spreading around the wealth.’[23] GM was swamped by $80 billion in debt and was going bankrupt.  Our current Neo-Marxist liberal/radical government now blends fascism[24][25][26] with socialism in an attempt to redistribute the wealth and they applied this in fact as we saw in the GM and Chrysler bailouts where bond holders and stock holders were wiped out [a 70% haircut in the parlance for the bond holders] and the shrunken remains given to the unions while the management was replaced by orders from the White House.[27] The unions retained some 17% of the company [for what?? Political reciprocity??] and the US and Canada lent them 6.1 billion to get restarted. From money lying around in sprawling government project accounts, they ‘repaid’ the ‘loan’ 5 years ahead of schedule and now celebrate. They intend to hire soon but at lower wages according to Mark Reuss who heads up GM of North America. Thus, their debt was wiped out by our government. The taxpayers are stuck with 45 billion in stock and now GM wants to offer an IPO, which will most likely dilute the shares and secure a loss for the taxpayers. This is all an illusion as their labor costs remain uncompetitive against other car manufactures who make profits in this country. We have substantially subsidized a failing company for a political return and we will have to perpetually rescue this monster from time to time. Wages and benefits must come way down before GM can be successful in a free market.

This project is now viewed as a positive interaction by the government in ‘fixing’ a problem with a corporation.  The ugly fact is that they were $80 billion in debt and could never make that up by selling cars. At a 10% profit margin per car, it would have meant sales of $800 billion to get that back by selling 26,666,666 autos, about double the US market.  At a profit level of only 1%, it would have required $8 trillion in sales or nearly one car for every person in the US. This is a political farce as we expect. The thrust here was, obviously, to repay the unions for their hard work and enormous political contributions to the Obama organization.  This form of bribery is common in politics. Thus, the government spent printed money in the form of debt to secure more votes.

As the celebrations over this feat subside we now turn to how we can ‘fix’ the derivatives markets and ‘prevent the taxpayer from being stuck’ with another financial disaster. Our government can do that they say.

The immense size of the derivative market, currently running $596 trillion[28], is daunting. It turns out interest rate contracts [$145.0 trillion] and foreign exchange contracts [$18.2 trillion] constitute 90% of the contracts in this market in the US. Thus, the rest of the world handles the remaining 432.8 trillion. This is the fertile ground where kleptocracy[29] maybe stealthily conducted by governments as they jockey currency exchange rates around to avoid debt repayments.  We need to know two salient features of this market. [1] It is based on risk aversion insurance instruments where, in principle, the number of buyers and sellers is algebraically zero and that most of these contracts are not highly capital based. [2] The business proceeds only on faith unlike standard insurance contracts. None of this is important in terms of details—what is necessary to understand about this market and the potential solution to the problem is this: derivatives are fueled by leverage and leverage is the driving force behind this market just as it is in every other financial market on the planet. This leverage extends to all financial transactions, banks and everything else particularly the carry trade that has generated billions of profit on the US dollar’s low interest rate.[30] We all use leverage. Our homes and cars are leveraged. Leverage is not evil unless you are a socialist.

Leverage in banks is debt-driven[31] so the bank capital reserve limits the upper bound of how high this can go and for an 8% capital-to-debt ratio it becomes simply 1/0.08 or 12.5 max. This is peanuts compared to how the government set up securitized mortgages.  We can complain about numerous  massive government failures such as the Great Society, HUD, War on Poverty, and the phony Community Communist Reinvestment Act[32][33]that allowed the liberals to buy votes by offering ‘affordable housing’ to deadbeats and illegal aliens and abruptly ended with an asset bubble. This process is ongoing. This real estate bubble brought down Bear Stearns [34] who conjured up a leverage of 35.5 to 1 with their total debt almost equal to our GDP [13.4 trillion[35]]. Fannie Mae and Freddie Mac probably hold $3-7 trillion of bad debt known as toxic assets. Such bubbles are a natural part of our economic system and have been happening almost yearly for the past 5000 years. All it takes for a bubble to form is an unreasonable demand for some good or service that pushes prices to levels way above the asset base.  The bubble is a free market correction to the supply and demand schedules. We are doubtless bulling another bubble with the push toward alternative “green” energy machines that only add cost to an existing asset.[36]

We read fluff like this from liberal politicians on derivatives:

"Ultimately, we were not able to reach comprehensive consensus that will fill in dangerous gaps while allowing companies to safely use derivatives to hedge their risks," Reed [Sen from Rhode Island e.d.] said in a statement. "I am hopeful that there will be bipartisan support for bringing derivatives out into the open, regulating trades and ensuring that regulators have the tools to keep up with new innovations in the system."[37]-- Senators divided over rules on the derivatives market. [Emphasis is mine in all quotes.]

If we thought GM had a tough frog march back to financial security we have to stand aghast at the notion that our government can fix this derivatives market. Since there is little or no capital behind some 600 trillion in derivatives we can ask if they could be restricted to a leverage of only 100 whereby somebody would post capital of 6 trillion dollars.  According to a leading expert on international financial affairs:

“Unless this capital [for investment in this context]  is forthcoming, a clutch of countries will prove unable to roll over their debts at a bearable cost. Those that cannot print money to tide them through, either because they no longer have a national currency (Ireland, Club Med), or because they borrowed abroad (East Europe), run the biggest risk of default.”[38]--The capital well is running dry and some economies will wither. The world is running out of capital. We cannot take it for granted that the global bond markets will prove deep enough to fund the $6 trillion or so needed for the Obama fiscal package, US-European bank bail-outs, and ballooning deficits almost everywhere.”--By Ambrose Evans-Pritchard  26 Apr 2009 [Emphasis is mine in all quotes.]

Our GDP is only 14.3 and ¼ of the world’s GDP so where could we get 6 more to hold leverage down to only 100, three times higher than what was able to sink Bear Stearns at 35.5?? The world GDP is only about 4 x 14 or 30 trillion. Governments fail to acknowledge that this market is a free market with thousands or millions of willing buyers and sellers. This is a classic free market.

So, to sum up: all this smacking about leverage and risk by politicians is misplaced. Our system runs on leverage and debt because credit is money! Debt fuels growth and future profits and more growth. Risk management saves capital and protects assets and financial instruments. There is no way to back derivatives with capital and guarantee no future financial crisis any more than there is a way to prevent a run on any bank. There is no way to back up the banks other than the printing presses running full tilt as we saw in late 2007. This position is not being made clear to the voters: government cannot possible do what they claim.

Our politicians have financial and economic advisors and are not as stupid as they first appear. The only purpose of any government intervention into capitalism is to gain power and collect more taxes to build up their power base. The 2007 Depression was a grand opportunity to hike spending and bloat government and the Goldman Sachs case is a prime example. The case against Goldman is flimsy and the target of the investigation [Paulson] is not even named in any indictment. The interesting fact that Goldman’s employees gave Obama a million dollars in campaign contributions [that he will not pay back] leads us to assume that this is a crass grunt and grab intermezzo for Washington. They just want some more power and tax revenues. Goldman should just pay a fine and continue on.

Goldman is the best of the best and can best any rules or regulations that our politicians can put up. They can move their operation to Singapore or Hong Kong where there is a more receptive business environment at any time and prosper. Politicians either don’t understand leverage and how it works to expand the money supply and its function in investments or they do not. If Goldman is cut up and trashed the remnants will simply reassemble someplace else and continue on with investments as they did with the fine people at Bear Stearns that needed new jobs. The US needs to participate in capitalism because Asia is growing under this mechanism and can now provide what the US could in the past. The populist view that the ‘big guy’ is cheating the ‘little guy’ out of his or her future is so sadly misplaced that we must wonder how we ever survived FDR, LBJ and JEC.[39] The reason was capitalism and Wall Street ingenuity. This makes the politicians look like bigger fools and uglier criminals than we might expect.

Now, let’s do some rational thinking about the derivatives market. Firstly, how much did we lose when some of our investment banks went down? That was 10 trillion at best and another 5 for Europe. So, what was the net effect of the existing market? We lost 15/600? A mere 2.5% of the market!?? Now, we push further on the Stone of Reason to see what lies beneath and ask: what can our government do about this risk? Put up a few trillion here and there in capital backing? No. There is no money to do this. Missing from the equation here is the data that might show that the derivatives market actually prevented some loses fr0m the financial meltdown on Wall Street. This market exists for a reason and because so many people buy products from this market we probably err greatly to summarily condemn this financial instrument or tax it to death.

The effect of government interference in markets is always the same: higher costs and a series of distortions. We seem to want to depend upon politicians who are only radical, racist-based chum chuckers[40] or outright criminals[41] or pervert enablers[42]  for help and advice on this issue. They profess to know the solutions to this problem. What solution can they offer? Why, they can get tax money to buy more political power.

The effect of government intrusion into such markets that address the important attribute of risk aversion is that the cost of buying risk insurance will soar thus fewer municipalities and pension funds will buy fewer contracts and the risk of damage from defaults and varying exchange rates will rise. That is an unnecessary cost and is inefficient.

Thus, you will be paying incompetents to tax you to make the risks in business and the currency exchange world increase. That sounds like the old politics we know and vote for. The new radicals like Bertha Lewis of ACORN fame, noisy propagandists like Joe Klein of Time[43], Andy Stern of the vicious street-gang and head bashing SEIU union and their Communist allies and other chum chuckers are trolling for money and power.  They try to play on the propagandist’s favorite themes: fear, corporate greed and racism. They attempt to show that the Tea Party people are Nazi thugs who want to round people up people of color and send them to internment camps and other crass lies.[44] And, notice that Democrats like Joe Biden, Hillary Clinton, and Harry Reid sit idly by and make no comments or corrections to these lies and their preposterous statements. These senators are just slugs stuck in the cracks of the Washington leftist movement. Reid has just sacrificed himself for the greater good of Marxian statism.

All these people want is the control over your money and future and they will get if we don’t chuck these parasites out in November.  All they have is your money. And, you don’t have enough to satisfy the far left. They will attempt to grab it all if they can. Lenin is still their patron saint.

rycK [a 5^th generation Californian in exile]