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Speculative Financial Attacks

from Asad Zaman and the WEA Pedagogy Blog

We live in a world awash with money. Not only can the banks create 20 times more money than the amount they receive as deposits, but an enormous shadow banking system has come into existence which creates massive amounts of credit without any regulatory restrictions. At a time of the global financial crisis, the value of financial instruments was more than 10 times the world GDP. Daily trade in foreign exchange is around $4 trillion, while actual merchandise trade is only $50 billion. This huge excess clearly represents speculation and gambling, rather than currency exchange for the needs of trade.

The ways of the super-rich Lords of Finance are far beyond the ken of ordinary mortals like you and I. Winning and losing bets in millions of dollars daily are just a small part of the thrill of living. One of the important tools they use is buying on margin. This means that you can buy $50 worth of stocks or foreign currency by paying just $1. In effect, the dealer loans you the remaining $49 by using your stocks as collateral. If the stock goes up to $51, you can sell and get out with a quick 100 per cent profit on your investment. If the stock declines to $49, you again sell and get out of the market, losing your marginal payment of $1.

In the 1970s, the dollar was de-linked from gold officially by former US president Nixon. Distrusting the unbacked dollar, the Hunt brothers decided to buy up all the silver in the world. By 1979, they had nearly cornered the global market, taking possession of nearly three million kilograms, about a third of the entire world supply. In the process, they drove up the price of silver from $6 to $50 an ounce, and became richer than the fabled King Croesus. The eight-fold price increase created a dire situation for jewellers around the world. Tiffany’s took out a full page ad in The New York Times, condemning the Hunt Brothers and stating “We think it is unconscionable for anyone to hoard several billion dollars worth of silver and thus drive the price up so high.”

The fates intervened to prevent the Hunt brothers from becoming the kings of silver. The Hunt brothers angered the Reagan Administration in the US, which played dirty to bring them down. COMEX, the regulatory body for commodity exchange, suddenly changed the rules for trading in silver, doubling the margin requirements. This required the Hunt brothers to put up about double the cash for the silver they had purchased on the margin. At the same time, the FDIC changed the rules to prevent banks from lending to purchase commodities. The bear trap closed around the Hunt brothers, who watched helplessly as silver prices started sliding and crashed on “Silver Thursday” on March 27, 1980. Although they lost billions, and eventually had to declare bankruptcy, we need not feel pity for the Hunt brothers. Their rich daddy had foreseen this possibility and created protected trust funds for both brothers amounting to $100 million each, more money than common folks see in a lifetime of earning.

One of the favourite games played by the super-rich is speculating in foreign exchange. Buying on margin provides enormous leverage; one can buy a billion dollars worth of currency for a paltry $20 million. This allows you to attack weak currencies and take them down, making an enormous profit in the process. George Soros created the Quantum Fundto attack the British Pound, speculating on its devaluation. The Bank of England tried to protect the pound with all the means at its disposal, but was eventually forced to yield, creating billions in profits for Soros. Similarly, big money forced open the doors of the East Asian Miracle economies to foreign investors, and crashed these economies while yielding tremendous profits to the investors.

The use of leveraging, derivatives and other complex financial tricks within the unregulated shadow banking system creates a huge amount of excessive credit, which actually changes the rules of game. As the Global Financial Crisis of 2007 demonstrated dramatically, the conventional textbook theories currently being taught in universities throughout the world, do not apply to the modern economy. The most radical change has been the failure of the quantity theory of money. Professional economists were very surprised when huge increases in the money supply did not result in proportional increase in prices, in violation of the quantity theory. The US printed trillions of dollars for the Iraq War and for bailouts and quantitative easing following the Global Financial Crisis, but there was no corresponding increase in consumer prices. Similar phenomena were observed throughout the world. In Pakistan, there has been a 350 per cent increase in the money supply, but only a 250 per cent increase in prices over the past decade.  Professor Richard Werner has solved the mystery by showing that the excess money goes into creating price bubbles in land, housing, stocks and other speculative financial assets. Prices of these assets do rise, but these do not enter the consumer price index, and hence do not cause inflation. Interestingly, Werner’s theories are not well known among economists.

Another serious consequence of excessive money supply being held in the form of inflated assets is that the concept of an equilibrium exchange rate is no longer well defined. Previously, the equilibrium was defined by matching supply and demand for currency, which was based on the real trade balance between exports and imports. Now the speculative transactions, being done at whims of the super-rich, overwhelm the real economy. What controls the exchange rate is largely expectations. The topic of self-fulfilling expectations has gained prominence in the recent literature on monetary theory. If rumours are spread that a currency will decline, people will sell the currency and cause it to decline. Equilibrium theories do not show any significant misalignment of the Pakistan rupee exchange rate, as current popular accounts would have it. The ultimate test today rests on Central Bank interventions. If the State Bank is intervening in the markets by selling dollars to prevent a fall in the price of the rupee, then the rupee is overvalued. However, State Bank Reserves are steadily growing, showing that the rupee is actually undervalued, contradicting the views of leading economic pundits in Pakistan.

  1. July 2, 2015 at 9:46 am

    I don’t think the failure of the quantity theory would have been such a mystery to those post-Keynesian economists who understand what it means for money to be endogenous.

  2. Michael Kowalik
    July 2, 2015 at 9:46 am

    One could argue that Quantity Theory of Money holds true but, rather, it is the measure of inflation that is inadequate. The asset bubbles that wee see in the real estate market are of course a form of localised inflation which is not captured by the CPI. Real estate is one of the existential needs, irrespective of wether one rents or owns a small ice of land, and so every economic agent is bound to be exposed to their price fluctuations. In regard to the shadow banking, the notion of inflation is as abstract as the financial ‘assets’ that are being traded, which often little more than cleverly disguised scams (wealth redistribution mechanisms) directed at gullible investors.

  3. July 2, 2015 at 4:21 pm

    Keynesianism as ultimate profit machine
    Comment on ‘Speculative Financial Attacks’

    Imagine that the American Onepercenters sit around a table and play poker throwing in chips that are backed one-to-one by their financial and valued real wealth. In the course of the game spectacular gains/profits are made. TV, press, youtube, and the blogs are full of stories about how A outwitted B, how C had an improbable streak of luck, how D got away with cheating, how E committed suicide after loosing all, and so on.

    From the economist’s objective perspective in this story full of sound and fury actually nothing happens but a voluntary redistribution of wealth. Nothing is created, nothing is lost. The effect on the rest of the economy is zero. Only the names attached to different pieces of wealth change.

    Of course, there are other games that may spill over to the rest of the economy and may have adverse effects on non-participants. What is important in the example above is that the gains/profits of the players are different from profits that are made in the sphere of production. The latter were the profits that Adam Smith and Karl Marx had before their eyes when they praised/condemned the capitalistic economy.

    The first point for theoretical economics is that there are two different types of markets: the product and the asset market. Both markets run on entirely different principles, hence the standard supply-demand-equilibrium explanation does not apply. To treat all markets alike is the first analytical blunder of standard economics (2011b).

    The commonplace Quantity Theory asserts a causality between the quantity of money and the prices on the product markets. The ignorance of asset markets, however, is only one of the numerous defects of the QT (2011c).

    The third point is that there are two fundamentally different types of profit, monetary and nonmonetary profit. The latter stems from the change of value of assets. The former emerges in the sphere of production (2011a). In this context it is important to realize that conventional profit theories are provable false (Desai, 2008). What has to be kept in mind is that speculative financial attacks as a rule aim at realized profits from changes in valuation of various assets. Their main effect is a redistribution of existing financial wealth among the players (2011b).

    Keynes himself, just like Walras and the rest, had no correct profit theory and because of this Post Keynesianism never realized that Keynesian policies themselves are an important source of monetary profits.

    The interrelationships are as follows (for details see 2015). The employment equation is given in the simplest case by

    The employment multiplier contains the expenditure ratio rhoE. If rhoE increases, employment L increases. An expenditure ratio rhoE>1 means deficit spending. Thus, the equation contains the Keynesian assertion that deficit spending increases employment.

    The profit equation is in the simplest case given by

    Overall monetary profit Qm of the business sector, too, depends on the expenditure ratio rhoE. Thus, this variable constitutes the link between changes of debt and profit, and in turn of changes of financial wealth. All this is quite different from a zero sum game.

    With the correct structural-axiomatic profit theory we now arrive at the remarkable result that nobody other than Keynes, the most outspoken critic of the Laissez-faire order, has in effect stabilized this order, such that the profits of the business sector increased exactly in step with the deficits of the private/public households. This, and not the redistribution games on the financial markets, led to the spectacular increase of the volume of financial wealth that Keynesians wonder about today. Overall monetary profit has nothing to do with performance or productivity but is the mirror image of the increase of debt.

    In this global game, it is the American and the Greek people who got the short end of the stick. But only the Greeks are actually aware of it.

    Egmont Kakarot-Handtke

    References
    Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume (Eds.), The New Palgrave Dictionary of Economics Online, pages 1–11. Palgrave Macmillan, 2nd edition. URL http://www.dictionaryofeconomics.com/article?id=pde2008_P000213
    Kakarot-Handtke, E. (2011a). The Emergence of Profit and Interest in the Monetary
    Circuit. SSRN Working Paper Series, 1973952: 1–22. URL
    http://ssrn.com/abstract=1973952
    Kakarot-Handtke, E. (2011b). Primary and Secondary Markets. SSRN Working
    Paper Series, 1917012: 1–26. URL http://ssrn.com/abstract=1917012
    Kakarot-Handtke, E. (2011c). Reconstructing the Quantity Theory (I). SSRN
    Working Paper Series, 1895268: 1–28. URL http://ssrn.com/abstract=1895268
    Kakarot-Handtke, E. (2015). Essentials of Constructive Heterodoxy: Employment.
    SSRN Working Paper Series, 2576867: 1–11. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2576867

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