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Derivatives: Facts and Fallacies by Michael S. Rozeff
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Comments?
To worry or not to worry
Derivatives scare many people. They don’t know what they are, or they may be quite unfamiliar with them. They don’t know how they work, and it’s not easy to learn. The amounts tossed around are fantastically huge. Most are traded behind the scenes. They are purchased in margin accounts, and this worries the untutored. Mysterious bankers, corporations, and dealers handle them mostly. Then there are the unnamed speculators and hedge funds. People worry about the financial system melting down. They worry about chains of bankruptcies. Sometimes there are big failures like Enron or Barings Bank or Orange County. People get scared. Regulation seems lax. Accounting for derivatives is tough and highly technical. Deciphering derivatives in footnotes of annual reports is unpleasant. People worry and worry, and there seem to be many reasons to worry. When they’re not worrying, they’re predicting disaster.
The worry is greatly overdone. Derivatives are worth some thought for investors, but they’re a side show. They’re the tail, not the dog. The tail won’t wag the dog. They’re worth some concern, but not too much. There are more important issues to worry about. (See Callahan and Kaza for another readable and useful introduction and defense of derivatives.) The degradation of responsible accounting because of government interference is a bigger concern. The Fed’s too big to fail policy is a bigger concern. The root causes of bear markets are a bigger concern.
Monetary causes of bear markets
Stocks and bonds will again have their bear markets. Economies will recess and even depress. Trade cycles will cycle. Debts will deflate. Bankruptcies will rise. So will unemployment. Teeth will be gnashed. Hardship will spread. Times will be hard. Rhetoric and the blame game will boom. Austrians will be cleared of all charges of being bears. The depression may even merit the words Great II. Who knows when? Whenever this happens or some facsimile thereof, fingers will point at derivatives. They shouldn’t. They should point elsewhere at basic causes such as the banking system, currency disruptions, wars, and benighted government policies that produce large economic dislocation. The big bear markets of the past nearly always have been associated with these sorts of causes. The press won’t blame government policies as it should, or the Federal Reserve, or the perils of fractional reserve banking. It will blame the tail, not the dog.
It’s happened before. The Congressional Pecora hearings in 1932 sought blame for the Wall Street crash and the Great Depression in Wall Street practices. They focused the spotlight on various Wall Street figures. Did these practices and people, shady or innocent, cause what happened to the economy? This defied fact and reason, but it satisfied the political lust for convenient scapegoats in reflection of voter anger. It led to new government regulations and agencies such as the SEC. The stock market crash on October 19, 1987 produced a similar result. The blame was shifted to program trading, to portfolio insurance, and to arbitrage. However, the crash began in Hong Kong which had none of these mechanisms at work. Crashes and price movements in general are notoriously hard to explain, but in this case the evidence points clearly to concerns about the international currency system. The latter was one of the basic causes at work in 1929 and again in 1972–74. After several such experiences and others in the nineteenth century, we have every reason to believe that monetary concerns are often central to bear markets. This important fact is not as widely known or appreciated as it should be.
Derivatives are like the cans of tomato soup moving along a conveyor belt in a factory, or so we can imagine. The cans move from one place to another on a conveyor belt. The farmer’s tomatoes at the beginning end up inside cans being shifted to consumers at the other end. In our system, derivatives move risk and return from one person to another. This is done smoothly along a financial conveyor belt consisting of financial markets. It all works very smoothly. If the tomatoes go sour, don’t blame the cans or the conveyor belt. If the boss turns off the electricity or the machine breaks down, don’t blame the cans or the conveyor belt. When the government throws sand into the economic machinery or revs it up too fast, don’t blame derivatives for currency and banking problems.
When financial markets again run into widespread and severe trouble, the root causes won’t include derivatives although they may be blamed. Derivatives are a highly successful free market invention. They provide a model for how free markets can govern themselves and how they can quickly correct the errors that are bound to occur. And there have been some notable errors and failures, which, however, were absorbed and didn’t unhinge the economy. No, look instead to government policies, politics, catastrophes, and/or major economic causes, especially emanating from the monetary system, that trigger major losses in market values. If derivatives play a role in these declines, they will reflect other more fundamental causes.
Bank failures and derivatives
.
.
.
Derivatives scare many people. They don’t know what they are, or they may be quite unfamiliar with them. They don’t know how they work, and it’s not easy to learn. The amounts tossed around are fantastically huge. Most are traded behind the scenes. They are purchased in margin accounts, and this worries the untutored. Mysterious bankers, corporations, and dealers handle them mostly. Then there are the unnamed speculators and hedge funds. People worry about the financial system melting down. They worry about chains of bankruptcies. Sometimes there are big failures like Enron or Barings Bank or Orange County. People get scared. Regulation seems lax. Accounting for derivatives is tough and highly technical. Deciphering derivatives in footnotes of annual reports is unpleasant. People worry and worry, and there seem to be many reasons to worry. When they’re not worrying, they’re predicting disaster.
The worry is greatly overdone. Derivatives are worth some thought for investors, but they’re a side show. They’re the tail, not the dog. The tail won’t wag the dog. They’re worth some concern, but not too much. There are more important issues to worry about. (See Callahan and Kaza for another readable and useful introduction and defense of derivatives.) The degradation of responsible accounting because of government interference is a bigger concern. The Fed’s too big to fail policy is a bigger concern. The root causes of bear markets are a bigger concern.
Monetary causes of bear markets
Stocks and bonds will again have their bear markets. Economies will recess and even depress. Trade cycles will cycle. Debts will deflate. Bankruptcies will rise. So will unemployment. Teeth will be gnashed. Hardship will spread. Times will be hard. Rhetoric and the blame game will boom. Austrians will be cleared of all charges of being bears. The depression may even merit the words Great II. Who knows when? Whenever this happens or some facsimile thereof, fingers will point at derivatives. They shouldn’t. They should point elsewhere at basic causes such as the banking system, currency disruptions, wars, and benighted government policies that produce large economic dislocation. The big bear markets of the past nearly always have been associated with these sorts of causes. The press won’t blame government policies as it should, or the Federal Reserve, or the perils of fractional reserve banking. It will blame the tail, not the dog.
It’s happened before. The Congressional Pecora hearings in 1932 sought blame for the Wall Street crash and the Great Depression in Wall Street practices. They focused the spotlight on various Wall Street figures. Did these practices and people, shady or innocent, cause what happened to the economy? This defied fact and reason, but it satisfied the political lust for convenient scapegoats in reflection of voter anger. It led to new government regulations and agencies such as the SEC. The stock market crash on October 19, 1987 produced a similar result. The blame was shifted to program trading, to portfolio insurance, and to arbitrage. However, the crash began in Hong Kong which had none of these mechanisms at work. Crashes and price movements in general are notoriously hard to explain, but in this case the evidence points clearly to concerns about the international currency system. The latter was one of the basic causes at work in 1929 and again in 1972–74. After several such experiences and others in the nineteenth century, we have every reason to believe that monetary concerns are often central to bear markets. This important fact is not as widely known or appreciated as it should be.
Derivatives are like the cans of tomato soup moving along a conveyor belt in a factory, or so we can imagine. The cans move from one place to another on a conveyor belt. The farmer’s tomatoes at the beginning end up inside cans being shifted to consumers at the other end. In our system, derivatives move risk and return from one person to another. This is done smoothly along a financial conveyor belt consisting of financial markets. It all works very smoothly. If the tomatoes go sour, don’t blame the cans or the conveyor belt. If the boss turns off the electricity or the machine breaks down, don’t blame the cans or the conveyor belt. When the government throws sand into the economic machinery or revs it up too fast, don’t blame derivatives for currency and banking problems.
When financial markets again run into widespread and severe trouble, the root causes won’t include derivatives although they may be blamed. Derivatives are a highly successful free market invention. They provide a model for how free markets can govern themselves and how they can quickly correct the errors that are bound to occur. And there have been some notable errors and failures, which, however, were absorbed and didn’t unhinge the economy. No, look instead to government policies, politics, catastrophes, and/or major economic causes, especially emanating from the monetary system, that trigger major losses in market values. If derivatives play a role in these declines, they will reflect other more fundamental causes.
Bank failures and derivatives
.
.
.
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