A companion blog, The Metacognition Project, has been created to focus specifically on metacognition and related consciousness processes. Newest essay on TMP: Goals and Problems, part two

Friday, May 14, 2010

Financial Derivatives

Various people and institutions have accumulations of wealth often in considerable excess of their needs, wants and even usefulness. Two things are done with the excess that is too much to even spend in the classical sense of that venerable activity: first, as much as possible it is hidden from those who might have legal claim to it like tax collectors, and second, constant efforts are made to find places to put excess that cause its amount to increase.

This last is the especially tricky part. Money left sitting untended slowly rots away – a bit like those movies were the treasure crumbles to dust in the hand, even refrigerating it does no good. It must be (carefully, remembering the taxman) put out into the dangerous Autobahn of high speed and high stakes monetary transactions; but where?

A savings account? No, the amounts involved will not be covered by the FDIC, and the interest rates that banks pay to use the deposits are almost zero. People with great excess want it to increase on steroids and are willing to take considerable risk, especially if they can hedge their bets or even use the power of wealth to manipulate the “investment environment.” Besides, they know that banks are screwing depositors since they often own banks.

Stock market? Better! Careful selection of stocks can increase the yield and over the long term the aggregate stock value has gone up ahead of inflation. But again the amounts involved, record keeping and regulation of the stock market and the difficulty of being really ‘creative’ (read ‘manipulative’) make this option less desirable. The same can be said of the bond market.

With the traditional investment options looking less than exciting and with millions and billions of dollars that must be put into some fructifying motion, the “smart ones”, who make money by moving the excesses of others, looked and looked for all the possible ways to get that excess moving at the fastest possible speed. Investment of this excess also must be done in such a way that the return is in real wealth and as little as possible the trading of virtual wealth among the wealthy, although a certain amount of this virtual trading is required to perform the necessary slight of hand to turn virtual into real wealth.

And the question was never ‘should it be done?’; never ‘what will be the consequences?’ The only question that mattered was: ‘Will it work to protect excess wealth from rotting and also grow it very fast?’ And certainly it was never asked: ‘What is all this excess and virtual excess wealth really good for anyway?’

* * *

It is claimed that the derivatives market is too complex for ordinary pea brains to understand – only the geniuses of financial wizardry can get it. It is supposed to be like quantum mechanics combining with relativity in grand unification theory.

But that is, frankly, crap. It is actually more like the castles, cars and giant robots made of Legos that used to be seen in shopping malls; outsized, seemingly complex representations made up of many little pieces; though it is true that no ordinary human would spent the time and effort. What is not clear is how someone thought up such things, but how they actually got made is not such a mystery, more a matter of many details strung together.

In essence, a small (comparatively) amount of real wealth is given to a financial institution to write an IOU for a much larger amount of virtual wealth and various bets are made on whether the virtual wealth would be successfully turned into real wealth. The bets are made using the virtual wealth and act as a hedge that will turn some that virtual wealth into real wealth. And when this scheme failed as it must, it had grown so large and the real vs. virtual wealth so confused that the banksters could argue that the only way to not have the whole economic system collapse was for the real wealth of the general public (taxes) to cover the virtual wealth created by their bets.

That is derivatives. It doesn’t matter so much what the details of each derivative structure is or was; there is no question that they are ‘computer complex’, but they are also manipulated by those with control of the derivatives speedway like a clever dealer can manipulate a card game.

Poker is complex, so is even ‘little’ blackjack, but ultimately they are, like derivatives, gambling games. They are bets against one outcome and for a different outcome. When you bet with money you don’t actually have, the amount you bet becomes real money in the minds and behavior of the people at the table. If you win, you will be paid even if your bet was an IOU. If you lose, you have to pay off even if you had nothing but the IOU to begin with.

Derivatives and hedge funds, for all the fancy language about ‘creative financial instruments’ and ‘risk spreading to support financial innovation’, are ad hoc gambling games driven by huge excesses of both real and virtual wealth looking for some place to go (and virtual wealth ‘looking’ for the magic door to go through to become real wealth). And in this game the dealers get paid real money for writing IOUs for the players when they make leveraged bets. The players then gamble with the IOUs – some of the time treating them as real wealth and some of the time betting on whether they will become real or not (new bets invite new IOUs and so on).

On a small scale this would be like a backroom poker game with card mechanics in which the bets are made with pennies that the players get to cash-in for dollars taken from the customers in the bar out front. But derivative markets and hedge funds is a world wide game; IOUs for from 500 to 1000 trillion dollars have been written, far more wealth than the earth holds (world GDP is about 70 trillion), and are treated as a debt that the people of the earth must honor at least in part. Since the IOU holding people are the oligarchs who dominate governments, we ordinary working stiffs are being told that we have to cover the IOUs that were written, more or less, out of thin air.

Now how hard is that to understand? No matter how cloaked in legalize and economic jargon, it comes down to the excessively wealthy, believing themselves entitled, have written a number on a piece of paper and the rest of the world is supposed to honor it as if it were a tangible asset. Asked for proof of its value, we are told to look at a Lego structure of a castle.

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