EPILOGUE

THE CASE OF THE ROGUE

E C O N O M I S T S

the ideas of economists and political philosophers, both when

they are right and when they are wrong, are more powerful than

is commonly understood. Indeed, the world is ruled by little

else. Practical men, who believe themselves to be quite exempt

from any intellectual influences, are usually the slaves of some

defunct economist. Madmen in authority, who hear voices in

the air, are distilling their frenzy from some academic scribbler

of a few years back.

John Maynard Keynes,

The General Theory (1936)

Privatisations and stock market capitalism were essential components of the new world order after the disintegration of the Soviet Union. The opening of new stock markets from Warsaw to Mongolia, the free movement of capital, and the unfettered trade in foreign currencies that characterised the early 1990s were welcomed by economists and Western politicians alike. After centuries of controversy, it appeared that speculation had finally achieved respectability‑according to the authors of a history of Wall Street, published in 1991:

Now, however, no opprobrium beclouds the activities of those who seek stock that will show the greatest price increase over the shortest time period, precisely that for which the old‑time speculators were condemned. Speculation has come of age; it can sit quite comfortably side by side with investment; and


it is as legitimate and necessary as the securities markets

themselves.1

In economics text‑books, speculators were now portrayed as benign economic agents who helped markets assimilate new information and made markets efficient. According to modem economic theory, speculators serve to increase the productive capacity of an economy by providing liquidity in the financial markets, thus reducing the cost of capital for companies. The benefits they bring are not confined to the domestic economy. Their resourcefulness and ingenuity take speculators abroad, where they bring liquidity to the stock markets of developing nations. Again, the effect of speculation is to provide capital for local companies, promote growth, and contribute to the optimal allocation of resources on a global basis.2

Speculators are credited with assuming the risks inevitable to the capitalist process. In the early 1950s, Professor Julius Grodinsky of the Wharton School of Business remarked that “investors in common stocks ... are the genuine risk bearers in the system of capitalism and free enterprise. . . [as] nobody knows what future profits will be.” 3 The speculator's appetite for growth stocks enables the entrepreneur to raise capital in the stock market (what has recently been called "IPO capitalism").* More companies are founded as a result. Speculators may lose money on occasion but the economy as a whole prospers by their activities. Professor William Sharpe, a Nobel laureate, has argued that the increased appetite of Americans for stock market risk in the 1990s was producing a more dynamic economy. Federal Reserve Chairman Alan Greenspan agreed. In November 1994, he announced: “The willingness to take risk is essential to the growth of a free market economy ... If all savers and their financial intermediaries invested only in risk‑free assets, the potential for business growth would never be realized.” 4

Speculators also scrutinise the policies of governments to judge whether they are sustainable or evenwise. They make politicians accountable to the people. In an interview with the Financial Times

* IPO stands for “initial public offering,” the American term for a stock market flotation.


in November 1997, the Chinese dissident leader Wu’er Kaixi claimed that the establishment of the stock market in China was creating a civil society: "The stock market has that magic power that makes people concerned about the country's economic policy ... once the will of the people is awakened, they will not sleep again.”5 In the early 1990s, Britain was sunk in a recession that appeared to be without end. It was caused by her political masters linking sterling to a basket of European currencies dominated by the deutsche mark. Owing to the inflationary effects of German reunification, this policy inflicted on the British economy far higher interest rates than domestic conditions warranted. On Wednesday, 16 September 1992, the financier George Soros, manager of the Quantum Fund, came to the rescue of British industry by taking massive bets against sterling, thus forcing a devaluation and knocking Britain out of the European Rate Mechanism. This resulted in lower British interest rates and was followed soon after by economic recovery. “Black Wednesday,” on reflection, became “White Wednesday,” a day to celebrate.

Speculators also serve to discipline the behaviour of corporate managements, making them more accountable to their shareholders. They seek out value, rewarding companies which create value with high share prices and punishing companies that fritter away their shareholders’ funds with low share prices. Out of this has emerged the cult of “shareholder value,” the management fad of the 1990s, which asserts that executives’ prime consideration should be their companies’ share price. Because the interest of management is nowadays more closely aligned with shareholders through executive stock‑option schemes, speculators effectively determine the level of management compensation. They hold the whip and will crack it when necessary.

TREND‑FOLLOWING SPECTULATION

These arguments in favour of speculation are predicated on the assumptions that markets are inherently efficient and that the actions of speculators are both rational in motivation and stabilising in effect. The Efficient Market Hypothesis rests on the observation


that stock movements are unpredictable since, at any moment, shares reflect all information relevant to their value, so that their prices change only on the receipt of new information which by its nature is random. As we have seen, this so‑called random walk theory is incompatible with the notion of stock market bubbles, since during bubbles investors react to changes in share prices rather than new information relating to companies’ long‑term prospects (what economists call the “fundamentals”). Such behaviour is termed “trend‑following,” and there is ample evidence that it has been a key feature of the financial markets in the 1990s.

In the American stock markets, trend‑following speculation has recently acquired a new name: it is called “momentum investment” and has been popularised by best‑selling investment books which advise buying stocks that are rising and selling those that are falling (these stocks are said to exhibit, respectively, high and low “relative strength”).* Momentum investment has acquired a multitude of followers, particularly among the Internet day traders who use their immediate access to the market to execute lightning trades. This strategy has produced great volatility in individual stocks, especially those of high‑tech companies, which have become the speculative "footballs' of the late twentieth century.

Recent experience suggests that foreign currency markets are also dominated to an unhealthy degree by the trend‑following behaviour of professional traders who have the ability to create self‑fulfilling currency crises. When a financial crisis afflicts an emerging‑market nation, foreign exchange dealers rapidly reexamine the economic situation of its neighbours. They realise that if one of these countries were to suffer from a loss of confidence, interest rates would have to rise to protect the exchange rate. Fligher interest rates, in turn, would exacerbate any fiscal weakness of the govermnent, by increasing its cost of borrowing, and also cause local asset prices to fall. damagino, local banks and businesses. The net result of these events might lead to a currency devaluation, possibly accompanied bv a full‑scale financial crisis if banks and local businesses have borrowed

*The two leading investment books that propose momentum investing as the optimal investment strategy are James P. O’Shaughnessy’s What Works on Wall Street and The Motley Fool Investment Guide. both published in 1996.


excessively in foreign currencies. Thus, a nation which is otherwise sound can have its economy seriously damaged by a sudden and contagious loss of confidence. Having weighed these considerations, traders realise there is little to gain by continuing to hold the currency of such a country‑selling the currency short becomes, in trading terminology, a “no‑brainer.”

The ability of trend‑following speculators to create self‑fulfilling prophecies was witnessed after the Mexican crisis of late 1994, when a crisis of confidence swept through other emerging markets. The so‑called Tequila effect came to an end only after the United States and the International Monetary Fund arranged a massive bailout for Mexico. Just over two years later, the devaluation of the Thai baht, in the summer of 1997, sparked off currency devaluations and stock market crashes across East Asia, even though some economists asserted that the loss of confidence was not justified by economic “fundamentals.”* However, as the Asian crisis brought high interest rates, bankruptcies, unemployment, and economic chaos to the afflicted nations, economic conditions soon changed and the loss of confidence was retrospectively validated.† It appeared that Soros’s notion of reflexivity, where investors’ perceptions serve to shape reality, was at work.

Efficient marketers claim that foreign currency crises arise only when governments pursue poor policies, such as Britain's excessively high interest rates in 1992 or Russia's failure to collect taxes in 1998. In particular, they argue that foreign currency pegs are an open invitation to speculators, who probe any weakness they can

* Jeffrey Sachs and Steven Radelet argue that the Asian crisis of 1997 was caused by foreign creditors acting not on economic fundamentals but on what they believed other creditors would do. (“The East Asian Financial Crisis: Diagnosis, Remedies, Prospects,” Harvard Institute for International Development, spring 1998.)

† Dr. Mahathir, the Malaysian prime minister, presented his case against foreign currency trading to the W/World Bank meeting in September 1997: “When they [Western speculators] use their big funds and massive weight to move shares up and down at will, and make huge profits from other manipulations, then it is too much to expect us to welcome them . . . Other than profits to the traders involved there is really no tangible benefit for the world from this huge trade. No substantial jobs are created, nor products or services enjoyed by average people ... I am saying that currency trading is unnecessary, unproductive and immoral. It should be made illegal.”


find. Yet it is not only countries with currency pegs that have suffered from the herdlike activities of foreign exchange traders. Professor Paul Krugman of the Massachusetts Institute of Technology recently observed that the appreciation of the yen (an unmanaged currency) against the dollar from 120 in 1993 to 80 in 1995, and its subsequent decline to 120 in 1997, appeared to be the result of traders riding a trend rather than a reflection of changing economic fundamentals. The rise of the yen was extremely damaging to the Japanese economy at a time when the country could ill afford it.6 George Soros has claimed that “in a freely fluctuating exchange rate system, speculative transactions assume progressively greater weight and, as they do, speculation becomes more trend‑fol.lowmig in character, leading to progressively greater swings in exchange rates.”7

DANGEROUS DERIVATIVES

According to most finance professors, derivatives perform a vital function in the capitalist system. In the age of floating exchange rates which has followed the collapse of the Bretton Woods system, derivatives enable businesses to hedge their risk exposure and increase production. Professor Merton Mi1ler, a Nobel laureate and a zealous defender of derivatives, observed recently that “contrary to the widely held perception, derivatives have made the world a safer place not a more dangerous one.” 8 Federal Reserve Chairman Alan Greenspan also enthusiastically supported the unregulated growth of the derivatives market.* Yet the economists’ claim that derivatives are simply “risk management tools” does not withstand scrutiny.

* Greenspan has argued that derivatives create the most efficient mechanism for directincapital to the most suitable users at the lowest cost: “It is a system more calibrated than before to not only reward innovation but also to discipline the mistakes of private investment or public policy.” In the summer of 1998, Greenspan claimed that “dramatic advances in computer and telecommunications technologies” had combined with “a marked increase in the degree of sophistication of financial products” to direct effectively “scarce savings mito our most potentially valuable productive capital assets” (reported in Barron’s. 28 September 1998).


Such is the baffling complexity of many new derivatives products that even George Soros has declared that he used derivatives sparingly because he could not understand how they function.* Financial risks that were formerly well understood have become arcane,† Soros and others have argued that many new derivatives serve no purpose other than to facilitate speculation‑in particular, enabling fund managers to circumvent prudential restrictions on their investments.‡ What conceivable risk exposure, it has been asked, is a “LIBOR‑cubed swap”—a security that multiplies by three times changes in the London Interbank Offered Rate, the rate of interest in the wholesale money market—designed to hedge? 9 And to what bona fide purpose is a “Texas hedge,” a combination of two related derivatives positions whose risk is additive rather than offsetting?

Over‑the‑counter options may also pose a threat to the investment banks that issue them. At the end of 1996, ten U.S. banks had nearly $16 trillion worth of derivatives on their books. These banks must continually hedge their positions by buying and selling the underlying’ assets (i.e. shares, bonds, and currencies) from which the options derive their value. This activity, known as “Dynamic” or “Delta hedging,” requires the banks to sell the underlying assets when prices decline and buy when they rise. Soros warned that Delta hedging sales during a market panic might

* In April 1994, Soros told the House Banking Committee that “there are so many of them [derivatives] and some of them are so esoteric that the risk involved may not be properly understood even by the most sophisticated investor, and I’m supposed to be one. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would not otherwise be permitted to take.” (Cited by Richard Thomson, Apocalypse Roulette, London, 1998, p. 107.)

†Richard Thomson observes that a great deal of activity in the derivatives market is otiose: “the effect is to chop up risks that people are familiar with and understand quite well, only to repackage them into new risks that are at best poorly understood.” (Apocalypse Roulette, p. 261.)

‡These suspicions were vindicated by the bankruptcy of the municipality of Orange County, California, in December 1994. Orange County's losses of $1.7 billion derived from the activities of its septuagenarian treasurer, Bob Citron, who had bought a variety of derivative bond hybrids, known as structured notes. Although Citron reportedly had the math skills of a schoolboy, he had turned to derivatives to avoid prudential restrictions on his investments and to leverage his portfolio.