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Wednesday, April 21, 2010

Derivatives: Less Theory, More Facts... and More Capitalism, Please!

In response to my Monday post on derivatives reform, Troy Jones appears to assert that unregulated derivatives are good for the economy, providing "lubrication to the system's liquidity."

Lubrication, heating oil...

Sean Cota runs a family-owned heating oil business in Vermont. He says using derivatives purely to speculate on the price of oil has hurt his business and consumers' wallets.

SEAN COTA: We calculate that this unregulated market has encouraged speculative fervor that costs about a $1 per gallon.

[Brett Neely, "Businesses Differ on Derivatives Reform," Marketplace, 2010.04.20]

Neely's report pokes some other holes in the theoretical capitalist defense of unregulated derivatives, which seems about all the GOP can muster as it fights this latest really good idea from Democrats. Neely notes that derivatives were "boring and safe" for centuries. Deregulation happened only in 2000. Hmm... credit was plenty liquid in the twentieth century, wasn't it?

Neely also notes that, under deregulation, derivatives have operated in a distinctly uncapitalist fashion. Outside of exchanges, banks set prices, keep them private, and prevent buyers from getting information about the risk involved. Capitalism requires a free flow of information right alongside capital. But the big five banks that control most of the derivatives don't want us to get information and compare prices:

Because there's not efficient pricing [in the current system], these big five derivatives dealers can really charge through the roof for these derivatives products and that's one big reason why they've been so profitable [David Min, quoted in Neely, 2010].

Neely finds a good capitalist from the Chamber of Commerce to defend unregulated derivatives:

The whole point of the exercise is to transfer that risk somewhere else so that you can be in the business of producing beer or making widgets or whatever it is you do [David Hirschmann, quoted in Neely, 2010].

Hold on: transfer the risk?! I thought risk was an inherent and necessary part of being in business. You don't get to make beer or widgets without risk. If I choose to produce art or make speeches for a living, I don't get to transfer my risk to someone else. I assume the risk that people just won't buy enough of what I'm selling to keep me in paint and shiny shoes... right?

Perhaps I misunderstand capitalism. But the more I listen to conservative arguments against regulating derivatives, the more I hear a vague theoretical declarations that ignore the facts of what unregulated derivatives have wrought. In practice, unregulated derivatives look like an inherently anti-capitalist financial product, one that withholds the information buyers need to make good choices, removes the risk the market needs to check unwise actions, and threatens the stability of the free market economy.

"Boring and safe"—that's what derivatives regulation gets you. And after the excitement of seeing your mutual funds wiped out in the recession, couldn't you use some boring and safe?

Update 17:02 CDT: Senator Grassley from Iowa joined 12 Dems on the Senate Ag committee in approving derivatives regulation today. Grassley is no Olympia Snowe; his vote may be a sign that Republicans see it's time to stop saying no to ideas that will be good for the economy.


  1. Cory,

    I see you can't let this lie despite your limited understanding of the entire financial situation. It is unwise to look at derivatives as a single item to be dealt with but it must be part of the whole.

    There are grains of truth and good understanding of the nuggets you reference but the problem is not with the products but the reality we have too much power and risk concentrated in a few large banks.

    I opposed the "deregulation" that occurred with Gramm Leach but this proposal is not a return to the world prior to Gramm Leach but actually an institutionalization of the big banks and protects their position in the marketplace.

    If the proposal was to repeal Gramm Leach, I'd be for it. I am opposed to this fiasco.

  2. Oh, boy. Here I go again, poking my nose into a conversation I'm probably not qualified to discuss. But hey, this is a blog, right? So here goes.

    Troy, doesn't the proposed law provide better protection by creating a mechanism whereby the banks, not the government (the people) have to put up the money to cover their losses?

    I suppose your point might be that this drain of capital makes less available for loans, but isn't part of the problem that they're not loaning now because trading in derivatives is by far less risky and more profitable?

    And finally, doesn't the proposed new law provide the very mechanism by which the banks will be broken up and sold off in chunks should they fail again?

    So in essence, doesn't the proposed new law seem to offer the very protections and consequences you say you're looking for?

  3. Bill,

    I don't think our goals are different. I just think this bill is designed to institutionalize the power of the largest banks. The problem started with Gramm-Leach yet nobody is willing to go there. Instead, they just implement a cobbled together "reaction" to give the appearance of doing what we want.

    As much as you think it will decrease risk to the taxpayer, it actually increases it. We bailed out AIG even though it wasn't federally insured. We will do it again.

    Why wait til they fail to break them up. Too big to fail means they are too big.

  4. How, Troy? Who can do it? Obama? Congress?

  5. (...this is BF looking up "Gramm-Leach...)

  6. Okay, got it. Repealing Grahm-Leach would break them up automatically. They couldn't be both banks AND insurance companies. But how would that affect the sale of shady derivatives?

    i.e. don't the other measures in the bill still make sense?

    (I really do get your point Troy. Why do you suppose Congress and Geithner won't "go there?")

  7. In the old days, we had hundreds of investment banks staking our expertises in all facets of financial products. This diversity and competition was de facto unregulated mitigation of risk.

    I don't care if companies who screw up fail. What I care about is failures that has ripple effects beyond the stockholders. This makes the aggregation of financial products in these largets banks so risky. No regulation will prevent the next "bubble" or failure. It is necessary in a capitalist economy. What we can't have is the failure affect beyond stockholders.

    Finance depends on liquidity and fluidity. Regulation and oversight are by definition impediments to both. If we can achieve our goal (remove systemic risk to the system) without regulation, our system will be safer and more dynamic/effective.

    Liquid financial markets helps the economy, jobs and the poor.

  8. Risk is for the little guy or the American taxpayer. UBS and Goldman Sachs are able to transfer their bad debt to AIG who then are bailed out by Joe Blow taxpayer.

    We do not need more laws, if they lose money and don't have the capital to back it up, let them fail.

    We have used car salesmen in South Dakota who could negotiate better than our own Senators with these bankers.

  9. Thad, I suspect the used car dealers would fold as well, with all the money floating around on this. The huge lobby effort makes me skeptical that anything meaningful will come of it.


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