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ECONOMICS

Best of 2012: The upside down world of global capital

  • 09 January 2013

The unfairness of the global financial crisis has been hard to miss. Greek pensioners impoverished, American home owners bankrupted, unemployment throughout the developed world soaring. And the worst that seems to happen to bankers and financiers is a loss of their oversized bonuses, and even that has not happened often.

How has such injustice been allowed to develop?

Imagine the global financial markets as a block of flats. On the first floor is the 'real' economy, the commercial exchange of goods and services. This equals about $50 trillion, with growth increasingly coming from developing economies because Europe, the US and Japan are experiencing declining growth rates.

The second floor is the conventional world of money: bank lending, shares, land, bonds. It is about $350 trillion, according to the McKinsey Global Institute.

The third floor is derivatives. These are complex financial instruments 'derived' from more conventional forms of money (that is, it sits on the second floor). It is possible, for instance, to take out a derivative, such as a futures contract, to bet on the direction of a company's shares on the stock exchange. This 'derived' trade can create much larger profits or losses than would be possible with the actual shares and may not even require buying or selling the actual shares.

The initial catalyst for the GFC was the failure of a derivative called collateralised debt obligations (CDOs). These were derived from conventional mortgages. The mortgages were securitised (aggregated into a security), and the bits sold off around the world. When things went wrong, it was realised that the CDOs were not like a normal mortgage secured against the underlying property. No-one knew what the lines of ownership and accountability were any more. That uncertainty led to a collapse of trust in the system and the crisis.

Derivatives are not new. They have long been used to hedge (price insure) commodities like wheat and pork bellies. But over the last 15 years their usage has increased dramatically. Changes initially made by US president Bill Clinton and reinforced by former US Federal Reserve chairman Allan Greenspan allowed financial institutions and traders to grow spectacularly.

The Bank for International Settlements estimates that the global stock of derivatives is over $700 trillion.

The construction of the global capital markets is thus looking a little top heavy, not to mention unstable. The third floor is twice the size of the second floor, and 14 times the first floor.

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