When the credit crunch hit at the end of 2008, the Bank of International Settlements estimated that the derivatives market had a notional value of 1.14 quadrillion (1,140 trillion) dollars. (That estimate is now down to about 625 trillion.) The value of the entire real world economy is about 65 trillion dollars. Can a market exist that is 10 times larger than the entire world economy? Obviously, yes. So, is the derivatives market fiat currency hyper-inflation layered on top of the real world economy? If not, what is it?
First, lay out the criterion for what constitutes hyperinflation.
I second the statement that “hperinflation” must be defined prior to becoming meaningful in this context. Otherwise, one risks the trap of arguing over the definition of the word rather than the material of the question.
What the derivative market essentially was/is is over-optimized gambling, N.N. Taleb probably has the best perspective on this issue than anyone else, and if you are actually interested in learning more on this topic, listen to his appearances on econtalk with Russ Robets.
OK. Let’s use the common definition: inflation that is rising at such a high rate as to beyond control by anyone. So, by that criteria, the derivatives market can’t be hyperinflation - since it is not a loss of currency value. Still, having this elephant in the room bothers me. There is no place to sit my money down without worrying about the elephant squashing it.
I think Russ Roberts sums it up when he points to over-optimized gambling as the cause of the derivatives explosion. Public policy helped, but I don’t agree that it was the primary cause of the over-optimized gambling. I don’t recall any politician suggesting that the government should cover the bad loans of failed business. Yet, they agreed to the bailouts because they thought the sky was falling.The Clinton administration pushed to expand home ownership, as did the Bush administration after Clinton was gone. Expanding home ownership should have been OK, as property owners often take better care of the property than renters and neighborhood value goes up. The problem came when the risky sub-prime loans became part of derivative packages with AAA ratings. It was impossible to see the risks hidden in these packages, since they had AAA investment ratings. Why? Not because David X. Li came up with the Gaussian copula function. Because the credit rating agencys were eager to use any rationale to increase their business and profits. Li just gave them the tool they needed to make the sub-primes smell good to buyers. (Many of whom were poorly trained ex-clerks who had worked their way up the ladder within some government or pension fund.) The smarty pants boys on Wall Street had their way with the buyers, who thought AAA meant something. The rating agencys will say they are innocent, that they were duped by the math. Li will say he is sorry that the GPF didn’t hold up in the light of day. Probably no one will even be charged with a crime for any of this. In the end, it was just ordinary folks doing what they were paid to do - make money.
OK, my take on this.
Derivatives are nothing but insurance policies. Let’s take currency swaps. Say my company just won a major contract in Japan, and I am to receive a million yens a year form now. Those yens could be seen as a risky investment, seeing that the exchange value with to US dollars, which is what I really need, is variable. Will the rate eat up part of my profits? Will I make a gain? Do I really want to take that risk? Am I specialized in that?
I can insure myself against the eventuality of the dollar value of my future yen holdings falling by buying a currency swap, where I agree (with some bank) to exchange yens at a preset rate a year form now. At the very least, now I know that whatever loses I may incur due to the rate falling, is capped and well-known (though I still retain my full opportunity cost, and there is nothing that can be done about that).
Such are derivatives: they are used to mute or even annul the variation of prices of whatever asset you might hold: foreign currency, shares, credit interest rates, you name it.
Seen in this way, practically every decent company should hold derivatives to limit its exposure to non-primary risks (those in which it is not trying to make a profit). So, when I hear things such as ‘the derivative market is ten time bigger than the world economy’, I thing that there must be a countervailing set of assets to match those. And indeed, if one adds sup all the world traded shares, foreign currency transactions, corporate credit letter and many, many other instruments, one gets an impression that the derivative market is really only a small part of the potential assets it could cover.
And just as one does not consider shares to be money (and hence to bring inflation), one should not consider derivatives to be inflationary: they serve a purpose as they are and in themselves, and do not serve as just a fiduciary mean. They are the product, they do not represent it.
So all this talk of ‘a derivative-induced crisis’ is just scapegoating: the higher-ups just pick something that they know most people will not understand, and blame the crisis on that. Next time it will be the large hadron collider that brings the crash. Derivatives where not invented in 2001, they have existed probably as long as there has been a stock exchange. So all this media hype is just sheer nonsense.
Thank you, Merlin, for an excellent post. Can you summarize your view on the cause(s) of the 2008 credit crunch?
"I can insure myself against the eventuality of the dollar value of my future yen holdings falling by buying a currency swap, "
You can’t do any such thing. The use of the term “insuring” to describe hedging is a figure of speech that, unfortunately, has led most people to refer to its use in its literate meaning. You can’t insure against business failure. We’ve discussed this in the past and I’m not going to get into this again.
I’ll just say this. You are not insuring anything with derivatives. When they are allegedly used as instruments to hedge risk, you are really just mitigating potential losses of particular investments that you hedge against. When used as mere instruments of speculation, then the are nothing more then just that: instruments of speculation.
So, if you hold an option to sell your yens a year from now against, say, 1 cent per yen and the actual exchange rate plunges to 0.5 cents per yen, you make the exact same loss with the option as you would without it?
Good old inflation. I’ve heard somewhere that the us monetary stock was actually doubled from 2001 to 2008. What else would one need for a boom-bust cycle?