The alchemists

By William Pfaff

Friday, May 23, 2008

PARIS: The global financial market has become "a monster," responsible for "massive destruction of assets," according to the president of Germany and former head of the IMF, Horst Kohler. It "grotesquely" remunerates its executives, he added.

According to Kenneth Griffin, founder and head of the $20 billion Citadel Investment Group - one of the biggest and most successful American hedge fund companies - international finance has been functioning on the judgment of "29-year-old kids" who "control the capital markets of America ... young guys right out of business school."

In the big banks that provide universal financial services, he said in an interview published in the International Herald Tribune, the chief executives often "only understand a part of the business."

In the celebrated case of the French bank Société Générale, it appears that the head of the bank had little idea what went on in its trading rooms, where a young man, eager to earn the approbation of his superiors and a larger bonus, made trades involving sums exceeding the total worth of the bank.

Griffin says his "tentative" conclusion is that the industry needs greater regulation. To the industry outsider, regulation is needed not only because of what the CEO does not know, but because of the discrepancy between reality and the academic market-models that provided the rationale for the vast deregulation of the global economy in recent years.

As viewed from universities, the international economy is thought to be composed of well-informed individuals and companies acting rationally in their own and their customers' best interests, maximizing profit opportunities, aware of risks and managing them prudently, committed to the integrity of the system upon which they and their national economies depend.

The academic model of commodities trading does not regard speculation as a problem because any anomalies are corrected by rational consumer reactions.

Paul Krugman wrote last week in the International Herald Tribune that if the world oil price had been quadrupled by speculation, "drivers would cut back on their driving; homeowners would turn down their thermostats; owners of marginal oil wells would put them back into production."

I'm sure they would. Industry would develop Canadian shale oil, the big oil companies would resume exploration (which they have neglected) and start building new refineries, General Motors and Ford would make smaller cars, and the Japanese and Europeans who already make small cars would have booming sales.

That's what happened in the wake of the 1973 OPEC oil price crisis, which was a deliberate oil producers' boycott. By 1982 the oil price was forced down.

That experience has nothing to do with the present situation. No market speculator intends to hoard his oil until the price goes up.

Speculative trading deals in points and quarter-points. You buy a contract if the oil price is moving up, and sell it three minutes later to someone convinced it will go higher. Traders buy their contracts and spread rumors suggesting increased shortage of the commodity (not too hard to do with nonstop financial TV, which lives by reporting every scrap of news affecting commodity or stock prices). When the price begins to move, the trader unloads.

Real or rumored problems in the Nigerian oil fields, political troubles for Hugo Chávez in Venezuela, Gazprom uncertainties - all have been the stuff from which trading fortunes are made.

Futures trading in commodities originally had a necessary role in stabilizing prices. As the financial frenzy of recent years took over the big banks, the markets obliged by creating derivatives and other new instruments of trade, while the futures market retained traditionally low margin requirements.

The Chicago commodities markets, the Mercantile Exchange and the Board of Trade, merged to form a new company in order to create new trading opportunities. The volume of this year's trades - now over a million a day - is already close to the total for all 2007.

As a general rule, the margin required to buy an oil futures contract is 10 percent. Pledge $10,000 and buy $100,000 worth of oil. Or why be a piker? Put up $100,000 and buy a million-dollar contract. The price goes up one dollar five minutes later and you've made a million.

These are not transactions between producers and consumers, when the classical economic rules would function. These trades, unregulated, have virtually no useful economic role. They have become a form of parasitical professional gambling that distorts the transactions between producers and buyers.

Kohler compared the speculative bankers with alchemists, who purported to make gold from dross. It is not a bad comparison, and our contemporaries have, thus far, done better than their medieval counterparts, who often ended burned at the stake.

Source: http://www.iht.com/bin/printfriendly.php?id=13161495