New data on the size of the derivatives market have been released. There was a Reuters story last week that summarized this information. The story received no attention. It began with a paragraph almost guaranteed to avoid attracting attention.

The global derivatives market continued to grow in the second half of 2005, though at a slower pace as the market matured, the Bank for International Settlements said on Friday.

This did not sound like anything important. Surely, it was not the stuff of front-page and network news stories. But the second paragraph caught my attention.

National amounts of all types of over-the-counter contracts excluding credit derivatives stood at $285 trillion at the end of 2005, 5 percent higher than six months previously. Gross market values, or the cost of replacing all contracts, fell 12 percent to $9 trillion.

Let that number sink in: $285 trillion. That is over a quarter of a quadrillion dollars. Whenever the word “quadrillion” is applied to dollars, I think the market in question is worth considering.

This figure does not count credit derivatives. Also, because the derivatives market is international, no agency supervises it. No agency mandates that statistics of these contracts be reported under penalty of law. The Bank for International Settlements (BIS) reports the statistics it gathers, but it is not a government agency. It is the central banks’ agreed-upon clearing house.

So, the derivatives market is much larger than $285 trillion. We just don’t know how much larger.

Interest rate products saw 5 percent growth in the second half, slower than in previous years and bringing the total outstanding to $215 trillion. Growth was faster in the over-the-counter market than on exchanges, the BIS said.

The known market is so huge that for all of the participants to close out their positions and then rewrite them, the commissions would be $9 trillion.

That probably doesn’t count lawyers’ fees.

How much is $9 trillion? It is the entire product of the private sector of the United States for a year: the estimated $12.9 trillion GDP, minus the U.S. government’s $2.6 trillion, minus state and local spending/taxing.

Note: The official overview of the Bush Administration’s spending nowhere mentions the total spending figure. It offers only percentages. It provides a chart of happy-face assumptions about the reduction of the budget’s percentage of GDP that will take place between now and 2009. It does provide specific figures for popular programs, such as delightfully named “Health and Compassion.”

WHAT ARE DERIVATIVES?

Over the last two decades, the derivatives market has come to overshadow all other investment markets, yet few investors and few business owners use them or even know what they are.

Derivatives are a form of futures. People speculate on the move of interest rates and the effects that these moves will have on specific prices. To play in this market, you must have a lot of money to lose. Because margins are low, meaning leverage is high, unexpected moves in a specific market can produce huge profits for investors on one side of the contract. These gains are matched by losses on the other side.

There can be a domino effect, as losses spread for one derivative instrument to another. These instruments are specifically designed to transfer specified risks to parties that are willing to bear such risks in search of a profit.

Yet these markets allocate more than risk. They allocate uncertainty. Risk is what insurance contracts deal with: calculated losses. The law of large numbers applies to certain categories of events, such as life expectancy and fires. Uncertainty applies to types of events for which no widely known statistical formula applies.

An entrepreneur may believe that he possesses such a formula, which converts uncertainty to risk. He then enters the derivatives market and takes a position in the belief that his formula can beat the market. This is what bankrupted Long Term Capital Management in 1998. Their formula, which had been developed by a pair of Nobel Prize-winning economists, turned out to be the economic equivalent of a race track tout’s easy money system. When that pony failed to win, place, or show, large multinational banks had to pony up an additional $3 billion in loans to keep the $4.6 billion company from defaulting, which would have threatened the futures markets and the bank payments system.

On October 1, 1998, Alan Greenspan sat before the House Banking Committee and defended the decision of the head of the New York Federal Reserve Bank to call the bankers into an emergency meeting to suggest that they cough up more loan money. In his speech, he rejected the word “pressure.” New York FED officials merely “facilitated discussions.”

It was in this speech that Greenspan referred to the possibility of a worldwide financial domino effect, which he called “cascading cross defaults.”

In that environment, it was the FRBNY’s judgment that it was to the advantage of all parties — including the creditors and other market participants — to engender if at all possible an orderly resolution rather than let the firm go into disorderly fire-sale liquidation following a set of cascading cross defaults.

For some reason, this speech, which I regard as the most important public speech that Greenspan delivered in his 18 years as Chairman, has disappeared from the list of speeches by Board members on the FED’s site. You cannot find it, even if you know the year he gave it. The speeches are listed chronologically by each FED Board member. There is no speech listed for October 1, 1998. It used to be there, but no longer.

Google can locate it if you search for “Alan Greenspan” and “Long Term Capital Management.”

MORAL HAZARD

The phrase “moral hazard” refers to a condition of the not quite free market that arises when investors believe that the government or its licensed central bank will intervene in a specific market to keep it from harming the interests of investors. The belief that the government will intervene leads investors to ignore market risks. They believe that the government will bear the worst of these risks. This leads to a higher level of prices in this market, or a larger number of participants who put more of their money at risk than is warranted by the safety of the market.

Greenspan usually was content to say that moral hazard is a bad thing. He did so in his 1998 speech — briefly.

Of course, any time that there is public involvement that softens the blow of private-sector losses — even as obliquely as in this episode — the issue of moral hazard arises. Any action by the government that prevents some of the negative consequences to the private sector of the mistakes it makes raises the threshold of risks market participants will presumably subsequently choose to take. Over time, economic efficiency will be impaired as some uneconomic investments are undertaken under the implicit assumption that possible losses may be borne by the government.

But then he invoked moral hazard to justify the Federal Reserve System’s interference in the LTCM crisis. This crisis was larger than LTCM. It called into question the solvency of an entire market. Here, the price system must not be allowed to operate.

But is much moral hazard created by aborting fire sales? To be sure, investors wiped out in a fire sale will clearly be less risk prone than if their mistakes were unwound in a more orderly fashion. But is the broader market well served if the resulting fear and other irrational judgments govern the degree of risk participants are subsequently willing to incur? Risk taking is a necessary condition for wealth creation. The optimum degree of risk aversion should be governed by rational judgments about the market place, not the fear flowing from fire sales.

What is a “fire sale”? He did not say. Apparently, it is any sale in which losses will spread to a large segment of the capital markets. But the question remains: Who is competent to judge when a fire sale has begun? Greenspan elsewhere insisted that no one knows when there is a bubble market. How can central bank officials know when a sale is a fire sale?

In other words, he was arguing that the free market is just not good enough. What is needed is intervention by wise men who have access to fiat money.

He argued that moral hazard does not apply when the goal of the intervening agency’s officials is to keep fear from spreading inside a highly leveraged, low-margin market, which the futures market surely is.

The Federal Reserve provided its good offices to LTCM’s creditors, not to protect LTCM’s investors, creditors, or managers from loss, but to avoid the distortions to market processes caused by a fire-sale liquidation and the consequent spreading of those distortions through contagion. To be sure, this may well work to reduce the ultimate losses to the original owners of LTCM, but that was a byproduct, perhaps unfortunate, of the process.

Six months later, Greenspan told that same House committee that bank account deposit insurance, i.e., the FDIC, is an example of moral hazard at work. First, he explained the nature of moral hazard.

The benefits of deposit insurance, as significant as they are, have not come without a cost. The very process that has ended deposit runs has made insured depositors largely indifferent to the risks taken by their depository institutions, just as it did with depositors in the 1980s with regard to insolvent, risky thrift institutions. The result has been a weakening of the market discipline that insured depositors would otherwise have imposed on institutions. Relieved of that discipline, depositories naturally feel less cautious about taking on more risk than they would otherwise assume. No other type of private financial institution is able to attract funds from the public without regard to the risks it takes with its creditors’ resources. This incentive to take excessive risks at the expense of the insurer, and potentially the taxpayer, is the so-called moral hazard problem of deposit insurance.

Second, he raised the question of that most feared of all economic conditions, systemic risk.

Thus, two offsetting implications of deposit insurance must be kept in mind. On the one hand, it is clear that deposit insurance has contributed to the prevention of bank runs that could have destabilized the financial structure in the short run. On the other, even the current levels of deposit insurance may have already increased risk-taking at insured depository institutions to such an extent that future systemic risks have arguably risen.

Third, he justified the need for government regulation of a government-protected market, since the protection — or perception of protection — undermines the free market’s phenomenon of self-policing.

Indeed, the reduced market discipline and increased moral hazard at depositories have intensified the need for government supervision to protect the interests of taxpayers and, in essence, substitute for the reduced market discipline. Deposit insurance and other components of the safety net also enable banks and thrift institutions to attract more resources, at lower costs, than would otherwise be the case. In short, insured institutions receive a subsidy in the form of a government guarantee that allows them both to attract deposits at lower interest rates than would be necessary without deposit insurance and to take more risk without the fear of losing their deposit funding. Put another way, deposit insurance misallocates resources by breaking the link between risks and rewards for a select set of market competitors.

The problem with this argument in the capital markets today is that there is no government agency that regulates the derivative markets. If that is what is needed to overcome moral hazard — I mean other than removing the cause, government intervention in the first place — then what protects the world from systemic risk of a bank payments gridlock?

FAITH IN CENTRAL BANK INFLATION

Modern capital markets rest on the assumption that central bank’s monetary policies should, can, and will protect investors from a systemic breakdown.

The modern division of labor has come into existence because investors have faith in two factors: (1) the free market’s ability to allocate risk and uncertainty in an efficient manner; and (2) central banks’ ability to insure against the breakdown of the fractional reserve banking system. In other words, investors believe that systemic risk can be mitigated by central banks. Or, more to the point, investors believe that the inherent risk of fractional reserve banking can be overcome by the concerted intervention into the capital markets by central banks.

Greenspan in 1998 warned Congress about cascading cross defaults. Cascading cross defaults impose the threat of gridlock on the bank payments system — the ultimate fire sale.

Investors today believe that Milton Friedman was correct in his 1963 book, A Monetary History of the United States. They believe that the Federal Reserve System could have intervened to save the American banking system from a wave of bankruptcies in 1929—32.

It is not just investors who believe this. Most economists also believe it. Most important, Ben Bernanke believes it. He said so in his 2002 speech congratulating Friedman on his 90th birthday. I have never seen any more laudatory review of Friedman’s book. He wrote that “the direct and indirect influences of the Monetary History on contemporary monetary economics would be difficult to overstate.” He was quite correct in this assessment.

Today I’d like to honor Milton Friedman by talking about one of his greatest contributions to economics, made in close collaboration with his distinguished coauthor, Anna J. Schwartz. This achievement is nothing less than to provide what has become the leading and most persuasive explanation of the worst economic disaster in American history, the onset of the Great Depression — or, as Friedman and Schwartz dubbed it, the Great Contraction of 1929—33.

Bernanke identified the book’s major discovery: “the Great Depression can reasonably be described as having been caused by monetary forces.”

Rothbard made the same argument in America’s Great Depression, also published in 1963. But his book was ignored by the academic world for the opposite reason that Friedman’s was accepted: He showed that the FED’s policies in the 1920s had caused the boom, which produced the bust when the FED ceased inflating. Friedman’s book was a call for further FED inflation. Rothbard’s was a call for no more inflation. It is available free of charge here.

The cause of the depression, as Bernanke described Friedman’s conclusion, was the gold standard.

Friedman and Schwartz’s insight was that, if monetary contraction was in fact the source of economic depression, then countries tightly constrained by the gold standard to follow the United States into deflation should have suffered relatively more severe economic downturns. Although not conducting a formal statistical analysis, Friedman and Schwartz gave a number of salient examples to show that the more tightly constrained a country was by the gold standard (and, by default, the more closely bound to follow U.S. monetary policies), the more severe were both its monetary contraction and its declines in prices and output. One can read their discussion as dividing countries into four categories.

The tragedy, according to Friedman, was that Benjamin Strong, the head of the New York FED, died in 1928. Strong could have staved off the great contraction. Bernanke believes this: “Friedman and Schwartz argued in their book that if Strong had lived, many of the mistakes of the Great Depression would have been avoided.” Rothbard’s book shows that it was Strong, in association with his close friend, Montagu Norman, the head of the Bank of England, whose policies created the boom.

Then Bernanke told us in 2002 what he and the world’s central bankers have learned from Friedman.

For practical central bankers, among which I now count myself, Friedman and Schwartz’s analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman’s words, a “stable monetary background” — for example as reflected in low and stable inflation.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna:

Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

The reigning assumption in this speech is obvious:

Central banks can offset systemic risks in a market, thereby transforming them into nonsystemic risks. Money creation is the ultimate risk-reducing tool.

WARREN BUFFETT’S WARNING

In the 2002 Annual Report of Berkshire Hathaway, Warren Buffett’s famous firm, he issued a warning on derivatives. He said they are like hell: easy to get into, but difficult to get out. He warned of systemic failure.

Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

Buffett might ask today: “Given the size of the derivatives market — over $285 trillion — what world central bank could deal with cascading cross defaults?”

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

[Close associate] Charlie [Munger] and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

The derivatives market is much larger today than it was in 2002.

CONCLUSION

The problem today is simple to state but difficult to solve: The derivatives market is huge. It is far beyond the ability of any or all central banks to solve, once cascading cross defaults spread to the international bank payment system. The modern division of labor, which keeps billions of people alive, has a sword of Damocles above it: the threat of fractional reserve banking’s gridlock in a wave of defaults. This is the ultimate fire sale.

The combination of moral hazard, fractional reserve banking, faith in central banking, and speculators’ desire to make a bundle of money from highly leveraged futures contracts has created a time bomb condition.

Bernanke, following Milton Friedman, thinks that a government-licensed monopoly, the Federal Reserve System, can overcome cascading cross defaults. He has bet your life on this.

I hope he wins the bet. But I always keep assets on the other side of the table.

May 24, 2006

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