One of the themes I developed in my 2010 book, “Inflated: How Money & Debt Built the American Dream,” is the idea that significant amounts of the reported GDP and employment of the post-WWII period and especially since the 1980s has been based upon debt and inflation. The debt-deflation crises today affecting both the US, EU and even China and other “emerging” nations seems to confirm this view.
Two of the key symptoms we should consider to support this thesis regarding the role of inflation and debt in the industrial economies are 1) the rise of fair-value accounting and 2) the increase of derivatives, especially derivatives that settle in cash and have no direct link to any cash markets.
In an important paper by Mingzhe Yuan and Huifeng Liu of Shandong University, “The Economic Consequences of Fair Value Accounting,” the authors note there are two fatal intrinsic flaws of fair-value accounting:
One flaw concerns its non-complete existence, that is, the required fair value may not exist under certain conditions. One direct consequence of the flaw is that a huge fair value trap may be created by fair-value accounting when the fair value does not exist. Another flaw of fair-value accounting is its self-expansion, that is, the fair-value accounting acts as a share price bubble maker based upon the normal net incomes from the operations of listed firms. The bubble may then expand much larger than the original incomes.
The implementation of fair-value accounting in the US not only allowed for the creation of bubbles in asset prices, but the changes made by the Financial Accounting Standards Board in 2009 has enabled banks to hide hundreds of billions of dollars of unrealized losses on their balance sheets.
Before Treasury Secretary Tim Geithner lectures our European allies about going “too slow” on debt restructuring, he should clean up his own house. We have discussed the failure of Geithner to deal with the situation at Bank of America.
At a meeting of Professional Risk Managers International Association in 2007, Sylvain Raynes of RR Consulting, who also teaches at Baruch College, put the role of fair-value accounting into stark perspective:
Valuation is not the most important problem in finance; valuation is not the most interesting problem in finance; valuation is the only problem for finance. Once you know value, everything happens. Cash moves for value. More price does not mean more value. If you do not recognize the difference, the fundamental difference between price and value, then you are doomed… The Chicago School of Economics has been telling us for a century that price and value are identical, ie, they are the same number. What this means is that there is no such thing as a good deal, there is not such a thing as a bad deal, there are only fair deals.
The role of new era concepts such as fair-value accounting in fueling the crisis is just part of the story. The other symptom of a lack of real economic growth in the G-20 nations is the rise of cash settlement OTC derivatives and complex structured securities. From leveraged ETFs to currency swaps, the global financial markets are polluted with all manner of speculative instruments with no basis in the real economy.
Forward, futures and options markets are traded on exchanges and in organized markets, and are tightly disciplined by a limited supply of underlying assets, the cash “basis” for the derivative, which is not a problem. But when you talk about credit default swaps, collateralized debt obligations and other instruments which settle in cash and where the underlying basis does not have to be delivered, these instruments seem to validate the debt-deflation thesis. Unable to create real assets from real economic activity to meet the demand from investors holding fiat paper currencies, the markets create liabilities without any corresponding assets. The disease of cash settlement derivatives and structured assets is destroying many cash markets and banking systems around the world.
The derivatives epidemic is already visible in the US and EU economies, and is also affecting emerging markets. In Hungary, for example, global investment banks first used FX derivatives to blow up the local currency mortgage and banking market, driving consumers into foreign currency-linked home loans. The major derivatives dealers then left local lenders to fail as the currency market exposure turned catastrophic. Local lenders, who wrote massive foreign-currency swaps to enable domestic real estate lending, were decimated when the Hungarian currency weakened.
“The EU central bank just published a 100 page report on FX swaps alone,” notes a consultant to the central bank. “Derivatives ballooned Hungary’s FX exposure and debt. We are now trying to find a way to rebuild the domestic loan market amidst the smoldering ruins of this fiasco.”
Note the similarity between the situation in Hungary and that of Spain, Greece, Portugal and Ireland. In each case, derivatives allowed these nations to greatly increase domestic debt far beyond levels that the cash markets can support. In many cases these domestic borrowings carry foreign exchange exposures created via derivatives that magnify solvency problems enormously.
The leaders of the G-20 nations need to ask questions about the role of fair-value accounting and cash-settlement derivatives in fueling the current debt crisis. Until we accept that many of the economic problems we face today stem from efforts to create the illusion of growth in financial markets, there is not likely to be much progress on fashioning a sustainable solution.