Sunday, September 23, 2007

Financial Market Speculators Jump Back on the Merry-Go-Round

Scarcely a moment had passed after the Fed announced its interest rate cuts before speculators jumped back into the financial markets. As reported in the Wall Street Journal (9/20/07, p. C1) and the Washington Post (9/22/07, p. D1), the Fed's interest rate cuts prompted increased speculative interest in emerging markets and the petroleum markets. These markets are expected to benefit from the rate cuts, but aren't tainted by the subprime mortgage and other other asset-backed securities messes. Thus, investors haven't lost confidence in them and they are ripe for bubbles. As reported by the Journal, one gambit is to jump in now, at an early stage, and pray for irrational exuberance. Speculators aren't gun shy about bubbles; they hope for them.

It goes without saying that the Fed would not have wanted to encourage more speculation,. Speculative excess has already brought us the 2007 credit crunch. The emerging markets were the bubbly source of the 1997-98 financial crisis. That, as you may recall, culminated in the near-collapse of Long Term Capital Management, hailed by some as an unsinkable battleship among hedge funds. And it was in the energy markets last year that Amaranth Advisers, another large hedge fund, foundered on the shoals of high leverage and high risk.

Profiting from government subsidies, however, is a time honored way of making easy money. Is it a surprise that agriculture has shifted away from the family farm to big-time enterprise? The availability of the government subsidies attracts capital and makes large-scale, subsidized operations the sensible thing to do.

There is a lot of speculation in agriculture. Farmers are gamblers by the nature of their occupation. But the amount of cropland available, and a variety of other factors, limit the extent to which farmers can speculate. Yields can increase by 10%, 20% or even somewhat more for any given crop from year to year. But they can't increase by several hundred fold.

Financial derivatives, on the other hand, allow investors to transact in equivalents of the underlying assets, and can multiply the amount of money invested with respect to those assets many times over. There is only so much crude oil being recovered at any given moment in time. But there are few effective limits on the amounts of derivative contracts based on crude oil that can be traded or held. And derivative contracts based on emerging markets are similarly without effective limits. Thus, the amounts of speculative risk derived from these markets can balloon upwards quickly, constrained only by the instincts of market participants for caution. The latter, as we now know from the subprime mess, may be scant.

Also scant is the Fed's ability to monitor ongoing and future speculation. The near complete absence of regulation of hedge funds and other entities of their ilk leaves the Fed with no comprehensive information about the extent of the risks building up in the financial system. Instead, it must rely on anedoctal information, making monetary policy perhaps in response to hearsay.

Could speculation in the emerging markets and the petroleum markets create levels of risk comparable to the problems of the mortgage markets? There's no way to know. There's no way to prevent it. And there's no reason to believe that it won't eventually endanger the stability of the financial system.

Past opposition to the regulation of hedge funds and the derivatives markets has been ideological in its fervor. But what ideological purpose is served by the government indemnifying the financial system from unmonitored, unregulated and unlimited risk? We have what is government insurance of financial assets on the one hand, without any controls over the risks to which those assets are placed. No commercial property insurer would provide coverage without assessing the risks involved and insisting on some controls over them. Moreover, it would charge premiums.

The Fed's interest rate cuts may bolster the economy. Or they may not, depending on how things go. With a falling dollar, rising oil prices, rising food prices and continued Brobdingnagian federal deficits, the prospects for inflation are hardly rosy. Now that the asset speculators have resumed their merry romp, perhaps we should ask the question that should have been asked with respect to another government policy: how does all this end?

Animal News: Cat returns from Oz.

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