Subject: Hazards of Free Market: Deregulation.
From: “Syed Ehtisham”
Hazards of Free Market: Deregulation
On 8/15/1971, Nixon told the Treasury Secretary to suspend the
sale/purchase of gold and international finance changed forever and
heralded the beginning of the end of Bretton Woods agreement of 1944.
On 1/1/1974, the U.S,. following Canada, Germany and Switzerland in 1973,
abolished all restrictions on international capital movements. Britain
followed in 1979, Japan in 1980, France and Italy in 1990, Spain and
Portugal in 1992.
Fixed rate had offered low profit of arbitrage.
In 1973, daily world foreign currency trading was $10-20 billion. In 1980,
it reached 80 billion; ratio to world trade of 10:1. In 1992, it had gone
up to $88 billion, with ratio of 50:1 and in 1995, 1260 billion; ratio of
Most currency trade is speculative-fear of gain and loss.
Between 1983 and 1993, US Treasury Bonds rose from $30 billion to $500
billion; from 3% of GDP in 1970 to 9% in 1980 and 135% in 1993. In the UK
they rose from about 0% to 1000% of GDP. Beyond 1990, tradable security
rose to $ 2.5 trillion (US 40% of the total), which helped the US finance
its trade deficit. (2).
By mid-1990’s, capitalization of emerging market/stock market (developing
and transitional economy) rose to 13% of the world total, up from
negligible ten years ago. International lending was $265 billion in 1975;
it rose to 4.2 trillion in 1994. In the 1997 Asian crisis, there was 100
billion reversal of lending. (3).
International cooperation in financial management and regulation is
fragmented into Bank for International Settlements in Basel, International
Organization of Securities Commissions, International Association of
Insurance Supervisors, which will need supra-national powers. Only a
Bretton Woods like conference and creation of an IMF like body can ensure
that a 1929 like depression would not recur (4).
US banking panicked in 1907, resulting in stock market crash and sharp
decline in Agricultural and industrial output, resulting in the 1913,
Federal Reserve Act (creating the Federal Reserve Bank) to conduct monetary
policy, act as lender of the last resort and regulate and supervise the
banking sector. Congress had realized that regulation was necessary for the
operation of efficient market. (5).
Market economy creates a complex division of labor, and links every
individual to thousands through the world and money is an essential
*Money is power. But you can’t eat it or wear it or live in it. *Its
importance lies in its acceptance as payment. The government enforces
acceptance as legal tender and refusal to accept is a legal offense. Loss
of confidence in the government is loss of confidence in money. After
Germany was defeated, its currency became useless. Cigarettes and nylon
stockings became the currency.
Money and financial institutions have no intrinsic value (unlike a house)
and are more susceptible to swings of confidence.
Default leads to plant closures, loss of jobs and lowered standard of
Markets are dominated by simple slogans; deficit equals higher interest
rates, increased money supply leads to high inflation, public expenditure
is bad, high employment leads to high inflation. At one time it was
believed in the UK that balance of payments was fundamental. Now current
account is no longer fundamental.
If the market believes an institution will fail, it will.
Deregulated markets are a threat to society.
Financial stability is a matter of convention. Convention was changed when
risk was privatized. Risk is reduced when assets/investment is liquid. If
everyone wants to sell, value will go down. Limiting the ease with which
investors can switch can enhance stability. But without liquidity,
investors would not take risk.
*Markets suffer from asymmetric information*. Many traders, pension funds,
share/bond holders know little about them.
*Investors underestimate or ignore the cost to society of the systemic risk
they take.* It is like the effect of pollution on environment. The producer
does not have to pay. Financial managers will behave, if they could be held
responsible. A bit of jail time would work beautifully.
Regulators and risk takers share ideology and go through revolving doors,
risk taker one day, regulator the next. Risk takers eventually grind down
the best-intention-ed regulators too. There is more regulation after crises
and more welfare after eruption of protests of destitution.
Lender of last resort takes money away from tax payers to rescue the risk
International regulation began in mid-1970’s. In 1974, the Committee on
Banking Regulation (Basle Committee), which reports to a committee of
Central Bank Governors, was set up. In 1980’s, Capital Adequacy
Requirements for banks were ordained. Most countries signed on to it.
International Association of Insurance Supervisors does the same thing for
the insurance industry.
Neoliberal theology and economic performance:
Since 1870’s, there have been three periods of deregulation-High Gold
Standards before WW I, Gold exchange Standard between the wars and
neo-liberalism of today. (6).
1870 to WW I, Bank of England dealt with macro-adjustment. Capital flow
stabilized the system; gold moved out of London when interest rate was low
there. Low interest rate stimulated investment in borrower countries. When
the British economy recovered or interest rate was raised, capital would
flow back and force raw material to be sold on unfavorable terms and
improved British trade and balance.
Before the 1893 crisis, US adopted bi-metallism. (7). Another crisis
followed in 1907, and led to the creation of the Federal Reserve Bank as
the public lender of the last resort, the function previously undertaken by
Wall Street Banks marshaled by J. Pierpont Morgan.
But repeated crises in the US, and even in Britain failed to topple gold
due to the support of Banque de France, Indian surplus and South African
Gold. But by WW I, other countries had established their own Central banks,
with Gold reserves becoming free of London interest rates. Gold standard
was becoming unsustainable.
Free international capital market grew hand in hand with high interest
Between WW I and WW II, the US became the biggest international lender. Its
national savings were in excess of its domestic investment.
Between the wars International cooperation was weak. Earlier on, Britain
could depend upon Continental institutions. Bank crises spread across
Europe in 1931. In Germany and elsewhere a large part of domestic deposit
was owned by foreigners. Fear of withdrawal led in the same way to the
Asian Crisis of 1997, and the Russian one of 1998.
Fear of devaluation made banks scramble for gold. Adherence to rigid fixed
exchange rate sent negative demand shocks around the world. Countries like
Britain, which broke early from gold (1931) did a little better with
That led John Maynard Keynes to design a system, which did not depend on
Gold reserves. (8).
Bretton woods (1944) replaced liberalization with controls on capital
movement. Nations could pursue full employment free of anxiety of free capital
Success of Bretton Woods; growth, employment and productivity grew to
historic heights till 1970’s.
Breakdown of Bretton Woods and privatization of foreign exchange started
the explosion of foreign exchange markets and global bond market in 1980’s
and global equity markets in 1990’s.
The international financial flood started with Euro-dollar and later with
Euro currency as a tiny current in 1950’s, with dollars deposited outside
the US. The US and Britain did not mind at first as commercial banks could
use their excess reserves. The Soviet block countries used it too, as they
were scared of expropriation by the US for wartime debts. Euro currency
deposits were $10 billion in mid 1960’s and $500 billion by mid 1980’s. By
mid 1980’s, industrial countries deposited 25% in currencies other than
their own, the so called Basket.
Between 1964 and 1973, US imposed interest/equalization tax, which raised
the cost of banking in the US, which led to increased Euro-currency
deposit. (10). OPEC countries deposited a lot after the first oil shock.
Euro banks used it to increase the debt of Latin American countries by
giving loans. Mexican default of 1982, led to a lost decade of growth in
LDCs except in Asia, which had its own crash in 1997. It also taught
investors on how to transfer funds in anticipation of interest and exchange
Liberalization and deregulation changed commercial banks’ way of doing
business, as did the 1983 law requiring banks to have capital adequacy on
their liabilities according to Basel standards. They moved off shore and
off balance sheet operations like over the counter and derivatives (small
investment, heavy loans). In the 1997 Asian crisis, value of assets
collapsed and guarantors went bankrupt.
In the US and later in Europe, people instead of keeping money in the banks
started putting them in pension/mutual funds. Between 1978 and 1993, banks’
share fell 57% to 34%; funds went up from 32% to 52%. (11). Bank deposit
share in people’s savings; funds moved abroad and to shorter term
placements (7 years in 1960’s, 10 years in 1983, to 2 years in 1993).
Banks and other financial institutions developed risk management
techniques; individual and firms should estimate value at risk by analysis
of assets and liabilities.
Regulators must also look at risk to overall financial system. In 1998, the
Fed rescued it by inducing private lenders to inject funds in Capital
Management Hedge Fund, which had billions in loan and no assets (12).
But it was not easy. In 1975, Franklin National Bank went down. The Fed
assumed the bank’s foreign exchange loss.
Volatility and Contagion:
In Developed Countries short term volatility, measured at two weekly
intervals, tripled in the last 25 years. Long-term swings have taken the
real value of the dollar from an index of 100 in 1980 to 145 in 1985, 64 in
1990 and 134 in 1998. (13).
Volatility increases the risk; cost of capital formation goes up. Junk
bonds appear. US Corporate default rose steadily in 1980’s, default rate of
2% in 1990’s, exceeded only in the Great Depression (and briefly in
1970’s). Corporate bankruptcy, at all time low in 1950-70, is reaching the
It fuels the contagion. Current deregulation cannot cope with it.
The New Deal Glass-Steagall Act acted as a firewall between commercial
banks and the finance service industry. Up to 10/1987, this segmentation
worked. With integration in late 1990’s, it no longer works. All segments
of the system are now highly interdependent.
From N.Y, the Stock market crash of 1987 spread all over the world (2008
was much worse). (15). The 1994 Mexican Tequila effect spread over Latin
America, Africa, Eastern Europe and South Africa. This was a powerful
argument against deregulation, and became imperative after 2008.
US economists saw this as a moral hazard in post 1930 financial choices,
unemployment insurance etc.
Corporations moved towards high leverage positions; increase short term-ism
and mergers (16).. Junk bonds helped this.
The Fed protected the intermediaries. Money market funds interests were
raised to Euro dollar level in 1970 (17) . Derivatives and hedge funds
appeared. Deposit insurance, played a role in the S&L crisis of 1980’s.
Garn, the St Germain act of 1982, allowed any number of insured $100,000
deposits (now $ 200,000) after the S&L crisis. (18).
*Moral **hazard** plays a central role in financial crisis. Government
underwrites reckless dishonest investments with implicit insurance.*
Hazards of Liberalization:
International liberalization has increased market volatility. It has
resulted in less public sector expansion and lower investment in the
private sector. It has given benefit to a select few. Finance, insurance,
real estate (FIRE) has more of US GDP than manufacturing has (19). Other
bubbles burst too. ‘FIRE’ income flows to the very rich and increases
inequality; no taxes to equalize. Lower 90% get little. It gives the
ability to offload risk in the foreign exchange markets.
Hedging was made possible by liberalization and is a consequence of
Cost of Liberalization are regulatory problems with financial system,
dangerous linkage with economy-Asian crisis was directly related.
Volatility increases and has contagion effect. Public sector moves away
from growth and that has resulted in high unemployment. Private sector has
reduced funds for investment. Fragility spawned disaster in Brazil.
Government cut back aid to destitute sub-Sahara Africa.
In the ERM (Exchange Rate Mechanism) crisis, Hedge funds made massive
profits. In the Minski “Ponzi Finance” income was less than interest
payment. *Securitization is the bundling of financial sector assets such as
consumer credits for resale to third parties. **(20).*
Regulatory Control and Banking failures:
1974-US Franklin National Bank, a small bank failed, but threatened not
only just other such banks, but the entire Euro-Dollar market. In 1974,
Herstatt Bank in Germany closed and nearly caused the collapse of the
*American* Bank clearing system.
Bundesbank hesitated in acting as lender of the last resort for domestic
and international liabilities and cause damage in the US. 21
It was clear to central bankers around the world that the era of purely
national lenders of last resort was over. The Fed acted as the
International lender of last resort with Franklin National, to maintain
confidence in the Dollar and money markets and in the US banking system. It
required cooperation of the Bank of England and all major central banks.
In 1974, the committee on Banking Regulation and Supervisory Practices set
up the Bank for International Settlements at Basel for collective action
The international debt shock of 1982, brought home the fact that economies
were vulnerable to events in Less Developed Countries. The possibility of
Mexican default threatened the US and world banking. The Fed, the Bank of
England and the Bank for International Settlements acted in concert to
The Fed and the Bank of England argued for capital adequacy standard, but
had to resort to bilateral agreement of 8% capital to assets as others did
not agree. But others signed on later.
The Stock Market crash of 1987 was contagious. Fear was about $ exchange
rate. Investors held a lot of U.S. securities.
The market crashed in mid-October and it spread all over.
In the ERM crisis of 1992, Italy and the UK were expelled from the exchange
mechanisms of the European Monetary System. The British had tried to
maintain fixed parity between the Pound and the Mark and also had attempted
to weather a severe domestic recession and high unemployment and falling
asset values. Interest rate required to maintain parity with Mark made
domestic situation worse, and Pound devalued 20% against the Mark. 22.
In the ensuing ERM Crisis, George Soros reportedly made $1 billion against
Derivatives: it is an asset whose value depends upon the value of one or
more variables. The variables are the basis of the contract between other
parties/players. The parties receive payment or lose money depending upon
the values the basic variables assume.
In sophisticated financial centers, derivatives have been around for a long
time. Chicago, dominated by financiers, has had trade in grain and
livestock Futures since mid-19th century AD. Originally it was a way for
farmers to hedge risk. Contractors will buy the harvest at a fixed price,
gain or lose, and offset risk by spreading it through a range of
transactions. It had social benefits. Farmers survived bad crops, and akin
to insurance, the risk was diversified and shared by a broad section of
They can be highly leveraged. A speculator with a capital of $100.00
promises to buy $1000.00 worth of goods. If the price falls by 10%, the
speculator loses all his capital.
Derivative contract can be written on any number of bases, interest,
currency, exchange rates etc. They hedge risks and assume risk in the hope
of profit. Less than 30% was the standardized risk, specific to parties,
and was called Over the Counter Contract (OTC). (23).
Privatization of foreign exchange risk has caused enormous expansion of
derivatives instruments, from $1000 billion in 1986 to 100,000 billion (3
times the world’s GDP) in 1998. (24).
The New Financial Order caused larger fluctuations in exchange rates and
variability in interest rates. It is a part of liberalization.
85% of the US Fortune 500 use derivatives to protect themselves from swings
in interest rates. Liberalization creates the possibility as well as the
demand for derivatives.
The structure of derivative position limits the ability of a firm to
monitor and manage risk effectively. Orange County and Baring Bank scandal
exhibited the inability of senior executives to understand what was being
done as did regulators.
On 7/24/1994, Eddie George, the governor of the Bank of England wrote in
the Observer, “We now have an expert team monitoring derivatives who are
getting better all the time…” Three months later Barings was destroyed by a
“rogue” derivatives trader. An investigation “…the bank should explore ways
of increasing its understanding…”. (25).
Further element of risk introduced by the mathematical models used…based on
characteristics…random movements…Black-Scholes model assumes that prices
follow the same movements as Brownian motion of many physical phenomenon. (
26). The model is not in full agreement with facts. More prices tend to
concentrate on extremes than the other formula would indicate.
The best-designed derivatives may be undermined by liquidity. In 1995,
Metallgesellschaftchaft AG, Germany’s 14th largest industrial company was
destroyed with a $ billion loss of its US subsidiary in derivative trading in
oil and the Deutsche Bank declined to finance the trading further (27).
Some economists laid the fault at the door of the bank arguing that the
Market could do no wrong.
Risk aversion is infectious and likely to rise with the scale of borrowing,
a phenomenon known as “principle of increasing risk”, and can provoke
general rush to cash.
Liquidity depends upon belief in asset value.
Systemic risk inherent in highly leveraged market became clear on
8/17/1998. Russia defaulted on payment of short-term bonds; it spread to
Asia and the US Bond Markets. (Long Term Capital Management-LTCM), Hedge
fund specializing in highly leveraged bets on price movement. Investors
dumped corporate bonds and went into US government bonds. Still on
9/21/1998, LTCM lost $500 million. Its investments were worth $1.25
trillion. The Fed organized a consortium to take over LTCM. Bail out cost $
3.4 billion. (28).
Bibliography and References:
1. www.forexfloor.com/forex-histor.html; enwikipedia.org/wiki/world_currency
4. Washington, DC: BiblioGov.2011 Code of Federal Regulations: Title 40
*5*. Grieder, William, “Secrets of the Temple,” (New York: Simon and
*6*. Kemmerer, Edwin Walter, “Gold and the Gold Standard: The Story of Gold
Mine, Past Present and Future,” (Princeton, N.J: McGraw-Hill Book Company
*7*. Friedman, Milton, “Bimetallism Revisited,” Journal of Economic
Perspectives, vol , no Fall 1990. .
*8*. Keynes, Maynard J., “*The General Theory of Employment, Interest, and
Money*,” (London: Macmillan, 1936).
*9.* Hobsbawm, E.J., “Industry and Empire: From 1750 to the Present day,’
(Harmondsworth, Middlesex, England: Penguin Books Ltd, 1969).
*11*. Eatwell, John and Taylor, Lance, *“Global Finance at Risk; The Case
For International Regulation*,” (New York: The New Press, 2000).
*12*.Dunbar, Nicholas, “Inventing Money: The Story of Long-Term Capital
Management and Legends Behind it,” (New York: Wiley, 2000).
*15*. Schiller, R, “Investor Behavior in the October 1987 Stock Market
Crash:Survey and Evidence,” in Shiller, Robert, “Market Volatility,”
(Boston: MIT Press, 1990).
*16*.Zukoff, Mitchell, “Ponzi Scheme: The True Story of a Financial
Legend,” (New York: Random House, 2005).
*17*. “To Treat the Fed as Volcker Did,” The New York Times, December, 4
*18*. Black, William K, “The Best Way to Rob a Bank is to Own One,”
(Austin: University of Texas Press, 2005); Mayer, Martin, :The Greatest
Ever Bank Robbery: The Collapse of Savings and Loan Industry,” (New York:
Scribners and Sons, 1992).
*19. Ibid 15.*.
20. Tempest Matthew, “Treasury Papers Reveal Cost of Black Wednesday,” The
Guardian, London, Feb 5, 2005.
21. Time Magazine October 21, 1974 http://www.time.com/time/
*22*. ibid 20.
*24. ibid 10.*.
*25. Fay, Stephen, “The Collapse of Barings,” (New York: W.W. Norton,
*26. Szpiro, George G, “Pricing the Future: Finance Physics and the 300
Year Journey to the Black-Scholes Equation; A Story of Genius and
Discovery,” (New York: Basic Books, 2011).*
*28*. ibid 12