As commodity prices and inflation soar in the ‘real’ world we may be witnessing a prelude to another 2008-style crisis triggered by the foreign exchange markets. The risks certainly look similar and can be described with a simple question. Can the fictions produced by out-of-control financial actors survive reality?
The situation has been brought to a head by Western countries’ attempt to destroy the Russian economy by using sanctions, banning the country from the cross-border payments system (SWIFT) and stealing about two thirds of the nation’s central bank’s foreign exchange reserves.
So far, it has completely backfired. It was supposed to force the rouble into free fall and bring the country to its knees, but the opposite happened: the currency is back higher than before the war in Ukraine began.
Russia has turned the tables by asking European countries to buy gas in roubles. Those countries are absurdly crying foul – some are even calling it extortion – but they have little choice. It seems they are yet to understand that for a transaction to occur, two willing parties are essential. Who would have thought?
There are two major implications. First, it is a stark demonstration that national governments do not control the global financial markets. Nobody does. Most of the turnover comes from private actors but none of those players has control; they are all just gamblers at the biggest casino that has ever existed. Governments do not even mediate. If there are disputes they are solved informally by a group of lawyers.
Second, it points to the unreality of financial markets that are bent on endlessly creating money out of money. Real things, such as traded goods, or oil, are actually quite a small component of the overall activity.
According to the Bank for International Settlements, about $US6.5 trillion crosses borders every day, with about nine tenths involving the US dollar on one side. If we annualise that we get about $2,372 trillion a year. Total annual global trade is valued at $US28.5 trillion. That means trade represents only about 1.2 per cent of the total foreign exchange turnover. Oil sales are in turn only a fraction of global trade, about 3.8 per cent.
In other words, foreign exchange is not really a mechanism for trade; it is mostly about financial magic tricks. The BIS reports that foreign exchange swaps accounted for 49 per cent of total market turnover in April 2019 and “trading of outright forwards” also picked up. (A swap is when counterparties exchange given amounts of a certain currency. A forward is when two parties have a contract to exchange currencies in the future. It is money playing with money.)
The enormity, and absurdity, of this is rarely fully appreciated. The participants, the traders, have no reason to think about it much, and outsiders understandably either know little about it or find it too complex.
Failing to appreciate the size of this forex casino leads analysts astray. For example, many are predicting that the era of the American petrodollar is coming to an end, signalling a decline of US financial power. The petrodollar is ancient history. As documentary maker Adam Curtis brilliantly explains, denominating oil sales in US dollars was important 70 years ago and it was how America came to dominate world finance. But that was 70 years ago.
Now, we have a financial system that is extremely difficult to analyse. It is hard even to know what finance is exactly. The foreign exchange turnover represents transactions, but they are not really money in the way we normally understand the meaning of that word. The massive gambles are notional and when they are closed out the amounts left over tend to be small. Is this money or not?
What is sure, though, is that it is a battle between a ‘real’ world of goods and services, and assets and liabilities, versus an ‘unreal’ financial world of algorithms and derivatives and swaps and forwards and options and spot prices. We saw a similar dynamic with the global financial crisis of 2007-08, when derivatives (financial instruments derived from real assets) nearly destroyed the global financial system.
The crash of 2008 was blamed at the time on the US housing market, but that was only the trigger; it could have been any number of things to set it off. The ammunition was the ridiculous number of financial gambles (derivatives). At some point a near collapse was inevitable.
The collision between reality and financial fiction that Russia has exposed will not be the same as the global financial crisis, and the outcome is, as ever, hard to pick. But what is certain is that, contrary to the popular refrain of traders and pundits and cryptocurrency advocates, the blame should not in the first instance lie with governments, central banks, or fiat currency (money created by government edict). Governments are in the invidious position of having to clean up the mess; it is as if the umpire has been banished then, when things go wrong, the players say the umpire is to blame.
The fault rather lies with the private players who generate these ridiculous gambles and on the regulators, such as the former head of the Federal Reserve Alan Greenspan and president Bill Clinton, who initially let them have their head.
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