Derivatives: The Looming Disaster

As if the total failure of government in the face of Brexit was not enough of a problem for the British state all on its own, the potential catastrophe in the area of Financial Derivatives can make all other considerations trivial.

It is very hard for me - who has been a horrified observer of the development of this market through the thirty-or-so years when it has been in existence - to get my head round what is involved when derivatives meet Brexit. Most people have never had the time to understand this type of 'product', and have never felt the need to do so. Yet as far as the international financial community is concerned derivatives are by far the largest set of 'assets' that they trade in. The bankers have induced their customers, taking in all other financial traders and pretty well every firm that does real-world business, to take part in derivative business as part of the process by which unknowns and unforseeables can be wished away from the the business scenario.

As the financial world has plunged headlong into cyberspace, the possibility of counterfactual events unsettling the market has increased. In response, very clever people have developed ever-more 'advanced' derivatives. Back in the Thatcher era, when the concept was now, most derivatives were derived from real-world events; such as the incidence of severe thunderstorms in the American midwest. Insurers found that the damage that such storms could do to crops was severe; but it was highly specific to very small areas where the storm might well destroy the crop in one large field but leave the surrounding area unaffected. Meteorologists set up businesses, equipped with satellite observation and reasonably sophisticated computer programmes, that could certify whether a storm was likely to have hit a particular farm at a given map reference on a given date: this enabled an insurer of the crop to make a snap judgement, whether to accept the claim at once, or whether to investigate whether it was genuine.

This enabled a secondary business to be established, whereby the information derived about the probability of of an event [such as storm damage] occurring could be tidied-up and used as the basis of a bet on the probability of storms causing damage. Such contracts enabled insurers, and bankers who lent money to farmers, to hedge against the actual occurrence of damage. Most areas do not have storm damage in any period, so a derivative based on the probability of a storm occurring leads to no payout: but if a storm does occur, the insurer can claim against the contract and thus meet at least some of the costs of real storm damage.

Once real-event related derivatives were deemed to be viable, there was an explosive expansion of derivative contracts. The probability of an asteroid striking New York is pretty low: but a derivative can be envisaged to cover it, and offered to firms that may be anxious about concentrating their property investment in that city; and why not earthquake damage as well? Such contracts could support insurers' capital; but they soon became a means of dealing with any possibility for loss both in the real world and in the fantasy world that the derivative creators were  erecting in cyberspace. Nowadays, any improbable 'risk' can be subject of a derivative and companies are [effectively] required by their financial advisers to place their bets on the subject matter of the derivative that they want to sell.

This huge trade in bets based on synthetic probabilities is focused on the great financial centres in New York and London. The world, led by the other countries in the European Union has bought and sold derivative contracts that are legally based in the UK: and now some clever observers have pointed out that all London contracts - ever since the market was invented - have been governed by the law of England within the overall regulatory system of the EU. Some commentators have suggested that all these contracts would become void when the UK leaves the EU at midnight on 31 March 2019: unless they can all be re-written - which is an impossible task. The ministers in Mrs May's government do not even seem to be able to understand the need to keep lorries crossing the channel taking components to and from factories in the UK and on the continent: so how can they be expected even to listen to the apparently-esoteric arguments that will be put to them with increasing urgency about derivatives [and other 'products' like options]?

This country is hurtling towards a disaster that will make the 2007-9 'crash' seem nothing. The calamity will occur in markets that the ministers probably don't want to understand: but those ministers will bear responsibility for the biggest-ever financial crisis if they continue on their present course. The headbanging Brexiteers are driving us all towards ruin: and if they succeed, they will plead innocence.

Ignorance and stupidity are no defence, in law or in the court of public opinion.

No Crisis of Capitalism

Fashionable babbling in the media and among politicians has now fixed on the vague idea that that there has been a crisis or even a failure of capitalism. So what is Capitalism?

By 1800 Political Economy taught that there were three factors of production without which economic activity could not occur:
land: which means both the site where production and/or trading takes place, and all the natural resources that are needed as direct and indirect components of the process;
labour is all the manpower and womanpower that has to be brought to bear to start and to maintain the production of the output and of all the components that go into making it, including the management of all stages of the process;
capital is the accumulated saving from the output of past times that is deployed to meet all the costs of running a business until an exchange of output for revenue to take place. The capital must cover rent for the site, the cost of the materials, and the wages of people who build and equip the factory and start production; it must also fund the original marketing of the output.

In a quest for transparency between 1800 and 1860 Political Economists developed the concept that there was a symmetrical means of computing the fair return to each factor:
Land was remunerated with rent which was the price that had to be paid for the use of the land for this purpose rather than for any alternate use. Landowners could chose to keep their estates undeveloped, for hunting; but they can optimise their income by farming it for crops [or leasing to tenant farments], or by letting sites for all sorts of purposes, including urban property which is most lucrative.

Labour was remunerated with wages that must be sufficient to attract the necessary labour, with the necessary skills and experience [where relevant]. The vast majority of people who are not peasants need to earn a living, and they learn that location, luck, experience, skill and physical fitness can attract differential wages. There are differing wage-rates for different jobs, and for the same job in different locations even within a small country. Intellectually able, fit, skilled people who are able and willing to migrate can maximise their earnings.

Capital was rewarded with profit which must be sufficient for the capital to be allocated by its owners for one selected purpose rather than for any possible alternative use. Instead of being invested in business, with all the risks that follow from such an investment, capital - in the form of cash - can be lent to the government [whose borrowing was believed to be absolutely guaranteed for the lenders]: so money will only be invested in trade and industry if it is at least likely to produce a return to investors that is greater than the rate that can be got from the government.

Political Economy earned the nickname 'the gloomy science' [or 'the dismal science'] because of the stark realities that it exposed [notably the Law of Diminishing Returns, the Iron Law of Wages and the Principle of Population]. Attempts to make aspects of the subject look more humane produced more confusion than clarity; and when clever concepts like the Labour Theory of Value were brought to bear in an attempt to explain wage differentials the oppotunities for reductionist quibbling became infinite.

After reading about these issues in depth, the young Dr Karl Marx declared that all the theorising masked one essential fact: that the system of production was not fair and was programmed constantly to become less fair. Progress in industry and in agriculture was derived from the application of ideas and of human ingenuity, but these natural resources - which brought about all the progress for mankind - could not be employed without capital and unless access was granted to land. Land was controlled by landlords, often aristocrats, who could demand increasing incomes for letting their land be used for factory and housing sites, and/or for growing crops more intensively, or for allowing quarrying and mining on and under their land. Even more outrageously unfair, to Marx's perception, was the fact that operators of factories and of rented modernised farms captured the surplus value that was generated in the process. The owner-managers of factories paid the lowest wages that could be forced on uneducated and anxious people, selected factory sites where they would pay as little in rent as possible [which is why so many works and mills were built in grim Pennine valleys] and bought raw materials from the cheapest sources: and then they sold the produce at the highest possible markup. The difference between what the output cost to make and to deliver and the price that was received at the point of delivery, was surplus value. The chap who took the money that represented the surplus value put the greatest possible amount of his takings into his firm as additional capital: which was used to expand the factory, increase the stock of raw materials and take on more labour. He squeezed costs as tightly as possible, and sold his produce for the highest possible price: so that he could invest even more in the next period and appropriate even more surplus value. The purpose was not to feed or clothe or otherwise benefit human beings: the sole objective of the new dominant class - the capitalists - was to accumulate more capital through the expansion of the system of production.

Marx constructed a political ideology based on the concept that the community must capture the control of economic activity from the capitalists: hence his system adopted the name communism: which had a special resonance with radicals after the experience of the Paris commune in 1870.

Transcending the Teutonic complexity of his formal writing, Marx and his associate Engels used journalism and pamphlets to popularise his message and to report on the obviously detrimental conditions in which many wage-earners lived, especially in the most industrialised areas of England. Anyone who combined Marx's explanation of the depredations of capitalism with the Laws of Political Economy was drawn to the conclusion that the outlook was bad. Capitalists controlled the system, and they faced diminishing returns; so they would demand even more surplus value proportional to the falling prices for which output could be sold. In an attempt to preserve their income they would reduce costs by cutting wages and demanding more work from their employees: the workers would have to take that, or become unemployed with a risk that they and their children could starve. The capitalists would also use their power vis-a-vis the landlords to reduce the prices they would pay for materials; and they would eventually dispossess the landlords either by buying them out or by the exercise of political power.

Capitalist and capitalism were created as terms of opprobrium, characterising a class and a mode of economic organisation that had emerged with modern industry and was perceived by the inventors of the concepts to be essentially inhumane. At the same time as Marxism became the ideology of the political 'left', between 1860  and 1900, successful businessmen in North America and Europe came to accept the term capitalist as a description of themselves. In the twentieth century as communism became more oppressive and inefficient after Lenin had grabbed power in Russia, the more businessmen and politicians in the 'free world' became proud of being 'capitalist'. The doctrine that a free market enabled investors of capital to maximise economic growth came to a shuddering check in the early nineteen thirties. Politicians and the few perceptive Economists [most notably Keynes] recognised that only government action could recalibrate the system. Capitalism - of a new kind - was able to survive in parallel with an interventionist state.

The resulting 'mixed economy' of the post Second World War era was very little like Marx's capitalism, but at its best it fostered the development of investor-funded businesses which provided employment, taxes and innovation that were the main contributors to economic growth. Even social democrat governments worked closely with 'civilised capitalism' and after 1970 they followed  right-wing parties in privatising nationalised and state-created industries. It became the fashion to argue that this variant of capitalism was the best form of economic organisation. But - unfortunately for the long terms health of the economy - this heavily regulated and highly-taxed market economy became less and less like Marx's capitalism. Far from being concerned obsessively to invest in the expansion of productive facilities, Thatcherite capitalism became a system from which spending power could be extracted for taxes, for dividends [returned to collective investment funds: investment and unit trusts in the 'sixties, then pension funds in the 'seventies, then venture capitalists in the 'eighties, now hedge funds] and for increasingly inflated remuneration packages for directors, managers and star traders. That system of chaotic and inflationary economic disorganisation was not capitalism: nor was it anything like Leninism although it was controlled by the state through regulatory regimes, licensing systems, discretionary taxation, procurement policy for the overweening public sector, and the manipulation of monetary and fiscal policy.

The growth of the chaotic real-world business system was funded by the emergence of the parallel system of credit expansion in cyberspace that enabled firms and individuals - and governments - to borrow money to spend greatly in excess of what they earned. The gross overexpansion of that fantasy universe led directly to the credit crunch and to the slow realisation in the countries that were most affected by it that their economies had been despoiled of any solid foundation.

Some individuals have recently become rich by manipulating shareholdings and by creating or capturing intellectual property. Only a very few of them have behaved like classic Marxian capitalists and put their profits back into their real-world businesses as new investments; and even those few have realised that taxation will destroy their personal business empires on their death [if not before]. The portion of the economy that is controlled by individual capitalists [and by capitalist dynasties] is trivial; and the real economy is overshadowed by the nexus of fantasy businesses that is called casino banking.

We live with a systemic crisis: but it is decidedly not a crisis of capitalism: it is crisis caused by the absence of any system to ensure that the investment that is necessary for the future survival of the economy is being made. The present standard of living of every nation in Europe, except Germany, and of the USA is only maintained as it is by borrowing: most notably the borrowing that governments undertake to subsidise the welfare state. However incoherent, incomplete and insensitive the welfare state may be, it still maintains millions of people. The decisions about this system are taken, always have been taken, and always will be taken by politicians. Contemporary politicians have no serious business experience, no knowledge of Political Economy, no recognition of the nature or depth of the crisis that it is their duty to resolve. The mess was created by politicians, with the enthusiastic support of would-be capitalists who have been encouraged to 'go for it'. Few non-politicians believe that the political class have the intellectual power, or the integrity or the guts to meet these challenges. Recently the media have followed politicians in using diversionary tactics by decrying and individuals who can be characterised as 'fat cat' capitalists. But it is impossible to sustain the assertion that a predator class  of 'bankers' is exclusively responsible for the recent crisis. The pseudo prosperity of the era from 1980 to 2007 was achieved by the symbiosis of the human economy with the finance generated in cyberspace: that was not  capitalism.

Eternal Truths?

Having deferred the publication of its report on morality in the [business] City of London, the Saint Paul's Institute is now issuing it. A large sample of employees in financial institutions were asked basic questions: and the majority answered that the existing distribution of incomes was unfair, in their favour, and they saw no particular reason to do anything about it. There is no surprise there: but confirming common assumptions is a valid outcome of research.

The development of electronic trading in cyberspace is a huge source of earnings for the City workforce, and a lesser source of profit for their firms [where typically the firm is responsible for any losses, while staff take more than 90% of the return in salaries and bonuses]. This is a totally different market from the old-fashioned face-to-face dealing of the Stock Exchange before the 'big bang' of 1986. The occasion for the Saint Paul's report is the twenty-fifth anniversary of the loosening of market controls, which made possible the expansion of trade [especially of socially-useless churning of contracts] and the invisible evolution of electronic markets. The pre-big-bang markets could not possibly have run up the liabilities that almost sunk the economy in 2008; which could still cause huge problems if the running-repairs that were made in haste should be unsustainable in the long term.

 Despite the unimpeachable evidence that Economics is a failed subject, with no scientific validity, Economists continue unabashed to draw large salaries for analysing City events, 'products' and firms. Little of what they write directly refers to the Economic theory that still has a monopoly of university syllabuses: much of their output is common sense, exposition of statistical data and the repetition of market folklore. But behind all of that their mental world is at least partially structured around normative theories that are at best unhelpful to any attempt to understand what actually happens in the economy, and at worst have served as the sanction for ruinous excess.

The Bishop of London has invited a retired banker - and active churchman - called Ken Costa to lead a new study of the relationship of humanity and morality to business. In an interview on the Radio 4 Today programme he proclaimed himself open to any new idea, he spoke of Ethics as a separable aspect of human cerebration, and he took it for granted that human business relationships exist in a 'market economy'. Perhaps due to the constraints of time, there was no exploration of what a market economy might be or how it may be improved, dismembered or renewed. Costa commented that views for and against 'capitalism' were polarised: that no side to the dispute was intrinsically right, and that any dialogue must accept points from both sides. Most ecclesiastics who have made any comment on these issues, especially in the context of the naive claims made by the campers at Saint Paul's, have been couched in soft-left platitude. As such, they have failed to resonate in the media and in bar-room discussions.

Historically the emergence of capitalism has been linked to Protestantism, with its tradition of encouraging individuals to implement their own interpretation of biblical teaching on morality; while Catholicism and Islam have been much more explicit in outlining an official interpretation of scriptural guidance on business matters. None of these streams of dogma has pronounced capitalism to be 'evil'; while socialism - especially explicitly-atheistic Communism - has been anathemised. John Wesley, the founder of Methodism, said that "the making of money is a worthy and a Godly pursuit": but he, like all other significant religious leaders, also argued strenuously for the 'right use' of money and the obligation of the faithful to support the poor and needy.

 Markets are merely social media: their purpose, structure, processes and rules are made by human beings who participate in markets on their own account or as agents of firms. Those individuals cannot avoid making their decisions in markets in the light of their understanding of their function; and of their personal needs, beliefs, prejudices, and judgements. These may or may not include religious aspects and ethical consciousness. Personal charity is still significant; but most of the care for the poor and needy - as for the sick - has been appropriated by the state. To pay for it, the state taxes firms and persons who participate in economic activity; and taxes are broadly proportional to turnover.

People decide on a daily basis whether to put a coin in a rattling collecting-box, as they hurry along carrying newspapers that show more and more 'gaps' in provision by the 'welfare state'; and most people are becoming more and more concerned that they will personally fall into some of those gaps. The perceptual separation of markets from society, with the political system taxing markets to maintain society, was slowly developed between 1870 and 1980, sanctioned by Economists: and now it is busted. A wholly new basis for understanding these relationships is essential. With the best will in the world, Saint Paul's Institute and Ken Costa will not resolve the dilemma with their existing intellectual resources.

Capital, Capitalism and Humanity

No economy can function without capital: buildings, utilities, transport facilities, machinery and the cash float that is necessary for any household or firm to operate. This fact was recognised early in human history, and by 1800 it had become part of a systematic theory of Political Economy as one of the 'Factors of Production': Land, Labour and Capital.

The young Doctor Karl Marx absorbed Political Economy and combined that with a voracious acquisition of facts, and believed that he had found a more profound truth. This was his perception that a class had emerged in the modern economy who were not any part of the ancient classes of people as they had become segregated by economic role and circumstances over the centuries: farmers, handicraft workers, landlords, soldiers, priests and civil servants. This class was the capitalists. Marx reckoned that this group collectively aimed to seize control of capital and use it for their own purposes rather than for the general good of humanity. He assumed that the capitalists would use the capital that they brought under their control to expand industrial production [including ultimately production on factory farms] and that this would be taken to extreme lengths. As industry expanded and machinery improved, output would increase; but then would occur a crisis. The  capitalists would have expanded productive capacity  to a point where there was not enough demand to meet the output. So the capitalists would cut costs and, as their priority was to carry on buying more more-intensive machinery, the obvious economy that they could make would be to reduce the cost of labour. Some workers would be sacked and the others offered lower wages: there would be plenty of unemployed available to take the jobs if the remaining workers would not accept the lowering of wages. Meanwhile the natural increase of population would produce large numbers of relatively healthy young people looking for work on any terms.

Marx presented capitalism as a machine that would inevitably generate excess production, lower living standards and create a growing 'reserve army of the unemployed'. This did not happen.

For a century and a half after Marx's death economic growth produced a diversification of products and a rising general living standard in the relatively free economies of Europe and the Americas.  Owners of businesses accepted being known as capitalists, and there was a consensual acceptance of the term 'capitalism' to mean 'an economic order in which a least a major portion of industry and commerce belongs to companies and to individuals'. Meanwhile the Russian Empire was captured by revolutionaries who claimed to be Marxists [and whose dogmas spread to central Europe and China after the Second World War] and those people made a disastrous mess of managing their economy by authoritarian means that were asserted to be leading towards the blissful condition of 'communism' that Marx had envisaged. Largely because Marxism failed, the people in the [relatively] free countries accepted their environment being described as 'capitalist'. But the term capitalism has no clear meaning, other than the pejorative term that Marx coined .

The fact that the members of a 'capitalist' society have no clear understanding of what they mean by the term has had disastrous consequences. If there had been acceptance of a definition of 'good' capitalism as an economic system that recognises the importance of managing capital investment effectively the present economic crisis could not possibly have arisen. Individuals in their various roles as politicians, business leaders, investors, voters, workers, pensioners and consumers would have seen that the crazy combination of de-industrialisation with untrammelled credit-creation and house-price inflation that built up after 1980 was preventing a rational allocation of capital from taking place. The survivability of the economy was being undermined in an orgy of imported consumption funded by borrowed money. Financial phenomena - mostly invisible in the internet - absolutely dominated the economy: and the creators and managers of those phenomena included many of the brightest graduates in maths, science and engineering who could have used capital to lead into new worlds of physical output, energy generation and medical science.

It is precisely because politics and society allowed the economy not to be capitalist in any rational sense that the crisis now exists. It is not a 'crisis of capitalism': it is the consequence of the economy ceasing to be capitalist.