I have just been reading a very good book, which I recommend. It is called The Final Crash and is written by Hugo Bouleau, the pseudonym of an experienced investment banker, who works in the Channel Islands. The argument will be a familiar one which supports views which have been expressed in contrarian publications. The publisher is the Pendula Press. The author gives the book a subtitle “Addiction debt and the deformation of the world economy”.
The book covers a lot of relatively familiar areas, including gold, oil, raw materials, inflation, U.S. debt and so on. I noted the figures the author gives on the growth of derivatives. “In 2004 the market in credit derivatives increased by 123 per cent, creating an exposure of $8.4 trillion to these instruments of insurance. In 2005 they grew by 105 per cent, such that their so-called notional value stood at $17.3 trillion, which is the excess of all outstanding corporate debt on the planet. The total derivatives market across all sectors is worth an incredible $298 trillion. To put this into context, the value of such instruments was equivalent to less than a third of the world economy in 1990 but equates to nearly 800 per cent of global GDP in 2006. Much like Lloyd’s re-insurers, someone somewhere must be exposing themselves to these credit risks.”
What is certain is that nobody has any real understanding of these risks, either in detail or globally. Their ultimate base, like that of any bookmaker, must be that the banks which issue derivatives keep their books balanced. In theory, as in other forms of banking, every liability is balanced against an asset. But – as we all know – bookmakers can go bust and so can bankers. If the counterparty responsible for matching the risk becomes illiquid, then the whole system can be put at risk.
There were plenty of years in the first half of the last century, when events were so overwhelming that it seems unlikely that this derivatives system could have survived them. 1914, 1917, 1923, 1925, 1929-31, 1939 all produced events which caused major global financial shocks. We cannot calculate the risk of similar events in the future, but they would include revolutions, global wars, hyperinflations and slumps.
Warren Buffett says that he cannot get his head round derivatives. So the rest of us can excuse ourselves for being in the same situation. I cannot envisage how one could unwind $298 trillion, if it had to be unwound. But I look at the Middle East and reflect that major wars, revolutions, inflations and slumps have not permanently disappeared from the modern world.
for The Daily Reckoning Australia