President Bush poked his head outside yesterday just long enough to read a prepared statement about how bad the economy is. Using phrases such as “losing their homes,” “abusive practices,” and “freezing up,” he so firmly emphasized how fraught with peril the current economic circumstances are that I am not sure more than a few people heard the rest of what he said.
Bush hinted that Washington had done, or started on, essentially all that it could do, and that there was little more he could do at this point but wait to see whether these actions have any effect.
And he suggested that ordinary citizens and Wall Street traders were partly to blame by buying into the sense of crisis that he himself had created in Washington to try to get the Paulson slush fund through Congress two weeks ago. Anxiety, he said, can feed anxiety, and that doesn’t solve any problems.
Bush might as well have said, “I have nothing to be anxious about but anxiety itself.” He was very clearly anxious, and rightly so, as the anxious actions of most of the people in the country are currently making his policy initiatives look downright foolish.
But where does anxiety come from? Anxiety is a kind of fear, but with a focus on dangers that are mostly unknown. There is a lack of clarity in the financial system that makes the current crisis seem to move in frightening fits and starts. If we knew what was really going on, we would not be nearly so anxious.
But we know there is much we do not know about what is going on in the financial system. We were startled to learn this week that the financial statements of Wachovia, one of the largest banks in the country, had given us the wrong idea about that bank’s financial condition. They seemed to say that Wachovia had two or three quarters to try to turn itself around. In court papers this week we found that Wachovia was already on the brink of collapse last week.
If a company that merely seems to be stumbling is actually dying before our eyes, what other surprises are on the way? And if the President cannot keep a straight face while telling us that the economy is likely to survive, what does he know that we don’t know?
The overarching sense of uncertainty about the economy is an accurate reflection of the magnitude of things that are kept hidden. As we have learned how derivatives function in the financial system, for example, one of the things we have learned is that much of what happens at a large 21st century bank is not on its financial statements at all. A bank could have paper assets and situational obligations that amount to trillions of dollars, and we would have no way of finding out. Even the banks’ own executives cannot get this information, although some are now trying to. But the best estimates we have so far is that the average large bank is, in financial terms, a tower of derivatives that stands much, much higher than all the assets and liabilities that are reported on the balance sheet.
This is why Washington would not let AIG fail last month. Trillions, probably tens of trillions, in liabilities are not recorded on banks’ balance sheets because of the convenient fiction that they are guaranteed by AIG. It should be obvious to everyone that AIG is not in any financial condition to guarantee anything — it has managed to keep itself going only because Washington is feeding it a billion dollars a day — yet its solvency is the key to keeping the financial system standing. If AIG were found to be insolvent, accounting rules would require banks to recognize trillions of dollars in liabilities that they currently are allowed to ignore. The day that happened, we are led to believe, almost every major bank in the world would instantly be insolvent.
How large is the derivatives bubble? One economist two years ago estimated it at a little over $10 trillion in paper assets. That was an eye-popping number that at the time he hesitated to publish, but as we have learned more, it now seems naively conservative. A separate, more recent estimate is that over $100 trillion in derivatives change hands each year in the United States alone.
To put these numbers in perspective, the largest company in the world is worth less than $1 trillion. The total amount of U.S. currency in circulation is a similar size, less than $1 trillion. Given the size disparity, it should not surprise anyone if the derivatives market sneezes and the economy falls over.
It certainly seems as if derivatives are being overused, to the point of becoming an accounting fiction at times, and that they are a dangerous and destabilizing influence on the economy, but how can we know when derivatives are unregulated and almost entirely secret?
If we want people to believe the financial system can still function, the derivatives it is built on cannot remain secret. A good first step would be to require the public disclosure of all derivatives. And to make sure that there are no loopholes, it would make sense to require the public disclosure of all contracts that spell out financial arrangements between public companies, including their subsidiaries and partnerships. Is there really any public purpose served at this point by keeping these documents secret? Don’t the stockholders, at least, have a right to know?
And so that is my proposal: a law that would override the secrecy clauses in derivatives contracts and other contracts that spell out financial arrangements between public companies, and require these contracts to be disclosed or disclaimed within a relatively short period of time.
Until that is done, no one can really say whether the U.S. financial system will stand or fall. But after the secrets are out in the open, we’ll be able to say. And then, the President may be able to keep a straight face when he talks about the economy.
Or maybe we will find out that the whole system is already bankrupt. But it is better to find that out now than to delay, as Iceland did, and allow the system to keep piling up losses. Now people are asking whether the entire country of Iceland could be bankrupt. As far as I am concerned, that is all the warning we need about the potential cost of the secrecy our financial system currently employs.
Most politicians agree by now that derivatives need to be regulated. As Ralph Nader wrote last night:
Defenders of deregulation argued that sophisticated players were
involved in the derivatives markets, and they could handle
It’s now apparent that not only could these sophisticated
players not handle themselves, but that their reckless gambling
has placed the entire world’s financial system at risk.
It seems to be then a remarkably modest proposal for derivatives
to be brought under regulatory control.
Perhaps that is true, but what regulations are needed? How can we tell when the derivatives themselves are protected by a veil of secrecy? A blanket requirement to disclose derivatives would help us pinpoint abuses and show areas where legal restrictions could make the economy more stable. It would also help to avoid the financial calamity that could result from poorly conceived regulatory language. If we are at risk of having our economy toppled by derivatives, it is only prudent that we look at them and add them up. At this point, we cannot even do that, and so it is no wonder that there are people who feel anxious about the economy.