THE ATTACK ON PROSPERITY
How Speculators Are Causing the Cost of Living to Skyrocket
Spiegal ( Germany )
June 13, 2008
Two worlds have developed. One is the world of the traders at hedge funds and investment companies, and
the other is that of farmers, grain dealers and mine operators. They may be dealing in the same commodities -- barrels of oil or bales of cotton, for example -- but for some these are nothing but abstract concepts while others see them as down-to-earth products.
The problems arise when these two worlds intersect, the fantasy world of speculators and the real economies of cotton processors and coffee roasters. It leads to distortions, like those currently affecting the cotton market.
Speculation is not necessarily a bad thing. When a market sees billions in new investment, it can
stimulate trade, which benefits everyone, improves efficiency and brings about a surge of modernization.
But for some time now, the massive gambles being taken by new financial investors have allowed the commodities futures exchanges, especially in Chicago and New York , to function like a perfect casino. Traditionally the exchanges enable farmers and grain wholesalers to sell harvests early using so-called futures. In a futures contract, the volume, price and delivery date of a given commodity are stipulated in advance, even when the grain is still billowing in the wind on farmers' fields.
For farmers and their customers, futures contracts are a way of hedging against adverse weather conditions. In the case of metals and energy, futures help market players offset excessive price fluctuations and control the delivery of their product.
It is precisely this mechanism that speculators use to their benefit. They buy contracts for the delivery of commodities like wheat or oil when prices are low, thereby betting the billions they invest on prices going up. Traditional commodities traders stand little chance of successfully resisting such speculation. Speculators, by virtue of sheer volume alone, now control the markets. In Chicago, the home of the world's largest commodities futures exchange, the volume of grain futures being traded is already 30 times as high as annual grain production in the United States. This trend is unlikely to be curtailed anytime soon. This year, brokers in Chicago have already entered into 20 percent more contracts than in the same period last year.
Prices for wheat, rice or pork have always been negotiated among farmers, dealers and their customers.
The same thing normally holds true on the commodities exchanges. In the end, futures transactions eventually lead to the actual delivery of a product. In industry parlance, this is called real trading.
But those days are gone. Real trading, says Hubert Gabrisch of the Institute for Economic Research in the eastern German city of Halle , has "become the exception on the exchanges." In the case of wheat, for example, only three percent of traded volume actually changes hands. Prices are now determined by speculators, financial jugglers with no interest whatsoever in having any contact with or physically delivering the vast amounts of grain they own.
A bushel of wheat, a biblical quantity, has become an abstract number in the offices of New York hedge funds, a number perfectly suited for gambling purposes. In most cases, that number has very little to do with the actual value of the staple food behind it.
Speculation is mentioned for the first time in the Old Testament. The ruler of Egypt , who had dreamed that seven abundant harvests would be followed by seven poor harvests, encouraged the practice. To avert this disaster, he created what might be seen as the first government fund in world history, with which he stockpiled grain on a large scale, thereby driving up prices.
A classic archetype for all future panics is the Dutch tulip mania of the 17th century. In 1636, at the height of the bubble, the most highly coveted bulbs, such as the Viceroy and Admiral van der Eyck species, commanded prices on par with the cost of an entire house. All social classes succumbed to the hysteria. Contemporary paintings depict butchers, guards, shipping agents, students and chimney sweeps trading the bulbs in taverns.
But then the Dutch public's faith in a permanently golden future for the tulip collapsed. At a tulip
auction in the city of Haarlem on Feb. 4, 1637, not a single finger was raised when the first bulb went under the hammer. The auctioneer dropped the price, but still no one moved. This led to a widespread selloff of bulbs, causing prices to plummet.
The country plunged into a deep depression. As is so often the case after overheated speculation, the
government had to step in and banned the use of futures contracts, which was already customary at the time. Preachers castigated the speculators from their pulpits, calling the affair "God's punishment for the blasphemous greed and stupidity of the masses."
Failed speculation, followed by hardship and suffering, has been around since human beings first engaged in commerce. And it has always been the fatal combination of excessive liquidity and the herd instinct of speculators that has caused markets to climb and then explode and ultimately collapse.
It seems that every generation has its own speculation to cope with, must experience for itself how unlimited optimism can turn into despair and surefire investment opportunities into laughing stocks practically overnight. Speculative bubbles of the past have included the run on the South Sea Company in 1720, the British railroad bubble in 1846, the stock rally leading up to the 1929 world economic crisis and the dot-com bubble of the late 1990s. The sheer folly of a bubble never becomes apparent until after it has burst.
The boldest speculators are either ridiculed or admired, depending on how well they have done. In 1992,
George Soros's successful decision to gamble billions against the British pound launched his reputation as an ice-cold gambler. Others ended up in prison, like Nick Leeson, a young British stock trader who gambled away more than £800 million in the mid-1990s. When he could no longer hide his losses, he left behind a short note at his desk ("I'm sorry") and fled. His actions led to the collapse of his employer, Barings, England 's oldest investment bank.
America's Capital Markets Are Run by 29-Year-Olds
Speculators -- and speculation bubbles -- have always existed, as a look back in history shows. What is new is the sheer volume of speculation, numbering in the billions, in recent years.
This has something to do with modern financial markets and their instruments, known as derivatives, which major American investor Warren Buffet has rightfully described as weapons of mass destruction. But these weapons are only effective because the central banks have created the necessary environment. Never before in history has the world been deluged by such a flood of money.
Since the beginning of the 1980s, interest rates in the world's major economies have trended downwards. The volume of money has grown accordingly, initially at about four percent a year and now at more than 10 percent. When more capital produces less interest income, investors automatically seek higher-yielding investments.
It is relatively easy to follow the trail of this money. Whenever a large amount of capital floods a
market, it leaves behind a broad riverbed. First there was the rally in the Asian Tiger nations in
the mid-1990s. Billions of dollars in Western investment helped fuel the booming economies of
Thailand, South Korea , Malaysia , the Philippines and Indonesia . But then, in the autumn of 1997, came the crash.
The one party had hardly ended before the next one began. In Moscow , Western speculators gambled with
short-term Russian government bonds until Russia became insolvent in 1998. This led to the spectacular collapse of Long-Term Capital Management, a giant hedge fund, which almost dragged the international financial system down with it.
In his book "The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash," American author Charles Morris wrote, "No matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles." He was describing the policies of the Federal Reserve, America 's central bank, and its chairman of many years, Alan Greenspan.
After the dot-com crash and Sept. 11, the Fed lowered the prime rate by five percentage points, thus ensuring that the market would be literally inundated with money. At the time Greenspan, who was worshipped and practically treated as a sorcerer, kept rates at only one percent for 12 months. His successor, Ben Bernanke, took exactly the same approach when the American subprime mortgage crisis struck last year. He has reduced interest rates seven times since last September.
"The liquidity available worldwide is a driving factor in speculation and innovation," says one expert at the European Central Bank (ECB). In addition to the US 's aggressive low-interest-rate policy, he cites a considerable expansion of the money supply in Asia . Several teams at the ECB are seeking ways to better understand how the financial markets affect changes in the money supply, thereby indirectly influencing inflation.
Out of fear that the markets could collapse, US central bankers have made money cheaper and cheaper, but in doing so they are fighting fire with gasoline instead of water. As capital grows, it seeks increasingly rigorous new sources of return.
Hedge funds are the most aggressive, collecting vast sums of money and investing them in an extremely
speculative manner. If all goes well, they can earn extremely high returns for their investors and, for
their managers, salaries that would have seemed inconceivable until not too long ago.
John Paulson is a case in point. A former investment banker, he has managed his own group of hedge funds, largely unnoticed, since 1994. In 2006, he was earning an estimated annual income of $100-150 million (Eur 65-97 million). Though certainly a vast sum by ordinary standards, Paulson's income was relatively modest within the industry, and not enough to merit any media attention.
That changed in 2006 when Paulson, 52, decided to place his bets on a crash in the US real estate market, especially in the subprime sector, while the overwhelming majority of speculators were still betting on unbridled growth. Last year one of Paulson's funds, Credit Opportunities II, climbed in value from $130 million (Eur 84 million) to $3.2 billion (Eur 2.1 billion), a 2,362-percent increase. Paulson himself made it to the top of the industry publication Trader Monthly's ranking of the top 100 earners in the industry – with an estimated annual income of more than $3 billion (Eur 1.9 billion).
The man in the No. 2 slot on that list, Phil Falcone, recognized potential in Australian iron ore. The senior managing director of Harbinger Capital Partners, Falcone invested heavily in one of the key producers in the industry, Fortescue Metals. The investment paid off, earning him a 114-percent return, and contributing to Harbinger's annual earnings of about $1.5 billion (Eur 967 million).
The new rulers of the financial markets look different than their predecessors, the consistently well-dressed bankers of Wall Street. John Burbank, 44, in his beard, fleece vests and dented old SUV, could easily double as a park ranger. His small company is headquartered in a modest building in San Francisco , as far removed from New York 's Wall Street as possible, and yet Burbank is Wall Street's latest boy wonder. Last year his hedge fund, Passport Global Strategy, earned a record 219-percent return.
"You can only achieve these kinds of profits if your opinions are well outside the mainstream," says
Burbank. One of his investments was in African coalmines.
Recent data generated by the US market analysis firm Barclay Hedge point to the massive influx of hedge fund money into the commodities futures markets in the past few years. Since 2003, these investments have increased by 372 percent, to the most recent figure of roughly $190 billion (Eur 123 billion).
Sometimes, of course, there is more at stake than investments in coal and iron ore. And in some cases
speculators, with their lack of transparency, have bet on an entire economy. The drama currently unfolding in Iceland is a case in point.
In the past few years, the small country's three largest banks speculated against their own currency
because they had borrowed heavily abroad. A few hedge funds got wind of the banks' move and acted on the
speculation that the situation would spin out of control.
"Unscrupulous dealers" from abroad were trying to drive Iceland 's financial system to collapse, said David Oddsson, the head of the country's central bank. He raised interest rates to a record high of 15.5 percent in an effort to save the Icelandic currency, the krone. Since the beginning of 2008, the krone has lost 20 percent of its value against the euro, partly as a result of the actions of the Icelandic banks.
The investors have another trick up their sleeve, though. Now they are speculating that the Icelandic banks will go under. But the Icelanders are fighting back. To raise fresh cash one of the institutions, Kaupthing Bank, is attracting German investors with a record 5.65-percent interest rate on money market accounts.
Meanwhile, the central banks are preparing for the worst. The Scandinavian countries have pledged to
provide Iceland with up to Eur 4.3 billion ($6.7 billion) in emergency cash if its central bank ends up having to bail out the banks. The ECB has also been made aware of the problem. It looks as though it is time for the hedge funds to admit defeat, at least for now, in their battle for the island nation.
It is not unusual for hedge funds to speculate and lose, and many have already failed as a result.
Although there has been no major meltdown yet, the possibility cannot be ruled out. It will happen if
several of these funds bet on the same horse, lose and then drag their lenders down with them. This is because hedge funds operate primarily with borrowed money, which makes them both highly promising and risky at the same time.
Of course, speculation is not a business reserved exclusively for these major financial jugglers.
Millions of small investors are part of the game, consciously or not. Commodities speculation secures
their retirement pensions (unless something goes wrong), and it is part of the diversification strategy
of their life insurance companies and investment plans. Small investors are now also able to invest directly in oil and grain futures.
"A lot of money can be made in this business if you properly utilize growing worldwide demand," Charles Valdes said enthusiastically less than two years ago. He is in charge of investments for America 's largest pension fund, the California Public Employees' Retirement System (Calpers).
Valdes has already invested more than $1.1 billion (Eur 710 million), compared with $450 million (Eur 290 million) in the commodities markets on behalf of the pensions of 2.5 million California public employees. The money is intended to "diversify our portfolio and reduce our risk," says Valdes.
To be continued
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"The master class has always declared the wars; the subject class has always fought the battles. The master class has had all to gain and nothing to lose, while the subject class has had nothing to gain and everything to lose--especially their lives." Eugene Victor Debs