Adventures in Global Finance [Part I]

Understanding Global Finance:
An Introduction.


"You, in your personal lives ... will need to make decisions. These decisions will be affected by the price of commodities, every day of your lives. And all of that happens right here." -- Chairman of the New York Mercantile Exchange

Most people -- until about last week, myself included -- are not very interested in reading about global finance. I know about two people who even understand it. However, what happens in the markets affects all of our lives... and will probably do so even more in the future.

Therefore, it's worth educating ourselves on it. But where to begin?

I began at the nearest node of it, for strangely enough, something as nebulous as global finance does have certain centers, certain geographic locales where it takes place. Yes, this week I paid a visit to Wall Street, where I learned many strange and interesting things. In this four-part series, which attempts to explain some basic history of global finance, I will share with you what I learned from Wall Street.

Please keep in mind that I am thoroughly underqualified to write about this topic, so please help out by posting comments to correct any errors-- and don't believe anything written here unless it corresponds to your own research & conclusions.

That disclaimer given: Let's go downtown & attempt to understand what's going on inside these implacable monolithic buildings . . .






COUNTERING COMMON ASSUMPTIONS.

-- We tend to think that the financial system is kind of a fixed thing that has certain rules that it has always operated with.

-- We think that it is a technological, rational system, taken care of by economists who know a lot more math than we do.

At least, this is what I thought, until I began looking at what actually goes on. I knew that markets could behave erratically, but I considered finance something that is generally looked-after by experts who have been doing this for a really long time.

However, my impression now is of a vast improvisation, a grand experiment that you and me and everyone on the planet is a part of. But this is no science experiment -- there is no experimental design no control, no stated hypothesis or goal. Rather, it is an uncontrolled venture into the unknown, with all our futures at stake.

Dramatic? Maybe, but let's look at some key points.

Most of the financial instruments that are now in use are very new.

Trading in derivatives was up to 681 trillion USD at the end of Dec. 2007 [citation].
(I will explain more about derivatives in the third part of this series -- for now, understand that "a derivative product is a contract, the value of which depends on the price of some underlying asset. You can buy and sell all the risk of an asset without trading the asset itself."-- The Globalization of Finance: A Citizen's Guide, Kavalijit Singh)

So we have this huge amount of trading going on in things that don't actually exist.
What's being traded is contracts to buy things; what's being traded is risk.


To put that 681 trillion in perspective:

• U.S. annual gross domestic product is about $15 trillion
• U.S. money supply is also about $15 trillion
• Current proposed U.S. federal budget is $3 trillion

The GDP for the whole world is just 50 trillion.

So, the value of derivative trading is now 13 times the value of the world's actual production. And this has happened only in the last few years.

(See this article on MarketWatch for more information; citations.)


In the 1980s, most of the "private capital flows" took the form of investors lending to foreign governments, through banks. Now, we have private capital going to the private sector through these financial insturemnts (paraphrased from Citizen's Guide). Stock-index futures began to be traded in 1982; interest-rate futures in 1988; but this trading only exploded in the 2000's.

Also, institutional investors (like investment banks, mutual funds, hedge funds, pension funds) only really emerged in the late 1980s and early 1990s. Instead of investing money themselves, people have these institutions invest their money for them. These institutions now control about 50% of U.S. stocks.

There is thus a fundamental change in financial structure: savings are being shifted away from regulated and insured
banking institutions to entities that are sometimes not insured, and that operate in different regulatory regimes and
have different investment objectives. This rising institutionalisation of savings has a profound impact on the structure
and functioning of the world's capital markets.
-- Hans Blommestein, "The Rise of the Institutional Investor", OECD journal

I'm not really qualified to comment on the consequences of these two developments -- derivatives trading and the increase in institutional investors -- my point is simply that these are radically new developments.

*

What I'm trying to explain is: we don't have a tried-and-tested financial system that manages things; we have a very new, very untested system-- and nobody really knows what the consequences will be.

It is not a game whose rules are fixed:
it is a game where they make the rules up as they go along.

As for the second assumption -- we think that it is a technological, rational system, taken care of by economists who know a lot more math than we do -- I would paint a picture of a system run on emotion, hype, and primitive human impulses as much as mathematics and rationality. The financial system seems shockingly human.

This claim is hard to substantiate, given that not too many people really understand the hows & whys of the markets-- so I offer not evidence, but impressions.

a stock trader, on video at the New York Stock Exchange:

"there's a lot of gut decisions that we make down here ... decisions not only technical or fundamental....

"at the end of the day people want to trade here
they feel comfortable
It's New York
It's the New York Stock Exchange"

The Myth & Mystique. Not just of the places, but of the legendary players. J.P. Morgan. George Soros. Jeffrey Sachs. Alan Greenspan.

"Remember that the stock market is manic depressive" -- Warren Buffet

"The market's judgment is often colored by irrational swings instead of realisitc , measured thought." -- display, Museum of Finance, 48 Wall Street


The look in the eye of the bull as it is beaten by the bear, in the famous sculpture that stood in the NYSE. The primal struggle. Somewhere, this primal struggle, this battle, lies in the human heart of the market.

"it's very primitive
you scream and yell to make yourself heard
It's all about eye contact" -- oil trader on the NYMEX

Global finance from one angle: computer transactions darting across the borderless globe.
Global finance from another angle: Men in a room, a room in New York, a room in physical geographic space, sweating and yelling, high on adrenaline, primitive biochemicals coursing through their blood.

Both these impressions are true, I think.