Derivative Markets: The Real Underground Economy – De Soto

A distinguishing mark for an advanced economy is the extent to which its informal sector diminishes in importance and the ease with which to appraise the stocks and flows of assets within it. This may no longer be the case as Hernando De Soto rightfully points out in a recent article for the Wall Street Journal.

De Soto who is renowned for his work on property rights and the informal sector through his book The Mystery of Capital, Why Capitalism Triumphs in the West and Fails Everywhere Else states that:

(A)t the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

Until I read this, I had no idea that a quadrillion (a one followed by twelve zeros) was an actual number. By getting an idea of the sheer magnitude of these "hidden assets", it should become apparent that no amount of fiscal stimulation by the world's biggest economies will resolve the crisis or prevent another one from springing up if the growth of this shadow economy remains unchecked.

It appears that the market in which hedge funds now operate may be more akin to property markets prior to the enforcement of a consistent land titling system or the unsupervised securities market prior to the Great Cash of 1929. This is a bit worrying since the success or failure of the newly unveilled blueprint for dealing with "toxic assets" rests on the same set of players that originated the mess. The time has come to incorporate this new form of trading within the formal sector so that the spillover effects that imprudent risk trading has caused is prevented from wreaking havoc on the rest of the system in the future.

The Economics of Feeling

It seems that the crisis has cleared the way for new orthodoxies in economic thinking to replace the dominant neoliberalist mode, which is not so much about the "magic of the market" as it is about the rational utilitarian way of assessing choices in the marketplace. Behavioural economics, or what I like to call the economics of feeling puts emotion into the equation. Under this new paradigm, it is not unusual to encounter words such as “confidence” and “trust” as part of the lexicon forming the bedrock of the financial system. De Soto fits in perfectly with this view as he boils down the crisis to a lack of trust by saying,

(T)oday's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it. The real villain is the lack of trust (emphasis mine) in the paper on which they -- and all other assets -- are printed.

De Soto would be of the same mind as European leaders who will be pushing for greater regulation of this new market at the G20 meeting in London this April. Without much needed reform, De Soto asserts, the world capitalist system remains vulnerable to another round of defaults from say college loans or credit card debts that have been bundled, repackaged and sold the same way sub-prime mortgages were.

Attention now turns to what form regulatory supervision and control would take. Already there are calls for a super body from US Treasury Secretary Tim Geithner on behalf of the Obama economic team, which is being opposed by US Republicans. Again, this debate should not be construed as one of markets versus a managed solution. As De Soto points out,

(A)bove all, governments should stop clinging to the hope that the existing market will eventually sort things out. "Let the market do its work" has come to mean, "let the shadow economy do its work." But modern markets only work if the paper is reliable.

Even the most ardent libertarian would not question the role that governments have in enforcing contracts. At the heart of the enforcement problem is the language of a typical derivative contract which lends itself more to a French deconstructionist reading (i.e. signs signifying significations of some other signified) than a common sense interpretation by a third party lay person. It would be better to leave hermeneutics to literary critics. When it comes to valuing one’s assets, plain language that even a fifth grader could grasp would be preferable.