Signs of the Economic Apocalypse 5-2-05

From Signs of the Times 5-2-05:

The U.S. Stock market gained a bit by the end of the week, with the Dow closing at 10,192.51, up 0.34% from the previous Friday’s close of 10, 157.71. It was a volatile week, however, with the Dow gaining 122 points on Friday. The NASDAQ, while also gaining nearly a percent on Friday lost ground for the week, closing at 1921.65, down 0.55% compared to the previous week’s close of 1932.19. The yield on the ten-year U.S. Treasury bond closed at 4.20 percent down from last week’s 4.25%. The dollar rose against the euro closing at .7772 dollars to a euro, up 0.44% from last week’s .7738. A euro then, would buy 1.2866 dollars compared to the previous week’s close of 1.3066 dollars. Oil dropped sharply last week, below $50 at $49.72, down 11.4% from the previous week’s $55.39. Oil in euros would be 38.64 euros a barrel, down 9.7% compared to last week’s 42.39 Gold closed at $435.50 per ounce, down a dollar (0.23%) from the previous week’s close of $436.50. In euros, an ounce of gold would cost 338.49, down 1.3% from last week’s 334.07. An ounce of gold would buy 8.76 barrels of oil, up 11.2% from last week’s 7.88 barrels.

Before we break out the champagne about the growth in stocks and the drop in oil prices on Friday, we need to look at the reason for it:

Economy Surprises Experts With Sudden Slowdown

By Nell HendersonWashington Post Staff Writer

Friday, April 29, 2005; E01
U.S. economic growth slowed sharply in the first three months of the year, to the weakest pace in two years, as surging energy costs caused consumers and businesses to rein in their spending.

The nation's gross domestic product, which is the value of all goods and services produced, rose at a 3.1 percent annual rate during the first quarter, down from a 3.8 percent rate in the final three months of last year, the Commerce Department said yesterday.

The news confirmed other recent signs of a cooling economy. Job growth, retail sales, factory production and consumer confidence fell in March. New orders for big-ticket manufactured goods have declined in each of the past three months. The trade deficit keeps growing to new monthly records.

The economy has slowed after two years in which growth was boosted by government stimulus -- in the form of tax cuts and low interest rates -- provided in response to extraordinary turmoil.

The Fed cut its benchmark rate dramatically, from 6.5 percent in late 2000 to 1 percent by June 2003, to support the economy through a succession of shocks, including the bursting of the late 1990s investment bubble, the 2001 recession, the terrorist attacks that year, the wars in Afghanistan and Iraq, and corporate scandals.

The White House and Congress also passed several tax cuts during that time, spurring additional household spending. Policymakers had expected that consumers would keep the economy going at a decent pace until businesses eventually rejoined the game and started investing, expanding and hiring again with some gusto.

That last piece of the recovery seemed to be falling into place late last year, when business spending on nonresidential structures, equipment and software rose at double-digit rates. Economists had hoped that would continue into the new year, even after the end-of-December expiration of a tax break designed to boost investment, providing plenty of fuel for economic growth even as consumers grew
winded.

Instead, business spending in that category slowed in the first quarter, rising at a 4.7 percent annual rate, down from a 14.5 percent pace in the previous quarter.Meanwhile, consumers also pulled back, finding their wallets pinched by gasoline prices above $2 a gallon, lagging wage growth and rising interest rates. Consumer spending rose at a 3.5 percent annual rate in the January-through-March period, down from a 4.2 percent pace in the October-through-December quarter.

The slowing U.S. economy led investors to conclude that there is now less pressure on the Federal Reserve Board to raise interest rates, which led to a rise in stocks. The way the mainstream press is describing this weakening (a “soft patch”) presumes that we were in a healthy recovery in the last four years. There is nothing healthy about an anemic expansion fueled by government military spending, tax cuts and personal debt built on asset inflation, or as Kurt Richebacher put it, “wealth deception:”

The Great Wealth Deception

April 27, 2005

This is the most important economic question in and for the world: Has the U.S. economy's rebound since 2001 been aborted, or is it only delayed? Our rigorous disagreement with the global optimistic consensus over this question begins with four observations that we regard as crucial:

1. In the past four years, the U.S. economy has received the most prodigious monetary and fiscal stimulus in history. Yet by any measure, its rebound from the 2001 recession is by far the weakest on record in the post-World War II period.

2. Record-low interest rates boosted asset prices and, in their wake, an unprecedented debt-and-spending binge on the part of the consumer.

3. What resulted was a badly structured economic recovery, which - due to grossly lacking growth in capital investment, employment and wage and salary income - never gained the necessary traction to become self-sustainable.

4. Sustained and sufficiently strong economic growth implicitly requires a return to strong business fixed capital spending. We see no chance of this happening. Above all, the outlook for business profits is dismal from the macro perspective.

This takes us to the enormous structural changes that the Fed's new monetary "bubble policy" has imparted to the U.S. economy over the years. While consumption, residential building and government spending soared, unprecedented imbalances developed in the economy - record-low saving; a record-high trade deficit; a vertical surge of household indebtedness; anemic employment and income growth from wages and salaries; outsized government deficits; and protracted, unusual weakness in business fixed investment.

None of these shortfalls is a typical feature of the business cycle. Instead, they are all of unusual structural nature. Yet the bullish U.S. consensus simply ignores them, bragging instead about the U.S. economy's resilience and its ability to outperform most industrialized countries.

To be sure, all these structural deformations tend to impede economic growth. Some, like the trade deficit and slumping investment, do so with immediate effect; others become repressive only gradually and in the longer run. Budget deficits stimulate demand as long as they rise. An existing budget deficit, however large, loses this effect. Rather, it tends to become a drag on the economy. In the past few years, clearly, the massive monetary and fiscal pump-priming policies have more than offset all these growth-impairing influences.

Assessing the U.S. economy's future performance, it is necessary to distinguish between two opposite macro forces: One is the drag on the economy exerted by the various structural distortions; the other is the enormous demand-pull fostered by the housing bubble and the associated rampant credit creation.

Measured by real GDP growth, the demand-pull driven by the housing bubble has, so far, overpowered the structural drags, provided you believe in the accuracy of the GDP numbers. We do not. Yet even by this measure, as repeatedly explained, it is actually by far the U.S. economy's weakest recovery on record in the postwar period. In fact, measuring the growth of employment and wage and salary income, there has been no recovery at all.

Our stance has always been and remains simple. Asset bubbles and their demand effects invariably fade over time; structural effects invariably worsen over time if not attended to. It is our strong assumption that the negative structural effects are overtaking the positive bubble effects.

We come to another feature of economic recoveries that American policymakers and economists flatly ignore. That is its pattern or composition.

Past cyclical recoveries were spearheaded by three demand components: durable consumer goods, residential building and business fixed investment, regularly following prior sharp downturns caused by tight money during the recession. Importantly, the tight money had always created pent-up demand in these three categories, which promptly catapulted the economy upward when monetary policy eased. For sure, the pent-up demand played a key role in the recovery dynamics.

With its rapid and drastic rate cuts, the Fed rewrote the rules of the traditional business cycle and related policies. It managed a seamless transition from equity bubble to housing bubble. Consumer spending on durable goods continued to forge ahead during the 2001 recession at an annual rate of 4.3%. Residential building never retreated, while business fixed investment took an unusual plunge.

From 2000-04, consumer spending soared by 27.3% on durable goods and 25.4% on residential building. Government spending, too, rose sharply, by 13.9%. Together, the three components accounted for 123% of real GDP growth.

But in the rest of the economy, it was all misery. Despite a modest rebound, business nonfinancial fixed investment in 2004 was still down 0.2% from 2000. Exports of goods posted a minimal gain of 0.1%, whereas imports of goods shot up by 16.5%.

…For generations of economists, it used to be a truism that "wealth creation" implies capital formation in terms of generating income-creating tangible assets. The emphasis was on capital formation and the associated income creation. To indiscriminately put this label of "wealth creation" on rising asset prices in the absence of any income creation is plainly a novel usurpation of this concept. It is in essence wealth creation through a stroke of the pen.

Measured by their net worth (market value of household assets minus debts), American households have amassed unprecedented riches in the past few years, despite spending in excess of their current income as never before.

…The growth of home mortgages exploded from an annual rate of $368.3 billion in 2000 to an annual rate of $884.9 billion in 2004, compared with a simultaneous increase in residential building from $446.9 billion to $662.3 billion. Altogether, the United States experienced a credit expansion of close to $10 trillion during these four years. This equates with simultaneous nominal GDP growth of $1.9 trillion. America's financial system is really one gigantic credit-and-debt bubble.

…A credit expansion in the United States of close to $10 trillion - in relation to nominal GDP growth of barely $2 trillion over the last four years since 2000 - definitely represents more than the usual dose of inflationary credit excess. This is really hyperinflation in terms of credit creation.

More and more people blame Alan Greenspan for the asset inflation bubble, Morgan Stanley’s Stephen Roach prominent among them:

In all my years in this business, never before have I seen a central bank attempt to spin the debate as America’s Federal Reserve has over the past six or seven years. From the New Paradigm mantra of the late 1990s to today’s new theories of the current-account adjustment, the US central bank has led the charge in attempting to rewrite conventional macroeconomics and in making an effort to convince market participants of the wisdom of its revisionist theories. The problem is that this recasting of macro is very self-serving. It is a concentrated effort on the part of the Fed to exonerate itself from the Original Sin of failing to address asset bubbles. The result is an ever-deepening moral hazard dilemma that poses grave threats to financial markets.

I am not a believer in conspiracy theories. But the Fed’s behavior since the late 1990s is starting to change my mind. It all began with Alan Greenspan’s worries over “irrational exuberance” on December 5, 1996, when a surging Dow Jones Industrial Average closed at 6437. The subsequent Fed tightening in March 1997 was aimed not only at the asset bubble itself, but at the impacts such excessive appreciation in equity markets were having on the real economy -- consumers and businesses alike. It was a classic example of the Fed playing the role of the tough guy -- the central bank that, to paraphrase the words of former Chairman William McChesney Martin, “takes away the punchbowl just when the party is getting good.” Unfortunately, the tough guys weren’t so tough after all. Predictably, there was a huge outcry on Capitol Hill as the Fed took aim on the US stock market. But rather than stay the course as an independent central bank should, the Fed ran for cover in the face of political criticism. Not only were its initial bubble-containment efforts put aside, but Alan Greenspan went on to champion the notion of a sea-change in the macro climate -- a once-in-a-century productivity miracle that would justify the stock market’s exuberance as rational. That was the Original Sin that has since been compounded in the years that have followed.

Out of that pivotal moment in the late 1990s, a New Economy actually did come into being. But it was not the new economy of ever-accelerating productivity growth that infatuated the New Paradigm Crowd and legions of equity-market speculators. Instead, it was the Asset Economy that enabled consumers and businesses to draw on the pixie dust of a new source of purchasing power -- asset appreciation -- as a means to augment what has since turned into a stunning shortfall of organic domestic income generation.

Unfortunately, the asset-based spending model has given rise to many of the distortions and imbalances evident in the US today. That’s especially true of low saving rates, the housing bubble, high debt loads, and a runaway current account deficit. When the equity bubble burst, asset-dependent American consumers barely skipped a beat. Courtesy of an extraordinary shift to monetary accommodation, the pendulum of asset depreciation quickly swung into property markets; US house-price inflation has since surged to a 25-year high. To the extent that equity extraction from ever-rising property appreciation was viewed as a substitute for organic sources of labor income generation, hard-pressed consumers went deeply into debt to monetize the windfall. As a result, household sector indebtedness surged to nearly 90% of US GDP -- an all-time record and up over 20 percentage points from levels in the mid-1990s when the Asset Economy was born. Secure in the asset-driven spending posture that resulted, consumers saw no need to save the old-fashioned way out of earned labor income. That’s why the personal saving rate has collapsed and currently stands near zero. Asset-based consumption is also at the core of America’s current-account problem. In an income-based accounting framework, the “missing saving” has to come from somewhere. In this case, that “somewhere” is the foreign saver -- giving rise to the current-account and trade deficits required to attract the foreign capital. As a result, the US current-account gap probably exceeded 6.5% of GDP in the first quarter of 2005 -- easily another record and well in excess of the 4% deficit prevailing in the mid-1990s.

This whole story, in my view, remains balanced on the head of a pin of absurdly low real interest rates. And the Fed has certainly been pivotal in nurturing this low-interest-rate regime. In an extraordinary display of policy accommodation, the real federal funds rate is only now moving above the zero threshold after having spent three years in negative territory. Of course, a central bank has little choice to do otherwise if it has made a conscious decision to underwrite the Asset Economy. After all, it takes low interest rates to provide valuation support to most financial assets -- initially stocks, then bonds, and now property. Furthermore, it takes low rates to make refi debt -- and the equity extraction it sponsors -- look attractive from a carrying cost perspective. Low rates also discourage income-based saving by underscoring the paltry returns available to savers in traditional asset classes. A migration to riskier assets -- such as property and “spread” products (i.e., high-yield and emerging market debt) -- is encouraged as a result. And low real rates make it easier to finance an ever-widening current-account deficit -- especially if the incremental flows come from foreign central banks, where there is reason to tolerate subpar returns in exchange for currency competitiveness. In short, without low real interest rates, the Asset Economy -- and all of its inherent imbalances and excesses - is nothing.

The Fed is not only hard at work in the engine room in keeping the magic alive with a super-accommodative monetary policy but is has also become the intellectual architect of the New Macro. Time and again, since Alan Greenspan rolled out his New Paradigm theory in the late 1990s, senior Federal Reserve policy makers have taken the lead role as proselytizers of a new macro spin that condones the saving, debt, property bubble, and current-account excesses of the Asset Economy. The examples are far too numerous to mention, but consider the following highlights:

* Chairman Greenspan has made light of traditional measures of household indebtedness -- even going so far as to urge consumers to move from fixed to floating rate obligations (see his February 23, 2004, speech, Understanding Household Debt Obligations. Note: All references are to speeches available on the Fed’s website at www.federalreserve.gov).

* Fed governors have also borrowed a page from the Roaring 1990s in denying the possibility of a housing bubble (see Chairman Greenspan’s October 19, 2004, speech, The Mortgage Market and Consumer Debt, and Governor Kohn’s April 1, 2004, speech, Monetary Policy and Imbalances).

* More recently, an army of senior Fed officials -- namely, Chairman Greenspan, Vice Chairman Ferguson, and Governors Bernanke and Kohn -- have unleashed a veritable broadside against the time-honored notion of the current-account adjustment (see their various 2005 speeches, especially Governor Kohn’s April 22 speech, Imbalances and the US Economy, Vice Chairman Ferguson’s April 20 speech, U.S. Current Account Deficit: Causes and Consequences, and Chairman Greenspan’s February 4 speech, Current Account).

* Governor Bernanke has also led the charge in coming up with a new theory of national saving -- that the United States is actually doing the world a favor by absorbing a so-called glut of global saving (see his April 14, 2005, speech, The Global Saving Glut and the U.S. Current Account Deficit); Vice Chairman Ferguson has been on a similar wavelength in dismissing concerns over subpar personal saving (see his October 6, 2004, speech, Questions and Reflections on the Personal Saving Rate).

Is this is an appropriate role for a central bank? In my view, absolutely not. The problem with an activist central bank is that decision makers in the real economy -- consumers and businesspeople alike -- mistake the Fed’s point of view for strategic advice. And so do financial market participants. After hearing the Fed pound the table, consumers feel left out if they don’t spend their housing equity. Business managers felt equally deprived in the late 1990s if their companies didn’t achieve the dotcom-type valuations in the stock market that Chairman Greenspan insisted in the late 1990s and even early 2000 were well grounded in a once-in-a-century productivity miracle. The resulting overhang of excess IT spending was a direct outgrowth of this perceived deprivation. Needless to say, when investors and financial speculators saw the equity train leave the station and the Fed condone the high growth of a productivity-led economy by leaving interest rates low, they saw no reason to believe that a bubble was about to burst. When consumers hear from a Fed chairman that it makes little sense to take on fixed rate debt, they rush to floating rate instruments; not by coincidence, the adjustable rate portion of newly originated mortgage debt shot up in the immediate aftermath of Chairman Greenspan’s comments on consumer indebtedness. And should asset-dependent, saving-short, overly indebted American consumers feel at risk if the Fed assures them that there is no housing bubble -- that the asset-based underpinnings of their decision making are well grounded? A record consumption share in the US economy -- 71% of GDP since 2002 versus a 67% norm over the 1975 to 2000 period -- speaks for itself.

The rhetorical flourishes of America’s central bankers have dug the US economy -- and by definition, a US-centric global economy -- into a deep hole. To this very day, the Fed has never confessed to the Original Sin of condoning the equity bubble. On the contrary, Greenspan & Company have been on the defensive ever since by dismissing the increasingly dangerous repercussions of the original post-bubble shakeout. Far from playing the role of the tough guy that is required of independent central bankers, the Fed has become an advocate of the easy money of a powerful
liquidity cycle. One bubble has since begotten another -- from equities to bonds to fixed income spread products (i.e., emerging market and high-yield debt) to property. And financial markets have gone along for the ride -- not just in the US but also around the world as global investors and foreign central banks have rushed with reckless abandon to finance America’s record current-account deficit.

The day is close at hand when US monetary policy must get real. At a minimum, that will require a normalization of real interest rates. Given the excesses that now exist, it may even require a federal funds rate that needs to move into the restrictive zone -- possibly as high as 5.5%. Yes, this would cause an outcry -- perhaps similar to that which occurred in the spring of 1997 on the occasion of the Original Sin. But in the end, there may be no other choice. Fedspeak has taken us into the greatest moral hazard dilemma of all -- how to wean an asset-dependent system from unsustainably low real interest rates without bringing the entire House of Cards down. The longer the Fed waits, the more perilous the exit strategy.

One of the things I have been meaning to write about recently, particularly in the context of strategically placed financial explosives that could cause the economy to collapse in a “controlled demolition” is the financial time bomb of derivatives and hedge funds. It occurred to me that one set of strategically placed explosives could easily be the derivatives market. Michel de Chabert-Ostland said this in a post from Le Metropole Café sent to me by a friend:

RE DERIVATIVES RISK TIME BOMB: I'll quote from the FT of April 11th, article by John Plender:

" Equally worrying is that the number and size of the black holes in the financial system appears to be increasing by the day. Take the burgeoning derivatives market. Of the $88,000bn notional value of derivatives at US-insured commercial banks at the end of 2004, according to the latest data from the US Comptroller of the Currency, no less than 93 per cent was traded in the non-transparent over-the-counter market in which banks trade directly with each other. Five banks account for 96 per cent of the $88,000bn. Most of their shareholders, I suspect, have little grasp of the risks involved. "

Do you fully realize the meaning of the words above " ....traded in the non-transparent over- the-counter market ". I read that to mean that NO ONE knows where the skeletons in the closet may be and when we do find out, it will be too late to act ( except for a few insiders who will get the news before you and I read about it ). The numbers above are simply mind boggling and I have to believe that, in the not distant future, there is going to be some hair raising losses and systemic financial problems. When this happens, the dollar will have its biggest single day fall ever, gold and silver will fly, and the stock market will take a severe tumble.

The problem, though, was that I didn’t understand enough about the reason why derivatives (basically leveraged futures contracts pegged to values of currencies, stock indexes, commodities or interest rates) present such risks to write about them. Then I read an article by the CEO of Financial Risk Management Advisors Co., Ed McCarthy, whose main point is that these financial instruments are so complicated that virtually NO ONE really understands them, which is a main reason why they present such risks for the whole financial system. He compares them to the types of financial arrangements made by Enron:

There is, at least, a workable hypothesis that the Enron rise and collapse is a possible microcosm of the global bubble ongoing, stoked by massive credit emanation currently believed to be the New Wave of Economic Growth. In its time, Enron was believed to be the new model of corporate growth, expanding exponentially more rapidly than prosaic forebears, incorporating marketing and financial genius, transforming industries and economies and enriching vast constituencies. It was, in fact, a gigantic scam and sham able to deceive with aplomb virtually all areas of expertise in understanding and analyzing risk and reward. A combination of fraud, greed, obliviousness, unbridled ego, unquestioned belief in growth, and fascinated obsession with financial innovation catalogues the “E” debacle. Virtually all these elements are in plentiful supply in global financial markets and the players therein as the world “reflates” with a vengeance in every nook and cranny having a medium of exchange and the means to exchange it.

There is no question of the criminality of many of the players in the Houston company’s demise, however, there is also clear proof that the complexities of modern finance are beyond the comprehension and understanding of many extremely intelligent and supposedly well informed “leaders” of the mammoth organizations now proliferating at excessively rapid growth rates across the global economy.

…Market and corporate growth have expanded beyond the ability of those in charge to be aware of and comprehend the indcredibly rapidly growing risks, both business and ethical/integrity, assumed in this growth!

… Layered on top of the “visible” credit expansion (balance sheet) and the aforementioned “repo” world of credit is a new game rapidly reaching prodigious proportions. CDS (Credit Default Swaps) is the fastest growing game in Speculation Town, the fastest growing gambling town in human financial history. A survey done by Fitch found the total under the purview of U.S. banking regulators at $3.1 Trillion by the end of 2004, having DOUBLED during the course of the preceding year. A recent look at the Bank for International Settlements year end derivatives numbers showed this category globally at $6.4Trillion and Bloomberg totals $8.4Trillion throughout all markets. By the way, the same annual compilation by the BIS showed total notional derivatives outstanding at the end of 2004 of $221 Trillion! The mind
boggles.

… “Financial Engineering, applauded by the eminent Alan, may disperse risk, thereby reducing it, or it may contain the seeds of greater risk an/or deals of questionable or even fraudulent provenance. Warren Buffett, of unquestioned integrity, is now caught up in the Greenberg/AIG deal, of which he knew. The fact that on March 29, Berkshire said in a statement repeated in the WSJ 3/30 that Mr. Buffett “WAS NOT BRIEFED ON HOW THE TRANSACTIONS WERE STRUCTURED OR ON ANY IMPROPER USE OR PURPOSE OF THE TRANSACTIONS.” Leaves two possibilities. 1) He is dissimulating or 2) the size of Berkshire and General Re, the complexity of financial engineering and some generalizations by a, presumably, trusted subordinate after a non-detail conversation with Greenberg previously, left Buffett feeling comfortable about a questionable transaction.

We are inclined towards 2 above and that makes the point of the thesis: The best, most honest, brightest of CEO’s cannot possibly stay on top of what goes on in these complicated financial megaliths. If the presumed honest, such as Buffett cannot, how can anybody believe that it is possible in the convoluted world of an AIG, driven by a CEO consumed by the company’s stock price (per statements by Wall St. analysts on the pressure from “Hank” for laudatory comments) and executives, motivated by excessive compensation for achievement of outlandish financial goals, that anyone within the company actually knows what is really going on. AIG is clearly out of control and only time will tell the order of magnitude. The question is how many other Financial Giants and BFB’s (Big Famous Banks) are in similar condition.

As best as I can understand it, derivatives provide a hedging for financial institutions that protect them against normally foreseeable risks. The problem is that certain unusual circumstances can cause them to crash in unimaginably costly ways. What has kept money pouring into these devices is a tacit understanding that the U.S. Federal Reserve Board will step in in the case of a hedge fund collapse and flood the market with money to avoid the hedge fund collapse causing the collapse of the whole system. This happened in 1998 with the famous Long Term Capital Management bailout. Bailouts like that work until the one time it doesn’t work. What the bailout can accomplish is to spark rises in stock markets right after crises (see here) because investors see that the Fed has bet heavily on a rise in stocks. And that, in turn prevents smaller, more manageable crashes while increasing the magnitude of a crash when it finally does happen.

Two years ago, in March 2003, Robert Samuelson wrote the following in the Washington Post:

Just last week, legendary investor Warren Buffett denounced derivatives as "financial weapons of mass destruction" that could cause economic havoc. By contrast, Federal Reserve Chairman Alan Greenspan says derivatives haveimproved economic stability. Who's right? This is an important debate, because derivatives have exploded and are implicated in two recent financial scandals -- Enron's bankruptcy and the near-bankruptcy in 1998 of Long-Term Capital Management (LTCM), a private investment fund.

…Hedging has spread far beyond the farm. Four-fifths of derivatives now involve interest rates; another 10 percent or so involve currency exchange rates. These provide protection for companies whose businesses involve lots of debt or foreign trade. One benefit, Greenspan has argued, has been the mortgage-refinancing boom. Investors in mortgage-backed securities face the risk that, if interest rates fall, homeowners will refinance. Investors lose. To minimize that risk, they can hedge against lower interest rates. If they couldn't, they might impose larger prepayment penalties or charge higher interest rates.

Similarly, Greenspan has noted that despite $1 trillion in worldwide lending to telecommunications companies from 1998 to 2001, the subsequent telecom bankruptcies have not caused any major bank failures. One reason, he contends, is that banks spread their lending risks to other investors (say, insurance companies) through "credit derivatives." Dispersing risk has made the financial system sturdier, he argues.

Buffett doesn't deny derivatives' theoretical benefits. Indeed, he's not worried by standard futures contracts such as wheat (traded on exchanges, such as the Chicago Mercantile Exchange). What frightens him is the possibility that newer derivatives (traded "over the counter'' -- between one customer and another) could trigger a panic. Financial markets require trust. Without it, people won't deal with each other. Credit and confidence shrivel. To Buffett, derivatives are "time bombs" that could shatter confidence in three ways.

First, a few big banks dominate the market. Among U.S. banks, seven (led by JPMorgan Chase, Citibank and Bank of America) account for 96 percent of derivatives holdings. "The troubles of one could quickly infect the others," he writes.

Second, weakness could feed on itself. A company whose credit rating is lowered -- for whatever reason -- typically has to put up more collateral against its derivatives contracts. A "corporate meltdown" and defaults could ensue because the company needs more cash just when cash is least available.

Third, complex accounting rules for derivatives can lead to overstatements of profits (this was true of Enron) and confusion. All the "long footnotes" on derivatives convince Buffett "that we don't understand how much risk" is involved.

…Even Greenspan concedes "the remote possibility of a chain reaction, a cascading sequence of defaults" that would impel the Fed, heeding Bagehot, to try to rescue the financial system -- an outcome that no one should want.

That was two years ago. Since then, the growth of derivatives has continued to explode, calling into question the ability of the Federal Reserve Board to rescue the system in case of a default. Now we see this:

Hedge Fund Assets Top $1 Trillion for First Time

From Bloomberg News

April 28, 2005
Hedge funds attracted a record $27.4 billion from institutional and wealthy investors in the first quarter, helping to push assets to more than $1 trillion for the first time, according to Hedge Fund Research Inc.

Money streamed in faster than at any other time since Hedge Fund Research began gathering data in 2000, topping the fourth quarter's $27 billion, the firm said Wednesday.

Total industry assets reached $1.01 trillion, it said.

Pension funds, endowments and other big investors have been pouring money into the loosely regulated private pools to boost returns and diversify their investments. Hedge funds pursue a wide range of investment strategies, unlike most conventional mutual funds, which tend to buy and hold stocks or bonds.

Hedge fund assets have grown from $39 billion in 1990, when there were 610 funds. There now are more than 7,900 funds.

Common sense should tell us that the exponential growth in hyper-complex financial instruments may lead to a hyper-collapse at the point when the default tsunami becomes greater than anything the U.S. Federal Reserve Board can handle. That day may be coming soon, since, in the end, the Fed represents the hegemony of the U.S. dollar and the U.S. empire, both of which are now running on fumes.