Speculative financial attacks

Published: June 7, 2015
The writer is vice-chancellor of the Pakistan Institute of Development Economics

The writer is vice-chancellor of the Pakistan Institute of Development Economics

We live in a world awash with money. Not only can the banks create 20 times more money than the amount they receive as deposits, but an enormous shadow banking system has come into existence which creates massive amounts of credit without any regulatory restrictions. At a time of the global financial crisis, the value of financial instruments was more than 10 times the world GDP. Daily trade in foreign exchange is around $4 trillion, while actual merchandise trade is only $50 billion. This huge excess clearly represents speculation and gambling, rather than currency exchange for the needs of trade.

The ways of the super-rich Lords of Finance are far beyond the ken of ordinary mortals like you and I. Winning and losing bets in millions of dollars daily are just a small part of the thrill of living. One of the important tools they use is buying on margin. This means that you can buy $50 worth of stocks or foreign currency by paying just $1. In effect, the dealer loans you the remaining $49 by using your stocks as collateral. If the stock goes up to $51, you can sell and get out with a quick 100 per cent profit on your investment. If the stock declines to $49, you again sell and get out of the market, losing your marginal payment of $1.

In the 1970s, the dollar was de-linked from gold officially by former US president Nixon. Distrusting the unbacked dollar, the Hunt brothers decided to buy up all the silver in the world. By 1979, they had nearly cornered the global market, taking possession of nearly three million kilograms, about a third of the entire world supply. In the process, they drove up the price of silver from $6 to $50 an ounce, and became richer than the fabled King Croesus. The eight-fold price increase created a dire situation for jewellers around the world. Tiffany’s took out a full page ad in The New York Times, condemning the Hunt Brothers and stating “We think it is unconscionable for anyone to hoard several billion dollars worth of silver and thus drive the price up so high.”

The fates intervened to prevent the Hunt brothers from becoming the kings of silver. The Hunt brothers angered the Reagan Administration in the US, which played dirty to bring them down. COMEX, the regulatory body for commodity exchange, suddenly changed the rules for trading in silver, doubling the margin requirements. This required the Hunt brothers to put up about double the cash for the silver they had purchased on the margin. At the same time, the FDIC changed the rules to prevent banks from lending to purchase commodities. The bear trap closed around the Hunt brothers, who watched helplessly as silver prices started sliding and crashed on “Silver Thursday” on March 27, 1980. Although they lost billions, and eventually had to declare bankruptcy, we need not feel pity for the Hunt brothers. Their rich daddy had foreseen this possibility and created protected trust funds for both brothers amounting to $100 million each, more money than common folks see in a lifetime of earning.

One of the favourite games played by the super-rich is speculating in foreign exchange. Buying on margin provides enormous leverage; one can buy a billion dollars worth of currency for a paltry $20 million. This allows you to attack weak currencies and take them down, making an enormous profit in the process. George Soros created the Quantum Fund to attack the British Pound, speculating on its devaluation. The Bank of England tried to protect the pound with all the means at its disposal, but was eventually forced to yield, creating billions in profits for Soros. Similarly, big money forced open the doors of the East Asian Miracle economies to foreign investors, and crashed these economies while yielding tremendous profits to the investors.

The use of leveraging, derivatives and other complex financial tricks within the unregulated shadow banking system creates a huge amount of excessive credit, which actually changes the rules of game. As the Global Financial Crisis of 2007 demonstrated dramatically, the conventional textbook theories currently being taught in universities throughout the world, do not apply to the modern economy. The most radical change has been the failure of the quantity theory of money. Professional economists were very surprised when huge increases in the money supply did not result in proportional increase in prices, in violation of the quantity theory. The US printed trillions of dollars for the Iraq War and for bailouts and quantitative easing following the Global Financial Crisis, but there was no corresponding increase in consumer prices. Similar phenomena were observed throughout the world. In Pakistan, there has been a 350 per cent increase in the money supply, but only a 250 per cent increase in prices over the past decade.  Professor Richard Werner has solved the mystery by showing that the excess money goes into creating price bubbles in land, housing, stocks and other speculative financial assets. Prices of these assets do rise, but these do not enter the consumer price index, and hence do not cause inflation. Interestingly, Werner’s theories are not well known among economists.

Another serious consequence of excessive money supply being held in the form of inflated assets is that the concept of an equilibrium exchange rate is no longer well defined. Previously, the equilibrium was defined by matching supply and demand for currency, which was based on the real trade balance between exports and imports. Now the speculative transactions, being done at whims of the super-rich, overwhelm the real economy. What controls the exchange rate is largely expectations. The topic of self-fulfilling expectations has gained prominence in the recent literature on monetary theory. If rumours are spread that a currency will decline, people will sell the currency and cause it to decline. Equilibrium theories do not show any significant misalignment of the Pakistan rupee exchange rate, as current popular accounts would have it. The ultimate test today rests on Central Bank interventions. If the State Bank is intervening in the markets by selling dollars to prevent a fall in the price of the rupee, then the rupee is overvalued. However, State Bank Reserves are steadily growing, showing that the rupee is actually undervalued, contradicting the views of leading economic pundits in Pakistan. 

Published in The Express Tribune, June 8th,  2015.

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Reader Comments (7)

  • Arifq
    Jun 8, 2015 - 12:49AM

    I am impressed, this is a really well written financial piece! One can disagree with some of the hypothesis but overall very impressive, great job guys this was a financial thrill to read.Recommend

  • Economist
    Jun 8, 2015 - 8:28AM

    Nice to see such an artictle published at ET. Though there will be no readers for this thing. People don’t know what economic mayhem is coming their way.Recommend

  • London Banker
    Jun 8, 2015 - 12:54PM

    More inaccuracies, “Now the speculative transactions, being done at whims of the super-rich, overwhelm the real economy”. The majority of speculative traders are retail traders also known as scalpers who aren’t rich. They are just so many of them in volume that they drive market movements.

    The author also clearly has not read about MIFID / MIFIR and conduct regulation. You cannot just ‘attack’ a currency. Market manipulation equals instant jail time today. Soros did not manipulate the market, he just noticed an incoherent policy / loophole / unsustainable economic activity and bet against it. This is Soros’ genius which is why he is not in jail today. Such arbitrage opportunities are spotted only by some of the finest minds in the world which is why they are so rare.Recommend

  • London Banker
    Jun 8, 2015 - 12:58PM

    “However, State Bank Reserves are steadily growing, showing that the rupee is actually undervalued, contradicting the views of leading economic pundits in Pakistan.” – Using loans and ‘grants’ from Saudi Arabia to prop up reserves does not show that the rupee is undervalued! Mr. Writer please read this article:


    9% of the increase was attributed to IMF and privatisation. I cannot go on catching the inaccuracies and fallacies of this article but at least we now know more about the “Pakistan Institute of Development Economics”Recommend

  • Uzair
    Jun 8, 2015 - 4:10PM

    This is an amazing article. I am surprised that ET publishes financial analysis of this caliber. Be it the Peso crisis (1998) or Global Financial Crisis (2008), speculative financial attacks trigger all of this. I would love to see scholars of behavioral economics/financial to disentangle the rationale behind financial decision of such high bearings. Great piece!Recommend

  • Shahid
    Jun 8, 2015 - 11:35PM

    @London Banker:

    i completely agree with you. Its sad that Pakistan’s premier ECON teaching institution has Dr. Zaman as VC. And mind you, this is one of the more saner articles. What is happening is that Dr. Zaman, a devout tableghee, wants to fit everything into his world view that is centered around a narrow interpretation of religion. This makes him come up with such hilarious ‘gems’ as ‘British hated money but Americans made them love it’ and ‘every child knows how Britain became superpower’. Sad. Wonder what he teaches to his students at PIDE? Recommend

  • London Banker
    Jun 9, 2015 - 12:12PM

    @Shahid That explains a lot – I made the effort to literally correct the article including mentioning how the merchant trade number is incorrect and what derivatives are used for and how they are legal and not just ‘tricks’ (same for leverage) – And guess what? ET censored my commentRecommend

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