Hernando de Soto, the author of the Mystery of Capital, has an interesting opinion piece in the Wall Street Journal (here), which pins much of the blame for the financial crisis on ‘derivatives’ and the lack of regulation around their use.
De Soto first takes on those who want to blame subprime mortgages for the mess where in, but argues that the numbers simply don’t add up.
“Today’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 in the paper on which they — and all other assets — are printed. If we don’t restore trust in paper, the next default — on credit cards or student loans — will trigger another collapse in paper and bring the world economy to its knees.”
This could also be seen as a reminder of why so many people are worried about abrogating contracts with AIG, since contracts are another piece of paper that only have value based on trust.
As De Soto explains “derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone’s property.”
I have always found De Soto’s perspective refreshing in that he manages to balance capitalism and social democratic ideals better than most. So far it does not seem as if the Obama administration agrees with this perspective, but that could be subject to change. Considering how volatile things are these days, i.e. populist outrage over AIG bonuses, it wouldn’t take much for this to become the new focal point of the general public’s concern.
What De Soto makes clear is that any ideas of ‘letting the markets work it out for themselves’ should rightly be abandoned. The neo-liberalism twisting of laissez faire capitalism hopefully has come to an end, but perhaps that is just wishful thinking. However, as De Soto points out that “Adam Smith and Karl Marx both recognized, finance supports wealth creation, but in itself creates no value.”