Financial Weapons of Mass Destruction

The following is an excellent excerpt from the book “MAKERS AND TAKERS: The Rise of Finance and the Fall of American Business” by Rana Foroohar from Chapter 6: “Financial Weapons of Mass Destruction: Commodities, Derivatives, and How Wall Street Created a Food Crisison page 179 and I quote: “Shortly after becoming head of the United Nations’ World Food Programme in 2007, Josette Sheeran started carrying a small red cup with her to meetings with world leaders.  To make them understand how the rise in global food prices could translate into starvation, she would pull out the standard-issue cup that the WFP used to portion out porridge, one full serving of it a day, to 20 million schoolchildren around the globe.  On the bottom of Sheeran’s cup was scrawled the name Lily, identifying the little girl who’d once used it.  Sheeran would show finance ministers and presidents and billionaires the small object, which held another day of life for each child the WFP fed.  Then she would show the 1/2 cup line to demonstrate how a doubling of food prices had driven 140 million more people into abject hunger worldwide.

It’s a stark reminder that for most of the world, food is something you eat to stay alive.  But on Wall Street, it’s also something you trade–and the more it gets traded, the higher prices the rest of the world must pay.  In 2008, for the first time in thirty-five years, the world faced the serious and unusually synchronized surge in inflation, the bulk of it due to a precipitous rise in the price of food and energy commodities.  Some of that was the result of global growth, which had been going stronger prior to the financial crisis of 2008; people in emerging markets were eating better and driving more cars.  But as the Great Recession began to sink in, and demand around the world dropped like a stone, it also became clear that something aside from supply and demand was at work in inflating the price of commodities, which had been rising in every category, across every country.  That something was financialization.

The real price of food in 2008 reached its highest level since at least 1845, according to The Economist.  The year 2008 was also the first on record that one billion people worldwide went hungry.  In the United States, prices of food, fuel, and other commodities like cotton kept rising for more than a year afterward.  We felt the pain at the gas pumps (in the spring of 2009, gas prices increased fifty-four days in a row, the longest streak on record since 1996), in restaurants, and while paying our heating bill.  In vast swaths of the developing world, hyperinflation due to rising commodities prices used much greater pain: widespread hunger and even in some places starvation, riots, and political instability.  In Russian, for example, consumers went back to stockpiling food, as they did in the days of chronic shortages under communism, hoarding enough staples like flour, pasta, and oil to last for months–as inflation reached a staggering 15 percent.  Meanwhile China faced record power shortages, as soaring coal prices and government-set electricity tariffs forced smaller power plants to shut down.

There were food-related riots in twenty-two countries; a government in Haiti fell after massive rioting because of food and fuel inflation.  Even in the United States, price volatility caused serious pain in the agriculture sector.  A letter to President Obama in March 2009, signed by 184 human rights and hunger relief organizations urging him to curb commodities speculation, put the problem of price volatility in stark terms.  Rapidly rising food prices caused children in developing countries to perish, the letter said.  And later, when prices plunged just as fast, they “forced farmers in the developing world and the United State from their farms.”

A Morgan Stanley report released in June 2008 summed it up this way: “Much to our own surprise, we find that 50 of the 190 or so countries in the world now have inflation running at double-digit rates,” including most emerging markets.  In other words, Morgan Stanley was shocked to learn–which is somewhat ironic given Wall Street’s role in the spike–that about half of the world’s population was experiencing double-digit price increases on basic living staples.

Much of this is forgotten now because the $1.3 trillion subprime mortgage mess, which happened at roughly the same time, dwarfed the food crisis in terms of economic impact and also eventually caused prices to fall by throwing much of the world into a recession.  But you can’t eat stocks.  And after the meltdown was over, and the central banks of the world led by the Federal Reserve, began dumping huge amounts of money into markets to try to stem the effects of the Great Recession, commodity prices began rising once again.  Global economic growth was still slow, yet the cost of basic food and energy, costs that make up 60 percent or more of the budgets of most of the people in the world (and around 20 percent of the typical household budget in the United States), started to rise precipitously.

Why?  Because investors had more money to play with–and they put it into commodities.  As Michael Masters, an American hedge fund titan, pointed out back in 2009, for years there had been something fishy about the fact that commodities didn’t seem to be rising and falling on supply-and-demand dynamics alone.   In Senate testimony on the issue of market speculation back in 2009, Masters said, “US economic output was dropping during the first six months of 2008.  During that time, the worldwide supply of oil was increasing and worldwide demand for oil was decreasing . . . And yet, despite this glut of unwanted oil, the price has risen an amazing 85 percent per barrel.”

The same was true across many more categories of commodities just a couple years later, starting in 2010, when things like rubber, wheat, corn, and oil began to spike again.  In the spring of 2011, the US recovery was only just beginning to take off in earnest.  Yet Walmart CEO William Simon warned shoppers to be prepared for what he called “serious” inflation.  “We’re seeing cost increases starting to come through at a pretty rapid rate,” he said.  That same year, with many middle- and lower-income Americans suffering the aftermath of the financial crisis, the effects of food inflation began to be more keenly felt.  Data from the US Agricultural Department showed that 21 percent of American households with children were now “food insecure,” meaning that they worried about not having enough money to buy food, or had to skip meals or eat less for financial reasons.

Meanwhile, the world saw the first bout of the social unrest in Tunisia that would eventually become the Arab Spring, a change that has totally transformed the Middle East.  It began, as so many revolutions do, with food riots.  “Food is a radically different threat [than other kinds of financial crises], because it affects so many of the world’s poor so profoundly,” Erwann Michel-Kerjan, managing director of the Risk Management and Decision Processes Center at the Wharton School, told me at the time.  Food is also an amplifier of many other kinds of risk, particularly political risk.  And today its effects are traveling much more rapidly because of the increasing interconnectedness of the world, as well as the increasing power that Wall Street has over the price of a loaf of bread.

There has been much debate since about the role that Wall Street has played in commodities markets.  The effects have been difficult to tease out, precisely because for the five years leading up to the financial crisis, the world as a whole grew faster than ever before.  Yet nearly every economist and many bankers I’ve spoken to believe that financial speculation is playing a greater and greater role in fueling volatility in commodities, a suspicion that is bolstered by the fact that prices of all kinds have begun rising and falling in sync with one another–a historically unusual trend.

In April 2011, journalist Frederick Kaufman wrote an article for Foreign Policy magazine titled “How Goldman Sachs Created the Food Crisis,” which put the blame squarely on Wall Street.  Kaufman outlined many of the headlines statistics about just how financialized food and all sorts of other commodities had become.  Since 2000 there has been a fiftyfold increase in dollars invested into commodities-linked index funds.  It was a shift that was due to several things: the creation of a commodity index fund by Goldman Sachs in 1991, which allowed raw materials to become securities that could be bought and sold by investors; the deregulation of commodities markets in 2000, which poured gasoline on that process; the financial crisis of 2008, which scared everyone out of stocks and drove investors into “safety” bets like raw materials; and the beginning of the Federal Reserve’s quarantine easing program the following year, a $4.5 trillion money dump that was meant to help Main Street but ended up giving up in commodities markets, dramatically boosting the prices of those commodities–the raw materials that people depend on to heat their homes, fill up their gas tanks, and feed their families.  For many people around the world, this made something as basic as eating literally unaffordable.

The Price of a Loaf of Bread – Commodities markets are tricky in all kinds of ways.  For starters, they involve raw materials that are often owned and extracted by state-run firms in difficult places (Russia, the Middle East, West Africa, and so on).  Access to these materials–such as corn, wheat, oil, metal ores, uranium, gas, coal, and rare earth minerals–is dependent on many volatile factors, like weather and politics.  The commodities aren’t just what we all need to survive; they are also the basic building blocks of business.  Asset flows between two banks can certainly affect the real world, as we saw in 2008.  But flows of commodities are even more important.  They are essential to the daily economic operations of the entire planet.  Quite simply, we can’t live without them.

Commodities are also inexorably tied to one of the most crucial, and yet most problematic, financial markets out there: derivatives.  The traders who helped trigger worldwide food riots and drive up gas prices were in some cases buying actual raw materials for their clients (or their own banks), but in most cases they were merely buying bets on the future price of those materials.  Derivatives are a financial tool that has been used for centuries, even millennia, as an insurance policy on the risk of owning things like rice, or oil, or property.  Purchasing a derivative that helps you hedge against a loss or an adverse shift in the markets can be useful.  Farmers, for example, need to be able to make such bets to lock in prices for their crops in advance, lest they drop before the crops get harvested.  Airlines or trucking companies might need to “hedge” oil so that price increases don’t put them out of business.

But by the 1990s, and much more so after 2000, derivatives began to explode and expand in a way that made it clear that at least some of what was being traded had nothing to do with protecting people or companies in the real economy, but was more about speculation–one could call it gambling–with an increasingly complex array of financial instruments, on things like interest rate swaps, credit default swaps, and even bets of what the weather would be like from day to day.  Derivatives are best known to most people as the “financial weapons of mass destruction” that Warren Buffett has warned us about, the complex securities that blew up our financial system in 2008.  These financial instruments–be they interest rate swaps, foreign exchange bets, or grain futures–have very real, very tangible impacts.  Yet to the banks, hedge funds, and the other institutions that trade them, they are simply another part of the economy that can be arbitraged for profit.  That kind of trading for its own sake is part of the closed financial loop described in the introduction to this book, a loop that enriches mostly financiers but can endanger both businesses and consumers.

As if Wall Street’s ability to buy as many grain or oil futures as it wants–often with our retirement money–and contribute to runaway inflation weren’t enough, there’s another problematic wrinkle that finance has brought to the commodities markets: Today bankers can both trade commodities and buy up the physical goods being traded.  Goldman Sachs can technically own farmland, for example, and trade the grain grown on it.  Although Wall Street has long bought and sold commodities futures and swaps, the combination of purely financial trading and ownership of physical commodities was a trend that began to accelerate around 2000, thanks to deregulation and a torrent of pension money that began to flow into commodities as an asset class.  Only financial institutions have this ability to both make the market and be the market–to trade the products they own, hoarding or even manipulating them if they like, to raise or lower prices at will.  They are the fox in the henhouse–except they also designed and built the henhouse, and they get to butcher the hens, and sell the eggs if they want.  This unique market position does more than enable them to push food prices so high that people go hungry.  It also puts them in direct competition with the businesses that actually need such raw materials means that American business now has to compete with its own bankers.  It’s a perverse cycle that is wreaking competitive havoc on US industry, as described in the story below.”

(THE FOLLOWING IS A QUOTE FROM MOHAMED A. EL-ERIAN AND I QUOTE:

“In this well-written, refreshing and provocative book, Rana Foroohar analyses how Wall Street went from an enabler of prosperity to a headwind to growth and a contributor to inequality.  This engaging analysis identifies five key policy areas that will rightly be the subject of debate and, hopefully, some political action.  This is a must-read for those looking to better understand how, why, and when financial engineering went too far, and what to do about it.”  —MOHAMED A. EL-ERIAN, chief economic adviser, Allianz; former CEO, PIMCO; and author of The Only Game in Town

MY COMMENTS: THIS CHAPTER IS THE BEST BECAUSE IT SHOWS THE GROWING, UNREGULATED, TOXIC DERIVATIVES AND HOW IT’S CAUSING ALL THE COMMODITIES–FROM FOOD TO OIL–TO INCREASE IN PRICE AND MAKE IT HARD FOR THIRD-WORLD COUNTRIES TO AFFORD FOOD.  THE BATTLE IS ALWAYS GOING ON WITH THESE BIG, UNREGULATED HEDGE FUND DEALERS.  WHO SHOULD CONTROL THE ECONOMY–A FEW BIG UNREGULATED INVESTMENT BANKS OR THE GOVERNMENT ITSELF? RUN LIKE PRES FRANKLIN ROOSEVELT SET UP WITH A FAIR INCOME TAX SYSTEM, WHICH HE HAD, A WELL-RUN SOCIAL SECURITY SYSTEM [WITH THE GOVERNMENT NOT CONSTANTLY BORROWING FROM IT TO PAY FOR OTHER MISTAKES THEY MADE, MAINLY IN BIG BANKS], REGULATIONS ON THE BANKS WITH THE GLASS-STEAGALL ACT WHICH WAS ABOLISHED IN 1999 BY PRES BILL CLINTON AND THE BIG BANK LOBBY WHICH SATURATED BOTH PARTIES WITH HUGE CAMPAIGN CONTRIBUTIONS TO GET WHAT THEY WANTED. HOPEFULLY, A MODERN VERSION OF GLASS-STEAGALL GETS DISCUSSED IN THE PRESIDENTIAL DEBATES BECAUSE BOTH CANDIDATES ARE INTERESTED IN REINSTATING IT.

LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran

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About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog (my.barackobama.com) and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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