How To Bring The Cancerous Derivatives Market Under Control

by Christopher White

Printed in the American Almanac, September 6, 1993

End of Page Global Speculation -- Derivatives Site Map Overview Page

On March 9, Lyndon LaRouche intervened in the economic crisis to propose a plan that is as simple and direct, as it is potentially effective in its execution: a sales or transaction tax on the turnover of ``financial derivative'' securities or financial instruments. Each time such a security or instrument is traded, he said, it should be taxed at 0.1 percent of its face value, or, as it is called in the derivatives trade, its notional principal amount.

LaRouche's tax would have two purposes. First, it would help to bring under back under control markets which have careened off into outer space, by identifying the kinds of practices which have been swept under the regulators' rug for all too long. Second, the tax might raise between $60 and $80 billion in federal tax revenues in its first year of application. That would be a very handsome sum for the U.S. government, even if it is going to be a self-liquidating kind of tax.

Talk to most people about ``derivatives'' and you pretty soon discover that they have no idea what they are. Still less do they have any comprehension that the financial practices which have developed, since especially 1981-82, represent one of the most serious threats to the very existence of their country and the human species.

That isn't because they don't know about, or understand derivatives; it is because they don't know anything about economics, and because they don't consider that they might have the power to do anything about such things if they were to get themselves educated. That kind of ignorance is what poses the threat to the very existence of the human race, never mind the existence of a nation whose form of government, a republic, is supposed to be based on citizens' self-government.

It is the kind of moral swinishness which asserts that the spread of starvation and disease in the Southern Hemisphere of the world, among peoples of darker complexion, even diseases that are new, and presently incurable, is of no concern. That considers the developing economic breakdown of mainland China and the territories of the former Soviet Union as irrelevant to more pressing every day concerns. That wants to hide from the consequences of collapsing employment, cities and social services in the United States by retreating into the psychotic fantasy world of TV soap opera, sports events, and lotteries.

Time to Study Economics

Anyone who wants to do anything effective about all, or even any of those kinds of problems, each of which on its own sets a short term to the existence of the human race as we know it, has to take on the question of financial derivatives. To take on the question of derivatives, they have to get themselves educated in economics. To get educated in economics they have to go back to the founding documents of this republic, the Declaration of Independence and the Constitution itself, and make the ideas on which those documents were based their own. It isn't the dangers that you know of which kill you, they can be avoided. It is the ones you don't know about which all too often prove to be fatal.

The ideas involved are as old as the recorded history of Western Civilization and the conflict spawned from those ideas yet older. They involved two irreconcilably conflicted views of man, of government, and wealth. On the one side, that man, the living image of God the Creator, is thereby endowed with the divine potential to create, and that in consequence all human life is sacred; that governments were created among men to secure those rights which follow from the sacredness of all human life, that wealth is the fostering of those human potentials which are the living image of the Creator, on behalf of the improvement of mankind and all Creation. Against this stands the view that man is really no different than the lower beasts, that government is a mere administrative matter of ruling over those who cannot rule themselves, that wealth is money, or a title to something that can be turned into money.

Contrast the Declaration of Independence's defense of man's inalienable rights to life, liberty, and the pursuit of happiness with the deepening misery of what passes for economic life around the globe: two-thirds of the human population living at or below subsistence levels, unemployment in Western Europe and North America affecting between 50 and 60 million whose talents have never been more needed. Manufacturing employment in the U.S.A. has not been lower since the mid-1960s, and, as a direct consequence, hunger and unemployment have increased.

What is too often said about proposals to reverse such obscenities? ``It costs too much, we can't afford it. In these days of budget deficits and all, we have to cut, not spend.''

And people believe it.

That's where derivatives come in. While billions of people go hungry, and millions are out of work, the volume of trading in financial derivatives by some measures has grown eightfold since 1987; there was about $12 trillion outstanding at the end of last year, on a turn-over estimated at between $80-100 trillion per year. Some $1 trillion, and more, is traded every day on currency exchanges around the world; half, at least, is accounted for by transactions in derivatives. Three hundred billion dollars of U.S. government debt is likewise traded every day, enough to turn over the entire ``publicly held'' portion of the debt every 12 trading days. Daily trading of derivatives inside the U.S.A. runs at approximately $300 billion per day, roughly the same ballpark as the federal government admits its annual budget deficit to be.

Yet, hunger and unemployment cannot be effectively attacked because ``it costs too much''; after all, ``we have to be realistic about the constraints we are operating under because of the budget deficit.'' But, inside the United States, no one objects to piddling away $50 for every man, woman, and child living on the planet, every day, in pursuit of what the moral degenerates in the financial community call ``risk adjusted return on capital.''

Those who do know what derivatives are, will, if asked, for the most part regurgitate what the bankers and others have told them to say: that derivatives are a necessary part of what they call the ``financial industry ... they hedge risk, ... they make the markets more efficient,'' and so forth. Derivatives embody the lessons that should have been learned from all the financial debacles of the 1980s, from the collapse of Third World debt in 1982, through the looting of the S&Ls, to the real estate bubble of the mid-years of the decade, the leveraged-buyout binge and the collapse of the S&Ls. It is all baloney.

The Point of No Return

The growth of derivatives went past the point of no return at the end of last summer, on Sept. 16, to be precise. That was the day when the European Monetary System was wrecked, the day for which people like George Soros, and Citibank, borrowed billions of dollars to blow out the currencies of Britain and Italy. They showed that day that the speculative cancer that had been unleashed had grown beyond the point that monetary authorities could control.

Farmers who have been ruined by short-sellers on commodities markets know what this is all about: selling what you do not own in order to buy it back later for less. Last summer, it was whole countries that were put through a short-sellers' market play financed with borrowed funds, not just farmers.

That's what derivatives do. They are purely speculative highly leveraged instruments, designed to capture spreads, or pricing differences between different interest rates, currencies, or commodities. So-called rates of return on financial derivatives can vary from 10-15 percent, up to 2,000 percent, and even higher. Why do that? If you think it's to make money, you would be wrong. It isn't actually money anyway, just computer-generated increases in computer-generated accounts. These are instruments of financial warfare, deployed against nations and the populations in much the same way the commodity market short-seller has been deployed to bankrupt the farmer.

That's what we can afford to do, and finance, while the world goes hungry, and jobless.

Taken as a whole, the financial derivatives market, orchestrated by financiers, operates with the vortical properties of a powerful hurricane. It is so huge and packs such a large momentum, that it sucks up the overwhelming majority of the capital and cash that enters or already exists in the economy. It makes a mockery of the idea that a nation exercises sovereign control over its credit policy. What good is a U.S. government policy to inject a few billion or even hundreds of billions of dollars of credit into the economy for jobs or other programs, when the financial derivatives market can overwhelm and counteract the effects?

One hundred billion dollars is but 1/1,000th the size of the financial derivatives market. It is the financial derivatives market that organizes the overall geometry of, and thus significantly determines, how the U.S. credit system functions.

In his weekly ``EIR Talks with Lyndon LaRouche'' radio program on April 28, LaRouche told interviewer Mel Klenetsky: ``This is sucking the lifeblood, in the same way that Michael Milken and his raiders were doing, who were stealing from people's pensions and so forth with junk bonds and these acquisitions. It's sucking the lifeblood out of industries, out of pensions, out of households--out of everything--out of our businesses, out of our farms. These people are thieves.''

Expect a Meltdown

This vast market in the tens of trillions of dollars is international in scope, although 65 percent of financial derivatives trading occurs in the United States. But lawfully, this international market must melt down. It will follow the path of every bubble in history, since the tax-farming pyramiding schemes of the treasury of ancient Babylon and Imperial Rome up through A.D. 300, to the notorious John Law financial bubble in the seventeenth century. The violent effects of an explosion of the derivatives market bubble will far overshadow, the collapse of the leveraged buyout bubble combined with the October 1987 stock market crash, liquidating one-third the value of the market within weeks, and the $350 billion expended since 1987 for the bailout of the commercial banks and savings and loan institutions.

And, that collapse will not be too long in coming. The eightfold growth of these instruments since 1987 is not sustainable, against a backdrop of a world economy collapsing from depression into the nightmare of chaos. Those who have made their paper fortunes out of the speculative fit that has accompanied the growth of derivatives, like George Soros, are moving into tangible assets like gold and real estate. This bubble's days are numbered.

Hence, LaRouche proposed that America reassert sovereign control over its power of credit issuance through the transactions tax. The tax will also introduce transparency, and help show exactly what will have to be done to reconstruct the nation's rotten bankrupt banking system. Half of the $12 trillion outstanding derivatives in the U.S.A. are carried on the books of the top ten banks, like Citibank, J.P. Morgan, and Bankers' Trust. Their paid-in capital is many times exceeded by what they have helped to let loose.

Such tax proposals have been made before. The financiers fiercely resisted them, and usually prevailed. But this time, the stakes are immensely greater than ever before in history.

What the LaRouche tax proposal would do, if enacted, is knock the usurious speculation out cold. That means his tax proposal would permit the properly constituted authorities, under Section 1, Article 8 of the Constitution, to recapture control of the issuance of money and the creation of credit. That is the precondition for any kind of job-creation program, or economic recovery and reconstruction program.

Here's how it would work.

Currently, the derivatives markets, and other financial markets, pay zero percent sales tax on trades. Most states apply a general sales tax of between 4.5 and 9.0 percent on the dollar; that is, a tax is assessed equal in value to between 4.5 and 9 percent of the value of the purchase (transaction) made at the store. Under the LaRouche tax proposal, each trade of a financial derivatives market instrument will be assessed a ``sales'' tax equaling just 0.1 percent of the value of the purchase, far less than the rate ordinary citizens pay every day. It is absurd and dangerous to continuously raise the tax on Social Security and to apply an energy tax, which will devastate every sector of the economy, while the transactions--as opposed to the realization of profit--of the financial derivatives market, which are harmful to the economy, go untaxed.

Let's take the case of the single most widely traded futures contract in the world. It just happens to be the U.S. Treasury's Bond future and it is traded at the Chicago Board of Trade (CBOT). The government issues bonds to raise funds to finance its deficit, and refinance its outstanding debt. Such bonds are issued regularly, by auction, in a variety of different maturities. Interest rates on other obligations, such as fixed-rate mortgages, are effectively linked to the yield on longer term government bonds. Shorter term ones are tied to adjustable rate mortgages, and so forth, in the same way.

The worldwide trading in U.S. bond futures makes a mockery out of all the pious nonsense that is uttered about ``cutting the deficit,'' and ``getting the growth of the national debt under control.''

In 1992, a whopping 71,099,955 contracts in this future were traded. That figure represents one-quarter of all contracts of all types traded on the CBOT, which is the world's largest exchange. The notional principal value of the underlying bond of the U.S. Treasury Bond contract is $100,000. It is usually a bond of 15 years or longer maturity. The speculator buying this contract does not pay $100,000, but only a fraction of that, which is called the ``initial margin requirement.'' Margin requirements vary from contract to contract, but for this one, the initial margin required is $2,025. The leverage in this contract is the notional principal amount, or $100,000, divided by the margin bond requirement of $2,025. Thus the leverage is a spectacular 49 to 1.

Assume, for a moment, that the bond underlying this contract is a 15-year bond bearing an initial yield of 8 percent. Assume further that, during the first hour of trading, the interest rate on 15-year Treasury bonds fell marginally to 7.995 percent. As bond yields are inverse to prices, that would push up the price of the bond to $100,050. The speculator holding a U.S. Treasury Bond contract has made a $50 profit (to realize it, he must either take physical delivery of the bond, or sell the contract to someone). That $50 represents a rate of profit on the investor's original margin investment of $2,205, of 2.47 percent.

The reader may think that $50 is a very small return. Not at all.

First, speculators in these markets play with very large volumes. A speculator may buy 100 contract units of U.S. Treasury bond futures on the CBOT, meaning that the profit realized in one hour of trading (less commissions, etc.) is $50 multiplied by 100, or $5,000.

Second, the actual rate of return placed on a daily or yearly level is huge. For example, were the speculator to continue to realize this 2.47 percent hourly rate of profit for a week, his rate of return would be above 85 percent. Who will invest in steel plants, which return about 5 percent per year, when spectacular rates of return can be made in the derivatives market in a week's worth of trading?

Now, if LaRouche's 0.1 percent transaction tax is levied against the $100,000 notional principal amount of the U.S. Treasury Bond contract that has been purchased, the tax would yield $100, and could be collected by the exchange. But, in this example, the tax is a necessary, unbridgeable hurdle: The speculator will pay more in tax ($100) than his profit ($50). The LaRouche tax makes the deal unprofitable.

Just to break even to cover the cost of the transaction tax, the speculator would have to make $100 profit, which represents a rate of profit of 5 percent on this particular transaction. To go over breakeven, the speculator would have to make $150 or so, representing a 7.5 percent rate of profit on his investment. The chance that a Treasury bond will move up $150 in an hour is slim, although hardly impossible, especially in a manipulated market. But markets can turn very suddenly, as speculators very well know. In markets, in which the time it takes to transact a trade is measured in fractions of a second, a speculator can be severely burned if he is constrained to wait in the market long enough for it to realize a full 5-7.5 percent rate of return. If it doesn't in that time frame, the market jolts the other way, he is doomed.

The threshold level for real or net profitability, introduced by the 0.1 percent transaction tax, will, like a surgical tool, slash trading in this market instrument by at least one-fifth to one-quarter of its volume, puncturing this market, and beginning to dry it out: precisely as the tax is intended.

In this way the tax knocks the bottom out of the existing high turnover speculative market in U.S. government debt, which, at $300 billion per day, is second only to foreign exchange markets in size. Bringing that monster under control is the prerequisite to stabilizing the financial side of the government's operations, and bringing interest rates and credit-generation back under control.

The other example is the Major Market Index (MMI), which is also traded on the Chicago Board of Trade. The MMI is an average of a basket of 20 leading stocks, such as AT&T, Du Pont, or Mobil, and is the favorite of the program traders. By using the MMI in the Chicago futures market, they can send the Dow Jones Industrial Average gyrating up and down. The MMI was one of the chief culprits behind the October 1987 stock market crash. The notional principal of the underlying MMI contract is calculated by a formula, which is 500 times the MMI index's closing price. On May 13, the MMI index closed at $356.40, so the notional principal amount of the MMI futures contract was $178,200. The initial margin requirement that a speculator must commit to buy an MMI futures contract is only $5,400. The leverage built into this contract is 32 times.

Assume that the MMI index trades upward for the day by 25 percent, which, multiplied by 500, per the formula, makes a profit on the contract of $125. However, the 0.1 percent transactions tax for the single trade in the Major Market Index will yield $172. Thus, once again, the tax level is higher than the anticipated profit. A trader in the MMI contract would have to make more than 3.2 percent on his margin investment to go over breakeven. Again, the trading volume of the market in this destructive contract will shrink.

This is how the tax acts to exert reverse leverage. The higher the leverage of the transaction, as in the case of the U.S. Treasury Bond futures contract, the more bite the derivative tax takes, thereby shrinking the markets. In the case of stocks traded on the New York Stock Exchange, the effect is important, but less remarkable. The tax is applied in similar fashion to every section of financial derivatives markets, such as currency and interest-rate swaps held by the banks in the United States.

Human Physical Economy

What is involved here is not so complicated. When people think of the economy they generally jump first to the question of money, ``how much will it cost? ... how can we pay for it?'' It is more useful to think of the economy in two ways. First the physical economy, the production and distribution of the goods and services which permit a population to reproduce itself, by bringing up a new generation of human beings, and qualifying that new generation with the conceptual skills to work productively with the successive levels of technology which will be in use over its coming productive life time.

Thus, unlike the lower beasts, man has progressed from a neo-Pleistocene potential of a few millions, to the approximately 6 billion humans who inhabit the Earth today. Science and technology, increasing the productive powers of human labor, have made this possible.

The financial side of things ought properly to be subservient to the advance of this process. Hence, the power to create money and credit was given to Congress by the drafters of the Constitution, not some self-chosen collection of financial wizards, or some assembly of private institutions. Credit issuance properly should subserve the ``health and general welfare'' provisions of the preamble to the Constitution, to ensure the intended ``more perfect union,'' for ourselves and our posterity.

The increase of the productive powers of labor, through the beneficial effect of technology, cheapens the cost of producing what is necessary for life, as well as of producing new, more skilled labor.

Then we hear, as the financially orthodox tell us all the time, ``We're in debt, we can no longer afford to do those things, we've got to cover the interest charges of servicing the debt, we've got to cut.'' And what gets cut? Employment and social welfare programs, like education and health. These are precisely the kinds of activities which, if encouraged, could reverse the crisis. If these activities are not encouraged, everything gets worse, starting with increasing debt.

The derivatives are the means employed over the last few years to bet on the looted transfer of wealth out of productive economic activity, and into the speculative excesses of what the monetary system has become.

A generation or so ago, the matter of what derivatives are might have been adequately summarized by contrasting the difference between investment, on the one hand, and gambling or speculation, on the other.

The instruments which ``underlie'' derivatives--stocks, bonds, commodities, money--represent a claim, usually through ownership--on wealth produced in the economy. Such claims can be bought and sold. Thus, shares in a company can be bought, as can bonds issued by governments or corporations, or hard commodities produced by agriculture, forest industries, or minerals extractors and refiners.

The instrument so purchased provides a means by which the wealth produced may be turned into money. In the case of stock, this may take the form of the company's dividend payment, the part of after-tax profits distributed to shareholders, or it might take the form of capital gains realized through the appreciation of the stock's value.

A generation ago, such monetization, or potential for monetization, would have been more or less directly related to the economic performance of the company, in contributing to an increasing overall rate of wealth generation through productivity-enhancing increases in the powers of labor. So too are bonds directly related to economic activity, though where stocks represent equity ownership, bonds represent indebtedness. The interest paid corresponds, more or less, to the dividend yield of a stock. And like stocks, bonds can provide capital appreciation.

A generation ago, such financial instruments were the means for transforming economic surplus into monetized net profit.

``Hard'' commodities are very different than these paper claims on the monetary form of society's wealth producing powers. Such commodities are part of the materials-flow needed to sustain production and consumption--and ought to be bought and sold so that production and consumption might proceed--outputs of production on the one side, are also the inputs for the next level of productive transformation on the other: Wheat becomes flour, flour becomes bread; iron ore becomes steel, steel becomes machinery, buildings, automobiles, and household appliances. Such activities used to contribute to generation of surplus, but their monetization is not part of after-tax profits.

Purchases of stocks and bonds would once have been seen as investment for the long haul. Trade in commodities would have been seen not as investment, but as purchases and sales.

With what are now called derivatives, we move from investment, and purchases and sales of hard commodities, to speculating on the future price or yield performance of what were once investments, and relatively simple, economically necessary transactions. It would be like going to the horse races to bet, not on the race, but on the size of the pot. Who would care about what's involved with getting the runners to the starting gate?

The futures market has exploded, largely through the introduction of trading in financial derivatives. All through the 1950s and 1960s, up until 1970, the volume of yearly trading of futures rarely exceeded 10 million contracts. By 1992, however, annual trading volume had climbed to 289 million, 29 times the annual level of 1970. The futures market, valued at roughly $25 to $30 trillion, comprises the largest share of the dollar value of the entire U.S. derivatives market.

All derivatives are actually variations on futures trading, and, much as some insist to the contrary, all futures trading is inherently speculation or gambling. That's what the financiers are talking about when they say derivatives help with ``risk management.'' How big a kitty must you maintain to back up the chips that have been staked.

Futures and Options

Thus, until late in 1989, all futures trading, of any sort, was outlawed in Germany, under the country's gambling laws. Such activities were not treated as a legitimate part of business activity. And, who will contend against the observation that Germany did quite well without them?

There are two types of futures trading; each can be applied to each of the instruments, like stocks and bonds, which, bought directly for cash, monetize what used to be after-tax profits. The first type is, as it were, a second step removed from economic activity as such. This is futures trading per se: contracting to buy or sell at a future date, at a previously negotiated price. Here the presumption used to hold, that commodities, for example, would actually change hands for money, as the agreed-on contracts fell due.

The other kind of futures contract, called an option, moves another step further away from economic activity as such. Now what is bought or sold is the right, but not the obligation, to buy or sell a commodity, stock, bond, or money, at a future price on an agreed-on date.

Where the futures contract speculates on what the price that would have to be paid against delivery will be, the option simply speculates on the price. And then, a futures option, buying the right to buy or sell at a futures contract at a future date and pre-determined price.

At yet another remove from economic activity per se is an index. An index is not the right to buy a commodity or stock in the future which is traded, but the future movement of an index based on a basket of stocks, commodities, bonds, or whatever.

All of these depend on leverage, that a relatively small sum staked, can be turned into more, faster, than by actually buying the underlying instrument itself. In futures trading the leverage is called the margin.

In futures trading, the ``notional principal amount'' refers to the value of the underlying assets in a futures contract. For example, in a corn futures contract to take future delivery of 5,000 bushels three months hence, the notional principal amount of the contract would be the price of a bushel of corn times 5,000. If the price of corn were, for example, $2.00, the notional principal value of the corn futures contract would be $10,000. But the actual price of the contract, however, is the margin set by the exchange; the CBOT, for example, requires $270 be paid to purchase a futures contract that on May 15 had a notional value of $11,637.50.

Since financial deregulation in the 1970s, futures contracts have been developed for things that are not assets or commodities. The first move was the introduction of futures contracts on foreign exchange rates. In May 1972, the International Monetary Market of the Chicago Mercantile Exchange (CME) began trading in the first financial futures: futures contracts on the British pound, Canadian dollar, German mark, Dutch guilder, Japanese yen, Mexican peso, and Swiss franc.

In October 1975, the CBOT introduced trading in the first futures on interest rates, on the Government National Mortgage Association's (GNMA) mortgage-backed certificates. In January 1976, the CME began futures trading in 90-day U.S. Treasury Bills. Trading in futures contracts on 15-year U.S. Treasury Bonds began on the CBOT in August 1977. Trading in such interest rate futures, as they are called, quickly grew to become the most heavily traded futures contracts in the world. On the CBOT, trading in Treasury bond futures and options has risen from 28.3 percent of total volume in 1981, to 64.4 percent of total volume in 1991.

In February 1982, futures contracts for indexes of asset values began trading, with the introduction of futures contracts based on the Value Line Average Stock Index, on the Kansas City Board of Trade. Two months later, the CME began trading in the Standard and Poor's 500 Stock Price Index, which is now one of the most heavily traded futures contracts at the CME. Trading in this contract is considered so important, that the CME set up a special room in a different building to allow continued trading in the S&P 500, when the CME was forced out of its building by the flooding waters of the Chicago River in May 1992, closing trading in all other futures contracts. Not coincidentally, the S&P 500 Stock Price Index futures contracts is one of the instruments the U.S. Federal Reserve has reportedly used since October 1987 to reverse collapses on the New York Stock Exchange.

These markets have mushroomed as the economy has been shut down. The benchmark years identified, 1971, 1977, 1982, are bench marks of the accelerating economic disintegration of the U.S. and world economy, as resources were shifted out of productive activity and into increasingly fantastic and degenerate forms of parasitical speculation.

And now, since the great stock market crash of 1987, we've gotten into the most degenerate of these forms. These are the so-called ``over-the-counter'' instruments, traded between and among the world's largest banks. ``Swaps'' are among them, and are designed to transform a nominally long- or medium-term contract into a succession of shorter-term maturities, now using a purely synthetic instrument, for example, a hypothetical bond which exists only in someone's computer, whose behavior models what a real bond would do if it existed.

The so-called Over-The-Counter instruments account for about half of the total derivatives outstanding in the U.S.A., And they are almost exclusively issued by the large money center banks. Of roughly $6 trillion at the end of 1991, Citibank, accounted for 25 percent of the total, and J.P. Morgan and Bankers' Trust the next largest chunk. That is $1.5 trillion for Citibank alone.

The banks insist that this is not only safe, it is a socially useful and valuable service which they are providing to their clients. ``Why, you must be naive if you do not know that. Let me tell you all about it.'' That is the approach which they adopt.

The amounts involved dwarf the paid-up capital of the banks. But don't worry, they insist, that is only the notional capital amount, and the notional capital amount, as anyone who knows anything will inform you, doesn't mean anything. What's important is the replacement cost, which can be anywhere from one-thirtieth to one-one hundredth of the notional amount. But, hey--wait a minute. It is not only the notional amount which swamps their paid-in capital. The replacement cost would too, if there ever came up a problem which required it to be called on.

They claim these agreements only affect them and their clients. Yet to put such agreements into effect involves going into the financial markets to buy, and sell the derivatives which conform to the parameters of the swap agreements.

For example, swapping a floating-rate Swiss franc-denominated obligation for a fixed-rate dollar instrument between banks, involves the Euromarket, the currency markets, the swap market, and also the interest rate futures and/or options markets. The intrepid might want to try to calculate how far we now have moved from the first level of cash purchases of stocks and bonds.

In the Roaring Twenties, the names might have been different. But the effect was just what it will be again. It all ended up with Roosevelt's bank holiday of 1933, and with the passage of laws which were designed to make sure that such a disaster could never happen again, laws like the Glass-Steagall Act, which barred banks from the securities business, and the Commodities Exchange Act, under which options trading was made illegal and futures could not be traded outside the exchanges.

But now, you see, derivatives, and especially swaps, are not securities, nothing is traded; and therefore they can't possibly be in violation of Glass-Steagall. Nor are they futures. And therefore, they are not covered by the provisions of the Commodities Exchange Act. And, just to be on the safe side, Congress was induced to empower the head of the Commodity Futures Trading Commission to grant waivers from the law to that effect. All those laws have been circumvented by such typical lawyers' tricks. But the end result of such practices cannot be circumvented in that way.

Interest rate swaps and currency swaps are among the largest outstandings. Derivatives on currencies have become the weapon of choice in the war of these speculative practices against the world-wide productive economy. More than $60 billion was deployed into the onslaught against the European currencies last fall. Most of it was borrowed money.

How Big Is It?

If one adds up the value of the annual transactions in all the diverse segments of the financial derivatives market--the many and varied derivatives in currencies, stocks, bonds, interest-rate futures, commodities, etc.--the sum of the notional principal value traded is between $80 and $100 trillion on a yearly basis.

Compare this to the size of the Gross Domestic Product, the official indicator of economic activity. GDP is around $6 trillion, one-thirteenth the size of the smaller range. GDP is not a measure of economic activity, however. It purports to be the net money value of all purchases and sales transactions. Less than one-fifth of such transactions pertain to the reproductive functions of the physical economy. The rest are swallowed up in administrative and sales overhead, around 80 percent of employment, and in transactions which are immoral and also criminal. Now we are down to a ratio of about one dollar in economic activity for every $40-$50 nominally tied up with derivatives.

If derivatives were to continue to increase at the eightfold rate of the last six years, and the economy to continue to decline, that ratio would continue to shift in favor of derivatives, but faster. But, the declining $1 is all there is to provide the loot for the growing $40-50.

The total of $80-100 trillion annual volume is an estimate. The actual magnitude of the problem is not known. LaRouche's tax would bring that out into the light, so that everyone could take a look at what is involved.

This estimate does not include substantial categories of unreported activities. There is no reporting of derivative exposure by any bank in the U.S.A., which includes derivatives instruments with maturities of 14 days or less; yet the purpose of bank swap arrangements, for example, is to transform nominal medium- and long-term maturity instruments into short-term instruments, such that daily trading subserves a contract which is renegotiated every three months.

No consolidated accounting exists of activities by bank holding companies and all their subsidiaries, or by so-called non-bank financial companies--e.g., GE Capital Corp. and General Motors Acceptance Corp (GMAC). Volume estimates are based either on particular banks' activities, or on activities of holding companies as such. The reports for both cover different time frames. They are neither complete, nor are they compatible. Non-deposit-taking lending institutions (non-bank banks in the present parlance) are not covered at all, because they are not regulated. Yet GE Capital and GMAC (and they are only two) are as large as the largest of the bank banks.

LaRouche's transaction tax on derivatives would compel such outfits to account for all their activities in this respect, whether they be regular banks, or nonregular banks, and no matter what the maturity of the instrument might happen to be. The tax would, as we have seen, eliminate the leverage which makes the instruments what they are.

The broader purpose of such a cleanup is straightforward:

So long as present methods of organizing credit flows within the economy and financial system are continued, there will be no prospect of economic recovery, nor a feasible job-creation program, nor any capital- and technology-intensive renewal of the economy. That applies to the world economy as a whole, not just the United States.

Derivative markets--options, futures options, options indexes, swaps, strips--whether on or off exchange, given the rate of growth in their international volume and turnover, especially in currencies and bonds, have become key in setting financially ``acceptable'' rates of return, thus interest rates, and thus overall credit flows. The result has been the strangulation of useful economic activity, as represented by the expansion of productive employment, in favor of the most degenerate forms of speculation.

Bush administration policy and Alan Greenspan's Federal Reserve commitments to avoid at all costs the spillover of the savings and loan banking crisis into the nation's commercial banks, by increasing spreads between bank lending and borrowing, made the problem much worse than it would otherwise have been. Returns from commercial and industrial loans cannot match the derivative-enhanced yield on the tax-free 4-5 percent spread the banks have been given in recent years.

Organizing a Recovery

To organize a recovery is to create new wealth. New wealth can only be created by putting the unemployed back to work in modern infrastructure construction projects, necessary to support expansion in employment and economic activity, and in technologically progressive capital goods industries, to increase productivity. In the U.S. alone, 8 million jobs could be created in the first year of this kind of approach, rebuilding water management and treatment systems, modernizing the nation's transportation system with the technology of magnetically levitated (maglev) high-speed trains, and expanding the power supply, through construction of nuclear electrical generation centers. This type of approach would increase the tax base without increasing tax rates. It would not only be wealth-creating, it would actually help to bring the deficit under control too. Every one million jobs created at $50,000 per year gross income will add more than $7 billion to the Treasury's personal taxation revenue stream directly, and will obviously have quite dramatic additional indirect effects.

It is no different worldwide. To put people back to work in jobs fit for human beings, to solve the food shortage, to begin to tackle the problems of disease, all require the same kind of approach. Nothing can be done in a world which continues to tolerate the practices associated with trading in derivatives.

Therefore, either derivatives and their users will submit to an exercise of national will, or the country will submit to the continued rule of those who employ derivatives.

This article is adapted from a just-released New Federalist pamphlet titled ``Tax Derivatives Speculation; Pop the Financial Bubble, Rebuild the World Economy.''

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``Anyone who wants to do anything effective about today's problems, each of which sets a short term to the existence of the human race, has to take on the question of financial derivatives. To take on the question of derivatives, they have to get themselves educated in economics.''

Business as usual at the Chicago Board of Trade.

``Farmers who have been ruined by short-sellers on commodities markets know what this is all about: selling what you do not own in order to buy it back later for less.''

``The financial derivatives market, orchestrated by financiers, makes a mockery of the idea that a nation exercises sovereign control over its credit policy.''

Cargill grain elevators in Dickinson, North Dakota. Financial p>per on this food will be traded and re-traded before it ever gets to market.

``Daily trading of derivatives inside the U.S.A. runs at approximately $300 billion per day, roughly the same ballp>rk as the federal government admits its annual budget deficit to be. Yet, hunger and unemployment cannot be effectively attacked because `it costs too much.'|''

``Inside the United States, no one objects to piddling away $50 for every man, woman, and child living on the planet, every day, in pursuit of what the moral degenerates in the financial community call `risk adjusted return on capital.'|''

Left, Chicago's South Side; right, a poor family in Houston. As the derivatives markets suck trillions of dollars out of the economy, America's infrastructure, industry, and population collapse.

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The preceding article is a rough version of the article that appeared in The American Almanac. It is made available here with the permission of The New Federalist Newspaper. Any use of, or quotations from, this article must attribute them to The New Federalist, and The American Almanac.

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