Basically it comes down to the production, in August 1972, of an affordable pocket calculator
Who is to blame?
The world is echoing to the cacophony of regulatory doors being slammed.
On 23 July 2002, Johnathan Freedland wrote in the Guardian:
It's like a scene from the latest first-class American TV import, Six Feet Under – a dark comedy set in a family-run undertaking business.
Picture: the coffin sealed and varnished, the final farewells uttered and the conveyer belt humming into motion, gliding the dear departed into the flames. Suddenly there is the sound of knocking and muffled cries. 'Omigod!' the mourners collectively realise: the corpse is alive!
The reaction to the wave of financial scandals from the US has felt a little like that. Enron, WorldCom and Xerox's fudging of the numbers:'a billion here, a billion there' as President Bush so coolly put it , has had the left putting on its best black suit as it gets ready to bury American capitalism. They've been bidding goodbye to a system they reckon is in grave crisis and terminal decline. Cause of death: the exposure of some of America's starriest corporate names as hollow shams. And, they predict, if the US economy is on the skids then surely the big bogeyman, globalisation, cannot be far behind. Today, WorldCom; tomorrow international capitalism itself will lie in ruins!'
Mr Freedland went on to say that all would be well, that the financial world would learn from their mistakes, and that there would be new, bigger and better regulation: a better world.
He was, of course, completely wrong.
Quite why anybody is in the least surprised at the present situation is beyond me. But now, to divert any pointing fingers that might be aimed at them, the world's financial journalists are frantically trying to find someone to blame.
They are also (mostly) entirely wrong, and it most certainly wasn't the fault of poor old Gee-Dubbya-Shrub, he's far, far too stupid to be responsible for anything.
What can be derived?
In no circumstances enter the derivatives trading market without first agreeing it in writing with me ... at some time in the future it could bring the world's financial system to its knees.
– Sir Julian Hodge (1990 Memo to senior executives of his Bank)
... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
– Warren Buffett (2002 Chairman's Letter – Berkshire Hathaway Annual Report)
The first spate of present-day derivative disasters started in 1994 and involved Metallgesellschaft, Orange County, Sears Roebuck, and Proctor & Gamble, all 'losing' millions on 'bets' that had nothing whatsoever to do with their core business. More followed in 1995 when the Daiwa and Barings banks discovered that their backroom boys had bet the entire contents of the vault on which financial fly would crawl up the windowpane fastest.
On their own, none of these really threatened to topple the system, but three years later, the $3.5 billion Long Term Credit Management(remember the name) bail-out certainly threatened its long-term credibility.
Ten years down the wobbly line, in March 2008, the FED really did have to do something to avoid what the pundits termed a derivatives Chernobyl. Bear Stearns' (the bankers' bank) $17 billion 'reserve cushion' had suddenly been found to have just vanished.
That didn't avert disaster; it just delayed it – throwing a straw to the man overboard to clutch at. But the roulette wheel was still spinning and the game went on. Now the trillions of dollars, pledged by governments to shore up the banks – in October, is just the whirlpool created by a sinking ship that sucks everything down with it.
None of the actions by governments or the regulatory authorities have been more than dabbing a mild antiseptic on the festering sore. Not one action on their part has actually addressed the underlying cause.
Sir Julian Hodge's apocalyptic warning came over three years before the leaks first started appearing in the financial hulk. He had spotted the cause all right, but didn't offer any solution to the problem other than to avoid it.
Fair enough then – but what is the root cause of the problem now?
Basically it comes down to the production, in August 1972, of an affordable pocket calculator.
The rise and rise of the brothers grim
Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers together audit all of the FTSE 100 companies. That's not a bad concentration of oligopolist power by any standards. Between them, the Big Four Bean Counters employ over half a million people and generate around $100 billion in revenues, that is $200,000 per employee and not bad going.
There were five, of course, but after Enron and Worldcom, something really had to be done about old Arthur Andersen, whose sudden purchase of hundreds of paper shredders indicated that he 'might just' have been up to something, although his only real crime – in the eyes of the accounting world – was 'getting caught'.
But, instead of locking them up where they belonged, every last one of the tens of thousands of Andersen's 'associate partners' (other than a very few who took their 'retirement bonuses and stock options') went and joined one or other of the remaining Big Four.
Despite voluble inhalation of breath through gritted teeth on the part of governments and financial regulators, nothing, absolutely nothing, really changed.
To any normally sighted, sane person with an IQ of something over 75, it is pretty obvious that if you are doing an audit of a company for a fee of $300,000, and at the same time, you have a $1 million consulting contract with them to 'fix the books', you are less than unlikely to be 100% 'independent' with the audit.
But it gets better. When the government or their regulators write the rules covering 'counting beans', whom can they get to write them? It's all far too complicated for mere politicians or their legal advisors, so they get someone out of the back office of the Big Four (who really do understand beans) and pay him $1,000 with free luncheon vouchers to do it for them.
This is not a matter of 'poacher turned gamekeeper', it's not even gamekeeper turned poacher; it is just sheer, utter, crass stupidity.
If you suggested that Josef Fritzl wrote the law on child care and then appointed him to run a girl's seminary, whilst giving him the role of chief inspector of schools, people would say you are stark raving mad.
Yet that is exactly what the financial world has done since the end of the Second World War and Bretton Woods. Of course the banks and the company executives are to blame but, if you left a group of undernourished, uneducated, ill-disciplined children in a sweet shop, totally unattended for a whole day, would you really expect to find none of the sweets missing in the evening?
Accountancy now comprises conflict of interest; anti-trust, collusion and cronyism used to shuffle risk and fiddle company books on a monumental scale.
Accountancy is simple – if dreadfully boring. It's five-year-olds' maths: you add up two columns of figures – earnings and expenditure – and take one total from the other.
Our experts describe you as an appallingly dull fellow, unimaginative, timid, lacking in initiative, spineless, easily dominated, no sense of humour, tedious company and irrepressibly drab and awful. And whereas in most professions these would be considerable drawbacks, in chartered accountancy they are a positive boon.
– Monty Python sketch in which accountant Mr Anchovy undergoes vocational guidance counselling.
Hedge fund or fudge?
Annual income twenty pounds, annual expenditure nineteen pounds, nineteen and sixpence, result happiness; annual income twenty pounds, annual expenditure twenty pounds, ought and sixpence, result misery.
– Mr. Micawber 'David Copperfield' by Charles Dickens
Essentially, the development of the pocket calculator made the job of the accountant redundant and in order to remain in existence they had to re-invent themselves.
Hans Christian Andersen (author of 'The Emperor's New Clothes' (1830) must have been one of Arthur Andersen's forbears. Although there is nothing new whatsoever about 'derivatives' – just as there is nothing new about the phenomenon of 'telling lies', the scale on which the Big Bean Counters churned out new 'financial tools' and the derivatives to go with them beggars belief. However, the greed and willingness with which the corporate world 'bought the dummy' is totally beyond comprehension.
Derivatives, in their financial form, are 'things' that have no intrinsic value, but derive their value from something else. The idea is that you can offset the risk (and expense) of actually owning 'real' things that might be subject to unpredictable change; such as a bag wheat going mouldy, a $ turning out to be Zimbabwean, or a pig-in-a-poke needing feeding.
Derivatives' value can depend on anything from what the weather is like, the price of pig-swill or whether you had an argument with your wife before coming to work in the morning.
Or, to put it in plain English, derivatives are a way of fooling someone into parting with their hard-earned money for something that does not actually exist.
There is absolutely nothing 'new' about them. In the 12th Century, sellers at itinerant fairs signed contracts promising future delivery of the items that they didn't actually have with them there and then.
But, although 'derivatives' were not new, making an industry out of them was.
Derivative traders are like a bookmaker once removed, people who take bets on whether people will make bets and what they will make the bets on.
Quite why anyone would want to be a bookmaker once removed is an enigma but the even bigger conundrum is why anyone – other than the most compulsive gambler – would ever want to put their money into the hands of such a person.
So, if there is nothing new about derivatives, or the people trading in them, why did these latent weapons of mass destruction suddenly become (sub)-primed?
Where do the Bean Counters come in?
One clue to the answer can be found back in 1936.
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not the faces which he himself finds the prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.
It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree when we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.'
'The General Theory of Employment, Interest and Money', John Maynard Keynes, 1936
That was written during the 'Great Depression', an attempt to explain 'where it all went wrong'. Did we learn anything from it? – No.
But in 1965 Texas Instruments' developed the 'CalTech', a prototype pocket calculator. Within a very few years they were ubiquitous. By the early 1970s the accountancy world was rigid with fear as there was really no need to employ someone to add up two columns of figures when you could have a little plastic box, the size of a fag packet, in your pocket that, whilst a trifle expensive, didn't demand 'fees' and constant cups of tea.
Help was at hand for distressed and confused accountants when Messers Fischer Black and Myron Scholes – the 20th Century 'tailors' for the financial Emperor's new clothes – came up with the solution. They devised a way to determine just how much a 'derivative' was worth; and this opened the lid of the Pandora's box of creative accounting.
They came up with the natty concept that the price of the underlying instrument St followed a Brownian motion (read into that what you like!) and defined it with the wonderfully simple formula:
δSt = \μSt\, δSt + \σSt, δWt (where Wt is a Wiener process with constant drift μ and volacity σ).
Of course you did.
Well, if you didn't, you must be really, really stupid and you do need an accountant after all, because your 1972 Sinclair Executive doesn't have δ, μ, σ or St functions on it.
The Beaver had counted with scrupulous care,
Attending to every word:
But it fairly lost heart, and outgrabe in despair,
When the third repetition occurred.
It felt that, in spite of all possible pains,
It had somehow contrived to lose count,
And the only thing now was to rack its poor brains,
By reckoning up the amount.
'Two added to one—if that could but be done,'
It said, 'with one's fingers and thumbs!'
Recollecting with tears how, in earlier years,
It had taken no pains with its sums.
Almost overnight accountants started driving BMWs, wearing Armani suits and sporting Tag Heurer watches. Accountancy was suddenly smart, accountancy was clever, and if you hadn't a clue what they were talking about then it was you who were stupid.
'Taking Three as the subject to reason about—
A convenient number to state—
We add Seven, and Ten, and then multiply out,
By One Thousand diminished by Eight.
'The result we proceed to divide, as you see,
By Nine Hundred and Ninety Two:
Then subtract Seventeen, and the answer must be,
Exactly and perfectly true.
'The method employed I would gladly explain,
While I have it so clear in my head,
If I had but the time and you had but the brain—
But much yet remains to be said.
While the Beaver confessed, with affectionate looks,
More eloquent even than tears,
It had learned in ten minutes far more than all books,
Would have taught it in seventy years.
– Lewis Carroll: The Hunting of the Snark
It was so 'hip' that by 1975 the number of 'qualified' accountants being churned out per year in the UK had increased so dramatically that – had the increase continued at the same level – by 2020 every man, woman and child in the country would have been an accountant.
Of course people saw that it was complete nonsense but – just as with 'The Emperor's New Clothes', nobody, but nobody dared risk being branded as 'stupid' by actually telling the truth; that a 'brownian motion'is also a euphemism for a piece of excrement.
The Nobel Prize for Duplicity
So convincing were our two financial tailors that in 1997, on behalf of the Emperor, the Royal Swedish Academy of Sciences awarded the Nobel Prize for economics to none other than Professor Robert C. Merton and Professor Myron S. Scholes,
Just one year later the Emperor had to raid his piggy bank, and the Federal Reserve coughed up $3.5 billion to rescue a fudge henge called 'Long Term Capital Management ', as they were terrified that its demise might lead to the collapse of the entire financial pack of cards.
Even then, nobody thought to ask – let alone do anything about – the fact that the two tailors, Merton and Scholes, just happened to be principal shareholders in the henge!
Rather than take their Nobel Prize away, and incarcerate them safely where they couldn't do any more damage – the FED poured more money into their pockets so that they could carry on selling the invisible derivatives of their fertile imagination to hapless investors who still believed that the Emperor was fully clothed.
There is, however, a difference between Arthur and Hans. Our financial tailors didn't just calculate on the vanity of an Emperor and the stupidity of his fawning courtiers and lackeys, they reckoned on greed – everybody's greed – and they had it in plenty.
'Risk' became even more fashionable, risk became 'fun'. Dam it all – if you get away with losing $3.5 – what the hell? Loadsamony.
Through the last quarter of the 20th Century creative accountancy produced an entirely new breed of corporate employee – the Risk Manager – and they shimmied their way up the org-chart even faster than HR managers.
Gone were the days when soap manufacturers made soap and municipalities spent local taxes on public amenities. With clever accounting and Merlin-the-Manager on the board, you could double your investors' (or taxpayers') money and give them slightly better dividends (or amenities), whilst quadrupling your own 'index-linked financial package' and stock options.
Did anyone actually ask the shareholders whether they wanted the money that they had invested in soap production placed on an each-way bet as to whether the interest rates in Vanuatu would change? Did anybody ask where the man in the brown suit, who totted up the figures, had gone to?
No, there was no need to, they all prayed six times a day to the prophet (peace be upon him) of profit and HIS word was the manor.
The Four Professionals
Even if they had asked the shareholders, even if they had explained the sums to them, it would probably have made little difference. Investors had changed, and as society got greedier, so did the investors.
In the late 1980s and early 90s Robert Maxwell had epitomised just how trustworthy managers of pension funds and Thatcherism could be. The only significant change was that the accountants stepped in with their magic 'financial tools' and made all of the fudged figures invisible.
Everybody was happy and even happier still as it started to become apparent that you really could 'hedge your bets' in the investment casino of Wall Street and the City. On the Black & Scholes managed Wallcity Wurlitzer, even if your stake did disappear down the plug-hole, the FED or the Treasury would step in to make everything OK.
Even the dumbest punter knew that if you put ten-and-sixpence on number seven to win the 4:30 at Kempton Park and number seven came in last, you didn't get to have any beer that night and Messers Hill, Ladbroke & Coral got to fill up their Rollers. Nobody minded – that was the name of the game.
If – perchance – number seven did win the 4:30, Messers Hill, Ladbroke & Coral would dutifully dig deep into their silk-lined pockets and pay you exactly what they owed, and, if your further bets turned out to be correct, they would continue to pay you to the extent that – if necessary – they would pedal to work on their bicycles rather than sitting comfortably in the back of their Rollers – that was the name of the game.
Of course – that never happens and has never happened, as Messers Hill, Ladbroke & Coral know their jobs a damned sight better than any Nobel Prize winning Hedge Fund Manager.
Bookmakers really understand risk management and they don't hype it up in a tissue of jargon to conceal lies. Compared with the average fund manager or auditor, they are scrupulously honest, as they have no 'vested' interest. They rely entirely on their skill and know full well that – if they get it wrong – they cannot go whinging to the Treasury or FED and ask to be bailed out.
Luck doesn't even get close to the door, let alone getting its foot in it.
But we didn't ask, we didn't think and we certainly didn't learn.
We put our trust (and money) in the promises of the bean counters, and as the fire of invisible assets died down, we heaped paper money on the smouldering embers of the dying economy, and blew it until the whole lot exploded in a ball of fire.
Oh – and if you are in Ol' Bighty, don't rely on gold. Between 1999 and 2002,George Brown-Trousers (blessim) swapped 60% of the UK's gold reserves (at a 20-year low), for some Black & Scholes nearly new, nice neat asset derivatives.