Can A Free Marketeer Defend Regulating Derivatives?

Well, Hernando de Soto does. The great Peruvian expert on building markets in underdeveloped countries points to the irony that our ultra-sophisticated Western market system has replicated everything that is wrong with a Third World informal economy: uncertainty about who owns what, uncertainty about who owes what, and uncertainty about who will or can enforce these ownings and owings.

If you think about it, everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

These 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.

Ever since humans started trading, lending and investing beyond the confines of the family and the tribe, we have depended on legally authenticated written statements to get the facts about things of value. Over the past 200 years, that legal authority has matured into a global consensus on the procedures, standards and principles required to document facts in a way that everyone can easily understand and trust.

The result is a formidable property system with rules and recording mechanisms that fix on paper the facts that allow us to hold, transfer, transform and use everything we own, from stocks to screenplays. The only paper representing an asset that is not centrally recorded, standardized and easily tracked are derivatives.

Property is much more than a body of norms. It is also a huge information system that processes raw data until it is transformed into facts that can be tested for truth, and thereby destroys the main catalysts of recessions and panics -- ambiguity and opacity.

Meanwhile, over at the Peterson Center, Adam Posen and Marc Hinterschweiger question whether the derivative explosion ever really helped the economy that much. Their chart tells the story, but for those who prefer 1,000 words over a picture, here's the text. (h/t Ezra Klein.)

Like most innovations, the theory behind the most-recent financial developments made sense. Innovative financial products such as credit default swaps and collateralized debt obligations were supposed to promote an efficient allocation of risk and hence allow those market participants to bear the risk of an asset who could do so best. Freed from the burden of such risk, nonfinancial companies would be able to engage in more-productive capital formation, generating growth for the entire economy. Furthermore, financial companies would be more stable because they would be able to get illiquid assets off balance sheets and not be tied to collateral. This mantra of Wall Street investors and financial economists alike implied that expansion in the use of newer derivatives and the like would lead to an expansion in the country’s capital stock, and that these financial products would be useful to nonfinancial companies, not just to banks.

The growth of derivatives and real-sector investment in the United States tell a different story . Between 2003 and 2008, US gross fixed capital increased by about 25 percent, a reasonable number during an economic expansion, but hardly a boom. During the same five-year period, the global amount of over-the-counter (OTC) derivatives increased by 300 percent, while derivatives held by the 25 largest US commercial banks rose by 170 percent. Clearly, growth in new financial products has outpaced fixed capital formation both globally and in the United States by a large margin. This has been especially true since 2006, when investment stagnated, but derivatives continued to grow at a rapid rate. There only seems to be a weak link, if any, between the growth of the newest complex—and now proven dangerous if not toxic—financial products and real corporate investment.