Yesterday we went out to dinner with friends and one of our friends happened to be working in banking, more precisely in oil futures and options in London financial industry. He is a financial engineer. We asked him what he thought was going on with the oil price and he gave an interesting insight.
The reason, according to him, why oil price and other prices in general (as food) suddenly went up, was related with two factors. The first one, the sub-prime crisis in America. The trillions of dollars in mortgages that cannot be repaid, require the government to issue dollars to finance the losses. The availability of more dollars not matched by a corresponding increase in production (GDP) causes the value of money to drop. And since most goods in international markets are indexed to dollars, including oil, the prices went up as dollar went down. He does not believe in current unbalances in production and demand or speculation, although he doesn't exclude it may yet happen. The second factor, which had to do only with the price of oil, was related with problems in America to refine oil into gasoline, forcing them to look for gasoline in the european market, which caused prices to rise because of more demand.
Now what amazed me the most was his explanation of the financial system. A great amount of the money currently circulating in financial markets, does not exist, nor is there any real chance it will ever exist, and believing that it exists requires a faith as great as believing in God himself.
How it works most of the time, according to my friend, is like this. Say for example Jim has 100 euros. Jack comes along to get a credit with Jim. He asks for 100 euros. Jim does not really hand him the 100 euros, but rather he hands a note that says "I owe you 100 euros". Jack trusts Jim, because he's such a nice fellow and he knows Jim actually has 100 euros somewhere and he will be able to collect it any time in the future when he really needs it. Now Jim knows Jack trusts him, and is convinced he'll get some more money in the future anyway and Jack is not in a hurry to collect so he goes ahead and spends his actual 100 euros somewhere else.
Jack takes the note Jim gave him and goes into a car stand where John works and asks to buy a car, the car costs 100 euros, Jack doesn't have the money but he has the note from Jim, which is good for 100 euros. John also trusts Jim and accepts the note from Jack in exchange for the car. John goes down to Jill's furniture store, and again manages to get the note pushed through in exchange for a complete new set of furniture for his living room. So up to now a lot of transactions have been made purely trusting on Jim's ability to cover that 100 euro note, sometime in the future.
This whole financial system is based on trust and faith. It is enough that the word comes out that Jim is not to be trusted and that note he gave away looses its value and the whole system collapses. So the only way to slow down these fluxes of virtual money is to force interest rates on these credits (by the way have you noticed how interest rates have risen since 2004?)
source http://www.bank-banque-canada.ca/
Of course this happens at a scale much larger than Jack and Jim and the purchase of a few items, it goes on at the scale of countries, and global gigantic financial transactions...
Finance specialists actually attempt to measure the amount of money flowing in the economy, and that amount grows at a rate of 10/12% a year. The GDP which should equal the production of value in an economy grows currently at less than 2%. So there is clearly a lot of virtual money flowing around to purchase futures, options, insurance on profit losses and other crazy financial products, which cannot ever be matched by real hard cash...
This brings us to what happened in the States with the sub-prime loans. Mortgages taken by people who had to make extraordinary effort to pay the installments, to buy houses which were extremely over-valued by speculation. Then the economy slows a bit, unemployment raises or people get sick (and have no health coverage) and they can't pay back, the bank takes their house, a lot of houses appear in the market, their over-valued price drops like stones, the bank has no way to recover the money, the government steps in to issue more money, money drops value, etc...
"The problem for financial markets is that the virtuous circle which pushed asset prices higher in the middle of this decade may be turning vicious. Banks lend money against the collateral of assets, most notably in the form of housing. As house prices increase, the collateral rises in value and the banks are willing to lend more. That enables buyers to bid up prices even further. But when banks stop lending, buyers are unable to purchase assets. Some investors are forced to sell to pay off loans. The value of collateral falls, making banks even more reluctant to lend. Markets freeze up, as neither buyers nor sellers have the confidence to do business." (in Economist 5th July 08)
This was the second person I've met in the last 2 months who says he's working in the financial system to make as much money as possible as quickly as possible and then get out, because everything is so virtual and ethereal, that it is hard to believe it exists at all...
The catch is this though, it is a system that you can't believe can ever work, but if you don't believe it and remove the trust it comes tumbling down... let's pray my sisters and brothers...
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