One of the loudest critics of liberal capitalism in Australia, Robert Manne, has blamed derivatives for the crisis. In this he is not alone. In America another prominent anti-capitalist crusader Richard Katz has also pointed the finger at “the explosion of unregulated derivatives in the United Stats and globally” building on the housing bubble.
This is the perfect enemy for the anti-capitalists because the cause of the problem was the financial market itself. Boo. Hiss.
But, like the “blame savings” thesis, the “blame derivatives” thesis fails to explain the main problem.
The idea is that the markets packaged bad home loans into new financial vehicles and these were widely traded around the world. Derivatives are a financial asset that gain their value by leveraging to real underlying asset. They enable people to shift risk to people who are most able or willing to accept the risk. They also allow people to take a more nuanced position in any market. With home loans, the original writers of the debt were able to sell the risk as a derivative, and as home loans have gone bad these derivative holders have faced losses.
But this answer fails to address the initial problem – which is the existence of the bad home loans in the first place. Derivatives don’t create the underlying asset. They are an add-on to any pre-existing asset. Further, derivatives don’t increase the risk or the loss. They simply allow the risk to be traded.
If it was the existence of derivatives that is the main problem, then all derivatives should have the problem and not only those derivatives related to home loans. But that isn’t the case.
True, people wrongly assessed the riskiness of the property-based derivatives. But that isn’t the fault of the derivatives. The real questions that need to be answered are (1) why did people over-invest in property; and (2) why did people incorrectly assess the risk of those loans? The existence of derivatives doesn’t answer either of these questions and so leaves us none the wiser.
(Previous articles in this series are about Lehmann collapse, greed & the savings glut).