Stop the gamblers on stock market

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By Will Hutton (China Daily)
Updated: 2008-10-29 07:51

The FTSE falls 5 percent. The pound collapses against the dollar in the biggest one-day fall since floating exchange rates began in 1971; oil prices are in free fall; Asian markets in near panic. What happened at weekend was dumbfounding.

Sure, there are problems in the real economy, but movements in the markets have been so violent that they are reinforcing the cycle of gloom and making moderately bad economic news seem like Armageddon. A decline of 0.5 percent in British GDP in a quarter should not make an already depressed the United Kingdom's stock market fall a further 5 percent.

Systemically unstable, but highly interconnected, the global financial system is accelerating the effect of news that the world could enter a simultaneous recession into a potential cataclysmic disaster.

G7 governments, genuflecting to the now disgraced titans of modern finance and the pet market theorists who supported them, have permitted, over the past 15 years, the creation of a shadow international financial system.

This system consists of what are essentially gambling chips, such as credit derivatives, options, swaps, contracts for difference and stock lending for short selling. These are used by a vast global hedge fund industry to bet on movements of prices in the first financial system - shares, currencies, interest rates and commodity prices.

But the tail now wags the dog. The size of the movements on Friday is only explicable in terms of hedge fund activity; funds in difficulty trying to clear their balance sheets and healthy funds making hay on the price movements, both exacerbating the situation.

It's mayhem out there, so much so that financial speculation may turn recession into slump. The G7 governments must consider taking coordinated action about regulating the pricing and trading of all forms of derivatives. Hedge funds should be licensed only if they trade in assets in government licensed exchanges. The element of gambling should be taken out of the system.

This will raise fundamental issues about the business models of many banks, which have become dependent on profits from the shadow financial system. This cannot continue.

To get banks back on a normal footing, governments will have to support them with more than capital. They are going to have to insure and guarantee debt if credit is to flow again.

All this is crucial for the UK. We have a very large financial sector compared to the size of our economy - a mega Iceland - and so are heavily exposed to both the destructive shadow second financial system and to banking's bust business model. We could find our entire real economy being shaped by these titanic and irrational moves in currencies and share prices. This crisis is moving into a dangerous new phase.

The Observer

(China Daily 10/29/2008 page9)