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From Wikipedia 18 Apr 2009 version:

Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying value on which a derivative is based can be an asset (e.g., commodities, equities {stocks}, residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index {CPI} see inflation derivatives), weather conditions, or other items. Credit derivatives are based on loans, bonds or other forms of credit.

The main types of derivatives are forwards, futures, options, and swaps.

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.

Before going on, the three forms of capital need to be in mind. They are:
  • Human (where it all starts), is the first kind.
  • Items of manufacture (implements, processes, products, edifices, literature, music), and land, the second kind: all products of human hands and minds, and
  • Money, the currency of exchange between the other two forms of capital, is the third kind.

Commentary: Stop and think about this. Money is capital. Smart money {most sophisticated in forecasting trends) ends up becoming more smart money. Those already loaded with dough are in the best position to increase their dough. Who can argue with that? We all want to win. Is it right? Is it really this simple? Neither.

As a society, we seem to have lost contact with true capitalism. Most fundamentally capitalism is the science, technology, and practice of value creation and exchange. It can operate in any social system, even the most social ones. Capitalism is deeply ingrained in China, a one-party state, and also in Sweden, a leading democracy. The fundamental problem for societies is then: Which society returns the most for its investment. This is the national measure that counts. On that score, the US badly trails the pack.

What makes capitalism complex, not to mention erratic, is the human equation. Humans, products of the jungles and savannas, are primarily emotional creatures. Many writers we have read claim humanity is political by nature. It is the emotional element they refer to. And emotions manifest in several ways, aggression, obedience, conventionalism, altruism, and parenting. Combine the first three and you have the makings for creating groups that have the same inclinations for competition and even violence that individuals do. Combine the last three and you have their counter-point--preservation of life itself first and foremost. We are are at war with other societies because as individuals we are still at war with ourselves.

Many people, perhaps most, rise above emotions. But to make capitalism work well, emotions must be set aside, or controlled until they can be. Unless and until that can be done, our pocket books will not balance in any equation of fairness to all. A few people will wind up with everything. It is like the world series of poker, one ultimate winner. Study the US history of the last two decades and a marked widening in the extremes of personal value is markedly apparent, a factor of ten or so above most comparable democracies. The rest of the world is in this sense more democratic than we are.

Equal opportunity?
Are we as well off or worse off than many other nations?

Democracy itself is thus not as compatible with capitalism as it might otherwise be if humans were free of emotions. For example, democracy is supposed to guarantee freedom. But is not our freedom affected by our richness as a nation? Our richness as a nation has just taken a huge hit, we owe other countries much more than they owe us, and that imbalance is increasing and will not reverse anytime soon, short of a national default as a nation. There is such a thing as "too-bigness." There some ten huge banks in America that are too big to be allowed to fail. If that is not a problem crying out for solution, we have never seen one.

So how do we start? For how we got where we are, Las Vegas serves as a medium for understanding what happened in the housing market. By analogy, yhe little guys, the dice rollers, are on the short end of the odds. So on average they must lose. They may well rationalize that they have had fun in Vegas, and indeed they may have. At the end of the day, however, the dice rollers go home with less currency than they once had. The casino owners take what is left after paying their employees and operating expenses; and that is almost beyond imagination. Where fun leaves off and robbery begins is a question with no good answer. Is it really robbery, when we citizens are as culpable as the casinos.

This is human nature in action. If this was all there is to the money equation, there should be no effects beyond making some people richer than others. But what happens when bankers begin rolling dice with derivatives? Unlike Las Vegas, the derivative dice depend directly on tangible capital of the second kind. In a decade, we have witnessed two bubbles in value, the and the Housing. The differ most in their severity, not at all in fundamental cause.


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