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THE MONETARY SYSTEM IS COLLAPSING

 

(The following testimony was submitted on April 13, 1994 to the 

Committee on Banking, Finance and Urban Affairs, of the U.S. 

House of Representatives. It was written by Christopher White, 

contributing editor of Executive Intelligence Review [EIR] 

magazine, and Richard Freeman, of EIR's economics desk.)

 

[From the May 30, 1994, *The New Federalist*.]

 

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Mr. Chairman,

 

It is now just over one year ago since Lyndon LaRouche, the 

editor of our magazine, put forward a March 9, 1993 proposal to 

levy a 0.1 percent tax on the sale of all the various mutations 

of financial transactions known as "derivatives."

 

The intent of this proposal was to permit constitutionally 

mandated institutional authorities to regain control over 

"runaway" deregulated electronic financial market places. The 

proposal will determine what the magnitude of the threat posed to 

the generality by derivatives is; and, to create the 

circumstances in which the structure of derivatives markets might 

be properly investigated. Moreover, the tax constitutes a precise 

means to surgically lance and dry out the derivatives bubble, to 

eliminate it within weeks.

 

The derivatives market, in which there are $16 trillion in 

derivatives holdings held by commercial banks and financial 

institutions in the United States, with an annual turnover 

trading volume of $300 trillion, is the greatest bubble in 

history. It dwarfs the Mississippi Bubble in France and the South 

Sea Island bubble in England. This bubble, like a cancer, has 

penetrated and taken over the entirety of our banking and credit 

system; there is no major commercial bank, investment bank, 

mutual fund, etc. that is not dependent on derivatives for its 

existence. These derivatives suck the life's blood out of our 

economy. Our farms, our factories, our nation's infrastructure, 

our living standards are being sucked dry to pay off interest 

payments, dividend yields as well as other earnings on the 

bubble.

 

Need for action has long been evident. In testimony by these two 

authors to this committee on October 28, 1993, entitled, "Tax and 

Dry Out the Derivatives Market, Don't Regulate It," we stressed 

the necessity of the 0.1 percent tax. On March 28, 1994, the 

chairman of this committee, Rep. Henry Gonzalez [D-Texas], 

stated, "I think ultimately the only way you could stop, in fact, 

overnight [derivatives trading activity, is] if you imposed a 

1/10th of 1 percent tax on those transactions. You'd see an 

immediate deflation."

 

However, what the violent events over the first three months of 

this year prove, is that while LaRouche's March 9, 1993 proposal 

is still vitally essential, it, by itself, will not be sufficient 

to control the emerging situation. Events have far advanced. *The 

derivatives transactions which are subject to taxation are in the 

process themselves of collapsing. What is needed now is an answer 

to the question: Is there life after the derivatives bubble has 

been and gone?*

 

That which was feared, is in progress. That which the proponents 

of derivatives insisted could not come to pass, because of their 

sophisticated methods of "risk assessment" has come to pass. The 

supposed liquidity of the market, allegedly proved by computer 

simulations, dried up overnight. The mere catalogue of wreckage 

shows losses of the size that even a few years ago would have 

been unthinkable: from the $600 million lost by speculator George 

Soros's Quantum Fund on one day, Feb. 14, 1994; to the $1 billion 

loss of Steinhardt Management's hedge fund; to the early April 

bankruptcy liquidation of the entire market holdings of the $600 

million in assets, exotic mortgage securities derivatives of the 

David J. Askin's Hedge Funds. This same process of mega-losses is 

occurring around the world.

 

To those who congratulate themselves that they "got through" this 

period, we offer this timely warning: Those whom the gods would 

destroy, they first make mad. *This is a systemic crisis; we are 

now in the midst of an ongoing, snowballing systemic collapse, of 

which the events of the first quarter of 1994 are merely a tiny 

foretaste.*

 

It is time that Congress, through its appropriate committees, 

begins to discuss the question of how our national monetary and 

financial affairs might be reorganized such that national life 

can continue, after the collapse of the biggest financial bubble 

in human history has run its course.

 

For which reason we append to this statement the vitally 

necessary draft legislation intended to reorganize the Federal 

Reserve System, through the re-establishment of a National Bank, 

the Third such National Bank in the history of the Republic. This 

is the first order of business.

 

Such a proposal is consistent with Article 1, Section 8 of the 

Constitution, in which Congress is allotted the power to raise 

taxes and create money and credit.

 

With an ongoing financial collapse, the time has come to 

reappropriate those powers which from the beginning were 

allocated, for cause, to the constitutionally created branches of 

government, that the General Welfare provisions of the 

Constitution might once more inform the laws of the land in 

substance as well as intent.

 

What is now under way can only be efficiently addressed by act of 

government. There is no private agency which can provide the 

volume of credit required to ensure the continued functioning of 

national life. There will shortly be no private agency with 

credit anywhere in any case. Federal government must again become 

the sovereign source of credit, in the form of Treasury note 

issues, providing banking agencies with the means of issue to 

finance the economic activity of the country, thereby eliminating 

the subversive "discounting" practices of the Federal Reserve, 

and the so-called "Keynesian multiplier" methods of money 

creation through manipulation of federal debt.

 

The destruction of inflated financial assets over the first three 

months of the year to date exceeds the havoc wrought by the stock 

market crash of October 1987. The nominal bill for such "losses" 

during the first quarter will, in the not-too-distant future, be 

confirmed to start at about $2 trillion. Such "losses," under 

detailed investigation, will turn out to be about 14-15 percent 

of the notional value of all derivatives contracts traded, 

swapped, or whatever else it is they do with them.

 

If we, as a country, were not so idiotically attuned to the day- 

by-day, minute-by-minute jerking around of the "Down-Jones" Index 

as our basic indicator of the economic health of the universe as 

a whole, this elementary reality would have been grasped already.

 

The initial losses of the first quarter are only the beginning. 

There is the proverbial other shoe left to drop. The "blow off" 

of the remainder of the bubble is going to make clear that this 

country has been living in the equivalent of "loud cuckoo land" 

for about a generation. Over the course of that generation, there 

have been no "recoveries," there has been no "rebuilding of 

competitiveness."

 

There has been looting and asset stripping. There has been 

economic depression. That is shortly to come to the fore in the 

kind of rude way which our accumulated national fantasy life, and 

its televised mirror image, will find impossible to ignore. 

Obviously those who most violently dispute this now will soon 

find themselves among the ranks of the most rudely shocked.

 

The turmoil of the last three months is not a "market 

correction," despite all the analysts and investment strategists 

who proclaim about their proverbial 10-15 percent decline blowing 

the froth off an over-heated "bull-run." Nor is it merely a 

matter internal to the market. What is going on is without 

precedent in human history.

 

There is a global financial collapse in progress -- a global 

financial collapse which was already in progress before the 

beginning of the year. From 1993 onward, from Chile, and the case 

of the Codelco raw materials company; to Argentina, and its bond 

and stock market; to Venezuela and the case of Banco Latino; to 

Spain and the multi-hundreds of millions loss of that country's 

fourth-largest bank, Banesto; to the United Kingdom and the Hong 

Kong and Shanghai Bank-owned Midland Bank; to France and the case 

of the multi-billion dollar loss at Credit Lyonnais; to Germany 

and the $1 billion plus loss at Metallgesellschaft; to the 

reputed several billion dollar losses at Malaysia's central bank, 

and the banks of Indonesia.

 

What is developing is global in scope. The losses are all related 

to derivatives trading. Sound companies and industrial concerns 

are being sacrificed to the vagaries of derivatives. Germany's 

Metallgesellschaft, the country's 14th largest industrial 

concern, will now lay off one-fifth of its work force, and asset- 

strip its operations to pay for the loss.

 

This committee is correct to highlight the activities of the 

hedge funds. They engage in the most wildly speculative behavior. 

Hedge funds are, for the most part, offshore, unregulated 

gambling casinos, relying on mountains of leverage. They are 

specifically constituted, by having 99 or fewer U.S. investor 

partners, to circumvent the Investment Company Act of 1940, which 

would otherwise regulate them. Hedge funds work on anywhere from 

5 to 1, up to 50 to 1 leverage. That means for every $1 billion 

of the hedge fund's own money which it has under management, it 

borrows from $5 to $50 billion. The over-300 hedge fund's have 

$75 billion in assets under management, meaning they could 

control an astounding amount of publicly traded bonds and stocks 

of anywhere from $375 billion to $3.75 trillion in value. By 

comparison, the average trading volume on the New York stock 

exchange is but $11 billion daily.

 

But every congressman should ask the obvious question: If for 

every $1 billion the hedge fund puts up, the hedge fund is 

getting from $5 to $50 billion from someone else, isn't that 

other party, lending the $5 to $50 billion, far more important? 

The answer is, of course. The committee must note the dominant 

role of the commercial banks, especially the Morgan banking 

group, and the investment banks, who lend the money to the hedge 

funds, and use the hedge funds as their "bird dogs," having the 

hedge funds make the speculations that the commercial and 

investment banks would be too embarrassed to make on their own. 

Not only that, but every congressman should know that the 

commercial banks put money from their own accounts into these 

hedge funds, and it is claimed, put money from the banks' trust 

departments into these hedge funds.

 

The largest derivatives trading banks are: Chemical, Citicorp, 

J.P. Morgan, Bankers Trust, Bank of America, Chase Manhattan, 

First Chicago, and Republic National Bank of Edmund Safra. Morgan 

Bank, and the Bankers Trust which it set up in the 1903-07 

period, and controls to this day, control together 31 percent of 

the $12 trillion of derivatives holdings of the major commercial 

banks. Morgan dominates derivatives trading. Among the investment 

banks, the largest derivatives traders are: Morgan Stanley; 

Goldman Sachs; Salomon Brothers; Lehman Brothers and Merrill 

Lynch. These are the institutions that control the hedge funds. 

These are the institutions whose activities, above all, must be 

investigated and controlled.

 

Moreover, there is an equally huge scandal. It is open knowledge 

that the entire financial market structure of the United States 

has been artificially rigged for the last three and a half years. 

Short-term interest rates were set at 3 percent and long term 

rates at 6.5 to 7 percent, the largest spread in post-World War 

II history, to benefit and enrich the commercial and investment 

banks who made derivatives plays on this spread. The losers on 

this operation were the American population, which paid dearly to 

"bail out" the banks. [CN Editor -- This sweet deal for bankers 

was also covered on the Saturday, June 11, 1994 "News From 

Neptune" show. I will try to feature excerpts in an upcoming 

"Conspiracy Nation".]

 

Oversight on the markets must begin with how the Federal Reserve 

Board of Governors, and the Federal Reserve Bank of New York, 

working with the Treasury Department, starting in the Bush 

administration, rigged this hideous operation.

 

Thus, the danger of derivatives trading and its damage is not 

limited to headline catching speculative excesses, and failures, 

of some outfits like the now notorious, U.S. legal-code-evading 

"hedge funds." There may be the financial, or electronic, 

equivalent of dead bodies left by the side of the financial 

version of the electronic superhighway. But they are the result 

of a pile-up, not its cause.

 

The cited cases all involve the use of financial derivatives.

 

Our estimate of losses sustained during the first quarter of 1994 

is not, however, based on adding up reports of losses sustained 

by individual banks, corporations or funds. The whole so-called 

asset base on which the derivative bubble depends has been 

devalued. The ongoing devaluation of assets has set in motion a 

collapse which proceeds as the so-called leverage, or pyramiding, 

of the derivatives transactions unwinds. In this it is not only 

the most egregious which are affected, but all, for all financial 

assets are being devalued.

 

The ongoing financial collapse is characterized by the 

application of "reverse leverage" against those institutions and 

banks which had resorted to the use of leverage or pyramiding to 

inflate their so-called gains, or nominal so-called assets.

 

The increase of interest rates, long-term as well as short-term, 

has been the trigger for the process by which the bubbled assets 

have been deflated, and the effects of reverse leverage, 

unleashed.

 

For example, there are over $3 trillion of U.S. government 

securities held by what the Treasury and the Office of Management 

and the Budget are accustomed to call the "public." Bond yields 

have risen by almost 20 percent since the beginning of the year, 

25 percent since October 1993. Since prices and yields move 

inversely, it is merely conservative to assume that the face 

value of the bonds has shrunk by as much as the yields have 

increased -- $600 billion on that account alone. This would be 

100 times what George Soros's Quantum Fund reported its losses to 

be over the days between Feb. 10 and Feb. 12.

 

The same approach can be taken to inspect "collateralized 

mortgage obligations" in their "principal only" and "interest 

only" strip form. Mortgage rates have risen as fast as have the 

yields on the Treasury's debt. Municipal bonds, too, and more 

exotic such instruments as, for example, the secondary market in 

so-called "emerging country" debt.

 

Now, U.S. Treasury bonds, whose world-wide daily trading volume 

was estimated at $300 billion one year ago, increasing by 100 

percent and more in the twelve months to February and March in 

exchanges in Chicago, London and Paris, are the core of the 

"hedging" operations undertaken by derivatives dealers. Borrow, 

against bonds, borrowed or held, to finance positions for or 

against various currencies, "hedged" back into something else, 

and so on.

 

It was less than one year ago that the International Swap 

Dealers' Association began to insist that "notional value" was 

not a useful way of looking at derivative exposure. Better, they 

insisted then would be "replacement" cost. This because, even a 

year ago, the notional sums that had been generated out of 

whatever electronic device they employ had grown to mind-boggling 

proportions. "Replacement cost" shrank the numbers back to more 

manageable proportions.

 

The difference between the two was a measure of the leverage, or 

pyramiding, applied from original "position," at cost, borrowed 

or not, to notional value.

 

The 20 percent increase in bond yields [CN Editor -- Apparently 

this means, in other words, the decreasing of the actual value of 

the bonds.] has undone a lot of the accumulated leverage that has 

been built into the world monetary system. For example, "hedge 

funds" can be leveraged up to 100 times, in which case, a 1 

percent movement is sufficient to wipe out the collateral or 

"margin" position. "Hedge funds" disposing, according to "Mar- 

Hedge" and others, of around $100 billion in total assets, are 

typically leveraged 10 to 15 times. A movement against them of 

6.6 percent to 10 percent on the notional values at stake, wipes 

out all their margin or collateral.

 

The matter is not the unwinding of leverage against hedge funds 

alone, but the whole accumulated mass of some $16 trillion 

notional so-called value in the United States -- and $25 trillion 

worldwide -- unwinding against everything else.

 

The bubble has been premised on a perpetuated fraud about the 

growth of the earnings of the U.S. economy. There has been no 

growth in the earnings of the U.S. economy. There has been no 

growth, not in the U.S. economy, not in the world economy, since 

the period 1967-70.

 

The country needs a reorganized, constitutional credit system. It 

needs such, so that we can begin to do the things which most 

living Americans are too young to remember their country ever 

having done. We need to create qualified employment for our 

people, through rebuilding our basic economic infrastructure in 

transportation, power generation, and water supply, and in our 

attenuated capabilities for capital goods production.

 

Credits issued for such purposes will generate more wealth than 

their original cost. We can create 6 million productive and 

decent-paying jobs in infrastructure and manufacturing and 

agriculture. The world economy must likewise be reorganized 

around development programs, which Mr. LaRouche has specified. 

This includes the "Productive Triangle" for the development of 

the Eurasian land mass, and the "Oasis Plan" for the development 

of the Middle East. This latter plan, which includes irrigation, 

and cheap abundant nuclear power, would provide the rock-solid 

basis for the praiseworthy Israeli-PLO peace process to succeed.

 

The collapse of the biggest financial bubble in history requires 

urgent action; it also provides the opportunity to put the 

country back on its feet, and under its own law.

 

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"The New Federalist" is published weekly. Subscriptions are 

available at $20 for 50 issues, $35 for 100 issues. Make checks 

payable to "New Federalist" at Circulation Department, The New 

Federalist, PO Box 889, Leesburg, VA  22075.

 

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