At first, I didn’t believe it. The number, $500 trillion dollars, was so large as to defy reason. Let me put it in perspective. The world gross yearly economic output is only $65 trillion (the US part of that is $13 trillion). The value of all of the stock, in all of the companies of the world economy, is only $51 trillion, bonds excluded. If you include bonds, it still is only $141 trillion. And so, when you realize that there is $500 trillion dollars (actually about $520 trillion as of March, 2007) invested in “derivative securities” markets, around the globe, it ought to make you pause and think, where did all that money come from and what is it doing there? First, one more factoid, in case you’re not yet fully impressed by significance of the existence of over half gazillion dollars floating around in the world economy. Here’s another way to look at it. If you take that number (the $520 trillion) and divide it by number of people on the planet (6.3 billion) it represents about $82,539 for every man woman and child on earth. And that doesn’t even include the other global dollars invested in stocks and bonds. If you throw those in, the global value of investment rises to $104,920 per person. What this all means comes in three parts.

Part one, how it got there. In a word, profit. All of the money that exists in financial markets around the world has come from a combination of corporate profit and individual investment. Corporate profit is simple enough. Companies exist to make money, and some of them are extremely good at it. What they do with that money is invest in their own expansion, invest in buying other companies, and, when they don’t have anything else to do with the money, they put it in the bank, that is an investment bank. The purpose of an investment bank is to make a profit by investing money in the creation of other new businesses. When times are good, that’s mostly what they do, and that investment does what all business is supposed to do, create wealth by creating more business, which creates goods, jobs, etc.

That part of this activity also results in the creation of the traditional stocks and bonds that used to make up the bulk of the “securities” that exist in financial markets. Stock in particular are interesting because it represents a share of ownership in a company, and so has a real value, as long as that company (and the economy) is in good shape. It’s important to think about stocks in this way, because so long as they maintain their value, they actually are a “thing” that has value in a similar way to a car or a loaf of bread.
So, when economic activity creates wealth, what it really creates are “things of value”. Bread, grain, and agricultural products, have value because they are innately valuable to human needs. In fact, the value of anything is based on our need or desire for it. A car has a value, as long as you have the means to make use of it, gas, roads, and repair shops. A better example is a house. A roof over your head has great human value even when other things do not – let’s say there were no roads to drive a car on. In that case, a car would not be worth much, but a house still would be. You get the idea, that there are some things that are innately more valuable than others, food and shelter, and the value of those lesser things depends on our ability to make use of them. Of course, there are some who argue that there are material things that humans will always value, gold for example. But, were food to be in very short supply, even gold would be of little value unless you could convince someone who had a lot of food to trade you some of it for your gold.
The basic idea to remember here is that human needs determine the primary value of things, and that our desires and wants and whims can only conjure up the economic worth of lesser things when our basic needs are fairly met, and met in ways that are predictable and sustainable.

Back to the half a gazillion dollars. Another source for the money that is now floating around in world financial markets is the invention of mutual funds and the personal retirement accounts that have greatly fueled them (like the 401K plan in the US). What people used to do was save money for their retirement by budgeting excess income into a savings account at a local bank. These days the personal savings rate for Americans is less than zero, and this has come about for a number of reasons, only a minor part of which is employer funded (or partly funded) 401K contributions. But still, this scheme for retirement saving has greatly increased the amount of money that average Americans have invested in financial markets, even when they don’t own any other stocks or other securities investments.

What all this means is that, up until recently, Wall Street, and the other world financial markets, have been doing a great business. Such a great business in fact that there is more money floating around in all of these markets than there has ever been in the history of the world. Even those Wall Street firms have gotten in on the act, as most of them are publicly traded companies with their own stock and profit margins. All of it is counted in the national and international economic activity numbers, and so the more investment they can generate, the better their profits get and the more, more, more GNP or world economic output there is for everyone.

The one problem in all of this is stocks. For a given amount of economic activity, there is only so much stock to go around, only so many companies, and only so much reasonable value that that can represent. What do you do when you have more profit floating around than you know what to do with, that is, more money that can be invested in things of value, than there are things of value to invest in?

The answer is “financial innovation”. Back in the 1990’s, Wall Street pushed hard, and got, nearly complete governmental deregulation of its activities. What this did was to enable them to create new and innovative forms of investments. Investments that would soak up the growing glut of cash that exists in the world. Most of these investments fall under the heading of “derivative investments”, that is they are derived from other more traditional forms of investment. Simply put, most derivatives are “bets” on the value of other investments. This allowed Wall Street financial firms to offer a way for professional traders to make money in riskier ways, and so possibly with greater returns. At the same time, those traders could assume a portion of the risk that investors in traditional securities faced, so that Wall Street could offer “insurance” to conventional investors. Sounds like a win-win, right? `Only when times are good.

When times are bad, who wants to be assuming the risk for other people’s shaky stocks and bonds? That’s where we are now. All it took was a down turn in the investment value of many of the “sub-prime” mortgages that were converted to securities and sold to investors (another result of the “financial innovation” that came of deregulation). This came about with the realization that many of those mortgages were not worth the paper they were printed on, because the ongoing game of “musical chairs” refinance, that them afloat, could also not continue. What brought that about was that too many homes started going into foreclosure (and house values stopped going up).

The financial market side of this is that some big Wall Street investment banks, like Bear-Stearns, had a lot of these mortgage back securities and so billions of dollars of their value, and the value of that company’s stock have been lost. This has caused other big banks to tighten up their in their lending practices, and this has lead to a contraction in the easy money that has kept this American economy going great guns for about ten or fifteen years now (with a small down turn in 2000 and 2001).

This hasn’t had too much impact on the stock market yet because much of those investments are from the mutual funds that average Americans own, and so the major investment banks are not the ones pulling out of those markets, and so far, mutual fund managers have not sold short on stocks. This has to do with the fact that, so far, in our mostly service based economy, companies are not reporting huge losses even though we are in a down-turn. Sometimes I wonder if it’s because fund managers know that if they get too cautious, it will start an avalanche that will destroy the real value that still exists in stocks.

The difference between the stock markets and the derivative markets, that loom large behind them (they have sometimes been referred to as the “shadow markets”) is that when stocks lose value, real money is lost. That is, a thing of some assumed value, a share of stock, is now worth less money and the person who owned that share is out real dollars. If economic conditions were to get bad enough, or that particular company were to make bad business decisions in the face of a contracting economy, the value of that share of stock might not ever recover and it may become completely worthless, should the company go out of business. This is the real risk that is inherent in stocks and bonds, one that has been a part of investing since the earliest days.

Derivatives, in contrast, are bets, and so, if one party bets well and the other does not, money can greatly change hands, but no real value is lost. “Great” you say, that means that the half a gazillion dollars is not in danger of disappearing, any time soon. `Yes and no. In one sense, what that half a gazillion dollars represents is money that is stuffed into the mattresses of excess corporate profit that is not, and never has been, able to do any real work in the economy. Instead, it is being used as a mechanism for assuming part of the risk inherent in the real value of things like stocks and bonds, and when it can’t do that, it is a free agent looking for a return.

Part two, what all of this is doing.
Since I’m an average guy, and not a Wall Street insider, I have no way of knowing what the real value of investment in the derivatives markets is right now. It may be up, or it may be down. In many of the fancy risk assumption derivatives, I suspect that the quantity of those investments are way down. What I do know is that in another part of the derivatives market, the commodity futures markets, investments are way up, and so are commodities prices for everything from wheat and rice, to oil, gas, and diesel fuel.

The oldest part of the derivatives markets are the commodities and futures exchanges, such as the New York Mercantile Exchange. This is where the prices of everything that is considered a commodity, mostly agricultural products and energy products, are set and regulated. The way it works is simple. A seller, lets say a wheat farmer in the mid-west, is growing a crop of winter wheat that will be ready to sell in the fall.
He can wait until the wheat is harvested and then sell it at whatever the market price is, or a month or tow ahead of time, he can go to the futures exchange and find someone who will pay him now for his crop. Once again it’s a bet. The investor is betting that wheat will go up in a month, and the farmer may just want to sell now because he needs the money, or because he’s afraid that there will be a bigger supply, or a decreased demand. And so, the farmer thinks, and wants to bet, that the price now is better than it will be later. The result of all this betting is that it sets the daily prices of traded commodities. The prices that wheat and corn, and oil and natural gas, are selling for, today, is the price that these traders are willing to risk money on in their bets. That’s how all of these prices are set.

Enter the half a gazillion dollars. This is money looking for a return in a weakening economy. The best place to make money when things are looking bad is the commodities exchange. It was said that in the week following September 11, 2001, traders on the commodities exchanges made more money in one week then they had all year. In other words, bad news and uncertainty pushes investors into these exchanges, and so what we are in right now is in a speculative bubble in food and fuel prices that is the result of excess investment dollars in the futures markets pushing up prices in hopes of making a return. In the grand scheme of things, it doesn’t take much excess investment to do this. The amount of money that is currently in oil futures is about $250 billion (up from $90 billion in 2000), and so even a relatively small shift in investing in the derivatives markets can create a huge run up in prices. Food and energy prices are up an average of 18% from a year ago, and some insiders are predicting $200 a barrel oil before the end of the summer.

Of course there are those, conservatives, who say, that there is no “speculation” and it is all just supply and demand. But when president Bush went to Saudi Arabia to ask them to increase supply, the Saudi oil minister said what oil insiders knew, that, supply is not the problem, that oils stocks are up and that demand is down. Ironically, a few days later, our Government released a report saying the opposite, but oil market analysts have been saying that it is not a supply problem for months now. Even the head of Exxon Mobile said so, a few months ago, but not last week when he testified before an angry congressional panel. There, the oil company executives changed their story, even though, when asked what they thought the fair market price should be, the answers came back between $35 to $80 a barrel, instead of the $132 that it closed at last week.

Since they are making huge, world record, profits, from all of this, what could they say? I’m surprised that they even admitted that the fair market price should be lower. Now it’s just a game of follow the money.
Oil companies are making enough money that they could be the ones behind the price run up in the commodities markets, or it could be investors in OPEC countries. Or, it simply could be that commodities are hot investments now and given a little initial run up, it didn’t take long for other investors to flood in and create a bubble.

Trouble is that all of this has real world consequences for people around the globe. Food riots have broken out in Asia as a result of rising rice prices, and the Indian Parliament suspended trading on one of the Indian commodities exchanges in an attempt to regain control of prices.

Back in the US, because of rising prices, the economy is slowing down even more than it would have from the credit squeeze that followed the mortgage crises. By the way, that mortgage crises was also a bubble, one that was created in part by too much speculation on the part of investors. Some of these investors were individuals, and some of them were larger financial institutions. In any case, the unreasonable run up in the price of housing created a sense that you no one was going to lose by writing flimsy mortgages or by buying and selling people’s homes. That sense was wrong then, as is the idea that no one will be hurt by rising oil or food prices.

The big picture is the one that is often only seen in retrospect, but is predictable none the less. A continued slow down in the US and world economies has to eventually effect the price and value of stocks in world stock markets. This is inevitable as higher prices mean consumers have less money to spend on goods and services outside of food and fuel. Energy and agricultural stocks may stay up, but most other companies will see losses and so will lose share value. At the same time, they will cut back jobs, wages will not rise, and consumers will continue to have less dollars to spend. In other words, Wall Street will lose out along with everyone else, as a result of this speculation, and real money will be lost by nearly all.

Instead of recognizing this, and taking some collective action to correct it, say, discouraging investors from being in the commodities markets, it was a man at the Wall Street firm Goldman-Sachs who was the one predicting $200 a barrel oil. Go figure. In their mind, any investment is good investment, and catch a rising tide while you can.

This is the kind of insanity that having too much money trying to make money on itself will create. Wealth is created by the creation (and continuous recreation) of things of value, not by making bets on the future. At the same time, in the US, average household wages have been stagnant for over twenty years. In large part, that’s where most of that half a gazillion dollars has come from. It has come from the diminishment of working people’s wages, their savings, and, in the last bubble, the value in their homes (now down to the lowest level since the depression). In other words, when, by and large, average people can’t actually own the things of value that are the substance of real wealth, there will eventually come a point where the value of those things decreases, and so overall wealth will also decrease (regardless of how much paper money is chasing after it). We are quickly coming to that point. The mechanisms for accomplishing this are the speculative bubbles we are seeing. First things shoot up in value, then they crash, and when they crash, people get hurt as much or more than by the initial inflation. This will eventually happen to food and fuel, but it may take awhile.

Part Three, what to do
I’m an advocate of stern measures here. I would suspend trading on the US oil markets. The argument against this is that then oil trading would just move to the European markets, but since Europe is more socialist than the US, they could easily be entreated to act in a similar way. This does set up a war against, and a hop scotching of, financial markets around the globe, and may not be workable for that reason.

A less severe measure would be to have periodic and unannounced releases from the US strategic oil reserves. This might shake up the commodities markets enough to scare away some excess investors, but it is not a certainty. Also ironic here is that, until congress stopped it last week, the Bush administration was instead filling the reserve with ultra high dollar oil, as if that’s any surprise.

In the oil futures markets, it may well be that there is a hope that the US will attack Iran, because this will create an instability in world oil supplies and investors may see huge profits, if they just hang around long enough. Since the Bush Administration has been posturing for this for several months now, this may be a substantive reason for much of the oil speculation. A cure for this would be low-level talks with the Iranians that might lead to some resolution. Since it is part of the indirectly stated objectives of this administration to engage Iran in an armed conflict, this will probably not happen without some substantial congressional pressure.

Agricultural prices are a product of the cost of production, and so as oil prices have risen, so have agricultural commodity prices. Correct oil prices down to where they should be for the existing conditions, and food prices will follow.

As for the half a gazillion dollars that is indirectly causing all these bubbles, it needs real avenues for investment, ones that can give real returns. It would be good if those avenues were productive and beneficial for the world instead of destructive. This is the conundrum that is currently built into the world economy. For the world economy to grow, and for developing nations to take part in that it, the growth that happens has to be sustainable in terms of limited resources such as fuel, water, and the natural environment. What is currently happening is that America and the west are exporting unsustainable agricultural, industrial, and energy systems to developing nations, and there is, and will increasingly be, competition for the limited resources on which these systems depend. So, even if the vast majority of the population of say China, wanted a Big Mac and Wal Mart way of life, it is impossible to give it to them. Hence, it is also impossible to invest the excess global profits in real returns there. Any more substantial attempts to do so will only result in increasing demand on things like oil that will result in real, not speculative rises in price. Our current way of doing things is both economically, and resource limited. And if we try and exceed those limits, we will get problems like what we are seeing now, or worse, more armed conflicts over scarce resources.

The long-term way out of this is to focus on and invest heavily in more sustainable improvements in the ways we currently do things. And also, as we are doing that, focus on what is exportable to developing nations. This is the role of government, and good leadership within and outside of government. Much of what is required, alternative energy development, for example, is in conflict with out existing systems, and their large financial interests. As a democratic country, we do, still, have the power to change that, as long as we have a real understanding of what is happening, and therefore what’s truly required for us to make changes.