Hedge Funds, Financial Markets and Nation-States
Sheng Hong
There have been various explanations forwarded about the East Asian financial crisis taken
place since 1997, some of which were even fraught with intense sentimental smog, such as
the allegation of “conspiracy” from social critics, or the invariable fallout of the
“globalization” of social apologists. The purpose of this paper, however, is to retreat to the
traditional economics in which an analysis will be carried out with its “down to earth”,
classical economic approach. Such an approach will as a result give its own different verdict
in respect of the Asian turmoil. The first is that all agents in the crisis are merely acting upon
their own self-interests; the second is that the dynamic path and the result of these actions
could be different. At one extreme, an action could be at the direct expense of others, or
precisely, create negative externalities in economic terms; at the other, it could possibly reach
the so-called “win-win” position, an optimal solution.
As we will not only concern with the situation within a country, but also with the
interaction among countries, it is necessary thus to distinguish these two circumstances where
relevant actions are executed. The first is that within a nation-state, there is a society with a
national government, whereas in the similar sense the phenomenon has not yet been found in
the international sphere where all nations in the world are virtually living in the situation of
not far from anarchy. The second is that people have the freedom to move from one place to
another place, but they do not have the same freedom to do so among countries. That said,
hence, the same action or policy executed would lead to different outcomes on national level
and international level.
Economic freedom the liberal economics emphasizes is the one under certain rules, which
excludes such an action that might hurt others, so that the pursuance of self-interests will
simultaneously enhance social welfare. Heretofore, these rules could be approximately
realized only when there ais a government. As with discussions of international affairs,
therefore, we should pay attention to the change of meaning of Freedom. Our purpose here is
to try to come up with likely ways of establishing rules necessary whereby the mutual benefits
would result, or the actions to hurt others may not only lead to an unfair distribution of wealth,
but also decrease the global welfare (including that of ones who hurt others’ interests) by the
damaging of ones to others and the retaliating of ones who were hurt together.
For our analysis, we select hedge funds, financial markets and nation-states as the
protagonists among many others in the crisis. What makes the selection intriguing is that the
three of them not only are three kinds of different institutions, but also represent three groups
of people. We will thus search for the possible answers to the financial crisis amidst the
interaction between the institutions and the groups of people.
1.
A Nation-State And A Monetary System
A monetary system is a kind of institution, which as a public good is provided by a
nation-state. A nation-state is no more than the specific embodiment of a government, a kind
of institutional arrangement, in nowadays world, for governments respectively offers
protections to peoples who are differentiated from each other by historical, cultural or
biological factors. The intriguing issues raised so far have been: why a monetary system is a
kind of public good that corresponds to the domain of a nation-state and what sort of factors
prevents it from becoming universal? What kind of role does a government play in the
operation of a monetary system?
Long before, people started to realize the benefit of a currency with insufficient value, since
1
it could circumvent a plight where the growth of economy would be depressed by a short
supply of precious metals. Once a currency of insufficient value comes into being, especially
many of them, a tendency of “adverse selection” in which badies replace goodies would
nonetheless ensue, which will invariably create the instability in a monetary system1. As the
functions of a currency entail among other things the stabilization in its value, a government
backed by force will with no choice but monopolize its issuing so as to guarantee the stable
value. Along with a lengthy evolution of the currency that is ultimately settled upon the paper
money, such a government action that enforces the credit of the money in circulation will be
required even further.
Once such a currency with insufficient value being accepted by people, the issuer of the
currency can without doubt pocket the sure profits so induced, normally called seigniorage,
which equals the difference between the face value of the currency and the producing cost. As
the seigniorage is usually collected by the government of a nation, the wealth generated as
such should be owned by the whole people of the nation. If, however, the government forwent
the right of issuing to another nation, it would be tantamount to depriving its people enjoying
what should belong to them. This is one of the important reasons why a nation-state has to
issue its own currency.
Another reason has to be the impossibility of free flow of population between countries.
Suppose there were only one currency in circulation in the world with free flow of
commodities and the capital. The money supply of one country would as a result be
determined by its trade balance, surplus or deficit (Peter Lindert and Charles Kindleberger,
1985, p.360), which in turn would rely primarily upon the productivity of tradable good's
sector. As such, some countries running trade surpluses would have more currency in
circulation, whereas others with trade deficits would end up with the shortage of the money
supply. If the imbalance in the productivity of trading nations remains, the situation with
money supply will be here to stay for probably a long period, enough to check the growth of
those economies with short supply of the currency. The free flow of money and capital would
enlarge the difference of money supplies between nation-states, for the nature of capital
makes it seeking for the profits in the flourishing regions or industries (Gottfried Haberler,
1963, pp.434-481). One of the relatively quicker adjustments to the situation is a free flow
of population, namely migration. Yet in the present world, the proposition has been a bit out
of the question. Consequently, a nation would be much better off to have its own currency up
in operation.
In abstractive terms, the target of money supply is to materialize all the transactions that
would lead to the full employment of the resources available, including labor, mediated by the
currency in circulation. To achieve such a target does not necessarily require a central
government to issue the base money as much. Rather, it relies upon the financial markets that
consist of two main categories in general: the equity market and the debt market (Frank J.
Fabozzi and Franco Modigliani, 1998, p.11). With the complementary effect of the two, the
financial markets as a whole will push the money supply to its limit in an economy, namely, to
the last transaction that depends on the intermediary of money or the productive activity
related to that transaction.
As market participants realize that the debt instruments based on currency issued by
government have their credits as high that they themselves can be used as means of payment,
these instruments thus possess the functions of money as they continuously change hands in
money and/or capital markets. In particular, the existence of banking system can expand the
1
In the long history of China, almost from the age of Spring and Auturm and War States to that of Republic of
China, we may from time to time find the situation of coexistence of various currencies, of flooding of iligel
minting, thus of bad currency’s driving out good one, and as the results, the confusion of menetary system and
chaos of society. See Shi Yufu, 1984.
2
money supply by a multiple of the injection of base money, as the system can repeatedly
create deposits by making loans which then become new deposits except a portion of reserve
( John Commonce, 1983, Volume II, pp.1-86 ).
In addition, the financial markets through the exchange of financial instruments constantly
searches for and probes the boundaries of money supply. Under the ideal circumstances, an
economic activity accomplished with an arrangement of the market for debt will be deemed
efficient so long as the rate of return of an economic activity is not lower than the market
interest rate which is at the level of so called natural interest rate that reflects the typical
consumer’s time preference between current and future consumption. When the market rate is
equal to the marginal productivity, hence, an equilibrium between the money supply and
money demand that represents the economic activities in a society would be reached ( John
Commonce, 1983, pp.248-58).
In reality, however, economic activities are not as simple as they look like that, since the
modern circuitous production mode prolongs the cycle and hence increases risks. Should such
risks be too high, the debt market could not operate in its normal function, as unredeemable
debts could not only destroy the market credit, but also lead to a contraction of money supply.
In consequence, the market on one hand applies means of collateral to reduce risk. On the
other hand, it pushes those financial transactions involving economic activities with too high
risks to the equity market that, distinct from the debt market, does not have the redemptive
problem so that it would not cause a contraction of money supply once an incident of loss
occurred.
In brief, the cost of capital would become prohibitively high and money supply would be
constantly under a severe pressure if there were no existence of the debt market. On the other
hand without the equity market, financing those economic activities with too high risks would
either become next to the impossible, or the transaction of debt is riskier than normal, and
leads to instability in the supply of money. An equity market is such an institutional
arrangement that avoids the instability in the monetary system because of high risks, while
finances those economic activities with high risks. The scales of the two markets, furthermore,
are inter-related at a certain proper ratio that is determined by their relative prices. Therefore,
there is a sensitive relation between the prices of the two markets.
In the perspective of international economy, the monetary system of one nation can not be
in the state of complete independence. The flow of commodities and capitals will invariably
have impacts on the money supply of a nation. Given a certain monetary policy, a surplus or
deficit in a trade balance will increase or reduce money supply directly in a country, and a
loan from a foreign bank will be multiplied (such as the effect of a US dollar loan in Europe,
see Peter Lindert and Charles Kindleberger, 1985, pp.443-8). Such a phenomenon will
naturally tie a currency of one nation to those of others. The relative prices (i.e., the exchange
rates) of currencies will fluctuate just like those of common commodities do. The level of
exchange rate is related with the trade balance as well as with the level of the domestic money
supply that can be judged by the real interest rate (i.e., the difference between nominal interest
rate and inflation rate) of an economy. Hence, rates of interest and of exchange are sensitively
related to each other if currencies may be convertible.
As for the government of a nation-state, one of the public goods that it should provide is the
effectiveness and stability of its monetary system. As the financial markets have a function of
creating money and of probing the boundary of money supply, the government should foster
the development of the markets, while recur to their force. To do so will lead to a higher
efficiency of the monetary system, thus every one unit of currency may work with a larger
multiplier. Insofar as international effects are concerned, moreover, uncertainty has been and
will remain the dominant feature in the global economy. The external factors can sometimes
propel the development of an economy (e.g., via trade surplus), and sometimes restrict it (e.g.,
3
via capital flight), or even threaten the stability in the monetary system of a nation-state (e.g.,
via shocks of international hot money). A government in considering its monetary policy,
therefore, must take into account the policies regarding the trade and exchange rate while
keeping external factors in mind.
The paradox a government faces has been that if the economy becomes wide-open, it will
be subject to all sorts of external shocks that will not only induce instability to the internal
markets, but also offset the effectiveness of domestic economic policies. However, if the
government regulates its international economic affairs, for instance, with imposing a fixed
rate on foreign exchange, its domestic macro-policy might meet a dilemma. For example, a
government may usually raise the interest rate of the domestic currency when a trade deficit
occurs, but the result is to reduce the money supply that has already been tight. Therefore,
there is no a certain conclusion in the modern international economics about what kind of
exchange rate policy should be adopted by a government (Peter Lindert and Charles
Kindleberger, 1985, pp.406-431). Nevertheless, there is at least one point clear that the
monetary system of a country is not only founded on the fiat currency, but also needed
fine-tuning and protection through various policy mixes.
2.
Financial Markets and Hedge Funds
Rather than being dry in perception, the financial markets as a kind of institutions are vividly
made up of a group of people whose pursuance of maximizing self-interests engender the
function of the market in allocation of resources in society, and bestows upon it an
indispensable status in the monetary system. In the modern period, the financial markets,
through their innovations of financial instruments and organizations, such as the financial
securitization and the emergence of stock exchange, continually lowers transaction costs that
in turn enhances the efficiency of the monetary system. The benefits brought about by these
innovations have been shared out within as well as without of the markets.
Driven by their interests, the markets have been exhibiting the vigor in their continuous
innovation. Such interests, however, are not always running in the same direction as that of
society. The benefit of a stock exchange, for example, is closely related to the volume of the
trade. In other words, the larger the volume, the higher the commission it obtains. As a result,
there is enough incentive involved in the innovation as to increase the trade volume. Insofar
as a society is concern, it is not always the case that the benefits go along with the volume.
Exuberant growth of the credits or excess investments, for example, may break a delicate
balance in an economy. From an economics’ viewpoint, only those transactions proved to go a
long way towards improving the market efficiency can be acceptable, or they would not be
much different from the Las Vegas’ zero-sum game: it is like a transaction, but has no
function to increase efficiency.
A competent government, therefore, would exercise a great caution as to the innovation of
the financial markets. Ever since the 70s when the first financial futures contract came into
being in Chicago Board of Trade with the purpose of increasing the volume of trade, the
innovations of the financial markets thereafter have been centered around the financial
instrument of Futures and Option, called “financial derivatives”. Nevertheless, these
innovations have only been legalized after the intense investigation (i.e., public hearings and
inquiries) conducted by American Securities Commission (Frank J. Fabozzi and Fanco
Modigliani, 1998, p.306). One of the principal reasons for their legalization has been that
these financial derivatives can serve as hedging exposure risks contained in financial
transactions, and hence can be regarded as an improvement in the efficiency from the
economics’ point of view.
4
However, things will start to take an about-turn when
these financial derivatives intertwine with one kind of
innovation in financial organizations – the rise of Hedge
Fund, which has come alongside the financial derivatives.
The original purpose of the fund, though, is to hedge the
exposure risks in financial transactions, once in operation,
some of them ( represented by Soros’ Quantum Fund )2
have gradually found the attributes of the derivatives
previously unknown that can be used in their profit making.
The first attribute (taking the option as an example) is that it
can be used to leverage a larger transaction with a certain
quantity of capital to influence the market prices, provided
the transaction is large enough (see Figure 1)3. The second
one is that as a buyer of an option contract has the right, but
does not have the obligation, the buyer of the contract does
not have to actually exercise it if the strike price on the date
of delivery is not favorable (see Lawrance Galitz, 1998,
pp.193-8). This kind of arrangement lowers the buyer’s risk
while encourage people to invest more riskily (i.e.,
speculation). The third that actually makes it much easier
for the hedge funds to speculate later on is that, the larger the
deviation of the strike price of an option from the spot price
of the object asset upon it the option bases, the lower the
price of the option contract is (John C. Hull, 1997, p.161)
.
Figure 1
D
S
S’
P
P’
Q
Q’
The hedge funds may drive
down the prices through
increasing quantity of supply.
To increase quantity of supply
equals to move the supply
curve from S to S’, then the
quantity of transaction from Q
to Q’, and the price therefore
from P to P’.
When a hedge fund has a firm grip of the attributes of the derivatives, its investment
strategy will start to change. The original hedging portfolio begins to evolve to such a strategy
that will obtain profits by manipulating prices of related financial markets through trading
large transactions. In the previous section, we have pointed out that there exists a sensitive
relationship between prices of different financial markets, which can also be expressed with
mathematical formulas. The relationship between the price of the stock market and that of the
money market, for example, is expressed as follows,
Sm = (p / i ) Sb
Where:
Sm = market price of a stock;
p = rate of profits;
i
= interest rate;
Sb = book value of a stock. ( see David W. Pearce ed., 1988, pp. 545-6 )
In the same manner, the relationship between the price of the currency market and that of
the money market can be formulated as,
ef (1 + ia ) = es (1 + ib)
There are a lot of types of hedge funds, most of them are still “traditional” (see Yi Gang, Zhao Xiao and Jiang
Huiqin, 1999; Van hedge fund advisors international, 1999(a)）. What are discussed here are those represented by
George Soros’s Quantum Fund.
3 Along with the repetition of operations and accumulation of experience, people gradually realised that the
financial derivatives could bring a new force for a trader. For instance, Nick Leeson, the famous rogue trader who
was in charge for the closing down of Barings Bank, acknowledges that he intended to make the price moving
towards the direction which he desired by trading a large quantity of futures (1996, p.144, p.198). Afterward,
people clearly realise the impact of transactions of financial derivatives, and use the transactions as a one of means
to make profit in the financial markets.
2
5
Where:
ef =
es =
ia
=
ib
=
forward exchange rate;
spot exchange rate;
domestic interest rate;
foreign interest rate ( quoted from Rao Yuqing, 1983, p.325)4
The knowledge about these relationships are regarded as a kind of public one and written
into many textbooks in economics or finance. However people in the past view these
relationships only as the results of interactions between markets. It is who the central bank of
a country may use this kind of relationships, for instance, to influence prices in its stock
markets, currency markets and others by adjusting the rediscount rate. What the hedge funds
represented by Soros innovate, is that they assume that if price in one market (e.g., the
currency market) was sharply changed for a short period, that of another market may be also
changed correspondingly. With a proper portfolio of the investment, the hedge funds could
possibly squeeze the profits out of various markets in which favorable price movements take
place. Of course, the so called “beauty contest” effect after the social panic button being
pressed could also be included in their strategy as it would further induce instability to the
market prices.
The financial derivatives have indeed been a centerpiece in the process of manipulating the
markets. The kind of strategy, though not yet to be told openly, can possibly be seen in a few
typical showcases. In May 1997, for example, the Thai currency, baht, was under attack by
the hedge funds, in that they sold short the currency on hand and option in large quantity. On
the other hand, they purchased beforehand the put option on baht at exchange rate before baht
devaluated. The linchpin of the success in this investment combination is a devaluation of
baht, and they made it. Another showcase is the attack on HK currency, but in a slightly
different fashion as the target this time is stock prices with interest rate being the intermediary.
First, the hedge funds purchased the put option in the stock market, and then sold the currency
in large quantity in the spot. As the SAR government bent over backwards to protect the
exchange peg, the interest rate sky-rocketed, and this in turn crashed the share prices in the
stock market. The hedge funds succeeded again.
As the investment strategy of the hedge funds changes, so is the role of the institution. It is
thus about time in the aftermath of the financial “mayhem” for its activities to be put under a
close scrutiny of whether being in line with the interests of society and up to of global welfare.
In the perspective of economics, price manipulation will bring about inefficiency, since firstly,
it distorts the market signal for the allocation of resources. Secondly, a large amplitude of
price fluctuation in the financial market within the short period would induce instability to the
monetary system, and could even lead to its total collapse. A theory of economics points out
that a stable pricing system is more efficient than an unstable one (Peter Lindert and Charles
Kindleberger, 1985, pp.554-8 ). And the collapse of monetary system may further lead to the
damage of real economy.
Indeed, it is hardly a mistake in the real world to match the manipulating behavior to that of
monopolists in general, since the core rule of the typical monopoly is the same as to rig
market prices by its sheer quantity so as to attain the profits so generated. The difference,
however, is that as one of the financial institutions, hedge funds have the scale unmatchable to
that of typical monopolistic monsters in the good's market, and the duration of manipulating
transactions is much shorter. It might be for this difference that the hedge funds are still at
large with less condemn and no restrictions imposed5. Nevertheless, there is one thing clear
that the monopolistic behavior, be it in financial markets or in general, runs in counter to the
4
About the relationship between interest rate and exchange rate, Paul Krugman and Maurice Obstfeld have
discussed in detail in their work, International Economics: Theory and Policy ( 1998, pp.352-5 )
5 In fact, there is a few economists, such as Pual Krugman, to have pointed the nature of market manipulation of
the hedge funds, and to claim regulating it (1998).
6
rules of the market.
3.
Mercantilism and International currency
As we have talked about, the balance of trade can have an impact on the money supply of a
country. Hence, a trade policy, to a certain extent, also has the function of a monetary policy.
The truth could not go any further in the extreme case of existing only one currency in the
world where a trade policy would be the sole monetary policy. In fact, we can from this
perspective get hold of the long lasting mercantilism that has existed ever since the outset of
the modern era.
In the early period of the modern history, the current account of the trade between countries
was settled by a precious metal, such as silver. Thus, it will not be wrong if only one currency
is assumed in the world economy then. Under such circumstances, the regular trade surplus
would be entailed if the money supply for sustaining the speed of the growth in a nation was
maintained. This has in one way explained why the countries with rapid economic growth are
those who have successfully exercised the notion of mercantilism.
The trade policy of mercantilism, to a certain extent, can be regarded as the expansionary
monetary policy. As being long pointed out by Keynes, mercantilism goes a long way towards
the economic growth of a nation as it not only creates overseas markets for domestic products,
but also increases domestic investment by reducing interest rate ( 1963, pp.285-6 ). The
modern international economics also attests that under the fixed exchange rate, a trade surplus
is tantamount to a direct increase in money supply (Peter Lindert and Charles Kindleberger,
1985, pp.360-1 ).
Yet, to sustain the money supply is not a sole objective for adopting mercantile policy. In
the world of being fraught with many different and vying nation-states, a free trade policy,
though, will bring about an enhancement of the national welfare that mainly reflects from
consumers’ surplus via lowering prices of commodities. Such welfare cannot be gathered
together in a way that would form a so-called “state capacity”. Mercantilism could
nonetheless do the job through currency based wealth (i.e., precious metals or foreign
currencies) that can be controlled and mobilized by a central management, and thus has a
strong implication in international political economy. In other words, such a wealth will affect
in the power struggle among various vying nation-states6.
In return, the state capacity is not only able to “promote” the trade and maintain the
firmness of a currency, but also capable of protecting domestic industry and impairing that of
rival countries, and thus locate the nation to the further advantageous position. Among the
nations that have made their rises in succession from the early modern age onward, be it
Spain, England, France, or U.S.A, Japan, and so-called four tigers of East Asia, are there no
exceptions as to adopting mercantilism7.
Suppose, however, that all nations in the world equipped themselves with mercantilism,
then no sustained trade surplus would be available. Why the sort of policy can exist is that
there have to be some countries who do not adopt the same, as they can in one way or another
bear up their trade deficits for a long lasting period. Such a kind of countries are either those
who were enforced to unilaterally curried out the free trade policy because of being defeated
6
Hence, the pursuit of mercantilists, as Keynes points out straight from the shoulder, is State interests and the
relative growth in State capacity (Keynes, 1963, p.295).
7 About the history of the mercantilism in these countries, especially in Britain, see Chen Xiwen’s work, A
Research on Britain’s Economic Reform and Policies in Sixteenth Century (1995, pp.156-83), Joseph A.
Schumpeter’s work, History of Economic Analysis ( 1996, pp.500-52 ), W.W. Rostow, How It All Began: Origins
of the Modern Economy ( 1997, pp.31-86), and L. S. Stavrianos’s work, Global Rift: The Third World Comes of
Age (First Volume, pp.178-83 ), and so on.
7
or occupied, such as China, India8; or those who have status of so called “money hegemony”.
The currency of a money hegemony had and has in time been accepted by its trading partners
as the means of payment and storing value.
With the shift in the form of money, there has been being an evolution in the form of
international currency. In the early stage, the role of the international currency was assumed
by a certain precious metal that had been incidentally found by some countries like Spain. As
time went by, the role had increasingly been interwoven with a nation’s economic and
military power. By the time of the rise of British Empire, the international currency in
circulation had started to shake off the precious metal contained, as the British realized that
the currency supply backed by the government decree could be multiplied so long as a certain
proportion of precious metals was kept as reserves. Hence, for the first time in the evolvement
of the international currency, the seigniorage was collected by British Sterling.
Since the end of the WWII when U.S. became dominant in economic, political and military
sphere, the role of the international currency has subsequently been settled upon the U.S.
dollars. After the collapse of the Briton Woods system in the 70s when the dollar disconnected
with the gold standard, and finally was supported only by the economic, political, and military
power of the country, thus more seigniorage was collected for every dollar. Because of
seigniorage, the currency hegemony could tolerate the trade deficit. In fact, it is the trade
deficit that is the main way for the currency hegemony to issue the dollar to the world. A kind
of equilibrium between mercantile countries and the “currency hegemony” has as a result
temporarily reached.
In the long run perspective, however, such equilibrium would hardly be sustained. On one
hand, the mercantile policy can not be implemented for a long run, since it would at finally
result inflation, increment of the cost of labor, and the low interest rate (i.e., excess of
capital)9. In consequence, competitiveness in the external sector would be weakened and the
trade-induced stagnation would slowly wear the economy down.
On the other hand, the indefinite tolerance of the mercantile behavior will create an uneven
playing field that would in the long run weaken or even destroy the domestic industries of the
“currency hegemony” country, and might make it decline, even it once had relatively strong
economic strength. In the modern history, there are some countries that successfully carried
out the policy of mercantilism, and achieve the position of superpower, including currency
hegemony, such as Britain and United States, and there also are some countries that paid the
costs of the mercantilism, and fell down, such as Spain.
As for those countries who still keep a firm hold on the policy of mercantilism, therefore, it
would be better off for them to opt gradually change their protectionist policy and make
efforts to shift their currencies to be the international currencies. On the other hand, regarding
those so called “currency hegemonies”, what they should do is to reduce the long-term trade
deficits and find other way to issue their currencies to the world.
After the WWII, the United States can be regarded as the country with the status of
“currency hegemony”, whereas Japan and other Asian states can be seen as newly established
mercantile countries whose rapid growth has indeed been heavily assisted by the U.S.
economy, that is, the U.S. market that has endured constant trade deficits. In fact, the smog of
the Cold War has reinforced the atmosphere where the U.S. in consideration of international
political strategy had by and large countenanced the kind of mercantilism. What the States is
For example, during 1864 to 1948, China had only 8 years’ trade surplus in the 85 years ( Lu Chuanding, 1985,
table 4-14, table 5-1, table 6-1, table 7-10, table 7-11 )
9 Keynes has said, it would have negative effects, decreasing of cost and increasing of interest rate in foreign
countries as well as increasing of cost and decreasing of interest rate in home country, if the mercantilist policy
would be carried out excessively ( 1963，p286 )
8
8
worried, however, is that the speed with which these countries developed is too rapid. In order
to avoid the situation where its domestic industries become a sort of sacrifice of the
mercantile behavior, the United States has since pressed hard for the adoption of the free trade
policy. Not only would such a policy benefit consumers of all nations, but also could benefit
U.S. itself. On the other hand, the United States may not desire the reduction in the
seigniorage because of that in trade deficit. Another way of issuing US dollars is to provide
the U.S.-dollar loan to foreign countries. Therefore, the argument of “free flow of capital”
implies the interest of the United States.
In addition, from the pure currency point of view, there is an existence of the implicit
imbalance within the balance between mercantilism and “currency hegemony”. The currency
with the international status has unmatchable higher generality than others in the global
transaction. Such a difference can be shown with an analogy in that a domestic currency
possesses higher generality than a commodity, even though currency itself is a kind of
commodity. As we can manipulate the prices of commodities with a kind of domestic currency,
people can also rig the prices (e.g., exchange rate) of the national currencies by exploiting this
property of an international currency to the full in their interests. Therefore, it is easy for us to
find that it is the US dollar that is the materials used by the managers of hedge funds, such as
Soros, to attack the monetary systems in Asian countries.
4.
Attacks upon Nation-State by Hedge Funds
Being maximizers of self-interests, the hedge funds’ managers would choose those
nation-states with the most vulnerable monetary system the as best targets. Such nation-states
thus possess their particular features.
Firstly, the economies, especially the financial markets, of these counties are relatively
small with scale. On one hand, therefore, the hedge funds could possibly achieve the
maximum outcome, that is, the favorable movement of the market prices, with a certain
amount of a currency. On the other, it could also minimize the costs associated with financing
an attack, provided the target level of the price movement, that would usually be easier to be
obtained in small economies, is given. Secondly, there is the existence of the problems with
macro-fundamentals as well as balance of payments, such as inflation, trade deficits and so on.
In other words, a strategic timing of an attack on a financial market should be chosen in this
kind of period. Thirdly, fiscal problems in both governments and enterprises are prevailing in
these economies, which are reflected on, for example, a diminishing return to the capital
invested, too high the ratio of leverage, and their debts to be exposed to the risk of insolvency,
and so forth. Finally, at tactics' level, the time of day to launch an attack is when the debts
would be matured.
Insofar as the Asian financial turmoil is concerned, the countries having been under the
attack, in general, are those with similar characteristics. These economies and their money
supplies are much smaller compared with that of U.S ( see Figure 2 ). As these nations
( except Singapore ) had reached the final stage of mercantilism, their domestic prices were
rising, labor costs were creeping up, and trade deficits were emerging. In 1996, the proportion
of trade deficits in the GDPs of Thailand, Hong Kong, Malaysia, Philippines, South Korea
and Indonesia are respectively as 7.9%, 11.6%, 4.8%, 2.4%，7.4% and 3.1%10. Under the
policy of mercantilism for a long time, the profit rate went down because of more and more
severe competition in the world market; the ratio of assets-liability of firms in almost all these
10
Hong Kong is a very particular region. Until 1997, it was governed by Britain, so it could not carry out the
mercantilism policy as an independent political entity did, it was a free port in surface. However, the way of its
growing up is similar to that of other countries of East Asia. Therefore, Hong Kong may be regarded as a “final
stage of mercantilism” region in 1996: the cost of labour went up, and trade deficit increased.
9
countries was plummeted to a dangerously low level, since most of them adopted the debt
financing strategy during the period of rapid growth when the market risk was relatively small
with imitating and learning tactics; and firms had no sense about financial risk under a fixed
or peg exchange-rate system, thus did not hedge their foreign debts.
Figure 2
GDPs and M1s of East Asian countries
( 1996, taking those of U.S. as 100%)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Thailand
Hong
Kong
GDP
0.025
0.021
0.014
M1
0.033
0.06
0.017
Philipins
South
Korea
Indonisia
U.S.A.
0.013
0.011
0.066
0.031
1
0.018
0.01
0.049
0.026
1
Malaysia Singapore
Besides the foregoing, under the pressure of the “liberalization of capital”, those countries
have abruptly and disorderly opened up their capital markets. The inflow of foreign loans on
one hand made the domestic monetary policy lose efficacy and lead to a inflation, on the other
hand increased a large quantity of reckless short term debts (such as the situation in Thailand,
see Kirida Bhaopichitr, 1999) All of these made Thailand and other southeast Asian countries,
since the beginning of 1997, the best targets of the hedge funds.
In fact, it can be argued that the massive problems associated with these economies would
have been dealt with by their governments, the markets, or both, but by and large with soft
handed approaches, even if without the attack by the hedge funds. These approaches, for
10
example, could take the form of fiscal, trade, exchange rate or tariff adjustments, so that they
would lead to an alignment between the macro-fundamentals and the trade balance.
Nonetheless, on one hand, the governments have lost their measures of policies for their
opening the financial markets at improper time. On the other hand, the hedge funds would
prefer the sharpness of price-fluctuation rather than a moderate price-adjustment. They
launched attacks.
The key step of the attacks is to affect the price by selling a large quantity of financial
products in a financial market (e.g., currency market), which results the price to be sharply
changed to the direction the funds expect. It would consequently bear off two possible
approaches by the government of an attacked country, one is to protect the current fixed
exchange regime, resulting in the hick of market interest rate and a subsequent fall in the price
of the stock market; the other is to float the exchange rate after a futile attempt to protect it,
causing a large depreciation of domestic currency. If the hedge funds could foresee either of
the outcomes, profits would be within reach.
However, both outcomes will on the other hand bring damage to the real economies of the
countries under the attack. Firstly, the victory of the hedge funds is based on the cost of loss
of firms and even governmental agencies. They would go bankruptcies in the term of finance
because of the losses. Secondly, the prices of the financial markets (exchange rate, interest
rate, and prices of stocks) are the important parameters of the businesses of the firms and
other economic organizations. Once these parameters were sharply changed, the structures of
assets and liabilities of economic organizations were thrown into confusion, some of them
could not survive in term of finance even if they were healthy in the term of technology. For
instance, a large depreciation of domestic currency equals a sharp increment of foreign debt,
which would result the insolvency; the rise of interest rate cause the financial cost of a firm to
go up; and a fall of stock prices may shrink the asset of the firm which hold stock to be its
asset.
Once some firms and financial organizations could not repay their debts at term, other debts
at once become matured debts. They have to go bankruptcies. A bankruptcy means the default
of debts and leads to other bankruptcies of the creditors with poor financial condition. Chain
reaction occurs. A large number of bankruptcies worsen the crisis in two respects. In the
respect of real economy, the bankruptcy of firms means disintegration of the production
factors that have once been put together, discontinuity of the process of the production or
service, and the reduction of social output. In the respect of monetary term, the bankruptcies
of firms, especially of financial institutions, discharge of liability, and the destruction of credit
by default of debts, may lead to a deflation in the whole society, for most of money is
constitute of debts. On the other hand, a great deal of capital flight under the condition of the
depreciation of the domestic currency furthers the deflation, since foreign currency has been a
part of money supply under the condition of free flow of capital.
The damaged real economy may in return affect the deteriorated financial markets. The
accretion of losses and bankruptcies of firms may directly lead to the fall of stock prices; the
weakening of domestic economy may further the depreciation of the domestic currency. And
the more disadvantaged prices of the financial markets again worsen the business
circumstances of enterprises. The deflation reduces the total demand of the country, thus
strikes the real economy again. Along the process of a positive feedback of worse and worse,
an economy rapidly goes down to the bottom. At an extreme, the collapse of monetary system
and real economy may result political and social crisis, even lead to the government of a
country (even a big country such as Russia) going bankruptcy11.
Keynes said, “To destroy its monetary system is the most excellent and most efficient way, if one want to
overthrow a current social fundamental. This process can stimulate all potentialities of destroying economic orders,
and to do so in a way that no one can diagnose it.” This economist who know the secret of monetary system very
11
11
It is obvious for us that the prices of the financial markets would continuously change
towards the direction the hedge funds expect only when the disturbance of those prices causes
the damage to the real economy and the monetary system. Therefore, the more grievous the
destruction to the economy of country under attack is, the more advantage to the hedge funds
who launch the attack. As the result, there would be redistribution between the hedge funds
and the state-nations. In the term of fairness, what the hedge funds gain is next to
monopolistic profit if we regard their behavior is similar to that of monopoly. As what the
circle of economics acknowledges, the monopolistic profit is made as an unfair redistribution.
The reason the mainstream economics has less condemn to the kind of profit is that not only it
is not easy to be aware of the monopolistic feature of the manipulation by the hedge funds,
but also their transactions seem to be accord with convention of the market. In a market,
prices either rise or fall, economic agents either win or lose. Why people are willing to
tolerate loss is that they deem in general a market not only provides equal opportunities to all
agents, but also is an efficient mechanism to allocate resources, as long as there is no any to
manipulate prices. However, once prices are manipulated, not only the opportunities for
people to the game are not equal, but also the markets themselves, including monetary system,
are destroyed, so is the efficiency of the markets. Therefore, the gain of the hedge funds by
manipulating prices is a kind of unfair income, which costs a larger damage of losers and the
losing efficacy of the monetary system and economic mechanism: a net loss of global welfare.
Following the analysis above, we may deduce that some monetary transactions may lead
to a consequence of hurting fairness as well as damaging efficiency, although those
transactions seem to be fair in the surface. Fernand Braudel once pointed out that “the money
is a measure of exploit others both in home and abroad "(1992, p.522). We may discover that
the transactions of money can become a means of plunder, if we notice that the significant
difference between currencies, and different ways to trade currencies. As discussed above, US
dollar as an international currency may be the means of manipulating the prices of other
currencies. Recurring to financial derivatives, advanced information technology, and modern
credit system, the hedge funds may obtain money at much cheaper cost. With such a cheaper
currency, one may rob the currency with higher cost from general residents and firms just like
making staggering profits by manipulating in a particular commodity with a general
currency12.
5.
Several Possible Consequences and International Political Economics
Now, we start to base our thinking on the larger picture, that is, the global community with
different nation-states as individual units of this enlarged society. Our first set of questions
asked thus is, what will be the consequence for the community if the hedge funds are on the
loose, continuing its manipulation as well as speculation in financial markets? Under such
circumstances, how many options are there for the global community, or a nation-state for that
matter? And what impact will each of the options result in? The second set of questions is
what the total global welfare and what kind of redistribution among different nation-states
will eventuate under the different options? The last is, whether or not it is likely under the
present international political setting for the world community to agree upon a scenario as to
maximize the global welfare?
As with the first set of questions, there would be about 4 options for the global community
or a nation state: 1) adopting a hands-off approach; 2) setting up rigorous regulations, such as
well had revealed the whole process discussed above.
12 A story that Fernand Braudel tells may help us to understand the kind of practice of making money with money:
In 17 century, Portuguese discovered a kind of money called “cinbo” made of shells, “Portuguese considered
thoughtfully: they controlled the “field of manufacturing money”, that is the fishing ground of producing cinbo
around Loanda in 1650. This kind of money devalued 90% from 1575 to 1650 (translated from Chinese version,
1992, p.525).
12
returning to fixed exchange regime with a strict restriction on capital or even currency flow,
for the transnational financial activities, and banning all transactions with derivatives; 3)
opting tit-for-tat strategies, namely a government intervention in the currency market by
counter buying or selling domestic currency; 4) applying an targeted approach with policy
instruments, that is, restricting the behavior of price rigging in financial markets while
ensuring the normal flow of currencies and capitals.
In concern of the first option, the result would spell the eventual collapse of the global
financial markets and great economic depression. It would be more and more resources
entering into the field of financial speculation, because of the success of hedge funds13.
Meanwhile, however, this tendency may reduce the possibility of success to manipulate prices
of markets, since it may lower the degree of certainty of the investment strategies. The main
reason why hedge funds can succeed is that its expectation bears high degree of certainty
when the number of them in actual price rigging is small. The players, therefore, are more
capable of “foreseeing” a subsequent price movement. With the number increasing, however,
the degree of certainty would decrease as the strategies applied by various hedge funds can
exert offsetting or reinforcing effect in the same market. Even they operate in different
markets, one sure operation in one market by one hedge fund could possibly create an
uncertain outcome for another since prices of different markets are inextricably related. This
makes the hedge funds harder and harder to be profitable14 with higher and higher risk, and
may lead to the fall of the hedge fund itself who engages the manipulation (e.g. the failure of
Long Term Capital Management in U.S.).
When some hedge funds go bankruptcies, those commercial banks as their creditors may go
downfall because of huge loss. Then the crisis in the financial market combined with “credit
crunch” will in turn eat into the real economies, especially that of the United States, in which
most of hedge funds are originated and developed. Together with crisis of East Asia, Russia
and Latin Americas, the collapse of American economy may at last lead to another great
depression of the world.
Regarding the second or third option, they are indeed a kind of reaction to the behavior of
the hedge funds. The main difference, in general, is that the former is rather passive whereas
the latter is with a more active approach. The second option, though greatly insulating an
economy from the possible external shocks and enhancing the effectiveness of domestic
policy instruments, will cut off the normal flow of capital, that will in turn reduce the degree
of efficiency in allocation of international financial resources. Furthermore, the global
financial system and the international specialization would be disintegrated if more and more
countries adopt such a policy. As for the third, it could immediately leave a government, or
financial institutions for the matter, to a higher degree of risk expose, and what is more, would
aggravate the financial and economic crisis caused by the manipulation of hedge funds.
Comparing to the first three, the last option is much more positive, as it on one hand
regulates certain financial activities so as to restrain or eliminate the behavior of market
manipulation and thus prevent the global financial system from moving toward systemic
breakdown. On the other hand, it ensures a healthy flow of global capital and currencies that
will in turn enhance the efficiency of allocation of global financial resources.
Coming to the second set of questions, in terms of the total global welfare, the first and the
third option would unfortunately bring the worst result to the world community, since the
13
Data support this judgement. Statistic by Van Hedge Fund Advisors International (Nashville) in U.S. shows that
from 4th Quarter of 1993 to 3rd Quarter of 1998, the returns of the top ten of hedge funds in U.S. is higher by 14.4%
than those of mutual funds, and those of top 10% of hedge funds is higher by 38% than those of mutual funds (Van
Hedge Fund Advisors International).
14 Also Data and information show that the performance of the hedge funds has been getting worse and worse
since 1998. See Van Hedge Fund Advisors International，1999b；CCTV，1999。
13
systemic breakdown so induced in both financial and real economy will directly forgo part of
the global output, thus constitute a net loss to the welfare. About the second option, which by
and large blocks the free flow of global capital and thus checks the enhancement of allocating
efficiency, it could be anything but ideal. To the increment of the global welfare, the fourth
option, by rather adequately dealing with the disadvantageous fallout of the free flow of the
global capital, becomes the only contributor among all.
As with the issue of redistribution among different nation-states, the first option is in favor
of financially developed western countries, especially United States with the status of
“currency hegemony”, and prejudiced against newly industrialized countries or regions. This
is because, firstly, the hectic activities of hedge funds in speculation and the increment of
trade volume brought about by the derivatives will yield great benefits to the financial sector.
Secondly, the profits obtained by the hedge funds’ manipulation in external financial
markets will ultimately end up in their native countries.
Thirdly, the gain of hedge funds through attacking mercantile nation-states (e.g., most of
East Asian countries) represents, to a certain extent, the redistribution of the wealth achieved
by the mercantile policy in the form of foreign currency reserve back to the countries with the
status of “currency hegemony," thus alleviates the acuteness of problem in their trade deficits.
Fourthly, the continuing instability in the international monetary system resulting from the
attack by hedge funds will inevitably persuade more and more people in other countries to
adopt U.S. dollar as a means of transaction and storing value. Such a so-called
“Dollarization”15 will implicitly broaden the seigniorage base for the U.S. government.
Although the second and the third option lessen the benefits accrued to the countries with
the status of “currency hegemony” while reduce the damage to other countries, they would
also cost the inefficiency of capital allocation and increment of financial risks. Hence, it will
be the fourth option that is much fairer in terms of the redistribution, especially in the long run,
even though it is not as favorable as with the first option to those financially developed
countries immediately. To say so reflects the truth that by restraining the price rigging
activities in financial markets, it will bring the stability into the international monetary system,
which will no doubt benefit all.
However, in the perspective of international political economy, it is more than difficult to
have the fourth option implemented, even though it is the best choice on hand. This is because,
firstly, there is an intense competition for the international capital and financial transactions
among financial centers and among different nation-states. Regulations or restrictions of any
sort on capital flow in one country will be more than likely to reduce the competitive edge
over its rivals. Hence, it would be a rather futile attempt to regulate one way or another in a
single country or region, or out of unanimity, since the competition will grossly weaken the
efficacy of the very regulation16. Even those countries or regions having implemented some
About Dollarization, see Stephen Fedora’s article, To lose or to dollarize, ( January 19, 1999 ); Reuters,
Dollarization splits Latin Americans, ( January 31, 1999); Discussion and Research on it, see Steve H. Hanke and
Kurt Schuler, A Dollarization Blueprint for Argentina, ( March 11, 1999 )；Zhang Yuyan, Dollarization: reality,
theories and implications of policies (1999).
15
16
In fact, from very beginning, there is the restriction on the quantities of the transaction of financial derivatives.
In the United States, the Exchanges regulate the largest quantities of option contracts one investor holds. For
instance, the quota of Digital Equipment Co.’s share is 8000 contracts when contracting (John Hull, 1997, p.149).
Once crisis coming, many of the Exchanges impose automatically regulations on the derivatives transactions. For
example, after the failure of Long Term Management, some countries and some financial institutions put some
restrictions on derivatives transactions one after another. London Mental Exchange declared new order of
transaction, preventing hedge funds and other speculators manipulate the markets by selling short. Japan revised its
Security Transaction Law, forbidding beating down the prices of stocks by selling short. Before then, Hong Kong
14
kinds of regulations may loose the restrictions again because of competition between them, as
in the case of rivalry between Hong Kong SAR and Singapore (Chen Dingyuan, 1998).
Secondly, in an international society without a world government, a unanimous action of
the global community entails vigorous participation of heavy weights – large countries with
economic as well as political power. It is a bit unfortunate, however, that most of these
countries are likely to be direct or indirect beneficiaries of manipulating activities of hedge
funds. Hence, we can not expect, at least in the short run, that there is any incentive for them
to carry out such a heavy duty of implementing the Option 4, that is to be united together for
regulating financial manipulation.
6. Conclusion
(1) Until today, almost all so-called “economic freedom” can be approximately realized only
when there is a government. Therefore, in the international area we can not guarantee an
economic activity, even being called “freedom”, is really one that lead to both efficiency and
fairness, the true meaning of freedom, since there is no a world government in the
international circumstance.
(2) An efficient and stable monetary system is a kind of public goods, to which the
government of any nation-state has responsibility to provide it and protect it carefully with
institutional arrangements and policies.
(3) Without a world government, the dream of free trade has never been realized in the world.
The balance of international trade is not that of free trade but that between the mercantile
countries and the “currency hegemony”.
(4) The core strategy of the hedge funds is to manipulate the prices in the financial markets,
which is a behavior similar to that of monopoly. Therefore, those managers of hedge funds
represented by Soros are not the heroes of free market but its destroyers.
(5) The gain of the hedge funds through financial speculation costs more losses of the people
in the countries attacked, even including that of the collapse of the monetary system and the
real economy. This results net loss of world welfare, including the damage of global financial
system and real economy. Therefore, the behavior of manipulation by hedge funds is a kind of
crime to those countries attacked and the world, which is like a behavior to kill an elephant
for ivories.
(6) Two factors facilitate the hedge funds’ manipulating behavior. One is the introduction of
financial derivatives, which makes a quit large quantity of transaction reality; another is the
status of “currency hegemony” for US dollar which is used as a weapon to attack those
nation-states with much weaker currencies.
(7) The solution to avoid the perspective of great depression in the world is to regulate the
manipulating behavior by an international organization, which needs the unanimity of most
countries, especially those dominant countries in the world. However, those countries have
benefit from the result of financial speculation at least in short term, so we can not expect
such a solution mentioned above to be carried out soon.
(8) As to East Asian countries including China, this financial crisis tells us that, (a) the “East
announced a series of regulations on short sale of stocks and holding quantities of futures, for purpose of
guaranteeing fair play of transactions and restricting manipulations. The regulations also include the demand of
disclosure of information to big traders, and the ceiling of loans provided by the commercial banks to hedge funds,
and so no (Zhou Shuchun, 1998). However, once the crisis is over, those regulations may loose gradually.
15
Asia’s miracle” after WWII is just a particular case in the history of modern economic
development; (b) the situation of monetary system and of financial institutions may in return
affects the real economy heavily; (c) there is neither free trade nor free flow of capital with
fairness in the world, because of absence of world government. The precondition of achieving
economic freedom in the global level is a fair order of international economy. To form the
order needs the participation of all countries including East Asian countries.
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──
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17