Understanding the Financial Crisis summer 2009

A Brief Review of Exchange Rates
Let’s begin with a brief review of exchange rates. We start with what we already know, that e.g. Germany and the U.S. have different currencies, and that Americans might want to buy German products, invest in German financial assets, ( bonds or stocks ), travel in Germany, give a gift in money to somebody in Germany, invest in real capital/assets ( productive facilities like factories ), or speculate, e.g. buy deutschemarks ( DMs )today with the belief that they will increase in value ( appreciate ) sometime in the future, so that exchanging them at a later date back into dollars will result in a profit.

So there are all sorts of reasons for exchanging dollars for DMs and DMs for dollars. And this requires that there be some more or less stable rate at which these currencies exchange, e.g., four DMs exchange for one dollar. Some of these exchanges take place in banks. How does a U.S. bank come to be in possession of DM?

Well, say Germans want to buy a Microsoft product. Since Microsoft wants to be paid in dollars, the Germans need dollars. The DMs they give up for dollars end up in U.S. banks. But Seattle banks don’t need so many DMs, i.e. there is a relative oversupply of DMs, so the banks offer them for sale, i.e. the banks go into the market asking for dollars. Because of the excess supply, the price of DMs will fall relative to the dollar.

For our purposes now, the most important lesson to be learned from the above is that the value of a currency is ( supposed to be ) determined by supply and demand, in the same way that any commodity’s value is determined by supply and demand.

Some Basics Regarding Currency Speculation and the Asian Financial Crisis
The financial crisis in East Asia was bad for a lot of people: factories shut down, unemployment increased dramatically and wages plummeted. But one group that did quite well during the crisis were currency speculators. As we have seen, the fact that there are ( and must be ) more or less stable exchange rates among different currencies makes it possible to speculate in foreign exchange markets. After all, since these rates do fluctuate to some degree, as the forces of supply and demand wax and wane, there is the possibility of profiting from some currencies appreciating in value. As we have seen, if a speculator expects currency A to appreciate, i.e. to rise in value, at some future time, relative to currency B, then she will buy currency A now, paying for it in currency B, and then sell currency A later, after it appreciates ( rises in value relative to currency B ), taking payment in currency B. She will then end up with more currency B than she earlier put out to pay for currency A.

We probably don’t want to argue that all currency speculation is necessarily bad. Think of an American buying a German car. He pays for it in dollars. But Volkswagen has to pay its workers and suppliers in DMs. So somewhere along the line the American buyer’s dollars have to be exchanged for DMs. Now currency traders can function as middlemen in this process, and profit from a service charge. But the currency trader can also speculate, trading with the expectation that the dollars she holds can be sold at a higher price, and therefore at a profit, in the future. Clinton’s Treasury Secretary Robert Rubin argued that this type of activity is beneficial to the world economy because it expands the market for foreign currencies, and the resulting “increased liquidity” makes it easier for traders and investors to access the foreign currencies they need to buy and sell. And this lubricates the machinery of global economic activity. While there is an element of truth in this claim, it overlooks the ways in which currency speculation makes financial markets more liable to crisis by turning minor problems into disasters.

The example above ( an American buying a German car ) has to do with currency speculation’s connection to trade. But currency speculation can also facilitate foreign direct investment (FDI ), when residents of one country buy or set up production facilities in another country. ( FDI in the U.S.: Sony in Hollywood, Mercedes Benz in Alabama, Toyota in the Midwest ) If a foreign wants to build a plant here, they have to exchange their currency for dollars. That is, they need to find buyers of DMs or francs or yen or… These buyers will buy the currency in question for same reason anyone who buys for reasons other than consumption does: to make a profit. And how would someone make a profit from buying a currency? They will profit if the currency they buy gains in value. So they will buy only if they expect the currency in question to appreciate. And such a person is by definition a currency speculator.

So far we have been looking at arguably non-disruptive uses of currency speculation in connection with trade and productive investment. The sum of currency transactions directly related to trade and investment is referred to as the “primary exchange market” because of its link to the exchange of real ( as opposed to financial ) goods and services. But most currency transactions do not occur in this market. In fact, five times as much money changes hands in the secondary or speculative market. The biggest market in the world, at least up until 1992, is the speculative market in foreign exchange.

Who are the currency speculators? Most of them work for multinational banks like Citibank or Deutsche Bank. So they think like bankers. And we know that the priorities of the IMF are a paradigm case of Bankthink. It comes as no surprise that the IMF’s recommendations for the Southeast Asian economies were strikingly similar to the standard Structural Adjustment requirements: loosen labor standards, deregulate financial markets and further open their economies to transnational business. And since the IMF regards these policies as good for business, and the opposite policies as bad for business, currency speculators too entertain optimistic expectations, i.e. expect a given currency to gain in value, when the country in question introduces “business friendly policies”, policies that promote “business confidence.” And such policies are reasons, from the speculators’ point of view, to buy the currency. Correspondingly, policies that are perceived to reduce short-term profitability lead speculators to sell the currency in question.

Let us see how this kind of behavior can disrupt trade, hamper economic development and produce a general climate of economic havoc that is always harmful to working people. Let’s begin with a question that is analogous to the question we raised in connection with the private investment decision. That question was: What are the principal determinants of private investment decisions? We have already had a look at a number of considerations taken seriously by capitalists when contemplating a given investment, such as the size of the market, the price of labor, the strength of labor, the extent of business regulation, the level of taxation, etc. We saw that taken together these determine the level of “business confidence.” So now let’s ask the analogous question regarding currency speculators: What determines their decisions to buy or to sell a given currency? This comes to the same as: How do speculators determine whether to expect the relative value of a currency to rise or to fall?

Here matters are murkier for speculators than they are for investors in real assets. The element of guesswork is far greater for the former. In guessing whether a currency will appreciate or depreciate in value, speculators try to minimize their risk by using strategies they believe will increase the likelihood of an accurate forecast. Here are three of the most typical ways of doing this: 1) gather information on what makes for a robust economy ( similar to what we saw re determining business confidence ), 2) ape the decisions of other speculators, especially the big ones, and 3) use “forward exchange” markets. [ Forward exchange markets are distinguished from “spot markets,” where present exchanges take place, e.g., when dollars are exchanged for francs or guilders or DMs right now. But a speculator can also make money in the forward market, where she can commit herself to sell a fixed amount of a foreign currency at a specified future time, at an exchange rate that is set today. There are basically two reasons why someone might enter a forward exchange market, one having to do with “hedging” against risks, the other purely speculative. “Hedging” happens when a currency trader e.g. has made an export deal that guarantees that she will have a certain amount of foreign currency in her possession at a specific time in the future. In this case she is hedging against the risk of losing money if the currency loses value between now and the future date. On the other hand,the speculator may enter the forward market based simply on a more or less educated guess that a foreign currency will move in a certain direction. Here she is engaging in speculation.] What is most important to keep in mind here is that each of these three strategies can lead to financial turmoil and prevent governments from implementing policies that benefit the working class. Let’s look at each of these strategies for increasing the likelihood that a certain expectation regarding the movements of exchange rates is accurate.

Strategies #s1 and 2, gathering information about the health of the country whose currency is traded, and following the decisions of other speculators, especially the large ones: there is all sorts of information out there, much of it conflicting, about unemployment rates, inflationary pressures, productivity growth, labor-management relations, the stability of financial markets, and the like. When speculators deem that these indicators suggest higher profits, they expect the currency to appreciate in the future, and will accordingly buy the currency. But if the indicators seem to portend lower profits, speculators will expect the currency to fall, and they will sell their holdings. Now the big catch here is that speculators’ expectations, whether based on reliable or faulty information, will tend to be self-fulfilling. Here’s why.

Reflect on the case where a speculator expects a currency to fall in value. She will then unload the currency, which in itself increases its supply, which drives down its value. Of course in the real world the value of a currency depends on the judgements and activities of many agents, for the same reason that the price of any commodity depends, in laissez-faire economic theory, on very many individual decisions. Our conclusion still holds, for the speculator is a herd animal. Look: the original expectation is not based on some unambiguously “objective” assessment of the available information. For the information itself is typically ambiguous and contested, and so needs to be interpreted. And one of the canons of interpretation employed by speculators is… to check what other speculators are doing! This is what some commentators call “herd behavior.” For if large numbers of speculators behave in the same way, a currency will, for that reason alone, gain or lose in value. And this is what the traders guessed in the first place! [You will recognize the dynamics of the bubble of the late 1990s here.] Say, for example, that the original guess was that the currency will appreciate. When a herd of speculators act on that guess, i.e. when they proceed to buy the currency in question, the heightened demand has an inflationary effect: it drives the value of the currency up. This then acts as a signal to these same traders, and to others who may have been initially skeptical, that they should buy more of the currency, and that in turn drives its value even further up. In fact, after the initial buying causes a rise in value, the initial buyers will have provided selected information to convince prospective buyers to buy the currency also. As a broader consensus builds around buying, the currency continues to appreciate, perhaps at an increasing rate, and we see a phenomenon that is in these times familiar to us all: a speculative bubble in currency values.

Here we learn an important lesson: the type of economic crisis that appears to be characteristic of Oligopoly Capitalism in a time of global excess capacity and the resultant rampant financial speculation ( of all sorts ) is financial crisis. This is not to rule out the possibility of a global recession/depression. We are in fact experiencing such a thing now. It merely points to a type of economic crisis whose imminence is most conspicuous and which we have in recent years seen in action. There are all sorts of bubbles about: stocks are still overpriced, and so another crash is entirely possible; there is the very large housing bubble that is still in the process of deflating; the dollar is notably overvalued; and debt has piled upon debt at an unsustainable rate. And of course don’t forget that the foregrounding of financial instability in our times is a direct consequence of the paucity of profitable investment opportunities in the real, industrial economy.

We should be able to see at this point how it is that these kinds of speculative activities can be harmful to working people. We can begin by reflecting on the most vexing question for speculators: when to get in or out of the market. ( This question is of course as important to stock-market speculators as it is to currency speculators. ) There are two broad reasons for speculators to, say, get out of the market. They either think that they’ve made enough money, or they expect the currency to fall in value. A key consideration in directing traders to the latter expectation is that local profit opportunities are decreasing. What would such a situation look like? Well, the government might be increasing, or just thinking about increasing, regulation of business, or perhaps responding to popular pressure for tougher environmental standards. Or perhaps a labor movement is forming. To working people, these developments look good. But to speculators, they portend decreasing profit opportunities. This is a signal to speculators to unload the local currency. If enough of them do so, the value of the currency will fall. This in turn is a signal to more speculators to sell, which causes the currency to depreciate further still. You can see that this process feeds on itself, and tends toward a downward spiral.

Now this scenario was evident in the Asian financial crisis of 1997-1998. For most of thesecountries, the sell-off was in response to particular domestic events. ( Questions for you: what were the events? What precipitated them? ) Now in most cases like this, governments will attempt to halt the decline of their currency by reversing the policies that initially led the speculators to sell. ( You should be able to see that this typical pattern enables currency speculators to be agents of a strike of financial capital, the mere prospect of which can discourage governments from pursuing policies that benefit the working class. ) In the immediate aftermath of the Asian crisis, in 1997, the governments of South Korea and Indonesia were reluctant to reverse their initial policies. This made speculators wary of buying these countries’ currencies again. [ We will have a lecture on The Theory of the State. We will see something exactly like the above when the then-leftist Mitterand was elected in 1984. The confidence of both real investors and currency speculators was dealt a blow, and the speculators immediately began to unload francs. ]

Recall the distinction discussed above, between the spot market and the forward exchange market. The above discussion focuses on the spot market, i.e., exchanges in the present. We saw above that there is also the forward exchange market, which we referred to in connection with the three main strategies speculators use to increase the likelihood of an accurate guess as to whether a currency will appreciate or decline. What we have been doing in the last few pages, remember, is examining each of these strategies to uncover the ways in which they harbor the potential, perhaps the likelihood, of financial crisis. We have also seen the inherently reactionary nature of these strategies. We have discussed the first two strategies. Let’s conclude with the third.

Strategy #3, entering the forward exchange market: in this market someone commits herself to sell a fixed amount of a foreign currency at a specific time in the future, at an exchange rate that is set today. We also saw that there are two reasons for engaging in a transaction in the forward market, one in order to hedge against losing money, and the other to speculate. Speculators can make huge sums of money in this market. Here’s how:

Suppose she expects the Swiss Franc ( SF ) to appreciate over the next three months. She contracts to buy SFs in three months at a fixed exchange rate, say today’s rate, which is say 75 cents per SF. Now she thinks the SF will rise to 80 cents in three months, so she tries to set up a forward contract to buy let’s say $10 million worth of SFs in three months, but for today’s rate, 75 cents/SF, so that she will get SF 13,333,000. Now if things go as she expects, she will be able to sell those SF immediately at the current market rate of 80 cents/SF. This will get her $10,667,000. In the amount of time it takes her to sell the SFs, which could be a matter of seconds, she has made a profit of $667,000. ( This is how George Soros made much of his money. )

Forward transactions harbor the same dangers that are implicit in the first two strategies we considered. They can become self-fulfilling prophesies. This is especially true of forward sales, which have in fact been at the core of various recent currency crises. Remember, in a forward sale, the speculator guesses that the value of a currency will fall in the futue. What she does then is to establish an agreement to sell a fixed amount of this currency at a specified time in the future, at something as close to the current, higher ( than what she expects it to be in the future ) rate as she can get. If her guess is on the mark, she will buy the currency cheaply in the future, and then sell it at the higher contracted exchange rate. But note that her offer to other market participants of a forward sales contract signals that she thinks the currency is going to depreciate in the future. This signal can have a big impact, since the number of large currency speculators is relatively small. If George Soros decides to offer a forward sale on say Thai bhat other speculators will take notice and adjust their expectations re the future value of the bhat downwards. If enough speculators do this and act accordingly, i.e., start selling their holdings, the value of the bhat will for that reason be driven down, and Soros will have been “proven” to be a financial genius for… having made a correct prediction! Never mind that Soros’s prediction was at least in part made correct by the herd mimicry of the class of speculators.

A Brief Note On How Low Margins Can Generate High Profits
Even though the margins between the selling and buying prices of a given currency are usually less than 1%, speculators can make lots of money betting on these minute marginal changes. A speculator expects that DMs will appreciate. So she buys $10 million worth of DMs. Suppose the original price is 1.50 DM per U.S. dollar ( 66.7 cents per DM ). So she gets 15 million DM. Now suppose that after 20 minutes ( or 50 seconds ) the value of the DM increases from 66.7 cents to 66.8 cents. The 15 million worth of DM she bought a few minutes ago can now be converted back into U.S. dollars, yielding $10.020,with a profit of $20,000. These kind of big profits in a short time are possible because of the huge volume of each transaction. In order to be successful in this way as a speculator, you’ve got to have a lot of money to start with. So it comes as no surprise that big speculators are mainly multinational banks.

A Potential Disaster For The Banking System?
Because speculative transactions in foreign exchange can be so profitable, big multinational banks were devoting more and more of their investable surplus to these transactions. Moreover earnings from these transactions were, at leat until 1992, the fastest growing part of bank incomes. So billions of new dollars continue to enter global currency markets. In the context of an immensely fragile financial system, a new financial crisis carries ever greater risks for the world economy.

Possible Progressive Responses To Speculation
To reduce the potentially catastrophic consequences of currency speculation, the total volume of such transactions would have to be lowered. This could not be done by a single country. An international policy is required. Now one way to make foreign currency trading logically impossible is to make it so that there are no foreign currencies. This would mean establishing a single currency for several nations. Western Europe has already gone some way towards this goal with the establishment of the euro. The problem here is that this requires all participating countries to unify their fiscal and monetary policies. If they are required to unify around neoliberal standards, e.g. as with the European Union, where the government deficit can be no more than 3% of GDP, this can cause massive unemployment. Another much discussed is the so-called “Tobin Tax,” a tax on all foreign exchange transactions. Here again, all trading partners would have to introduce this policy simultaneously, and, most importantly, be prepared to resist effectively the political opposition of the speculators. One form this opposition could take is, as we have seen, a strike of financial capital.


Alan Nasser is Professor emeritus of Political Economy and Philosophy at The Evergreen State College. His book, The “New Normal”: Persistent Austerity, Declining Democracy and the Globalization of Resistance will be published by Pluto Press in 2013. If you would like to be notified when the book is released, please send a request to

Follow me on Twitter: , and Like me on Facebook: