The Accidental Theorist (12 page)

But the modern business cycle bears no more resemblance to the economic fluctuations that afflicted preindustrial Europe than NATO does to the Holy Roman Empire. It may be tempting to ignore the very real lessons of the last century because of some alleged parallels with the distant past. To do so, however, would be to use history not as a guide to the present, but merely as an excuse for some very ahistorical wishful thinking.

T
he 1990s have been a great age for financial speculation.

Markets have been rigged, currencies overthrown, vast sums made and lost with an abandon not seen for generations. The essays in this part try to make some sense of it all. The first essay here, “How Copper Came a Cropper,” discusses the amazing story of Sumitomo’s initially successful “corner” on the world copper market. The next, “The Tequila Effect,” turns to a more tragic case—the havoc wreaked on Mexico and other Latin American nations by the currency crisis that erupted at the end of 1994. With “Bahtulism” we move on to the Asian currency crises of 1997; and the final piece here, “Making the World Safe for George Soros,” tries to step back for a broader view, albeit one with a special European focus.

In 1995 the world was astonished to hear that a young employee of the ancient British firm Barings had lost more than a billion dollars in speculative trading, quite literally breaking the bank. But when an even bigger financial disaster was revealed a year later—the loss of more than $3 billion in the copper market by an employee of Sumitomo Corp.—the story quickly faded from the front pages. “Oh well, just another rogue trader,” was the general reaction.

It eventually became clear, however, that Yasuo Hamanaka, unlike Nick Leeson of Barings, was not a poorly supervised employee using his company’s money to gamble on unpredictable markets. On the contrary, there is little question that he was, in fact, implementing a deliberate corporate strategy of “cornering” the world copper market—a strategy that worked, yielding huge profits, for a number of years. Hubris brought him down in the end; but it is his initial success, not his eventual failure, that is the really disturbing part of the tale.

To understand what Sumitomo was up to, you don’t need to know many details about the copper market. The essential facts about copper (and many other commodities) are (1) it is subject to wide fluctuations in the balance between supply and demand, and (2) it can be stored, so that production need not be consumed at once. These two facts mean that a certain amount of speculation is a normal and necessary part of the way the market works: It is inevitable and desirable that people should try to buy low and sell high, building up inventories when the price is perceived to be unusually low and running those inventories down when the price seems to be especially high.

So far so good. But a long time ago somebody—let’s say a Phoenician tin merchant in the first millennium
B.C
.—realized that a clever man with sufficiently deep pockets could basically hold such a market up for ransom. The details are often mindnumbingly complex, but the principle is simple. Buy up a large part of the supply of whatever commodity you are trying to corner—it doesn’t really matter whether you actually take claim to the stuff itself or buy up “futures,” which are nothing but promises to deliver the stuff on a specified date—then deliberately keep some, not all, of what you have bought off the market, to sell later. What you have now done, if you have pulled it off, is created an artificial shortage that sends prices soaring, allowing you to make big profits on the stuff you do sell. You may be obliged to take some loss on the supplies you have withheld from the market, selling them later at lower prices, but if you do it right, this loss will be far smaller than your gain from higher current prices.

It’s a beautiful idea; there are only three important hitches. First, you must be able to operate on a sufficiently large scale. Second, the strategy only works if not too many people realize what is going on—otherwise nobody will sell to you in the first place unless you offer a price so high that the game no longer pays. Third, this kind of thing is, for obvious reasons, quite illegal. (The first Phoenician who tried it probably got very rich; the second got sacrificed to Moloch.)

The amazing thing is that Sumitomo managed to overcome all these hitches. The world copper market is immense; nonetheless, a single trader, apparently, was able and willing to dominate that market. You might have thought that the kind of secrecy required for such a massive market manipulation was impossible in the modern information age—but Hamanaka pulled it off, partly by working through British intermediaries, but mainly through a covert alliance with Chinese firms (some of them state-owned). And as for the regulators…well, what about the regulators?

For that is the disturbing part of the Sumitomo story. If Hamanaka had really been nothing more than an employee run wild, one could not really fault regulators for failing to rein him in; that would have been his employer’s job. But he wasn’t; he was, in effect, engaged in a price-fixing conspiracy on his employer’s behalf. And while it may not have been obvious what Sumitomo was up to early in the game, the role of “Mr. Copper” and his company in manipulating prices has apparently been common knowledge for years among everyone familiar with the copper market. Indeed, copper futures have been the object of massive speculative selling by the likes of George Soros, precisely because informed players believed that Hamanaka was keeping the price at artificially high levels, and that it would eventually plunge. (Soros, however, gave up a few months too soon, apparently intimidated by Sumitomo’s seemingly limitless resources.) So why was Hamanaka allowed to continue?

The answer may in part be that the global nature of his activities made it unclear who had responsibility. Should it have been Japan, because Sumitomo is based there? Should it have been Britain, home of the London Metal Exchange? Should it have been the United States, where much of the copper Sumitomo ended up owning is warehoused? Beyond this confusion over responsibility, however, one suspects that regulators were inhibited by the uncritically pro-market ideology of our times. Many people nowadays take it as an article of faith that free markets always take care of themselves—that there is no need to police people like Hamanaka, because the market will automatically punish their presumption.

And Sumitomo’s strategy did indeed eventually come to grief—but only because Hamanaka apparently could not bring himself to face the fact that even the most successful market manipulator must accept an occasional down along with the ups. Rather than sell some of his copper at a loss, he chose to play double or nothing, trying to repeat his initial success by driving prices ever higher; since a market corner is necessarily a sometime thing, his unwillingness to let go led to disaster. But had Hamanaka been a bit more flexible and realistic, Sumitomo could have walked away from the copper market with modest losses offset by enormous, ill-gotten gains.

The funny thing about the Sumitomo affair is that if you ignore the exotic trimmings—the Japanese names, the Chinese connection—it’s a story right out of the robber-baron era, the days of Jay Gould and Jim Fisk. There has been a worldwide rush to deregulate financial markets, to bring back the good old days of the nineteenth century when investors were free to make money however they saw fit. Maybe the Sumitomo affair will remind us that not all the profitable things unfettered investors can do with their money are socially productive; maybe it will even remind us why we regulated financial markets in the first place.

Relations between Mexico and the United States are not what they were in the early 1990s. In the eyes of many Americans, Mexico is a corrupt nation ruled by drug lords and wracked by economic crisis. In the eyes of many Mexicans, the United States is simultaneously tyrannical and self-indulgent, imposing harsh economic medicine on its neighbor while blaming it for a drug trade that is really our own fault. The voters who turned on the ruling party in Mexico’s 1997 elections were also, at least in part, showing their displeasure for a government too close to the United States.

And yet things could easily have been much worse. In particular, if Bill Clinton hadn’t done the right thing early in 1995, Mexico’s economy could have imploded, ending forever the hope of reform in that long-suffering nation.

In the months after the crushing Republican victory in the 1994 Congressional elections, much of the Clinton administration’s inner circle was still in a state of stunned stupor. Yet in those dark days a handful of officials persuaded Clinton to support a daring, risky, and extremely unpopular policy initiative: the rescue, with a huge loan, of Mexico’s collapsing economy. Had that initiative failed, it might well have doomed Clinton’s presidency and much more besides. But it succeeded, and history may record the decision to go ahead with their plan as Clinton’s finest hour.

In the early 1990s Mexico was the darling of international investors, who were convinced that the economic reforms of then-president Carlos Salinas would produce robust economic growth. The warnings of a few economists that the hype about Mexican prospects was not matched by actual performance were ignored, and money poured in at the rate of $30 billion a year. But over the course of 1994 a series of disturbing news items—a peasant rebellion, the assassination of a presidential candidate, and some bad economic statistics—made the markets increasingly nervous. Finally, in December, the number of fidgety investors reached critical mass, and there was a full-blown run on the Mexican peso.

So far this is not too unusual a story; currency crises are actually quite common, and often do little long-run harm. But it soon became apparent that Mexico was different: Having placed the nation on a pedestal for several years, investors were shocked—shocked!—to discover that the country was not a combination of Singapore and Switzerland, and began pulling their money out as blindly as they had put it in.

The exact details of what happened next are not a matter of public record. But it seems clear that the key figure was Treasury Undersecretary (now Deputy Secretary) Lawrence Summers, a former Harvard professor who has emerged as the economic brains of the Clinton administration. Summers reached two conclusions about Mexico’s crisis: that there was a chance that American intervention could make the difference between recovery and catastrophe, and that this chance was worth taking.

What Summers and others at the Treasury realized was that Mexico was plunging into a sort of political-economic death spiral. The panic of investors could not be rationalized by the weakness of the economy alone: What was driving money out of Mexico was political fear, the concern that Mexico’s recent openness to foreign capital and foreign goods might be about to be reversed, that the country might revert to a populist anti-Americanism. The capital flight inspired by this fear was causing a disastrous business slump. And it was this slump that, in turn, was the most powerful cause of political unrest. In short, there was every prospect that pesssimism about Mexico’s future could turn into a self-fulfilling prophecy.

The answer, as they saw it, was to give Mexico a bit of breathing room: to lend the Mexican government some money, allowing it to stay afloat and to cushion the blows falling on the private sector. If all went well this would in turn give private investors a chance to recover their nerve, and the vicious circle of decline would turn into a virtuous circle of recovery. Of course if all did not go well, the loan might not be repaid. And then there would be hell to pay. Mexico is not a small country, and a loan would do no good unless it was big enough to matter; in the event, the United States and other countries (whose elbows still hurt from the twisting we gave them) provided a credit line of $50 billion. Just imagine the public reaction if any substantial fraction of that money had been lost!

Why, then, take such a huge risk? Because Mexico is not just any country. Not only does it share a 2,000-mile border with the United States, it is a traditionally difficult neighbor which at the moment happens to be ruled by U.S.-educated technocrats, but whose friendliness can never be taken for granted. To have “our guys” preside over an economic collapse, as seemed all too likely in early 1995, would have been a major foreign policy disaster. There was also, to be frank, the question of protecting the large sums of private money already invested in Mexico; but it is possible to be too cynical. For what it is worth, my sources say that foreign policy, not the interests of Rubin’s Wall Street friends, was the decisive concern.

And so one winter day Rubin and Summers marched into the Oval Office with their plan—and, incredibly, Clinton agreed. Lending taxpayers’ money to Mexico when private investors were pulling out was not a popular idea. In fact, it quickly became clear that Congress would not allocate the necessary funds; instead the Treasury engaged in some fancy footwork, exploiting a legal loophole to lend Mexico the money without Congressional approval. Furious Republicans, led by Senator Alfonse D’Amato, denounced the plan, and prepared to hang Summers from the rafters when the rescue failed.

But the rescue did not fail. Mexico’s economy, after plunging 10 percent in the first year after the crisis, has recovered the lost ground. Private investors have returned, stabilizing the peso; and the Mexican government, years ahead of schedule, has repaid that emergency loan. Mexico is not yet completely out of the woods, but U.S. taxpayers are.

So what are the morals of the story? One is that sometimes it pays to listen to the experts: many people find arrogant technocrats like Larry Summers annoying, but smart is as smart does—and he did. The other is that sometimes it actually pays to do the unpopular thing: If Clinton had listened to the polls that winter day, Mexico would probably be a basket case—and Bob Dole would probably be president.