The financial economy and the real economy
By Justin Podur

Luckily, there are occasionally exceptions. A book by Eric Briys and Francois de Varenne, The Fisherman and the Rhinoceros: How International Finance Shapes Everyday Life (Wiley, 2000. The original French version was called La mondialisation financiere: Enfer ou Paradis? and was published in 1999), teaches how the financial economy works and explains why it is such a great thing. At the time their book was published, the stock market collapse of 2003 had not yet occurred, and nor had the collapse of Enron, the Iraq war, the oil and food price crises, and the current mortgage meltdown. Briys and de Varenne were working for Deutsche Bank when the book came out. They had both previously worked at Merrill Lynch (which no longer exists, sold to Bank of America) and Lehman Brothers (which no longer exists, largely sold to Barclays). The authors are excellent writers. They provide a rare and wonderful thing: a clear, confident explanation by practitioners of ideas and attitudes which, when implemented, proved unambiguously disastrous.

Briys and de Varenne start their book with a question that is today on everyone's minds:

The skill of risk management

The fisherman's (and in their book it's a man) parable is used to explain the importance of the futures contract.

A fisherman has a great skill set, sailing, navigating, handling the risk of storms and accidents, catching and hauling fish back to port. That fisherman will be familiar with taking and managing certain kinds of risks to his physical safety in his work. On top of these risks and these skills, though, he also has to worry about the uncertainty in the price of his catch. When he brings his fish to market, what if there happens to be a glut of fish, and he can only fetch a very low price, one so low that he can't pay his expenses?

He can hedge against this risk by taking a futures contract. He can sell his fish before he catches them if he can find a buyer at an agreed-upon price. He will agree to deliver a certain quantity of fish at a certain time at a certain price.

Who might buy this contract from him? Two kinds of people. The first kind is another business, say a fish canner. The canning factory needs a steady supply of fish to keep running. While the fisherman is worried about risk that the price will go down, the cannery is more concerned that there won't be any fish when they need it. They might be willing to pay extra in order to know that they will get the fish they need when they need it, rather than trying to get the cheapest possible price for their supply. The fisherman might be willing to accept a lower price than the best possible price he could get, so that he could guarantee that the price won't be lower than what he can accept. Both parties win, and importantly, both can focus on what they're good at: the fisherman at catching fish, the cannery at canning fish.

The second person who might accept the fisherman's contract and buy the fish before they are caught is the speculator. While the cannery will take a futures contract out of a need for a steady (if higher than perfect) supply, the speculator is not interested in fish at all, but is merely betting that the price of fish will be higher than what he bought it for. The speculator hopes merely to turn around and sell the fish. To someone not trained in finance, this might seem like mere gambling, and that the speculator is adding no value. But the speculator is providing a social service, and has a skill to bring to bear as well. The fisherman's skill is catching fish. The speculator's is managing risk. When both focus on what they do best, they both profit, and society at large profits as well. Again, everyone wins.

The Monte Carlo strategy and the importance of regulation

So, according to the proponents of finance, the speculator is not a parasite on the real economy, but almost a saint, someone who helps everyone by taking on the specialized task of managing risks. For assuming these risks, the speculator gets the chance of profits.

All is well, in this world, except when the speculator can use someone else's money. The next parable in the book is that of the blind pearl-fisher. These pearl-fishers, like fishermen, assume huge risks in swimming on the sea floor for oysters with pearls in them. They almost all come to lose their sight – but active pearl fishers have a kind of self-help organization where some of their catch is reserved to take care of pearl fishers who have gone blind. Active pearl-fishers can feel assured that they will be taken care of when they lose their abilities, so they feel safer in assuming the physical risks of their work.

What if, instead, these pearl fishers pooled their money and gave it to a banker? The banker takes $9000 from them, promising them their principal plus interest. He takes their $9000, adds $2000 of his own, and goes to the casino in Monte Carlo with the $11 000. There, he bets $1000 on red (his own money) and $10 000 on black (the $9000 from the fishers and $1000 of his own).

Now, if black wins, he gets $20 000, pays the fishers back their interest, takes back his $2000, and is seen as a financial genius for making huge profits.

If red wins, he's just lost all of the fishers' funds, but he still keeps his own $2000. Now he tells the fishers “sorry, I can't pay you back after all”, and walks away. Because he did all this on behalf of a corporation, his liability is limited, his personal money protected. He's unlikely to go to jail, and if his bank is big enough, he might just get bailed out by the government.

He was supposed to be providing a service: helping the pearl-fisher's assets find their most efficient use in the real economy, where they would earn the biggest return, a return he and his clients could share in. Instead, he used a permissive environment (for which the government is to blame) to engage in a Monte Carlo strategy. He went for broke with other people's money, took care of himself, and lost.

If the government creates a permissive environment for this, by acting as guarantor of bankers who act this way, then these crises will continue to occur, the proponents of finance argue. Instead, what the government should do is create a regulatory environment where bankers and insurers are encouraged and free to use these instruments responsibly. Or, alternatively, so deregulate finance that depositors know they will have no protection except their own hedging if the bank defaults. The depositors thus have an incentive to keep an eye on the banks – in a system where the government is present, they do not. The problem with the banker and the pearl fishers in this parable is, in their view, that they did not use financial instruments to hedge!

Instead of trusting the banker, the pearl fishers could have avoided ruin by using insurance, through a credit default swap! They could still have given their money to a banker (though not the irresponsible gambling banker), but they should have paid a series of regular payments to someone else. That person, the seller, would take the payments, but would pay the pearl fishers the value of their assets ($9000) if the banker defaulted on the loan. The pearl fishers accept a lower rate of return on their money, but are insured against a default by the banker because they bought a swap. The real economy is served, the pearl fishers are ensured, and the risk is managed.

Briys and de Varenne explain the option contract using a parable of a Genovese merchant, Zaccaria, in 1298. This skilled merchant, was going to get a shipment of alum from Aigues Mortes to Borges. Zaccaria had contacts in Borges and the means to hire the ship. He also was well aware that there were storms at sea and possibly pirates. So he sold the alum to a partnership, Suppa and Grilli. The partners sold Zaccaria the right to buy the alum back if it reached Borges.

Suppa and Grilli would make a profit if the ship reached Borges, but would lose their investment if the ship sank. Zaccaria, meanwhile, had covered his risk. If the ship didn't reach Borges, he had made a small profit by selling to Suppa and Grilli. If the ship did reach Borges, he would buy the shipment back and re-sell it in Borges at an even higher price and at an even higher profit. He could concentrate on doing what he did best, moving and selling goods, and let Suppa and Grilli do what they did best, assume the risk and take a premium for it.