Derivatives as a Sponge

‘Do you desire to be in a situation to decide between liberty and protection? Do you desire to appreciate the impact of an economic phenomenon? Inquire into its effects upon the abundance or scarcity of commodities, and not upon the rise or fall of prices. Distrust nominal prices; they will only land you in an inextricable labyrinth.’

Frederic Bastiat – The Bastiat Collection

We think it’s pretty safe to say that share prices will never go down again. The Bernank, the Drag and the Steve have you covered. They have a simple solution for all the world’s ills.

When in doubt, print.

‘What’s that? You have a structurally flawed economy (geared towards satisfying debt-fuelled excess consumption) and you’re having trouble keeping the game going? Just print more money my good man. Keep the nominal price level up. The dozy and ignorant populace always fall for the nominal trap. They can’t distinguish between what’s real and what’s nominal…print!’

We’re surprised that no one else in the history of money and economics has thought of this before. Like the classic three chord rock song, sometimes the best solution is the easiest.

That being the case, you probably should go and borrow some more money from the banks…preferably to buy a house. Because if everyone does this, it will increase the value of residential property (and we thought houses were a depreciating asset!) and make us all much wealthier.

Then we can buy things with that magically created wealth. This consumption will fire up demand for manufactured goods, which creates employment, income growth and more wealth!

We jest of course. We haven’t lost our mind…not yet anyway. But it does raise the important question of whether you should speculate in the hope that nominal prices will keep heading higher, while the real economy continues to deteriorate from central banking price manipulation.

To try to answer that question, have a think about just how an economy creates growth. Economic growth, as measured by GDP (gross domestic product) is income produced by a stock of, hopefully productive, assets.

Consistent investment in those assets (investment that comes from real savings) combined with innovation, enhances productivity. Higher productivity means a given stock of assets can produce more income with which to buy even more goods and services. In this way an economy achieves non-inflationary growth.

In fact, a highly productive economy with a somnambulant central bank tends towards falling prices. That’s because its output of goods and services is greater than money supply growth, meaning money in relation to goods and services falls…which means money’s purchasing power rises!

But that’s very much an example of a free market type economy, one where the market sets the price of money through the preferences of savers and consumers. Or, if you prefer, one where the market sets the supply and demand for money.

In this day and age, that type of analysis is fantasyland stuff. If just doesn’t work like that.

We have credit dependent Western economies where central banks set the price of money/credit by creating reserves (let’s call these reserves ‘manufactured savings’) so commercial banks can utilise fractional reserve lending and extend credit. In the absence of real savings (which comes from deferred consumption) central banks manufacture savings via the printing press, which keeps the price of money and/or credit low. High supply, low price.

This low price of credit in turn encourages demand for it, mostly to speculate on asset prices. Once this demand becomes widespread, an economy develops structural flaws, as its productive capacity shifts to satisfy speculative demand caused by cheap credit. Business investment falters because speculative demand for credit is largely unproductive.

In such an environment, easy money creates an unproductive economy, which should lead to higher inflation. But’s that’s not happening. We’ll speculate on why it’s not happening in a moment.

But first, we need to get to the next step in the unfolding economic debacle. Because Western economies have structural flaws created by easy credit, they are vulnerable to deep recession/depression once the flow of credit stops.

So when the private sector maxes out its credit card, the government steps in and fills the void. It continues to underpin the unsound structure of the economy through Keynesian spending. In the case of the US, it’s generating deficits of US$1 trillion plus per year to prop up the economy.

It issues paper, takes in global capital and disperses it throughout the economy. Because of the structural flaws, the economy consumes the borrowed capital. The point is, government spending is completely unproductive. Because of the distortions rendered by the prior years of easy money, the economy consumes the governments’ capital and just wants more and more of it.

After the capital disappears, the outstanding debt remains (it’s some poor fools’ asset) and interest must be paid on it. Of course, by this stage the economy cannot produce the income to service the debt AND keep spending, so central banks step in and announce debt financing schemes with shifty lies like ‘Quantitative Easing’.

So if cheap credit produces an unproductive economy, which in turn forces government spending to prop up the structurally deformed economic apparatus, and if government spending is entirely unproductive, why don’t we have an inflation problem?

Leaving aside the fact that governments and their statistical agencies doctor inflation statistics to suit their needs, there are a few other reasons why inflation has disappeared…for now.

Globalisation, and the rise of China, and Asia in general, as a low cost manufacturing hub for western economies is clearly a big reason for the absence of inflation despite full scale central bank financing of western government deficits.

But we also think the derivatives market has something to do with it. Because of the broken financial system, credit is not flowing into the real economy. We reckon central bank money printing just flows into financial markets via derivatives. It pushes up NOMINAL prices, which tricks everyone into thinking things are getting better.

These days, if a US based investor wants to protect themselves against inflationary money printing they go and buy an oil ETF. They don’t buy physical oil, just a futures contract to take delivery if they want it in the future. Which they don’t. They just want ‘exposure’ to it.

Meanwhile, real demand languishes because the real economy is a mangled wreck. So if paper prices set the price for the physical product, you get higher prices coming through in a period of weak real demand, which creates oversupply and, eventually, falling prices.

In other words, derivatives absorb the supply of money coming from the central bank without raising real prices in the economy. This process causes all sorts of confusing price signals, which creates volatility and turns the derivatives market into a casino with a bomb hidden under one of the tables.

Which leads us to think the stock market is actually that casino. Remember the ‘London Whale’ from JP Morgan, whose speculative derivative bets blew up earlier this year? According to this time line, he stopped trading in early April. On April 30, the risk management group took over the derivatives trades.

That date represented the market peak. It plunged throughout May. Was it the unwinding of the derivatives book that send the market into free fall? Or was it just a coincidence?

If you have any thoughts, or know more about the derivatives market than we do (which wouldn’t be too hard) drop us a line at

In the meantime, we’ll continue thinking about how the derivatives market might be the sponge absorbing global central bank liquidity, hiding the underlying inflation that will one day emerge with a bang.

If you like the thought of higher nominal prices and want to do some speculating, check out what Dr Alex Cowie and Kris Sayce are telling their subscribers right now.

Personally, we’ll stick with the dead bloke, Mr Bastiat, and distrust the nominal price level.

Greg Canavan
for Markets and Money

From the Archives…

Liquid Paper
28-09-2012 – Greg Canavan

Banks versus the Farms
27-09-2012 – Greg Canavan

A Familiar Sequence: Print, Spend, Crash
26-09-2012 – Bill Bonner

The Hamburglar’s Budget
25-09-2012 – Dan Denning

The Cheeseburger Police
24-09-2012 – Dan Denning

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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4 Comments on "Derivatives as a Sponge"

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Shares don’t get first use of newly printed money. Primary dealers and Governments do.


Yep. Which is why the market can still plunge if the PPT let it. In fact now that Ben has every last bull on board they may well drop it off a small cliff…. but then I wouldn’t short term trade any particular idea…rather just buy and hold a small position. A position you would unlikely be under any compulsion to liquidate.


OT but starting at the 10 mins Marc understands. I see freedom starts from within. Our attitude to ourselves and then each other by extension. You can be free therefore even if your surroundings are restrictive however inner freedom necessarily manifests into a political ideology that pertains to the material world. Some form of which Marc has from what I can see here. Have not studied anything else he has said however.

truth and integrity
Good article Greg. You missed a previous reply where I spoke of GDP. While we talk of consumption, GDP, growth and derivatives we need to keep in mind several basic principles. 1. Balanced budgets we know that Assets = Equity + Debt. Derivatives are considered in the vicinity of $quadrillion yet the equity of the world is likely worth less than $100trillion. See the problem I would like to know who in Australia has increased their assets or equity since 2008? I would suggest less than 0.1% implying that no one generally has increased assets; yet debt in the public… Read more »
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