Thursday Book: The profits of boom and doom

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The Independent Culture
PLAY THE computer game Sim City and, as a benevolent dictator creating a town, you can raise funds two ways: either tax the citizens, or issue a bond. If you tax your residents too heavily, some will leave town; but issue too many bonds, and you find that the amount of taxes needed to pay off the interest explodes - your city will swiftly empty and crumble.

The creators of the software obviously share the Peter Warburton view of debt. His preface to his book advises readers to pay off all their loans and mortgages, and his conclusion urges them to spread their savings and investments around to safeguard against the bank failures he confidently predicts will take place this year. Indeed, he urges the Government to run an advertising campaign with the slogan: "Lost your home in '89? Don't lose your shirt in '99." That, and plan for emergency powers to maintain public order in the wake of catastrophic financial failures.

Unlike many books warning of impending catastrophe and the collapse of capitalism, Debt and Delusion has the great merit of being written by an economist. It contains evidence and argument rather than relying on breathless prose alone. Peter Warbuton is a prominent City pundit and has worked in the City since 1975. So when somebody like this warns that the stockmarket is massively overvalued and banks have lent ludicrously large amounts to uncreditworthy borrowers, it would be silly not to pay attention.

The basic argument is actually very familiar. It is that increasing financial sophistication, particularly in the use of derivatives, has obscured excessive risk-taking. The bottom line is that government, corporate and personal indebtedness has grown unsustainably since the mid-1980s. The longer it takes before the reckoning comes, the more cataclysmic the shock to the financial system will be.

Now derivatives - those odd things that nobody outside the financial markets, and very few inside, really understand - have often been blamed for cataclysm and crisis. They brought down Barings Bank and bankrupted Orange County, California. They have inspired jolly books with self-explanatory titles like F.I.A.S.C.O. and Apocalypse Roulette. Because derivatives are essentially rearrangements of shares and bonds, they can be either more or less risky than the underlying investments; and the presumption is that, because they are harder to understand, they are therefore riskier.

As Warburton puts it: "When the next global bear market in equities and bonds arrives, the unwinding of highly geared derivatives positions will trigger financial explosions in every corner of the developed world." Translation: when share prices everywhere start falling, financial institutions will make huge losses on the large-scale bets they have placed via derivatives using borrowed money. Some banks will fail, causing panic and calamity among ordinary people who wouldn't know a derivative from a digestive biscuit.

The trouble with doom and gloom like this is that it makes such extreme claims. Logically, it could be right, but it is hard to know what odds to put on it. Last summer saw a world financial crisis when, after a year of turmoil in Asia, Russia defaulted on its foreign borrowing. This set off a chain of financial reactions that bankrupted Long Term Capital Management, a speculative investment fund. Barclays was one of the banks that had invested its - our - money in LTCM. For a while, some bits of the financial markets stopped functioning altogether; it was not possible for sellers of some investments to find buyers at any price.

Yet, while the crisis made clear the depth of the abyss at whose brink the financial system tottered, the plunge into chaos never came. The central banks blamed in this book for their foolish tolerance of financial gambling managed to stabilise within a few weeks what was clearly the most serious crisis the system has faced for a generation. I find this rather cheering, but it obviously alarms Peter Warburton. He is not so confident they could carry on sorting out the problems a Wall Street crash would cause.

There is a good parallel in the Millennium Bug problem. It is a bit alarmist to believe that computers will fail catastrophically when the clock ticks past midnight on 31 December. But, on the other hand, there is no harm in not being airborne at the time and in stocking up on a few extra candles just in case. Likewise, a worldwide financial meltdown is pretty unlikely, but there is no harm in arranging one's affairs to cope with one, should it occur.

Readers might like to know, therefore, that the maximum amount in a bank or building society account protected by the government's deposit protection scheme is 90 per cent of 20,000 euros (or about pounds 13,800). Oh yes, and the value of shares can go down as well as up.

Diane Coyle