The risks of hedging

[00:00:00] So it's incredible, because it's not just the price of the barrel of oil, it's also the refining costs that have gone up to convert it into jet fuel. So, you know, that is something we're all exposed to. It's good that we're hedged, it's good that in Europe we take proactive hedges, so it means that we can manage that situation for longer. This is the Debunking Economics podcast with Steve Keen and Phil Dobbie.

[00:00:28] Now, airlines have avoided putting up airfares with fuel surcharges for the most part, even though oil prices are rising, because they have hedged. It's the one volatile factor that really influences their business costs. So that makes sense. But that's just one form of hedging. Does it all make sense? Or does a lot of it distort behaviour and benefit the financial sector? This week, hedging, for the most part, is it good or is it bad?

[00:01:04] So hedging. We are all familiar with the idea of hedging, for example, you know, we talk about hedging our bets, not putting all our eggs in one basket. We think about insurance, that's a form of hedging, isn't it really? And it is rife, of course, in the commercial world, Steve, and the finance industry are all over it. I mean, and it's acceptable, isn't it? I mean, in many walks of life, hedging is not acceptable. So for example, we choose one wife. We can't hedge.

[00:01:33] In our marriage, can we? We can't sort of like, you know, say I've had an affair. But really, don't worry, darling, because I'm just hedging. Just in case it doesn't work out between us. I've taken out this contract. You get from hedging to sledging very quickly.

[00:01:46] Exactly. Yeah, it's just a short step, isn't it? But in the finance world, it's very acceptable. And I guess there's different types of it. But I mean, to me, what it does mean is that particularly if it's, for example, an airline that says, well, okay, let's hedge our fuel, because we're worried about fuel prices going up.

[00:02:06] So we are going to set our forecast at, say, $75 an hour, an hour, $75 per gallon, or whatever, or barrel, or whatever. And then that price goes up, they can still work at that $75 price. Because in effect, somebody has taken out a contract and said, well, we'll pay the difference. And so they can carry on as normal. But it's not as simple as that. It gets complicated. But is it also distortionary?

[00:02:36] Are they carrying on oblivious to what the real price is? Is that a bad thing? You mentioned a couple of forms of hedging there. One is to have huge stocks of whatever you need, so that when there's massive fluctuations in the ongoing price, you can dip into that stock and not pay the higher price. I'll give a trivial example. Bath crystals in my local supermarket vary between full price and half price.

[00:03:05] If you buy 10 of them at half price, then by the time you want to buy them again, they're at half price again. You never fade full price. That's sort of retail hedging. Not that I do that, but that's obviously a tactic to use. So you've got a bath full of crystals now. You can't put any water in the bath. That's right. There's no room. I've got too many crystals stored in my bath to have a bath. But the Chinese have clearly done that with oil in a dramatic fashion.

[00:03:27] And this is one reason why we haven't seen a squeeze from the Strait of Hormuz as yet on global energy supplies and capacity to bridges output. Apparently, they had one and a half years' worth of China's supply. And since China's one of the world's largest economies, that's a substantial part of global oil demand was in stocks they had all over the country for security reasons. And also because the Chinese, for good reasons, don't trust the West or the Middle East for that matter. So it meant that they could run that stock down.

[00:03:57] And probably they're even selling it on the market because the price they would have bought that huge stock for was far less than the price reached in the early days of this conflict. And that's what kept the price from rising so much. But now they're going in the opposite direction. So you can hedge via physical stocks, and that's a form of hedging that I'm quite in favor of. But the type of hedging we see talking about in the finance markets tends to be based on theories of economics. And that's the sort of hedging I'm not interested in.

[00:04:26] I'm not so convinced by. So just finishing that one off where you just buy a load of something that's available while it's cheap. And so you've got it so when prices go up, you're not paying that high a price. I mean, that was the idea behind the common agricultural policy as well, wasn't it, in Europe? That when we've got a big supply of something, the government would buy it because it's cheap, and then they'd sell it back to the market when there were bad crops. But that didn't work out very well. Was that just because it was Europe and it was bureaucracy?

[00:04:57] Probably. Probably. But certainly Australia had the same thing with wool at one stage. And you can get extreme events, like, for example, with wool. I mean, one thing that caused a price spike was the Korean War because suddenly you needed to have winter clothing. And bang, Australia made a fortune out of exporting the wool, but the stocks were completely eliminated. And this sort of thing can happen. You can have insufficient stocks so you don't make it through the buffer.

[00:05:23] I think that's what the rest of the world's going to see when they've got 90 days or less of buffers versus China's effectively 450 days. Then a smaller buffer is a problem. Yeah. But the type of hedging they talk about in the markets tends to be based on the idea that you can reduce your risks by buying a range of non-financial assets.

[00:05:45] And this is, pardon me being a pedant here, but even though we call them financial markets, shares and houses and other assets of that nature are non-financial assets because a financial asset is your claim on somebody else. But a non-financial asset is your asset and nobody else's liability. So in that case, they're non-financial assets.

[00:06:10] But people, the theory is that if you want to diversify, you buy a range of shares which are negatively correlated with each other. So if one goes up, the other goes down. And that therefore allegedly hedges your bets. But then overlaid on that is a belief in economic theory, which is not hedging, that's sledging your own brain.

[00:06:34] And that tells them that these negative correlations will remain indefinitely. Now, when you get something like the global financial crisis or whatever we get coming our way out of the straight up on wheels and so on, people will be, in some cases, if you get a severe downturn in your cash flow, so you're about to face bankruptcy. And therefore, you've got to liquidate one of your non-financial assets to be able to cover that. Then that negative correlation will turn into a positive correlation. Yes. And that's the danger.

[00:07:05] Yes. I don't know who it was you were talking to, but I had caught a bit of one of your podcasts. And that's what made me think we'd talk about this today. Precisely that. But if you're holding gold, for example, right now, because you think I'm holding gold because it's hedging against things going wrong with oil, for example, or the AI boom going all wrong. If it all goes wrong and you're holding, particularly if you've borrowed money to buy those shares, you're going to be caught short. You're going to have to sell your gold. Exactly. Everyone sells gold. Gold prices come down as well. So hedging is not working in that case.

[00:07:35] And this is one of the fallacies. Conventional economics encourages people to think about the world in a fallacious way. Okay. So we would, you know, it makes sense to say that when you have a complete market collapse, then everybody is trying to liquidate anything they've got, which can get them to be able to cover the financial claims they're actually under. So they liquidate their non-financial assets to try to meet their financial liabilities.

[00:08:00] And like the classic was during the Great Depression, you can still find historic photographs of, you know, some speculator outside Wall Street selling a Rolls Royce for 10 quid. I know there's not even 10 quid, but it was a trivial amount of money compared to what's actually price because he faced a margin call.

[00:08:20] And, you know, if you don't liquidate what you've got, then the margin call is unlimited and everything you've got to – so this means that what you think is hedging depends upon the stability of the system in which you're in. And the standard practice of saying, you know, bonds and shares move in opposite directions or gold is a hedge against what happens with the stock market and so on and so forth. That's fine so long as you don't get a crash like the global financial crisis.

[00:08:48] And, of course, we do get a crash like that. So at the time you most need the buffer from hedging, it's not going to work. Does that mean we're more likely to have something like the global financial crisis because you've hedged, you feel secure, you have a false security in a way, so you take bigger risks or you borrow more money because that's all right. I'll borrow more to – I'll leverage more because if things go wrong, I've got the hedge. I've got all these alternative investments which I can turn to if things go wrong. And that's what happened with long-term capital management.

[00:09:18] This is something – again, these are immense historic events when they occur and forgotten if you give it enough time. So long-term capital management was a so-called hedging firm following mainstream economic theory because guess what? They had not one but two economics Nobel Prize winners on their board. And so they basically – their proposition was everything returns to equilibrium. Yeah. Everything returns to equilibrium. Everything returns to equilibrium.

[00:09:46] So what we do is we take positions expecting that any diversions between share price ratios or bond ratios will compress over time. Okay. Okay. And so they – and then they went to banks. They had three – I think they had five billion in total capital. And they'd leave that at up to $1.2 trillion. Okay.

[00:10:08] And then they took a set of positions expecting, again, the usual story, any divergence between yields they thought would be arbitraged away. So therefore, they took positions where there was a gap and they expected the gap would compress over time. So whether they took put or calls depends upon that assumption that you will turn to equilibrium relationships. Then the Russian financial crisis hit and everything went totally skewiff and they lost about $800 billion.

[00:10:34] And there had to be literally a coordinated rescue through the Fed Reserve to avoid that bringing down the rest of the financial system. So you get this combination of hedging which works only if the negative correlations that you're exploiting remain all the time and they will not in a major downturn.

[00:10:53] And then because you get people believing in equilibrium as a feature of a capitalist economy, which is a bit like believing in fairies as a characteristic of your garden down at the bottom there, that they will exaggerate this and think, well, on a hiding to nothing, what we're going to do is pick up pennies in front of a steamroller and we'll buy lots and lots of steamrollers because we all expect them to do the same thing and bang, you get steamrolled. Well, isn't it?

[00:11:21] Well, isn't the way it works with these contracts that, and I have to say, even though I talk about markets every day, I do get confused with hedging. We're in an area where I get confused as to how it actually works. But my understanding is if I've got an entity, let's take aircraft oil, aircraft fuel, and let's take a share.

[00:11:46] Yeah, let's say I've bought shares and I've hedged against those so that if the shares go down by $30, for example, from $100 down to $70, and so the bank or whoever sold me the package which is covering me will pay the $30 difference. Then they'll go, but you've sold those shares and made a loss, so the shares are lower, so we're going to buy those shares now, and that'll cover us for the losses we've just made.

[00:12:15] So we've paid you $30, but we've also bought cheaper shares because that's – and so that magically balances itself out. I mean, that's sort of like the equilibrium that you're talking about. How can that be? In stable circumstances, yeah. When everything goes the same way, no. And this is the thing. When you look at stock market crashes, you have shares that are going up and down, and you can imagine positive and negative correlations to win those shares.

[00:12:43] Then when the stock market crashes, like if it winter fell 10% in one day in 1929, everything is going down. There was nothing going up at the other side. So all the positions you thought were hedged went in the same direction, and people were wiped out by that phenomenon. And it's a bit like the old story that there's falling, no problem jumping out of a plane. Falling doesn't hurt you. It's when you stop that things change.

[00:13:08] And so this is a classic instance that it's okay so long as current trends continue, but when those trends break, those correlations that you locked into your hedge are going to disappear. But it also seems quite a dangerous way of operating for whoever's providing that hedge. Because if you're saying, hey, look, the share's gone down by 30%, so we're going to cover you for that 30% that you've lost. And because shares have come down by 30%, we're going to buy those shares because they're cheap now.

[00:13:35] Well, the shares might be cheap now because the company's crap or some other circumstance. If you are just buying it without any consideration, you're just saying, we're just trying to recover our position. It's just a mathematical formula. That's a very dangerous way of operating, isn't it? Well, that's what long-term capital management proved, despite the fact they were trying to prove the opposite. So, yeah, it is something which can bring the market unstuck at a time when you want it to be somehow having stabilizing forces in there.

[00:14:05] Like a lot of hedge funds, I mean, the whole word, the name hedge fund, really, it typifies people who take lever positions in stock markets. Yeah. And so it's not hedging. It's believing that there's a consistent margin you can exploit and then levering the hell out of it because the margin is quite small to make your gains. Well, that's not reducing risk. It's increasing it.

[00:14:28] And we see that whenever there's a massive blip on the market, then any sort of dominant institutions are the ones that seem to fall most rapidly. All right. When we come back, I want to look at when you buy gold and other things as a hedge. Is that good or bad for the economy? You probably figure out already where I'm going to take you, which you'll jump onto instantly when we come back. That's next on the Debunking Economics podcast.

[00:14:57] This is the Debunking Economics podcast with Steve Keen and Phil Dobby. So, Steve, I'm running a business and it's reasonably profitable, but I'm a little bit concerned about my investments. So I've and my investments are all in trying to make my business grow. But I'm worried about just having to carrying too much risk.

[00:15:25] So I've got my rainy day fund and with my rainy day fund, I go and buy gold. So that's a form of insurance. But it means that all the money that I'm putting into gold is money that I could have been spending more productively in the economy. Instead, it's sitting there as a nonproductive asset. So that's a problem, isn't it? Well, I mean, when you buy the money, the gold, the money goes to somebody else's account. So it depends what they're doing.

[00:15:53] This is one reason that so many neoclassical theories about money are false. They only take a look at one side of a transaction. All this stuff about general equilibrium doesn't apply to how to think about the monetary system in a general way. But yeah, what you do, you're transferring money you could be using in the physical economy and making more podcasts and maybe making more coffees and that sort of thing. You're transferring it to the financial sector.

[00:16:17] And what tends to happen there is that money in the financial sector turns over rapidly in terms of speculation inside the finance sector itself, but very little purchasing from the finance sector back to the real economy. So the more money we put into these financial instruments to supposedly hedge our positions in the real economy, the less money there is turning over in the real economy and you actually slow the real economy down. So should the government be getting more involved in this then?

[00:16:43] Should we be saying, well, okay, if you want to manage risk, the government can help you do that rather than getting the finance sector involved in it? So I'll give you an example. I used to work for the British Choice Authority years ago and when I was working for them, you could never take out insurance because they would say, well, you're part of the British government. We've got insurance. We're half the frigging economy. So why would we use somebody else? Why would we get involved in the finance sector to provide the insurance for something?

[00:17:11] We just pay for it if things go wrong. And could the government be doing that for a broader section of the community? So say don't hedge into the financial sector and buy derivatives or whatever these instruments to hedge against. Use the government for that. Well, that's in effect in some ways what government bonds are regarded as because you've got a guaranteed cash flow stream from them.

[00:17:38] Like a lot of the market manipulations are based on the efficient markets hypothesis that assumes that bonds are a risk-free investment. But what they mean because they're risk-free in the sense the government will always honor its bonds that are issued in its own currency. That's a guarantee, which most people can't understand. But that's an essential part of MMT's understanding and it's correct.

[00:18:03] The government will always be able to create money in the currency in which its bonds are issued. So in that sense, it's safe. But the way they treat it as safe is saying there's no variation in the yield. And of course, there is variation in the yield. The rates on bonds are going up and down in various ways. But they presume that the return on bonds... Up lately. Yeah. But they assume the return on bonds is always lower than what you can get as an average for return if you invest in an indexed stock market fund.

[00:18:33] So the assumption is always the yields in this market are higher than the yields on the bonds. Now, that is involved in a whole range of fantasies about the market, which you have to read the original papers to be aware of these fantasies. But for example, one of the fantasies to make that assumption is that people can predict the future accurately. And therefore, share prices reflect accurate future predictions of yields on the companies in which you've bought shares.

[00:19:01] Now, who in here is Nostradamus or Jesus? I keep on forgetting which one you are. But companies do that as well, of course. You know, they have forecasts. I mean, they don't know. And a lot of those... Yeah, yeah. Price action is often related to those forecasts, whether they believe them or not. So when we're predicting the future based on evidence which is being provided to you, though. Yeah. But the thing is, evidence is always... Well, they assume we have forward-looking information.

[00:19:27] They talk about forward-looking expectations, which is another fairies in the bottom of a garden or maybe more appropriately angels on the head of a pen. But it's companies giving forecasts, though. Yeah, you will do it. The point being that share market return can be well below bonds at various times. Yeah. You don't have that guaranteed positive relationship with what they call the capital market line. That doesn't exist.

[00:19:49] And so what that means is if you take positions based on that theory and therefore you lever up the gap between bond yields and share yields and expect that to be how you're minimizing your risk, it'll blow up on you on various occasions when the market falls across the board and you'll end up in a strongly negative position. So, you know, I mean, back to your question about the government on levering those or taking the risk out of it.

[00:20:19] In a sense, the government is the institution that can take a long-term view. So it does make more sense for the government doing things like, you know, having, for example, stocks of, I don't know, face masks in case a pandemic comes along. Yeah. Okay. Good idea. So in that sense, the government needs to be the one that provides those buffers. But again, a conventional theory says, no, that's a waste of money. The government shouldn't waste the money. We're much better off waiting until the pandemic occurs and then killing everybody. Pardon me.

[00:20:48] And then, you know, importing the mask from another country. So, or, you know, you gave the example as well of China sort of like buying up oil and other resources as well, which the government could be doing, which is a form of hedging as well, which keeps the price more stable for everybody who's reliant on that for their own industries.

[00:21:06] So there's also the question, isn't there, about how if you buy into precious metals that have other purposes, so you're pushing up the price of that metal. I mean, gold is not a great example because we don't use gold a great deal. We use silver. Well, we use gold a fair bit on circuit boards and chips and wiring and stuff. But there's a lot of it and it's a very small proportion of it that's used for that though.

[00:21:35] And we've, you know, a lot of it is sitting in bank vaults. But nonetheless, it means anybody making computer chips has to pay the speculative price for gold. Yes, exactly. And that's my point. And then more so with silver. And so, yeah, so that means that that hedging is influencing other industries of which you've got nothing to do with. And that's distortionary. Yeah, and that's like, I don't know the current cost of mining gold. I don't even know the current price of gold. I have very little interest in this.

[00:22:02] But I think the price is about $4,000 and the cost is about $1,200 from what I've seen. So it means that rather than paying $1,200 per ounce to buy gold for your circuit boards, you're paying $4,000 per ounce. And the basic idea is hedging is supposed to reduce costs. But as you make the point there, if you then, pardon me, have people buying things like gold as a speculative commodity, then they drive up the price for the real sector.

[00:22:32] And in that sense, it damages the real economy. Yeah, and platinum is a great example as well because that's really, I mean, it's a much shorter supply than silver or gold. And so it's got potential to rise that much more because it's being used as a speculative investment. But it's in short supply but in high demand.

[00:22:55] And it could derail the, not necessarily this is a bad thing, but it could derail the whole development of AI because AI could find that it just can't grow to its full potential because it just can't get the resources because people are buying up the metal to hedge against things completely unrelated to it. So I don't know. And that's just, so there's two things happening here, isn't there? There's that distortion.

[00:23:15] And then there's the other distortion where companies to hedge are getting involved in contracts, which is placing them into the vagaries of the finance market rather than the fundamentals of their business. Yeah, yeah. So, I mean, I think hedging and the whole, the argument of the finance sector is good for you. I mean, this is the point that I'm departing on that I think the finance sector is far too big as it is right now.

[00:23:40] We'd be off with the finance sector one third the current size and basically servicing the physical economy, enabling payment systems fundamentally and credit for corporations and for entrepreneurs. That's what it should be doing. But instead, we've got it intruding its nose everywhere and including, as you say, in speculation, you get the potential for crashes coming out of the changing, change of correlations between assets when there is a general downturn.

[00:24:06] And then making essential inputs into production processes more expensive. So, having an impact on the cost of production as well. And is it also not helping people, the providers, the companies that are doing the hedging? Are they not seeing the real element of risk in all of this? Do they believe they are so protected they will take riskier decisions than they perhaps would otherwise? Possibly.

[00:24:34] I mean, I think that does happen because there's a false sense of security coming out of all this stuff. And then when there's a turnaround and suddenly all those positive-negative correlations become positive correlations, then bang, the impact is far greater than people would estimate in their portfolios. So, the extent to which they think their hedge falls apart at the time they need the hedge most. And this is why I think it's illicit.

[00:24:59] So, when we're looking at investment portfolios, I mean, maybe it's fair enough in that context because you're just dealing with paper. I mean, it does involve the real- Yeah, but paper which makes claims on physical goods and services and cash flows from real businesses. Yeah.

[00:25:18] So, if you hedge on into a company just because they look like they are a good hedge against a company that you've invested in, I guess that's not good because you're going to help that company go along even though they might not be doing particularly well. They might not deserve their share price to go up. Their share price has only gone up because they're in a sector where you're hedging against. Like, for example, I lost your camera, by the way. You've just gone blank. I didn't hedge my bets properly on my battery on my camera.

[00:25:47] I thought 48% battery charge would be enough to get through our conversation and it's all gone and my camera's turned off. Right. So, there you are. I didn't have a big enough buffer stock to get me through the conversation. Okay. Well, a lot of people are listening to us rather than watching anyway. Thank God for that. So, they'll be going to see- Maybe it'll even look better as a reversed image. Yeah, we'll see what it does to ratings. If it improves, then if it doesn't, then next time we'll just try and I'll disappear and we'll see if people will watch you. But okay, I've got one- That's a possibility. I've got one final question then.

[00:26:16] So, if you've just got a portfolio, does that matter if you're hedging? If you just go, well, okay, I'm going to buy it because it's all paper. Does that matter too much? Because it's not the real world. It's just the finance world. Well, I mean, what troubles me is that because we've gone from like- You're talking about government versus state. Because we've gone from government pensions to state pensions, some government pensions to private pensions.

[00:26:41] But you've now got pensioners who've got to take a look at the stock market returns each day to know whether they can afford to go and buy milk. And to me, this is ridiculous. So, that's a form of hedging. Like we all know are going to get older. We know we need to continue eating when we can no longer work for a living. Society itself should hedge at the collective level rather than bringing it down to individual so-called responsibility.

[00:27:03] So, that's one area where I think the idea that you can hedge your situation is basically rather than being a way of stabilizing people's lives, it's made them incredibly stressful. And it forces asset inflation as well, doesn't it? Because there's more money that's being put into these investments. And the hedging thing. So, for example, all over the world, people invest in Australian banks because they're seen as a safe bet.

[00:27:28] So, their share prices do well, not because they're necessarily very good. It's just that they're quite stable. And so, their share price gets inflated for reasons of hedging, for no other reason other than that. And, of course, that happens in all sorts of categories. If you are seen as a hedge, your price is going to go up. So, again, that's just distortionary. Yeah, yeah.

[00:27:52] So, I think that the concept of hedging, like in general in physical things, makes plenty of sense. So, you have stocks in case you run down a supply. And that's what a stock enables you to have an effective hedge on variations in the price of the good over time. But when you put it into the finance markets, we're caught up in a whole lot of leverage speculation. And what is called hedging is actually more likely leveraging. And that means you get more volatility rather than stability. Yeah, yeah. Okay, good point to leave it on. You're looking good, by the way. Thank you. Thank you. That's a my new hairdo.

[00:28:22] We will catch you next time. Thanks, Steve. Okay, no. Charge up that battery. See you next time. I will. Okay, see you. The Debunking Economics Podcast. If you've enjoyed listening to Debunking Economics, even if you haven't, you might also enjoy The Y Curve. Each week, Roger Hearing and I talk to a guest about a topic that is very much in the news that week. It's lively. It's fun. It's informative. What more could you want?

[00:28:48] So search The Y Curve in your favourite podcast app or go to ycurve.com to listen.