Sassen on Derivatives and Central Banks

Saskia Sassen’s Territory, Authority, Rights is not a particularly easy read. Sassen explores her title concepts as they develop from the medieval era through the mid-20th century and into the post-1980s world of globalization. She argues that the modern period is both novel in certain ways, and a continuation of older trends in others, and thus tries to chart a middle path between the Wallersteinian “one world since 1600” folks and the Tom Friemdan “OMG Globalization?!?!?!” crowd. I’m with her on that one, but so far I’m having trouble deciphering exactly what she thinks is new vs. old in the present conjuncture – she focuses a lot on the expansion of presidential power (citing Elena Kagan’s now famous law review article at length) in the US as one sort of novelty.

But the most interesting, and prescient, discussions so far are in chapter 5 on the expansion of global financial markets and the effects of that expansion on the capacity of nations to self-govern. Sassen’s earlier work (which I need to read) explored global financial markets in the context of the key financial capitals – New York, London – and her expertise shows here. For one thing, Sassen notes the incredible growth of derivatives as one of the differences between the modern period of financialization and earlier moments of high finance (248-264). Writing in 2005, Sassen presciently argues that these computer-enabled complicated financial transactions designed to liquefy previously illiquid assets have the capacity to make financial crises much worse, much faster than previous financial innovations.

Sassen does not focus much on the mortgage-backed securities, CDOs, or CDSes we’ve come to know and love in the unraveling of the financial crisis. Rather, she makes a very provocative argument about interest-rate swaps, a form of derivative developed in the 1970s and 1980s (for a detailed account, see Gillian Tett’s fantastic Fool’s Gold). Interest-rate swaps let companies and governments do just that: trade interest-rate risks. Sassen argues that the proliferation of these swaps has leveled out the interest-rate dependencies of the various sectors of the economy, and that leveling out has weakened the capacity of central banks to affect the economy:

[T]he impact of interest rates on the economy, in turn, has been diminished by the widespread use of derivatives. Derivatives (futures, swaps, option) are meant to reduce the impact of interest rate changes and thereby can be seen as reducing the effectiveness of interest rate policy by governments on the economy. Indeed, an estimated 85 percent of U.S. Fortune 500 firms make some use of derivatives to insulate themselves from swings in interest rates and currency values, as do public sector entities, exemplified in the notorious case of Orange County in California. Most of these derivatives are actually on interest rates, which means that as their use expands, the power of central banks to influence the economy via interest rates will decline further, no matter how much significance the media attribute to central bankers making a change in rates. (260)

She doesn’t elaborate much on this point, but we can infer an example: before the interest-rate swap, real estate and construction were heavily responsive to interest rate fluctuations (low interest rates –> more mortgages –> more homes bought and built), while the service sector was relatively unresponsive (although with the rising use of debt for consumption, and credit cards and such, this may not be 100% accurate – but still, I’d bet the consumption of services was much less interest rate-dependent than housing). So, when a central bank changed interest rates, it reliably affected the two markets differently, and thus interest rate policies had specific, predictable effects.* After the proliferation of interest-rate swaps, these risks were somewhat shared or minimized, and thus the economy as a whole responded less (or at least differently) to central bank interventions.

I don’t know how well this theory would hold up empirically (especially as I’m not sure that Sassen is right that most derivatives were interest-rate swaps, as opposed to the other derivatives that have been the focus of post-crisis narratives), or exactly what an empirical test would look like, but it’s very plausible and provocative and points at one of the many ways that empirical economic regularities are very much a function of the tools available to actors to assume and shed different kinds of risks. Do any economists or economic sociologists have thoughts as to whether or not Sassen is right and/or how you could test her idea?

* On the complex interactions of credit, interest rates, and housing in the post-War, pre-deregulation 1950s & 1960s, see Krippner (2011).

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1 Comment

  1. Sean

     /  December 7, 2010

    I know when i took my graduate level public finance class which focused heavily on the Orange county debacle and other financial failures almost no attention was paid to interest rate swaps it was mostly cdos that we were concerned with. I would still have to disagree with the conclusion that interest rate swaps would severely weaken the feds ability to influence the market, and if i recall correctly interest rate risk is only readily apparent in long term assets and liabilities. Now if all of the investments are done with interest rate swaps then yes there would be complete insulation from the interest rate but then some other indicator of risk would be used instead and i am sure the fed would find some way of manipulating it.