The danger of paper profits

The danger of paper profits
Jamaica Observer – Kingston,Jamaica
Contributed by Dennis Chung
Friday, August 01, 2008

The unregulated financial organisations (UFOs) have one after the other stopped paying out monthly amounts to participants, start-ing with Cash Plus last year. What is even more evident is that many of the over 20 UFOs, identified by the FSC, seem to be “genetically” linked, leading to the collapse of many at one time. This no doubt has led to significant fall-off in the income levels of many Jamaicans, and will no doubt affect industries such as the motor vehicle and real estate sectors.

I have been speaking with some people who have been severely affected by the fallout, as many have not only placed the great majority of their savings in these schemes, but also bor-rowed money to secure assets based on the income flow they expected to continue in per-petuity. The decision to rely on ‘risky’ investments to main-tain a lifestyle of course is one groun-ded in stupidity, as even if a risky investment is legitimate, the fact that it carries such a high risk means that one cannot prudently expect it to continue forever.

Foreign currency trading

I have always indicated that foreign currency trading is a well-established trading activity, and people do make significant returns from trading cur- rency. Within the global context, foreign exchange trading accounts for over US$2 trillion traded daily, and is much larger than any single tra-ditional investment type. On the other hand, I have always been at pains to point out that there is a high degree of risk associated with this type of activity – and just as one wins big, one can lose big also. So even if high-risk investments are regulated, in many instances they will make huge losses and go out of business, causing much pain to those who have invested. In fact, one legitimate hedge fund in the US last week reported that it was going out of business as it had lost some US$3.2 billion on oil longs when the price of oil futures significantly fell off.

There are, of course, methods that can be used to minimise losses, but on average a hedge fund may last for around five years and then usually suffers significant losses because of its risky nature. The lesson, though, is that anyone who significantly upped their lifestyle based on risky returns should not only see a psy-chiatrist, but also a neuro-surgeon to determine what part of their brain was not functioning when they made that decision.

The bigger picture for Jamaica, however, is that these returns were nothing more than paper profits. And the problem with paper profits is that there is no productive asset to back it up, so what it creates is a false sense of wealth for the country, with no productive base. As a country, this is not a strange phenomenon for us. In the 1990s – because of a high interest rate policy – we did create a “paper profit” economy which effectively killed the productive sector, and on its way helped to create that monstrosity we call FINSAC.

Paper profits create a notional return that cannot be backed by the creation of any goods for consumption. So wealth is created by means of money on paper, and is unsupported by an increase in assets, which eventually leads to inflationary pressures. The effect of these inflationary pressures is to push up prices or interest rates in order to keep prices stable, or to borrow money in order to buy more goods for consumption – or a combination of both.

So, when paper profits were being created by high rates of interest on government paper in the 1990s, in order to prevent the inflationary pressures from pushing prices up, we borrowed money to create an illusion that there was real stability when all the time we were only setting up ourselves for the pain that comes with debt repayment. This was not the result of any unregulated scheme, but was the design of legitimate government policy – which had the same effect as the collapse of the UFOs. The only difference was that in the 1990s, taxpayers bailed out those that would have lost their investments, whereas today those that invested directly will lose out.