Wednesday, November 2, 2011

There are markets... and markets...

John Kay makes a very good point -- that the ideology and rhetoric surrounding the allegedly wonderful properties of markets has taken us a long way from where we ought to be. We need a more balanced perspective on what markets do well and what they do not do well, where they are useful and where they are not:
A semantic confusion leads us to use the word market to describe both the process which puts food on our table and the activity of gambling in credit default swaps. That confusion has enabled people to claim the virtues of the former for the latter.
 In his book Extreme Money, Satyajit Das makes a closely related point which, I'm sure, many economists and finance people will probably find incomprehensible:
Banks are utilities matching borrowers and savers, providing payment services, facilitating hedging etc. The value added comes from reducing the cost of doing so. Paul Volcker questioned the role of finance: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence. US financial services increased its share of value added from 2% to 6.5% but Is that a reflection of your financial innovation, or just a reflection of what you’re paid?”

The idea of financial services as a driver of economic growth is absurd – it’s a bit like looking at a car’s gearbox as the basis for propulsion. But financiers don’t necessarily agree with this assessment, unsurprisingly.


  1. Mark,

    Credit Card, Debit Card and electronic funds transfer capabilities is what enables web-based enterprises such as amazon, bloggers and their advertisers to make a living on the web (just kidding abut the blogger part).

    Also, if we all had to go to the bank building with the many Roman columns to deposit and withdraw, one could assume that most businesses would remain centrally located rather than sprawling out into suburbia, so things like ATM's and branches also played a role.

    It is much more of a facilitator role than a driver, though. If nobody wants to build a store, the developer will not develop, even if there is an ATM nearby.

  2. @David - I don't know about the US, but banks in Canada were dragged kicking and screaming into the 20th century, (ATMs, online banking, ecommerce etc) The were certainly not leading, witness the fact that it took a startup like PayPal to provide these services when banks did not.

    Banks only care about borrowing your money (or fed money) for 0%, using as little of their own money as possible and investing in 'sure things' like gov't bonds. They add almost no value in this respect. And when you consider the negative impact of stupidity like VIE's and MBS (separating risk from reward) these large financial engineers have destroyed more capital than they have created. VC's and others like them arguably do create wealth because they take real risk to create new things. But bond traders, stock 'market makers' and the like have no purpose. We can better replace them with machines and websites.

  3. Mr. Satyajit Das -

    I suppose the development of the high yield bond market when commercial banks in the inflation-ridden 1970s and early 80s wouldnt touch troubled, small, or new companies like Ted Turner's CNN and Steve Wynn's casino did absolutely nothing to drive growth.

    I suppose currency swaps and options haven't allowed main street companies to hedge risk and focus on their strengths, new products, and industry competitiveness instead of forecasting where the Korean Won will be in 6 months and whether that will determine their profit margin. That hasn't driven economic growth either.

    I suppose mortgage derivatives, despite their abuse on Wall Street, Washington, AND Main Street, haven't allowed people to sell home faster, get a mortgage easier, tap liquidity from an illiquid asset, haven't helped growth much either.

    I suppose WTI and Brent futures contracts haven't mitigated information asymmetries and cartel pricing power that OPEC and Big Oil have had in the past. Yep airlines could just line up in Irving Texas and get a fair price to hedge their cost of fuel for the next 12 months from Exxon. That hasn't driven growth either.

    Ignorance may sell books to a public looking for a scapegoat for a crisis EVERYONE had a part in, but it won't make what you say necessarily true.

  4. Dear Anon...
    There's certainly value in all of that, but we're long past the era when Sperry-Rand could help kickstart the CDO game with a bundle of computer equipment leases. Let's get real: the walking dead were getting liars loans to keep the fires stoked. Don't you think it got a little out of hand?

    For all the new uses of debt you've listed above, your missing a crucial point. The criticism has never been about innovation, but about the poisonous end game, the one driven by greed, stupidity, and the unlimited computing power needed to create and distribute the trash as fast as possible.

    And the financial sector is not a scapegoat, not at all. That's because it's guilty as charged. Convinced of their superior understanding of these products, the suits proceeded to scale these vehicles up to ridiculous levels all the while skimming off their bonuses and commissions, even as they knowingly bet against these very same "investments". That's criminal behaviour any way you slice it or dice it. It's also an appalling use of debt and credit.

    Of course, having bought off all the regulators, they could rest assured they would never be called to account like the addicted gamblers they became. Instead they had to come begging, hat in hand, for trillions of dollars in public funds to bail their stupid butts out once the system, filled with endless feedback loops, blew up. Some capitalists, huh?

    The machine that was created is beyond anyone's control, don't you know. The silly equations for predicting risk are useless. This isn't about probability, it never has been. These markets are discrete, nonlinear, iterated dynamical systems. The state space they inhabit probably has multiple wings on the attractor. In a nutshell: the system can likely transition in a flash to one of those other orbital wings, as in flash crash. These are some of the most interesting inhabitants of the mathematical bestiary. And the quants appear to have no idea that these systems are built out to behave in this way.

    You're right, everyone played their part. That's because everyone was told over and over again, by politicians, economists, pundits, financial gurus,... that they should. It's no different than a junky handing out bag dimes of smack on a street corner. Endless debt was the dope that kept that machine on an endless high. Wall Street wanted it that way. To whit: It's time to take the controls out of the hands of the debt-mongers. They simply don't know what they're doing or what they've created.

    And make no mistake, it will kill again.

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