Divorce finance from commerce

There are growing signs that an intellectual edifice that has dominated economics and finance for about a quarter of a century is starting to crack. Let’s call it the Market-Finance Myth (MFM). It should be self evident, at least for those of us who bother defining our terms, that financial markets need to be considered differently from commercial markets. Commercial markets have essentially three components: price, output of a product, and the rules that govern the market. Trying to keep regulation to a minimum makes sense — that is, letting price be the main organising principle — because it allows the system to self organise according to the collective knowledge and interests of the participants. Regulation should be cautious and always be done with an eye to unintended consequences. At the same time, of course, it should set boundary conditions and also ensure against oligopolistic behaviours (such as those in Australia’s ridiculously concentrated supermarkets sector). That is a precondition to having price be the main organising principle.

This model starts to break down when price is problematic. It is fine in consumer product markets, but in areas like health (where there is really no price for pain and death), education (where the supplier, not the consumer, defines value) or, say, defence (where pricing of national security is highly problematic) we start to enter greyer areas.

It is this failure to recognise the limits of pricing in markets that has led us astray, as John Lanchester’s review of Harvard academic Michael Sandel’s book “What Money Can’t Buy”  notes:

“”Over the past three decades,” Sandel writes, “markets – and market values – have come to govern our lives as never before.” Sandel is no socialist and isn’t against markets per se. He is forthright about the positive impact markets can have in their correct sphere. “No other mechanism for organising the production and distribution of goods had proved as successful for generating affluence and prosperity.” His focus, perhaps unexpectedly, isn’t on the 2008 crash and the great recession that followed. Instead, Sandel is interested in what he sees as a deeper and more consequential loss of our collective moral compass. “The most fateful change that unfolded in the last three decades was not an increase in greed. It was the expansion of markets, and of market values, into spheres of life where they don’t belong.”

I would argue that the model collapses completely when it comes to finance. To repeat, in commercial markets there are basically three elements. But in financial markets price and rules fuse into one. Because price is a rule: a rule that something is worth so much and has such and such obligations attached to it. There are, in other words, only two elements: rules and output (or activity) based on those rules. It is a binary, not a tertiary system.

That binary, dyadic, structure leads to all sorts of tautologies and contradictions. So, for instance, when people talk of de-regulating financial systems, they are literally talking nonsense because finance is rules. What happened instead is that rule setting shifted from government to traders, which led to an explosion of rules (derivatives, securitisation algorithmic trading etc). Not deregulation but hyper regulation, albeit made up by traders.

My personal favourite in the nonsense stakes is argument for high frequency trading, which is said to improve “liquidity”. Well, of course it does. Liquidity is the rate of transactions, high frequency trading increases the rate of transactions, therefore … high frequency trading increases liquidity. Blue is blue, red is red and the sun will almost certainly come up in the morning.

What it means is that finance requires a third element to be understood and managed properly. There are signs that economists are finally beginning to wake up to this distinction, as a report in the AFR notes about comments from Columbia University professor ­Jagdish Bhagwati, speaking at the Australian Conference of Economists:

“Mr Bhagwati reiterated his claim that free trade was less of a risk for economies than free-flowing capital. “That’s like fire,” he said. “The downside is enormous.”

He said he had been pilloried for that claim, but now the International Monetary Fund had joined him in acknowledging the asymmetric risk- return ratio of free-flowing capital.

He conceded that capital flows per se had not been to blame for the most recent financial problems, but the “destructive creation” of advanced financial products.

At the same time, Professor Bhagwati, speaking on the topic “Can we still defend globalisation after the current crisis?”, made an impassioned defence of “free trade.”

This is a long overdue distinction between commercial and financial markets. About time. Some of the nonsense is also finally being exposed, one hopes:

Earlier, Nobel laureate James Mirrlees said the lessons of the global financial crisis were yet to be learned and creating complex financial markets that generate liquidity had been celebrated for too long.

The Cambridge professor of economics argued that the creation of more markets and financial derivatives could be undesirable and said a ban on short-selling would be positive for the economic welfare of society.

Sir James attacked the foundations of modern economics and the functioning of financial markets.

He took issue with the intellectual basis of much of economics, saying that the assumptions that underpinned many common economic models, such as rational expectations theory, should be challenged.

“We must be prepared to say, ‘That’s absurd!’ ” he said.

Yes, no lessons have been learned. And the reason is the MFM myth, I contend. What is needed is a third element in financial markets, so that they match commercial markets. We should know by now, having seen what happened with Marx’s binary system of bourgeoise and proletariat, just how dangerous binary models can be. How they feed on themselves and create false imperatives. That has happened with the financialisation of developed economies. I do not know what the third element should be — some notion of utility, perhaps, or social goods — but a third element is needed. Something that is outside finance markets that we can use to understand and frame them properly. There are signs that such a realisation is dawning.

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  1. Perhaps the first move equired is for Politics and Finance to have seperate beds.

    So while debate and challenge of the current ‘view’ of commerce / finance /politics is welcome, who has the guts to bring on the debate???

    Great thoughts, and will be facinating long term discussion.

    • But Politics and Finance have never had separate beds, just like Politics and Commerce and Politics and Industry have never had separate beds.

      It all goes back to Kant’s antimony of freedom and nature.

      All Fichtean-inspired idologies which assert that freedom is absolute and the consequent demand that objective nature be annhilated, whether they be Marxism, anarchism, libertariansm or most recently the California ideology with its techno-utopianism, have resulted in nihilism and ultimately a loss of human freedom.

  2. Finance is certainly manichean, granted, but so are most things in the so-called Western tradition. Even in the so-called East, home of the middle way and the Advaita, things appear to be largely binary. Moving from dualism to trialism in general would require a great leap in the dominate worldview of society and until then I think people and systems will tend to duality.

    • Hmm Why would you use a word like “manichean”, “dualism”, or “trialism”? Not very common terms.

      Deciphering your comment you could have said “in Western societies we treat things as either good and evil, it would take a great leap to move to a more holistic approach”.

      • You’re right. I studied a lot of comparative philosophy when I was at uni and the terms are pretty common enough within the area, but you forget you can sound like a complete wanker when you use the lingo in a more general context… 🙂

        • I didn’t want to come out and say it, but you straightened it out successfully…. 🙂

          • Thanks guys (gals?). I needed a good laugh and that little exchange was just the ticket.

        • McPaddyMEMBER

          Wow. I was expecting a flame war to erupt. Kudos, Flashman. Seems your study of philosophy has paid off!

  3. Maybe the financial markets should be made more illiquid as the intrinsic value is over looked when money is made on small interval transactions.
    In the commercial market, if I want buy some shoes, it costs me to get to the shop in transport and time before I can sure up if the shoes are worth it.

  4. But aren’t all facets of the MFM binary? Buy/Sell;Borrow/Lend;Rise/Fall;Profit/Loss…the last pairing being the real problem? That the Loss part of the regulating binary pair has been removed or circumvented…..

  5. ” Because price is a rule: a rule that something is worth so much and has such and such obligations attached to it.”
    Same applies to a carton of milk. If the milk is poisonous, with or without government rules, the price will eventually reflect the product

  6. Great article, but there are so many manifestations that only a full economic apocolypse would provide the quick answer.

    I put this article in the same category as “What aliens look like?”. We will never know until we see it.

    • I like Howard Bloom’s thesis in “The Genius of the Beast”. He argues that every crisis of capitalism has resulted in lessons being learned and new efficiencies being gained. A regulatory over-reation in times past might have resulted in cheques being banned, or legal tender being banned, or “credit” being banned.

      What went wrong with the complex derivatives 2000-2007 was simply that the price of mortgage risk was calculated far too low. The disaster insurance industry would tank too, if they assumed that natural disasters had ceased for a while.

      The under-pricing of risk attaching to MBS derivatives, related to one fundamental false assumption: “house prices can never fall”. It really is as simple as that. And that assumption, in tandem with a new epidemic in housing-supply distortions, causes massive damage to any economy, regardless of whether you have complex derivative bets being made or not.

  7. SON you are both right (to involve morality in your question) and wrong (markets are only tools).
    There is a fourth thing in commercial markets ..quality for want of a better word. Everyone is trying to dissociate markets from people when in fact markets are people. How something is produced, its use, the story behind it, in fact everything about the producer and the buyer is important. Commercial markets are a tool for us to collectively improve our lives. One of the elements I admire is the Japanese principle MONOZUKURI and its application to commercial markets. Facebook is one of the modern ways that people are reintegrating themselves into commercial markets.
    I find separating out financial markets as somewhat curious. Money making money doesn’t make sense in a purely collective society. It’s not until we add the competitive side of our nature that I can understand it. Finance is much like gun manufacture, both are tools in a commercial market and both have a story. A gun in the hands of the police is a good thing but not in the hands of a homicidal maniac. I think we continue to see financial markets as separate because of their incredible power.
    SON I think your article can be reframed to how can our modern society acknowledges and integrates both the cooperative and competitive components of our human nature. That is the polarity you are having difficulty with.

    • I agree. I find there to be a great deal of mythmaking involved in the working of all markets, not just financial markets.

      A leading legend being promoted most aggressively today is the partial truth that markets are “free.”

      One of the last economists of any renown to dispute this, to recognize and articulate that markets are not entirely free, and that this is not necessarily a bad thing, was Robert L. Heilbroner. He was one of the best-known economists in the United States in the post-WWII era, and the fact that he is now practically unknown is testimony to how thorough the triumph of money-culture ethics has been.

      To illustrate what I am speaking of, here are some excerpts from Helibroner’s book Behind the Veil of Economics:

      I am more interested in economics as a veil that obscures our social understanding than as a technique for discovering how our society works. What does the veil obscure? That the price system is also a system of power…

      For I have gradually come to see the market system as one in which the same underlying processes that assure discipline and order as those of older societies continue to exert their force, although in a manner that escapes our recognition…

      Let us commence with the element of freedom—-or rather, since freedom is a social condition and not an individual behavioral property, with the idea of individuation, i.e., the desire or capacity of individuals to seek lifeways other than those imposed on them by the prevailing structure of social interests. That such a drive to individuation also exists at a primary level (although its manifestation comes slightly later in the rhythm of infant maturation) seems well established by psychoanalytic investigation; and from all historical evidence, there seems no doubt that the life chances of the individual are vastly enlarged by the rise of market society. On the other hand, we must not ignore the constrained behavior that is required to achieve this increase in autonomy. To be viable, market systems require conventionalized responses to the signals of price arrays and movements, and when those responses fail to evince their required “well-behaved” expectations—-market systems break down. Thus the gain in individual freedom must be set against a necessity for routinization of behavior in the very sphere of activity that officiates over the provisioning process. The motives of economic “rationality” that replace those of tradition and command are imperatives, precisely as are the motives they displace. The thrust for individuation in the individual’s social behavior—-the expansion of his or her life chances—-is accommodated at the cost of newly added constraints on his or her interactive behavior, taken in its entirety.

      In this same spirit it is useful to recall that for all its historical association with freedom, market society—-i.e., capitalism—-does not appear as the spontaneous upwelling of a drive for individuation, but is at first imposed over earlier forms of social orchestration. The extension and generalization of exchange relationships does not come until the eighteenth and even nineteenth century, with the enforced commodification of labor and land, first vividly described by Marx. No one, reading of the manner in which dispossessed agricultural labor was forced into the early English mills, would describe this as a manifestation of freedom working its way in history…

      The brutality, not merely the monotony of work; the decline in real wages that lasted until in the 1820s; the rise of the industrial slum that drew from de Tocqueville the remark that “civilization works its miracles and civilized man is turned back almost into a savage”—-all these were failures of a kind that Smith failed completely to foresee. These material—-not moral—-consequences of rapid accumulation were not an integral part of Smith’s scenario but were unquestionably an integral part of English (and to a lesser extent of Continental) and American early capitalist history.
      **end quote**

      It seems like this history is now being repeated in rapidly industrializing nations like China and Mexico.

  8. Bryan Kavanagh

    I’m more than a little concerned that when finance IS divorced from commerce, private rent-seeking of publicly-generated land rent still needs to be delimited, because land price still requires to be funded.

    Short of regulation, which I don’t advocate, this may only be done by employing something like Ken Henry’s suggestion for greater public capture of land rent via an all-in land tax.

    Not only would this ensure housing becomes more affordable for future generations–because there’s less rent available be capitalised into land prices–but it would also have the virtue of putting an end to these repetitive land price bubbles which, along with excessive credit have a habit of generating financial collapse.

    It’s one thing to seek to separate finance from commerce, and yet another to keep the lid on what most credit ends up financing.

    • Land taxes are a good idea, period, but they will not prevent a bubble and crash in urban land in the event that “supply” of urban land is rationed.
      Texas has land taxes and no urban growth constraints. New Jersey has land taxes and urban growth constraints. The latter had a price bubble, the former did not.

      The rent-seeking surrounding publicly-generated land rent is bad enough, but it is nowhere near as bad as the “quasi monopoly rent” generated when urban growth is “constrained”. Paul Cheshire and Edwin S. Mills, in their Introduction to the 1999 “Handbook of Urban Economics, Volume 3”, mention an estimate that the most expensive land (usually CBD land) in the most expensive growth-contained cities is 100,000 times more expensive than equivalent land in typical non-growth-constrained cities. That is not a typo: that really is 5 zeros. One hundred thousand times more expensive.

      The family trusts that have owned the centre of London for centuries are literally billions wealthier today because of London’s 1947 “Green Belt”, than if London had been allowed to spread without restraint.

      The activists who claim that “greedy developers” are behind calls for deregulation of fringe development, need to be confronted with the reality of where the real BIG money is in this issue. It is perfectly rational for one single significant CBD property investor to spend millions funding “growth constraint” activism. A 1974 article by Gary Allen, “Big Brother Wants Control of Housing”, predicted all this – he named certain Rockefellers as prime movers in the fledgling “growth constraint” movement. Of course our growth constraint activists will convince themselves that the saintly Rockefellers (and/or whoever else is funding them) just CARE about the environment…….. Yeah, RIGHT.

  9. Today’s third element could well be property, or some other suitable descriptive name! In general terms, once one produced the product it generally lost its value or was discarded after use, now we use property as a multiplier of value but it does not sit in the economic matrix except as a location in which to produce or to be productive – try finding property in an economics textbook.
    Society has always had property but to use the example of housing. In the past, it was lived in by a generation and when the next generation came along they simply knocked it down and replaced it, it didn’t retain value; it was a fully depreciating product.
    Property could provide that third element (“— some notion of utility, perhaps, or social goods —“) and at last would be reflected in the matrix.

  10. Market Finance Myth is a good name for this absurd belief that there is a price setting honesty to the finance rules. Even in the commercial world the rise of the M&A teams plays off this myth, where the purpose of improving the product/service has long been subjugated to the benefits of gaming the finance rules.

  11. Examples of politics and finance having seperate beds as I mentioned earlier include,
    Oversight of capital controls
    Soverignity of credit creation ie end fractional reserve banking.
    Protect future generations from politically induced debt.

    The myth we are discussing is that markets in and of themselves, vicariously provide good outcomes to third parties.
    And that financial markets are just like physical markets …. they ain’t.

    • tonydd said:

      The myth we are discussing is that markets in and of themselves, vicariously provide good outcomes to third parties.
      And that financial markets are just like physical markets …. they ain’t.

      You’re certainly not going to get any argument from me over whether “markets in and of themselves, vicariously provide good outcomes to third parties.” They don’t. Here’s how Michael Allen Gillespie sums up this fantastic notion in The Theological Origins of Modernity:

      By the end of the Enlightenment, many thinkers treated human beings as quasi-divine… Divine or at least quasi-divine powers reemerge although always in disguise. Nature is an embodied rational will; the social world is governed by an “invisible hand” that almost miraculously produces a rational distribution of goods and services; and history is the progressive development of humanity toward perfection.
      **end of quote**

      But if you are arguing that physical markets are not also flawed, then that is where you and I part company.

      There is a congenital flaw built into physical markets as envisioned by Adam Smith, and the flaw in financial markets would not and could not exist without this underlying flaw in physical markets. Heilbroner explains the fundamental flaw in Smith’s market ideology as follows:

      What was then the source of rents and profits? As we already know, Smith saw in it a fundamental inequality of bargaining strengths that prevented labor’s wages from absorbing the full value of the product. “A landlord, a farmer, a master manufacturer, or a merchant,” he wrote, “though they did not employ a single workman, could generally live a year or two upon the stock [capital] which they had already acquired. Many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment.” Thus the “necessity” of employment, despite the contractual freedom that set it so decisively apart from the status of serf or slave, provided the disparity in social power from which arose the rights to payment called rent, or to claims to a residual called profit, without which the access to resources called employment would not be offered.

      –Robert L. Heilbroner, Behind the Veil of Economics
      **end of quote**

      Here’s how Hannah Arendt put it in On Revolution:

      For the liberation of the labourers in the initial stages of the Industrial Revolution was indeed to some extent contradictory: it had liberated them from their masters only to put them under a stronger taskmaster, their daily needs and wants, the force, in other words with which necessity drives and compels men and which is more compelling than violence.
      **end of quote**

      This congenital flaw in physical markets created what Arendt called “maldistribution,” as she explains in The Origins of Totalitarianism:

      The tremendously increased wealth produced by capitalist production under a social system based on maldistribution had resulted in “oversaving”—-that is, the accumulation of capital which was condemned to idleness within the existing national capacity for production and consumption.

      And it is this “superfluous capital” which enabled the rise of financial capitalism, as she goes on to explain:

      Only the fortunate coincidence of the rise of a new class of property holders and the industrial revolution had made the bourgeoisie producers and stimulators of production. As long as it fulfilled this basic function in modern society, which is essentially a community of producers, its wealth had an important function for the nation as a whole. The owners of superfluous capital were the first section of the class to want profits without fulfilling some real social function—-even if it was the function of an exploiting producer—-and whom, consequently, no police could ever have saved from the wrath of the people…

      [The financiers] had taken advantage of the overproduction of capital and its accompanying complete reversal of economic and moral values. Instead of mere trade in goods and mere profit from production, trade in capital itself emerged on an unprecedented scale… The main economic characteristic of the financier is that he earns his profits not from production and exploitation or exchange of merchandise or normal banking, but solely through commissions.
      **end of quote**

      And your notion of “politics and finance having separate beds” seems somewhat Utopian to me, at least if the financiers have anything to say about it, as Arendt goes on to explain:

      Only the unlimited accumulation of power could bring about the unlimited accumulation of capital…

      Power became the essence of political action and the center of political thought when it was separated from the political community which it should serve…

      Hobbes was the true, though never fully recognized, philosopher of the bourgeoisie because he realized that acquisition of wealth conceived as a never-ending process can be guaranteed only by the seizure of political power…

      What Hobbes actually starts from is an unmatched insight into the political needs of the new social body of the rising bourgeoisie, whose fundamental belief in an unending process of property accumulation was about to eliminate all individual security.
      **end of quote**

  12. Turn to “Treasure Islands” Chapter ‘The opposite of offshore’ and you will find that Keynes had this ideal a long time ago. In fact, it details how the Bretton Woods agreement was watered down from the original intent of Keynes.

    Page 69 has at least somewhat of a teaser


  13. Jumping jack flash

    “The most fateful change that unfolded in the last three decades was not an increase in greed. It was the expansion of markets, and of market values, into spheres of life where they don’t belong.”

    I find this fascinating. It seems to touch on the concept of worth.

    What is something worth?

    For essential items such as food and energy, worth is quite high.

    With no other controls in place, prices of essential items are free to reflect their worth, which is quite high.

    Who sets the price? Well, the market of course. And who sets the market price? The people who are willing and able to pay the most for the items. Everyone else necessarily misses out, finds cheaper substitutes, or finds some way to pay the market price.

  14. anonysubscribe

    the 3rd element should be social and public policy which puts the nation and citizens first above all other elements. otherwise whole countries suffer while other fashionable destructive elements impoverish their citizens and the state at the expense of business and world considerations which override the fundamental integrity of the state and its citizens.

    it is easy to talk of the benefits of free markets in product areas where ultimately losses are socialised for Holden and Ford and all other service industries which then hop on the same bandwagon.

    It is easy to deny consumer [citizens?] interest biasing businesses which produced product against the public interest [and citizens’ well-being.]

    AS a long suffering consumer in many parts of my life, I see the support of regulators who fear business undermine the consumer safeguards which always take last place at the altar of business profit or authority over consumers.

    REal estate is especially evil in the way governments pander to the self interested groups which rid rough shod over buyers and sellers, renters and landlords, and strata managers and develops who flout the public interest and bully legislators and regulators to gut the public service so that regulation is never able to catch up to past business vioaltions, let alone anticipate new ploys to cheat the citizens [consumers] and state for the greater public interest and good to be achieved in societies.