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.