Money is power

For the last couple of years, in the wake of the financial crisis, the banking and finance community has darkly warned about the dangers of over regulating the sector. “We mustn’t impede the free flow of capital”, it is claimed, “otherwise efficiency and productivity will be lost and the real economy will not recover.” The other camp claims that the finance sector must be reined in, re-regulated, otherwise crises will continue to happen. The dichotomy is entirely false. Finance is rules. You cannot increase or decrease the amount of rules in rules. You can only change their character. And you can decide who will set them.

And that is what this argument is really about. Power. Who has the power to set the rules of finance. For a quarter of a century, governments have progressively given up their power to set the rules and given it over to private players, who, to say the least, made up their own rules: forwards, futures, options, swaps, CFDs, CDSs, CDOs, securitisation … And my favourite, volatility derivatives, which can be translated as “we make the mess, then we make money from the mess.”
False dichotomies are the stuff of political rhetoric and make no mistake, the wresting of power from government by the private sector has been a political exercise, starting in the Reagan and Thatcher years. It has been spectacularly successful. Well, up until the point where its absurdities started to result in the system almost collapsing, that is. When the serpent began to eat its own tail.
The false dichotomy about regulation inevitably led to another false dichotomy. That the only choice facing us is between bad government and good markets. You can see how it works in the Economist article on LIBOR (the London Interbank Offered Rate that sets the interest rate for the world). Never let a chance to blame government go past, even when the traders have been caught cold rorting the system:
BOOSTERS of financial regulation are making hay from the widening scandal over allegations that LIBOR, a key interest rate, was rigged repeatedly for at least five years since 2005. Yet the trove of documents that have emerged also reveal the very flawed nature of regulation, in which government bureaucrats are asked to keep tabs on high-flying financial sorts. Transcripts of calls between officials at the Federal Reserve Bank of New York and traders at Barclays show that regulators didn’t really pick up on cues, even when they spelled out misbehaviour.
The same sort of bashing of government can be seen in Karen Horn’s article for Standpoint, one of many examples of the rear guard action being mounted against criticisms of the ideology of the market state. ¬† Horn announces that the “anti-capitalists are coming out of the closet”, eliding, as ever, democracy and markets. Underlying her critique is the neat use of dichotomies, bad government, good markets. Markets have pricing. Governments don’t:
Of course it is only through ignoring the pervasive evidence of government failure that they can have their cake and eat it: sure, spontaneous coordination in the marketplace is efficient and¬†innovative, but let’s rein it in as we see fit. Rules are not enough; we are entitled to some enlightened ad hoc regulation. That will make the market process non-spontaneous? Oh well, it’s for our benefit, and some greater good.
This circular bashing of the state is typical of the quasi logic of the pro-market apologists. The market is defined as inherently better because it has pricing and supply and demand, whereas the state is defined as inherently inefficient because it doesn’t have those things. In other words, the market is the market, the state is the state, and therefore the state is not the market.
Such Manichean circularities are pursued, wittingly or unwittingly, to create the impression that, although markets may be bad at times, governments are always worse. Yet such a dichotomy of bad government v (mostly) good markets is not the choice that faces us at all, at least not in the financial markets. The choice is between good government and bad government. In the final analysis, as we are graphically seeing, governments have to set the rules. Traders rely on the basic legal structures that underpin transactions, even when they are based on assent rather than enforcement.
If they are allowed too much freedom to set their own rules, it eventually collapses and guess who has to pick up the pieces? Governments. The euro crisis, for example, has become so intractable, because there is no single government underlying the currency. If one needs reminding how political finance is, go no further than Europe.
It is at this point that 25 years of the political rhetoric of the de-regulation proponents has become so damaging. Francis Fukuyama alluded to this recently in the Financial Times. He commented that the Left has no answers, and that the best way forward is for the right to rethink:
If contemporary conservatives could get over their ideological aversion to the state, they would recognise that American government is both necessary and in great need of reform rather than abolition. Private sector companies have undergone huge in recent decades, flattening managerial hierarchies, upgrading workforce skills and experimenting ceaselessly with new organisational forms.
American government, by contrast, seems trapped in a late 19th-century bureaucratic model of rules and hierarchy. It needs to be smaller but also stronger and more effective. And this will not happen unless people see public service as a calling, rather than a despised occupation for people unable to make it in the private sector. In this regard, conservatives have an advantage because they can call people to public duty on the basis of the American nation rather than abstract ideals.
What will eventually emerge is a recognition that government must set the basic rules of money. Even taking into account the fact that there are massive cross border flows of capital which are beyond the reach of any one government. The only question, I suspect, is if this will occur after yet another set of crises, or in advance, through an effort to improve the quality of government from within, as Fukuyama is urging. The reality is that, just as you cannot have a legal system without government setting the rules, you cannot have a financial system without government setting the rules.
Improving government will then require the asking of some basic questions about ethics, morality and what the financial system is for. Political questions, in other words. Questions about what is a good and bad society. Of course, while the finance sector enjoys such political reach through its various funding and lobbying campaigns, such a discussion will be hard to instigate. But in the end, as we are seeing with the dysfunctionality of the system, it is inevitable. The political debate contest over the role of governments and the markets has not been conclusively resolved. Political contests never are.
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  1. It’s a human problem that can’t be resolved IMO, but we need to regulate it properly, you just need to read history.

    The finance/banking industry as well as the regulators are out of control. We’ve had MF Global, PFG, Libor, Madoff, etc. in the US and EU, but what’s going on here in Australia? We’ve opaque, and even a FOI does not seem to work here.

    I believe that many senior banking and finance former employees should be banned from regulator roles. I don’t believe you can get fair regulation until this happens.

    The political aspect of this is the most difficult one to resolve as they are above the law and will serve their vested interests.

  2. i’ve always found the notion of “free” markets unfettered by state intervention to be a bit contradictory. There will always be implicit and explicit rules, set either by industry bodies, contracts and govts. Consumers participate in the market as much as business, and they will generally act in their self interest. Acting in one’s self interest INCLUDES voting in legislation that better serves consumer interest WHEN consumers perceive the market does not serve their needs. Voting in govt rules and regs is as much a part of the “market” as pricing / supply v demand / industry regulation. The problem for big business is that OFTEN govt regulation is something they have more difficulty controlling (although arguably big business has been very successful of recent getting their way via scare campaigns, lobbying and donations).

  3. It is a dilemma that can’t be solved. However the idea that governments set the rules however is in my mind totally wrong. Governments are reactionary, not proactive. Markets are created by the need of economic actors to buy and sell goods and/or services – not by some government decree. Because governments backstop and guarantee a lot of the system regulation to protect them is required – what if they didn’t?

    The financial markets are rules sure – but who is better at defining, enforcing, and maintaining the integrity of the rule system with which financial transactions operate? Governments or the common sense of the person transacting? It comes down to whether you favour a centralised or decentralised approach to rule setting.

    Each system has it’s own weakness – you can never eliminate market failure/corruption, etc. What you can do however is limit the points of corruption and the ability of actors to circumvent the rules and create a system that passively motivates actors to punish factors that cause market failure.

    Hybrid systems in between the free market ideals and total government management will always come short – as they have additional points of failure and moral hazard. Rules can be bent with enough lobbying and money.

    The nature of regulation is reactionary and as such will always be behind the game. The government itself becomes a central weakness of a centralised market system where economic actors have every motivation to lobby/convince the government into changing the rules of the game to their own benefit. This creates more dysfunctional markets in the long run setting the scenes for a much bigger crisis.

    How often do we have bond buying on the expectation of a bailout? How many bad businesses have been kept afloat because of their size and government connections when a lean and mean operation would normally overtake them? How often do we put our money in high risk banks with high interest bank accounts knowing that government guarantees everything?

    Counterparty risk is ignored in financial models because regulation is assumed to take care of that and there is an assumption that there is enough capital to backstop infinite losses which inevitability causes the risk to grow to a point where even the back stoppers can’t shoulder it all.

    In a free market system sure there would be rigging. But there would also be punishment for people that did so when the truth comes out – because the people who trusted the rule breakers know that no one will save them.

    • drsmithyMEMBER

      Governments are reactionary, not proactive.
      Not implicitly.

      Governments *can* be proactive (eg: pollution regulation, food standards, drug testing, etc).

      Markets, however, are inherently reactive.

      But there would also be punishment for people that did so when the truth comes out ‚Äď because the people who trusted the rule breakers know that no one will save them.
      Which is fine if the damage is contained only to those people. Far too often, however, they carry along a whole bunch of innocent bystanders with them, many of whom they have willingly deceived with their fraud.

      • When it comes to market regulation governments have been reactive. They guarantee the markets without understanding all the potential risk factors and unintended consequences.

        Markets are neither proactive or reactive. They are just a bunch of actors doing transactions. People try to personify the market – which is human I guess. Each person however has the freedom to be proactive/reactive or whatever. Governments however skew the risk/reward profile of these participants.

        Your last point is valid. However you can’t prevent fraud and that’s the gist of it. My point is that absolute power corrupts absolutely. I think its very dangerous to give one institution that much power to regulate and set the rules. Initially it starts with very good intentions but it gets worse down the line.

        “Far too often, however, they carry along a whole bunch of innocent bystanders with them, many of whom they have willingly deceived with their fraud.”

        True. But in the end someone has to pay for it. The question is should they who have been deceived pay for it (unless they can recover the damage from the fraudster) or should the taxpayer pay for it – people who had nothing to do with the transaction at all. I think what your proposing is the worst of the two alternatives. There is no perfect system – I would rather one where damage is localised rather than systemic.

    • I think in the USA we have ample example (via Treasury and The Fed) that govts are totally beholden if not controlled by the banking elite.

      The book ‘Shock Doctrine’ alludes to this.

      Or watch the doco “Inside Job”.

      The senate grilling of Jamie Dimon was appalling. All they didn’t do was shuffle over and buff his shoes and kiss his ring.

      How many banking executives in the USA have gone to jail since 2008? ZERO.

  4. russellsmith55

    Top article SON. Simple minds like simple rules, i.e. ‘freer markets are always better’ and ‘big governments and lots of regulations are always worse’. Clearly, nothing about the world we live is that simple though – especially the world of finance.

  5. “For a quarter of a century, governments have progressively given up their power to set the rules and given it over to private players”

    What a load of crap.

    The U.S alone has about 10 times as many pages of financial regulations as they did two decades ago, before LTCM.

    Just because the regulations are written to favor crony industries, doesn’t mean the government has given up and power at all.

    Everything from Fannie and Freddie, to the ratings agency, is a big soviet style planned industry.

    • The regulations you are talking about are all catch up on out of control financial markets. Think of it this way. The capital markets have at least $700 trillion in derivatives, pretty much all of it private players. Then think about how much capital governments can call on — only a fraction of that figure. That $700 trillion is a measure of how much the private sector has been allowed to take over. The current euro crisis is the latest iteration: the euro was created to stave off the hedge funds/private actors. It worked for a while, now the private traders are calling the shots again.

      • How about requiring the private traders hold enough capital to cover their derivative bets and have it cleared at the end of each day. And if they can’t clear it they loose the bet.

      • We have the worst of both worlds SON. We have private traders trading freely with the government backstopping the system – in effect creating more moral hazard and greater system instability.

        We don’t need governments – governments assume that they can shoulder, regulate or transfer the risk inherit in financial markets. They can to a certain extent but by the nature of government they will always leave holes. Finance markets are almost like technological markets – they change quicker than regulation can catch up.

        If the government got out of the way completely people would be careful who they dealt/traded with. The financial markets would look very different than today. People would be taught from childhood to assess the risk of any investment including putting your money in the bank rather than assuming the government would guarantee it for you.

        In any event the system isn’t changing. Europe is highly regulated compared to America and look where that got it. Imagine if these banks thought that their wouldn’t be an implicit guarantee from the ECB. The debt crisis wouldn’t be got worse in the last two years. That’s just one example and there’s plenty more.

        There is a role for governments to play but I don’t think roadblocking and rules upon rules is the way to do it.

  6. I don’t have the opportunity ATM to respond, but I just want to say that these kind of posts – meta-market analysis maybe, or what used to be called political-economy, really – are my favourite to read on MB. Excellent thinking and writing S-O-N, thank you.

  7. “With the development of the credit system there is an extraordinary spread of buying on time. To the extent that the credit system is developed, and hence production based on exchange value, the role of money as means of payment will increase, as compared with its role as means of circulation, as agent of purchase and sale. In countries with a developed modern mode of production, and therefore a developed credit system, money as specie effectively figures almost exclusively in retail trade and in petty trade between producers and consumers, while in the sphere of large-scale trading transactions it appears almost exclusively in the form of the universal means of payment. In so far as the payments are in balance, money appears as a transient form, a merely notional, imaginary measure of the exchange magnitudes of value. Its bodily involvement is confined to the settlement of relatively insignificant balances.
    The development of money as the universal means of payment goes hand in hand with the development of a higher, mediated form of circulation ‚Äď that returns upon itself and that has already been taken under social control-in which the exceptional importance that money has on the basis of the simple metallic circulation, …, is transcended. But then, if sudden credit upheavals should interrupt the mutual settlement of payments and upset the payments mechanism, it is money that is suddenly in demand as the real universal means of payment, with the requirement that the whole volume of wealth should have a two-fold existence: once as commodity and again as money, so that these two modes of existence are identical to each other. At such moments of crisis, money appears as exclusive wealth, which is manifested as such not in some merely imaginary depreciation, as it does in, say, the monetary system, but in the active depreciation of all real wealth. With respect to the world of commodities, value then continues to exist only in its adequate exclusive form ‚Äď as money.”

  8. anonysubscribe

    the first time a sane report has come from a writer who has courage to face the vested interests which are destroying whole nations in the interests of the greedy few