The menace of financial markets
Financial markets are unstable, unhelpful and often immoral. They should be kept under better control.
My disdain will be dismissed by free-market enthusiasts. For them, lively markets where equities, bonds and currencies are sold at publicly disclosed prices are clearly a good thing; they may even be capitalism at its best. Such open markets, they say, both improve economic efficiency and make society more free.
Not so; these markets are economically and morally harmful. Let me be clear. I am not discussing what non-economists usually mean by markets, the generally useful supermarkets and farmers’ markets. Nor am I debating the merits of what economists refer to as the “market” – the real or virtual place where buyers and sellers make transactions. Nor is this a screed against all of finance. Banks and insurers do not need financial markets to gather savings and make loans and investments.
My issue is with those open financial markets – particularly in shares, bonds and currencies. In each of these markets, cash is traded for something entirely intangible and uncertain: a promise of fixed cashflow for bonds, potential cashflow for shares, and potential purchasing power and interest income for currencies. The problem is simple. Because the valuation of the financial asset is necessarily unknown, there is no hard reality to restrain irrational optimism and rampant cupidity. Both flourish.
In financial markets, prices wander all over the place like escaped cattle. That judgment is supported by solid analysis. In the 1980s, economist Robert Shiller demonstrated that actual changes in the economy and in companies’ fortunes together cannot possibly explain the magnitude of share-price moves. He concluded that psychological factors – mood swings – play a major role.
Moods have not stabilised since Shiller did his studies. Why is the U.S. S&P 500 Index almost twice as high now as in March 2009, adjusted for inflation, while U.S. GDP is only 8 percent higher? Why is it 23 percent lower, adjusted for inflation, than in August 2000, while GDP is 23 percent higher? Why do exchange rates change far more than GDP growth rates, interest rates or trade flows? Shiller’s answer to these questions is still persuasive; dramatic shifts between doubt and credulity lead to huge market swings.
Excessive market volatility distorts the rest of economy. Exchange rates always move too fast for companies to respond sensibly. Share price frenzies lead to unhelpful excesses and shortages of new capital. Bond prices are generally less flighty, but the rapid emotional gyrations in the euro zone government bond market – overconfidence followed by panic – brought the region into crisis. When a decade of blind investor optimism suddenly exploded into the financial panic of 2008, developed economies entered a recession which has not yet ended.
Financial markets do have a good side. Prices are disclosed, new capital is raised, and unwanted assets can be sold. But these benefits add much less to the economy than feverish trading and unjustified volatility subtract.
What about the moral claim for financial markets? They are correctly associated with freedom – most notably the freedom to set prices – and surely freedom is basically a good thing? Yes, but freedom is not good when it is habitually misused. Then it becomes harmful licence.
That is what happens in financial markets. Participants look for gains which are totally out of proportion to the effort expended. That’s unjust. Their desire for unjustified gain is inevitably stained by greed, and the vice spreads through the entire financial system. Greedy investors are willing to pay ridiculously high fees to investment banks and brokers, and the employees at these firms often end up unjustly rich, and frequently especially greedy.
Financial markets should be tamed.
First, kill the myths. Economists currently flatter investors with silly fantasies about “efficient markets”, “the wisdom of crowds”, and the economic importance of financial market signals. Central bankers have a magical belief that rising asset prices strengthen the economy. Such stories have no place in an efficient economy, nor in a just one. Change attitudes, and policies will follow. Central bankers and politicians will find ways to make wild fluctuations in asset prices less likely, and will feel obliged to protect the real economy from investors’ mood swings.
Foreign-exchange markets are especially harmful, since their dramas frequently wreak havoc on business plans. There is no virtue in allowing the free movement of money across borders for no good reason. Governments and regulators from different countries should constrain excessive flows and price moves.
Contrary to the enthusiasts’ claims, financial markets make the capitalist system less stable and less attractive. They provide a dreadful example of free markets in action. Capitalism would look more appealing if these markets were taken less seriously. Restraints would not limit true freedom; rather, they would free people from undignified slavery to emotion and greed.