The menace of financial markets

By Edward Hadas
February 20, 2013

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.

19 comments

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Very good sir! Great suggestions.

Posted by tmc | Report as abusive

“Banks and insurers do not need financial markets to gather savings and make loans and investments.”

Yes, they absolutely do. Where would they find investments or sell loans if there were no market for them?

“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.”

Do you have an empirical justification for such an outlandish claim?

“There is no virtue in allowing the free movement of money across borders for no good reason.”

I’m not sure that money ever gets moved for no reason. Whether that reason constitutes a “good reason” is purely subjective conjecture on your behalf.

Tell me, Mr. Hadas, now that you have asserted that greed and volatility in markets is a burden to all, what is your proposed solution? Let me take a wild guess: more government control; yes, because government somehow knows better than the collective makers of the market what equilibrium prices should be…right?

Posted by jaham | Report as abusive

An all too rare and introspective challenge to the “status quo”. Bravo!

“Central bankers and politicians will find ways to make wild fluctuations in asset prices less likely…” You have more faith than I in their ability and inclination to do so.

“There is no virtue in allowing the free movement of money across borders for no good reason.” Interesting observation. Effective curbs would make taxation more effective and efficient. They would put a real monkey wrench in the financing of terror and the “business as usual” of international drug cartels.

“…financial markets make the capitalist system less stable and less attractive. They provide a dreadful example of free markets in action.” So long as Capitalism does not lose in the process it’s unique ability to move in the “right” direction when all other economic systems are clueless and frightened it would be nice if it’s image were “more appealing” and the “system” more stable and less risky for investors.

But what is REALLY necessary is for bankers to be held financially responsible for their own bad decisions with none “too big to fail”. The “system” can NEVER be “just” so long as these bozos keep their generous compensation and bonuses even as taxpayers and government printing presses make good their debacles.

Posted by OneOfTheSheep | Report as abusive

So Mr. Hadas, are you suggesting that the morality of you and people who think like you is superior to the evil capitalists or some other group you’re intent on demonizing? All we have to do is put you and people who think like you in charge and all will be ok? We’ve heard this communist manifesto before…most frighteningly in Nazi Germany. What is this country coming to…

Posted by sarkozyrocks | Report as abusive

Nice to see you finally “got religion”, Mr. Hadas!

If you want to apply morality to economics, the massive negative effects the supposed “free markets” are having, not only on the economy but on society as well, is the exact and appropriate place to do it.

I agree they are the problem, since they are the practical application of miscreant tax, trade and banking regulations passed by the wealthy-controlled government. It is where the “illegal payoffs” are made.

The markets take these abstract laws and use them to extort wealth from a nation.

VERY strict regulation of their excesses is indeed the only peaceful solution.

If you continue to pursure this line of reasoning, I look forward to reading more of your articles.

Posted by PseudoTurtle | Report as abusive

@jaham,

I have, on occasion, been accused of being too much of a free market enthusiast of Capitalism. But at heart I am much less interested in philosophical “purity” than in what sustainably “works”.

You see reducing “greed and volatility in markets” as inviting a policeman to a party. No fun. Instead, I perceive the benefit of regulation AS NEEDED; i.e. when the results of no regulation are adverse to the legitimate goals of a given society.

To illustrate, I would point out the municipal swimming pool. When a swimming class is being taught, the “rules of participation” limit risk of drowning and so no lifeguard need be present. Later in the day, those rules are relaxed so the general public can have relatively free enjoyment, but dedicated supervision and lifeguards are required to maintain safety and, as necessary, civil order. Isn’t THAT “reasonable”?

As always, the “trick” is achieving a “proper balance between NO supervision (chaos, and no one dares swim) and TOO MUCH supervision (no fun, and so people choose to do something else).

Posted by OneOfTheSheep | Report as abusive

We have a system where the Fed picks winners and losers and there is the true immorality. The Fed distorts market forces and a disgusting caricature of capitalism is the end result. These Fed guys love to feel like the “The Great and Powerful Oz” and most people are predisposed to the idea of mommy and daddy being in control in some way – sad really.

If real consequences were established the little boys and girls who currently operate the financial world will be forced to pick up their toys and go home. It is the corruption created by the revolving door that allows these children to keep mucking things up. This will not eliminate problems but looking at what has been the result of past meddling will it be any worse?

Posted by keebo | Report as abusive

Brilliant!
Why has it taken five years for some simple, common sense, scientifically-sound economics to surface in the media and enter a pseudo discussion that has been dominated by nonsense and the ideology of the Idiocracy?
Bravo!
Of course, the wackos will completely misunderstand this approach to level dialogue and whip out their favorite evil baddies: government, the Fed, the Nazis and the One Percenters who demand those high returns for their gambling debts covered by taxpayers at full value.

What is the morality of the too-big-too-fail and too-big-to-prosecute who feel entitled to steal from government “trust” funds leaving IOUs forever unpaid while having the audacity to claim that it is those self-funded “entitlement” programs that are draining our economy?

Posted by ptiffany | Report as abusive

As Mr. Hadas relates, “Financial markets do have a good side”.

I don’t see any particular reason why “free” markets should be good for the people (the 99%, let’s say). Some fully-free market advocates seem to simply take it as a given, much more like a religion than a rational assertion. No one has proven it to be true.

Given that financial markets have good sides, then it seems that it would serve the people’s interests best, as Mr. Hadas advocates, if some controls are placed on them. There are infinite possibilities for market control, but only one way to have a fully-free market.

As we see, the freer the market, the more ways the market manipulators and market abusers (or simply market free-loaders) have to take advantage of market participants. We can certainly do better with some control.

As one simple example of the free-loaders: Renaissance Technologies LLC. From Forbes: James Simons, “The “Quant King” retired from his $15 billion hedge fund firm”. Not bad bucks for applying some advanced (I assume) statistical analysis. I wouldn’t begrudge him that money, except that some of it probably came out of my pocket, as a simple continuous drain on the stock market. Obviously, it skims money off the top, and too no advantage for the market that I can see. Why shouldn’t any participant have equal chance at a little luck in the market, instead of having to face the headwind of 100′s of statistical physicists? Now, this problem with high frequency trading, Renaissance being only one example, can easily be fixed: a simple tax per trade. Let’s level the playing field a little.

Of course, there are much much bigger market manipulators then Renaissance. And more careful rules need to be worked out. As OneOfTheSheep and keebo point out, the banks and their Feds are in there for the killing: get whatever they can from the hoy-ploy saver. Instead of a decent reward for savers/investors, they get a kick in the teeth when they miss the banker/Fed’s next step, or the next balloon.

Posted by xcanada2 | Report as abusive

My old retired Dad for years was making some side money on short term trades like so many others (the etrade people) but he also had saner and more stable investments. But I recall twenty years ago while he was helping me put up my house that he couldn’t rely on dividend income from slower stocks and certainly not bonds – because it was being out performed by frenzies surrounding all sorts of higher performing stocks like those involved with M&As, the Dot Com boom and bust, and more recent real estate bubble. This issue is much more sophisticated than I truly understand but I think I got the gist of his complaints.

But at least ten years ago he realized he was out of business in short term trading because of the huge advantage the high speed trading powered by super computers and highly sophisticated programming that really could not be competed with unless the investor – as he tends to say – was willing to be eaten by the big “predators”. A lot of the puffing done on FNN is really designed to help the sheep part with their wool. Only the very big gamers can ever use those tools.

And in many ways this country has become something of a predator itself. The advantage and sophistication of our own economy can pick off the little fish, nearly at it’s pleasure, and can grab up hard assets and resources through financial leveraging vehicles that are really a variety of forms of debt.

I think the greatest fear the financial markets may have is that people in less sophisticated economies will start to try to get loans and cash from other countries or do it themselves. The last few years shed a bright light on the flimsy nature of our economic might and revealed it as more of a con game and come on than most realized. They didn’t call the tycoons of the late 19the century robber barons for nothing. They had such scale they dwarfed the government and many big fish want them back.

But all remedies will be useless unless the rules of the game are established globally and that isn’t likely to happen. Without “funny” money (some of the more dicey derivatives) driving this economy, the emperor may find he is not only naked, but he lost a hell of a lot of weight.

There’s something perhaps to be said for old-fashioned ideas that were imbedded in Islam. They liked to make sure that even financial transactions were “halal” or kosher. That was never so well defined in Christianity and not very well established in Judaism either. Judaism was rather lacking in global outlook. It tends to see itself as a tribe but that is not true of all its believers, not even in ancient times. Christianity is the odd man out, financially speaking. It seems to be all or nothing in Christianity.

Posted by paintcan | Report as abusive

@paintcan:

So, do you think there is an economic way in Islam that could be useful to the West?

Posted by xcanada2 | Report as abusive

when the speculation tries to bring down the euro , it is the legimate market reaction. When the markets wake up and find out that the Uk defict in % of Gdp is higher than Greece, the devaluation of the pound has brought zero benefits to the export, the inflation is out of control and the triple dip is even deeper than expected, than we must rein in the markets.
Sorry, this time the entire world will have quite some fun watchin the disUnited Kingdom collapsing. And don’t even dream of some help from the Fed or the ECB

Posted by phoen2011 | Report as abusive

@jaham, yes indeed the banks do not need those specific markets. An old American movie called “It’s a wonderful life” will explain it to you. Many Americans still believe in the type of banking it portrays as they lived it in there youth and middle age. It has only been since the 1970 when we reformed baking that this changed. Many of us would like to see it change back.

Posted by tmc | Report as abusive

@Paintcan, great post sir. I agree with you and can see the values you speak of in Islam. There are other religions and practices that ask for morals in business. This country had forgone that to win the cold war maybe? But we can’t put the genie back in the bottle. Can’t put morals and ethics back into finance.

Posted by tmc | Report as abusive

I suggest that those holding both vision and opportunity to influence the shape of our nation using wealth will never create adequate employment or better society because they’ll never sacrifice short term opportunities in order to achieve a sustainable economy.
We live today amidst a daily lottery of increased threat of job loss and or underemployment, increased threat of loss of savings, increased theat of bodily harm and a workplace shedding itself of obligations and long term commitments.
What’s needed now is that nation’s conscience, reminder of past mistakes and early warning system, fair media, which will inspire us to gather overwhelming public opinion in order to force changes restoring democratic principles. Too few today control too much news media and their control poses the most flagrant conflict of interest. I remind us of our having stripped such ownership in the past and I remind us that nations that once had fair media once had good government.

Posted by donee | Report as abusive

@xcanada2- Not details – Just that honesty is demanded. A lot of the problems of the last thirty years have resulted from dishonesty and completely irresponsible self-serving activities and they have been defended as freedom and the pursuit of happiness or the needs of security.. I am very small potatoes and that’s what an irresponsible person like me should be. Some very big, big shots want the rewards and almost no responsibility for their actions like OOTS complains.

I think I know why old middle-eastern autocrats, like the Sultan of Constantinople, used to behead disgraced government officials. The Sultan’s probably knew that the grunts of society always took the burdens of life in their flesh. They are the one’s who worked like beasts and died like flies whenever the top made a move. They expected their governments to feel the pain too. Walking on a tight rope tends to weed out the garbage and the gadflys (no offense txgadfy). Any government that is truly compassionate knows this. This government is ridiculed frequently for being to liberal or too kind – but the real issue is one of self-sacrifice. The wealthy do no one any service simply by being wealthy. The less lofty don’t do anyone any favors by being poor and stupid either. But I always sort of thought they did like they were cogs in a well functioning and self-correcting machine.

The last ten years has proven to me “the machine” (with or without ghosts in it) is a clunker. .

It must be obvious I’m getting religion again (I haven’t quite figured out which one) and hope it sticks a little better than the last times I tried and gave up because it didn’t look any better than what I couldn’t understand anywhere else.

And at TMC – the US invented the bomb and used it and it hasn’t left them alone since.

BTW – a society with little self-respect, with hardly any self-control and indulging in every vice imaginable, will get a government that reflects them perfectly. I’m getting religion and it’s scaring the merd out of me. I’m not sure there is anything left in me if I ever see “the light”. I hope it isn’t the spiritual equivalent of a nuclear bomb. I think I can handle about a flash bulbs worth of “illumination” at a sitting.

Posted by paintcan | Report as abusive

Mr. Hadas, you’re opening up the magic curtain and I’m pretty sure the wizards aren’t going to like it. I often wonder if they believe their own nonsense or are intentionally hoodwinking us (i.e. are they a lot more stupid than I am or a lot smarter?). One of my amusements is to watch the explanations that the financial press provides for movements in the market. A drop in unemployment can be the “cause” of a rising market one day and a falling one some other day. One report will attribute change to the trade balance, while another says it’s the payroll data. Anyone even half paying attention soon realizes it’s all malarkey. Except it’s not. It impacts whether I have a job tomorrow and the price of a loaf of bread. Not because of any actual change in economic reality, but because of the change in perceptions.

Most folks think that a firm makes money when its stock price goes up, when of course they have already collected all the revenue they’re going to get with the original stock issuance (until more stock is issued). Once this is pointed out, we can all see that stocks held for growth potential are only legalized gambling instruments of (almost) no relevance to the real economy. Dividend-paying stocks are another matter and have a much older and fairly venerable history.

Posted by Sanity-Monger | Report as abusive

I thank those above who comment that it is not a perfect system but more those who recognize that “greed” is prevalent in this system that never seems to close the door to making it possible…
nothing is perfect but what makes it so difficult to understand “the wrong”…
this article is about what, the fix, the wrong, the errors; it comes down to those who want more with no concern about right or wrong…

and “TES” it is the American dream to be wealthy but please remember some will never be so fortunate and “maybe you and I share the blame for this”…

Thank you.

Posted by chapapet | Report as abusive

I don’t mind people gambling with their money. It is their money. But I do have problem with Banksters that “spin” gambling into a financial market and demand that others play. It is immoral.

Posted by tmc | Report as abusive