Over the last 7 weeks we’ve explored Pozsar’s work on institutional cash pools. We’ve seen that the wealth diverted from wages to profits (increasing inequality) has largely ended up in these huge cash balances, increasing at least 3-fold in 17 years such that they are now double the size of annual UK GDP.
Such a huge concentration of wealth has transformed and destabilised financial markets. Financial markets are seen as a way of intermediating saving to investment, but cash pools are not interested in long-term investments in productivity, with their inherent risk. They want safe, short-term assets (such as Government bonds).
In addition, the traditional narrative states that financial markets intermediate household saving. But now it is the corporate sector that is the main source of savings. As this post showed, from an accounting perspective the main reason for businesses to retain earnings should be to invest in their own productivity, but now this process has been distorted.
In sum, we have seen a seismic transformation and destabilisation of financial markets, all going on while most economists remained happily oblivious.
Last week I presented Pozsar’s conclusions that the long-term, fundamental solution is reforming the financial ecosystem, using taxation to address imbalances in wealth distribution and trade balances. What I want to draw out this week is the implications for an economy that provides enough for everyone.
In particular, I want to focus on what we need from financial markets. In the opening section of the blog, “Models“, I ran through a series of simple models of the economy, focusing on the dynamic of saving in every one. What we saw consistently is that national saving was only possible through an accumulation of physical goods.
In the section on “Productivity” I then presented the formal proof of this: the saving-investment identity. The proof shows that national saving must always be equal to spending on investment (plus the trade surplus). Economics textbooks state that the reason for this identity is that saving is needed for investment, a wholly fallacious conclusion. Most people studying economics will accept the textbook explanation then not think about this ever again, but this error will unconsciously underpin all their thinking about saving, investment and financial markets.
In fact, causality runs in the opposite direction – it is the level of investment that determines the value of our savings. I summarised this in the following statement which I explored over several posts:
If saving is not channelled to investment the value of all our savings falls. But this fall in value is not necessarily reflected in financial markets – financial assets can be overvalued.
It was these theoretical ideas that told me that I needed to research financial markets if I was to find answers to all the questions listed on the home page of this blog. And that research led me, via Perry Mehrling, to Pozsar’s work. And his empirical work confirmed the theoretical conclusions I had reached.
Pozsar is focused on the stability of financial markets, and highlights the need to redistribute wealth and address trade imbalances. These steps are necessary, but to create an economy that provides enough for everyone we also need to reform financial markets to ensure they actually channel funding to productive investment. As shown earlier, this is absolutely not what is happening.
Of course, the orthodox dogma is that unfettered free markets are the best way to allocate resources. The exposition of this for financial markets is the efficient market hypothesis. This theory is flawed, and has fallen out of favour with financial economists, but most economists are not aware of developments in this specialist area. The idolisation of free markets continues. Meanwhile, Pozsar and di Iasio (2017) conclude that currently financial markets are providing “sometimes grossly inefficient responses”. Pozsar is probably the foremost authority in the world on the structure of financial markets and, as pointed out last week, has worked for some of the most prestigious institutions (he’s not some fringe crank). His conclusions cannot be dismissed lightly.
How do we reform financial markets, I hear you ask? The secret to finding any solution is to fully understand the problem, so to enrich our understanding of the problems of financial markets next week we’re going to look at this from a completely different direction: quantitative easing. A review of this recent policy will illuminate all the failures of financial markets highlighted in this post.
