Three posts ago I drew the conclusion that there is a need to reform financial markets to ensure they actually channel funding to productive investment. This was based on the previous 7 posts, in which I had described Pozsar’s work exposing the dramatic shifts in financial markets in this century. An ever greater share of income is flowing to profits rather than wages, and being concentrated in institutional cash pools. The great imbalances in the global economy render financial markets highly unstable, and Pozsar’s conclusion is that steps must be taken to address both wealth inequality and trade imbalances, subjects to which I will return in the future.
However, I am also suggesting that major reform is needed to financial markets themselves, something Pozsar does not advocate in his papers. To shed further light on the terrible dysfunction of these markets, in the last 2 posts I examined quantitative easing and corporate stock buybacks. In both cases, we see how asset prices have been inflated away from their fundamental value, while the economy stagnates through a lack of funding for real investment in productivity.
So what changes do we need to make – what reforms are needed – to develop an economy that provides enough for everyone?
Well let us start with the final objective in mind: we want financial markets to channel funding to productive investment.
We want investment funding to be available to businesses that are going to produce goods and services that society wants and needs. This involves large upfront expenditure, which over many years will eventually pay for itself, recouping the initial investment and then providing a greater profit to the business than it would have made otherwise.
So ultimately it all starts with a decision by a business to invest in productivity. But any such decision is fraught with uncertainty. The business has to predict both the future demand for its product and the future price. And this future depends on what happens elsewhere in the economy. Are other businesses also going to enter this market? Will new products that don’t even exist now lure customers away? Will a strong economy put more money in people’s pockets, increasing demand, or will the economy slump leaving the business with no customers? And will inflation or interest rates move significantly up or down, affecting the real value of debt repayments and profits made?
When you look at all this uncertainty, you might wonder how any investment decision ever gets made! And when businesses fund investment by borrowing (rather than through their retained earnings), all this uncertainty is passed on to the lenders (i.e. the buyers of financial assets). Now you might assume that investment institutions are therefore looking closely at the fundamentals of businesses, so that the price of assets is linked to all the questions that the business itself has to ask. But this doesn’t go on nearly as much as you would think.
As I’ve described before, many funds buying shares simply follow an “index” – a representative group of shares from that particular stock market. Bonds, meanwhile, are given a credit rating by credit rating agencies such as Moody’s. These were in the news a lot at the time of the crash, because many assets that they had rated AAA turned out to be junk. But market traders still rely on these ratings, using them to judge the risk of default risk and therefore the price of the bond.
And behind all this, no one – no one – NO ONE – is looking at the fundamentals of business investment decisions.
While traders will be looking at general trends in the economy – particularly with respect to inflation and interest rates – they are not paying the slightest attention to the specific investment decisions of individual businesses. Business decisions around real investment, and trading decisions to buy specific financial assets, have become completely separated.
Instead, in addition to general trends in the economy, market traders are mainly looking at the behaviour of the financial markets themselves, and I will describe next week why this is such a bad idea.
But financial markets are not just stocks and bonds. Indeed, they are highly innovative and a whole range of other financial products have evolved – derivatives such as interest rate swaps, foreign exchange swaps, credit default swaps. Derivatives have developed a bad name – very few people understand them, and when journalists and commentators became aware of their role in the crash it was easy to demonise the unknown. The narrative was that these had developed unregulated and unrestrained (which is true), and derivatives became something of a bogeyman in popular discourse. But what was lost was the role that they played within the financial ecosystem. The market was, to some extent, regulating itself – every financial innovation was developed because there were market players who could make use of that innovation. So in that sense, if “the market” needed a product, that product would probably be developed.
Indeed, this is the very theory behind leaving everything to the market. The economy is so complex that no one could possibly manage all this uncertainty. Centrally planned decisions about investment are likely to be a disaster. It is the very complexity of the market that is giving it the flexibility and diversity to respond appropriately. This is what the derivatives represent.
However, don’t think that I’m saying that all derivatives are therefore a good thing. I’m saying that you cannot intelligently critcise what you do not understand. Derivatives are playing a role in this system, but once you study and understand that system you start to see better ways that things could be done. The previous 10 posts of this section of the blog have given the empirical evidence regarding the current instability of financial markets. These markets are completely dysfunctional in terms of the constant cycle of boom and bust – indeed, they are catastrophically dysfunctional if you are one of those who retires and draws your pension when the market has just crashed, or who loses their job in the resultant recession.
But the complete disconnect between the decisions of financial markets and the analysis of opportunities for productive investment in the economy also means that we fail to channel funding to real investment in those areas of the economy that give us the best prospects for the future. Remember, I said earlier that we want investment funding to be available to businesses that are going to produce goods and services that society wants and needs. But no one ever asked what would happen to all the waste products, particularly the plastic, generated by our economic growth. No one was even aware that pumping carbon dioxide into the atmosphere would cause global warming, but when its effects became known a common response was simply to deny it and avoid all the inconvenience this truth would cause.
An important investment decision for the UK, for example, is how power is going to be generated in the future. Any new house today will be built with a gas combi boiler for heating and water, and millions of older houses have converted if they can. This a perfect example of one of these “investment” decisions. Large amounts of wealth have been pumped into gas boilers on the basis that they are cheaper than coal or electric. The cost of these conversions is recovered over years of cheaper bills. So the implicit assumption is that cheap gas will be available for years, even decades, to come.
And this decision has left us dependent on imports of Russian gas. Do we feel this a good situation in terms of national security? Did “the market” consider this when it was making this decision?
What always happens when the decision-making power of the market is challenged is that a simplistic dichotomy is put forward: planned economies failed in communist countries, therefore it is proven that free markets work best. As this argument is taken to its logical conclusion we then see the kind of deregulation that has accelerated since the early ‘80s. As a result, financial markets have lurched around like some kind of Frankenstein’s monster, causing chaos, havoc and destruction.
Command economies won’t work*.
But the unregulated free market isn’t working either.
We need to find a different model for making investment decisions. Because when an investment decision has been made – it’s been MADE. With consumer goods, if you buy some clothes detergent and find you don’t like the smell or it’s not getting your clothes properly clean, then next time you’ll buy a different one. It’s so cheap, you’ll probably just throw it away without finishing it. But once you’ve invested, your decision is made for years to come. It’s sometimes called a “sunk cost”, which is a wonderfully evocative term.
So the popular trend of the last 30 years to convert heating to gas has saddled future generations with a dependency on Russia. If relations with Russia become that bad, can’t we just convert houses back? Well it’s expensive, and in addition we lose the value of all those gas boilers. It’s a horrific waste of the nation’s resources.
Decisions made today about investment in physical goods stay with us in the future, and with future generations. And so do the funding decisions. Credit markets are effectively borrowing off future generations – they are saddling future generations with the need to repay that debt. Just as a business has to make investment decisions in the face of all the uncertainty about the future listed above, as a nation we have to think about the future direction of our society as a whole.
To create an economy that creates enough for everyone we need the allocation of credit to be to those sectors that will provide us with the best possible future. This was a foundational concept established in the opening sections of the blog, that has been repeatedly referred to since:
Decisions about who to allocate credit to, and how much credit to allocate, are absolutely fundamental to the path the economy takes in the future.
So let’s put ideology to one side, and take a fresh look at this question of the best way of making decisions about the future.