As usual, the blog has become bogged down in reams of detail.
I start each section with an outline in my head of what I want to say, but the act of actually writing each post forces me to consider fully the detail, and brings into focus all the nuances that are essential to understanding the bigger picture. Overly summarising requires leaving out elements of detail that are actually essential to truly understanding what is going on – but also I start to realise that there’s another concept that complements what I’m saying, and I have no discipline in choosing to leave out these details!
But now that much of the detail is on the blog somewhere, this week I’m going to try and bring it all down to a broad brush summary.
If we want an economy that provides enough for everyone then we need the economy to produce enough. Hence, we are interested in its productivity, which in turn is dependent on investment. And investment requires credit. And hence a foundational concept of the blog, established in the first section, “Models”, is:
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.
And since credit is provided through financial markets, we can see that understanding financial markets is essential.
However, credit can be extended for any purpose. Only credit extended for investment funding will sustain and improve productivity (hence, “Decisions about who…”). Another concept thoroughly explored in the “Models” section is that the only way that a nation can save for the future is through increasing its fixed capital or inventories of goods – that is, through investment (in the correct economic definition of the term).
The third section of the blog, “Productivity“, used the saving-investment identity to provide a formal proof of this proposition. Economists incorrectly assume that the reason this identity holds is because savings are required for investment. In fact, the causation runs the other way. Investment expenditure sustains and improves the productivity of the economy on which the value of financial assets, in which our savings are held, depends. Underinvestment leads to a reduction in the value of financial assets. However, because financial markets are so incredibly inefficient and outright dysfunctional, they continually blow into bubbles that overvalue financial assets, deluding us that we have more wealth than is the case. Despite the economy not having recovered from the shock of the great financial crisis 10 years ago, financial and housing markets are once again grossly overinflated and the next big crash is likely less than 2 years away.
The summary above is what my studies of economics over several years brought me to, and is what was on my mind when I started the blog. In the meantime, I was still researching what was actually happening in financial markets, and came across Pozsar’s work on institutional cash pools. This confirmed everything I’ve just described. The theoretical model in the “Productivity” section is confirmed by what is happening in financial markets, described in far too much detail in this section of the blog. So here, then, is a summary of the last 15 posts.
The profits of the largest groups of companies are held in institutional cash pools running into billions of dollars each. These have grown 3 or 4 fold in the last 20 years, from being barely significant in the early ‘90s to now dwarfing most national economies. These cash pools are not interested in risky, long-term investments – the kind of investments that fund productivity. They want short-term, safe, highly liquid assets.
Meanwhile, underinvestment in productivity is hurting the performance of the economy, and hence the performance of our insurance and pension funds (ICPFs). These funds have been borrowing money off the cash pools to leverage their investments and try to improve their performance. Hence, the household sector (ICPFs are largely managing household savings) are now borrowing from the corporate sector. This is the exact opposite of the model you would find in an economics textbook, which will say that financial markets intermediate household savings to businesses. And if you think that doesn’t matter, how would you feel if doctors or engineers were trained using models that are the exact opposite to reality.
The mechanism within financial markets by which this is happening is highly complicated (described here), and these markets are inherently unstable. This instability is caused by a series of imbalances:
- Ever greater wealth being concentrated in a tiny number of hands (the 1% and 0.1%);
- Such vast wealth being managed by a small number of asset managers;
- The concentrations – the institutional cash pools – looking for safe, liquid investments (e.g. government bonds), rather than investments in private sector productivity that carry more risk but help grow the economy;
- Meanwhile there is an imbalance between the performance of ICPF portfolios and the promises they have made to their clients, making them willing to take on leverage to achieve their targets;
- And finally there is the imbalance in trade, with some countries producing the goods (particularly South East Asia) and others consuming them (particularly the US and UK) – the US funding this through sale of dollar denominated assets, for which an almost insatiable demand exists only because the dollar is the currency of global trade, and the UK being the centre of this international trade in dollars.
Pozsar’s conclusion is that we need to reform the “financial ecosystem”. He advocates addressing wealth inequality and trade imbalances, including using taxation to redistribute wealth. And this not from any perspective that wealth inequality is unjust, but because it is unstable.
He is advocating fundamental structural reform of financial markets, and is explicit that left to the private sector these markets are providing “grossly inefficient” responses. By implication, he is saying that you cannot just leave this to the free market, it takes government intervention, which is unpalatable enough. But even worse, these proposals would require global cooperation, particularly when addressing trade imbalances.
This point about financial markets being “grossly inefficient” is key to the argument put forward in the blog. Financial markets are not efficiently channelling saving to productive investment. Instead, productivity growth has stalled through a lack of investment. If anything, financial markets are acting as a blockage to the efficient flow of capital, and asset prices have inflated as wealth swirls around inside financial markets (the economist Dirk Bezemer has a brilliant paper on this).
As wealth inequality increases, more wealth accumulates in cash pools and is pumped into financial markets. The vast wealth held in institutional cash pools represents business saving. The natural purpose of such saving would be reinvestment in the business (as explained in this incredibly long and technical post, one of my favourite ones on the blog) – instead, as wealth inequality grows, this wealth is draining from the real economy into financial markets (causing the paradox of thrift). This is the dysfunction described above, rendering these markets so unstable.
This instability was described decades ago by Minsky in his “financial instability hypothesis” (summarised here). Ignored by economists in his lifetime, the financial crash and subsequent recession have essentially proved that Minsky was right.
To give a completely different perspective on this dynamic I described Quantitative Easing – what it actually was, how it operated in practice, and what its effects were. And what we saw is that while the creation of new money and the intervention in markets by central banks was necessary following the global financial crisis, the way it was done was woefully ineffective and a lost opportunity. The injection of new money simply didn’t reach the real economy – rather it served to re-inflate the bubble that had just burst, and which will now burst again in the next couple of years.
And just to cap it all off, I summarised William Lazonick’s brilliant empirical work describing how corporations are using their profits to buyback their own shares in order to inflate share prices, rather than reinvest those profits in productivity. Because we use stock market performance as an indicator of company health, this creates an illusion that these companies are performing well, and ensures that executives get their bonuses.
There is, therefore, an essential need to reform financial markets. Left to their own, unregulated devices, these markets are utterly failing to channel credit to productive investment, and are wreaking havoc on our economies and our well-being. And in fact, the role of the state in innovation in new technologies is a matter of historical fact, as recorded in the brilliant work of Mariana Mazzucato, described last week.
Next week I will draw out conclusions, based on the analysis in the blog so far, about steps that could be taken to create an economy that provides enough for everyone. And then we will move on to something completely new. Having spent all this time looking at the how we can produce enough, I’m going to look at the equally important question of how we can ensure that the economy distributes what is produced such that everyone in the world has a sufficient share.