My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author
Last week we opened a new Chapter about markets and looked at some simple examples.
Here is the link to last week: Issue 34
We move on to look in more detail about how markets are now so distorted that the notion of freely operating markets has been lost. Many commentators suggest that the cause is in fact a failure of capitalism itself and that the only answer must be socialism. I believe that this is a false conclusion as I hope the coming Issues will demonstrate. The turmoil in the stock and bond markets recently clearly indicates that we are not in ‘normal’ times. Here is some of the evidence.
CHAPTER 7
Markets
“Interest is the difference in the valuation of present goods and future goods; it is the discount in the valuation of future goods as against that of present goods.”
Ludwig von Mises: “Planning for Freedom”
Everything is determined, the beginning as well as the end, by forces over which we have no control. It is determined for the insect as well as the star. human beings, vegetables, or cosmic dust, we all dance to a mysterious tune, intoned in the distance by an invisible piper.
Albert Einstein
Trust in markets fails following the great recession in 2008
Events following 2008 have inadvertently created a high degree of mistrust between not only traders and institutions themselves but also from the general investors point of view who provide essential capital for the smooth running of markets.
Unsurprisingly, trust in the financial sector has eroded, whether individuals realize it or not, and is a major reason for the increase in ‘moral hazard’: “Governments, by guaranteeing or underwriting the prices of investments, have thus relieved the market participants of their individual responsibility for any losses”.
It has converted the primary function of markets, freely trading between parties to discover prices, into casinos for ‘speculators’ who take winning profits leaving losses to the public purse. When a government guarantees a price there is no need for trust.
The function of any market place is to allow players to come together and, through free negotiation, discover the ‘market price’ of a product or service. This is the essence of ‘capitalism’ and the system under which global markets are supposed to operate today.
However, when market participants become large enough they will influence normal supply and demand, manipulating prices which then become unrealistic. There are many recent examples of this effect which has been the case for as long as markets have existed and is used as an argument against capitalism by, in general, the socialist ‘left’.
Certainly current events seem to support the view that repeating crises occur during ‘market dysfunction’ which was the case during the last catastrophic disruption in the early 1930s Great Depression.
The current debate is fierce and centres around the question of whether ‘free markets’ would naturally cause major crises or whether it is government intervention artificially adjusting prices and risk that is the cause. This is what an eminent and well respected economist had to say about this issue.
Markets function best when capitalism is allowed to act without intervention
Ludwig von Mises, one of the founders of the ‘Austrian’ economics school, considered the question of whether economic crises are created by the unencumbered actions of free markets back in 1931 in the wake of the worst global economic downturn of the twentieth century and quotes from the period add colour to the argument:
“It is almost universally asserted that the severe economic crisis under which the world presently is suffering has provided proof of the impossibility of retaining the capitalist system. Capitalism, it is thought, has failed; and its place must be taken by a better system, which clearly can be none other than socialism.”
“That the currently dominant system has failed can hardly be contested. But it is another question whether the system that has failed was the capitalist system or whether, in fact, it is not anti-capitalist policy of interventionism, and national and municipal socialism that is to blame for the catastrophe”.
“The structure of our society resets on the division of labour and on the private ownership of the means of production. In this system the means of production are privately owned and are used either by the owners themselves–capitalists and landowners–for production, or turned over to other entrepreneurs who carry out production partly with their own and partly with others’ means of production. In the capitalist system the market functions as the regulator of production. The price structure of the market decides what will be produced, how, and in what quantity. Through the structure of prices, wages, and interest rates the market brings supply and demand into balance and sees to it that each branch of production will be as fully occupied as corresponds to the volume and intensity of the effective demand. Thus capitalist production derives its meaning from the market. Of course, a temporary imbalance between production and demand can occur, but the structure of market prices makes sure that the balance is re-established in a short time. Only when the mechanism of the market is disturbed by external interventions [by government or central banks perhaps] is the effect of market prices on the regulation of production prevented; they are disturbances that no longer can be remedied by the automatic reactions of the [free] market, disturbances that are not temporary but prolonged”.
In a free market, rooted in private property, the only way entrepreneurs are able to sustain profits is by serving customers better than anyone else. It is only when they receive special privileges through preferential regulation, subsidies, bailouts and political indulgence that they are able to reap the profits of that which they have not sown. A fine example of how the financial industry is becoming nervous about the very nature of the current system of government intervention is illustrated by this quote:
Extracted from the 2012 Institute of Chartered Financial Analysts (CFA) Annual Report was the following warning:
“The Global Financial Crisis has damaged the social contract between finance professionals and those we serve, causing a corrosion of trust that is eating away the industry’s foundation. Our businesses are not given a divine right to exist—that right is granted by consumers and based on the social utility of the services they receive.
Although global equity markets have largely recovered from their 2009 lows, the confidence in investors has not. As troubling as this is for the finance profession, the real impact is much larger. The true harm that comes from a breakdown in trust is more insidious and harder to see today. Families in our communities have been displaced, home values have dropped, and ordinary investors are reeling from immense losses.
Our families and friends who are investing to secure their future are now defensive and confused. Their retirement plans that counted on an 8% [annual] return on investments are now dealing with the reality of a 2% world. In turn, these families are now challenged by a savings gap, which means longer working lives, lower quality of life, and the attendant changes that are already affecting our children and grandchildren.
Over time, the defensive crouch of ordinary investors can become ingrained and lead to a savings gap that can take 10, 20, or even 30 years to show up. In essence, people are “borrowing long and lending short”—a recipe that any banker can attest leads to disaster over the long run.”
(CFA Institute, 2012)
To be continued next Saturday
