Divorce Finance From Commerce

Yves here. The post below does not quite nail the rather large topic it opens up, that of how financial markets differ from markets for goods and what the implications are for regulation (George Cooper’s The Origin of Financial Crises is very crisp on these topics) but I thought it would provide for conversational grist for NC readers.

By Sell on News, a global macro analyst. Cross posted from MacroBusiness

There are growing signs that an intellectual edifice that has dominated economics and finance for about a quarter of a century is starting to crack. Let’s call it the Market-Finance Myth (MFM). It should be self evident, at least for those of us who bother defining our terms, that financial markets need to be considered differently from commercial markets. Commercial markets have essentially three components: price, output of a product, and the rules that govern the market. Trying to keep regulation to a minimum makes sense — that is, letting price be the main organising principle — because it allows the system to self organise according to the collective knowledge and interests of the participants. Regulation should be cautious and always be done with an eye to unintended consequences. At the same time, of course, it should set boundary conditions and also ensure against oligopolistic behaviours (such as those in Australia’s ridiculously concentrated supermarkets sector). That is a precondition to having price be the main organising principle.

This model starts to break down when price is problematic. It is fine in consumer product markets, but in areas like health (where there is really no price for pain and death), education (where the supplier, not the consumer, defines value) or, say, defence (where pricing of national security is highly problematic) we start to enter greyer areas.

It is this failure to recognise the limits of pricing in markets that has led us astray, as John Lanchester’s review of Harvard academic Michael Sandel’s book “What Money Can’t Buy“ notes:

“”Over the past three decades,” Sandel writes, “markets – and market values – have come to govern our lives as never before.” Sandel is no socialist and isn’t against markets per se. He is forthright about the positive impact markets can have in their correct sphere. “No other mechanism for organising the production and distribution of goods had proved as successful for generating affluence and prosperity.” His focus, perhaps unexpectedly, isn’t on the 2008 crash and the great recession that followed. Instead, Sandel is interested in what he sees as a deeper and more consequential loss of our collective moral compass. “The most fateful change that unfolded in the last three decades was not an increase in greed. It was the expansion of markets, and of market values, into spheres of life where they don’t belong.”

I would argue that the model collapses completely when it comes to finance. To repeat, in commercial markets there are basically three elements. But in financial markets price and rules fuse into one. Because price is a rule: a rule that something is worth so much and has such and such obligations attached to it. There are, in other words, only two elements: rules and output (or activity) based on those rules. It is a binary, not a tertiary system.

That binary, dyadic, structure leads to all sorts of tautologies and contradictions. So, for instance, when people talk of de-regulating financial systems, they are literally talking nonsense because finance is rules. What happened instead is that rule setting shifted from government to traders, which led to an explosion of rules (derivatives, securitisation algorithmic trading etc). Not deregulation but hyper regulation, albeit made up by traders.

My personal favourite in the nonsense stakes is argument for high frequency trading, which is said to improve “liquidity”. Well, of course it does. Liquidity is the rate of transactions, high frequency trading increases the rate of transactions, therefore … high frequency trading increases liquidity. Blue is blue, red is red and the sun will almost certainly come up in the morning.

What it means is that finance requires a third element to be understood and managed properly. There are signs that economists are finally beginning to wake up to this distinction, as a report in the AFR notes about comments from Columbia University professor ­Jagdish Bhagwati, speaking at the Australian Conference of Economists:

“Mr Bhagwati reiterated his claim that free trade was less of a risk for economies than free-flowing capital. “That’s like fire,” he said. “The downside is enormous.”

He said he had been pilloried for that claim, but now the International Monetary Fund had joined him in acknowledging the asymmetric risk- return ratio of free-flowing capital.

He conceded that capital flows per se had not been to blame for the most recent financial problems, but the “destructive creation” of advanced financial products.

At the same time, Professor Bhagwati, speaking on the topic “Can we still defend globalisation after the current crisis?”, made an impassioned defence of “free trade.”

This is a long overdue distinction between commercial and financial markets. About time. Some of the nonsense is also finally being exposed, one hopes:

Earlier, Nobel laureate James Mirrlees said the lessons of the global financial crisis were yet to be learned and creating complex financial markets that generate liquidity had been celebrated for too long.

The Cambridge professor of economics argued that the creation of more markets and financial derivatives could be undesirable and said a ban on short-selling would be positive for the economic welfare of society.

Sir James attacked the foundations of modern economics and the functioning of financial markets.

He took issue with the intellectual basis of much of economics, saying that the assumptions that underpinned many common economic models, such as rational expectations theory, should be challenged.

“We must be prepared to say, ‘That’s absurd!’ ” he said.

Yes, no lessons have been learned. And the reason is the MFM myth, I contend. What is needed is a third element in financial markets, so that they match commercial markets. We should know by now, having seen what happened with Marx’s binary system of bourgeoise and proletariat, just how dangerous binary models can be. How they feed on themselves and create false imperatives. That has happened with the financialisation of developed economies. I do not know what the third element should be — some notion of utility, perhaps, or social goods — but a third element is needed. Something that is outside finance markets that we can use to understand and frame them properly. There are signs that such a realisation is dawning.

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  1. psychohistorian

    I would go as far as to suggest having finance related to commerce be a utility of the commons. That is, of course, within the context of having public money instead of private running all governments throughout the world.

    Which get us to who owns everything currently that they want to get compensated for or revalued within one or more systems of public money. I think that when this becomes public there will be a hue and cry for some significant controls on inheritance and ownership returning to public commons for all property, eventually.

    We can argue all we want about the relative efficacy of alternatives at this point but it is clear that to continue what we are doing is uncivilized suicide.

    Remove the global inherited rich and their money systems from control of our societies.

    1. ambrit

      Dear psychohistorian;
      All well and good; we here generally recognize the absurdity, (for the public good that is,) of the existing system. Young people I speak with generally show complete amazement when I point out the actual tax rates during the “Golden Age” of Truman and Eisenhower. They have been taken in by the NeoCon revision of history. I suspect the present generation of Economists are functioning well within the influence of this revisionist history. It doesn’t have to be overt. To steal a page from the NeoCons; what we need now is a truly ‘progressive’ political movement to shift the frame of reference back to the Left. FDR did it way back when to save Capitalism. He settled for a Hybrid. Absent that, Capitalism as we know it will fall back into semi-Feudalism. There is no rule that says that human society must always develop in a socially positive direction. Dickens here we come?

    2. JD

      Have you noticed? We currently don’t have a financial system. I’m so amazed this author tells us he can breath underwater.

  2. jake chase

    Resolving finance is just a matter of reimposing rules that lasted for sixty years (Glass Steagall) or twenty-five years (Bretton Woods), and outlawing OTC derivative transactions that make no sense but impose a heads traders win tails society loses cost, and taxing financial transactions to remove HFT incentives. And I wouldn’t get too complacent about the virtues of goods markets, since it is getting increasingly impossible to buy a single product that isn’t an utter piece of shit and practically falls apart before you leave the cell block from which our market crazed oligopolists condescend to dispense it.

    What ought to be obvious to anyone who thinks about these problems at all is that concentrated financial and business power is the root cause of our social undoing. When you atomize economic units you still have a good deal of fraud and criminality but you also have enough moral business behavior for society to limp along. In today’s economic world you have garbage products, cultural obscenity, propaganda and televised sports (which nicely combines best features of the other three).

  3. Schofield

    This is a spurious argument in the article:-

    “Trying to keep regulation to a minimum makes sense — that is, letting price be the main organising principle — because it allows the system to self organise according to the collective knowledge and interests of the participants.”

    when much heat is being raised about Romney’s outsourcing of jobs!

    1. Mel

      Well — Romney is not a collective. In the idyllic or Elysian markets, lots of people had votes, and the market decisions could reflect “the collective knowledge and interests of the participants”. Yeah, the Market we see now has left the rails, and a few thousand people have all the choices. I suppose you could make a grammatically correct definition of “collective” that would fit them, but within the world population, collective is not what they are.

      Regulations need to match Einstein’s criterion “as simple as possible BUT NO SIMPLER”.

  4. Eleanor

    I am not entirely sure about markets, though they certainly work at the level of Farmers Markets and may work for small business in general. But the 20th century is full of examples of corporations creating markets through advertising and marketing — or through buying up public transit systems and putting them out of business, as the auto industry did. In addition to this distortion or elimination of personal choice, there are many things that society needs and/or wants, which are not likely to be provided by markets: rural mail delivery, railroads, sustainable energy, sustainable farming, national parks, education, decent health care… There are good arguments for public utilities, co-ops and government run services, such as the VA, as well as a lot of government regulation. As the Njals saga says, “With laws shall our land be built up, but with lawlessness laid waste.”

  5. Ruben

    I think the OP is on to something. He/she says that a market is a trio composed of goods and services, the prices of the goods and services, and the exchange process. I think that the OP poster is arguing that in finantial markets the goods and services are the values of finantial products so that the three components are the the values of the finantial products, the prices of the values of the finantial products, and the exchange process. According to my reading of the OP in finance “the model collapses completely” because the goods and services and the prices of the good and services have the same units, say dollars. Sounds plausible to me. Probably it means that in many exchanges operators can position themselves “on both sides of every deal”, a remark that I am quoting from Roubini’s Bloomberg interview posted in this blog on 2012-07-08.

  6. LeonovaBalletRusse

    Caveat emptor: “free trade” is the creation of the British East India Company.

  7. LeonovaBalletRusse

    YVES, who has the nerve and muscle to CUT this Gordian Knot? See GRAPHIC at:

    “Visualizing TBTF: The Hub and Spoke …” (TD 7/14/2012 22:05-0400); and cf:

    “Trade-Off: A Study In Global …” (TD 7/14/2012 23:00-0400); on ZH.

  8. F. Beard

    We need to divorce government from private money creation. Let banks extend credit if they dare but without government deposit insurance, a lender of last resort, sovereign debt, or legal tender laws for private debts.

    The reason the so-called “free market” has problems is because our private money creation system is fascist, not free market.

    1. LeonovaBalletRusse

      FB, “free market” was a sham from the beginning, with the British East India Company.

  9. Susan the other

    The financial market is an absurdity. It’s like buying corn with corn. As Ann Pettifor says, it’s crazy to claim that financial markets should be free from regulation because money is not a commodity, it is created out of thin air and so can never find it’s own market value… I think she’s right.

    What this article adds is that it is akin to advocating a drop in a bucket to want more regulations for finance because finance is all rules as it is. Every financial “product” is just a bunch of rules. But it seems to me there are rules and then there are rules, and those rules (defining a financial product) are the actual product, not the rules of society imposed on that product.

    Maybe the missing element is full employment. If the financial market had to value its products based on full employment, it would not be creating money out of thin air but out of full employment. And that would make sense not just financially, it would give the ultimate integrity to the currency which is backed by the full faith and credit of the US. And the US is us.

    1. Justicia

      The missing third element is some notion of social utility, such as employment — and I would add ecological efficiency (resource conservation and waste minimization). Money is both the object and the measure of finance. We need some external referrant to assess the value of the service the financial system renders.

  10. Siggy

    You can’t separate finance from commerce. Finance is at the core of all contemporary commerce. If you want an alternative you need to consider barter.

    Blather all you want, its the unit of exchange that is at the core of our current distress. By way of the creation of excess credit money, the unit of exchange has been so devalued that where we once had one income households we now need at least two and probably three to achieve being middle class.

    And while we’re thinking about it; consider the impact of the failure to prosecute blatant financial fraud. It’s a pandemic and now we’re all upset about LIBOR.

    Read the sign: London Interbank OFFERING Rate. It’s an offerred rate to other banks. Seems to me that I can legitimately offer at one rate and transact at another all day. In fact, isn’t the process of OFFERING the initial step in negotation? So now comes the revelation that some boys on the trading desks have been quoting something askew from what the OFFERING rate might otherwise have been. Who’s to care? Well who cares are all those fools who used LIBOR as a reference metric in all those credit and interest rate swaps, that’s who. Criminal case, maybe after all, a fellow can go and missapply a whole shitpot of customer money and nary word is uttered as to a possible criminal indictment. Well that is what has transpired and the statute of limitations clock keeps ticking while the Justice Department does a sleep walk. You gotta love it, you can’t make this shit up.

    1. Fiver


      You are right that financial fraud is pandemic. You are also right that the Justice Department (and every other regulator in the Western world) has been and is being utterly negligent. And you may be right that the LIBOR scandal as delivered to us so far via FSA, the New York Fed, etc., is a deliberate feint in order to mask far greater criminality or even as an excuse to bring in some bullshit “getting tough” initiatives. It could also be the vehicle for bringing down the likes of Dimon, Bernanke, et al if pursued with a relentless intolerance for the sort of bleating denials as explanations of actions we’ve been given so far. We shall see.

      Re LIBOR, the scandal has nothing to do with whether it is an “offered rate” in the sense you portray it. The rate is an aggregate of estimates by contributing banks of what any bank (including themselves) could borrow at, thus providing the benchmark as part of banks’ “self-regulation” Project For Profit. As such, and given that it was some of those same key banks that created and marketed the products tied to LIBOR (Hello JPM and GS !) it could not be more prone to collusion and manipulation if designed specifically for that purpose – which it doubtless was. Add in the ability of the owners/contributors of Markit Group to set CDS prices at will, and the scope for financial pillage and extortion has exploded exponentially – to the point where banksters/hedge funds and their long-captured Central Banks and other regulators now hold almost every sovereign nation on earth hostage via the threat of deliberately “crashing” these pathetic jokes called “markets”. And of course, these same criminals have convinced virtually all politicians and status quo serving, orthodox analysts that nothing, even major war, is worse than a “crash” – which is total bullshit.

      This isn’t some sideshow. We’re talking about core elements of the financial system being set up as a for-mega-profit, permanent playground for banksters by the regulatory sludge that evolved from the likes of the “for the sake of financial stability” Plunge Protection Team. The Fed, BoE, JPM, GS, Barclays et al are up to their eyeballs in this.

      I fully agree all other financial crimes need to be prosecuted and at minimum hundreds of senior officials of government and officers of private financial corporations sent to jail, but that’s no reason to let Geithner, Bernanke, Dimon, Diamond et al off the hook on something which might just blow so wide open they are taken down – especially, as noted, when one considers Markit, European banks and sovereigns, and not least, currencies, must ALL now be considered as weapons for the very highest stake extraction and extortion, even geopolitical, pure and simple.


  11. Heretic

    I believe that markets are arenas of human interaction. These arenas
    will in some ways express the values of the designers of those markets and the societies in which those markets exist. The drive toward deregulation, is a manifestation towards indifference toward the outcome of the market participants, an effectively amoral (not necessarily immoral) view of the economy.

    If we want markets to help further human and community Wellbeing, then we need to understand what conditions in the market foster Wellbeing for the for the various groups of people and institutions involved in the market. At the broadest overview, their are customers, bystanders, suppliers and the environment. (although we cannot quantify well being of the environment, we do know that minimizing pollution is important and that the Wellbeing of humanity is not separate from the environment). I would argue, it is impossible for anyone or any group to be able to clearly define ‘Wellbeing’ for any group, hence it would be impossible to set specific regulations to uphold ‘Wellbeing’ for any group. In fact, it would lead to a form of totalitarianism and conformity. However, it I believe it is possible to affect market conditions such that the various groups have the
    necessary market power to be able to negotiate a good degree of wellbeing in the market.

    What is market power? I believe a study of power in the at of negotiation does reveal several factors; supply and demand, asymmetries in education, information, awareness of information, capacity for unified action and cooperation, and consequences of the transaction of the ongoing relationship. There are of course other sources of market power.

    Hence, I believe that governments are needed to either balance market power or regulate market participants. It is preferable that governments provide some balance of power among allow market participants and allow negotiate with each other, even of outcomes are slightly skewed
    Im favour of one party or the other. However There are situations where some participants can never have effective market power relative to other participants. A classic example is the case of healthcare, where we camnot expect an individual to negotiate on equal footing with an insurance company or hospital, especially in times of sickness.

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