The Greek Crisis as a case in point
Some of the peculiarities of the “Greek Crisis” give rise once more to ask where the social benefits of global financial markets lie. The most recent profit jubilations by large international banks, mainly their investment banking arms, raise the same issue. While especially small and medium-sized enterprises of the “real” economy still suffer from a credit crunch, trades in currencies, in derivatives, in stocks, in commodities, in companies and other investment banking activities generate once more large amounts of profit.
The Financial Times reports that speculators had bet 8 bill GBP on Greece failing in its debt obligations and depressing the value of the Euro. The Greek drama, as told by financial markets participants, can be outlined by looking at the evolution of “credit default swaps”, a largely unregulated, over-the-counter derivative, purportedly “insuring” investors against a Greek sovereign default. Basic flaw of this type of insurance is that the investors (speak: speculators) have no insurable interest in the wellbeing of the Greek economy, but rather in its demise. Like my neighbor insuring my own house against a fire: he has no insurable interest, thus will not find any insurer, he rather has an incentive that my house burns down. CDS institutions do not seem to have such a restriction.
Where is the Value?
While the Greeks are certainly not innocent of their problem, why do they have to be at the mercy of financial market analysts who react to (or create) momentary, short-term assessments, caused by events which have nothing to do with the medium-term prospects of the Greek economy and by speculators who do not have a solution for Greece at their heart, but “who would like to EU to help Greece”?. But again, any trade generates fees, and maybe capital gains.
Why do the EU Commission and analysts pin the Greek woes nearly exclusively on high wage increases which had impeded Greece’s competitiveness? Wage developments are only one factor influencing competitiveness, the production and service portfolio of the Greek economy, it innovativeness, its ability to produce high value-added products and services is even more important.
Why do pension funds, especially but not only in the Anglo-Saxon world, switch their capital on a minute-to-minute basis from one investment into another. Why do they suddenly invest in commodities? Should their objective not be a low-risk (and thus low-reward) investment for safeguarding the retirement income of their investors? Pension funds have become – because of their size – one of the prime movers and shakers of over- und undershooting stock markets.
What is the societal value of secondary trading in stock markets, where stock prices fluctuate by several percentage points day-in-day out – without any correlation with the medium-to-long-term profitability of the corporation? Billions are traded daily, leading managers to try anything to increase stock prices (which frequently determine the value of their own stock options). The high turnover in stockmarkets again generates fees, fees, fees, but no value, since it is a zero-sum-game between the buyer and seller. Actually less than zero-sum, because the fees reduce the value of the trade. It is positive that the stock market can provide new capital for newly registered firms and for firms increasing their capital base, but trading shares by the minute does not generate value, gives misleading signals and creates perverse incentives.
What is the societal value of merger and acquisitions trades? Yes, it generates fees for the lawyers, for the investment banks and others. In the recent takeover of Cadbury by Kraft, fees of more than 360 mill $ were billed – societal value? And: there is plenty of empirical evidence that only a maximum of 1/3 of all mergers is successful in the long run, meaning the merged firm still exists and generates income. Why do investors not invest in new capital and equipment, but rather in existing one – which, at the same time reduces competition and thus makes the economy less efficient?
There was a time, not so long ago, when the unregulated financial markets were supposed to exert efficiency discipline on the real economy. By evaluating at every moment the future earnings potential of each listed company, financial markets (i.e. analysts and rating agencies) were supposed to drive lax managers towards higher efficiency, thus towards a higher growth rate of the economy. This assumed that analysts had “true” information of the companies and that by selling and buying the real value of the company would be determined. This, the “efficient market hypothesis” has been shown to be wrong: event-driven evaluations, herd behavior of traders, computerized trading signals models – and the ignorance of many analysts have shown that many trades were rather self-serving and destabilizing for the economies.
Financial analysts and rating agencies have usurped the role of final arbiter of the global economy, its countries and firms. They may use sophisticated mathematical models determining continuous “buy”, “hold”, or “sell” decisions. But: do they correspond to economic rationale? Do they take the welfare of societies, of households, of workers into account – or only the interests of “investors”, or their own interests in generating fees and profits? Sovereign states have continuously subjugated their fates to the self-interests of speculators, some of whom have managed to destroy much value (e.g. Soros vis-à-vis UK) and brought whole economies down.
A radical-sober look at the future
The crisis should have shown that this is not a viable model, that we need a radical re-thinking of the role of the financial sector in the future economy of the globe.
A quick survey of the globa lattempts to re-regulate the financial sector as a result of the crisis shows that not very much has happened so far, but that quite a few restrictions are in the pipeline, be it on the part of the IMF, the Financial Stability Board, or national regulatory agencies and national banks. But: all of them do not get at the root of the problem and shy away from a sober vision of where we want the financial system to be in the future, what role it should play and which parts we want to eliminate.
It is clear that we need good old commercial banking, i.e. extending loans to businesses and taking deposits from savers. It is also clear that we need more than that, because we need heding against events and other insurance products. We need trans-border activities to export capital from net-saving to net-investing (catching-up) countries and their firms. But the insurance interest must be real and be superimposed on a “real” transaction. It is questionable whether we need futures markets, it is questionable whether we need large-scale hedge funds, financed by banks. The economic value of most derivatives is doubtful, but the “valuable” ones need to be traded on exchanges, counterparties need to be transparent and capital requirements underlying trade need to be higher the higher the risk.
Recently, President Obama has suggested the “Volcker” rule which would once more separate commercial banking (which takes deposits which are state-guaranteed and which has access to cheap central bank funds) from “casino” activites, ie. pure trading activities. French Finance Minister Christine Lagarde has recently threatened to take a “second look” at credit derivates, answering to the destabilizing effects on the Greek economy. Others politicians follow.
But: Will they really act? Financial market lobbyists are out in full force to dissuade politicians from asking the pertinent questions. There first-best alternative is to leave everything as is (“business as usual”), their second-best alternative is to have a few regulatory screws turned a little bit tighter, but they claim that anything more will slow down the incipient recovery, drive financial firms away from the country, lead to economic disaster.
Politicians should not listen, but put the welfare of their citizens and their economy first. Deleverage (=shrink) the financial sector towards its functionality and size where it performs its beneficial role for the economy, let speculative activities whither away , restrict the latter to risk-loving speculators, but shield the rest of the economy from their effects. While there still is a moral case to forebid and outlaw casinos, there is no possibility to forbid internet betting completely. But it should be relegated to the niche into which it belongs.