Bankers' self-interest vs market equilibrium

From that man again:

It is the self-interest of the butcher and baker that leads to the provision of meat and bread. This dictum, propounded by Adam Smith, has led to the proposition that the pursuit of self-interest leads to the achievement of market equilibrium; the neoclassical results follow from the effects in markets of action based on self-interest. It is in the self-interest of bankers to make loans, to spread the use of their services, and it is in the self-interest of investors to use bankers' services as long as the price of capital assets exceeds the supply price of investment goods. Whereas in commodity production the process of supply generates income equal to the market value of supply, in financial markets with responsive banking the demand for finance generates an offsetting supply of finance. Furthermore, if the supply of finance exceeds the demand at the current relative price of capital assets and investment output, the excess supply will push up the price of capital assets relative to the supply price of investment output, and this will increase the demand for investment and therefore finance.

In a world with capitalist finance it is simply not true that the pursuit by each unit of its own self-interest will lead an economy to equilibrium. The self-interest of bankers, levered investors, and investment producers can lead the economy to inflationary expansions and unemployment-creating contractions. Supply and demand analysis - in which market processes lead to an equilibrium - does not explain the behaviour of a capitalist economy, for capitalist financial processes mean that the economy has endogenous destabilizing forces. Financial fragility, which is a prerequisite for financial instability, is, fundamentally, a result of internal market processes.

Bits and pieces

1. A couple of TUC docs worth checking out. The latest issue of the trustee newsletter (PDF), plus a useful guide to investor engagement.

2. There's an interesting piece on page 3 of the companies and markets section of the FT on one of my favourite themes - the role of shareholders in corporate governance. I suspect this will be one of the big issues that needs to be thrashed out in the wake of the banking crisis.

3. Barclays is still in trouble, despite last week's rally. One to keep a close eye on.

4. Minsky quote of the day... "[Banking]... is a disruptive forces that tends to induce and amplify instability even as it is an essential factor if investment and economic growth are to be financed."

Market beliefs and regulation

I thought I'd probably posted enough Minsky quotes to last a year, but then I stumbled upon a nice paragraph the other night where he talks about the ideas that sit behind financial regulation. I'm not going to post it up because I have posted far too much from his book already, but basically he says that the regulatory environment is inevitably (if not explicitly) influenced by some view of how markets work.

This background view of how markets work which influences how we design regulation is itself informed by economic experience, so from the 1930s onwards the regulatory framework was informed by the Great Crash and following depression. In contrast the deregulatory impulse of the 70s and 80s was based in a view of markets formed in a period when there had been no systemic crisis of comparable size.

Inevitably there will be a change in regulatory stance in coming years as a result of the current crisis, so presumably this also indicates that our view of markets has also changed in some way. Certainly it isn't difficult to find quotes these days from recanting former true believers. Joseph Ackerman perhaps put it best when he said last year "I no longer believe in the market’s self-healing power."

But what new belief system is going to replace the very liberal view of market operation (at least financial markets) that appears to have been discredited? It presumably will be different from the post-Great Crash view because, although we're in for a rough time, people in the developed world aren't likely to be starving like their grandparents were. If that were the case then John Thain might have more to worry about than a subpoena and few nasty headlines. So I don't expect to see a shift towards anti-capitalism.

But equally we must be in for a significant shift in thinking, and one that will change the way we think about markets (at least in the back of our minds) for a prolonged period, until our kids have forgotten the experience that shaped the background views.

Personally I think if we take the current crisis and the experience of the TMT bubble not long before it this must point us in the direction of a view of markets that is more informed by psychology. The emergence of behavioural economics was already bringing this perspective to our understanding, but recent events must push us further in this direction. Or are there other competing alternatives out there?

Snippets

I'm being a rubbish blogger this week to to a mixture of work and pre-parenthood pressures. Just a few snippets today.

First up, Bellway looks like it has raised the white flag in its fight with investors over awarding its directors bonsues despite poor performance. I can't find the poll results of the AGM (maybe they lost the rem vote?) but they have put out the following:

The Board has noted shareholders' views on the Report of the Board on Directors' Remuneration and believes it was wrong in not consulting with major shareholders earlier. It therefore proposes to review future policy on this matter, in consultation with them, in the coming months.

This LSE research on the shorting ban (PDF) looks interesting from a techie perspective.

And finally yet another Minsky quote. This one stuck out because of this post on Touchstone before xmas.

[R]elative prices are the result of how market power over price is exercised; in a world in which firms have market power, the "optimality" of market-determined prices is a figment of the imagination of neoclassical economists.

Too busy to blog properly

so here's a couple more random chunks of Minsky broadly on the impact of government deficits during recessions:

If the wage bill in consumption and investment decreases because investment decreases, then in today's economy transfer payments increase and the tax take from wages drops, thus raising the deficit. If the increase in the deficit offsets the fall in the wage bill in investment goods production, then the unit markup on labour costs for the smaller consumption output will rise even as employment falls. As a result, profits and prices may both rise even as employment declines; this happened in 1975 and 1981-82.

And:

[T]he effect of government depends on its size relative to the size of the economy. If government is small, the deficit that can be attained may not have an appreciable effect in stabilizing profits or prices. Contrariwise, a government that is large enough to stabilize profits will put upward pressure on prices even as employment fall: inflation is one result of the mechanism by which we have successfully avoided deep depressions since World War II.

More Minsky

I'm really getting in to this book now, another snippet below. Neo-liberalism is all well and good, until you have a finance sector...

In market economies prices distribute outputs among households, and they allocate productive resources, which have alternative uses, to the production of various outputs. The price system therefore has distributional and allocational functions in the world of neoclassical price theorists. In a world with capitalist institutions, however, prices will or will not validate past financing and capital-investment decisions as well as distribute income to workers and to owners of capital assets. But the relations between capital-asset compensation and the allocation of capital-asset services to various outputs is not as direct and simple-minded as the relation between labour compensation and the allocation of labour services to various poductions. Time, investment, and finance are phenomena that embarrass neoclassical theory; once problems with capital accumulation in a capitalist environment are introduced, the theory breaks down.

Minsky snippet

My current bedtime reading is Hyman Minsky's Stablizing An Unstable Economy, which I've never read before. It probably would have made more sense to read it last year when everything was starting to kick off. I'm not finding it the easiest of reads either. But there's a lot of good stuff in there. Here's a brief snippet:

Whenever rapid innovations in ways of buying money and in substitutes for bank financing take place, the articulation between Federal Reserve policy actions and the volume of financing available loosens. The greater the number of alternative position-making techniques available for banks and for other financial institutions, the slower the reaction of the supply of finance to monetary policy of the Federal Reserve. The lag between restrictive actions by the Federal Reserve and a supply response by banks and financial markets will take longer when evolution is occuring than when a tight and invariant relation exists. Policymakers' impatience to get results will tend to make for serious excesses and overshoots when relations have been loosened. The likelihood that policy action will result in the economy going to the threshold of a financial crisis increases with the number of markets used for position-making, and with the proportion of bank assets bought through the various markets. Thus, as the financial system evolved over the postwar period, the potential for instability of the economy increased.

The Origin of Financial Crises

Just a bit of recommended 'crisis' reading. This is one of the better things I have read about the financial crisis. It's a nicely-written and clearly argued case against the efficient markets hypothesis (EMH) and the argument that left to their own financial markets will tend towards equilibrium. In fact a large part of the author's motivation for writing the book seems to be to drive a stake through the heart of the efficient markets hypothesis, which he sees as fundamentally wrong (no argument here!).

As such the book is broadly pro-Keynes, and very pro-Minsky. It takes as a given Minsky's view that markets are inherently unstable and will inevitably swing between ..er.. boom and bust, and that the busts can be very bad indeed if no action is taken. The suggestion is that Minksy's financial instability hypothesis should replace the EMH has our bedrock understanding of how financial markets work.

Notably this leads him query what central banks are trying to do. He is particularly scathing of Fed, which he suggests tries to combine a belief in the EMH with intervention, when logically they should preclude each other. He argues central banks should refocus their attention on credit expansion and asset price bubbles, rather than consumer price inflation. Notably he therefore believes that bubbles both exist (this might seem obvious, but it's actually an important point) and that central banks can do something about them, though in practice it's credit creation that he thinks should be monitored.

That's the headline argument, but there are lots of nicely structured points building up to it along the way. There's a great section on why even 'fundamental' company analysis on its own can fail to spot the distorting effects of bubbles.

Anyway, definely worth a read, and given that it's both very clearly-written and one of these double-spaced books you can get through it in no time.