The Role of Finance - II

People do not consume money. Let's be very clear on that. Money is always a means to an end. It can never be an end in itself. We need money in order to buy things for our survival and/or personal enhancement. Over the last 200 years or so, companies have been the primary mechanism through which we have been able to acquire the goods and service that we need or that we think we need. At the same time, we developed a economic philosophy of continuous growth. The finance sector lies at the intersection of these two trends. Companies need to grow year on year since the capitalist system requires this. In order to do so, they need capital. The financial system can mobilize capital and hand it out to companies that need them. Atleast that is the theory.

In practice, the financial system is subject to the same economic paradigm that affects other sectors of the economy: the need to grow year on year. Left to their own devices, people in the financial sector will seek to maximize their own gains. Economic theory indicates that this individual greed for more results in an efficient allocation of resources. Those sectors of the economy which need capital for growth will attract it while other sectors will lose out. Unfortunately, economic theory breaks down when it comes to the financial sector. The reason for this is that this sector will aggressively seek out areas which will maximize its own growth regardless of the requirements of other sectors. Since they are the providers of capital, they will essentially be able to dictate which sectors are invested in and which ones are ignored. Like most organizations, financial sector companies seek out maximum gain for minimum cost. In other words they will seek out opportunities that provide the quickest returns. The other problem is the financial sector's ability to create money. The fractional lending system literally creates money out of thin air. The result is that over time, there will be increasing amounts of money looking for returns. This  is an unstable situation which can be contained only as long as the ability to create money in this fashion is tightly controlled. When such constraints are removed, there is a massive infusion of money seeking quick returns that will distort vast sectors of the economy.

This is precisely what happened in the last decade. A tidal wave of money seeking quick returns swept around the world. This wave sucked in the best resources and the best talent available leaving other sectors starved of the same. It also caused major fluctuations in commodity prices leading to a general rise in specially food commodities thereby affecting millions of people around the world. However, the worst was that companies in other sectors which needed capital to grow were starved of needed financing simply because the returns to the financial sector were too low in such activities. Instead of an efficient allocation of capital to sectors which most need them, we have a distortion which leads to over investment in areas of quick returns to the financial sector and major under investment in other areas.

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The Role of Finance

We are not asking a very important question as a society: what is the role of finance in our economic system? This is an important and urgent question. Finance is usually treated as other types of business when in reality, it plays a special role in our economic system.

Typically, finance is viewed as a necessary intermediary between businesses and investors. Businesses need capital in order to grow and continue to provide new forms of goods and services. Investors have a desire to put their capital to productive use. Finance is the bridge that brings them together. This is rationale behind banks and stock and commodity exchanges. Ultimately, the health of the financial services firms depends on the health of the underlying economy.

Unfortunately, events have shown this view of finance to be hopelessly naive. Financial services firms have gone far beyond their role as intermediaries. They have introduced new financial products with the claim that such products would help reduce risk in the financial system; a claim that was largely true. What they did not say was that the risk would instead be sourced out to other sectors which were poorly placed to assess and take on the risk. At the same time, the financial system was deregulated and privatized in the name of efficiency. The claim was that self regulation would work because of the reputational risk factor. Thus the stage was set up for the perfect storm that engulfed the world. So the question is now urgent. What should be the proper role of finance?

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Materialism

The structure of modern capitalism rests on a foundation of materialism: the basic notion being that happiness comes from possession of material things. Satisfy material comforts and you will be happy. A fulfilled life is one which possesses the latest, greatest object or utilizes the latest, fanciest service. This is a reasoning which inspires people to put down large amounts of money for trivial objects. Why would someone pay $14.3 million for a car license plate? Why would anyone want to spend $1.3 million for a diamond studded mobile phone? What sort of satisfaction or peace of mind is obtained from acquiring such trinkets? Will a car go faster or perform better if it has an expensive license plate? Will phone calls be clearer if made from a diamond studded mobile? How will possessing a Gucci bag or acquiring a private yacht give lasting satisfaction?

All of us are essentially indoctrinated into materialism from childhood. Here's a nugget of information: the average child sees 20,000 ads in a year. Each ad touts a product or a service. Each one sends a message that health, wealth, happiness, success can be obtained by consuming things. The more things consumed, the better. Lasting happiness and eternal peace of mind is yours if only you have the latest, greatest product from BMW! Gucci! Coca Cola! [insert any company name here]! But ofcourse it does not work out like this. Acquiring the latest product from any company will make you happy until the next version comes out or your neighbor acquires something better. Then there is tension and unhappiness until the new product is also yours even if the old one is functioning perfectly well. The worth of a person is determined by the ability to buy. The less this ability, the less worthy the person.

Materialism imposes fairly heavy costs on the individual and society. As individuals, we are constantly under the stress of trying to obtain the latest version. The steady barrage of ads convinces us that our worth as a person is closely tied to our purchasing ability. Thus we acquire products that we don't really need. Not only that, now we are under pressure to buy the latest version of the same. This clutters our homes and ends up in landfills. So the cost of materialism goes beyond just paying for something. This added cost is also paid by society. The more we consume, the faster we consume resources and the more energy we end up using. Our land, water and air become increasingly polluted which has strongly negative effects on our health. So society pays through higher pollution costs which result in higher health costs.

Many of the problems that we face today on a global level are a consequence of rampant materialism. Diminishing resources, increasing levels of pollution, troubles in different parts of the world, global warming etc. are a result of an insatiable demand for material things because nearly all of us have bought into the notion that our humanity is dependent on acquiring every shiny new trinket that comes our way.

Innovation - II

Innovation. A buzzword like no other. Every business seeks to provide innovative products and services. All business gurus harp constantly on the theme. The media, electronic and otherwise, is in love with it. It is touted as the panacea of all (economic) ills. It is often obsessively measured. The number of patents issued in a country is often taken as a proxy for innovation. The questions of how does my country rank in the number of patents it issues and is its rank going up or down is examined in critical detail by business leaders, governments, pundits and others like them. However, we need to take a step back from this love fest and ask ourselves: how much innovation is actually going on? And what does this innovation do for the people?

For all the talk and hype about innovation, most companies have surprisingly little to show for it. Nearly all major companies have a major breakthrough; something that can rightly be said to be innovative at some point. Whether its an innovative product or service, whether its a new way of combing things that are already present, whether its some different method of producing and marketing a product or service, many companies have an aha! moment. Then they go off to sleep. Changes made are at best incremental. Usually they are nonsensical. And that is also when they start screaming loudly at how innovative they are. For example, car manufacturers unveil each year's model with great fanfare. They talk about the innovative new features in this year's model which makes it so much better than last year's model. But examine the car more closely and you will see that the emperor is wearing very few clothes. Why are we not driving around in electric cars? Where have the flying cars gone? Why can't we go from one end of the country to the other on a single tank of gas? Instead, we get a new shape or new headlights or some new power steering technology which feels just like the old one. The media falls over itself touting the "innovative" new features when what we get is essentially old wine in a slightly newer, shinier packaging.

Innovation is generally very hard work with an uncertain payoff. Most managers are conservative by inclination, training and the way they are evaluated. Most consumers are also conservative by nature. People have a very difficult time in imagining, much less articulating something completely new. That is why if they are questioned about what the future will look like five or ten years from now, they will paint a picture that looks very similar to the present. That is also why most companies prefer to rest on their laurels and be rent seekers rather than be continually innovative.

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Moral Hazard

It is a basic axiom of neo-liberal thought that the private sector is inherently superior to the public sector. Not only that, it is more moral than the government. However the private sector, specifically the financial sector, has for the last two decades suffered from the problem of moral hazard. For a long time, it has been accepted amongst economists and business people that government regulation is a form of market distortion. Regulations imposed by fiat lead favor some forms of behavior over others. Instead of the government imposing its will, the private sector should be allowed to self-regulate. This will succeed because any business that acts in a fraudulent or self serving manner will be punished by the market. Consumers will flee from such organizations and competitors will take advantage.

This idea presupposes that not only do consumers have complete access to information they need to make an intelligent, informed decision but they also have the capability to analyze and understand this information. Unfortunately, this is not the case. Producers generally have far greater information than consumers. They also have a very strong incentive to hide relevant information. Many of the products that they sell, specially financial products, are highly complicated and opaque. Indeed financial innovation has introduced products which can literally be understood only by mathematicians and physicists. In such circumstances, firms have a very strong incentive to accentuate the positive and downplay the negative. How then are consumers expected to make informed decisions?

This is the basis of moral hazard. When companies are insulated from the risks of their actions, they have a very strong incentive to behave in a riskier fashion. This has certainly been true of the financial sector. New, innovative products were highly opaque and extremely difficult to understand. These also had a very high element of risk. These were sold to parties that were far less sophisticated and in most cases were in a poor position to take on the associated risk. These products also did not stay confined to the financial sector; they spread rapidly into the industrial sector. By the time the whole house of cards collapsed in 2008, many firms which were (and still are) viewed as industrial ones had become in fact financial firms. Household names like GE and GM derived much of their profits from financial products. In addition, most of these firms were so large that their bankruptcy would have serious repercussions in the wider economy. This was the second leg of the moral hazard problem; companies that were simply too big to be allowed to fail.

This means that managers in these organizations have a strong incentive to take on extraordinary, even foolish risks. The probability of these risk exploding in their face was small and by the time the whole structure collapsed, they were likely to have moved on to greener pastures. Their entire remuneration structure encouraged them on to take these risks. The upside was simply too large to ignore while the downside was limited.

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Demand and Supply

Everyone who studies introductory economics get introduced to the demand and supply curve graph. We may remember nothing about economics but this is definitely remembered. Demand and supply curves are the bedrock of economics and fundamentally underpin the modern capitalist system. Intuitively, these curves make sense; we have a downward sloping demand curve and an upward sloping supply curve. The point where these intersect is a equilibrium. This is the point at which the quantity demanded is exactly matched by quantity supplied. Therefore this is the point at which optimal allocation of scarce resources. These curves help to explain the dynamics of all sorts of products and services.

Makes sense right? Then how does one explain the demand for luxury products? Or for antiques? Or for paintings of the Old Masters? Or for aged wine? Or for financial products? In all these cases, demand increases as its price increases. Some of these cases can be explained through a modification of the demand/supply curves. In the case of the Old Masters and antiques and aged wine, supply cannot increase with demand. So the supply curve is a flat line instead of an upward sloping curve. Increasing scarcity will increase the value of the product. But what about luxury products? Their supply is not finite. It can and does increase as demand increases. Why then does demand increase as their prices go up? Most interesting is the case of financial products. In nearly all of them, increasing demand will result in vastly expanded supply and rapidly increasing prices. This is basically how stock market bubbles form. In both cases, traditional analyses of demand/supply curves will lead to wrong conclusions. A basic failure to understand this was to a certain degree responsible for the financial collapse that the world has been going through since 2008 - a collapse that has affected not just the financial system but the real economy which underpins all of Finance.

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Market Assumptions - Time Lags

Among the many assumptions of perfectly competitive markets, there is one that is largely unspoken. This assumption is that there are no time lags in buyers and sellers entering or exiting the market. This assumption is quite critical because most analysis of this model and its variants has no time lags as a underlying basis. Taking no time lags as a fundamental basis of analysis also supports the other assumptions of this model.

When we assume no time lags, we can talk about instantaneous changes in demand and supply. Whenever there is a change in the supply of a commodity, the demand for it immediately adjusts appropriately and vice-versa. A new equilibrium price is swiftly reached and no extraordinary profits can be made. Some suppliers will swiftly exit or others will swiftly come in depending on the direction of the change. These changes will also be instantly reflected in changes in employment. Labor made redundant in one area is instantly available for other areas.

As a purely theoretical framework, the perfectly competitive model is excellent at understanding the basic forces that operate on different (but not all) commodities. However, problems arise when this model or any variant thereof is made to fit the real world. Take the problem of time lags. In the real world, things do not happen instantly. There is an often significant time lag between a change in demand occurring and companies responding to it. Similarly, there is also often a significant time between a change in supply occurring and companies and consumers responding to it. These time lags allow extra-ordinary profits to be made. They can also have the effect of entrenching existing companies such that new entrants find it harder to compete. Thus time lags can actually enhance entry barriers. Time lags can also result in a mis-allocation of resources. Projects take time to complete. A project can make perfect economic sense when it is proposed, analyzed and started. However, conditions can change almost overnight and a project that made perfect sense suddenly can become a perfect liability. Dubai discovered this when global economic conditions changed for the worse in 2008. All of a sudden, major real estate projects were forced on hold or cancelled. The result was a large number of sad, empty shells standing forlornly. Thus any model that neglects the effects of time lags will result in faulty conclusions being drawn regarding the economy. The actions that are taken as a result of such conclusions will often be worse than taking no action at all.