People's Democracy

The Truth About Finance And Markets

Jayati Ghosh

THIS is not the best of times for those who make a living out of being financial intermediaries. Recent times have seen more than an apparent meltdown in some major financial markets, such as that of the United States. They have also witnessed an unprecedented amount of analysis of how financial markets today actually work, and often devastating exposure of their many flaws. And some of this analysis comes not only from those who are well known to be critical of allowing too much freedom to financial agents, but also from the practitioners themselves.

Thus, several recent books have drawn on the personal experience of the authors to describe and critique the actual workings of different financial markets, especially banking and stock market activity. It turns out that, despite all the talk of "efficient markets", financial markets continue to suffer from most of the imperfections that economic theory described several decades ago. Of these, the many problems relating to asymmetric (or unevenly distributed) information turn out to be the most virulent and create conditions where financial markets are not only prone to frequent failure but are also deeply inequalising.

Two books in particular are worth noting. Philip Augar worked for more than 20 years with two British securities firms as an international investment banker, interacting closely with Wall Street. His fascinating book The Greed Merchants: How the Investment Banks Played the Free Market Game (Penguin Books 2006) is full of all the detailed insights that only an insider could have provided.

George Soros is, if anything, an even more famous finance insider � chairman of a highly successful international investment fund and the acknowledged guru of investors and fund managers across the world. His most recent book is The New Paradigm for Financial Markets: The Credit Crash of 2008 and What it Means (Public Affairs, New York 2008).

INHERENT

FRAGILITY

The extraordinary thing is that both books make remarkably similar points about the inherent fragility, conflict of interest and need for regulation of financial markets. Thus they both contradict quite strongly the prevailing establishment wisdom even in the face of evident crisis.

Augar notes that "inequality lies at the heart of the modern free market." His book focuses on some inadequately discussed features � "the dark corners of recent investment banking history" � that include the very high returns that accrue to a small number of large banks, despite the variable quality of their advice. Augar explains this in terms of the state of competition in the industry, which he sees as highly oligopolistic, and the integrated model of investment banking that gives some large firms a strong competitive edge. In addition, flexible management and "a ruthless approach to customers, competitors and regulations" has allowed a few of the large banks to reap extraordinarily high profits, which are camouflaged to some extent because some part of the profits is shared out as excessively high employee compensation.

A major part of the problem is that banks and other financial institutions now offer more than the standard range of products, such as bank loans, commodities and currency dealings, prime brokerage services, real estate financing and proprietary trading and investment in financial assets. They also tend to offer advice on debt and equity share issues, mergers and acquisitions and financial restructuring; research on equities and equity derivatives, sales and trading for institutional investors (including hedge funds); and the same for bonds and bond derivatives.

This generates huge conflicts of interest between the different functions that investment banks have taken on in recent times. There are conflicts of interest between the investment banks and the regulators, between the financial interests and the media, and so on. And these conflicts are seldom or inadequately regulated. This has enabled a few corporations and individuals not only to exert inordinate influence over both business and government, but also to acquire immense wealth in the process. And this has essentially been at the cost of capital issuers and small investors, including workers who have saved for the future by putting their money into pension funds.

Soros extends such arguments by using his theory of "reflexivity", which is based on the understanding that business decisions are never based on complete knowledge and that these decisions themselves affect the environment which has been taken into account in making them.

The housing bubble in the US, which has led to the current financial problems of major banks, resulted first from such a "reflexive" connection, since the willingness or incentive to lend to less-preferred (or sub-prime) borrowers influenced the value of the collateral (in this case, houses). But, the recent cycle is also different from those from the past, even if not completely unique. This in turn allowed the development of what Soros calls the longer-term super bubble. This was still based on credit creation, even if it involved many more sophisticated financial instruments. This trend gained momentum and continued as long as it did because of the basic misconception that markets are perfect and should be regulated as little as possible themselves. So Soros argues that market fundamentalism (which can be dated to the 1980s) generated the super bubble.

ASYMMETRIC

STRUCTURE

Things get worse because of the moral hazard generated by government policies. Every time the banking system is endangered, or a recession looms, the financial authorities intervene, bailing out the endangered institutions and trying to stimulate the economy. So financial players do not suffer from their own mistakes and are tempted, therefore, to repeat them. All this is made worse by the globalisation of financial markets, the progressive removal of financial regulations and the accelerating pace of financial innovations.

Soros argues that globalisation matters because it has an asymmetric structure. "It favours the United States and the other developed countries at the centre of the financial system and penalises the less-developed economies at the periphery." The resulting unequal relationship between the centre and the periphery has allowed for the flow of capital from the less developed to the developed. This supported the credit financed investment and consumption boom in the centre and played an important role in the development of the super-bubble. For these reasons, Soros advocates a system whereby authorities "keep the market under scrutiny and some degree of control."

But even this may not be enough, if Augar�s arguments about pervasive conflicts of interest are to be believed. These have spread across the system, creating ethical grey areas where anything goes. Media is clearly implicated, especially in building up speculative bubbles through the incessant encouragement to buy. But the role of regulators is no less problematic, since top regulators are usually appointed from among the group of senior bankers, and banks in turn tend to hire former regulators.

So the current shocks in the financial system may well portend losses that hit smaller investors hard, even as the big players manage to retain their highly profitable bottom lines.

As Augar points out in his preface, "If you look hard enough, the games that are being played in American capital markets can be found wherever you live. And if you look hard enough, you will find that you too are paying the price."