Price and Financial Stability

Rethinking Financial Markets

David Harrison

• Publisher: Routledge
• Year: 2018
• Print ISBN: 9781138299146
• eBook ISBN: 9781351579216
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Why are financial prices so much more crisis-prone and unstable than real economy prices? Because they are doing different things. Unlike real economy prices, rooted in the real goods and services produced and exchanged, financial prices attempt to value future income flows from financial and capital assets. These valuations fluctuate erratically because expectations of the future fluctuate – and large liquid financial markets can amplify, rather than correct, these effects. The book builds on the insights of economists Frank Knight and John Maynard Keynes, that uncertainty of the future is essential to understand the processes of economic production and capital investment, and adds to this Karl Popper's general explanation of how expectations of an uncertain future are formed and tested through a trial and error process. Rather than relying on fluctuating financial prices to provide a guide to an uncertain future, it suggests a better approach would be to adopt the methods common to other branches of science, and create testable (falsifiable) theories allowing reasonable predictions to be made. In finance, the elements of one such theory could be based on the concept of forecasting yield from capital assets, which is a measurable phenomenon tending towards aggregate and long-term stability, and where there is a plentiful supply of historic data. By methods like this, financial economics could become a branch of science like any other. To buttress this approach, the widely accepted public policy objective of promoting real economy price stability could be widened to include financial price stability.

11 A brief history of our time

The political economy of the global financial order has come under intense scrutiny since the 2008 financial crisis. Opinions are divided. On the one hand, since the collapse of communism few still seriously doubt that the market economy in some sense “works”, and that Adam Smith’s division of labour is a better route to prosperity than anything else available. On the other hand, few doubt that the financial system in some sense does not. And when it is explained that the last financial crisis was not unique, but merely the latest and the largest of a series of unfortunate events, anxieties understandably multiply.

This book will look into the disjunction more deeply. Why is it that the market economy can process countless transactions over many decades involving real, every-day goods and services without blowing up, and increase the wealth and wellbeing of the nations which participate; and yet the same or very similar processes, when applied in the realm of finance, end up not adding to but subtracting from this same wealth of nations, with periodic crises?

Common to both the market economy and the financial system is the price mechanism, whereby participants buy and sell both normal goods and services and also financial assets. It seems, at first sight, as if prices must mean the same thing in both cases. And yet, this may be something of an optical illusion. Prices in the real economy are rooted in the real goods and services exchanged, passing from producers and sellers to buyers and distributors on their way to final consumers. Prices usually have a close link to costs, and there is generally a mark-up, or margin, over cost as items pass from hand to hand. Similar goods or services can be compared for value for money.

But prices in finance are not performing exactly the same function. In finance, millions of titles, or claims in the form of securities, pass from hand to hand, very often in large organised international financial markets, but the price of a transaction of this kind reflects more of an anticipation or estimate of the value of something else represented, such as an underlying asset. There is no relationship to costs, and in fact nothing is produced which can be costed: securities are really claims on streams of income from existing real items (like factories, or companies, or the debt of countries); or else they are claims on such claims (like derivatives).

Real economy prices are relatively stable, and do not normally oscillate wildly around central values. In recent decades, inflation, measured in terms of real 2economy prices, has been subdued in most of the developed world, with near price stability becoming the norm. But in finance, prices are, as a matter of course, much more unstable, whether we are looking at stock prices, currency values or derivatives based on financial values. Stock markets boom and crash in ways totally unlike markets for cars, or furniture, or computers.

It was the American economist Hyman Minsky who explained there are actually two completely different price systems in the market economy: there is one price system for the current output of current goods and services and the need to recover costs; and then there is a second price system for the values placed upon future income flows from outstanding financial and capital assets.

It is the instability of this second price system, valuing income flows from financial and capital assets, which is the heart of the matter, and the subject of this book. And when we look into it, this question turns out to be of more than just narrow economic interest. It is a basic question of political economy, touching on the organisation of our society, the very nature of knowledge and how we should best deal with a future that is always uncertain.

The open political societies we value are clearly suited to much in the modern world, including the exchange economy where there is trade in goods and services, nationally and internationally. Yet these societies, no matter how open and advanced, have still been buffeted by financial crises as seemingly blind and inexplicable as the Furies of antiquity, leaving winners and losers in their wake. Is this something inevitable that can only be endured, like the weather, or can improvements be made? Can this modern world be made more stable?

To help answer these questions, and to see the scale of the issues at stake, we need to look at how finance came to diverge from the real economy, when a shift took place several decades ago in the developed world, with the ending in the early 1970s of the post-war Bretton Woods global monetary and financial system.

An entire book could be written on the full geopolitical and economic consequences. In many respects, the world we live in now was set by a seemingly technical decision to break the link between gold and the dollar, taken in 1971 by US President Nixon with the aim of winning a second term in office. Until that date, and since the end of the Second World War, the gold price had been fixed in dollars at US$35 per ounce, and under the rules of the Bretton Woods system other currencies’ exchange rates had been fixed to the dollar. (The precise gold/dollar rate predated the war, having been set by Roosevelt as long ago as 1934.)

The untying in 1971 of the world’s monetary and financial system from a secure anchor led waves of instability to wash progressively through the world’s economy, over the decades leaving hardly any political or economic order unshaken. Price signals became erratic and unreliable. Currencies shifted against other currencies. Commodity values (including that of gold) went up and down like yo-yos. Oil prices quadrupled, causing the disease of inflation to grip normal goods and services, until cured by a bout of extraordinarily high interest rates. The prices of capital assets – and financial prices generally – became detached from underlying economic reality, and instead became almost magnetically attached to each 3other. And no fewer than four waves of large scale international crises ensued, each one preceded by a credit bubble involving serious mispricing of financial and capital assets.¹

Before we go on to look at the underlying and deeper causes, a brief review of what has happened in the decades since 1971 will illustrate the scale of events, in political and economic terms.

From gold to lead, and crisis to crisis: the 1970s

When the link between gold and the dollar was broken in 1971, there was an immediate impact on the price of oil, an essential ingredient in the world economy. It resulted in a sharp 70% decrease over the next two years in the price, when expressed in gold, received by oil-producing member countries of OPEC. This reduction in the gold value of oil they offset by a threefold increase in the dollar price in 1973, through the Arab oil embargo. Oil, a commodity whose price had remained relatively stable in the entire post-war period, now became volatile. By the end of the 1970s, a barrel of oil, when expressed in gold, had returned to not far off its price at the beginning of the decade: but it had increased by more than 800% when expressed in dollars.² To this day, volatility in oil and other basic commodity prices is quite normal.

The massive oil price hike (in dollars) ushered in the leaden economic years of the 1970s, in the US and Europe. Inflation, high unemployment and low growth took hold. The long post-war period of high growth and low inflation was over. Political instability grew. In the US, the near bankruptcy of the city of New York symbolised the chaotic economic backdrop. In the UK, the government, faced with industrial turmoil, called a general election on the question of “Who Rules Britain?” – and lost. Across Europe, political institutions were shaken by extremism and terrorist violence.

The increase in the dollar price of oil had the side-effect of greatly increasing the volume of dollars held by oil-producing countries, including dollars held in the accounts of large (mostly US) international commercial banks, operating in the offshore euro-dollar market. These large international commercial banks then recycled their dollar inflows (“petro-dollars”) into new forms of lending, in particular to less developed countries without oil reserves.

In the course of the 1970s, commercial bank loans to governments and government-owned firms in Mexico, Brazil, Argentina and other developing countries grew at a rate of about 30% a year, and their external indebtedness increased by about 20% a year. This became the first major international credit bubble of the post-Bretton Woods era.

The 1980s

The build-up in private credit came to a halt in 1982, after US interest rates had risen in 1981 to 20% to combat domestic inflation and Mexico declared it could no longer service its debts. The flow of inward commercial bank credit stopped, 4there was a reversal in flows, and a serious Latin American debt crisis ensued, lasting for about a decade into the 1980s (a “lost decade”).

The 1981 US interest rate rise epitomised counter-inflationary measures adopted throughout the developed world after the inflationary 1970s. The UK experimented with three different types of controls: first a prices and incomes policy; then domestic monetary targets; and then an exchange rate anchor. In the European Community the European Monetary System, launched in 1979, largely succeeded in re-establishing an island of comparative internal exchange rate stability over the next decade. Exchange rate realignments became less frequent and inflationary pressures were cooled by the alignment of monetary policies in Europe on those of the German Bundesbank, committed by law to a policy of safeguarding the currency.

As capital controls were lifted on the ending of the Bretton Woods system, financial innovation took off. In the first decade estimated daily turnover on the foreign exchange markets grew to become 50 times that on the New York Stock Exchange, in dollar value. Notwithstanding this (or perhaps because of it) currency fluctuation persisted globally. The dollar fell by 56% against the German mark in the period 1968 to 1979; rose by 81% between 1979 and 1984; fell by 49% between 1984 and 1987; and rose by 12% between 1987 and 1988.³

The low growth and high debt of the 1970s affected not only the developed world, and market economies. At the beginning of the 1970s the Soviet Union was still seen by some as a candidate to overtake the United States economically,⁴ but as the 1980s drew on it too came under severe strain, with economic stagnation and mounting hard currency commercial debts in several Soviet bloc countries (Poland, Hungary and East Germany), as well as the Soviet Union itself. When Gorbachev arrived in power in Moscow in 1985 it was with a policy of restructuring the failing Soviet economy (through “perestroika”) not abolishing it. However, the attempts at reform, involving the introduction of market measures into the command economy, led to political liberalisation and the eventual secession from the communist system by Soviet bloc countries, and finally the dismantling of the Soviet Union itself.⁵

Nor was all well in the market economies, even as communism collapsed. In the UK, liberalisation of the financial markets in 1986 (“Big Bang”) preceded a major global stock market...

Table of contents

• Cover
• Title Page
• Copyright Page
• Contents
• Preface
• 1 A brief history of our time
• 2 Expectations, knowledge and prices
• 3 Beyond price
• 4 Savings, investment and liquidity
• 5 Models, theories and apples
• 6 Policy implications – finance
• 7 Competition policy
• 8 A new European capital market
• 9 Geopolitics
• Technical annex: Do we really need a new Bretton Woods?
• Index