Saturday, March 7, 2009

The Education of a Reporter

To study the properties of sub-atomic particles, physicists use particle accelerators to smash the atoms at high speed. The ensuring destruction creates extreme conditions in which the particles reveal new properties.

The economic/financial destruction brought about by the speculative capital has likewise opened up opportunities to learn economics and finance, if only one is willing to look.

A while back, I wrote that the Financial Times’ Gillian Tett is among the keener observors of the global financial collapse. Recently, writing about the upcoming G20 summit in London where the main agenda is expected to center around containing the crisis, she commented on the difficulties of regulating the markets:
The past decade of frenetic financial innovation and globalisation has created a western banking system where numerous entities are entwined in some unpredictable and near-indefinable ways. Just think of the chain reactions unleashed by Lehman Brothers’ collapse.

Thus, the $64 trillion question now is whether the risks created by this “interconnectivity” can be effectively controlled – without simply banning all entrepreneurial activity or innovation from finance? It is a fiendishly difficult circle to square.
The driver of the “frantic financial innovation and globalization” is of course speculative capital. The “interconnectivity” Tett is referring to is the linkage of markets brought about by the arbitrage activities of speculative capital. Tett knows none of these but she has noticed the tension between regulation and the way markets operate. The financial system cannot be regulated without banning “entrepreneurial” activity and “innovation”, which she vaguely suspects and implies, is something bad.

Let us help this perceptive reporter with the problem, beginning with a clear statement of the case.

1. Capital must expand, not because expansion is “good” but because “expansion of capital is the condition for its preservation.”

2. Expansion of speculative capital takes place through arbitrage. Arbitrage opportunities rise randomly and must be exploited rapidly. Speculative capital is thus nomadic and mobile.

3. Speculative capital is self destructive; it eliminates opportunities that give rise to it.

4. To rein in the self-destructive tendency of speculative capital, its movement must be reined in. That means blocking the expansion of speculative capital and destroying the mechanism of its self-preservation.

So what is to be done? Let speculative capital destroy the markets or suffocate it through regulation? That is Gillian Tett’s $64 trillion question. She calls the problem fiendishly difficult because she realizes there are not good options.

We could eliminate speculative capital. Speculative capital dominates the financial markets in the sense that it imparts the mode and the consequences of its operations to markets, making them appear as markets’ own characteristics. Hence, the increase in volatility, decline in spreads, and the bias towards short-trading horizons that have become the feature of markets across the globe.

Quantitatively, however, speculative capital is a relatively small portion of the mass of finance capital in circulation. It is within the realm of possible to curtail and even eliminate it altogether. That could be done through prohibiting hedge funds, proprietary trading desks of banks, day trading, derivatives, cross-border and cross-market arbitrage – in short, all vehicle through which speculative capital operates.

But as I showed in Vol. 1, the rise of speculative capital is logical and not accidental. The rise in volatility and linkage of markets and products, for example, increase liquidity. The fall in spreads makes financial transactions cheaper. In consequence, the markets become “efficient”, i.e. relatively less costly, to traders and investors. Within the prism of cost-benefit analysis, this efficiency is an incontestable fact. It was constant emphasis on this point – and the chicanery of framing all the issues in the cost-benefit framework – that made hollow men such as Milton Friedman seem to “have a point”.

Returning to our subject, the choices are now more sharply defined. To prevent speculative capital from destroying markets, we can choose to eliminate it. But that would entail returning to the crude days of bygone eras and more costly financial markets. With the profit margins under constant pressure, that is hardly an option.

We have just run into a conceptual wall. The problem, as presented, is insoluble. Both alternatives lead to the same dead end.

The solution lies in the realization that the seeming no-way-out is the result of the development of a contradiction that existed within speculative capital and finance capital since their inception. It is part of their DNA, existing in the latent form and pushed into the surface as a result of the severe financial crisis.

“The limit of capital is capital itself,” Marx wrote. Until recently, few could comprehend this supremely theoretical statement. The statement is cryptic because it contains information that cannot be squeezed into a sentence. It could only be understood if it is arrived at; it cannot be given.

Gillian Tett not only comprehends it but discovers it. For that, we have the current crisis to thank. Not that she ever was a dilettante, but she could not have noticed the contradiction a year ago. That is how educators get educated.

Next, when she realizes that the crisis is not an aberration but a logical consequence of what came before, she will be well on her way to making a bonfire of finance and economic textbooks, the way a fellow blogger of hers recently suggested. That would place her on the course to solve the next and final piece of the mystery, which is the source of the original contradiction.