Steve KelseyThe financial market is designed to fail.
Looked at as a network design our financial markets are optimised for efficiency. Optimising for efficiency in the financial markets is not optional, it is the inevitable result of competitive pressure. Markets that are fast to react capture the early opportunities and transmit their risks through the network, markets networks that are slow to respond lose out on the best trades and end up with all the risk.
Perversely, the efficiency of the financial market and its various sub-networks, which are designed to transmit risk efficiently across the network, are equally efficient at transmitting failure. We see this in operation on our news feeds as falling values roll across the world from exchange to exchange, New York to London to Tokyo responding as one.
The Global Financial Crisis is just the recent example of this effect. Stock market crashes are always fast moving rapidly transmitted events. As the Global Financial Crisis demonstrated, when put under pressure the financial markets fail and need rescuing by a far more resilient network, the real economy.
In their study of the US stockmarket as a network “Network Analysis of the Stock Market” Wenyue Sun, Chuan Tian, Guang Yang, identified the speed and depth of the spread of negative pricing pressure experienced during the GFC.
It is observed that the negative return first started from some famous insurance companies, financial services companies and cyclical consumer goods companies, such as AIG(American International Group Inc), JPM(JPMorgan Chase & Co.), DFS(Discover Financial Services), MER (Merrill Lynch & Co.), C (Citigroup Inc), HD (Homedepot), M(Macy’s) and SHLD(Sears Holdings Corp). The bearish performance then get quickly spread in these sectors. By the time of the end of Jan 2008, stock performances of a lot of department store companies has be- come negative more than -20 % (turning red in the network), such as LOW (Lowe’s), KSS (Kohl’s Corporation), JCP (J C Penny). It further influenced other cyclical consumer goods companies such as HOT (Starwood Hotels & Resorts World- wide Inc),MAS(Masco Corp), and even GE(General Electric Company) because of the limited consumer spending power at the time of credit crisis. By the time of Apr 2008, almost every big company in the financial and cyclical consumer goods sector is in big trouble, resulting in less than -20 % stock performance.
http://snap.stanford.edu/class/cs224w-2015/projects_2015/Network_Analysis_of_the_Stock_Market.pdf
Automation, the use of algorithms to direct trades, has only increased the fragility of the financial networks. High frequency trading utilises the speed of algorithmic trading to make trades that demand high volumes to exploit very small trades that have a limited lifetime. These are trades that are too fast for humans to complete, literally milliseconds or smaller. The increased fragility comes from many Algo-traders operating in the market at the same time and can result in very rapid and large swings in value.
“As an example, on May 6, 2010, the Dow Jones Industrial Average (DJIA) suffered its largest intraday point drop ever, declining 1,000 points and dropping 10% in just 20 minutes before rising again. A government investigation blamed a massive order that triggered a sell-off for the crash.”
https://www.investopedia.com/terms/h/high-frequency-trading.asp
And the systemic problems go even deeper, in fact they are foundational.
Ask Hy Minsky
Rather than ask Sir Melvyn King, the Governor of the Bank of England, why the banks failed in 2008 the Queen would have been better served by asking the economist that did know a crisis was coming. Hyman Minsky was a heterodox economist and he had warned that there were fundamental flaws in the prevailing neoliberal orthodoxy and the economic policies it promoted. In his paper ‘The Financial Instability Hypothesis” http://www.levyinstitute.org/pubs/wp74.pdf published in 1992. ‘Hy’, as he was known by his friends and colleagues, made an outrageous claim.
“The readily observed empirical aspect is that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system’s reactions to a movement of the economy amplify the movement–inflation feeds upon inflation and debt-deflation feeds upon debt-deflation.”
Minsky 1974
According to the orthodoxy, this is deeply heretical. Economies always establish equilibrium. Equilibrium is built into orthodox economic thinking and is a fundamental assumption behind neoliberal economic models. It is therefore no great surprise that Minsky was ignored and, even today, his name is not well known. But no one has ever successfully challenged Minsky’s insight.
Hedge, Speculative, and Ponzi businesses.
It goes like this. Minsky observed there were three layers of business operating in any the modern economy which he called Hedge, Speculative, and Ponzi businesses.
Hedge businesses are businesses that can meet all their financial obligations to pay off loans and the interest on loans by the profit they make. A bit like you and I, we can pay down not just the interest due on our mortgage, car finance and credit cards, but we can also pay down the loans themselves.
Speculative businesses are businesses that can only pay the interest due on the loans they have taken and cannot pay off the loans themselves. In this case the business can function happily by continually replacing its old loans with new loans. It’s as if you and I have loaded up on mansions and Ferraris but providing we can pay the interest on the loans and providing we can find new loans to pay of the old loans we are fine. We will only get into trouble if we miss interest payments and if we can’t replace our existing mortgage with a new one.
The third level of business operation, the Ponzi level, is difficult to get your head around at first. Ponzi financing cannot pay its interest, let alone its loan capital, from its earned income. To meet its obligations to pay just the interest due on its loans, the Ponzi business has two options. Either it can borrow money in order to pay the interest (or its dividends to shareholder’s) or it can sell some of its assets. The bet made by he Ponzi company is that the value of the business will rise over time allowing it to pay the interest, or that it can sell the business to another investor at a high enough price to cover its obligations and make a profit. This only works if the market price for the business is rising over time. But if it is in this happy state, it can attract even more investment and increase its market value even more, so there is no point in selling a rising asset and every reason to extend its ‘successful’ business model. And then the market stops growing…
As is probably obvious, the level of risk to lenders is far higher for a Ponzi business than it is for a Speculative business. The Speculative model has far less risk that the Ponzi model because if all else fails there is a good chance that at least some of the lender’s money can be recovered through the sale of the company’s assets. Your mortgage company is pretty relaxed about you making your payments because, via the contract you signed, if it all goes wrong, it’s got your house.
The Hedge busines doesn’t take money from anyone so its zero risk for an investor. The problem for the investor is there is no market for the investors’ money either.
What Minsky noticed was that businesses have a tendency to drift from the least risky models to the riskiest models over time.
“The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable.
The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system. “
Minsky 1974
This is an inevitable result of competitive pressure.
A busines that borrows more can grow faster than a business that self-finances and therefore becomes bigger over time than the Hedge model business. The bigger business can get better costs from its suppliers, can spend more on non-profit earning activity like marketing and advertising, and its economies of scale mean it can price its product more competitively, all of this competitive advantage increasing its market share. It is not surprising to find that most large businesses operate on the Speculative model. This business model can be stable providing it retains its ability to pay the interest on its loans.
But competition never goes away, and nor does stupidity. If you imagine a market where all businesses are maxing out their performance under the Speculative model the need to increase performance remains. Companies take on more debt than they can service on a bet. The bet is if it takes on more debt that it can pay the interest on today, it can force its growth so that it can pay the interest in the future. This can work well where a business his exposed to the stock market. The accelerated growth the additional finance brings will be recognised by the market and its stock price will rise which brings in the additional money it needs to make its bet come good.
In today’s hyper completive market all large companies are run at or close to the Ponzi model which appears to work while the market is growing but is immediately exposed when the market slows down for any reason.
“In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.”
Minsky 1974
If you are expecting a household analogy of the Ponzi model I am afraid you are going to be disappointed because no household could be run that way.
This is the foundational problem of our modern economic model and why I claim it is designed to fail. It follows that no amount of modification or adaptation to our existing economic model can overcome the systemic flaws that generate instability and chaos in our economy. We need to design something better.