Financiers and economists readily acknowledge that some market activity is simply gambling and should be eliminated. But what part of capitalism can be described as a “casino”? The popular but narrow view is that some derivatives are undisguised gambling. If this were the extent of the casino, then for capitalism to return to health we would simply need to identify and ban or regulate what American economist Robert Reich calls Wall Street’s tricks: “Derivatives, derivatives of derivatives, fancy-dance trading schemes, high risk bets” 1, alternatively described by Warren Buffett as “financial weapons of mass destruction” devised by “madmen” 2.The wide view of capitalism’s “casino” includes whole components of the financial economy.
In his book Debunking Economics (2001), Australian economist Steve Keen called the stock market “capitalism’s chief casino” 3. John Maynard Keynes also took the broad view. In 1936, before exotic derivatives existed, he identified even the prosaic activities of the stock market as an inherent problem. He likened share trading to a beauty contest aimed at predicting popular favourites: “We devote our intelligences to anticipating what average opinion expects the average opinion to be.” 4
In his book of 1954, The Great Crash, 1929, J. K. Galbraith observed that “…. the market came to be seen less and less as a long-run register of corporate prospects and more and more a product of manipulative artifice” 5. He described “New Era Finance” as a game aimed at raising prices, not assets, with financial trusts often being worth twice as much on paper as their quantifiable asset value.
In January 2009, British economist John Kay used the casino metaphor. “We have created a monster that is out of control … The modern financial services industry is a casino attached to a utility… In the casino, traders make profits from arbitrage and short-term price movements. The users of the utility look to fundamental values. The occupants of the casino are preoccupied with the mind of the market.” 6
In October 2009, when the Governor of the Bank of England proposed the separation of utility banking from market activity and declared the regulation solution a delusion because it fails to eliminate the risk of market activity contaminating utility banking, he did not use the word “casino” to describe market activity 7 – but BBC and Daily Telegraph reports 8 on his speech did.
If the entire financial economy is a casino then the ultimate economic challenge is to eliminate it from western capitalism without reducing economic freedom and without introducing authoritarian government control.
It also means that “ethical capitalism” is an oxymoron when the term is applied to any transactions, including so-called “ethical investments” which are made using the financial markets.
In a broadcast discussion about the Bank of England proposal to separate the “casino stuff” from “regular utility banking”, Oxford Professor of Economics David Vines made the refreshingly honest admission that he hadn’t spotted the casino problem earlier because he “just didn’t understand enough about the financial system” 9. This gets to the heart of things.
Primary and secondary markets
Championing both primary and secondary markets under the umbrella of “free markets” legitimises financial markets and allows them to escape philosophical scrutiny. But financial markets are different from Adam Smith’s primary markets of butchers, bakers and brewers in which traded goods have a utility other than forecast profitability. Financial markets are derived from the primary economy but are one step removed. The stock market is itself a derivative of the real economy.
Financial markets are based on primary markets. They form what I call a “meta-economy” which produces no goods.
Once out in the market place, shares issued by a company to raise capital are endlessly re-traded, unlimited by time or ceiling price without producing profit for that company. This is very different from the company’s profit-making trade.
The danger of a powerful meta-economy is highlighted by Satayjit Das, former derivatives trader and author of Traders, Guns and Money. He blames Iceland’s bankruptcy on the overpowering of the real economy by the financial economy:
“It shows that overreaching ambition in what we call the ‘new global market and financial economy’ is sometimes a very, very dangerous thing which can’t be sustained in the lack of a real economy. Essentially real businesses are necessary… There were really no goods and services being made.” 10
In 1997, George Soros also warned of the dangers of the domination of the meta-economy. He feared that “the untrammelled intensification oflaissez-faire capitalism” 11 had made the main enemy of the open society no longer the communist but the capitalist threat. He described the model that has taken hold in Russia as “robber capitalism”. 12
History helps explain how we got into this mess. The sub-prime mortgage crisis was the trigger for the current financial crisis but its origin can be traced back to a decision made by the East India Trading Company 400 years ago [see box insert, right]. History also provides case studies illustrating the dangers of accepting this long-established system.
1929: the meta-economy’s failure as a barometer of economic health
Before the 1929 Crash, it was widely believed that secondary markets were predictable barometers of economic health. On 15 October, 1929, Charles E. Mitchell, Chairman of National City Bank (now Citibank) announced, “The industrial condition of the United States is absolutely sound… The markets generally are now in a healthy condition…Values have a sound basis in the general prosperity of our country.” 13
That same day, respected Yale economist Professor Irving Fisher made his immortal statement: “Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a 50 or 60 point break below present levels… I expect to see the stock market a good deal higher than it is today within a few months.” 14
Nine days later, the Stock Market crashed, falling 92 points in two days.
This wasn’t a scam with the experts deliberately misleading the market; they really didn’t know what was coming. Irving Fisher lost not just prestige but over $100 million in today’s dollars.
Was a lesson learnt?
In The Great Crash, 1929, Galbraith notes what happened when stock market cynicism set in: “In the latter years of the Depression it was important to continue emphasizing the unimportance of the stock market.” 15 Influential people explained that the stock market was “merely the froth and that the real substance of economic life rested in production, employment and spending, all of which would remain unaffected”. 16
Unfortunately too much real money from the primary economy had been lost in the froth for this to be true. Expert opinion had lost its credibility so attempts to re-position the stock market, sincere or not, was disregarded. In the subsequent post-War expansion, any dour philosophical analysis of the relationship between primary and secondary markets was lost in the exuberance.
How wrong do things have to go before we question the system?
The power of markets to establish a fair price may work well in the real economy but market rationalism is now acquiring the rider that “markets inevitably have boom-bust cycles” when the principles are applied to the financial meta-economy. Investors who bought shares at their peak in 1928 had to wait until 1955 to recoup their investments. A 27 year “correction” is somewhat large to accept as healthy market rationalisation.
Western blindness to any alternatives to the system established 400 years ago by the East India Trading Company has us searching for excuses for the system’s inherent flaws.
The financial economy is no index of primary economic health
Like Charles Mitchell and Irving Fisher, former Federal Reserve Chairman Alan Greenspan failed to consider the possibility that financial markets did not truly reflect the health of the real economy. He blamed the collapse of the primary economy on bad judgement by high flyers in the financial meta-economy: “It’s not that they weren’t aware the risks were there. It’s not that these people were dumb. They knew precisely what was going on. The vast majority of them thought that they knew when to get out. It was a failure of our best and our brightest.” 17
Advising players when to “get out” only tells them how to win money from the meta-economy and become rich in real money terms, not just on paper. It tells us nothing about how to develop the primary economy or save it from collapse.
Canadian economist Jim Stanford, author of Economics for Everyone(2008), explains why the paper economy of the finance sector is “irrelevant” 18 to the primary economy but Greenspan continues to use the financial market as an economic determinant. In a television interview in October 2009 he predicted the US economy would slow in 2010 as the surge in stocks came to an end. “The odds are we flatten out,” he said, referring to the equity market. “That flattening out will put some sort of dull face on 2010.” 19 This may happen but the logic is flawed. The success of stocks doesn’t drive production in the real economy. In continuing to relate apples to oranges, it is only a matter of time until forecasts made on this basis wildly miss the mark once more.
With a life of their own, share prices cannot be expected to reflect the status of the real economy. Increased profit in the primary economy will cause rises in related company shares but increased share prices do not increase company profits. The causal relationship does not work both ways. Share prices can move independently of the primary economy, reflecting sentiment alone.
A rise in the price of nickel pushes up the price of shares in a nickel mining company. If this then attracts sufficient buyers to take on a life of its own, the price of nickel company shares can soar independent of the primary market. Share prices rise on the basis of scarcity of popular nickel shares, not directly on the scarcity of nickel. The demand for nickel shares does not increase demand for nickel. Exuberance over the nickel share price is just that; it holds no meaning for nickel production or output.
A company’s share price has no direct relationship to its Book Value, the raw value of the price per share of a company’s assets minus its liabilities. It’s what shareholders would get if the company went bankrupt. Book Value is quantifiable and publicly available but it is rejected as meaningless by financiers because it doesn’t reflect the “market value” of assets and liabilities. But what is market value based on? Nobody can be certain; the market is the result of our collective aspirations. It makes no calculation and cannot be interviewed.
When Rio Tinto was trading at $120 in 2008, its Book Value was around $17. There is no definitive explanation for the difference. It could represent speculative hysteria and the effect of the limited supply and high demand for their shares; intangibles like “business confidence”; the estimated price that a rival company could be expected to pay in a take-over; predicted future prices of commodities mined or a guess at the magnitude of resources still in the ground even though these must be exploited over time and do not represent a lump sum bonus on current prices. Financiers insist that these intangibles and estimates with their attempts to take the future into account are a reasonable basis for establishing value but spectacular crashes like that of Poseidon nickel mining company show that companies are not always rationally valued by the market.
The annual dividend or share yield is also quantifiable but is disregarded by traders when high share prices mean that the dividend percentage return is low. Shares are then bought for their expected capital gain and this produces a conundrum: the share price has no basis in reality if the quantifiable capital value of a company does not determine share prices.
This is no obstacle for quantitative finance which models the prices of and demand for shares. It makes no attempt to substantiate financial market prices on the basis of primary economic reality but attempts to predict price movements using the mathematics of random systems to account for maverick human variables. Modelling prices in speculative markets is as difficult as it is pointless to the productive economy.
Any formula used to evaluate company performance which includes share price as a variable simply feeds back into the equation a number based on sentiment, not an independent measure of value. This “reflexive interaction” is why George Soros, despite the fortune he admits making on financial markets, believes they are “inherently unstable.” 20
Every asset price crash from the South Sea Bubble to the Dotcom crash and Global Financial Crisis has proved that share prices do not reflect the health or assets of a company or economy nor predict future success. Although one can’t argue with the price somebody is prepared to pay in a market, it may be difficult to substantiate. How value is best determined has always been the economic chestnut and divides economists into those who lean to the left or to the right.
Economists are now breaking rank, criticising approaches taken by others in their field. Quantitative approaches to economics are coming in for considerable criticism. British economist Paul Ormerod, author of The Death of Economics (1993) and Why Most Things Fail (2005) criticises the 1600 British government economists who produce “ridiculous calculations…figures which simply bamboozle ministers and obfuscate the democratic process” and which didn’t allow any of them to see the crisis coming. 21 Nobel Prize-winning economist Paul Krugman asserted in theNew York Times that economists have mistaken the beauty of mathematics for truth and ignored the limitations of human rationality and the imperfections of markets, “especially financial markets”. 22
The possibility of human irrationality is a surprising omission from economic theory. Irrationality goes part way in explaining the independent behaviour of financial markets in relation to the primary economy. Economists have ignored this at their peril.
Olivier Blanchard, Director of the Economic Research Department of the IMF and specialist in the nature of speculative bubbles, outlined developments in economic modelling in a February 2000 paper entitled: “What do we know about macroeconomics that Fisher and Wicksell didn’t?” The first line in the abstract is: “The answer to the question in the title is: a lot.” He outlined enough developments in academic modelling to give the impression that economic shocks were a thing of the past. Unfortunately for him, his later MIT paper, “The state of macro” in which he confidently wrote: “The state of macroeconomics is good” was published in August 2008, three weeks before the economic collapse.
With share prices again rising above Book Value and dividends often lower than bank interest, it makes Ben Bernanke’s comments after his 16 November 2009 speech to the Economic Club sound ominously like Mitchell and Fisher in 1929: “I see no inflationary threat on the horizon” and “It is inherently extraordinarily difficult to know whether an asset’s price is in line with its fundamental value. It’s not obvious to me, in any case, that there’s any large misalignment currently in the US financial system”.
Causes and cures: smoke screens of blame
If we accept that vested interests make financial markets too entrenched to eliminate, something must change in order to prevent future crises. Again, economists don’t agree on what changes will do the job, so it is possible that none will.
Greed? Alan Greenspan blames the crisis on greed but ridicules the idea of controlling it through legislation. 23 Blaming greed is ideal for supporters of the status quo. Capitalism grants the freedom to be greedy. If failures of capitalism can be blamed on greed which can’t be controlled, regulators are exonerated and change is avoided.
Cheap credit? Easy access to cheap credit has been blamed for causing various speculative bubbles. J.K. Galbraith debunks this in The Great Crash, 1929. “Nothing could be further from the truth. There were times before and there have been long periods since when credit was plentiful and cheap – far cheaper than in 1929 – and when speculation was negligible.” 24 He nominates sentiment as the cause of speculation: “Far more important than rate of interest and the supply of credit is the mood. Speculation on a large scale requires a pervasive sense of confidence and optimism and conviction that ordinary people were meant to be rich.” 25
The same pervasive mood was palpable from 2004 until 2008. Unfortunately, speculation, like greed, is identified by motive rather than action. Not all short term trades are speculative; unforeseen circumstances may necessitate an early sale and some long term trades are speculative with price increases being slower than forecast. Motives cannot be controlled by legislation. Speculation is as inevitable as greed and impossible to control without restricting economic freedom.
The trading day? Economists like Keynes have recommended reducing the length of the trading day or limiting the market to one auction per day to reduce speculation. This might reduce all trading but the proportion of speculative trades has no reason to change.
Fraud? High profile cases helped give the impression that fraud caused the present global financial crisis. Unfortunately regulations don’t prevent fraud; they simply define it to allow subsequent prosecution.
The repeal of the Glass Steagall Act? The repeal of this act in the USA has been blamed for causing the crisis. The Act protected savings held in local banks but did not eliminate speculation or risky financial deals nor prevent retirement, health or government funds from being “invested” in the meta-economy via investment banks. The original investment banks that backed the Edison General Electric Company in electrifying the US in the 1880’s were very different from 20th century institutions that specialise in clever financial deals producing profit not products. If these remain available to health or retirement funds, member’s contributions remain at risk regardless of legislative Acts that protect main street banks.
Derivatives? These have taken an unfair portion of the blame because they clearly involve guesswork but primary economy derivatives serve a productive purpose. Pre-selling crops at an agreed price before planting gives financial certainty to buyers and sellers, aiding business planning. The concept of a derivative is not an inherent problem. It is the re-trading of these and other artificial constructs in the meta-economy that produces Buffett’s “time bombs”. No meta-economy, no time bomb.
Ratings agencies? These have not remained independent and some under-researched opinions may have been negligent but they have never claimed to be investor advocates, or to provide oversight or commercial credit ratings. They only provide an opinion on relative credit risk within and across sectors. This is why they are able to rate exotic derivatives that are almost impossible to value. That they may provide anything more, including guaranteeing market prices, is the wishful thinking of their users. There is a call for the ratings agencies to be liable for their opinions. This sounds reasonable but ratings agencies cannot be held responsible for “normal” cycles of the sentiment-based meta-economy in which junk bonds and blue chip companies are all caught. Cleaning up ratings agencies is useful but will not eliminate the extreme cycles that are normal in the perfect speculative vehicle of the meta-economy.
Regulation? The conventional panacea faces a conundrum. Market rationalism accepts cycles with considerable variation as normal market behaviour. If cyclical extremes are due to greed and speculation which are uncontrollable without restrictive, authoritarian government, then regulation is ultimately impotent or inappropriate in a democracy.
The real problem
In short, treating the symptoms of a sick meta-economy offers no “cure” for repeated crises. The structure that supports the meta-economy is the problem to be cured.
When the East India Company opened Pandora’s Box, financiers learned how to operate the tricks inside to best advantage and economists made textbook assumptions to explain how they worked and related to our daily lives. Government attention has focussed on controlling the contents, whatever they were, to render them benign. Pandora’s Box has always been left open and simply accepted, making financial capitalism the prevailing model. The Stock Exchange is a well-established and respected institution. This makes it a vested interest but doesn’t make it necessary.
President Obama’s intervention aims to shield consumers, tighten securitisation markets and monitor systemic risk. But it does not challenge capitalism’s structure. He has asked: “How can we control the system better?” There is a more fundamental question: is what suited the East India Trading Company in 1602 the best way of utilising spare funds for economic development in the 21st century?
If capitalism had been “designed”, would financial markets predominate?
Modern capitalist economies with their hallmark financial markets were not set up after careful examination of goals, checks and balances and enshrined in law as the best way of relating a community’s excess funds to productive enterprises in a free market economy. Financial markets were the creation of powerful market participants, evolving as players sought to improve their lot.
If the structure of capitalism had been established after legal scrutiny, financial markets may not even have been legal.
Re-selling concert tickets bought from a box office is a secondary market operation similar to re-selling shares bought in a company issue. Concert tickets are bought by speculators with the expectation that someone will pay more for them later. This has been declared illegal in the UK, Australia and most American states. Shares are bought by speculators for the same reason in a similar process with impunity.
With share ownership traded in any quantity, quickly and cheaply, the financial economy is ideal for speculation. Value is determined by the psychology of sentiment rather than economic principles. If minimising speculation had rated equally with economic freedom as a goal of “designed capitalism”, markets ideally suited to speculation would have been discouraged.
Financial market capitalism makes no requirement regarding productivity. If it was valued as much as freedom, speculation would have been discouraged in designed capitalism and unproductive financial markets would have been peripheral.
Can we change to a better capitalist model?
Conventional wisdom considers it impossible to change the structure of capitalism. Alan Greenspan insists that greed-induced crashes are an uncontrollable and inevitable side-effect of the free market system and blames any failures on human nature “…because there is no doubt that somewhere in the future we’re going to have this thing again. It will not be for quite a period of time, but it will occur because the flaws in human nature are such that it doesn’t work…” 26
If the current structure of free market capitalism really was the only alternative to communism, this pessimism would be understandable. But the economy is an artificial construct. Capitalism’s current structure isn’t necessarily “right” and there is no compulsion to accept it without change.
Capitalism has never been forced into a formal, legal structure designed with checks and balances. This would be an infringement of economic freedom and is why calls to ban the Stock Exchange made since the eighteenth century are impotent. The financial market infrastructure now involves the entire population of western democracies so it really is “too big to fail”. This doesn’t mean we must abandon all hope of change.
Contemporary western capitalism is so committed to its current structure that alternative models seem non-existent. But there is no need to all be Keynesians now it has failed. The alternative doesn’t have to be something on the socialist/communist spectrum; capitalism can take different forms.
Dutch “Golden era” merchant capitalism may have been simple and slow but it was stable. Islamic economics limits the financial meta-economy, prohibiting most complicated financial instruments and screening out over-leveraged corporations, which keeps investment closer to the primary economy. It should be no surprise that Islamic enterprises are buying large land tracts in third world countries or that this may prove more successful than the western preference for finessing financial regulation.
The ethical investment movement is attracting considerable attention. Al Gore’s funds management firm is producing surprisingly good returns using the economics of sustainability. He boasts of using various social, environmental, governance and long-term economic criteria beyond rejecting investment in tobacco, sweat shop labour, alcohol and gambling. This may extend socially responsible investing but it still uses the “casino” of the financial meta-economy, remaining only superficially ethical.
As long as it operates within the meta-economy of financial capitalism, the ethical movement will provide capitalism merely with diversity rather than a change of direction. The ethical investment movement can lead the next stage in the evolution of capitalism only if it bypasses the casino operations of the meta-economy.
How to take the casino out of capitalism
If ethical investments took the form of a term deposit or bond they could be separated from the casino. In this form dividends or interest would be paid at set intervals and, on the expiry date, the face value of the term deposit or bond would be re-paid by the company to the investor. New issues would occur regularly as previous issues mature. Funds would go directly to the company to develop their business. Risky ventures would still be expected to earn high returns but so would the most productive and innovative ventures. This is the sort of framework investors should have set up in the 17th century as an alternative to the trading arrangements supported by speculators.
Certifying an ethical movement that includes this investment format would formalise an alternative to speculation-prone trading. Investments tied to the financial economy would also be prevented from assuming superficial ethical credentials to cash in on a trend. Certification could include a new rating category aimed at giving ordinary investors what they want (or thought they had) from credit ratings agencies: investment advocacy resulting from an independent analysis of businesses against clear criteria.
Re-trading new-style ethical bonds need not be restricted. Maturity dates would make secondary trade self-limiting, rather like the sale of leasehold real estate where the price is high at the beginning of the lease period and dwindles when the known end date is imminent.
If certified, bond-style ethical investments were widely available, a grass roots ethical movement may see financial capitalism evolve into ethical capitalism with no more impetus than some good PR. New ventures or specific new investments in existing companies may take this form. This is not necessarily naïve; who would have predicted the success of Wikipedia or that the Berlin Wall would be demolished by ordinary people? If Al Gore’s fund is a reliable model, ethical investments make good economic sense and attract popular support. With a more rigorous definition and investment structure they are well placed to evolve as a significant economic alternative.
How to accelerate the evolution of Ethical Capitalism
To add impetus to the evolution of a new capitalist framework that favours investors over speculators, a single change to the existing structure would be effective.
If investments traded within the meta-economy required the express authorisation of individual contributors, the impact would be dramatic. The consent of a majority of taxpayers or contributors to health funds following the full disclosure of their investment’s nature and risk is not an unreasonable requirement. Certified ethical bond-style investments which are not traded in the meta-economy are a primary market activity and would be excluded.
It is unlikely that authorisation would consistently be granted by fund members or taxpayers for all proposed financial market activity. This public money would remain in the primary, ethical investment market.
Nothing else need be done to define a new form of capitalism.
Would Ethical Capitalism limit economic freedom?
In order to meet the criteria of the various Indices of Economic Freedom no existing freedoms need be rescinded in the evolution from Financial to Ethical Capitalism. All re-trading including short selling and trade in CDO’s could remain unchanged and legal. With express authorisation, an individual’s retirement funds could still be placed in secondary markets. Only fraud would be illegal and the human frailty of greed-induced speculation would be accepted as an unfortunate reality. Capitalism’s fundamental premise, the right to complete economic freedom, would remain paramount.
Even in a system accelerated by the requirement of consent by fund contributors, all that would be limited would be vicarious ”investment” in the meta-economy without express majority consent. It could even be argued that this increases individual economic freedom.
Greenspan’s “best and brightest” probably wouldn’t like playing with substantially reduced funds and without long-term investors to arbitrage against but they would retain their economic freedom. The secondary, “casino” market could be expected to wane. Dubious and risky business done under the guise of financial sophistication from Galbraith’s “gargantuan insanity” of leveraged trusts in 1928 to Mike Milken’s junk bonds in the 1980s and contemporary structured investment vehicles would never be central to free primary market capitalism.
“Ethical Capitalism” is only an oxymoron when it refers to trading socially responsible, green investments in the “casino” of the financial markets.
By separating genuine direct investment from the financial markets and causing the meta-economy to devolve into a speculator’s paradise which reluctant investors could avoid, more real money would remain in the real economy producing real goods and services. Production, not secondary market trade would dictate the world’s financial future. Output statistics and levels of household debt would replace stock market reports tracked daily as key economic indicators.
The creation and development of complex financial markets in a meta-economy may have been clever but it was not necessarily progress. Changing the status of financial markets could make capitalism respectable rather than a potential end-game.
Ethical Capitalism may be an oxymoron at present but it doesn’t have to remain so.
C.R.Macaulay, 21 March 2010
1. Robert Reich’s Blog, Sunday, 13 September 2009.
2. Warren Buffett, Letter to Shareholders of Berkshire Hathaway 2002.
3. Steve Keen, Debunking Economics, 2001, p.256.
4. J.M. Keynes, The General Theory of Employment, Interest and Money, 1936.
5. J.K. Galbraith, The Great Crash, 1929, 1954, p.104.
6. John Kay, “Lessons from Loss”, Sunday Herald [Scotland], 11 January 2009.
7. Speech by Mervyn King Governor of the Bank of England to Scottish business organisations, Edinburgh, Tuesday 20 October 2009.
8. “Governor warns bank split needed”, Stephanie Flanders BBC Economics Editor, BBC News.“King’s diagnosis of banking problem is correct, but his prescription is flawed,” Tracy Corrigan, Daily Telegraph, 21 October 2009.
9. ABC Radio National, PM, interview with Stephen Long, 5 November 2009.
10. ABC Radio National, Late Night Live, interview with Philip Adam, 10 November 2008.
11. George Soros, “The Capitalist Threat”, The Atlantic Monthly, February 1997.
13. J.K. Galbraith, op.cit., p.116
14. ibid., p.95, p.116
15. ibid., p.112.
17. CNBC “House of Cards” interview with David Faber, 14 February 2009.
18. Jim Stanford, “Beyond the Crisis”, power point presentation, Australian lecture, August 2009.
19. Bloomberg television interview, 30 September 2009.
20. George Soros, “The Capitalist Threat”, The Atlantic Monthly, February 1997.
21. Paul Ormerod on ABC Counterpoint, 16 March 2010 discussing Be Bold for Growth, by Paul Diggle and Paul Ormerod p.6, Centre for Policy Studies, 1 March 10.
22. Paul Krugman, “How did Economists Get it so Wrong?” New York Times, 2 September 2009.
23. CNBC “House of Cards” interview with David Faber, 14 February 2009.
24. J.K. Galbraith, op.cit., p.39.
25. ibid., p.187.
26. CNBC “House of Cards” interview with David Faber, 14 February 2009.
A Postscript: How the East India Trading Company caused the Global Financial Crisis
Far from being formally established by an independent body seeking to protect all parties involved, financial market capitalism began in 1602 when directors of the Dutch East India Company decreed that they would not buy back shares sold to raise capital. This was an audacious proposal. They would borrow capital from investors but never pay it back, committing instead only to the payment of an annual dividend should there be profits to share. The first stock market was established to trade their stocks and bonds. If investors wanted to retrieve their capital, they could sell their stocks there. This was not intended to be a model for 21st century capitalism. It was simply the result of a single 17th century company’s risk assessment and their “take it or leave it” attitude. In an age of prosperity, it worked. Observing the rapid accumulation of wealth by share owners and traders, entrepreneurs of other nations chose to follow this system and the slow path to merchant capitalism prosperity was abandoned.
As financial market capitalism evolved, innovation prevailed and scrutiny was retrospective. It didn’t take long for self-interested profit-seekers in Britain in the late 17thcentury to see the opportunity that re-selling securities on the secondary market offered. Speculative opportunities had previously been limited; this new market provided plenty. New government bonds were more reliable than bank deposits and more easily re-sold than real estate.
Business began slowly. Brokers worked part-time, matching a few buyers and sellers at an agreed price. By 1700 some people were earning a living as traders, buying securities in the expectation that they could be sold on for a profit. They became “jobbers”, middlemen who created a continuous market of buying and selling. The new arrangement improved business for brokers so it was encouraged. “Day-traders”, unpopular even then, began operating: inEvery Man his own Broker (1761), Thomas Mortimer complained that traders “transacted securities in a matter of hours without a shilling in any of them”.
Opposition to the evolving meta-economy was powerless. In 1716 a London pamphlet entitledThoughts on Trade and a Publick Spirit described the “vermin of stockjobbers” and the “corruption of companies in trade”. The author called for a ban on share trading as a “bane to all Honesty and Industry”. It was a lost cause, possibly the reason the pamphlet was published anonymously.
The unrestricted market mushroomed. Jobbers created constant demand and developed new financial instruments like continuations and backwardations. Futures, options, day trading, short selling, rumour spreading and speculation are not modern inventions; they evolved in Britain before 1700. Speculation on a secondary market was accepted as a legitimate means of earning a profit. Underpinned by economic freedom, the structure of the financial economy was established around jobbers’ speculative activities. The impact was enormous. The private funding of the British National Debt trebled in value, expanding from 60,000 to 250,000 investors in fifty-five years to 1815.
The idea that “anything goes” suited government. The South Sea Bubble was a British government creation. The Lord Treasurer founded the South Sea Company in 1711 to skirt monopoly laws and use a debt-for-equity swap to fund the war of Spanish Succession. When minimal profit was returned by the single trading ship monopoly on which it was based and more capital had to be raised, South Sea Company directors talked up the stock with extravagant rumours. The share price went from £100 to £1000 in one year before crashing. The estates of the directors were confiscated after the crash and used to compensate victims.
The judiciary did restrict economic freedom when matters were referred to them. In Britain, the Barnard’s Act of 1734 made the “time bargains” of forward contracts for shares illegal as they were considered a form of gambling. Government help was sought by victims of “tulip mania” in Holland who had bought futures contracts on the next season’s bulbs while prices soared in an unrestricted market and then collapsed in 1636. There no court enforced the payment of contracts. Judges regarded the debts to have been contracted by gambling and they were thus not enforceable through law.
Respectable 18th century investors were trapped. They were not interested in innovative deals or speculation but avoided bank deposits as more than one bank folded each year between 1720 and 1790. Without establishing their own primary economy investment market as a viable rival, the safest place for their idle funds was East India Company bonds or Britain’s National Debt, on which the government had proven able to pay reliable interest. They benefited financially from others’ speculative activity. Ideological doubts regarding the role of the developing meta-economy may have lingered but the general enthusiasm for financial markets eliminated the possibility of a reversion to primary market activities only.
Financial market trade was entrenched in Britain nearly a century before the London Stock Exchange was established in 1801. Its written regulations were aimed at protecting its own secondary market which was separate from the productive, primary economy.
For 400 years, we have simply accepted the system that evolved when the East India Company directors refused to buy back issued shares. Their risk assessment and economic freedom defined the structure of capitalism. Despite having regularly failed, this structure is accepted as if it were the only available model for capitalism. Though the financial meta-economy was closely linked to system failures, it grew to supplant the real economy as a measure of and stimulant for primary economic health. This is when capitalism’s troubles really began.