Market magic

I promise this will be my last post on economics. It's not something I enjoy thinking about--the Invisible Hand is so HP Lovecraft--but with financial fire-and-brimstone all over the news, I start to feel as though it could be important. The trouble is, media "experts" have a vested interest in the status quo, so I can't get an accurate picture or explanation of the carnage. Some things just sound wrong to me...


I know what real investment and assets look like: 1000 people get together and spend $1 million on a cracker factory, and it makes them $100 000 a year of profits for 50 years. All things being equal, you could even say that investment is beneficial for society by efficiently supplying a cracker-hungry nation. Inflation, depreciation, debt, and fluctuations in the price of labour and raw materials muddy the situation, but that's the basic idea. Combine a million factories and other productive assets, and you get macroeconomics. (That classical picture ignores social and physical limits, but I'll let that slide for now.) But it's the financial crisis that's in all the papers, and that's rooted in the speculative side of the economy.

First, let me just say that derivatives trading is the stupidest thing I've ever heard. People have been "investing" by betting whether a numerical value will go up or down. That's the same as betting on a horse race, and it has just as much to do with the real economy. Let them gamble if they want to, but the rest of us shouldn't bail them out when they have a losing streak. Worse still, it exaggerates the upswings and downswings of the market, which is making the current collapse even worse. (Warren Buffet himself called derivatives "financial weapons of mass destruction" in 2002.) From what little I understand of the other opaque 21st-century "financial instruments," the same is true for them.

But let's get back to that old august gambling house, the stock market. It's supposedly been the motor of economic growth for centuries. It's true that IPO's lead to real investment, ie mobilize unproductive wealth and labour. (Often it's more effective when the state mobilizes resources itself, but I digress.) But the currency, stock, futures, real estate, etc. speculation that occupy 95% of trading have nothing to do with real investment. It's a series of side bets. If Microsoft shares go up or down, that doesn't change its working capital, only the wealth of those who happen to buy or sell that day. And unlike the cracker factory, that value is entirely imaginary: just like tulips or baseball cards, shares only have value if someone else believes they do and is willing to pay. Elsewhere we call that a pyramid scheme. (Some shares give dividends, inside information, or voting privileges, which gives them some real value, but they are still grossly overvalued.) So why do we have billions of dollars tied up in the stock market? Why have we bet the entire global economy on "irrational exuberance"? It's true that small investors are often ignorant, emotional, and short-sighted, but the large investors who control most of the stock market have professional, expert staff, and they should know better. Maybe the Marxists are right--the whole thing is a shell game designed to transfer wealth from the working class to the rich, and whenever there is financial collapse, that's the biggest transfer of all.

It's been proven many times that the more stocks you own, the more you tend to make from them. The irrational cycles of the market punish small investors and reward large ones because large investors have more information, expertise, and control and can predict or orchestrate downturns. The speculative economy also impoverishes the working class by making small investors feel more rich than they are. If you bought $100 of my stock yesterday and now own $500 worth (on paper), you'll feel like celebrating, and you'll go ahead and spend some of your non-speculative money. Studies show a 3-4 cent increase in spending for every dollar of stock increase. You can see how that can lead to disaster: when your stock goes back to $100, or to zero, you just bought things you can't afford. Many people end up going into debt rather than sell their stocks, on the assumption that the value of their stocks will always go up faster than their debt. When stock prices finally do fall, the hardship is multiplied immensely because people have more debt and smaller savings.

I have one last rant, so bear with me. Lately, I've often heard TV talking heads say that global markets lost a trillion dollars overnight. That is, the total face value of global stocks went way down. What a catastrophe, right? But here's the problem: the listed stock price is its marginal price not its value. Let's say my company issued 1000 shares at $1. So $1000 of real money is invested. Then the next day people learn my grandfather is John Lennon, so 100 stocks are sold to Beatles fans for $5. Now $1500 is "invested" in my stock, $1000 in the company itself and $500 in the pockets traders. But the media would say the value of my stock is 1000x$5=$5000! If some investors change their minds the next day and sell for $2.50, economists go ballistic because the stock "crashed" from $5000 to $2500, even though there is still only $1250 or so invested. That's why trillions of dollars can be created and destroyed in the blink of an eye; it's a mathematical fiction. The true value of a stock would be something like this: the total cash raised if all stocks were sold one by one. It would be above $1000 since the marginal price is high, but it wouldn't be much above it.

If I have the time and the patience, I'll read up more and see what I can figure out. So I may come back and post an update. In the meantime, my advice is to ignore anything economists say and get on with your life.