Monday, August 3, 2009

Bad Actors, Bad Economists

Paul Krugman is hot under the collar. He has just discovered that speculators – of “bad” variety, to be sure, or as he calls them, “bad actors” – have been making money off the markets. It is good to be out of coma, Mr. Krugman.

The liberal columnist’s beef is with high frequency trading – he says it does not help “capital allocation” – and one oil speculator who is reportedly due $100 million in bonus thanks to profits he made for his company, a Citigroup subsidiary. Krugman writes:

Just to be clear: financial speculation can serve a useful purpose. It’s good, for example, that futures markets provide an incentive to stockpile heating oil before the weather gets cold and stockpile gasoline ahead of the summer driving season.

But speculation based on information not available to the public at large is a very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back in 1971, such speculation often combines “private profitability” with “social uselessness.”

The fiction of speculators’ useful function was concocted by the commodity exchanges in the late 60s and early 70s, as they were getting ready to step into vacuum created by the collapse of the Bretton Woods regime. It was then passed, through the intermediation of grants, to hollow men of academia who sold it as economic theory. That is what Milton Friedman parroted until he died. That 40 years later Krugman repeats the nonsense verbatim shows how far the discipline has progressed. Actually, the word is regressed.

So, just to be clear: Capital in circulation does not generate value. Hedge funds, mutual funds, exchange-traded funds, proprietary trading desks, investment banks, merchant banks, buy-out firms, market makers, exchange specialist, stock brokers, bond salesman, FX traders, day traders, high-frequency traders, insider traders, derivatives traders, options and futures traders, arbitrageurs, hedgers, credit default swaps writers, take-over artists – all these groups do not produce any vale whatsoever, in the sense of adding a dime to the country’s GDP. Their activities merely help realize the value that is created in the production process.

But that is only one error in an article littered with conceptual errors, all of which are linked by a common thread that is theoretical poverty. Krugman does not know that the subject of finance is movement of finance capital. Absent that knowledge, he looks around and sees people who look corrupt or mean by virtue of trying to make money in ways not done before because the old ways of making money are arbitraged away. So instead of analyzing, he harangues, never suspecting, for example, that high-frequency trading is the logical endpoint in a system where speculative capital has been constantly shortening the trading horizon. He goes on:
Now, you might be tempted to dismiss destructive speculation as a minor issue – and 30 years ago you would have been right. Since then, however, high finance – securities and commodity trading, as opposed to run-of-the-mill banking – has become a vastly more important part of our economy, increasing its share of G.D.P. by a factor of six. And soaring incomes in the financial industry have played a large role in sharply rising income inequality.

There is no such thing as destructive speculation, Mr. Krugman, if you are going to compare it against “productive” speculation. There is no such thing as high finance. Or low finance. Or just-about-the right-height finance. There is no such as thing as run-of-the-mill banking, unless your idea of banking is shaped by the reruns of It’s a Wonderful Life. There is only finance capital that, in the aftermath of the breakdown of Bretton Woods system, stepped in to introduce discipline to the markets. “Government regulate markets by decree; finance capital does by through arbitrage,” I wrote in Vol. 1 of Speculative Capital.

That is why 30 years ago, you could “dismiss” what you call speculation because finance capital was in its nascent form. It then grew – as it had to, to compensate for the falling spreads – to the point that it now dominates the U.S. financial markets and, from there, the tempo of the broader economy. Hence, its increasing “share of G.D.P by a factor of six”. That is precisely the definition of finance capital. It is capital in circulation, grown to a point that, in a tail-wagging-the-dog set up, influences the direction and cycle of industrial capital.

To understand what is taking place around us, we have to master the basics. Enough of mystification and hazy notions of high/low finance that betray a break in thought. Here is from the opening page of the upcoming Vol. 4, as an example of writing where words have meanings:
Finance capital is capital in the circulation, as distinct from the production, phase.

In Vol.1, in developing the concept of a security, we followed an entrepreneur who set out to raise $10 million for the purpose of producing “widgets”. He successfully presented his ideas to potential investors who agreed to give $10 million in start-up funds. With that money, our entrepreneur built the plant, bought the raw material and hired the workers and generally set the production process in motion. The first batch of the widget was ready after the prescribed 9 months.

At this stage, while the production cycle, defined technically, in terms of creation of widgets, is complete, the full cycle, defined socially in terms of the return of capital to its starting point, is not. That is because the widgets are not yet sold. That part is critical. The company’s investors who provided the initial funds, the workers and the creditors who extended credit for the purchase of raw material, do not want widgets. They want money. To satisfy them, the widgets must be sold. It is only through the sale – the conversion of the widgets to money – that their embedded value and thus, the company’s profit, will be realized.

The conversion of widgets to money closes the overall cycle of production and allows for the start of a new cycle. It is through its ability to repeat these cycles that the entrepreneur’s business is a “going concern”, meaning that its operation could continue to an indefinite future. So the role of the sales is absolutely critical to the existence and survival of the enterprise. No businessman was ever unaware of this.

But sales present a challenge to the entrepreneur because it must be affected by buyers over whom the entrepreneur has no control.
Here, we have the genesis of finance capital. See if you can begin with it and arrive at the current crisis. Everything will then be crystal clear.


jd said...

I am upset with myself that I only now discovered your blog. Your first volume on speculative capital was (and still is) the most insightful book I have seen on the subject.

I could quibble about your describing speculators having a useful function as a "fiction", since you later describe them as having playing a role in the realization of value (yes!) -- a modern economy is helped along by actors who buy and sell risk (if you include commodity speculation within your definition of speculative capital, which I am not sure if you do) or help to interconnect markets and price formation via arbitrage; even carrion feeders have a vital role to play in an ecosystem.

But that's just a quibble, and your other points are, well, appreciated and spot on.

I am looking forward to seeing Volume IV.


Nasser Saber said...

Dear jd,

Thanks for the kind words. You know the cliche about better being late, etc.

What I said about the role of speculators has to do with the distinction of creating and realizing value. They are two very different things.

Later, in Vol. 4, we will see that speculators, in the meaning of those who act as the agents of speculative capital (that would be, for example, hedge fund managers and prop traders) do not event contribute to the realization of value the way, say, merchants (and merchants' capital) do.

Your point about carrion feeders I understand if it is meant in the Hegelian sense that what is real is rational. That is, we have to explain why this economic deadwood exists. But it is not true at all that all the "agents" in the economy perform a useful function. Far from it.

I will make sure that this point will be made clearly and forcefully in future posts -- and Vol. 4, of course.