Business Skeptic

Efficient financial markets are supposedly a hallmark of our modern capitalist system. The vast portfolio of financial instruments is touted as providing global liguidity at low cost to support productive investment and thus improve economic growth and development. I have no doubt that new capital market technologies and infrastructure have reduced the administrative cost of capital and has thus made investing more efficient and cost effective, thus providing a improvement in capital and investment productivity. However, I question whether the system has involved into global on-line gambling and the “capital efficiency’ argument is merely a marketing whitewash.

An investment vehicle value, by definition, can be represented by a probability distribution. Trading, transactions and hedging are the result of differential view points regarding this probability distribution. I purchase an investment because I believe that it is currently undervalued based on upon “my” opinion of the future and how it differs from the imputed market consensus embodied in the current price. Said another way, I am betting that I can “beat the house” (where the house is the market consensus of the expected value of the probability distribution). This is fine and is the way that financial vehicle pricing is supposed to work and it is this dynamic and continuous trading flux that provides financial liquidty. If we all agreed on valuation, then no one would trade except when their personal circumstances required a change in investment strategy. Considering transaction volume and frequency, it is mathematically easy to prove that the bulk of trading has nothing to do with changing investor economic and life circumstances warranting a change in investment strategy but rather the continuous betting on differential views of the future outcomes. As mentioned before this at its foundation is the key to financial market liquidity.

There is an important presumption in this analysis, and that is that the “differential betting” is restricted to the amount of capital that is required by the global value creation machine. Or more specifically, you must have a differential outcome believe regarding the value that can be generated from a given amount of capital, since that is what defines the probability distribution. Therefore, the amount of financial instruments should be reasonable proportional to the underlying productive capacity of the economy and invesment capital employed. If the amount of “betting” exceeds the underlying productive capacity and invested capital, the market is no longer operating as a liquidity engine but rather speculative gambling in which, since there is no productive economic capacity underlying the speculation, must result in a negative return (a zero sum game minus the cost of transaction).

The global financial markets currently appear to be awash in speculative gambling, unsupported by global economic capacity. The worldwide value of credit is currently 4 times the global GDP. Hence the world has borrowed 4 times more than its output. If you assume (mathematically supported of-course) that value is created by increases in productivity, and that the rate of productivity is on average less than 10% per year, then it could be centuries before our investment market and our productive capacity are in alignment. More worrying is the amount of credit derivatives in the market. Currently there is 10 times more value in credit derivatives than in the underlying credit on which they are based. Stated a different way, the total value of worldwide credit derivatives is 40 times the value of global GDP. Since there is no economic rational between the total value of derivates and the underlying productive global capacity, the derivatives market is far more like a gambling casino than an efficient capital market.

There is a substantial difference between Las Vegas and global credit markets. In Vegas, the probability distribution of any game of chance is fixed and regulated. The probability distribution is not influenced by the amount of money being gambled. The probability I will beat the house in Black Jack is the same whether I bet one dollar or one million dollars. The difference in global credit markets is that the micro probability distribution (the probability distribution for each “gambler” can be altered by the amount the gambler invests, but the overall macro probability distribution does not change. Since there is no productive capacity underlying the bet (as there is no productive capacity in a deck of cards) the consolidated outcome of the game is at best zero sum (some will win and others lose). However, because of the interrelated nature of the capital markets, the size of your bet can alter your odds. If your odds improve, then consequently someone else’s odds must go down, since the game remains zero sum. Gamblers that have the resources to place the biggest bets, hold the financial markets hostage and thus, cannot be allowed to lose. Somebody has to pay. In order to pay, you must have productive assets (economic capacity), hence the final payer (I can use the word bail-out) must be those that actually produce something, product output. That means you and I. The government will step in and save the gambler and you and I will foot the bill in increased taxes and lower economic growth. When there is 40 times more money betting on the outcome than the outcome can support, there is going to be some serious problems. Ooops, I’m late. The serious problems have already arrived.