Although Australia’s economy is supposed to be a market system, and although much emphasis has been placed on freeing up markets so the economy will run more efficiently, our markets commonly function quite inefficiently and commonly yield perverse results. There are two basic reasons for this – markets in reality rarely function according to the predictions of standard economic theory, and markets can be (and often are) deliberately distorted for the benefit of powerful players, including both private enterprise and governments. With such dysfunctional markets it’s little wonder we feel no more satisfied with life even though we are supposedly getting richer all the time, as was discussed in the first article of this series.
The deregulation of the international financial system began in 1973. By 1993 the rate of currency trading was equivalent to trading the entire global stock of tradable assets every 24 days (Greider, 1997). This rate of trading is vastly greater than that required to serve the productive economy and to accommodate changes in the real value of companies and currencies. For example, the value of most companies changes substantially only over many years, not over a few weeks. Even in 1993 currency trading amounted to $1200 billion per day, compared with $10-20 billion in 1973 (Greider) and compared with $20-25 billion needed to serve the productive economy in 1993, according to Joel Kurtzman. Such estimates imply that currency markets trade perhaps 100 times faster than necessary .
Currency markets seem to be the most extreme, but share markets also trade at excessive rates. For example, Will Hutton reports that 10% of a firm’s ownership can change hands on a normal morning of the London stock exchange (Hutton, 1995).
These figures mean that ninety nine percent of currency trades and a high proportion of share trades have nothing to do with improving the efficiency of the global economy. Rather they are the result of speculation on a massive scale. This is no secret. George Soros (Wiley, 1995), himself one of the biggest speculators, has very publicly decried the level of speculation and its deleterious effects. There are two main undesirable effects — the speculation destabilises the markets and it siphons wealth from the productive economy into the pockets of wealthy traders.
An important cause of excessive market fluctuations is the attitudes and strategies of speculators, which commonly reinforce existing trends. If the market is rising, they bid it up further. If the market is falling, they sell and force it lower. As a result, market prices only loosely reflect real values. One clear demonstration of this occurred in the 1987 stock market crash, when prices dropped by 30-40% overnight. Forty percent of the world’s factories had not been bombed overnight, nor had forty percent of the world’s listed companies gone the way of Enron. In other words, the change was almost entirely in the minds of market traders, and not in the real world.
Financial market speculation is both parasitic and damaging. It seriously degrades the efficiency of the productive economy, not only because it extracts wealth without providing any service in return, but also because managers have to hedge against the large fluctuations in share prices and exchange rates.
All of this is quite contrary to the predictions of the neoclassical theory of markets. This theory predicts that free markets come to an equilibrium in which prices reflect value and the market operates with optimum efficiency. However the theory is built on assumptions that are wildly unrealistic, for example that there are no economies of scale, that we can all predict the future and that we all act rationally. The theory is thus innocent of assembly-line production, irrationality, incomplete information, crowd behaviour and the resultant self-reinforcing feedbacks, among other things. Not surprisingly its predictions differ wildly from reality, as is illustrated by the behaviour of financial markets.
A further undesirable effect of unregulated international financial markets is that companies have to be managed to maximise the quarterly bottom line rather than the long-term productivity of the company. If the quarterly dividend is low the share price falls, and if the share price falls there can be a stampede of shareholders to other companies. To avoid this managers cut services, neglect plant maintenance, squeeze employees and suppliers, and take environmentally damaging short cuts. No corporation is too large to be immune, and even whole countries can suffer disaster, as was demonstrated in the 1997 currency meltdowns of several south-east Asian nations.
Because global trading is so easy and cheap, the most exploitive companies globally set the pace and everyone else has to try to keep up. The fickleness of investors is a major factor in the marked decline of job security since markets have been deregulated , because firms must maximise short-term flexibility. Among their strategies is the move to casual and contract employment, even though this may involve a substantial loss of corporate knowledge and even though the long-term costs of outsourcing and of frequent recruitment and training may be higher.
Markets could be stabilised by imposing a small transaction tax, sufficient to take the profit out of speculation. Such a tax was proposed by Tobin to stabilise currency markets, but the principle applies to any market that is destabilised by speculation. Tobin-style taxes would have the dual benefits of stemming the flow of wealth to parasites and of inducing investors to be more loyal, so companies could be managed to maximise long-term productivity (and profit) instead of short-term share price. A further flow-on benefit is that it would once again pay employers to provide stable employment.
The market malfunctions discussed so far reflect intrinsic limitations of markets left to themselves, but other malfunctions are due to direct interference. A very common interference is to shift costs onto the community, and both governments and private enterprise are guilty. When governments outsource or cut services, the total cost to the community is often greater than the cost of government providing the service, but the cost is typically much harder to document. Thus governments avoid raising taxes and claim to be efficient providers, but the real costs are hidden. A great many practices of private enterprise also fall under this heading. Common examples are polluting the environment, using market dominance to under-pay suppliers, and shifting risk onto employees and suppliers through the use of short-term contracts.
Cost shifting leads to a fundamental failure of the market mechanism, because markets can only function well if price signals are accurate. That means full costs have to be charged to producers, so that full costs are reflected in the prices of products and services. If the likely costs of global warming were reflected in the price of fossil fuels their use would drop precipitously.
The remedy for cost shifting probably requires eternal vigilance, and the substitution of appropriate taxes if necessary. However the most important step will be to recognise the pervasiveness of the problem and to wean ourselves from the simplistic faith that markets, left to themselves and the machinations of their most powerful players, will ensure a fair and efficient system.
Although the dominant story of our time is that we have a free-market system, the reality is that there are many interventions in our markets. However only some interventions are publicly deplored. Too often, socially useful interventions like progressive taxation are demonised while many harmful interventions are overlooked. A direct implication of pervasive market failure, of which only a few examples have been mentioned here, is that markets cannot be left to themselves. In other words, markets must be managed, so we should tailor our interventions to ensure they function to the benefit of everyone, not just a wealthy minority.
This brief article has not covered dysfunctions in the so-called free trade regime, nor the profoundly distorting effects of advertising and marketing, nor the progressive unloading of corporate responsibilities and the progressive acquisition of corporate privilege, to mention only three other basic problems in our current system. An even more fundamental problem lurks in our monetary and banking system, and this will be taken up in the final article of this series.
Geoff Davies will be speaking at a conference organised by www.studentsofsustainability.org at the University of Queensland, Brisbane Campus, on Thursday 13 July at 1.30pm.