What lies behind power of "the markets"

Everyone is terrified of “the markets” - so terrified that governments throughout Europe are prepared to make massive cuts in public expenditure to appease them.

In Britain schoolteachers, nurses, police officers, tax-inspectors and lorry-drivers will lose their jobs. Many a small firm, and not a few big ones are likely to go under. The loss of real income, i.e. of standards of living, will be enormous, and will continue for years to come. And even then, it’s not clear that the markets will be satisfied.

Which begs the question, what is this monster with a seemingly insatiable appetite? On the one hand the markets are really made up of those City traders we see on our television screens whenever there is a financial crisis. Young men (seldom women) hunched over banks of computer screens trading financial assets around the world.

On the other hand, the markets are an interconnected system of trading  possibilities – financial instruments that can be traded, electronic exchanges they can be traded on, and a system of government-determined relationships that makes the whole thing legal.

Faceless forces The next obvious question is, so why do they do it? Why are these young men intent on putting a lot of decent people out of a job and destroying wealth? How can the authorities connive in a system that seems entirely negative, taking the power of economic decisionmaking out of the hands of governments and handing it over to entirely unelected, faceless forces?

I’ve posed the question in this provocative manner because the majority of commentators reflect an entirely different view. For example, The Economist magazine has argued that markets enforce “healthy” discipline, resulting in
better economic policies and performance:

To begin at the beginning, how do markets work? You might think that the markets are a means of linking savers to investors, channelling the savings of households into investments both public and private. You would be wrong. That does happen but it’s a tiny tail on a very big dog called “trading”.

The traders buy and sell financial assets. They even sell financial assets that they don’t have – this is the so-called “naked selling” where an asset is sold for delivery next month forcing its price down, and once the price is down it can be bought cheaply to immediately pass on to the first buyer, hopefully at a nice profit. A
sensational device for taking a risk and making a profit out of thin air!

Average opinion What determines traders’ behaviour? Keynes explained the core of what traders do. He called it a “Beauty Contest”. His insight derived from
contests that once took place in the more disreputable Sunday tabloid newspapers. The contestant had to place in order of pulchritude photographs of a number of young women – not based on his own views of beauty but on what he thought the average of all contestants would be. So each contestant had to guess what average opinion would be.

And average opinion spent its time trying to guess what average opinion would be! Financial markets are moved by the “weight of money”, i.e. by average opinion. So everyone is trying to guess where the average will move next. Inevitable average opinion is swayed by fashion, subject to swings of opinion, and deeply conventional.

Take the case of Greece. The growth of the Greek government deficit, brought about by the collapse of exports (especially the demand for shipping) in the recession, and hence the collapse of tax revenues, has sparked off a
wave of selling of Greek government bonds. Average opinion believes (correctly) that average opinion will take fright at the deficit numbers, and so prices fall.

Traders can sell bonds they don’t own, then later buy bonds at a lower price and pocket the difference. As sentiment swings with successive rounds of chaotic mismanagement by the Eurozone authorities in general and the German government in particular, the traders follow average opinion.

But is this opinion a reasonable assessment of the long-term value of Greek bonds, and of the likelihood that the Greek’s will default on their debt? It may be, or it may not be. The traders are not buying those bonds to hold to maturity for the income they yield. They are buying to trade.

Even so it might be argued that the trading is the way that markets discover the true, `fundamental value of those bonds, and their fall in value is the means by which markets discipline an errant administration. Well maybe. But it’s a brutal discipline, and the cure may well be worse than the disease.

That brings us to the UK. Just like Greece we are told. Well, no it’s not. The fall in tax revenues in Britain has been primarily due to sharp cuts in spending by British firms and households.

And what are they doing with the increased savings – lending them to the government. We are financing our deficit by borrowing from ourselves.

Lord Eatwell is Professor of Financial Policy at Cambridge University

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