What a Wonderful World (15 page)

A surprising, even shocking, feature of banks is that they never lend out the money that people have deposited. They hold it as a reserve against losses, and for day-to-day cash transactions. Instead, banks
create
money. ‘Money comes into existence in the very act of borrowing it,’ says economist John Médaille.
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Compare the situation of the farmer and the banker. ‘The farmer may increase his wealth only by work, the hard work of growing corn,’ says Médaille. ‘The banker may increase his wealth, or at least his assets, by pressing a few buttons on the computer.’ Disturbingly, some banks caught up in the 2008 financial crisis had lent almost thirty times more money than people had deposited with them. By comparison, banks in the nineteenth century lent on average less than five times their deposits.

To reduce their risks when lending money, banks use credit-rating agencies. The banks need to know that you will be likely to pay back what you have borrowed. In fact, credit-rating agencies – and a whole lot of other unseen infrastructure that protects traders – are needed to oil the machinery of commerce. When one person trades with a second person in another country,
for instance, he or she needs to know that the second person has the resources to pay and will not simply take the goods and run. The use of credit cards illustrates this well.

Credit cards are a form of short-term credit. In effect, someone takes out an ultra-short-term loan to buy some goods, a loan that is typically paid back in less than a month. Credit cards can be used anywhere in the world to buy goods. And the seller accepts a card as payment because he or she trusts that the issuer of the card checked that the card-holder had the resources to pay. Even if the issuer got it wrong, the seller knows that the issuer, who has shouldered the risk, will guarantee the payment.

In addition to banks, money and the rest, there have been many more milestones on the road to the commercial world we live in, each of which, to a lesser or greater degree, has boosted the number and frequency of trades. Many people still live in poverty. But the result of the frenzy of trading over the millennia has been steadily to increase the standard of living of the average person. Today, a typical home in the First World boasts a variety of goods that a couple of centuries ago would have been owned only by a king.

However, today’s standard of living has not been brought about solely by an ever more extensive web of global trading. Hand in hand with the expansion of trade has been a rise in the amount of energy consumed per person. Once upon a time, a person had no choice but to use his or her own labour or – as too often happened – the labour of other people as slaves. Later, with the domestication of horses, a person had access to the energy
equivalent of maybe ten people. This was later magnified by technological innovations such as windmills and water-powered factories. But the most significant boost in the energy available per person came with the utilisation of fossil fuels such as coal. These were resources laid down hundreds of millions years ago – trees, which had soaked up sunlight, died, and became buried and compressed deep in the Earth. This enabled each person to have access to the energy equivalent of maybe 150 people. Whereas windmills and water-powered mills exploited today’s sunlight – which of course drives the wind and evaporates water, which falls as rain – coal brought into the present-day economy the resource of
yesterday’s sunlight
.

So it is debatable whether it is trade or the exploitation of ever more potent energy sources that is responsible for the rise in the standard of living of the average person over past millennia. Trade makes it commercially viable to mine coal and develop nuclear power stations. And the energy made available boosts trade.

But all is not rosy in the financial garden. Not only do a large number of the people in the world remain in poverty but the global financial system has a tendency to lurch from boom to bust. The reasons for this are much debated. Certainly, in the boom times, people have a tendency to become over-optimistic and borrow more than they should. So, when the bust comes, they have debts to pay, which starves the recovering economy of any money they might invest. It means that the peaks of the financial cycle are steeper and the troughs deeper than they would otherwise be. But, although this exacerbates busts, it does not explain the
reason
for the booms and busts.

One possibility often touted is that they are caused by shocks from outside. Everything is chugging along nicely, goes the story,
then along comes a technological innovation that throws a spanner in the works – for instance, the World Wide Web, which triggered the infamous dot-com boom, followed inevitably by the dot-com bust. Another possible reason for booms and busts is that investors put the money into the construction of factories to supply certain goods. The factories employ many people. But eventually there are so many factories making the goods that they supply more than is needed. Because of this supply over-shoot, people lose their jobs. Ultimately, it is all down to the fact that, while investment sky-rockets, what people consume very definitely does not.

Another possible reason for booms and busts is that, when demand for goods slackens off, the suppliers of those goods do not react by reducing prices. One reason for this is that they know how much resistance there will be to cutting wages. By cutting wages and the prices of goods, demand might have been
stimulated
. Instead, demand falls and people lose their jobs.

Booms and busts, despite the periodic claims of economists, appear to be uncontrollable. The question then arises: do we really understand the complex, multiply connected commercial world we have created? The answer, worryingly, appears to be no. As the Canadian economist John Kenneth Galbraith said, ‘Economics is extremely useful as a form of employment for economists.’

Nick Leeson is infamous for sinking Barings, Britain’s oldest merchant bank, in 1995. In an interview on 30 September 2012,
The Sunday Times
asked the rogue trader, ‘What’s the most important lesson you have learned about money?’ His answer? ‘None of us ever knows enough about it.’

Capitalism is fascism minus murder, the American author Upton Sinclair once implied. Perhaps a little extreme. But it does throw into focus the question: what is capitalism? Bizarrely, despite it being a system of commerce in which most people in the world participate, few ever stop to think about what it is and how to define it.

Not surprisingly, perhaps, the central plank of capitalism is capital – goods, land, factories, and so on – the kind of things Karl Marx dubbed the ‘means of production’. In capitalism, people are free to own capital. This might not seem a significant freedom because we take it so for granted. However, contrast capitalism with communism, in which private property is forbidden, or medieval feudalism, in which only an elite had the rights of ownership.

The freedom to own capital, however, is only half the recipe for capitalism. The other ingredient is the freedom to trade that capital for profit.

How capitalism works in practice is complex. But highlighting some of the common myths of capitalism helps to shine a light on its inner workings.

Global capitalism has spawned an extensive web of trades called the market. The market automatically matches up the supply of goods with the demand for those goods in the optimum way possible – or at least that is the theory. To operate effectively,
such a market should be free – that is, unfettered by political regulation or regulation of any kind. This is the mantra of an influential group of people who advocate free-market capitalism as a panacea for all ills. The laissez-faire idea has its origins with Adam Smith, the Scottish philosopher and economist who, in 1776, published one of the most influential books in the history of thought. In
The Wealth of Nations
– or, to quote its full title,
An Inquiry into the Nature and Causes of the Wealth of Nations
– Smith argued that the free market was the best model for the economy.

Even Smith recognised that a true free market is a myth. It would be deemed unacceptable by the overwhelming majority of people. A free market would, for instance, permit a trade in anything and everything – including child labour. Once upon a time such a trade did indeed exist in countries such as Britain. But, nowadays, it is pretty much universally agreed that child labour is unacceptable, and stringent regulations are put in place to prevent it.

In addition to regulations controlling what kind of labour may be traded, there are also regulations that severely limit or forbid the trade in goods deemed dangerous to society such as heroin and plutonium. And it is not only the goods that can be traded that are regulated, so too are the companies that are permitted to trade. In order for a company sell its shares, for instance, it must be listed on a stock market. But, before this is possible, there is a rigorous vetting process that might last up to five years. Even when finally listed, a company is permitted to sell shares only to
certified traders. And, if the share price drops below a certain level, trading in the shares might be suspended for a market holiday.

‘Market forces don’t exist in a vacuum,’ says Joseph Stiglitz, author of
The Price of Inequality
. ‘We shape them.’
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‘All markets are not only constructed and regulated but constantly manipulated,’ says Ja-Hoon Chang, author of
23 Things They Don’t Tell You About Capitalism
.

Perhaps the most striking way in which the market is straitjacketed and defined by political decisions is seen in the wages of workers. These are wildly different for comparable jobs in different countries. For instance, a taxi driver in London might be paid about thirty times more than one in Dhaka, Bangladesh, in terms of the goods he can buy locally. If a free market existed, the wages of taxi drivers would all be roughly the same. After all, if a taxi driver in Dhaka was unhappy with his level of pay, he would simply relocate to London, where he would be paid a lot more. With taxi drivers shuttling back and forth around the globe in search of better pay like this, sooner or later the wages of all taxi drivers would equalise.

However, taxi drivers cannot easily up sticks and move around the globe because most countries have erected high and impenetrable barriers to immigration. This is the principal reason for why those wages are so wildly different in different countries.

If something as fundamental as the reward that people receive for their work is determined by political decisions rather than market forces, then the free market must be a mythical beast. Everywhere, the market is tightly constrained by regulations imposed from outside. Nowhere is it free – nor would any civilised country allow it to be free.

The idea that a free market will optimally match the supply of goods with demand has consequences. Those who believe in the idea push for deregulation of more and more of the economy. If the market does not work in delivering what they hope for, they say the reason is because the market is not free enough, and push for yet more deregulation. However, such deregulation is widely believed to have triggered the serious global financial crisis of 2008 when big financial institutions such as banks embraced very risky investments.
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But a free market not only permits risky behaviour that can threaten the global economy itself. It can have a more direct and malign effect if imposed on developing countries.

If such a country wants to create, say, a motorbike industry, then to get things going it might subsidise motorbike manufacture while, simultaneously, protecting its fledgling industry by imposing tariffs on imported motorbikes. This will often provoke developed countries to complain to the World Trade Organisation that the country is preventing a free market in motorbikes. The WTO can then authorise trading partners to impose sanctions on the developing country unless it removes its subsidies and its protective measures. It of course does.

The problem is that, when an industry is in its infancy, it is nowhere near as efficient as a mature industry. Also, its identity, or brand, is not well known or respected. Consequently, the motorbikes being built by the developing country cannot compete in either quality or price with imports, and the industry dies. Contrary to the free marketeers’ mantra, the free market has not made a poor country richer. At best, it has left it to stagnate.

The big irony here is that the rich countries of the world all got rich by
both
subsidising and protecting their fledgling industries over periods of many decades. For instance, nineteenth-century Britain, by imposing prohibitive tariffs on imported Indian textiles, effectively destroyed the Indian textile industry. It was then able to sell the products of its own textile industry to the subcontinent. Earlier, in the eighteenth century, Britain had used protection measures in order to catch up with the Netherlands. And, in the nineteenth century, the US used exactly the same tactic to catch up with Britain. ‘In forcing a free market on developing countries, the rich countries seem to have forgotten their own histories,’ says Chang. ‘Not surprisingly, those in developing countries find the double standards deeply annoying.’
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Behind the faith in the mythical free market is the belief that such a market will optimally match up supply and demand. Market advocates talk of this being achieved by the ‘invisible hand’. No one is able to define it but everyone claims it is working behind the scenes. Alan Greenspan, former chairman of the US’s Federal Reserve Board, has even stated that the market is simply ‘too complex for anyone to understand’.

Simultaneously promoting the market and believing it to be too complex to understand is to trust the lives of billions of people to an unpredictable system. The market has undoubtedly played a key role in delivering a rising average standard of living to much of the world’s population over the past few centuries. However, it has also delivered massive environmental problems of pollution, habitat destruction and, most seriously, global
warming caused by the burning of fossil fuels such as coal and oil. To say that the market is too complex to understand is to accept that the fate of the human race – global warming threatens to extinguish human life, though not life itself – is out of our hands, that we are at the mercy of the caprices of fate. ‘The conservative argument is that the economy is like the weather, that it just operates automatically,’ says Sidney Blumenthal, former adviser to President Bill Clinton.

Believing that the market is too complex to understand is a seductive idea. Economists and politicians need not worry about the hard problem of how exactly the market works – or does not. However, this is a cop-out, according to Chang. ‘No matter how complex it is, we must try hard to understand it in order to ameliorate its ill effects,’ he says. ‘The market, after all, is an entirely human creation.’
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Almost without exception, economists since Adam Smith have considered that the free market is in a state of equilibrium, naturally balancing people ’s conflicting aims and desires. This, however, rather contradicts reality. Every decade since 1776, there has been a crash, bust, downturn, depression or slump.

Economists often say that such events are merely unusual external shocks to a market. But there are so many of them that such an explanation is wearing a little thin. ‘The pronounced frequency of market upheavals is precisely what is most constant in economics,’ says physicist Mark Buchanan.
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There is now a growing belief that the current economic theory – which fails to predict crashes, the most striking feature
of the market – is inadequate. Many believe that a better economic theory is required that encapsulates the inherent instability of the market. This was actually a view advanced in the 1930s and 1940s by American economists such as Irving Fischer. But it was buried by Milton Friedman and his allies in the Chicago School, who vigorously promoted the idea of equilibrium in markets. ‘A well-designed policy must begin with a situation approximating that which actually exists,’ warned Nobel Laureate Ronald Coase. ‘The situation that exists in any real-world market is one rife with “market failures”.’
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The market has a peculiar and counter-intuitive feature. Large fluctuations in prices are more common than expected. Our intuition of everyday life, for instance, tells us that most men weigh between 9 and 13 stone, a few weigh 20 stone, and a very few 40 stone. This conforms to a so-called Gaussian distribution, more commonly known as a bell curve because of its similarity with a bell jar. An upturned bell jar is fat in the middle and tapers off far from its centre. This is exactly the shape you would see if you took a piece of graph paper and plotted the weight of men along the horizontal axis and the number of men at each weight of men up the vertical axis. Like the bell jar, the distribution of the weights of men clusters around an average and tails off rapidly far from the average.

Contrast this, however, with fluctuations of the market. In a typical day, the price of stocks changes by less than 2 per cent. But it is possible to have a fluctuation of 20 per cent or 50 per cent. This would be like there being men weighing 10 times the average. Or 25 times. Mathematicians say that, unlike the bell curve, the distribution of market fluctuations has a ‘fat tail’, which is just a technical way of saying that extreme events are far more
likely than our everyday intuition would predict.
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‘A credible economic theory of markets – something we do not yet have – would explain why the distribution of market returns shows such a preponderance of large events,’ says Buchanan.

In fact, according to Buchanan, market movements conform to a very simple mathematical pattern. Larger movements of, say, 10–15 per cent, are less likely than movements of 3–5 per cent. In fact, the probability of a movement of any size decreases in inverse proportion to the cube of its size. So, if moves of 5 per cent or more have a certain chance of occurring, moves of 10 per cent or more are 2
³
= 8 times less likely; and moves of 20 per cent or more are another 2
³
= 8 times less likely.

This striking pattern, which is seen in markets for stocks, foreign exchange and futures, is reminiscent of a whole range of natural phenomena, from solar-flare activity to frequency of mass extinctions to frequency of earthquakes on the San Andreas Fault.
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‘All these systems and many others exhibit a naturally irregular rhythm in which long periods of relative quiescence are sporadically broken by bursts of intense upheaval,’ says Buchanan.

If a financial market is a system in equilibrium it is hard to see why market movements should behave like earthquakes. But it makes more sense if a market is merely another system, like the Earth’s crust, which is constantly driven out of balance by various forces, and responds to those forces in complex, dynamic ways.

The new economic models that are being concocted, often by physicists, are driven by instability and feedback, which is the case in many natural systems. ‘It’s fair to say these models don’t yet give us an adequate understanding of the basic patterns we see in markets, but they at least move in the right direction by
taking the historical data seriously and trying to explain it,’ says Buchanan. ‘Nothing in mainstream economics seems as likely to succeed in this.’

Some of the converts to the new econophysics are calling for a new Manhattan Project for economics. With the well-being of 7 billion plus people depending on the global economy, it would arguably be money well spent.