Saturday, June 11, 2011

Speculative Capital and Investment Banking

So lately I've been on a quest to develop at least a rudimentary knowledge of economics, and as part of that quest I've been reading this book by Joseph Stiglitz.  While discussing the economic miracle of East Asia, he noted the following:
Even as they have opened up their markets for long-term investment, the two Asian giants-India and China-have restricted short-term capital glows.  They recognized that you cannot build factories and create jobs with money that can move in and out overnight.  They had seen the record of instability that accompanied these flows, risk that came without evident reward.
He proceeds to explain that market liberalization, with its accompanying influx of speculative capital, was related to stagnant growth that was built on borrowing, the sale of national assets,  and ultimately a recession.  He also noted that growth went disproportionately to the rich.  Even more significantly, he discussed the rapid market liberalization of former Soviet bloc countries.  Specifically,  average life expectancy in Russia decreased by four years in the period from 1990 to 2000.  It also led to hyperinflation ( with prices in Ukraine increasing by 3,300 percent per year), recessions, depressions, etc, ad nauseum.  


If speculative capital destroys the economies of developing countries, why is it a boon to the economies of developed countries?  Or is it a boon?

Michael Lewis notes that flaws in the Black-Scholes options-pricing model, which is intended to significantly mitigate risk, has contributed to a number of stock market crashes since 1987, the most recent being the mortgage bubble crisis of 2008, the effects of which are still being felt.  Take a look at this. Then read this. (If you're feeling really ballsy, read this).  To me, it seems that the probably isn't simply the Black-Scholes model, but rather a divergence between the utility of the financial industry (which absolutely exists) and the aims of investment bankers, which are driven by greed rather than utility.  


Take the housing bubble as an example.  The housing bubble was driven by derivatives traders who were making immense profits off the increased value of houses.  Banks were making increasingly risky loans to finance these homes, because there was a lot of money to be made doing complicated financial things with derivatives (which they inevitably had their hand in).  This led to a continued increase in housing prices, which led to increased profits, which led to increased risk taking.  Which led to the inevitable conclusion of the drama, which came when it turned out that people couldn't actually afford to pay their mortgages, and it turned out that significant portions of the financial industry had lost a massive bet that housing prices would continue to increase.  Because the Black Scholes model underestimates the likelihood and effects of a mass panic on market prices, but was used anyway on the assumption that it would nullify risk, the global economy collapsed.  


The point of all this amateur discussion of economics and markets and derivatives is this:  Speculative capital is dangerous.  It can really fuck up the economy.  It can really fuck up people's lives.  (Seriously, a four year decrease in life expectancy in Russia over the course of a decade).  The people who monkey around with speculative capital for a living stand to make immense profits if they take appropriate risks, and have very little to lose personally if those risks don't pay off.  There should probably be effective laws and regulations in place to curb their willingness to take those risks.  

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