The Folly of Financial Markets

By Mike Tudoreanu

MCT
MCT

In my columns throughout this past year, I’ve often talked about the way that Wall Street and the banking industry, which caused the current economic crisis, have been trying to pass on the costs of their actions onto ordinary working people – through such things as union-busting and cuts in social spending. But I have never talked about what is wrong with the capitalist financial system we have today, and why it needs to be completely replaced. It’s not a matter of greed, as we are often told. No matter if bankers and investors are greedy or not, they are players within a hopelessly broken system that will always cause recessions, unemployment, and hardship for working people.

Here is how the stock market is supposed to work, in theory. Investors have money, and they are interested in buying stocks and debt from the companies that are going to be most profitable in the future. The greater the future profits of a company, the more money you can make by investing in that company today. The way to make a company profitable – in this theory – is by being efficient and having good business practices. Thus, companies who follow this path attract investment and get rewarded for their good work; companies that fail to be efficient lose investors and go bankrupt. So, the theory says that financial markets reward good companies and punish bad ones.

In reality, even if it is true that long term profits are made by being efficient and having good business practices and so on, investors have no reason to care about the long term. Stocks are continuously bought, sold and re-sold every day. And if you buy stock in “Subprime Mortgages Inc.” today and plan to sell it tomorrow, you have no reason to care what will happen to that bank or company next month.

You don’t want them to be efficient and sustainable in the long term. You want them to look better tomorrow than today, so the price of their stock will be higher and you can sell it for a profit. If investors do this every day, the short term is the only thing the company will ever care about. This is how banks and companies end up making decisions that hurt both themselves and the rest of the public in the long term. This is how companies ended up creating tens of millions of bad mortgages. When a company’s stock and debt keeps changing hands rapidly in the stock market, it destroys the company’s ability to plan for the future.

That’s bad enough. But then it gets worse. Buying any kind of stock or financial instrument means placing a bet on something that you think will happen in the future. If you buy a company’s stock, for example, you are betting that the company will increase its profits in the time between now and when you plan on selling the stock.

If you buy a credit default swap, you are betting that someone won’t be able to pay their debt. Everything that happens in the world of finance is a kind of gambling. But it’s not really like a casino; it’s worse, because the players don’t know the odds of winning. If you roll a pair of dice, you know the odds of getting two sixes (1-in36). But what are the odds that “Subprime Mortgages Inc.” will increase its profits next week? Is it a safe bet or a long shot? No one can really know. So investors rely on the opinions of other investors to guess these odds. If all investors say that something is a safe bet, then it must be a safe bet – or so the thinking goes.

The problem, of course, is that all investors may be wrong. This is how price bubbles appear in the stock market. A company makes some profits. Some investors see this and bet that the company will continue to make such profits tomorrow or next week, so they buy its stock. If they guessed right, those investors make a lot of money. Other investors see this and join in, buying stock in the same company. The increased demand for the company’s stock causes the price to go up, so the bet that the price will be higher tomorrow than today becomes a self-fulfilling prophecy. More investors buy the company’s stock, which causes the stock price to go up, which causes more investors to buy it (in the hope that it will go up even further), and so on. The positive feedback loop continues, driving stock prices higher and higher and getting more and more investors to buy until there is no one left to buy it any more, the bubble bursts and the stock market crashes. This cycle of bubbles and crashes has repeated itself many times in history.

The stock market, and the private financial system in general, is not merely imperfect, it is an inherently bad system. It is actively making things worse. Many people have called for it to be more closely regulated, but any such regulation is just damage control. A regulated financial system will still make companies focus on the short term and it will still cause price bubbles and general economic instability. Regulations can only restrain and reduce these problems, not fix them. The only real solution is to get rid of private banking and Wall Street, and replace them with a system where investment is allocated by public institutions with a democratically elected leadership. Let the people decide which companies deserve investment and what kinds of loans we need, rather than leaving these decisions up to a bunch of wealthy gamblers who demand instant gratification.

Mike Tudoraneu is a Collegian columnist. He can be reached at [email protected].