Wednesday, May 19, 2010

Merkel Does Mahathir and Martin Luther: Tilting the Market Table

In theory, free markets provide "just" prices or a level market table and thus allocate profits such that all market participants are willing to exchange goods freely. This is the basis of the division of labor in a free economy. In practice, speculators are finding they can tip the table as well as any government or church, thus inspiring an increasing unwillingness to play their game.

In 1998, Malaysian Prime Minister, Mahathir Mohammed imposed capital controls ostensibly to protect Malaysia from speculators like George Soros. Then as now (with respect to German controls, also ostensibly to ward off speculative attacks) the financial press was full of quotes proclaiming the foolishness of such actions. The Church of Free Capital is, apparently, a dogmatic church- nation-states, according to the creed, have no right to impede the flow of holy money, or alter the terms of trade.

The Church of Free Capital's creed states that prices set by market speculators (i.e. big finance) are, in a sense, divinely inspired, leading to the best outcome. That big finance has been taking home an increasing share of decreasing profits has not shaken faith in the creed among speculators, but it has angered capital providers in Germany sufficiently to provoke a protest and policy schism.

This isn't the first time Germany has protested the policies of a major Church. Interestingly, both protests, in a sense, included the imposition of capital controls.

Roughly five hundred years ago, a monk named Martin Luther sent a list of complaints- the 95 theses- to his Catholic superiors. His main complaint was about indulgences, whereby a Catholic could buy redemption from sin. "Why does the pope," Luther argued, "whose wealth today is greater than the wealth of the richest Crassus, build the basilica of St. Peter with the money of poor believers rather than with his own money?"

Back then, the Renaissance Popes were rebuilding Rome. Men like Michelangelo, Bramante and Raphael were paid to work on St. Peter's Basilica (inter alia) with money raised, in part, from the sale of indulgences to northern Europeans. Germany, then as now, wanted to keep their money. Whether the current schism in capitalism becomes as widespread as the former schism in Christianity remains to be seen.

I, for one, think the Church of Free Capital is overcharging for its services about as much as the Vatican was then. To their credit, at least the Vatican left something for posterity. We'll have to wait and see if the Church of Free Capital leaves anything to posterity besides broken dreams.

Returning to Malaysia, by the time (15 months after the crisis hit Thailand) Mahathir imposed his controls in September 1998 (about which, more here, and here), the Ringgit had already lost about half its value vs. the US$. That is, most of the capital that could and wanted to flee the Asian crisis had already fled. Thus, I suspect, Mahathir imposed capital controls hoping to avoid "punitive" speculation, since he was about to put his second in command, Anwar Ibrahim, a favorite of Western Financiers, in jail.

One wonders, to the extent the analog holds, what surprises Germany has in store for the Free Capital faithful. Perhaps, alternatively, Germany is simply trying to ensure that profits made on any future EU bond issues remain in Europe, or at least accrue to EU bond holders.

I'm very interested in Germany's policy shift because it's the first time in decades a mature industrialized nation has protested the allocation of profits decreed by financial orthodoxy. At core, German bans of "naked" (held by those who don't own the securities) shorts, paraphrasing Ms. Merkel- perhaps unsurprisingly the daughter of a Lutheran Minister- stops people profiting from the destruction of their neighbor's house at cost of less liquidity in the restricted markets.

In a sense, the policy shift is akin to a theoretical banning of naked shorts, such as occurs in the futures markets, by grain speculators. In theory, grain speculators, by providing liquidity- more potential contract prices than would occur in a simple point of sale transaction- in grain markets, help producers (farmers) and consumers exchange goods more efficiently.

In practice, grain speculators charge producers and consumers a fee, in the form of speculative profits, to provide price liquidity. If the fee is small, producers and consumers will find that additional efforts, such as spending more time at market finding people willing to deal at their preferred price, cost more than the additional profits so produced. Additionally, speculators take on risks producers (who want high prices and thus fear a bumper crop) and consumers (who want low prices and thus fear a lean harvest) might wish to avoid. Importantly, speculation neither increases total profits nor decreases total risk, it merely distributes them differently.

For example, imagine a farmer who produces 5,000 bushels of wheat (one CBOT contract), a wheat speculator, and a bread maker willing to buy the wheat. Imagine the farmer's costs of production and transportation come to $3.50 per bushel while the bread maker can sell bread profitably so long as he can buy wheat below $5.25. Let's assume our speculator's costs come to $0.05 per bushel. Each bushel of wheat then provides a profit opportunity of $1.70.

Ideally, the farmer sells his wheat to the speculator for $4.20 and the speculator sells the wheat to the bread maker for $4.55. The farmer makes $0.70, the bread maker makes $0.70 and the speculator makes $0.30.

Sometimes, producers or consumers try to tilt the trading table their way. Farmers might get government to put a floor on prices, say at $5.00, and keep more of the available $1.70, which will eventually piss off the bakers. Bakers, alternatively, might get government to put a ceiling on prices, say at $3.75 and shift the profits their way, which will eventually piss off the farmers.

A third scenario, closer, I suspect, to the way things work now, might look something like this. Speculators, after getting government to bar farmers from speaking directly to bread makers, manipulate prices lower early in the growing season and scare farmers into selling their wheat at $3.75 and then manipulate prices higher late in the growing season forcing bread makers to pay $5.00. Under that scenario, the farmer and break maker split a $0.50 profit evenly while the speculator walks away with $1.20.

Over time, the third scenario leaves both farmers and bread makers short of capital and forces them to borrow from the speculator to make necessary capital improvements. Eventually, barring a revolution, the speculator owns both farm and bakery and has to manage disgruntled employees on both ends, which likely leads to both less wheat and inferior bread.

Hopefully, the above thought experiment explained some of the important work markets do in providing prices. When they work well, primary producers and secondary manufacturers both find it profitable to produce, and middle men are rewarded for managing the transaction risks. However, when the table is tilted too far in any participant's favor, the whole system, which requires willing cooperation from all for optimal results, risks deterioration.

The above model can be used to examine any market transaction, even government debt finance. German controls, in effect, reduce the share of profits (if any) of such borrowing going to middle men. We'll soon see if the service provided by those middle men was worth the cost.

500 years ago, the Germans defied orthodoxy and ushered in a revolution which moved the center of Europe from South to North. They are defying orthodoxy again, and I can't wait to see what happens next.


Gary said...

Nice historical context and I sympathise with your perspective

Dude said...


Thanks for the kind words.