Noble Work vs. Nobel Work

Author: M.A. Kevin Capuder

Position: Chair of Business Administration Department

Bankers like to tell us that global megabanks are beneficial for the modern economy. By addressing all aspects of multinational corporate financial demand, these institutions provide a required service and needed liquidity to global markets. Financial markets need liquidity to be sure. Liquidity can be simply defined as the ability to trade financial assets quickly for cash or for other assets which can be quickly converted to cash. The ‘other assets’ are high quality, relatively short term financial paper. 

That is where government debt provides the grease that lubricates the financial system. Therein lurks the real danger of U.S. government default on its debts (the largest grease provider). But, that is another story altogether. The megabanks sometimes wax poetic about their noble work. Lloyd Blankfein, CEO of Goldman Sachs, once famously referred to it as “God’s Work”.

The 2013 Nobel Prize in Economics has been awarded to three theorists whose work concerns the functioning of financial markets. One, Eugene Fama, is responsible for the ‘Efficient Markets Hypothesis’ which is the basis for all modern financial theory in Economics. Whatever the value of Fama’s work, the financial industry has long used the idea of market efficiency and extended  its application to virtually all financial markets, thereby arguing successfully for de-regulation over at least the last 30 years. In the process some very important distinctions are conveniently overlooked, and the real motivations of megabanks are obscured. Robert Shiller, another co-winner of this year’s Nobel Prize has strongly and correctly argued that efficient market theory does not accurately describe asset markets. It is difficult to understand how Schiller might be wrong when thinking about the dot.com boom and bust and various real estate booms and busts. Isn’t it just a bit strange that two somewhat opposed theorists share the same Nobel Prize? But the differences between the two are less than appear at first glance. For example, Shiller recommends more financial innovation to hedge housing price risk.

To understand the real world, as opposed to the theoretical economic world, it is instructive to look at the foreign exchange markets. According to the latest statistics from the Bank for International Settlements (BIS), covering April 2013, these markets now trade $5.3 trillion per day. Assuming 250 trading days, that translates into $1,300 trillion per year. By comparison, the total value of world trade in goods and services is roughly $23 trillion yearly according to the WTO. According to the UN, the total value of foreign direct investment for 2013 will be, at best, $1.5 trillion. Exactly what, you may ask, is being made more liquid? Perhaps it is only the  trading of financial paper itself?

The BIS describes the foreign exchange markets as follows, “The vast majority of trading of FX instruments (including spot transactions) continues to be conducted over the counter. OTC turnover by far exceeds the trading volume of standardised FX products on organised  exchanges.” What possible incentives do the megabanks have for OTC trading? Could it be a lack of price transparency and higher margins?

Further, the BIS states that, “Foreign exchange market activity has become ever more concentrated in a handful of global financial centres). The vast majority of global FX trading in 2013 has occurred via the intermediation of dealers’ sales desks in five jurisdictions: the United Kingdom (41%), the United States (19%), Singapore (5.7%), Japan (5.6%) and Hong Kong SAR (4.1%).” (Emphasis added)

If economics teaches anything at all, it is that a lack of price transparency and highly-concentrated oligopolistic markets do not lend themselves to efficiency in any economic sense. They lead to high prices, high profits and high costs for the poor saps who actually need the markets to hedge risk in the real economic sense. However, there seems to be no limit to the desire to hedge risk in trading financial paper, and no lack of willingness on the part of the world’s megabanks to fulfill that desire at a (high) price. Everyone lives to trade another day. Therefore the world casino in foreign exchange operates with deep liquidity. As in all financial markets, that is true precisely until the day it isn’t.

Noble work? It depends on your definition. It seems to be the work of men and women selling their services whether needed or not. History is full of examples of such work. Shamans of every sort, patent medicine providers, business strategy consultants, and development economists all come to mind. God’s work? Even Mr. Blankfein recanted after being excoriated in the world press. Nobel work? Surely, but never confuse the financial industry with anything that approaches the economic definition of an efficient market unless you like to gamble. And keep in mind that the house always wins.

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