Financial Regulation, Theoretical Poverty (1 of 2)

One of the issues being debated these days is the regulation of over-the-counter derivatives, the privately negotiated, customized contracts that exist in a legal world parallel to their standardized, exchange-traded cousins. The Financial Times was surprised that even the European industrial companies had come out against the regulation:

Some of Europe’s industrial companies have warned they could shift their financial hedging away from Europe if proposed reforms of the vase over-the-counter (OTC) derivatives markets go ahead as proposed by the European Commission ... The comments show that opposition to a key part of US and European proposals for reform of the financial system is gathering from an unexpected quarter: industrial companies.

The paper gave the reason for the opposition without, naturally, understanding the centrality of the issue to the current crisis:

Many companies use OTC derivatives, such as interest rate and currency swaps, to hedge routine business risks like fuel purchase and future pension liabilities.

This need of industrial companies for hedging is the genesis of the speculative capital, the latest and most versatile form of finance capital, that is born from the marvelously dialectical transformation of defensive hedging to predatory arbitrage. I was first to explain this metamorphosis in Vol. 1:

The most important point in the rise of arbitrage trading is that the practice develops logically from hedging and, on paper, is indistinguishable from it.

The purpose of hedging is preserving the owners’ equity. The hedger begins with an existing asset (liability) and seeks to find a liability (asset) which will offset its adverse price changes. The purpose of arbitrage, by contrast, is profit. The arbitrageur has neither an asset nor a liability. To that end, he looks for any two positions which will enable him to “lock in” a spread. The two acts are mathematically indistinguishable. What logically separates them is the purpose of each act which translates itself to the sequence of execution of trades. When done sequentially, the act is defensive hedging. When done simultaneously, it is aggressive arbitrage. Otherwise, the transformation of one to the other is seamless.

The sole subject of finance is studying the laws of movement of finance capital and its various forms such as speculative capital. The role of individuals, to the extent that it exists, is incidental.

The centrality of finance capital in studying finance is acknowledged – if only unconsciously and unknowingly – by the mouthpieces of the orthodox economics. They, who never tired of sounding off on the primacy of the individual and his supposed “free will” as an “economic agent”, these days talk of “jobless recovery”. Google the phrase and see how through sheer usage it has become an accepted term of discourse.

Writing in his column about the expanding army of the unemployed, Bob Herbert of The New York Times condemned this point of view without understanding its roots.

The Beltway crowd and the Einsteins of high finance who never saw this economic collapse coming are now telling us with their usual breezy arrogance that the Great Recession is probably over. Their focus, of course, is on data.

In the phrase “jobless recovery”, the news pertaining to the people is grim; there are no jobs to be had. Yet it contains “recovery”. So, what is it that is being recovered? The answer is: the agreeable rate of return of capital. The “data” measures the pulse and performance of capital, which the university professors study and comment about without ever understanding the larger issue surrounding it.

The outward appearance of the phenomena in economic life is deceiving. In fact, the appearances tend to show the opposite of what is actually taking place. Hence, the authority of the great thinkers of the classical economics who showed us the way.

The story-telling school of economics and finance that is in currency now concerns itself with the most immediately visible. Naturally, it gets everything wrong. Here is a full time professor of economics and finance at Yale explaining a crisis that has paralyzed much of the world for the past two years:

“The fundamental problem, as Franklin Delano Roosevelt said in 1933, is fear”, [Robert] Shiller, a Yale University Professor said. The great depression was deepened by a “sense of lost confidence and animal spirits that was a self-fulfilling prophesy. The worry is that we will have the same kind of issue rising again,” he said.

Even academics are beginning to see the superficiality of their theories; the long-present elephant in the room can no longer be ignored. The policymakers always knew it, which is why they practiced “pragmatism”. But in markets dominated by finance capital, pragmatism – doing the “proper” thing given the circumstances – is nothing but yielding to the diktat of finance capital. That is the part that neither the policymaker nor their critics who accuse them of “taking the side of their banker friends” understand. Like the focus on the data that Herbert criticizes, the problem goes much deeper.

I will return shortly with the second and final part of this piece.