Markets have lost their purpose
14 Jun 2011
Twenty years ago, it used to be the case that only in the foreign exchange
market was the underlying business activity dwarfed by speculation -
meaning that the foreign currency needed for the buying and selling of
imports and exports was well under 10% of the global daily volume.
Today, similar conditions have an impact on all manner of markets which are
simply not structured to cope with such waves of speculation.
We are now in a position where flows of hot money drive prices, not the
fundamentals of supply and demand. And because other markets lack the scale
and resilience of forex, the results are less benign.
The belief that markets know best rests on a couple of important factors.
First, there have to be a lot of participants in the market so that no one
can influence more than 5% of either supply or demand, which in turn means
no group is in a position to use its buying clout or monopoly power to
influence price or supply.
Second, it is important that people are principals, either acting in their
own name or for a company which is either supplier or end user. When these
conditions exist, it is reasonable to assume that price signals from the
market are fairly accurate reflections of genuine supply and demand.
This begins to break down when buyers and sellers are in a position to use
other people's money - thereby acting as agents rather than principals.
It is often - though not always - the case that this coincides with their
being interested in speculating on price movements rather than the buying
or selling of the physical goods for some business purpose.
There are two reasons things have gone wrong in financial markets.
In recent times - since technology advanced enough to allow capital to be
moved in seconds into or out of any market in the world - the ebbs and
flows of speculative money have increased massively.
Capital is now mobilised on a global scale and directed anywhere in the
world at the touch of a button. It dwarfs the resources of the original
At the same time, with a growing emphasis on trading profits and short-term
time horizons, money managers have embraced momentum - buying not on
fundamentals but simply because everyone else seems to be buying, or
selling because they all seem to be selling. They assume they will be able
to ride the price movement and then use instant-dealing technology to leap
off and take their profits just as the price is turning.
This has increased massively the amount of money swamping a market when it
is in fashion. It has also multiplied the power and influence of those who
are seen to have an edge in a market - the established traders or
investment banks - because where they lead others follow (or risk being
wiped out). The interaction of their expertise and third-party money gives
a few speculators disproportionate influence. These lead speculators now
have the power of the herd behind them. They have enough monopoly power to
Financial markets such as the oil market, the metals markets, the grain
markets or the sovereign debt market were created for actual users, not
speculators, but they are now so dominated by hot money that the sounds
from the original users are no longer audible. As a result, these markets
and their prices indicate what the speculative money believes at any one
time, and this is not necessarily what is happening in the real economy. It
also adds an overwhelmingly short-term perspective and huge layers of
We all pay a high price for this because the real economy is then forced to
adjust. In rich countries, oil consumption and economic activity get cut as
oil becomes too expensive. In poor countries, they have riots and
governments fall as food becomes too expensive.
In all countries, governments have to produce policies that put the whims
of the markets before the needs of their citizens - witness the way
policies across Europe are tailored to appease bondholders and debt
A letter to the Financial Times yesterday pointed out what are only the
most recent examples of how the financial market tail wags the dog.
In oil, pricing is based on two sources of supply: the North Sea's Brent
crude and West Texas intermediate. For years, the price difference between
them has remained between two and three dollars to reflect the oil quality
and its distance from market.
At present, however, the price gap is more than $17. Similarly, it has long
been a feature of metals markets that when stocks rise, the price falls.
But not since 2008. Today, stocks at the London Metal Exchange are high and
rising, but so are metal prices. In both these cases - as well as with
grain and foodstuffs - the new factor in recent years is that these markets
have become fashionable for financial speculators.
To sum up, we have financial institutions that have power without
responsibility. They are dedicated to using that power to make profits for
themselves. They now know they can drive markets in one direction or
another for most, if not all, of the time. The distorted signals these
markets then deliver hold governments and the world's citizens to ransom.
From being the servant of the world economy, the financial markets are
becoming its master.
This is not how the system was meant to work. This is not what a belief in
markets was meant to deliver. It is impossible to know how it will end but
it is surely unsustainable.