Showing posts with label finance. Show all posts
Showing posts with label finance. Show all posts

Saturday, 13 October 2012

A question of reality

In my recent post on the difficulty I have with mathematics, some of the comments appeared to suggest that mathematical objects that could not possibly exist in nature - such as perfect circles - nevertheless had objective "reality". This to me raises a fundamental question: can things that have no physical existence, but exist only in the mind (or in a computer representation of the human mind), be "real"?

This is not wholly a metaphysical question. I think it lies at the heart of the ongoing debate about the relevance of finance and economics to the world economy.

To me, economics is fundamentally a means of describing and predicting the transactions between real people for the real goods and services that they produce using the real resources of the earth. It is not about mathematical proofs, though economists do seem to spend a lot of their time developing these (not always with much relevance to the physical world). Nor is it, really, about money. But it seems to me that many academic economists now spend much of their time describing and predicting the behaviour of money.

Money is not a real good or service. It is a representation - a symbol - of real goods and services, that is all. And yet we have financial markets in which money, in various forms, is traded as a good in itself. Why does a virtual market for a virtual good (which is all money can ever be) demand so much attention from economists - and these days not just from economists, but from politicians and the media too? Why has the value of money become the primary driver of our economy?

In 1995, I designed a financial system that could model and account for a vast range of financial instruments, including complex derivatives, using contract theory. At the time, credit derivatives were just beginning to appear on the scene, and part of the objective of the system was to be able to understand and control credit derivatives. Sadly, the five-dimensional data model I created was too complex for the IT department to be able to translate into reality using their preferred technology, so the system was never built - if ever there was a case of the tail wagging the dog, this was it. However, that is not my point here. One of the things I had to model was cash, and cash-like instruments. And as I did so, I became more and more concerned about the unreality of the entire financial system. I saw the house of cards forming - and I saw the abyss upon which it is built, the black hole from which it draws its energy.  At the time, I didn't know what was in the black hole. But now I do. That black hole, I know now, is the real economy.

You see, our entire financial system is built upon a promise, that is all - a promise that we, the people, will produce enough goods and services to support the amount of money needed by the financial system. That's what a fiat currency system is. This definition should of course be the other way round: the amount of money in circulation should be enough to support the exchanges of real goods and services by real people in the real economy. But I have defined it as the financial system sees it, which is a mirror image of the reality.

Finance is a looking-glass world. Assets are liabilities, liabilities are assets, impossible objects are real, real objects have no meaning......The trouble with working for a bank is that you lose contact with reality. You can start to see the real economy as a black hole, something about which you know nothing and care less. It is simply a source of money: the connection of that money with the productive work of ordinary people is lost.

This is how money becomes a "good" in its own right, traded by people who know nothing of the real economy. Financial traders (no, I was never one!) occupy an "ivory tower" as high as that of pure mathematicians, and their "products" are every bit as unreal as a perfect circle. But we don't trade perfect circles, do we? At least mathematicians KNOW their objects exist only in the mind!

Back in 1995, I think we still knew that financial markets weren't the real world. But we seem to have forgotten this now. Monetary economics dominates: models of the economy concentrate on the behaviour of money: economic management is increasingly the province of central banks. Tweak an interest rate, buy some bonds, create some more money - those are the tools of economic management these days. Fiscal policy, too, is more concerned with the behaviour of investors than it is with the wellbeing of working people. The house of cards is bigger and more fragile than it has ever been, and it draws more and more money from the black hole to keep it alive. But the black hole is shrinking.

The IMF warned this week that there is a serious risk of global recession. And in a recession, the amount of money available to the financial system must fall. Production of goods and services declines: people's wages fall: people don't spend money. The engine that drives the creation of money for the financial markets runs at a slower pace. The UK, Japan and much of Europe are in recession: the financial engine is already running slower in these countries. Other countries, including emerging markets, are also slowing. There are suggestions that this slowdown may be permanent, that the world cannot return to the sort of growth levels seen prior to the 2008 financial crash. Yet the financial system still needs money in ever-larger quantities. So we respond to this by draining more and more from the real economy: the financial system grows ever more dominant, while the real world shrinks. The 2008 crash has so scarred us that we are terrified of the consequences of another crash: we would rather reduce whole nations to penury than allow banks to fail and investors to lose their money.

It seems to me that we are confusing the virtual market with the real market, the movements of money for real transactions. And the more time and energy we spend analysing and explaining the movements of money, and trying to influence the behaviour of investors, the further removed from reality we become. Christopher Cole, in an extraordinary article for Artemis Consulting, describes how the financial world - the simulacrum - is becoming the real world. His thinking is oddly reminiscent of the film The Matrix - and indeed he alludes to this in his article. But we really can't sign up to his vision. To do so is to consign the world to ever-shrinking real economies, growth of poverty and inequality, and social unrest. The image cannot become reality. Even traders have to eat, and you can't eat money.

The real tragedy is that we have never been so capable of feeding ourselves and producing all the goods we need. But the financial system depends on there being scarcity, because scarcity causes high prices, and only through high prices can the amount of money required by the financial system be justified. Allow prices to fall to a point where the real economy simply does not need the amount of money in circulation - what then happens to the financial system that depends on that money? Our "unconventional monetary policies" are all designed to raise prices, one way or another - by increasing world commodity prices, by raising domestic inflation, by pushing up financial asset prices. The claims of central bankers that these policies stimulate the real economy are hollow. They do not - they maintain the image.

Not only is finance a looking-glass world, it is a world of impossible contradictions. At the same time as  unconventional monetary policies are raising prices to enable the black hole to continue to produce the amount of money the financial system needs, the fear of inflation drives fiscal actors to cut spending and raise taxes, reducing real incomes and seriously constraining activity in the real economy, resulting in price cuts in non-essential goods and a falling money supply. The arguments used by economists to justify such behaviour in a recessionary environment are among the most convoluted I have ever seen. It seems that the economics profession has an ivory tower all of its own, in which it develops theories such as "expansionary fiscal contraction" that have nothing to do with economic reality and everything to do with trying to resolve the distortions in our financial image of the economy.

You see, although like mathematical objects, financial objects exist only in the mind, they are far from  perfect. They are illogical, contradictory and illusory. The real value of money is determined only by the value of the goods and services we produce. It has no intrinsic value of its own, and no meaning aside from that which we ascribe to it in the course of our real economic activity. We are paying a terrible price for our confusion of real with imaginary. All our productive energy now goes into feeding zombies.

The debate about "what is real" in economics - what the focus of the academic profession should really be - may run for quite some time yet. But to me, it is obvious. In 1995 I decided that I would eventually leave banking, because I could not spend the rest of my life propping up something that wasn't real. I wanted to live in the real world, even if I was materially poorer as a consequence. It took me another seven years, but I did leave, and I don't regret my decision. We can all make that choice. The financial world is not the real world. We do not have to live in it.