Financial Markets: Free and Compulsory

0:00I changed the title of the paper again. What I'm really doing in the paper is to analyze the place of financial markets in the division of labor. It's the first installment in a series of papers in which I try to develop an Austrian analysis of financial markets and of the institutions of financial markets. I'm working on this myself. I have a couple of PhD students working on this and similar subjects. So I hope we will turn out something in the two or three years to come. It's a field of inquiry that has been neglected by Austrians, but I'm glad to say not only by Austrians, because if you look at the financial markets literature, it's actually quite poor as far as the economics is concerned.

0:45So we get a lot as far as investment is concerned, investment strategies, risk evaluation and so on, But we do not really have an overall economic theory of the financial market in particular as far as their contribution to economic growth is concerned. Which is of course one of the crucial questions that we have to ask ourselves. What is actually the aggregate value added of financial markets? Looking at the sheer size of those markets, it's clear that they are very, very important. To give you a rough idea, world GDP is around $50 trillion. Right now, nominally, it might be shrinking. Financial markets, this was in 2005. 2005 also, the size of financial markets without derivatives, so just stock markets and bond markets, was about $140 trillion

2:16of the past 18 years. So can financial markets do any good? Intuitively as Austrians and probably more so as libertarians you should say well of course financial markets should make some positive contribution after all they result from contracts and so if people make contracts I mean they have a good reason for this so at least they improve their net value position as compared to a situation in which they would have been without financial So the whole point is to clarify these things in a systematic matter. And what I do in my paper, of which I didn't bring copies, but I'll be glad to send copies to those who are interested, I approach the subject from the point of view of the division of labor. Why the division of labor? Well, it's the most basic theoretical element by which we explain the benefits of social cooperation.

3:08Cooperation, and unfortunately, as all teachers of economics here know, it's a theory that's very much neglected in economic teaching and in economic theory. So the only place where mainstream textbooks today talk about the division of labor is in international economics. International economics always starts off with the division of labor, so you get Ricardo's and absolute advantages and comparative advantages, it's wonderful, but in all other classes apparently That's not really important. There's no mentioning of the theory in microeconomics and not even in macroeconomics where it would really be important. So, as Austrians, of course, we have always a presentation of the benefits resulting from the division of labor in our main textbooks.

4:00So human action, even before it gets to the market, we have a discussion of the division of labor, man economy and state, same thing. And this theoretical element is of fundamental importance also when it comes to evaluating the contribution of financial markets, because all special benefits derived from financial cooperation are in fact particular manifestations of the general benefits resulting from the division of labor. So what are these general benefits? The division of labor always creates a physical surplus and the amount of total products that result from human beings that are coordinated in a division of labor, that is, they do not just produce as if they were the only persons in the world, but also produce in view of the needs of other people, the total output is larger than the total output that would have resulted in such a in a physical setting which people just produced as if they were the only persons in the world.

5:02So we get a physical surplus. And this, ladies and gentlemen, holds, of course, whatever the two goods, five or six goods, or five thousand or five million goods, that are concerned. Now, we are not necessarily interested in a physical surplus. The surplus always results from a division of labor, but we are only interested in those surpluses that have subjective value for us. So we can, of course, organize this whole room into a division of labor where we are all producing paper planes. It might be actually fun, but they would not have that much value, actually, I guess, for most of us. So it would be actually a waste of time. It would be a higher opportunity cost. We would have to renounce too many projects because of pursuit.

5:47So the surplus must have value and the division of labor must therefore be organized in a way that is value productive for all participants, for all members of this society that engages in the division of labor. And this is the heart of the coordination problem. So we have the question, how should the division of labor be organized? There are various techniques. We can either have voluntary arrangements of which the free market is a part, or we can have coercive arrangements. We have one guy with a big stick that bullies people around and tells each one what he has to do. If we have voluntary agreements, there can be settings like we can have a big Soviet council, everybody sitting together and making a common plan.

6:39a common plan and then united with a common idea. We're marching separate ways. That's wonderful. Or we can have a division of labor even without having a common plan. And that's the great charm of the market economy. We don't need to have a common plan in order to have many, many million and billion of people actually be coordinated in production. We know that the market solves this is a coordination problem through the price system which creates different returns on investments on different investment projects which brings us to the subject of the coordination between savers and investors and that's fundamentally the problem that we have to discuss if our subject is concerned. So there is a division of labor between savers and investors and This division of labor is likely to produce a physical surplus, just as any other form of the division of labor is likely to produce a physical surplus.

7:41The physical surplus results, most fundamentally you can distinguish between the cases where saving an investment is united in the same person, and the other case in which saving an investment are pursued by different groups of persons. So there would be savings and investment, of course, even in the complete absence of a division of labor. People would simply specialize in different investment projects and therefore contribute a physical surplus from the aggregate point of view. If we have specialization, can we imagine this? Well, very simply, some people are just better at saving. Right, they are better at living a frugal way of life, well, I see it's not the American part of the story.

8:31What are these people like here? And other people, so this might be French, right, French people or Chinese, Japanese, Japanese are very frugal. And other people are better at investing, right, so you have other people who are not really particularly frugal, but they are very imaginative, very creative, And they have a good feeling of what prices might be realized for goods that we plan to produce now. So there is a scope for the division of labor between these two groups. How does this division of labor come about? Well, it can be organized by contract. That's of course the case of financial markets. So financial markets can be defined as the division of labor between savers and investors through contracts.

9:20of Contracts, but there is even a more fundamental way in which this division of labor can take place, even in the complete absence of contract, namely in the case of cash holdings or cash hoardings, which was, by the way, since we talked today about coinage and old ways of producing money, which was for many, many centuries and probably thousands of years, the traditional way for people in monetary economies to make savings, So they didn't have a bank, or if they had a bank they didn't trust the banker, but they had monetary revenue and they were saving a part of this monetary revenue. Savings being defined always as the difference between revenue and consumption, so consumer expenditure.

10:10So what happens when people save cash? If the demand for money increases, as the Austrians say, well they thereby exercise a pressure on the price level, which means that all prices tend to decrease. What it does not mean is that the goods that are on the market disappear, so the consumer goods are still there, the producer goods are still there, and these goods will only now be sold at lower prices. Now this means that the purchasing power of the money units used by the other entrepreneurs, other investors who have not been as frugal as those ones that we are now considering, they have a higher purchasing power so they can buy more.

10:56So there is an implicit and automatic coordination, well it might not be the strongest one, but there is this coordination between savers and investors, even in the complete absence of a contractual arrangement. Cash-holding is not a black hole, as some Keynesian theorists seem to believe, it's not just a black hole through which part of the money supply disappears and so we are impoverished, there's no more spending going on. It just means that those people who do not save now have a higher purchasing power and therefore have a greater say, so to say, in deciding which investment projects should be started. But then, of course, this coordination can also exist in the case of financial markets, so we have a coordination that comes through contracts.

11:51And here we need to distinguish two basic cases. In the first case, the savings result from income at a given money supply. Okay, so whatever the money supply is, the savings, or more precisely the constant money supply, savings are made from a constant money supply. And on the other hand, savings can also be made out of money production. So we have a central bank that is producing money and then a part of this money can be not be spent on consumer goods but spent on producer goods. So let's consider first what I do with the paper is to consider, distinguish these two cases and the result is if we now look at the impact of financial markets on the volume of investment and on the volume of savings, We find that of course the volume of investment depends on the volume of savings, which in turn now depends on the return on investments.

12:53So the new element that comes here into play compared to the case of cash holding is that there is now a return on investment. We are investing money, handing it over to another person, we are being paid an interest rate typically, or we are participating in the profits, so there is a monetary return on investment. So the aggregate positive effects that result from this is that the specialists, the better investors, get a greater hand, they are relatively more important. So investment, the quality of investment improves and this might have therefore a positive aggregate impact on physical output. On the other hand, the volume of investment of savings and the volume of investment does not necessarily increase.

13:44This depends on the time preference of the market participants. Let me maybe just give an example. So we have here an investment project and we are investing 100 units of money, 100 million dollars and at the point of time, G2, we get 120 million dollars of a return. Whereas before we had 100 units cash holding and now we get also 100 units cash holding.

14:29Well, what this means is not necessarily that we will now save more, it can also just be that we save less than before, we might for example just, so we have a 20% return here, it might be, we might for example reduce our overall investment, In the Austrian literature, we have a certain debate on the income effect. So we have people like Hans-Hermann Hoppe.

15:11In the Austrian literature we have a certain debate on the income effect. So we have people like Hans-Hermann Hoppe and Murray Rothbard who hold that as income increases, the total volume of savings always increases as well because time preference is positive. One of the few diagrams that we find in, so this is revenue, this is the social time preference, so the interest rate, so we have this diagram that we find for example in Hoppe, one of the few diagrams that he uses, and so the idea is that as society becomes richer, the time preference diminishes, so people are saving more.

16:01This has been criticized in a very good paper by Walter Block and Bill Barnett, who show that this is certainly, this might be so empirically, but it's not an a priori law, it's not necessarily the case, from a logical point of view, that people who have a higher income, therefore save more, it all depends on how much money they have. It's not necessarily the case, from a logical point of view, that people who have a higher income therefore save more. It all depends on the time preference. A person might save more if his time preference is actually low, but if he has a high time preference, the additional money available will not be used for saving but for consumption.

16:46So what does this leave us with? It leaves us with the conclusion that from a praxeological point of view there is no systematic impact of financial markets on the volume of savings and therefore on the volume of investment. It might have a positive contribution and it might also have a negative contribution. This is very difficult to evaluate empirically. Empirically we just observe what has happened. It's difficult to compare this to what would have happened in the absence of financial markets. What are the particularities if the savings come from increases of the money supply? Many Austrians would be inclined to deny that this is the case of savings at all. If we just increase the money supply, how can we say that the volume of savings has increased if we do not spend all of this money?

17:35But I think from a purely definitional point of view, one cannot get around this. Savings are defined as the difference between revenue and consumer expenditure. So if our revenue increases, and it certainly increases by money production, and we spend as much as before on consumer goods, then by definition savings increases. But what we have to do now is to distinguish between the monetary level of savings and the real level of savings. And of course, the real level of savings, the real level of investment does not necessarily increase. All that happens is that the money supply increases. So we benefit some investors, namely those that are closest to the money producer at the expense of later investors.

18:25So we have an impact on the structure of production, but we do not get an overall increase of real savings and of real investments. Financial intermediation does not bring any new aspects into play, because financial intermediation is just like indirect exchange, the use of money, it's just two financial markets subsequent in time, for example if you consider a bank, we have a bank customer giving a credit to a bank and then the bank hands over credit to another person, so we have two financial markets, so the general principles that are involved are not different. What are the conclusions that we can derive from such basic considerations?

19:11First of all, I think this is a very important point of stress, is that the division of labor would exist, of course, without financial markets. So, there would be saving and investment, and savers and investors would be coordinated, even the complete absence of financial markets. And there would even be a coordination between specialists in savings and specialists in investment without financial markets. So the possible contribution of financial markets from an a priori point of view is marginal. So there would be a positive contribution, but it's not the case that, for example, if we had to give a practical application, The present situation in which we have to ask ourselves, well, what would happen if we let the whole economy melt, the whole financial markets melt down, if the governments no longer intervene into the economy?

20:12Sometimes we're listening to President Obama who says, well, everything is based on credit, so no more credit, everything will just vanish, there will be this big black hole. Well, from basic consideration we can infer, well, that would not necessarily be the case. It would certainly not be the case that everything would just vanish. There would be different forms of investment, there would be different forms of coordination between savers and investors, more primitive certainly than in the case of financial markets, but they would provide a rock bottom from which financial markets, after having melted down, could rebuild anew. Thank you very much for your attention.

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