capital markets

QE3 was announced today and reactions have been relatively muted. There are some complaints that money is again being redistributed from asset holders to debtors via the mechanism of negative real rates. It seems like a good occasion to put forth two oddities that I’ve always seen as embedded in capital markets as they’re currently constructed. They are: the assumption that money doesn’t spoil, and the assumption of market optimality.

The first assumption. Most people expect money to be a store of value, of an almost contractual nature. This is why they keep it in the bank or invest in capital markets in the expectation that a non-negative real return is deserved. When this does not happen, they are understandably unsettled. However, whence comes the notion that money doesn’t spoil like food? In the days of barter, non-perishable goods were stored and exchanged as money is, but their non-spoilage was predicated on the fact that they were goods that were to be directly used during the consumption period. In separating the good from the money function, now, excess production can only be “stored” (it is of course actually immediately consumed) to the extent that the social contract will be honored to exchange them for goods during the consumption period. This is where non-perishability is presumed lost. The social contract does not specify the exchange rate of money to goods. In expecting a non-negative real return on money, we are essentially expecting that during the consumption period, we will get at least as much value as we “stored,” as measured by the valuation of goods at the time of “storage.” This is exactly the non-perishability assumption. This is very strong. As mentioned, everything in nature is perishable to some extent. We are already expecting more than is natural right off the bat. The only reason such a social contract is even possible is due to non-decreasing output, i.e. the assumption of growth.

Then there are those who expect not only to have a non-negative real return, but at least a market return. This is the expectation that during the consumption period, we will get at least as much value as we “stored” proportionally to the fraction of output we produced in the economy at the time of “storage.” For example, if technology improved, we would expect that our “stored” widget version 1, would be returned to us as the much improved widget version 10. This seems greedy yet fair. In contrast, the expectation for non-negative real return seems rather tame now, doesn’t it? Until you consider that the economy might actually contract. What if, due to whatever circumstances, the excess producers during the consumption period do not produce enough value to proportionally divide among those who “stored” value an amount that is more than what they stored? This could be by will or by necessity. What if all we had were widget version 0.5? Would it still be plausible to insist on non-negative returns? It would not.

In fact, following a period of great excess in production, especially one that prematurely fulfilled useful work for some time into the future (until new technology and demand develop), the right view is that the nominal amount of stored value is irrelevant — it is not exchangeable.

Now the second assumption. Capital markets are a great invention. They solve the centralized allocation problem in a distributed way. We assume that rational actors freely acting in their own self interests will produce a solution that allocates capital in the “optimal” way. Perhaps it isn’t a global optimal (requires cooperative strategies), but a more basic question is what planning problem do they solve in the first place? Let us give individual actors the benefit of the doubt that they can do planning and are perfectly rational. Nevertheless, it seems difficult to imagine that any would do planning much beyond their own lifespans. That would not be rational. Thus, capital markets are essentially solving an allocation problem based on each individual’s preferences for maximizing their own utilities during their lifespans. This has great implications. First, it puts an upper bound on the planning period for the allocation problem at the longest remaining lifespan among individuals. This is like 80 years or so. That is pretty myopic. It seems like a long time, but for many decisions, especially concerning resources, it is very myopic.

It gets worse. That was just an upper bound. Inputs into capital markets are weighted by the amount of money committed to a trade. It is a given that older (working) people have greater wealth, and as a consequence their inputs as expressed by capital commitment are weighted more in the allocation decisions. That is exactly what you don’t want, because a shorter remaining lifespan is now correlated with larger weight in decisions. The net result is that the capital allocation decisions are being carried out for optimality over very short planning periods, possibly only on the order of 10 or 20 years at most. It isn’t even optimal for most people alive any more.

So this is a fundamental problem in capital markets. Under the law of one price for open markets, only one view can be ultimately carried out, and it is one that is too myopic, and even myopic for most people. The only way to correct for this is to weight the inputs properly, and that would require external intervention to enforce a political planning decision.

No comments yet. Be the first.

Leave a reply