Australian Lefty on Politics, Governance, Science and Info Management

Capitalism dies of derivatoma

Posted by Dave Bath on 2007-12-19

Marx would not have expected capitalism to die in the way it already has.

It might be only a little premature to say that capitalism has died of derivatoma, a pun I’ve given to the cancer of the rampant growth of the use of derivatives, but it is certainly on life support, with the emergency supply of "oxygen" by central banks to overcome the credit crisis.

The problem is defining a good name for the current economic paradigm that so bedevils most world economies.

Perhaps "financialism" is appropriate.  The use of derivatives and finance methods, the volatility of investment first in one stock then another, has decreased the actual interest the investor has in the long-term viability of any particular stock.

This is why I say capitalism is almost dead.  Originally, capitalism was about people with surplus money investing in a business that had good prospects but was cash-strapped.  The investor was in for the long-haul – being unable to swap investments every minute (like you can with modern trading practices), and therefore wanted the company to do well rather than merely take profit from daily trades.

With use of all the new-fangled derivatives that are based less and less on the health of the company that receives the investment, the capital no longer gets allocated by Adam Smith’s invisible hand to where it is most useful.

While there derivatives and finance vehicles may be useful in specific cases, when they become so common that the entire market is skewed away from traditional capitalism, the system as a whole becomes pathological.

In computing, we had a rule of thumb that said that too much local optimization can lead to a global pessimum.  For example, when a whole lot of parallel subroutines optimize their loops for speed, this can make the system as a whole run like a dog – because the information flow between the routines is slowed and processing power is not allocated optimally between processes.

It’s the same thing in the economy with these financial instruments I would not regard as capitalist, and with high-speed trading.

While I’d be tempted to ban derivatives altogether, the compromise is to make trading in them highly regulated (as recommended by "The Economist") so they are less likely to be abused, and less likely to disappear in a puff of smoke like the CDO’s (Collateralized Debt Obligations) that have caused so much damage.

But free-market zealots don’t like the idea of government regulation, and should actually be objecting to the "government interference" by the reserve banks bailing out the free-market.

The current credit crisis is proof that the "free-market" has become dysfunctional because of these derivatives.  Those who object to socialist-style economies (and I’m a lefty) should attempt to preserve the best aspects of capitalism by regulating against pathological "financialism".


6 Responses to “Capitalism dies of derivatoma”

  1. Jacques Chester said


    A lot of libertarians do object to the bailouts — it’s seen as socialising risk with all the moral hazards and risky behaviour that encourages.

    The current orthodoxy comes from Chicagoan economics, that the Great Depression was caused by a liquidity crunch. In that framework the financial system must be supported at almost any cost.

    The competing libertarian strain of Austrian economics is more or less completely different from the Chicagoan approach. They see the cause of the Great Depression as inflation of money supply leading to irrational, exuberant investing. This in turn leads to big crashes. They prescribe a gold standard as a way to visibly regulate and slow the money supply.

    Google “free banking” for the latter view. You might also find Rothbard’s What Has The Government Done To Our Money? as a fairly punchy summary of the Austrians’ position.

    Based on my observation of the 1999 tech wreck and the current crisis I am sympathetic to the Austrian view.

  2. Dave Bath said

    Thanks for the link… interesting.

    You said

    A lot of libertarians do object to the bailouts — it’s seen as socialising risk with all the moral hazards and risky behaviour that encourages.

    From my lefty leaning, I’m in favor of socialized risk and profit when the direct beneficiaries are either the citizenry as a whole or the administration.

    The anti-socialist private sector fans who advocate bailouts of service sectors do seem hypocritical and self-serving, because they are going against the only philosophy that gives any justification to the private enterprise system.

    That said, when advocating socialist positions (such as the nationalizing of the Northern Rock Bank in the UK), at least The Economist admits its embarrassment: but while a believer in free markets, at least its position is nuanced by seeing the economy not as an end in itself but a means to bettering the human condition.

    It’s worth noting that a little while back The Economist predicted the disaster caused by the abuse of poorly regulated derivatives, as well as saying that if the US Fed (and other central banks) kept lowering official rates – and by extension the current bail-out – the objective was not the benefit of citizenries and economies as a whole, but the middle-men and traders.

    I agree that the current (and Great Depression) problems of the market were caused by "irrational, exuberant investing". The masses have been attracted into playing the market by the those at the top of the market food chain so they can get all the risk. When Costello proudly pointed out a few years ago that more Australians are playing the stock market than at any time since the 1920’s, he put the writing plainly on the wall.

    It’s worth recalling Carnegie and the Apple-Lady. I’ll post more on this later.

    When a lefty like me, who wants the profit motive abolished, laments the death of classical capitalism, you know the successor is worse.

  3. Jacques Chester said

    Well, like I said, there’s two camps.

    Chicagoans see a legitimate and important role for government in the monetary system. Essentially they exclude financial institutions from the general requirement that poor management leads to failure, because the effects of failure are not localised.

    Put it this way: the Chicagoans are saying that the failure of any financial institution has negative externalities. Very big ones, because of money’s centrality to every exchange. If the steel industry goes south, some people suffer. If there’s a drought, some people suffer. If nobody wants candy any more, some people suffer. But if finance goes south, everyone goes with it.

    The Austrian position is that money originates from the free market and should stay there. Rothbard’s analysis builds on the fact that deposited money is amplified by fractional reserve banking — a modern bank does not have enough reserves to meet all possible demands, by a large (and regulated) ratio. In the period of the Great Depression this led to the run on the banks, which destroyed a lot of people’s savings.

    Today a lot of banks multiply their debt exposures even more by acting as debt middlemen. They aren’t loaning multiples of their deposits: they go directly to finance markets and sell bundled-together homeloans.

    The Austrian view is that there’s too much money; or rather, much more money than there would be free banking or 100% reserve banking. When there’s so much money laying around, people will take punts on riskier enterprises. Those enterprises can bid up the price of resources from more established firms with more solid markets, driving their costs up. A lot of previously successful businesses go out of business in favour of risky gambles. Eventually it all unwinds and a process of reallocation takes place – a recession or depression.

    This is called “Austrian Business Cycle Theory”. Like I say, it squares with my understanding of both the tech wreck and the current state of play.

  4. Raf said

    Derivatives are an example of a snake devouring its own tail. There’s a good paper on my website by John Tomlinson which takes apart Barclays Bank’s balance sheet and exposes the true level of cash (at the time about 3bln against 1.3trln pounds in derivative contracts).

    The issue seems to be where do we go from here. A return to the Gold Standard seems a backward step. After all it failed the first time round and in fact was a failure from the beginning given that paper money grew out of lending practices from the goldsmiths.

    but one thing i think we probably agree on is that there must be some limit to the amount of money in the system. currently there is a reliance on interest rates to hinder the money supply. even though this is continually exposed as a waste of time it continues (of course, it’s how the financial system generates wealth). capital ratios are at best an illusion of risk management.

    perhaps we can look at 2 options: either a central control via some monetary authority which regulates directly the amount of money in the economy or a distributed network where people issue their own money, such as advocated by Ripple.

    Essentially we need to remove the speculative element on money itself as opposed to creating wealth through real growth which is more the classical position.

  5. […] "Capitalism dies of derivatoma" (2007-12-19) Posted in Economics and Business, Politics. […]

  6. […] on Euro v USD as premier currencyAdam Smith and the financial crisis « Balneus on Capitalism dies of derivatomaDave Bath on Adam Smith and the financial crisisRaf on Adam Smith and the […]

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: