From Positive, To Zero, To Negative-Sum Capitalism

by: Shareholders Unite

Capitalism, with its property rights and free markets, has been a great motor for economic wealth creation, technological advancement and bettering the lives of millions of people. One of the great institutional benefits of capitalism is that, by and large, it aligns private to social incentives. That is, people pursuing their private benefits usually increase social welfare as well.

This is simply Adam Smith's invisible hand. By creating products and services consumers want, entrepreneurs are creating economic activity, jobs, shareholder wealth, and these societal benefits multiply when much of the created incomes and wealth gets spend, increasing demand for other products and services.

As Friedrich Hayek explained in what is one of the most important economic publications of the past century (Hayek's "The use of knowledge in society"), it is the distributed nature of knowledge and information that makes centralized solutions distinctly second best. Capitalism works because it manages to link this distributed nature of knowledge and information with the incentives to make productive use of these.

For instance, at present there are literally hundreds of labs and start-up companies working to try new concepts and materials in solar energy (and, of course, many more working in numerous other fields). The price is to arrive at a commercial product that increases solar conversion efficiency and/or reduces its cost.

There are so many new concepts and materials tried, it's like a gigantic trial-and-error experiment, enlisting some of the best minds in very specialist niche categories of knowledge and expertise.

But solar energy also shows how markets are not always enough, as for most of the world, solar energy isn't cheap enough to be able to exist without subsidies so markets wouldn't exist in their absence. But, with a few notches, this can be remedied and the markets created which makes full use of the distributed knowledge and incentives to improve things.

Market failure
However, even Hayek knew that complete market liberalization is unworkable. In a review about a book on Hayek (and Friedman), Angus Burgin argues:

It has serious defects: successful actors reach for monopoly power, and some of them succeed in grasping it; better-informed actors can exploit the relatively ignorant, creating an inefficiency in the process; the resulting distribution of income may be grossly unequal and widely perceived as intolerably unfair; industrial market economies have been vulnerable to excessively long episodes of unemployment and underutilized capacity, not accidentally but intrinsically; environmental damage is encouraged as a way of reducing private costs-the list is long.

Indeed there is a long list of market failures that can often be addressed by some subtle institutional change and/or regulation or taxation. The solar subsidies above are addressing the problem of missing markets. Increasing mileage standards would go a considerable way to reducing pollution (an 'external effect', another type of market failure where private cost and benefit do not coincide with those of society at large).

A type of market failure that isn't widely recognized is when two parties to a transaction have different levels of information, known in economics as 'information asymmetries'. With products and services getting increasingly complex, the problem of information asymmetries is growing.

Information asymmetries can be exploited opportunistically, think of tobacco companies knowing for decades that smoking causes cancer, but not telling you, or plastic producers keeping their ingredients a 'trade secret,' whilst it now turns out there are numerous risks involved with some of the ingredients (if we even know what they are in a particular product, as these are often kept secret).

High Finance
Much of modern day finance is characterized by the following unfortunate combination:

  • Redistribution (zero-sum), rather than creation (positive-sum)
  • Information (and the timely access to it) is often key, creating widespread information asymmetries.

Much of modern financial activities are redistributive, rather than creative. That is, many transactions are zero sum, that is, one party's loss is the other party's gain. This is quite different from the capitalism described by Adam Smith's invisible hand. There isn't really any wider social good in much of modern finance.

Indeed, no less of a figure than the director of the FSA, the British financial sector regulator argued that:

a large part of financial activity is "socially useless"

In the original 2009 interview with Prospect Magazine, Turner was specifically mentioning financial innovation, what are the social benefits of stuff like abacus, shadow banking, high-frequency trading, naked short selling, credit default swaps, or off-shore tax havens.

Some are illegal (but nevertheless happen, or at the minimum did happen fairly widespread, like naked short selling), some are activities to escape regulation (offshore tax havens, shadow banking), the others are means to gain the upper hand in bilateral zero sum games, but we invite anyone to make a convincing case for their social usefulness.

What's more, in these zero-sum games on financial markets and in many financial transactions, information and timely access to it is the crucial variable determining outcomes. Unfortunately, much of the information is extremely complex, opening up the field for widespread opportunistic exploitation of information asymmetries. What happened to abacus sums it up this problem.

Financial institutions first used their information advantage to push mortgages to those who could manifestly not afford it. In the days of 'old finance,' this wouldn't have happened as these financial institutions would have to assume these risks themselves. However, in the new era of financial engineering, the resulting risky mortgage debt was sliced and diced to increase the complexity to such an extent as to effectively hide the risk. Most of it even got top rating from the rating agencies.

So the financial institutions could rid themselves of these risks by hiding and selling it, that is using 'information asymmetries' a second time. The most opportunistic of these even bet against the tradable financial instruments thus created, opportunistically using information asymmetries a third time.

It is perhaps the most dramatic, but of course by no means the only example of financial transactions being redistributive and falling victim to information asymmetries. It is long practice for management of companies to put out their prospects in a favorable light. Combined with incentives that were meant to align their interests with those of shareholders, this can be a rather toxic combination as we've seen in some big accounting scandals.

This holds even more true for many 'investor relations' outfits, or vulture finance firms that operate in the small cap world. Relatively new is the paid basher operating on message boards (Yahoo is particularly notorious), or 'short and distort' scheme's. But zero sum situations combine with information asymmetries in other parts of finance as well.

Such is the complexity of their positions in financial markets that valuing big banks is only really possible if you let specialist go through every position the bank has taken on at what time and under what circumstances, in order to assess what kind of obligations it is facing. But that is not enough, many of these positions are only really intelligible by considering the mathematical models on which they're based.

You have to have a firm grasp on these mathematical models yourself to make sense of it, which is not given to many, to put it mildly. This, by the way, is also the main reason these positions, some of which turned out to be extremely risky, were taken with such ease, or why they got ratings approval. There were simply too few people who really understood them.

This is no way to run a highly interdependent financial system where nobody really had a firm grasp on the risk of some instruments, much less on that facing a particular financial institution, let alone the financial system as a whole. Stuff like this doesn't create much, if any, wealth, it redistributes it. It doesn't reduce risk, it redistributes it and the efficiency of that redistribution leaves much to be desired. As we have seen in 2008, the distribution of risk was such as to make it systemic.

Yes, it's true, great fortunes were made. By some. But not, as in Adam Smith's positive-sum game capitalism, to the benefit of wider society, but rather at its cost. This isn't even zero-sum capitalism, this was negative-sum capitalism.

High frequency trading
Just another example of zero, or perhaps even negative-sum capitalism is the emergence of high-frequency trading (HFT). Yes, this also makes fortunes for many of those who practice it. But it's inherently zero-sum, and where it shifts wealth merely from those that have no access to it to those that have, the redistribution doesn't bring any societal benefits and might very well bring harm.

By 2010, computer (algorithm) driven trading constituted 70% of all trading volume in US equities and 30-40% of trading in European equities, according to a Bank of England report. Not all high-frequency trading (HFT) is equal though. Practices like 'queue jumping' (that is, getting in front of other bids or asks) or stuffing the system with bogus orders seem more harmful than merely executing trading algorithms.

It can be very profitable for its practitioners though:

A 2010 report from Barron's, for example, estimates that Renaissance Technology's Medallion hedge fund - a quantitative HFT fund - achieved a 62.8% annual compound return in the three years prior to the report. [Baselinescenario]

However, trading is a zero-sum game, it doesn't create any value, it merely redistributes it, and perhaps not in the best way:

A top government economist has concluded that the high-speed trading firms that have come to dominate the nation's financial markets are taking significant profits from traditional investors. The chief economist at the Commodity Futures Trading Commission, Andrei Kirilenko, reports in a coming study that high-frequency traders make an average profit of as much as $5.05 each time they go up against small traders buying and selling one of the most widely used financial contracts. [New York Times]

Apart from the purely redistributional effects, this might very well reduce trust of many investors in the financial markets, especially after deep sudden plunges of entire markets or when the more vile activities like queue jumping or bogus orders get the attention they deserve. Is this really the kind of practices we want on our financial markets, where the likes of Goldman Sachs can boast that they enjoyed yet another quarter without a single day of losses, paying out huge bonuses but leaving many investors in the dust?

Do we really want that our best and brightest engage in these practices that are at best of a zero-sum nature, and at worst make the financial system more fragile, could lead to widespread mistrust in our financial markets, and redistribute from the less wealthy to really rich?

Doomsday Cycle
Much of the rent-seeking, redistributive and sometimes predatory nature of modern finance couldn't exist if the 'rules of the game' didn't allow it to prosper. This is immediately clear if one considers that finance wasn't always like this, and it still isn't in many countries which have beter 'rules of the game' (that is, regulations and institutions).

So there is a wider corrupting influence spreading from this. Apart from attracting the best and brightest minds for activities that often don't create wealth, but merely redistribute it, bright minds that could have been trained and employed in productive activities that do create wealth, there are wider political ramifications.

Simon Johnson, former chief economist of the IMF, has spoken of a doomsday cycle in which the symbiotic relation between politicians, regulators and big financial institutions produced:

Bailouts have encouraged reckless behaviour in the financial sector, which builds up further risks - and will lead to another round of shocks, collapses, and bailouts. [Johnson]

His description of this quiet coup remains one of the best analysis of what led to the 2007-8 financial crisis and really is compelling reading. Johnson argues that over the past four centuries, financial development has strongly supported economic development, but:

in recent decades, parts of our financial development have gone badly off-track - becoming much more a 'rent-seeking' mechanism that draws support from politicians because it facilitates irresponsible public policy... The alliance that leads to unsustainable finance here is simple: the US financial system earns large 'rents' (excess returns to labour and capital) from the implicit subsidies offered by taxpayers. These rents finance a massive system of lobbyists and campaign donations that ensures 'pro-bailout' politicians win elections regularly. [Johnson]

The 2007-8 financial crisis will have increased public debt/GDP by about 50 percentage points, according to the Congressional Budget Office, only the Second World War had a bigger financial impact.

High speed rail versus high frequency trading
One can argue that in many, if not most nations there is a symbiotic relation between economic elites and the state. However, even in a thoroughly oppressive country like China, one could argue that the rent seeking behavior of economic elites at least lead to tangible wealth creation and leave a legacy of apartments, infrastructure, industrial capacity and jobs for the masses, rather than abacus or HFT

Chinese capitalism, for all it's faults (not to mention those of Chinese politics), is still generally of the positive-sum, wealth creating kind. High speed rails create jobs, infrastructure and improve the supply side of the economy, reducing transaction costs and creating wealth, it's a positive sum activity. High frequency trading does nothing of the sorts. The wealth it creates for its practitioners comes at the expense of those disadvantaged by it, it's zero sum, redistributing wealth from those who can't afford it to those who can.

Investor insight
There are some crucial take-aways for investors here.

Do your due diligence. Many, if not most financial products are extremely complex. the amount of information going into a simple foreign currency quote like EUR/USD is rather staggering, not to mention the knowledge required to interpret it.

Know your limits: be aware of information asymmetries and the fact that others might very well have an information and/or knowledge advantage. Don't trade stuff you don't understand, and realize that not everybody has your best interest at heart, and that it is relatively easy for well informed parties to opportunistically misrepresent info on a particular financial instrument, especially in situations where they can reap large profits from doing so.

Regulation is usually your friend. Retail investors benefit from financial regulation, they are often the main victims of better equipped or more opportunistic parties exploiting information asymmetries, and suffer again as taxpayers when institutions have to be bailed-out when they've taken on too much risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.