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Thursday, March 26, 2020

why do we have stock markets

In the wake of two major bailouts, a decade apart, following on a crash in 200-2001 and overshadowed by the twin phenomena of de-industrialization and an enormous increase in wealth inequality that should be compared not to the U.S. in the twenties but to Ancien regime France in the 1730s, the question arises: why do we have stock markets?  And, more broadly, why have we allowed, or even encouraged, the burgeoning of financial instruments  in the post Bretton Woods period? The so called shadow markets, or the other kind as well, that advertise themselves as security for other financial instruments, but always not only fail in that responsibility, but always crash themselves, bringing about chain reaction crashes?

Peter L. Bernstein, who was an investor, journalist and economist in one, observed that stock markets have increased in the post-war period from around 50 in 1948 to around 125 in 1998. This speaks to something attractive in the current period about the stock market. He examined the common defense of the market in a great paper entitled Liquidity, Stock Markets and Market Makers, published in 1987 – on the brink of Black Monday, 1987, when the great Reagan stock boom crashed.

Bernstein considers the standard defense of the stock market – that it allows liquidity and is an instrument for efficiency. Stocks, in this story, reward innovation and that kind of efficiency that squeezes profits from enterprises, allocating capital accordingly. On the other side, they punish enterprises that stagnate and that fail to be “efficient”.

Bernstein does not leave the story there. In his paper, he notes that the stock market system is embedded in  and necessary to the corporation system: “One of the great features of that legal creature we call the corporation is how readily it facilitates transferring ownership in business. Perhaps the most impressive consequence of that feature has been the development of organized stock markets.”
From that premise, Bernstein considers a tension – what a Marxist would call a contradiction – between the two poles of efficiency and liquidity:

“There is a tension between liquidity – a market in which we can buy and sell promptly with minimal impact on the price of the stock – and efficiency – a market in which prices move rapidly to reflect all new information as it flows into the marketplace.”

Hark ye at the information talk. One of the fruits of the ‘cyborg revolution” (to use Phllip Mirowski’s phrase) was the recasting of managerial and speculative activity in terms of information. Bernstein’s essay quotes amply from a lecture by Fischer Black entitled “Noise”, which is permeated with the information paradigm. It refers to Claude Shannon’s distinction between signal and noise. Primitively, these terms are just what they seem: if you broadcast a message, there is an amount of static – noise – that adheres to it. If you write down a message, there is a distortion in your handwriting that may make it hard to read. “Noise” is the ‘friction of information. If you exchange information with a person, the tone of your voice and expression on your face, your properties in the socius, all of these come with that information. We realize this at some Piagetian point in youth. Five year olds know how to say ‘yes’ to their parents in a tone that signifies ‘no’ – this is the noise of raising a kid.

To return to the handy information paradigm in economics (and observe my restraint: for those worried that I would get on the warpath about Hayekian ideology, which rode piggyback on Shannon’s communication science, rest assured – that isn’t my concern here) – Bernstein usefully takes from Black the idea, paradoxical as it may seem, that ‘noise’ provides us with the practical solution to our contradiction. Noise traders are essential to the liquidity of the market. In fact, they are as essential as information traders. Noise traders (“who trade on noise as though it were information”) are essential for information traders to have to sell to or buy from: why? Because information traders are, as it were, grouped at the efficiency end. Their “information capital” restricts the incentive to trade “They are reluctant to trade with one another, because, as Black puts it, “a trader with a special piece of information will know that other traders have their own special pieces of information and will therefore not automatically rush out to trade.” The P.T. Barnum principle (there’s a sucker born every minute) has a systematic effect that often rewards suckers and makes them useful, unbeknownst to themselves.


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