complete article: the stock market and its problems

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.

Bernstein’s use of the dichotomy between information traders and noise traders serves as a foundation for making some curious observations.

The one that concerns me is the “orderly” market. The theoretical defense of the stock market is that it discourages “unnecessary” volatility. Prices of stocks should point to some equilibrium valuation of the enterprise that has issued the stock. But there is a problem:

“What happens if the fundamental value or equilibrium level changes, however? In an orderly market, that change may take a long time to appear, as the price meanders rather than leaps to its new equilibrium. In that case, an orderly market is inefficient, in that its price information is giving false signals to potential buyers and sellers. Here is where we would want the noise traders to shut up and where market resiliency is a disadvantage rather than an attraction. In other words, orderly is not always a desirable property of a market.”

It is easy to read over economist’s prose, which seems to be iced over just to make the laiety glide slip and tumble, never noticing the enormities beneath his or her feet. Bernstein’s caveat here is basically that, in solving the paradox posed by liquidity and efficiency, we slip out of the true information defense of the market and admit that it is laced with false information – or false “signals”. Because these are not immediately corrected – because the market is constructed to slow volatility (especially going down – an asymmetry that comes with wanting to sell stuff), over time synchronous and chronic missignalling can and will happen. Whether the signaling is about the value of Latin American mines (the cause of one of the first stock crashes, in 1830, when the Bank of England nearly went bankrupt) or the supposed risk insured construction of mortgage backed securities, something is going to be going wrong. This is not a contingent truth, but simply a result of the rules of the market. It is as if you constructed a board game in which the very rules incentivized cheating and covering up the cheating.

  II.

Bridges sometimes collapse. Yet few people would argue an anti-bridge position from that fact.

But what if bridges collapsed in unison? What if one bridge collapsing in the U.S. caused half the bridges in the U.S. to collapse, which in turn caused bridges to collapse in China, Japan, and Europe? Would this change how we thought about bridges?

In 2008, according to D. McKennie, the collapse of the NY stock market caused other markets to collapse as well, so that at the end of 2008 35 trillion dollars worth of equity wealth was wiped out. This is rather like my case of the bridge. The bridge is probably the most efficient means to get people across rivers and abysses, but we would certainly want them to be built with maximum attention to safety if they threatened to bring about world-wide catastrophe if just one collapsed.

In actual fact, unlike bridges, there is one market more than any other that has the capacity to bring all others down in its fall, and that is the NYSE. However, this doesn’t really effect too much my parallel: we would in fact seemingly want to make sure the NYSE is the best secured stock market in the world given the structure of the international economy. And we would want a clear idea of what it does best.

That idea is not helped by a theory that says: bridges always operate efficiently, so that we don’t want to interfere with their building. Or the idea that if bridges went down and killed millions of people, but millions more than that theoretically flowed over them, everything is cool. 

My analogy is straining at the bit, or has broken the leash, at this point. The point, this point, is that we don’t know if stock markets are the most efficient ways to allocate capital if we don’t include in our overview the fact that markets collapse. 

When they collapse, there are always economists to say that the collapse only costs unreal money money in excess of the value actually destroyed. Which is another way of saying that the efficiency of the market is paid for by each stock by some speculative prime – some effect of the  famous price to earnings ratio. That is, for most companies listed on the stock exchange, the value of the companies assets and revenue are exponentially less than their capitalization. This is the root of Piketty’s theory of the inequality structurally produced by capitalism.

In terms of efficiencies, the premium put on capitalization seems oddly inefficient – do we really need to attract investment by creating these chances for extraordinary wealth for the speculators? It is a question that has been posed before, in the progressive era, when laws were considered to put a cap on the amount an enterprise could be capitalized over its non-capitalized value. This progressive proposal has fallen in the dust, along with so many others. But as the financial markets both increase inequality and seem inherently prone to massive government supports due to the crises endogenous to their structures, we have to start dusting off these proposals again. We have to start thinking about the abnormal size of the financial market in proportion to its function, and the price we want to pay for this system of corporate ownership. A question should haunt us: Does capitalism have to be this way?