Realist, not conformist analysis of the latest financial, business and political news

To Inform The Senior Lecturer – Yes, This Is How Capitalism Works

The Senior Lecturer at Islington Technical College is greatly exercised by the manner in which Deutsche Bank has laid off 18,000 people and, essentially, withdrawn from investment banking. The concern is misplaced, this is just how capitalism works. Which he’d know if he’d ever bothered to read – and understand, that slightly more difficult task – his Adam Smith.

We have some new thing. Doesn’t matter what it is, summat spiffing. It makes excess profits – above the normal rate of return upon capital – because it’s new and spiffin’. Capitalists are both lazy and greedy. They wish to have those excess returns and if they can spot an easy way of getting them then they’ll pile in. Those excess profits thus get competed away.

As is the way with markets they’ll likely overshoot so some who piled in will leave that activity, the capital – and labour, land etc – will wander off to be applied to the next spiffy.

The net effect of this over time? Recall that profit is value added. It’s the value being added above the alternative uses of those same resources. For, in a market economy those same resources, at their market value, are valued at their alternative uses. Profit is thus a signal that this spiffiness over ‘ere makes us richer than the more run of the mill things elsewhere. More value is being added to society by this new thing being done in greater volume.

That greed for profits thus directs capital – dragging with it other resources – to the most value additive activities. And, when in the fullness of time competition has reduced profits to normal levels – or below – then no new capital will enter the field, overshooting meaning that some will leave.

This also all being what we want to happen. We actively desire capital to flow to the new and excess value adding activities. We also want those excess profits competed away. The new thus becomes, over time, just part of the boring routine of the economy and we all carry on looking for the next new.

Investment banking has been offering pretty good profits these past 40 and 50 years. That looks like it’s coming to an end. Partly automation – the application of capital to the problem recall – and partly through competition. Good, this is what we want. Investment banking made excess profits, we wanted more capital in the field. Investment banking now makes normal profits, perhaps below. Thus capital is leaving the field. Excellent, we’ve a self-ordering system, no Fat Controller required, that organises such matters for us.

In more detail we might look at the effects of High Frequency Trading. The outcome of which has been to kill market making. Goldman Sachs bought an equity market maker (umm, 2004?) for $8 billion (?) and closed it a few years later (umm, 2011?) as being valueless. HFT had meant that for the vast majority of market transactions there simply was no spread, no buy/ask, at all. Therefore there was no margin for a market maker to live off. Thus they went bust and exited the market. The HFT guys are making some trivial pittance with which to feed their algos, all investors benefit from the absence of the spread.

This is just what happens in capitalism when leavened with those free markets. And glory be to it too:

[perfectpullquote align=”full” bordertop=”false” cite=”” link=”” color=”” class=”” size=””] Deutsche Bank is currently shedding 18,000 of its staff, most of whom have been involved in its financial trading activities. That is about one in five of its total employees. It could be argued that this is simply the sign of a bank that is continuing to fail, and that description may be appropriate for Deutsche. I do, however, wonder if there is something more to this. Suppose that Deutsche is in fact the tip of an iceberg and what is actually happening is that financial trading is ceasing to make money not just for Deutsche, but almost anyone? [/perfectpullquote] [perfectpullquote align=”full” bordertop=”false” cite=”” link=”” color=”” class=”” size=””] The evidence for this is quite strong. Just look at pension markets. As I know from quite regular discussions with those engaged in this sector, the move from managed to index tracking funds is now persistent and becoming a dominant trend. This is rational, firstly because the costs of managing tracker funds are much lower than those for managed funds. Tracker funds do also, secondly, rather embarrassingly for those who think that they can outwit markets tend to produce better results overall, with most managed funds persistently underperforming the market. There is, however, a third rational element to this, albeit that it is much more broadly based. Suppose that this third possibility is that there is little or no money to be made from financial trading anymore? [/perfectpullquote]

There is much less money to be made from trading. Because there’s lots and lots of competition. That competition these days requiring much less human labour and much less capital. So, labour and capital are flowing out of the sector as a result of both technological and market changes. Innit great, eh?

When investment banking was adding more value – those excess profits – than other fields capital flowed into investment banking. Now it isn’t then the capital is flowing out. Our self-regulating system does it again, just as in earlier generations it did with steel, canals, railways. And off to look for the next spiffy. It’s a hell of a system and wouldn’t it be wonderful if those paid to teach economics grasped a bit of it?

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