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Trend setters

19 April 2018

It should be no surprise to find August scarred by a financial crisis. Not only are the markets thin and more volatile, but with heads of department off at the beach, City dealing rooms are left in the hands of their more nervous, less experienced deputies. Yet this year has been worse than most.

It should be no surprise to find August scarred by a financial crisis. Not only are the markets thin and more volatile, but with heads of department off at the beach, City dealing rooms are left in the hands of their more nervous, less experienced deputies. Yet this year has been worse than most.

Nevertheless, you have to ask how much of this really matters. Twenty years ago one could argue that financial markets were closely hooked into the real world and therefore what they forecast would have real world consequences. Today it is much harder to make that case.

Twenty years ago only the foreign exchange market experienced underlying business activity being dwarfed by speculation, which meant that the foreign currency needed for buying and selling imports and exports was well under 10 per cent of the global daily volume. Today similar conditions impact all manner of markets, which are simply not structured to cope with such waves of speculation. We are now in a position where prices are driven by flows of hot money, not by the fundamentals of supply and demand. Unfortunately where markets lack the scale and resilience of Forex, the results are less benign.

The belief that markets know best rests on a couple of important factors. First there has to be a lot of participants, so that no one buyer or seller can influence more than 5 per cent of either supply or demand. No one should be in a position to use their buying clout or monopoly power to influence price or supply. Second, it is important that people are principals, either acting in their own name or for a company that is either supplier or end user. When these conditions exist, it is reasonable to assume that price signals from the market are fairly accurate reflections of genuine supply and demand.

This situation begins to break down when buyers and sellers are in a position to use other people’s money – thereby acting as agents rather than principals. This scenario often coincides with those involved being more interested in speculating on price movements, rather than in actually buying or selling the physical goods.

There are two reasons why things have gone wrong in financial markets. Since technology advanced to the point at which capital could be moved in or out of any global market in seconds, the ebbs and flows of speculative money have increased significantly. Capital is now mobilised on a global scale and directed anywhere in the world at the touch of a button. It dwarfs the resources of the original market participants.

At the same time, with a growing emphasis on trading profits and short-term horizons, money managers have embraced momentum. They are buying, not on fundamentals, but simply because everyone else seems to be buying, or selling because everyone seems to be selling. They assume they will be able to ride the price movement, using instant dealing technology to leap off and take their profits just as the price is turning.

Consequently the amount of money flowing in and out of a given market when it is in fashion has increased dramatically. The power and influence of those who are seen to have an edge in a market, the established traders or investment banks has also multiplied, because where they lead others will follow (or risk being wiped out).

Financial markets, such as the oil market or the grain market, were created for actual users, not speculators. Now they are so dominated by hot money that any signals sent from original users are no longer audible. As a result these markets and their prices signal what the speculative money believes at any one time,
and this does not necessarily reflect events in the real economy. It also adds an overwhelmingly short-term perspective, and huge layers of volatility.

We all pay a high price for this, because the real economy is forced to adjust. In rich countries oil consumption and economic activity gets cut when oil becomes too expensive. In poor countries governments fall as food becomes too expensive. In all countries governments produce policies that put the whims of the markets before the needs of
their citizens.

The distorted signals these markets deliver hold governments and the world’s citizens to ransom. From being the servant of the world economy, the financial markets are becoming its master. This is not how the system was meant to work. This is not what a belief in markets was meant to deliver. It is impossible to know how it will end, but it is surely unsustainable.

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