On teaching and financial markets
Source Julio Huato
Date 08/09/16/19:32

WHEN I TAUGHT at Ramapo, on the first day of class, I would typically
ask my international finance students to help me put together a
balance sheet for the whole global economy -- no estimated values of
course, just the items listed in the statement. The class was
typically made up by senior or, at least, junior students who had
already taken two heavy courses in financial accounting, one or two
micro courses, one or two macro courses, two courses in corporate
finance, perhaps one money and banking, and at least one econometrics.

The starting point was the balance sheet of a typical firm. On the
balance side, it'd have assets: cash and liquid securities,
receivables and other short-term financial assets, longer-term
financial assets, inventories, equipment, vehicles, buildings, and
real estate. I asked them to, first, consolidate the balance sheets
of all U.S. firms and then add them to the consolidated balance sheet
of the rest of the world.

At this point, they would start to see how all the financial claims
issued by U.S. firms and held by other U.S. firms would be on both
sides of the sheet and thus dropped out. At the end, they'd have on
the top of the U.S. asset side only domestically-held foreign
financial assets and the different forms of U.S. productive wealth.
All U.S. cash held by Americans, the bulk of M, would cancel out.

On the right hand side, they'd have the U.S.-issued financial assets
held by the rest of the world, including the portion of U.S. currency
not held domestically. In the rest-of-the-world balance sheet, they'd
report those same U.S.-issued financial assets plus the productive
wealth held by the rest of the world. On the liability side, the same
things that appeared on the left hand side of the U.S. balance sheet.

At this point, the students would start to come up with the punchlines.

The next exercise was, "on the basis of what you just figured out
about the global balance sheet, help me draw a diagram of the human
economy overall." First off, "What is the point of the whole human
economy? What is it for?" After a bit of discussion, we'd conclude
that it had to be some form of well-being or welfare. Or that's what
the economists would have us believe. (Please, economists, don't take
this as economics baiting.)

"How do people obtain well-being?" Through consumption of wealth
(goods). Okay. We drew a box and labeled it "Consumption." But
wealth has to be produced before (or at the same time as) it is
produced? A box on the left hand side labeled "Production" with an
arrow connecting it to the consumption box. Not all wealth produced
is consumables. We labeled the arrow "Consumption Goods." "What are
the inputs to production?" If a distracted student said money, the
rest of the class would correct him. "No, money drops out when you
look at the global economy." Exactly! The items that remain in the
global balance sheet! Natural resources and "capital goods." Natural
resources: an arrow from nowhere into the production box. "Capital
goods": an arrow coming out of production and looping back into
production. The classical economists and Marx, I'd say, called them
"means of production."

"What else is required?" Something that our accountant's global
balance sheet didn't show, because slavery is illegal. Indeed,
[hu]manpower. "What else is produced when people produce wealth?"
Somebody would say "garbage." Right! Garbage, pollution, waste,
noise, etc. An arrow out of production would indicate that. "Aside
from well-being, what else is produced when people consume?" "Garbage
as well." Another arrow out of the consumption box. And labor.
People replenish themselves and produce themselves as producers when
they consume. An arrow looping back into the production box. Do
production generate well-being directly? Do we get some of our
well-being from the things we do at work? How about the negative of
well-being, misery? We produce goods and garbage, and also social
garbage: "We get out of work [out of the production box] exhausted and
grumpy, and then go and become aggressive drivers, bad neighbors, bad
citizens." -- a female student once said. And from the consumption
box? "As well, sometimes we consume and feel empty inside." She made
my point much better than I could have. The arrows pointing out of
production and consumption labeled "Well-being" now had the
inscription ">=< 0."

A last push: "Do garbage get into our consumption and production
boxes? Is the bad side of nature feeding back into those boxes?"
Yes, the answers would pour. We live in noisy cities, breath polluted
air, our products have toxic chemicals, trash entertainment, etc.

When we had a more or less populated diagram, I'd pause and say, "This
is perhaps the broadest picture we can draw of our global economy.
This is the ultimate foundation of the international monetary and
financial systems. Those systems, very bulky and complex, are built
on top of our production/consumption metabolism." We often lose sight
of what lies underneath. So, what conclusions can you draw from these
exercises?" A shower of punchlines:

Wealth (and well-being) can only be produced the hard way, with
productive wealth: labor, capital goods, natural resources. Central
banks and regular banks can create money. And almost anybody can
create financial assets. But that is not the same as creating actual
wealth. Finance doesn't produce wealth. It consumes wealth.
Therefore it doesn't produce well-being. "Not directly" -- a student
would reply -- "but if financial markets transfer wealth to its best
uses, then financial markets help preserve well-being." The
markets-are-efficient argument. The efficiency of financial markets
can't just be assumed. It has to be shown that they are indeed doing
that job. But, in a reference to their micro courses, I'd ask: "Do
markets (e.g. financial markets) always lead to an efficient
allocation of resources, goods, and bads?" "No, there are market
failures." Etc.

At some point, I'd show them a chart with the estimated size of the
different financial markets. By comparison, the figures dwarf global
GDP. Are financial markets efficient? Why are they so bloated?
Remember, they use wealth, but they don't produce it directly. Are
they really giving the human race the bang for the buck? Forex
markets were the biggest: spot, forwards, futures, options, swaps.
I'd ask, "Look at what happened in Europe. What do you think would
happen to the forex markets if there were a single global currency?"
No need for them. And no need for a course in international finance.
We could be in the Bahamas instead!

* * *

I'm no finance historian. But, I bet it happened like this. It goes
back to Bretton Woods. It wasn't the worst possible arrangement. It
wasn't the classical gold standard, because when trade and the global
markets expanded after the war, the classical gold standard would have
been impossibly clunky and wasteful. Bretton-Woods was ultimately
based on gold. The U.S. had to keep a USD parity with gold. If
cautious in their macro policies, the other countries would have
stable exchange rates. The band of variation was narrow. Nothing
serious. For the most part, currency risk was eliminated. Except
that it wasn't, because the U.S. was in control and it messed up its
public finances -- Vietnam, etc. Nixon pulled the plug in 1972.
Exchange rate volatility came to stay.

Foreign traders, multinational businesses, everybody (if you think in
opportunity cost terms) had to cope with a new reality: exposure to
serious currency risk. (The Bretton-Woods type of currency risk was
never serious enough to span these huge markets. The excess liquidity
of oil rich countries in the 1970s fueled the phenomenon.) Was that
risk avoidable? In principle, but not politically. To be clear, the
issue was never gold or no gold. In principle, the system could have
been fiat-money based, but based on one single denomination, not on
many competing ones with volatile rates of exchange. It was
politically hard, particularly because financial interests immediately
saw opportunities to profit there. The Americans and the Brits, I
believe, one way or another, under ideological prejudice and/or the
pressure of special interests, sabotaged the Plaza and Jamaica
meetings. They just agreed to disagree. They sanctioned the
disintegration of that germ of that fragile global monetary
arrangement, namely Bretton Woods. No doubt, ultimately, the trend is
towards a single global currency. But that will have to wait for more
favorable political conditions.

The special interests grew, became stronger and stronger, and by their
influence on governments and central banks, they prevented any return
to stability in forex markets, let alone a rehabbed Bretton Woods, or
-- anathema -- an effective single-currency global economy (like the
euro in Europe, but generalized). In the U.S., they went for the
jugular and de-regulated banking, lifting the barriers between
depository and lending activity, on one hand, and investment so-called
"banking," on the other hand. If there's exposure and people have to
hedge forex risk privately, then there's demand for all that stuff.
But if you have big capitalist markets, you have all that follows from
them, i.e. cycles. Booms, bubbles, panics, crashes.

The global financial crisis of the 1980s was the first call. The
panics in Asia, Mexico, Russia, Argentina, etc. made the point
clearer. There will be other catastrophes like this if the Masters of
the Universe, blinded by ideology and the short-sighted interest of
parasites, don't get serious. A global capitalist economy begets a
global currency. That won't eliminate capitalist crises, of course.
Most likely, if things happen the way they will end up happening, a
new vintage of overproduction crises will be inaugurated. But, hey,
the business of capitalism is to kick the can down the road. It just
seems to me that the system is ready for a bigger kick of the can.
However, we don't see Paulson or Bernanke thinking globally before
they act locally, or do we?

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