What’s the purpose of financial markets? The conventional answer runs along these lines: Financial markets’ core function is to get resources from people who save to people who can use saved resources productively.
In the process of fulfilling this function, financial markets attach prices to different assets – for example, prices to different bonds and prices to different businesses, including prices to shares of corporate stock. In turn, these prices help to inform investors of the most promising opportunities. Asset prices also prompt people to make ‘efficient’ spending, savings, and investment decisions – decisions that direct resources into those particular lines of production that will best ensure sustained economic growth.
In short, the conventional story goes, financial markets exist to promote maximum economic efficiency.
There’s validity to this conventional story. Well-functioning financial markets do indeed promote economic efficiency and growth. And this achievement improves the well-being of all members of society, even of those who don’t themselves save or otherwise participate in financial markets.
Yet this conventional story disregards financial markets’ ultimate function – namely, to better enable each person to use his or her property as he or she chooses. Here’s Tim Worstall:
Well, people own property. We’re in favour of property rights. The definition of actually owning something being that you’re able to dispose of it. Sell it that is. Or give it away, or change the use of it. If society tells you which of those [you can do], and how you can do [it], then society owns it….
So what is a market in property or property rights? Well, it’s just that, it’s a market in which people can exercise their rights over their property. Financial markets are just clearing houses for our exercise of our rights over our own financial property. Sure, there are rules about what can be done and who may do it and all that but this is what is the point and purpose of the entire game. That people who wish to sell property may do so with a modicum of efficiency and that those who wish to purchase may do so with that same modicum of truth and honesty.
Everything else that comes after that is entirely secondary. Sure, companies get financed, the world gets richer as a result…. But the actual purpose? That people gain somewhere to buy and sell their own property.
Worstall offered the above explanation in response to the announcement by Oren Cass of a new project being undertaken by Cass’s think tank, American Compass. The project is tellingly named “Coin-Flip Capitalism.” The purpose behind it seems to be to expose the many alleged ways that today’s financial markets fail to promote maximum possible economic efficiency.
The Mistake Isn’t Marginal
Judging from the maiden product of this project – an essay by American Compass’s Wells King titled “Coin-Flip Capitalism: A Primer” – I fear that it will be conducted with insufficient economic understanding to give credibility to its conclusions. Consider this startling claim by King:
But the buying and selling of companies, the mergers and divestments, the hedging and leveraging, are not themselves valuable activity. They invent, create, build, and provide nothing. Their claim to value is purely derivative – by improving the allocation of capital and configuration of assets, they are supposed to make everyone operating in the real economy more productive.
In technical econ-speak, this passage reflects ignorance of the fact that economic choices and actions occur on the margin. In plainer language, King mistakes “necessary” for “sufficient.”
Financial-market activities direct resources toward the production of goods and services. And so it is indeed the case that the value of financial-market activities derives in part from the value of the physical goods whose production these activities finance. The physical production of goods is thus necessary for these financial-market activities to have the market value that they have.
But physical production is not sufficient. Precisely because physical production could not take place as it does without the resources directed to it by financial markets, financial market activities themselves are necessary for modern production to occur.
More generally, financial market activities are just as crucial to – just as necessary for – the production of goods as are the laboring and other activities that take place within factories and on farms and on construction sites. King commits a fundamental error by implying otherwise. His error is akin to asserting that the performances of a car’s engine, fuel pump, transmission, steering wheel, and brakes “are not themselves valuable activity” because the only parts of the car actually to touch the road are the tires.
It’s true that the value of the car’s engine and other parts depend upon the successful performance of the tires. But it’s untrue that the value of all non-tire parts of the car are “purely derivative” of the tires. All parts of the car contribute to its operation. The performance of the tires is just as dependent on the performance of the engine as the performance of the engine is on that of the tires. Both parts must work well for the car to move.
Just as a car would not be able to move as its driver wishes it to move were it stripped of its engine and other of its key parts, the modern-day physical production of goods would not occur without modern financing. Nor would this production occur without modern marketing, management, accounting, insurance, communications, transportation, wholesaling, and retailing – all of which are services the value of which is no less or more “derivative” than is the value of financing or of welding or of hammering or of snapping components together.
Wells King’s obliviousness to this foundational reality practically guarantees that the “Coin-Flip Capitalism” project will be a conflux of confusions. Indeed, investigation of its website disappointingly gives the sense that this project is motivated not by desire to do serious economic analysis but, instead, by naïve populist hostility toward that which most populists don’t understand: markets generally and financial markets specifically.
No Further Justification Needed
But back to Tim Worstall’s point. The ultimate justification for financial markets is simply that they arise when adults voluntarily save and invest. Period. As long as participants in these markets behave peacefully and use only their own funds (or funds voluntarily entrusted to them), their activities need no further justification, regardless of how closely or distantly these markets perform in comparison to some benchmark.
If pundits at American Compass, or professors at Wharton or Wherever U., don’t like the way these markets perform, they are free to offer financial market products that they believe will improve performance. These pundits and professors are free also not to participate in these markets. And they are free to identify the many ways that government interventions distort the operation of financial markets. This latter effort would be welcome and genuinely productive.
But no one has any business advocating, or even hinting at, the use of state coercion to mold financial markets into some different, fancied forms. Such coercion is sure to diminish the positive contributions that financial markets make to the larger economy. Even worse, such coercion would violate the rights of the property owners whose voluntary choices give rise to financial markets.