The Financial Economy and the Real Economy

This extraordinary capacity to finance not on past wealth but on the present value of future anticipated cash flows is at the core of America’s dynamic approach to wealth creation.

— Edelstein, R., and Paul, J.M. Europe needs a new financial paradigm. Wall Street Journal Europe, June 12-13, 1998. Quoted in The Fisherman and the Rhinoceros.

Writers on financial or economic matters rarely see the need to explain the basics of the field or justify them at the best of times, let alone in the middle of unfolding crises. What are these “financial instruments” — futures, options, and swaps? What are they for, and how did they increase the dangers of what occurred? What is the relationship between finance and the ‘real economy’? What exactly is wrong with that relationship? Events move so quickly that stories discussing them rarely stop to explain the basics.

Luckily, there are occasionally exceptions. A book by Eric Briys and Francois de Varenne, The Fisherman and the Rhinoceros: How International Finance Shapes Everyday Life (Wiley, 2000. The original French version was called La mondialisation financiere: Enfer ou Paradis?, and was published in 1999), teaches how the financial economy works and explains why it is such a great thing. At the time their book was published, the stock market collapse of 2003 had not yet occurred, nor had the collapse of Enron, the Iraq war, the oil and food price crises, and the current mortgage meltdown. Briys and de Varenne were working for Deutsche Bank when the book came out. They had both previously worked at Merrill Lynch (which no longer exists, sold to Bank of America) and Lehman Brothers (which no longer exists, largely sold to Barclays). The authors are excellent writers. They provide a rare and wonderful thing: a clear, confident explanation by practitioners of ideas and attitudes which, when implemented, proved unambiguously disastrous.

Briys and de Varenne start their book with a question that is today on everyone’s minds:

“Is the globalization of finance steering us towards heaven or hell? Ought we to be afraid of the new economic system that we live in? Should we fear the financial markets and their infamous derivatives? Should we be dreading the prospect of a domino effect that will drag the world economy into a chain of one collapse after another? In short, have we, like Frankenstein, given birth to creatures which can no longer be controlled and which are a permanent threat to our future?”

Their answer is no. Mine is yes. I will first summarize the lessons they teach in their book, then describe the problems with their worldview.

The Skill of Risk Management

The fisherman’s (and in their book it’s a man) parable is used to explain the importance of the futures contract.

A fisherman has a great skill set, sailing, navigating, handling the risk of storms and accidents, catching and hauling fish back to port. That fisherman will be familiar with taking and managing certain kinds of risks to his physical safety in his work. On top of these risks and these skills, though, he also has to worry about the uncertainty in the price of his catch. When he brings his fish to market, what if there happens to be a glut of fish, and he can only fetch a very low price, one so low that he can’t pay his expenses?

He can hedge against this risk by taking a futures contract. He can sell his fish before he catches them if he can find a buyer at an agreed-upon price. He will agree to deliver a certain quantity of fish at a certain time at a certain price.

Who might buy this contract from him? Two kinds of people. The first kind is another business, say a fish canner. The canning factory needs a steady supply of fish to keep running. While the fisherman is worried about risk that the price will go down, the cannery is more concerned that there won’t be any fish when they need it. They might be willing to pay extra in order to know that they will get the fish they need when they need it, rather than trying to get the cheapest possible price for their supply. The fisherman might be willing to accept a lower price than the best possible price he could get, so that he could guarantee that the price won’t be lower than what he can accept. Both parties win, and importantly, both can focus on what they’re good at: the fisherman at catching fish, the cannery at canning fish.

The second person, who might accept the fisherman’s contract and buy the fish before they are caught, is the speculator. While the cannery will take a futures contract out of a need for a steady (if higher than perfect) supply, the speculator is not interested in fish at all, but is merely betting that the price of fish will be higher than what he bought it for. The speculator hopes merely to turn around and sell the fish. To someone not trained in finance, this might seem like mere gambling, and that the speculator is adding no value. But the speculator is providing a social service, and has a skill to bring to bear as well. The fisherman’s skill is catching fish. The speculator’s is managing risk. When both focus on what they do best, they both profit, and society at large profits as well. Again, everyone wins.

The Monte Carlo Strategy and the Importance of Regulation

So, according to the proponents of finance, the speculator is not a parasite on the real economy, but almost a saint, someone who helps everyone by taking on the specialized task of managing risks. For assuming these risks, the speculator gets the chance of profits.

All is well, in this world, except when the speculator can use someone else’s money. The next parable in the book is that of the blind pearl-fisher. These pearl-fishers, like fishermen, assume huge risks in swimming on the sea floor for oysters with pearls in them. They almost all come to lose their sight — but active pearl fishers have a kind of self-help organization where some of their catch is reserved to take care of pearl fishers who have gone blind. Active pearl-fishers can feel assured that they will be taken care of when they lose their abilities, so they feel safer in assuming the physical risks of their work.

What if, instead, these pearl fishers pooled their money and gave it to a banker? The banker takes $9,000 from them, promising them their principal plus interest. He takes their $9,000, adds $2,000 of his own, and goes to the casino in Monte Carlo with the $11,000. There, he bets $1,000 on red (his own money) and $10,000 on black (the $9,000 from the fishers and $1,000 of his own).

Now, if black wins, he gets $20,000, pays the fishers back their interest, takes back his $2,000, and is seen as a financial genius for making huge profits.

If red wins, he’s just lost all of the fishers’ funds, but he still keeps his own $2,000. Now he tells the fishers, “sorry, I can’t pay you back after all,” and walks away. Because he did all this on behalf of a corporation, his liability is limited, his personal money protected. He’s unlikely to go to jail, and if his bank is big enough, he might just get bailed out by the government.

He was supposed to be providing a service: helping the pearl-fisher’s assets find their most efficient use in the real economy, where they would earn the biggest return, a return he and his clients could share in. Instead, he used a permissive environment (for which the government is to blame) to engage in a Monte Carlo strategy. He went for broke with other people’s money, took care of himself, and lost.

If the government creates a permissive environment for this, by acting as guarantor of bankers who act this way, then these crises will continue to occur, the proponents of finance argue. Instead, what the government should do is create a regulatory environment where bankers and insurers are encouraged and free to use these instruments responsibly. Or, alternatively, so deregulate finance that depositors know they will have no protection except their own hedging if the bank defaults. The depositors thus have an incentive to keep an eye on the banks — in a system where the government is present, they do not. The problem with the banker and the pearl fishers in this parable is, in their view, that they did not use financial instruments to hedge!

Instead of trusting the banker, the pearl fishers could have avoided ruin by using insurance, through a credit default swap! They could still have given their money to a banker (though not the irresponsible gambling banker), but they should have paid a series of regular payments to someone else. That person, the seller, would take the payments, but would pay the pearl fishers the value of their assets ($9,000) if the banker defaulted on the loan. The pearl fishers accept a lower rate of return on their money, but are insured against a default by the banker because they bought a swap. The real economy is served, the pearl fishers are ensured, and the risk is managed.

Briys and de Varenne explain the option contract using a parable of a Genovese merchant, Zaccaria, in 1298. This skilled merchant was going to get a shipment of alum from Aigues Mortes to Borges. Zaccaria had contacts in Borges and the means to hire the ship. He also was well aware that there were storms at sea and possibly pirates. So he sold the alum to a partnership, Suppa and Grilli. The partners sold Zaccaria the right to buy the alum back if it reached Borges.

Suppa and Grilli would make a profit if the ship reached Borges, but would lose their investment if the ship sank. Zaccaria, meanwhile, had covered his risk. If the ship didn’t reach Borges, he had made a small profit by selling to Suppa and Grilli. If the ship did reach Borges, he would buy the shipment back and re-sell it in Borges at an even higher price and at an even higher profit. He could concentrate on doing what he did best: moving and selling goods, and let Suppa and Grilli do what they did best, assume the risk and take a premium for it.

The Tyranny of the Real Economy

But now Suppa and Grilli, whose option contract effectively made them insurers, have a problem of their own. They are betting their money on the ship not sinking. The way they can manage that risk for themselves is to make many bets on many ships. Some of these will sink, and they will lose, but many will land, and they will profit. They set the premium they charge based on their assessment of the risks to the ships.

The same problem applies for the “seller” of the swap, who ensured the pearl fishers against a default by their banker. They are betting against a default, and their cash is on the line if a default occurs. They are speculators. Their job is to manage risk. How best to do so?

To the proponents of finance, the answer to this question has everything to do with the sources of risk. And the sources of risk are not from the financial economy, but from the real economy — what Briys and de Varenne call “the tyranny of the real economy.” This tyranny includes, especially, the weather, but also, presumably, the tyrannical biological systems on which life depends, the tyranny of there only being so much oil in the ground, and so on. What the financial economy enables us to do, they argue, is break free of that tyranny. Risks can be moved through the use of these derivatives not only to the right people, but also forward into the future for the right time! By trading swaps for swaps, bundling debts and re-selling them as assets, and selling derivatives on these assets, risks can be moved around until they are in exactly the right place, as determined by the market. Among the cases of businesses that have successfully broken free of this tyranny, the authors mention two: Enron and mortgage-backed securities.

They describe Enron’s innovations:

Peter Tufano describes Enron’s bold move as follows: “Their vision was to create a ‘gas bank’ that would serve as an intermediary between buyers and sellers, allowing both to shed their unwanted risks.” The move, although bold, was quite rational. Indeed, Enron’s core asset is a deep knowledge of the natural gas market, from exploration to distribution. The new generation of Enron products was born… From being a producer and distributor of natural gas, Enron Capital and Trade Resources became a natural gas banker managing the volatility of the price of natural gas. This mutation has far-reaching implications. First, the methane molecule is no longer anonymous: it bears Enron’s landmark. Second, to avoid failed promises, Enron had to make sure that it was properly equipped to monitor and trade the price risk of natural gas. To ensure this, it invested millions of dollars in the required technology and human capital. Nevertheless, the story would not have been a success if commodity derivatives had not been available. Enron would still be wondering how to redefine itself and the clients would still pray that prices remain stable . . . Obviously, the more tradable the risks at their disposal, the more efficient their construction.” (pp. 96-97)

Enron’s “bold move” was based on fraudulent accounting, in which present and future assets were counted but future costs were not. It ended in blackouts, swindles, and jail terms.

On innovations in the mortgage market, they have this to say:

“In the United States, commercial banks have gradually been driven out of the mortgage loan market. Much of their mortgage business has been swallowed up by financial market operators and specialist investment banks. Today, mortgages are tradable on a buoyant mortgage-backed securities market. In essence, the financing of mortgages has broken free from its traditional master and has become a ‘free agent’. This is the process known as securitization. Its scope now includes car loans, credit card loans, music rights… As individuals and consumers, we end up better off because we deal with financial institutions that are more efficient in delivering the products and services we need and want.” (pp. 91-92)

The “financial market operators and specialist investment banks” that outcompeted the commercial banks today either no longer exist or have been purchased by the very commercial banks they drove out, precisely because those commercial banks have funds from their depositors. As for the securitization of car loans, credit card loans, and music rights — those chickens have yet to come home to roost.

Arguments Against the Financial Economy

The point of reviewing an eight-year old, pro-financial economy book in such detail was not to kick these bankers when they’re down or to show how absurd they sound when real events reveal the falsehood of their breathless claims. On the contrary. Our historical and political memories are short. Financial memory is still shorter. These arguments, and the financial instruments they justify, however, will remain. There will not be a better time to discredit them as thoroughly as possible. There are four main reasons why the arguments of Briys and de Varenne fail.

First, they fail because they overstate the complexity of the financial economy. The complexity is more contrived than real, the financial instruments more convoluted than complex. The authors ask the rhetorical question: “On what grounds can one reasonably expect that a complex financial contract solving a complex real-world issue does not deserve the same thorough scientific treatment as an aeroplane wing or a micro-processor? Only ignorance would suggest such an idea.” (p. 76)

In reality, the aeroplane wing and the microprocessor deal with systems far more deeply understood than economies. It is not a question of complexity but of the depth of knowledge we have, and could conceivably have, about the topic. Liberal economist James Kenneth Galbraith wrote in his Brief History of Financial Euphoria (p. 19) that, “financial operations do not lend themselves to innovation . . . all financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.”

Second, they fail because the “tyranny of the real economy” is not so easily escaped. It is certainly possible to treat the future like a colony to be stripped of its natural and human wealth, a repository of pollution and garbage. But those who live in the future, like those who live in the colony, will suffer as a result. Breaking free of the tyranny of the real economy is always transferring the risk and the suffering on to someone else.

The business world has several different ideas on finance and the real economy. Proponents of the real economy, in contrast to Briys and de Varenne, argue that investors and finance should focus on serving the real economy: real assets and people working with them to produce real value. There would be a role for hedging and derivatives, but these could be very strictly regulated to ensure they were not being used for mere speculation. So, to return to the parable of the fisherman, futures contracts for fish might be regulated so that only people in the fish business could buy them. Many kinds of financial activity would thus be banned, and the tyranny of the real economy would shackle finance from its desire for freedom. Strict regulation of this kind would certainly solve some problems. It would prevent many types of bubbles from occurring and bursting. It would match investment to real production needs. It would not stop displacement of peasants and indigenous people from their territories, exploitation of workers, union-busting, environmental destruction by extractive industries, pollution by manufacturing industries, the depletion of resources and ecosystems by consumption, or climate change, since these are all artifacts of the “real economy.”

Third, they fail because they assume that the rules by which the economy runs are neutral. In fact, the rules favor some actors over others. Our system favors capital over labor, corporations over peoples, and the first world over the third world. But even at a more superficial level, the rules can be set to favor speculators and their activities rather than the businesses the speculators are supposed to serve by managing risk. By changing the rules of the game, speculators undermine the value of their activities to real economy business and subordinate that activity to their own. The psychology of speculation plays a role in this, which is part of why these crises recur. After a crash, the rules are changed to try to ensure it doesn’t happen again. After several years of increasing prices and values, everyone forgets the last crash and the government relaxes the rules to facilitate gambling.

Fourth, and most importantly, they fail because the ultimate absorber of any risk is always society at large. That is what happened with every bailout in the past, and it will happen again, despite the pretense of a private enterprise system. Margaret Thatcher famously said in 1987 that, “there is no such thing as society. There are individual men and women, and there are families.” But in economics, the exact opposite is true. There is only society — to make the rules, to enforce them, and to face the consequences. The economic lives of individuals are lived in society. Society has options for governing its economic life. Today it is organized to provide state support for corporations and elites to accumulate massive shares of wealth and power, guaranteed by us all. It need not be.

“Moral hazard” is the fear that people will take risks they wouldn’t otherwise because they know the government or someone else will bail them out. But it is not something that can be avoided through clever use of financial instruments, or even by selectively bailing out only the rich and not those who are losing their homes in foreclosures and evictions.

The people on whose behalf society is organized will always feel that they can take risks and have society save them. Are those people us? The question for a society is whether we want our lives to be devoted to saving elites from the monstrous power gambles for obscene amounts of money, or whether we would rather absorb the more moderate risks that everyday people have to take seeking decent survival. That would not automatically happen even if the rules were changed to reassert the “tyranny of the real economy,” but would require a very different sort of real economy.

Justin Podur is a Toronto-based writer and activist. He can be reached at: Read other articles by Justin, or visit Justin's website.

7 comments on this article so far ...

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  1. colin brooks said on October 15th, 2008 at 3:29pm #

    This is a very clear assessment of our current crisis and it’s recent origins. It seems as though “we” are constantly in a battle to shift the bias of our institutions from benefiting the few to the many.

    Maybe the scope of our consciousness has not kept pace with the complexity of our society. Malcomb Gladwell describes the 150 person rule in the “Tipping Point” stating the natural regulation of a group conforming to that size. Beyond this number one must implement outside measures of control. Maybe we have an evolutionary “knee jerk” reaction of fear that “kicks” in when things get too big. A survival skill that applied to hunting and gathering but not to the kind of complex and global relationships that we have now. As with any form of life threatened with the adversity of change, we must evolve or die–or both…

    This evolution seems to be of a Conscious nature as we have amply demonstrated our physical ability to create a dizzying array of “instruments”, financial and otherwise to hedge against the “Tyranny of the Real Economy”
    while not creating anything resembling wellbeing for the majority of the planet, physical or mental.

    I would go so far as to suggest that that means an involuntary evolution of intelligence that arises from the whole and is not centered in the mental capacity of our species.

    I dunno…

  2. john andrews said on October 16th, 2008 at 12:12am #

    This is a good explanation of economic principles for non-economists like me.

    I guess I was a little suprised not to see mention of something that seems particularly significant to me: the decrease of workers’ wages.

    We’re told that the present economic crisis is a consequence of ‘bad’ mortgages and that the banks are to blame. No doubt that’s true – but surely it’s only partly true, because the other side of the coin must concern people’s ability to pay their mortgages.

    Surely the fact that governments have presided over economies that encourage decreasing worker’s wages (whilst grossly inflating managers’ salaries) meant that the inability of people to pay their mortgages would be inevitable? Surely once again the real finger of blame needs to be firmly pointed at the same governments who oversaw and maintained deregulation of banking whilst also deregulating employment rights and protections?

  3. brs said on October 16th, 2008 at 9:16am #

    Imbalance of wealth and income is a primary culprit now and in the Great Depression. Another is speculation rather than investment. Most of the derivative schemes are like the margin investor of the 1920’s. They are a get rich without working scheme and little more than fraud. Another issue is the pervasive influence of marketeering and sales types in business. They are in the business of slanting and convince themselves of the truth of their own lies. When a business or a country is run on spin with no substance eventually the real world catches up. That is happening now. It will be very hard and painful to recover. Getting salesmen to quit lying or believing their own lies is a herculean task. Hercules unleashed a river to do it. Getting them out of senior leadership positions and back to a more appropriate role before the businesses are driven into bankruptcy will be difficult. Getting people to live within their means and weaning society from credit will also be difficult. Better balance of wages between workers and owners is absolutely necessary so workers can afford to live within their means. Returning to an understanding that all wealth rises from produtive labor rather than sales hype and inheritance is necessary also. We must get away from Peales Power of Positive (wishful) Thinking and around a power of realistic thinking.

  4. Lijandra said on October 16th, 2008 at 11:47am #

    I’d like to add that a massive brainwashing scheme a.k.a. the “American Dream” has been used very effectively to inflate the housing prices. It convinced people that everyone must own a house at any cost else they are losers. Yet like any parasite eventually kills the animal they feed on, they made people pay for houses beyond what they can afford.

  5. Sunil Sharma said on October 17th, 2008 at 1:10am #

    Good point, Lijandra. I’ve never really understood the peculiarly American fetish with home ownership. Especially during the run-up to the 2007 bubble deflation. Why people would want to pay such outlandish prices that are way beyond their means for even mediocre-condition homes rather than take the more logical economic route of renting is beyond me. If in a particular part of the country it makes more sense economically to buy a home than rent, or if you can actually afford to put down, say, at least 20% on a house that’s not being artificially valued at an unjustifiably high price (vis-a-vis market fundamentals), fine then. But to pay for a home that’s overvalued by 30% or more when we’re in the hundreds of thousands of dollar range, regardless if you’re getting into a questionable mortgage like a subprime ARM or a more solid A-Paper loan, when your potential debt-to-income ratio isn’t favorable is just plain ill-conceived.

    A lot of Americans got screwed by crooked loan, banking, and financial institutions that resorted to all kinds of chicanery to lure them into buying homes, but as many of these buyers are just as responsible for letting themselves be deceived into making a stupid financial decision that is leading them to foreclosure and economic ruin. Preoccupation with the material can be murder. . .

    – Sunil

  6. Max Shields said on October 17th, 2008 at 7:25am #

    The fundamental psychology of inertia seems to be the simple but powerful element.

    In terms of energy and the baseless economy we collectively float on – called debt – our dilemma is harrowing.

    The only way we can conceive of our circumstances are the little voices played over and over again, the human desire to believe that yesterday, today and tomorrow will look much the same I’m reminded of two movies: Butch Cassidy and the Sundance Kid; and The Perfect Storm.

    Both movies end with the ever optimistic motives of the main characters having absolutely no capacity to even imagine what awaits them. For each it’s just play it again, one more hurdle, a cycle, a blip in the chart. But in reality, they are about to face something, that for them, is unfathomable. Their belief in a kind of “flat world” theory that they will somehow keep away from the precipice because of some adolesent belief in immortality which persists even if only in a will to go on without changing the rules.

    What would Butch and Sundance have done if they’d known what awaited them?

    Who knows. Their response to the unknown was to tell themselves that this would be fairly simple – you go left; I’ll go right and we’ll meet beyond this momentary hurdle between death and freedom.

    And so it is with our economic calamities. The only real wealth is energy. There is no other bottom to this pit. It rules. Everything else is a postponement of the inevitable.

    If we can clearly see the scope of what we are facing, muster the will, we can go on (Beckett).

  7. siamdave said on October 17th, 2008 at 7:26am #

    useful info, but you need the basics too – where does the money come from in the first place, that all of these built-on schemes depend on? – BANKETEERING
    First we take back our brains, then we go for the country.