Condivergence: Why standard finance theory is incomplete

This article first appeared in Forum, The Edge Malaysia Weekly, on February 24, 2020 - March 01, 2020.
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Mainstream economic theory suggests that finance serves four main functions for the real economy — resource allocation, price discovery, risk management and corporate governance. This universal finance theory or model sounds reasonable and applies to all places and all times, forgetting the context in which money plays a role in the real economy. Just like no country is an island, operating in the global economy, money is not an island — it operates within a geopolitical systemic context.

US President Donald Trump’s “America First” policy exposed the myth that the US dollar-denominated global money and financial system is a global public good. If the US dollar serves only the national issuers, then the rest of the world needs to think through what this truly means for global monetary and financial stability.

Mainstream finance theory suggests that money is the life blood of the real economy, helping to provide liquidity, means of payment, store of value, market price discovery and risk management, and reinforcing credit and governance discipline.

These basic functions appear as self-evident truths — logical, consistent and convincing. But the 2007 global financial crisis revealed that these four functions can only operate depending on at least five more key interrelated preconditions of stability. Change in any one element would destabilise money and finance. These are: law and institutions, technology, politics, social inequality and climate change.

First, money and finance are legal contracts, subject to protection of the rule of law, including a functioning judiciary that is seen to be transparent, fair and efficient. As Trump has said, “the (US) legal system is broken”. What is there to stop judgements on contract disputes from being biased if the courts are subject to political interference?

Second, the speed and scale technological change in the 21st century, which was reasonably stable in the 19th century, has disrupted the economy in terms of lifestyle, process, institutions and jobs, threatening those without the knowledge and skills to compete. Financial technology is also disintermediating traditional financial institutions, while giving opportunities for cyber-fraud, insider dealing, market manipulation and predatory action against unsuspecting consumers. The concept of money has been disrupted by cryptocurrency, and cyber attacks can shut down any financial system.

Third, Mao Zedong’s dictum that “political power stems from the barrel of a gun” can be extended to financial power. In a military conflict between the US and China, where would savings flee to — the US dollar or RMB? The US dollar is defended not by the size of US foreign exchange reserves (small by global standards), but by the biggest military power in the world. Geopolitical rivalry, including the threat of geopolitical conflict, introduces political instability to exchange rates and, hence, to whole financial systems.

Fourth, political stability itself depends on social stability. Hence, it is no surprise that the rise of populism has been associated with widening income and wealth inequalities. The financialisation of markets has played a role in increasing leverage, lower interest rates, asset bubbles and the concentration of wealth and income in the hands of the few. Financial capitalism has ignored the issue of financial inclusion until almost too late. The poor and small and medium enterprises (SMEs) have had difficulty in accessing funding because they lack capital and collateral, whereas the rich and wealthy can borrow, hedge and use leverage and inside information to amass greater wealth and income.

Fifth, climate change was never a major consideration within finance theory. Stability in weather was taken for granted as a “normal”, but global warming has created major climate change and natural disasters such as floods, droughts, fires, tsunamis, earthquakes and, now, pandemics. These disruptions are not only increasingly changing livelihoods and creating new opportunities, but also causing social dislocations. Human migration arising from climate change and disasters are stressing regions, for instance, Europe’s challenges in coping with large numbers of refugees and migrants.

In pushing for nationalism and protectionism, Trump’s policies are no longer for a level playing field or the global public good, pushing ruthless self-interest (or mercantilism) over global growth or system stability as a whole.

Simply speaking, the conventional four functions of money and finance cannot function well with the five preconditions of institutional stability, technology, politics, inequality and climate change all interacting to change the system radically. We have to look at money and finance as an inter-related, inter-connected, dynamic and non-linear systemic whole. If the hegemon changes the game, money and politics cannot be separated.

Finance does not operate in a silo — it is part of a complex, dynamic and interactive systemic whole in which politics trump finance.

This throws hitherto simplistic finance models out of the window, but must take into consideration history, path-dependence, institutions, culture and different governance factors, including religion. For example, Islamic finance is not an aberration from conventional finance because it is fundamentally equity-based financing, with very strict ethics-based or syariah rules. Equity-based financing is about risk-sharing, whereas debt-based financing is about risk-transfer from the lender to the borrower. I have always argued that equity-based finance is much more inclusive and justified than debt-based finance.

From this viewpoint, mainstream money and finance theory are from the hegemon’s perspective rather than from the rest. The hegemon with the dominant reserve currency is the too-big-to-fail borrower since the rest have to hold that currency because there are few alternatives.

A small country cannot influence the global situation, so its currency is greatly influenced by the dominant players, including speculative players who are very large relative to the domestic players. Since there are no global financial market regulators, erosion of the US financial regulators’ ability to monitor global financial markets would create opportunities for insider trading, market manipulation and market abuses at the global level and, particularly, in smaller markets without the financial and enforcement powers to stop such abuses.

The idea that financial markets are level playing fields was always a myth. Financial markets have become more concentrated than ever and the regulators’ powers to check predatory behaviour, including basic rules — such as the fiduciary rule (that financial institutions should act in the best interest of their clients) — are being eroded.

Reforming finance therefore has been a major pre-occupation since the last financial crisis. Central bankers today are nervously tip-toeing into issues of inequality and climate change, which in the popular mind are exacerbated by quantitative easing. At the same time, cryptocurrencies issued by private issuers are eroding the central bank monopoly franchise to print money.

It is easy to criticise mainstream finance theory, but very tough to find what should replace it. A fashionable replacement is Modern Monetary Theory, which argues that we should not worry about increasing inflation, money supply and fiscal debt, but make sure that the real economy is growing and more inclusive. To conservatives, that sounds like snake oil. To liberals, that is a solution for Nirvana.

The 2020 US presidential elections will unveil which model the American voters like. Either way, with the US fiscal deficit running at over US$1 trillion annually, the world is buying short-term prosperity on the never-never.

Tan Sri Andrew Sheng writes on global issues from an Asian perspective

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