The Instability of Markets and the Need for Regulation - Example

The Instability of Markets and the Need for Regulation Table of Contents Introduction 3 Market Stability versus Instability: Theoretical Considerations 3 Instability of the Markets as Witnessed in Global Events 6 The Need for Market Regulation 8 References 11 Introduction This paper critically examines the notion that markets are unstable structures, and are thus, in constant need for organization and regulation. The basic argument that is presented in the paper is that, indeed, markets are completely unstable and that they cannot be relied upon to regulate themselves. This means that governments need to intervene in order to ensure that markets are regulated as a way of preventing the severity arising from instances of bursts and volatility that usually arise from the inherent nature of markets. Regulation is also meant to cushion the economy against the undesirable financial, economic and social consequences of the volatility of markets. The essay is divided into three key parts as follows. Part one is about a review of the theoretical bases of the two notions of stability versus instability of markets. The second part of the essay is about the global financial crisis in the context of other forms of financial and economic crises and the lessons that can be learnt from them with regard to the inherent instability of markets. The third part of the essay sums up the argument that it is necessary for government to regulate markets as a way of preventing the occurrence of crises and cushioning the economy from the effects of the volatility of markets. Market Stability versus Instability: Theoretical Considerations The argument as to whether markets are inherently unstable or stable is complex. What needs to be understood is that both arguments are compelling and have far-reaching ramifications in the world. On one hand, the assumption that markets are stable means that markets are efficient in nature and that there is no need for governments to interfere in the manner in which the markets operate by attempting to regulate specific aspects therein. This argument implies that markets are able to correct their own mistakes and therefore, advocates for a complete deregulation of markets. On the other hand, the notion that markets are unstable is borne out of the belief that the very nature of markets makes them prone to volatility and sudden changes in prices. It is this uncertainty that makes markets open to sudden changes which have the potential of disrupting social and economic equilibrium in the world. Two theories can be used to explain these two points of view: the efficient market theory and the Keynes-Minsky financial theory (Tabb 2004, 221). The argument that markets are stable and efficient has been based on the efficient market theory. Basically, this theory contends that markets are characterised by perfect flow of information among the agents working in the markets (Ang, Goetzmann and Schaeffer 2011, 6). What this implies is that the prices of products that are traded in a market, in this case financial products, is a reflection of all the information that is relevant to the products which are freely available to the market. The assumption that markets are characterised by a perfect and efficient flow of information forms the basis of this theory. Secondly, under the efficient market theory, it is assumed that the prices of the products that are traded in the market truly reflect the behaviour of agents in the market. According to Ang, Goetzmann and Schaeffer (2011, 6), this theory shows that it is difficult for market players to outperform the market by attempting to predict the movement of prices in the near future and basing their actions on their predictions. Therefore, the efficient market theory suggests that intense competition among the players of a market is the main reason as to why markets become stable. This is the case because as players compete with each other to identify products whose prices are mismatched, the chances of the players benefiting from this practice reduce drastically. Therefore, the prices that are set by the market are a true reflection of the value of the products and are at equilibrium as a result of the actions of rational agents acting with perfect information. On the other hand, the notion that markets are unstable is borne out of the basic assumptions of the Keynes-Minsky theory. One of the assumptions is that the future is characterised by uncertainty and that is based on this uncertainty that the agents of the market act (Crotty 2011, 16). As well, it is assumed under the Keynes-Minsky theory that market agents are not heterogeneous as it is assumed under the efficient markets theory (Crotty 2011, 17). Market agents are said to be individuals who are affected by their own feelings and act in different ways in response to their different perceptions of risk and expectations about the performance of the market (Crotty 2011, 17). According to Minsky (1980, 517-518), the instability of markets is a result of the nature of capitalism as a system. It is argued that the theoretical models that are used to indicate how markets work under perfect conditions are not applicable to real world markets simply because the capitalist system under which the markets operate is built on an unstable foundation. The expansion of debts, investments, and profits which are regarded as the forces that drive the capitalist system are ironically, the forces that make markets unstable. This is because the rate at which an economy is financed needs to be maintained endlessly for the capitalist system to avoid going through the typical cycles of boom and burst. Therefore, since this is not possible, the financing structure of the capitalist model makes the entire system and the markets that operate in it unstable. Similarly, Keynes (1930, quoted in Mouhammed 2006, 170) argued that the instability of markets is as a result of the internal functioning of the capitalist system. The same author also noted that the capitalist system is hinged on an increase in the rate of profits. It is as a result of increasing profits that capital is accumulated, consumption spurred and the growth of the capitalist system occurs. Therefore, the success of the markets is dependent on how well profits increase relative to the costs of production. In addition to increasing profitability, capitalism is hinged on the need for wages to increase relative to the productivity of the workers (Mouhammed 2006, 172). A sudden increase in the rates of wages without a corresponding increase in productivity usually results into a decline in profits. This creates a situation that favours the occurrence of bouts of market instability. The assumptions upon which the efficient market theory is based have been found to be untrue. For instance, Karstasova et al. (2014, 328) argue that if the basic assertion of the theory that the market is driven by a perfect flow of information and the actions of rational actions is true, then the seasonal fluctuations in the form of repeated booms and bursts that characterise all markets would not occur. Furthermore, the weakness of the efficient market theory lies in the fact that specific investors have managed to outperform the market and this has been done by use of careful analysis of the prevailing prices of the market and making sound predictions about the direction to which the prices are likely to go (Karstasova et al. 2014, 329). This is an important point, considering that under the theory, it is assumed that investors or agents are not able to outperform the market and that the effort that is put in researching and predicting market trends is usually futile. Instability of the Markets as Witnessed in Global Events The events that have occurred in the global economy over the course of history seem to attest to the argument that markets are inherently unstable structures that need to be managed using stringent regulatory measures by governments. In general, the history of the capitalist world economy has been characterised by the occurrence of different types of economic crises (Anderson 2000). The crises that have occurred have varied in terms of their nature, area of occurrence and intensity of their effects. For example, Claessens and Kose (2013, 26) note that different types of crises have occurred in developed as well as emerging markets over the course of time. The crises that have occurred in different regions of the world have taken the form of banking crises, currency crises, and sudden stops in the flow of capital within specific economies and difficulty in servicing foreign debts. As Anderson (2012) notes, it can be seen that the global capitalist system has been characterised by the repeated occurrence of crises. Although the crises have varied in terms of severity, nature and region of occurrence, the bottom line is that markets, as constituted under the capitalist system, are turbulent and that this turbulence arises from the very nature of capitalism. One example of a crisis that has shown that markets are unstable structures is the global financial crisis (GFC) of 2008. Allen and Carletti (2009, 8) state that the onset of the crisis was triggered by two key shocks. The first shock was a burst in the housing bubble in the United States as well as other parts of the developed world. This caused a massive reallocation of capital and a drop in consumption. The second shock was in the form of a sudden and sustained rise in the cost of credit which caused many stock markets in the world to collapse. These occurrences caused a crisis that affected the economies of different countries in different regions in the world. The occurrence of the GFC and its effects on the real economy has been associated with the volatility of prices in markets (Allen and Carletti 2009, 9). It has been argued that the crisis had far-reaching economic consequences because of one reason: the fact that the global financial system is integrated and that this made it possible for the shocks experienced after the initial triggers of the crises to be felt in different economies in different regions of the world (Allen and Carletti 2009, 9). On a different note, de Glossop (2011, 492) associates the occurrence of the crisis as well as other crises to the internal working of markets. The same author observes that by nature, markets go through the usual cycles of booms and bursts. Prior to the burst, high expectations that prices will continue to rise make people and institutions to acquire more credit to finance investments. This happens at the expense of savings. This situation inevitably ends in the form of a burst which leads to a financial and economic crisis in the form of a recession. Therefore, it can be seen that there seems to be a consensus that the causes of the GFC were as a result of the very nature of the structure of markets. The Need for Market Regulation It has been established that the nature of the capitalist system and the behaviour of agents makes markets highly unstable structures that keep on changing over the course of time. Internal as well as external factors make markets vulnerable to changes arising from volatility and increases in debt which eventually lead to bursts. It then follows that for markets to function effectively, they need to be regulated by governments across the world. There are several reasons as to why governments need to regulate markets. In the first place, the severity and frequency of the occurrence of crises is closely related to the approach to regulation that has been used at the time. Claessens and Kose (2013, 27) note that the period immediately after the Second World War was characterised by absence of financial crises. It is noted that whereas the first three periods that followed the Second World War were characterised by an absence of crisis, the recent three decades have been characterised by different types of crises (Claessens and Kose 2013, 27). The crises that have occurred in the recent past have varied in terms of form, severity and location. What is important to note is that the period immediately after the end of the Second World War involved the activity of the Bretton Woods institutions. These institutions were charged with the responsibility of developing rules and procedures that would regulate the financial markets in the world. Therefore, it can be inferred that the main reason as to why several financial and economic crises have occurred in the recent past as compared to the period following the Second World War when no crisis occurred is that the current trend of liberalisation has made the markets vulnerable to shocks. Similarly, Bresser-Pereira (2010 par 45) places the occurrence of the GFC within the context of the changes that have been occurring in the regulatory environment over time. It is stated that one of the underlying causes of the crisis was that governments across the world adopted the notion that markets are stable enough and can regulate themselves (Bresser-Pereira 2010 par 45). It was based on this notion that governments across the world adopted a liberal stand and avoided attempting to regulate markets altogether. During the 1970s, there was a massive wave of deregulation across the world. Governments abandoned the classical economic thinking that markets were supposed to be regulated and adopted the neoclassical thinking of deregulation. This, according to Crotty (2011, 27) set the precedent for some of the several crises that were experienced in different regions of the world after 1970. Two of them were the Asian Financial Crisis of 1997-1998 and the bursting of the dot.com bubble during the early 2000s. Therefore, it can be seen that regulation is necessary for effective functioning of markets and that lack of regulation increases the severity of the effects of cyclical fluctuations of markets. Conclusion Markets are inherently unstable structures that require constant regulation. The instability of markets is a result of the nature of capitalism. Accumulation of capital and increment in spending are reliant on inflation of profits. This model of financing the capitalist economy usually leads to an increase in the level of debt in the economy. Furthermore, the behaviour of individuals and institutions usually leads to volatility in markets. These factors lead to the cyclical booms and bursts that characterise markets. In theory, the efficient market hypothesis holds that markets are highly efficient structures and that government regulation is unnecessary. On the other hand, the Keynes-Minsky theory holds that markets are inherently unstable and that it is necessary for governments to step in to control credit and ensure that the effects of the natural cycles are minimised. Past events have shown that the proposition of the efficient markets theory is not true. The history of capitalism is replete with many instances of financial and economic crises. The crises that have occurred vary in terms of severity, nature and place of occurrence. Therefore, the occurrence of crises is testimony that markets are unstable and volatile. Interestingly, the pattern of occurrence of the crises shows that they have been more common and severe during periods in which government regulation of markets has been avoided while the crises have not occurred at all during periods in which markets are regulated by governments. Therefore, it can be concluded that regulation of markets is a necessary approach of addressing the issue of inherent instability of capitalism in general and markets in particular. References Allen, Franklin and Elena Carletti. 2009. “The Global Financial Crisis: Causes and Consequences.” http://www.bm.ust.hk/gmifc/Prof.%20Allen%20&%20Carletti_The%20Global%20Financial%20Crisis.pdf Anderson, Spencer. 2000. “A History of the Past 40 years in Financial Crises.” International Financial Review. http://www.ifre.com/a-history-of-the-past-40-years-in-financial-crises/21102949.fullarticle Ang, Andrew, William N. Goetzmann, and Stephen M. Schaeffer. 2011. “Review of the Efficient Market Theory and Evidence.” https://www0.gsb.columbia.edu/faculty/aang/papers/EMH.pdf Bresser-Pereira, Luiz Carlos. 2010. “The Global Financial Crisis, Neoclassical Economics, and the Neoliberal Years of Capitalism.” https://regulation.revues.org/7729#tocto1n4 Claessens, Stijn and M. Ayhan Kose. 2013. “Financial Crises: Explanations, Types and Implications.” International Monetary Fund Working Paper 13/8. https://www.imf.org/external/pubs/ft/wp/2013/wp1328.pdf Crotty, James. 2011. “The Realism of Assumptions Does Matter: Why Keynes-Minsky Theory Must Replace Efficient Market Theory as the Guide to Financial Regulation Policy.” http://people.umass.edu/crotty/Oxford_draft_April_27_2010_final.pdf de Glossop, Kim. 2011. “The Inherent Instability of the Financial System.” The Journal of Business, Entrepreneurship and Law 4(2): 483-503. http://digitalcommons.pepperdine.edu/cgi/viewcontent.cgi?article=1067&context=jbel Karstasova, Jekaterina, Rita Remeikiene, Ligita Gaspareniene and Deimanté Venclauskiene. 2014. “Transformation of Efficient Market Hypothesis under the Influence of Behavioural Finance.” Mediterranean Journal of Social Sciences 5(13): 327-333. http://www.mcser.org/journal/index.php/mjss/article/viewFile/3590/3529 McKibbin, Warwick J. and Andrew Stoeckel, A. 2009. “The Global Financial Crisis: Causes and Consequences.” Working Papers in International Economics 2.9. http://www.lowyinstitute.org/files/pubfiles/McKibbin_and_Stoeckel,_The_global_financial_crisis.pdf Minsky, H.P. 1980. “Capitalist Financial Processes and the Instability of Capitalism.” Journal of Economic Issues 24(2): 505-523. http://www.levyinstitute.org/pubs/tymoigne_1.pdf Mouhammed, Adil H. 2006. “Instability of Capitalism Inflation, Unemployment and Business Cycles.” Zb. 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