The dominant image of the financial markets is that of a giant casino. Brash young men in red braces, driven by insatiable greed, gamble with huge sums every day. When the bets go wrong the innocent suffer. Reckless financial markets pose an immediate threat to the future prosperity of humanity.
Susan Strange, who died just after the publication of her lastest book, was one of the most compelling academic advocates of the view that the global casino is out of control. Although she is not a household name, she played an important role in developing the intellectual framework to support the casino thesis. Her Casino Capitalism (1986) is a Keynesian account of the damage inflicted on the world as a result of financial deregulation which was taken up by many better known writers such as William Greider in the US and Will Hutton in Britain.
With the onset of the Asian financial crisis Strange's account of financial markets has become almost mainstream. Her ideas inform many of the discussions about a "new international financial architecture." Economists who would once have scorned her views now agree with her that deregulation has gone too far and that new forms of regulation are needed. The British government has floated the idea of a world financial authority to regulate global finance. The IMF, once a bastion of free market economics, has conceded that capital controls may be necessary under some circumstances.
Mad Money, the sequel to Casino Capitalism, takes into account the impact of information technology and the rise of financial crime. It also places new emphasis on the role of international institutions. For example, she backs George Soros's plan for an international credit insurance corporation as a complement to the IMF.
Yet there is one striking omission from Mad Money. She points out that the dominant theme of her earlier work was the danger of volatility-the gyrations in the price of financial assets. But then she fails to notice that the decade since the publication of Casino Capitalism has been one of relatively low financial volatility. This assertion appears to be contradicted by everyday experience. Every week there is news of a record fall on the London stock market-often followed by a record rise. But such impressions do not take account of long-term stock market growth. A 200-point fall when the FTSE 100 index is at 6000 does not have the same significance as when it is at 1000.
The low volatility of the main world stock markets can be precisely measured. And William Schwert, a professor of finance and statistics in the US, has produced a comprehensive study of the US, Britain, Germany, Japan, Australia and Canada which states that "all of the evidence leads to the conclusion that volatility has been very low in the decade since the 1987 crash."
Strange is not alone in misreading volatility. The striking feature of the past decade is the gap between the fear of risk-taking and the real level of risk. The obsession with risk management is at an alltime high. Financial markets are characterised by fear rather than greed. We should talk of cowardly capitalism, not casino capitalism.
Cowardly capitalism, for example, lies behind the explosive growth in derivatives, normally seen as one of the instruments of financial madness. Derivatives are bets on the way in which the price of financial assets move. They can be used for speculation-and often are-but they are mainly used to reduce financial uncertainty. (A survey of derivative use by non-financial US companies in 1994-95, at the University of Pennsylvania, found that the main use of derivatives was to manage cash flow and reduce risk.)
How do derivatives work? Imagine a British plastics manufacturer that depends on imports of crude oil-priced in US dollars-as its main raw material. The business suffers if the dollar strengthens. One way it can protect itself against this is to bet on a rising dollar. If it does rise the extra cost of the oil will be offset by the money it makes from its derivative contract. This practice is known as hedging. It is similar in principle to life insurance which can be seen as a bet that the policy-holder will die in a given period.
It is certainly possible, through dishonesty or incompetence, to lose huge amounts through speculation in derivatives, but the market is driven by risk aversion rather than recklessness.
Derivatives are far from the only instance of cowardly capitalism. Another example is fund management. Back in 1957 almost two thirds of the London stock market was owned by private investors. Today it is dominated by investment funds such as pension funds, insurance funds and unit trusts. The main rationale of such investment funds is to manage risk. Their guiding principle is: "Don't put all your eggs in one basket." If an investor holds a few shares his portfolio is likely to suffer from high volatility. But a fund manager with a large number of shares can diversify risk. Increases in the prices of some shares can cancel out falls in others.
The intellectual rationale for fund management explicitly casts risk as a problem. In his seminal paper on portfolio theory, Harry Markowitz argues that "the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing." The suspicion of risk-taking is embedded in the intellectual heart of cowardly capitalism.
If the financial markets are so risk averse it is not clear why they should be seen as irresponsible risk-takers. In reality both perceptions are closely related. Financial markets are seen as reckless precisely because of the strength of risk aversion in the contemporary world.
But the act of risk-taking should not be stigmatised, otherwise markets will cease to function properly. Susan Strange's notion of casino capitalism should be ditched or at least modified. And grand regulatory schemes based on the notion of out of control financial markets should be handled with care. In the world of cowardly capitalism, where risk aversion rules, it is more accurate to see money as sad rather than mad.
Mad money
Susan Strange
Manchester University Press 1998, ?13.99
