Austrian Economics on Financial Markets

This is a mid-term exam I recently had to do as part of my financial markets class. I am discussing different principles of Austrian Economics and how they relate to financial markets from a theoretical perspective. In case you didn’t get your fill of Austrian economics in academia, feel free to give this a read.

The role of money in extending the division of labor and facilitating capital accumulation.

Labor is an act of production. An act of production designed to create economic goods. In the division of labor, several persons associate by specializing in different types of activity. Each associate produces a particular good in excess of his personal needs, in order to share or exchange his surplus with the other associates. This is essential to creating a market of exchange, but this brings about the problem of coordination. Who does what? Who decides what? Lastly, how do we share the aggregate product or surplus? The division of labor brings about advantages for all associates involved through the exploitation of individual differences through specialization. Specialization reinforces initial differences and creates cultural differences. All these cultural differences are opportunities for cooperation. This is seen in places like South America where there is great cultural pride taken in the farmland goods produced by individual towns or regions. But these advantages are not just seen in labor, but in all factors of production throughout all peoples.

There comes to a point where saving must be introduced into the division of labor. The more savings we have, the higher the division of labor. These two things have a strong positive correlation, because without savings, higher civilization wouldn’t exist. Greece exemplified what could potentially happen without any saving. After the Greek economy collapsed, there was anarchy and chaos for a time. The coordination problem can be solved in two different ways: through violent means or mutual consent.  What only works is decentralized plan making and mutual adjustment. This is called the market economy and it is solely based on exchange between associates. The law of association states that people who have different advantages affect the economy differently through those advantages. The organizing principle of economics is that people have alternatives. A person will always choose the alternative that gives them the greatest value. A monetary economy or exchange is introduced in order to make this mutual consent, or valued alternative, available. Money is the generally used medium of exchange, however without money this exchange is recognized as barter. Barter economies in even the most primitive civilizations have never existed. They have always used money as a medium of exchange. A barter economy cannot survive because it is dependent on specialization of separate parties, and then a transaction between these two parties of their specific good. However, this transaction has a very difficult time of occurring because it always assumes that the two parties desire their associates’ specific goods. This is typically not the case. If a sword maker wanted bread, he couldn’t necessarily trade his swords to a baker for bread, because this baker would not have a use for many swords. The sword maker would have to shop around to find someone who would be willing to trade him for his swords. This might be a shoe maker, but he doesn’t necessarily have the certainty that the baker will trade him bread for food. This creates a serious problem. Using money in trade removes any disadvantage in trade of a specific production specialization. Money gives us the ability to specialize because we don’t have to deal with the issues of barter. Efficiency will always be chosen in exchange because there are monetary costs involved with exchange. This is the advantage of economic calculation. Economic calculation will provide monetary value for capital goods. This is seen through saving and investing. Without money we would not have saving and investing. Using money involves spending money, but it does not always mean spending money. This is where modern economists stumble. They believe that in order to have money we must constantly be spending and consuming, but this is not the case. Demand for money truly occurs by keeping it and holding a cash balance.

Total demand to own money comes in two forms, demand via exchange and reservation demand. Demand via exchange is the demand of money through exchange between people that do not have that specific good. Reservation demand is on the side where people already own that good. A baker has a low reservation demand for bread because he has plenty of it. Durable consumer goods and money have high reservation demands because there is always a need for things that are long lasting and facilitate more exchange. With money, there are two forms of balances: nominal and real cash balances. Nominal cash balance is the number you have to your name and real cash balance is the purchasing power we have through the nominal cash balance. We need cash balances in order to make investments. Investments only happen in a money economy. We exchange our savings for capital goods in order to make an investment. Savings is also a form of investment for someone with long-term time preferences.

Monetary exchange is what facilitates the division of labor.  It does this by alleviating the limitations of barter, which was discussed above. Monetary exchange makes it possible to compare production processes. Without money, we are incapable of comparing different abilities of investments to create revenue and bring in a good return on investment. Return on investment is an intellectual division of labor. It is much more roundabout and gives the market the ability to have more complex structures of production. A monetary exchange is steered by entrepreneurs and their firms. This is exemplified through different skill sets, and different methods of entrepreneurial firms. The crucial intellectual tool for the decentralized coordination between entrepreneurs and human activities is economic calculation here, especially the calculation of return on monetary capital. This gives the entrepreneur the ability to start capital accumulation. Capital accumulation is through saving and investing an entrepreneur can attain future consumption goods at future value goods. If the entrepreneur forgoes current time preference, he can make more. A big point about capital accumulation is at least one person has to be the saver in order for the exchange to occur. You cannot have two investors attempting to accumulate capital off of each other. One person must have a higher time preference while another has a shorter time preference. It is now evident how through the creation of money, we are able to get from simple barter all the way to capital accumulation, and through this saving and investing which lengthen the capital structure by creating ways to acquire wealth from exchange within an economy.

The role of financial markets in facilitating arbitrage.

Arbitrage happens when the same good is sold at different prices in different markets. Those who utilize arbitrage are people who leave markets that are less favorable to them to markets that are more favorable for value creation. Arbitrage specialists are entrepreneurs who focus on maximizing the profits in a different market. People will always forego the lesser value of something, while at the same time foregoing the higher cost for the lower costing good. This can be an element of arbitrage. An example of this is the low hanging fruit. A person will start by picking up the fruit that is ripe off of the ground, but after exhausting those resources will move on to the lowest hanging fruit on the tree. After picking the lowest hanging fruit, the person will find ways to pick the fruit that was at first out of reach. He might have to go find a ladder in order to reach it, but he will find a way in order to maximize his profits. This applies to different forms of energy as well. The world economy started with burning wood, moved to whale fat, to coal, to oil and we are currently at a place in which we are utilizing alternative methods of energy, such as fracking and solar powered energy. The value in these things shrinks through arbitrage and marginal utility. After the value is fully exploited we discontinue the arbitrage and look for something else to help us maximize our profits. These two forms could also be aligned with the methods of production.

By having financial markets we are actually able to take advantage of these value differences that we were unable to exploit before. Financial markets adjust more quickly to speculation because the transaction costs are much lower than most other costs, such as transportation costs if an entrepreneur was trying to move metals to a different part of the world where he could maximize profit. These values can be exploited in financial markets through previous inaccessibility, potential short term inefficiencies in the market through information asymmetry, or different time preferences recognized by a skilled entrepreneur. Credit markets are a good example of this, where savers and investors are now connected yet on different sides and reliant on each other. The entrepreneur is exploiting value differences that are inherent in different markets. In bond markets, it is interest rate differentials that are exploited. There might be treasury bonds that promise a certain yield that is more attractive than a corporate bond, and so the entrepreneur will exploit this interest rate differential in order to make a profit. With stock markets it is the differences in entrepreneurial profit that are able to take advantage of in order to maximize value. Financial markets also greatly limit risk by helping to create a more accessible means of trade and arbitrage. If an entrepreneur had to wait months to maximize the value differences, he could have been beaten by another skilled entrepreneur. By creating an efficiency through financial markets, this risk is limited.

Human Action is motivated by value differences. Human beings are finite. Means are scarce to us. Because availability is scarce, we have to choose between ends and decide between the means to attain these ends. Value must be analyzed when talking about arbitrage. There is a categorical difference between valuation in our mind and economic calculation. There are different marginal utilities for different goods. The entrepreneur allocates goods so that there is no difference in the marginal utility. This is the method of profit maximization. Arbitrage is simply the monetary manifestation of this. We are always doing this in every action, even if it is just an act of our minds. We are always trying to exploit this difference because we get more overall value from it. This is all based on the principle of diminishing marginal utility, which brings prices together because of the law of demand. If the buyers move, the demand will shift and prices will once again come together. For all goods there is different marginal value product, value of the additional output produced, for the production of different goods. The highest marginal value product is always what is picked first. The marginal utility goes down and the physical production eventually decreases. The entrepreneur will allocate factors so there is no difference in marginal value products, diminishing returns. We can value across times differently because there will be different marginal utilities for different goods at different times. This is shown through plain savings, where the entrepreneur allocates saving over time. This is simply the storing of these goods. Time preference creates a perfect distinction between present satisfaction and future satisfaction. Then the factors of production can be allocated across time and we can have future goods. There are different marginal value products for producing goods across time. The capitalist saving, which takes present factors of production and produce certain goods in the future creating a rate of return. The higher the standard of living, the higher the chance they are to extend the production process, because of the ability to lengthen out the capital structure and create a more intricate production process. There are always different marginal utilities in the minds of different people. More than one person will attempt the exploitation of different valuation in the minds of different people. Voluntary exchange is the way in which entrepreneurs attempt to exploit these differences in valuation. This can only be done with foresight, and can only be done by the skilled investor, because marginal utilities for different goods are the same for each person. Value differences are also seen because there are different marginal value products in the minds of different people. We see this especially in world trade. These differences motivate the division of labor, because it is more efficient to let the low cost producer specialize. The only reason for saving is the idea that present consumption is worth less than future consumption.

Time markets are all exchanges of present goods for future goods. This is arbitrage through time preferences and is very much reliant on financial markets to facilitate these exchanges. The easiest example to see is the credit market, which is a transaction that is not completed until the future. There are consumer loan and producer loan markets. Consumer loan market revolves around the need for those with shorter time preferences to consume in the present while a creditor facilitates this by having longer time preferences, accepting significant interest on the loan. Producer loan markets go into the lengthening out of the production process. Every production loan is used for production. This kind of crediting helps give produces the money they need in order to fund their company or firm. There will be arbitrage between consumer and production loans that is completely dependent on our time preferences. The capital structure is where all producer loans end up. It takes present money to buy inputs and produces something, sells output in the future and recoups the loan. No one will invest in this without a return. There are no formal contracts here. The entrepreneur buys inputs today and produces outputs in the future with the foresight to produce more than what was invested. This is his hope anyway. The demand slopes to the right all on the assumption of our time preferences. It is all about where the interest rates are and where the breakeven point is for suppliers and producers. These are all different markets in which we see how financial markets integrate everyone into a world economy. Without these markets it would be impossible exploit any value differences through arbitrage.

How do financial markets overcome the limitations of saving and investing?

Saving and investing is the phenomena of giving up present consumption for future consumption. This is the inter-temporal trade off. There are two forms of saving, plain saving and capitalist saving. Plain saving is diverting the consumer goods, which can be done with money as well. This would be simply money saving. Capitalist saving is the diversion of producer goods. A person only does this with the assumption that future production will be worth more. The only reason for saving is the idea that present consumption is worth less than future consumption.

The limitations of saving and investing start with savers having a lower time preference and investors having superior foresight. Financial markets give you the opportunity to transition from long term preference to short term preference. With financial markets you have the incentive to save, because without financial markets there is no incentive. Without financial markets, investing is costly, and economic calculation would tell you to utilize your money in other ways in order to satisfy the need for consumption. An investor with superior foresight would be seriously limited in opportunity without financial markets. Financial markets open up the doors to interaction between savers and investors. Savers might not have the organizational skill set to be good investors, but a skilled investor would. Markets open up the door to investors who might not have anything to start out with. Someone has to be the saver in order for this investing to take place. This promotes specialization in the division of labor by facilitating exchange between the saver and investor. It promotes the lengthening of the capital structure. Financial markets give the opportunity to invest for profit, not just consumption. It also allows for saving for profit, rather than saving for future consumption.

Two limitations of saving and investing are risk and uncertainty. We are able to define risk with class probability. Class probability says that any time we have probability or are making decisions based on probability, we are making decisions based on ignorance. This decision is based upon something we don’t know. The outcome is in fact completely unknown to us in advance. We then base our outcome on the assumption that we know the entire class of risk and can assume every possibility. It is a very systematic process, the ability to analyze entirely numerically. Case probability refers to uncertainty. It says that we do know something about each event. We can know particular information and we can make a better prediction of the outcome. When we bet odds, we are simply putting people against each other and adjusting odds in order to clear the market. You can run a business on this model without any unduly risk. This method is unsystematic as there is no formulaic way to analyze it. It requires a skilled entrepreneur in order to be successful and is an open economic question as to whether or not both of these are constantly involved in financial markets.

The efficient market frontier is another way financial markets help to overcome the limitations of saving and investing. The frontier tells us there is a relationship between return and risk in which it is standardized and positively correlated. The more risk you take, the more the possibility of a higher return. We see examples of this being fixed income returns on treasury bonds as being risk free investments, whereas trading in equities, or making venture capital investments requires a lot more risk being taken on by the investor, therefore delivering a much higher return. The efficient market does have class probability implications. The theory implies that at all times, the market prices reflect all existing information available to investors. This does, to a certain extent, create more uncertainty at times, because an investor might be susceptible to black swan events. A black swan event is a random event, that can never be foreseen and something that breaks all statistical models in the prediction of an investor. Some economists argue that risk is simply the attempt to quantify uncertainty in order to make models more easily understood. This is strongly up for debate.

Forward transactions are also ways in which financial markets help to overcome the limitations of saving and investing. Forward transactions are when two parties agree to make an exchange in the future based on the price determined today. This helps make an investor more resistant to current volatility, because an investor can have more certainty through his foresight. Superior foresight can enable transactions which in the current moment fulfill future time preferences. For example, a farmer, who knows corn is going to see a rise in prices in 1 year, buys contracts for a year out at current prices which are very low. He then makes an incredible profit off of the corn bought a year from now. This is another way to continue to lengthen the capital structure by giving more opportunities for unique and innovative investment ideas. It is constant inter-temporal exchange taking place.

There is plenty of congruence of saving and investing in time horizon. Liquidity in financial markets helps to relieve this problem. All long term investments need liquidity and so financial markets must be long enough to provide this. Although, liquidity can provide people with the incentive to take too much risk because they think they are capable of getting out of risky investments before any collapse happens. Liquidity can reduce caution, but those who take risky investments on, are more likely to be hurt in time of financial difficulty. This weeds out the unskilled investor, and gives more reward to the skilled investor. Higher time preferences are rewarded in times of less liquidity, and so the skilled investor looks at liquidity in the financial market accordingly. Liquidity also fulfills time preference by having lots of buys and lots of sellers in order to maximize profit, and without financial markets you would not have this opportunity. This creates the opportunity to create and find value for savers and investors. All of these opportunities are only available with financial markets, and without them would cease to exist.

The potential principle-agent problems in financial markets.

The principle agent problem is when an agent has the opportunity to exploit a principle. An agent is someone hired by the principle in the interest of the principle. This can be where the division of labor has savers provide capital funding and the investor uses the capital. Once the saver gives up use of the capital, the investor has the discretion on how it is used. There are three aspects to this problem. There is moral hazard, adverse selection, and transaction costs.

Moral hazard is a situation where the incentives that exist between the principle and agent are perverse. An example being the agent having a different agenda for the principle’s money that would not benefit him. We have seen this countless times over the last decade. Enron is probably the most popular example, in which we saw executives living incredibly rich lives and misleading the general public/stockholders as to the direction of the company. Another example would be Bernie Madoff, scamming billions of dollars from investors to run his Ponzi scheme. How the principle can change contracts to minimize all problems. The ability to avoid manipulation is a form of entrepreneurial skill. The skilled entrepreneur will avoid the principle-agent problem all together. This might be one of those things that makes a good judge of character. Most of the way a principle controls an agent is through contracting. In the stock market there is a separation between the ownership and control of a company, helping to create a positive separation between principle and agent, however this can also be a negative affect when an agent has too much control through ownership of common and preferred stock, he is able to manipulate the stock price, or trade on his own personal inside information. Adverse selection creates perverse incentives, creates moral hazard through the writing of contracts, attracting people that bring moral hazard with them depending on the stipulations of a contract. The greatest possible reason of this is information asymmetry. Where the agent knows more than the principle, and is able to take advantage of him in this fashion. An example is the used car dealer-buyer relationship. When a buyer wants to get a used car, the dealer knows everything about the car, yet the buyer knows nothing. It is up to the dealer to be honest, or else the buyer is clearly misled to his ignorance. This information asymmetry is also thought to be the biggest cause of market failures because there is distortion between the buyers and sellers, they both obviously have different ideas or information. In a company, typically the top agent is the CEO. He represents the principle in making ultimate decisions about a company’s future. Usual responses to this principle agent problem include monitoring techniques such as auditing reports. Compensation methods and compensation of the market. So C-suite executives are rewarded with stock options instead of salary in order to incentivize growth within the company rather than simple selfish behavior. There is also the threat of replacement and future job opportunities if the agent’s reputation is tarnished by the principle.

Transaction costs are the costs of trading and creating contracts. There are legal costs, search costs, enforcement costs. Financial innovators are very interested in reducing transaction costs in order to maximize a profit. An example of this innovation is the securitization of mortgages by Fannie Mae and Freddie Mac. Although, there were significant repercussions in this attempt to make a profit.

Over the counter trades/exchanges attempt to standardize financial products for participants within financial markets. They are much larger than financial intermediation. There is no brokerage fee, giving over the counter advantage in this affect. However, the downside is financial intermediaries alter the riskiness in the favor of the savor by providing downside protection. This is a form of innovation that has attempted exploit the value opportunity.

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