The market for financial derivatives is valued at a quadrillion dollars, give or take a few hundred trillion.
I can’t contemplate how big that is or what it even means. Where is that money? I know you can’t physically touch it — just as you can’t touch a company’s market capitalization or an index. But is it real? The financial and the real economies are obviously interconnected, as the events in one world have repercussions in the other. But can anyone really tell me where the financial economy ends and the real economy begins?
And can anyone today say with absolute conviction that the real economy needs the financial economy to be this big? In other words, is the financial sphere still subservient to the real world? Answer me this: Do you believe that understanding a stock and its price in the financial markets is the same thing as understanding a company and its worth to society? Do you think the models we use to explain our world aren’t also shaping it? You think that’s air you’re breathing now?
Today our politicians, corporate leaders, and investors look to financial markets for guidance and reassurance that their real-world policies and strategies are hitting the mark. The real world is increasingly just a shadow on the cave wall, reflected through the lens of modern finance and its associated simulations of real-world behaviors. Perhaps this is justified, as the rise of hedge funds and the tenfold increase in trading activity since the 1960s have undoubtedly created a much sharper and smarter pricing mechanism — one that might truly reflect the future earnings growth of companies and, indeed, economies.
If only. The truth is that financial markets are less efficient than they were during the era of railroads, steel companies, and automobiles. As French economist Thomas Philippon shows, the unit cost of financial intermediation is higher today than it was a century ago. All the improvements in information technology have been canceled out by trading activities with little social value. This is why a bloated finance industry has been shown to be a drag on productivity and real economic growth.
People chase fictitious returns in the financial economy thanks to short-term tricks. This tendency leaves the people who don’t optimize for the financial sphere looking like underperformers and prone to being replaced. These departures, in turn, make way for other people who will use similar short-term tactics to drive performance in the financial world. Our best and brightest are being sucked into hedge funds and banks that have little utility to society. When the simulation ends up being the focus of your real actions, the whole system can come undone.
But the simulation — the financial sphere — cannot survive over the long term without the real economy to back it up. Financial products are almost by definition virtual objects that sit between other objects. The value of such products lies in their ability to facilitate the creation of real things in the real world. We’d all likely acknowledge that modern economies, both real and financial, cannot exist without each other. But we should also remind ourselves that one of these economies — finance — should be, and remain, subservient to the other. You can’t make money from money forever.
How do we unplug and refocus? Generally, it’s the job of regulators, the architects of the financial world, to find ways to return finance to its secondary status. But there are some things we can do on our own. For example, we could avoid excessive speculation. We could limit our use of leverage. We could stop encouraging people to sell things they don’t own. We could avoid investing in firms that rely on interest revenue or that carry a lot of debt. We could make a pact to generate all of our investment income through shared business risk. We could ensure that every transaction we make in the financial markets has a real object tied to it. And last, the further we got from a simple “thing-for-thing” trade, the more time we could spend understanding the implications and incentives being created.
Perhaps some of the “freed minds” out there will recognize that I’ve just described much of what is central to Islamic finance. That’s intentional. As Harvard University academics Larry Beeferman and Allan Wain argue in an epic paper, all investors can look to Islamic finance to understand how financial products can deliver value in the real world. We need to shrink the distance between the financial and the real economies and remind ourselves which one exists to serve the other.
It’s in all of our interests — even commercial interests — to do this now. The short-term gains earned in the simulation rarely result in long-term value creation. And the truly brilliant investors have already come to realize that long-term success is about taking the long-term view of the real economy, ignoring the simulation whenever possible. I’m not saying these people can dodge bullets in the financial world. I’m saying that they understand . . . they don’t have to.