The time value of money is the corner stone of capitalism; it dates back to capitalism’s origins in the Renaissance (as historian Carlo Cippola “Clocks and Culture” describes). It is in deep trouble. The twenty first century capital markets are becoming so strange, this simple notion is being turned into a bizarre mixture of hyper-instantaneity and stagnation. First, the stagnation. In most of the developed world, the cost of capital is near zero. Japan has arguably never had a properly functioning cost of capital and interest rates in Europe and America are at extreme lows. And in many parts of the developing world, especially China, the discipline of the cost of capital does not function well. This means that the time value of money is not functioning as it should. The president of the Dallas Fed, dissenting from the majority view that rates should be kept low pretty much indefinitely, described what happens when the time value of money fails:
Now, put yourself in the shoes of a business operator. On the revenue side, you have yet to see a robust recovery in demand; growing your top-line revenue is vexing. You have been driving profits or just maintaining your margins through cost reduction and achieving maximum operating efficiency.
You have money in your pocket or a banker increasingly willing to give you credit if and when you decide to expand. But you have no idea where the government will be cutting back on spending, what measures will be taken on the taxation front and how all this will affect your cost structure or customer base.
Your most likely reaction is to cross your arms, plant your feet and say: “Show me. I am not going to hire new workers or build a new plant until I have been shown what will come out of this agreement.”
Moreover, you might now say to yourself, “I understand from the Federal Reserve that I don’t have to worry about the cost of borrowing for another two years. Given that I don’t know how I am going to be hit by whatever new initiatives the Congress will come up with, but I do know that credit will remain cheap through the next election, what incentive do I have to invest and expand now? Why shouldn’t I wait until the sky is clear?
This is pretty much what has happened for over two decades in Japan and is threatening to occur in America and Europe (much of Greenspan’s policies of monetary easing were designed to avoid a Japan-style slowdown, although in the end the measures proved counter-productive). Such stasis more resembles a socialist system than a capitalist system and the risk is that developed economies are turning in that direction.
Now, let us then turn to what is happening in the capital markets. The time value of money is being rendered useless, but for the opposite reason. Andrew Haldane from the Bank of England notes that the average speed of transactions on the NYSE has fallen from 20 seconds a decade ago to one second today. More than two thirds of the trade is high frequency trading (he describes the situation as the “race to zero”). Micro seconds are not what matters; a third of a second is an eternity for these algorithms. Algorithmic trading is also starting to dominate in foreign exchange markets and some futures markets. As Haldane describes it, it is a race to zero time, or at least dealing in nano-seconds.
Such speed represents an absurd misalignment between what capital is supposed to be for — funding commercial activity — and what it is being used to achieve. Money is being decoupled from what it is supposed to represent. A preposterous circular argument is mounted in its defence: that it creates “liquidity”. This is like saying “if we have more transactions, we will have more transactions.” True, and entirely useless. The point surely is that we must ask what the transactions are for, which is to exchange information and to trade based on differing views about the value of underlying assets. Algorithms are unable to do that; they work precisely because they can be applied to any asset or asset type indiscriminately. They simply read patterns of behaviour, they do not shift because the value of the asset has shifted. The result is that, as they proliferate, the utility of capital is being destroyed.
So on the one hand we have dangerously slowed down time, what is happening, or not happening, in the “real” world of developed economy commerce. And on the other hand we have dangerously sped up time, the absurdities of algorithmic trading. They both seem to me to be symptoms of the dying of the industrial era in developed economies, where there is over supply of just about every consumer product. As I have suggested before, the future lies in post-industrial commerce: for example changes to developed economies’ industrial systems that reduce their use of finite resources, or reduce pollution.
No doubt that is wishful thinking. Far more likely is a long period of low, or stagnant, economic growth in developed economies and unbalanced growth in emerging economies. However, the risks associated with an economic slow down are being compounded by the absurd acceleration of money. In the Great Recession, like the Great Depression, questions about the future of capitalism are being posed. So far all we are getting is a dangerous lack of governance and abrogation of political responsibility. Just as we need good governance to increase growth in developed economies (i.e. increase the rate of transactions), we also need good governance to slow down the trading systems (i.e. slow the rate of transactions). Neither is in evidence.
We know from experience that socialism and communism are not the answers; excessive central government control is not the right path. But knowing what we should not do does not help us find the answers to this situation when the very system of money is under threat, from two directions. The financial system is threatened by a cyber world of hyper speed, which sits on a “real” world of money that is dangerously slowing down. If there is no action to head off the risks.