This brief study assesses the limitations of economists’ idea of a perfect capital market as a basis for theorising modern global capital markets.
Today’s global capital markets have undergone a global tectonic transformation from the erstwhile discrete and largely controlled capital markets. This transformation has led economists to propound various theories to explain the aggressive and changing global economic landscape. However, economists globally still struggle with the continuously evolving environment across trade boundaries and capital market regimes.
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It is unfortunate that, like most other branches of economics, contemporary developments of knowledge and technology have not trickled back to further develop the fundamental models that most economists deploy to manage their thinking in respect of the global economy (Blecker, 2001, p 1-3).
Economic analysis today has been reduced to forecasting. Forecasting has now become the staple work of professional economists. It is impracticable to forecast econometrically in relation to a situation wherein new institutions will function, on the basis of factors forecasted under old institutions. The economic and political outcomes of new institutions need to be assessed as institutions, and not just as variables (Toporowski, 2003, p4-8).
This essay critiques the inadequacies of economists’ view of a perfect capital market. The study also assesses the same being a constraint for hypothesising contemporary global capital markets.
There is a distinct relationship between political economy and finance. Arguably, in an ‘era of finance’, political economy is liable to be marginalised due to the evident financial sector dynamism that guides economic development during such an era (Toporowski, 2003, p1). Political economy here is used in the conventional sense of the debate of the function of the state in the economy as well as the economic institutions, as also their impact on the key functions of production and distribution (Toporowski, 2003, p1).
The above opinion can be demonstrated considering that the classical political economy, (contending in favour of a laissez-faire state), was pushed to the limits of serious economic discussion during the latter half of the nineteenth century. This is because the increased international finance in the gold standard generated a sense of laissez-faire dynamism (Toporowski, 2003, p1).
The collapse of that financial boom culminated in the restoration of political economy of the Keynesian revolution. The financial inflation of the concluding decades of the twentieth century subsequently marginalised political economy again. Consequently, economists are looking forward to the restoration of political economy being ushered in primarily due to the deflation of financial systems throughout the advanced capitalist economies (Toporowski, 2003, p1).
The latter part of the twentieth century was acknowledged as witnessing the rise of finance. This broke the fragile Keynesian consensus for active state intercession to steady capitalist market economies. So long as the consensus was maintained, political economy was upheld by the apparent debate regarding the limits of state intervention (Toporowski, 2003, p4-8).
From the 1970s onwards, the financial markets saw the revival of activity. This activity along with the ensuing inflation of those markets resulted in the scope for political economy being reduced. Complacent certainties relating to the first neo-classical upheaval returned. The economy functions naturally in equilibrium. It is agitated only by imprudent monetary policies or wage rigidities. Also, keen re-financing is equal to comprehensive economic enterprise. This enterprise then, on the back of vigorous financial markets, requires no state support or overt social direction (Toporowski, 2003, p4-8).
This becomes obviously true since financial markets are so vigorous. The monetarist counter-revolution, on attaining consensus during the 1980s, ousted political economy. The new ‘political economy’ during that time was founded by writers like James Buchanan. It offered a ‘natural’ political economy of social and individual choice, from which the real economic and state institutions were detached, or reduced to merely choice-making mechanisms (Toporowski, 2003, p4-8).
Yet, political economy retained its vitality in newly industrialised and developing countries, where the economic volatility accompanying financial inflation has been most obvious. In fact, the re-emergence of such economic volatility within the more financially advanced economies is now laying the foundations for revitalisation of the political economy (Toporowski, 2003, p4-8).
“Toporowski (2000, p1) in his book The End of Finance, propounds the theory of an ‘era of finance’ as a “period of history in which finance prospers with such brilliance that it takes over from the industrial entrepreneur the leading role in capitalist development. In such an era, Finance becomes the most important political constituency, and is held to be a proper guide to the conduct of business, social and economic policy, and even our personal lives” (Toporowski 2003, p4-8).
Moreover, financial volatility causes the “finanzangst” that troubles the ever-increasing population influenced by advancements in the financial markets. That then turns, as argued by Toporowski (2002), into a cause for the concern of the economics profession with predicting economic variables (Toporowski 2003, p4-8).
Historical perspective of Global Capital Markets
The significance that Bryer (2000a, 2000b, 2004) attaches to Marx’s idea of total social capital has deep implications. Many such implications are yet to be explored. Bryer (1994, 1999, 2004) contends that Marx regarded capital as a social disciplining power working on workers, capitalists and managers. Scholars of contemporary business and society employ the term ‘globalisation’ for a wide description of business trends (Owen, 2005).
Bryer’s work, argues Owen (2005), lays the groundwork for inferring Marx’s idea of capital as an expectation of global capital markets. Building on this argument a little further, it may be argued that the schemes of contemporary capital markets can be comprehended as the recognition of Marx’s vision. Evidence of this can be found in the close association among stock markets worldwide as also among exchange rates and interest rates within different countries. This implies that capital can be considered to be a solitary fund of money which is indistinguishable by industry or country or legal form search for a return on capital (Owen, 2005).
The true test lies in the degree to which global capital markets have realised the potential that Marx predicted. If Marx is understood as expecting global capital markets the real test is the degree to which contemporary capital markets demonstrate the disposition of total social capital (Owen, 2005).
Good economic theory
A well-defined and enduring economic policy has characteristics that: (1) are based on concepts which are operational and well defined (2) explain behaviour in a lucid manner (3) are general and simple (4) are valuable for scholars and managers (5) are logically coherent and also (6) fit the facts (Owen, 2010).
Economic theory is also commonly criticised. The universal criticism is largely directed on the basis that it is based on intangible concepts that can not be operationalised (i.e. where values cannot be ascribed), that it is contradicted by facts, that it has no relevance to contemporary business and also that it lacks internal coherence (Owen, 2010).
There have been economists who have propounded numerous theories for example Simon’s (1959) theory that bounded rationality ‘satisficing’ rather than maximizing, Watts and Zimmerman (1978) theory that highlighted managerial self interest as a component of the principal agent relationship and Bryer’s theory of political economy of accounting’ (Owen, 2010). Yet, all these theories have, over time, also been over-shadowed by the perfect market approach which also suffers from weaknesses (Owen, 2010).
Perfect capital markets
A perfect market can be defined as one that bears one price that balances demand and supply, and where buyers and sellers are satisfied with such a price. It is a market where one price rules over the whole market and there are no special deals or offers (Owen, 2009a).
Further, a perfect capital market, according to the oft quoted definition, is a market without any arbitrage opportunities. The main characteristics of a perfect capital market would comprise of: one price that clears the market, one interest rate, one rate of return on capital, and also a single price for risk (Owen, 2009a).
However, the apparent weaknesses in the economists’ perfect market model emanate primarily from too much importance being given to individual decision-making and the associated assumptions being unrealistic (Owen, 2009a).
The weaknesses in the stakeholder approach, on the other hand, stem from too much importance lent to firm level thinking, the need for stakeholders to be prioritised, underestimating the usefulness of accounting and the separation of finance from accounting. These weaknesses in both the approaches highlight the need for developing another diametrically opposite approach to understand the contemporary markets (Owen, 2009a).
International economists braved the contemporary world of financial and capital market globalisation along with continually floating exchange rates. They organised this with analytical tools and apparatus that was inherited from the past which rendered them incapable to predict what that contemporary world evolve into (Blecker, 2001, p 1-3).
This contemporary era is mainly characterised by severe volatility of exchange rates, unrelenting breaches of purchasing power parity, persistent trade imbalances, recurring financial crises, and today’s globally interrelated business cycles for instance the recent global downturn of 2000-01. These characteristics were not really what the advocates of the new order had promised or expected (Blecker, 2001, p 1-3).
Primarily, mainstream global economists have endorsed the liberalisation of commodity trade as well as capital markets. They have also promoted the move towards flexible exchange rates. However, there have been a few noteworthy conventional dissenters regarding the last point that support permanently set nominal exchange rate parities (Blecker, 2001, p 1-3).
Limitations of economists’ views
Since the 1970s global economists have been busy developing novel theoretical and econometric models to attempt to understand the new realities of international finance. Such models are exemplified right from Dornbusch’s (1976) pioneering exchange rate overshooting model through to the latest work regarding self-fulfilling speculative attacks, panics and bubbles
Through their pioneering effort, international economists have endeavoured to elucidate the exchange rates’ volatility which was not forecasted by the earlier generations of models (Blecker, 2001, p 1-3).
Frequent econometric tests have found certain original “stylised facts” regarding the global financial system. These “facts” comprise fairly forceful findings. One finding is regarding the covered interest parity that holds amongst nations permitting liberalised capital flows, whereas uncovered interest parity as well as real interest parity do not hold. Another finding establishes that relative purchasing power parity (PPP) is usually broken at least in the medium and short term, and perhaps also in the long term. A further finding corroborates that no exchange-rates model which is fundamentals-based can forecast their short-term movements time after time better than the supposition of a random walk. Also, current account imbalances have only enlarged and more unrelentingly since the 1980s (Blecker, 2001, p 1-3).
Nevertheless, despite these real intellectual advances, the fundamental investigative framework of nearly all international economists stays mired in past intellectual habits. The core theoretical models relating to international economics are still based on suppositions that refute the current realities of global financial markets (Blecker, 2001, p 1-3).
Previous ideas for example PPP, the law of comparative advantage, mechanical “balance of 3-payments adjustment” and also expected exchange rates continue as benchmarks for
research. They also dictate both policy advice and pedagogy. As in numerous other spheres of economics, developments at the knowledge frontiers have not percolated back to transform the fundamental models that nearly all economists deploy to manage their thoughts regarding the global economy (Blecker, 2001, p 1-3).
After years of economic austerity and stringent monetary policies, economies across Europe have definitely reached a turning point in their economic development regarding downsizing of the public sector, sluggish growth of per capita incomes, mounting unemployment, job insecurity along with the surfacing of disadvantaged economic subcultures in many such economies (McNutt, 1996).
There is an acknowledged requirement to make heavy investments in a wide range of social sector programmes. This is needed to exploit the cluster economies entrenched in many economies. Economic theory does offer a few guidelines on the modus-operandi of the distribution of the proposed expenditure (McNutt, 1996). Endowment theories recommend that the expenditure be apportioned to the more prolific regions. Further, altruism theories advise that the expenditure be apportioned to the more underprivileged regions, whereas rent-seeking theories direct the flow of expenditures to groups that generate the maximum private benefit.
On the other hand, unemployment subsists in European countries possibly because of the linkage of real wages to the cost of living. In such a case, trade liberalisation may offer a considerable stimulus to output and employment through lowering of living costs as also the reduced costs to the transnational corporation of employing labour (McNutt, 1996).
Challenges for economists’ theorising of global capital markets
The recent financial crisis compelled both economic policymakers and economists to reassess various basic issues. These issues present numerous challenges, of which the major three are as discussed below. The first challenge is to properly understand the root causes that led to the financial crisis and how to avert their recurrence. The next challenge is to fix the damage caused to the public finances by the crisis. The third challenge concerns the necessity to draw the correct conclusions to enable economic analysis (Liikanen, 2010, p3-5).
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Accordingly, the primary challenge is to avert similar future crises. The financial crisis enlightened policymakers with many things. Possibly the most important were the holes in the knowledge base relating to systemic risks. The theory of systemic risk is not unknown as such, although the crisis exposed several fresh dimensions of systemic risk. Prior to the crisis, it was not comprehended how complex the links are amongst the global financial markets. It was also not known that a sufficiently extensive disruption could freeze the markets. Although the global financial markets did not give way in October-November 2008, yet it was so close that a similar risk could not be accepted any longer (Liikanen, 2010, p3-5).
A fundamental dilemma in the present debate is the inability of economics to offer lucid guidance as to the kinds of instruments that could be deployed to execute this kind of stability policy. The conventional toolkit of monetary policy viz. money supply analysis and interest rate policy is well-established at the centre of the economics discipline. Yet, the integration of financial intermediation and financial markets with the consequent macroeconomic analysis is even today in its infancy. The appropriate approaches are yet to be established and this provides a distinct challenge for the economics discipline in the future years (Liikanen, 2010, p3-5).
The second main economic policy challenge lies in the restoration of the crisis damages to public finances. Subsequent to the financial crisis and the consequential economic crisis, public finances have by and large deteriorated along with increased unemployment, which in some countries has risen quite sharply. The deterioration of general government finances partially reveals the results of various stimulus measures, financial system support and automatic stabilizers. Perhaps even more revealing is the fact that the fall in GDP levels has resulted in clear erosion in the public revenue base. The revenue base is estimated to stay smaller than earlier predicted for many countries. The reason for the smaller revenue base is the estimated reduction of their output potential due to the crisis (Liikanen, 2010, p3-5).
The third challenge concerns fundamental issues in economics. Paul Krugman, the acknowledged economist, queried last year appropriately in his already admired column: “How did economists get it so wrong?” Krugman’s fundamental argument lay in the economics profession having gone astray. “The fascination for analytical elegance and mathematical acrobatics had locked economics into an ivory tower of frictionless markets and rational economic agents while marginalising attempts to understand the economy as it actually is”(Liikanen, 2010, p3-5).
Globalisation, Technological Revolution, and the Restructuring of Capitalism
Globalisation encompasses both capitalist markets as well as sets of social relations. It also involves flows of capital, commodities, technology, forms of culture, ideas and people across geographical national boundaries through a global networked society. The metamorphosis of both capital and technology functioning together now continues to construct a new interrelated and globalised world (Kellner, 2009, p2-3).
A technological revolution concerning the formation of a computerised network of transportation, communication and exchange is the premise of a globalized economy. This co-exists with the expansion of a global capitalist market system which is attracting ever more areas of the world along with different spheres of production, consumption and exchange into its orbit. The technological revolution presumes global computerised networks along with the open movement of information, goods, people and services across national boundaries (Kellner, 2009, p2-3).
From this viewpoint, globalisation cannot be comprehended without appreciating the technological and scientific revolutions as also the global capital restructuring which form the matrix and motor of globalisation. Many globalisation theorists, nonetheless, fail on either of the following two counts. They either fail to detect the basic importance of technological and scientific revolution along with the novel technologies that help initiate globalization; else they infer the process via a technological determinist structure that blocks the economic aspects of the institutions and imperatives of capitalism (Kellner, 2009, p2-3).
Such biased economists fail to appreciate the co-evolution of capitalism, science and technology. They also fail to appreciate the highly ambiguous and complex system of globalisation that unites capitalism with democracy as well as technological mutations with a further turbulent mix of costs, losses, gains and benefits (Kellner, 2009, p2-3). In this context, economists can be considered to be singularly unqualified to assess the theorising of modern global capital markets based on the above paradigm and evolutionary shifts in the deployment of economic resources.
It is evident from the foregoing discussion that the vigorous current debate on the global capital markets and its attendant crises cycles has again provoked a reassessment of the prevalent economic theories and their weaknesses.
The global capital markets have transformed radically during the twentieth century, especially in the last four decades. To address this transformation, economists have propounded various theories, largely unsuccessfully, to rationalise and explain the tectonic changes.
It is evident that contemporary developments concerning capital, technology, knowledge, science and other economic resources’ deployment have not percolated back to improve the weak economic models that are used to fashion a large part of contemporary economic thinking.
Economic analysis has now been reduced to forecasting. It is apparent that the economic profession has failed in its primary function of assessing and managing the integrated and globalised capital market economies, primarily due to inherent limitations in its economic theories. To understand today’s integrated and seamless global capital markets, economists need to take a holistic global view on the evolution across all economic, political, scientific and technological advancements worldwide. Economic theories will need to address all the relevant challenges to avert future capital market crises.
This analysis has particularly exposed that it is impossible to foretell econometrically regarding circumstances wherein current institutions will operate, based on reasons that are predicted under old institutions. Therefore, economists’ ideas of perfect capital markets are unable to aid the theorising of contemporary global capital markets.
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