Sunday, July 19, 2009

Marx’s Theory of Finance

To develop a basic, classical Marxist theory of finance; we must understand the basic profit principle of Marx: M'=M+ΔM or Money-Capital-Money'. In Marx’s mature thought, everything is built on this principle and all human economic activity is reducible to achieving M'. But, because Marx discussed his theory in terms of labor-produced goods and set labor as the only way to create profit, applying Marx to finance and especially trading becomes oblique in some ways. The reason why we must consider Marx’s perspective (and why you should continue reading this article) is that it helps us understand the difference between good finance and bad finance. But first, a short word for the anti-communists out there about the difference between Marxist thought and communism and their policy implications.

Marxist thought, at its core, is a theory of economics that described how we make profit by combining capital investments and labor. Communism is a political ideology based on the ethical and political implications of the labor abuses that this drive for profit can create. While Marx himself was certainly anti-capitalism because of these abuses, I do not believe that there is any metaphysical reason why we cannot produce profit humanely. In fact, I believe that a fully humane capitalism is possible. I will not discuss why here. I only mention this to assuage conservative readers that this is not another hate-mongering polemic on capitalism and private property.

Now, the key problem with applying Marx’s thought to finance is that finance does not produce goods in the traditional sense. They do not buy low and sell high to their investors. On top of this, the tertiary finance sector which trades in derivatives, is two steps removed from the traditional economy. Thus, Marx’s M-C- M' profit formula and fundamental motivation becomes, at best, only indirectly applicable. In the most traditional finance sector – savings and loan – the leap is relatively easy for Marx. Financiers invest (add M) for a slice of the final profits M'. This formula for motivation and economic causation however does not apply to speculative derivatives trading, collateralized debt obligations (CDOs), and other tertiary financial economic activity that has become a mainstay in our system.

Why is this such an issue and why should we care what Marx might have to say about it? First, since these tertiary activities are mainstays and they do not fall into a smooth image of how profit motives translate into real, goods and services-based profit; it is crucial that we understand how they interact with the main economy to better predict and regulate these activities. Second, Marx’s theory is very clear about the relationship between what people think, what they do, and what happens because of it. While his thought itself is very general and now analytically outdated, it is still in line with the basics of micro and macro economic theory. Thus, it offers a comparatively clear way of interpreting tertiary financial activity while not seriously violating basic economic principles.

So, what makes tertiary finance so special and un-amenable to a basic understanding of capitalist economics that we have to create a whole new interpretation of it? Capitalism, at its core, works because it adds real value to real things and earns a fair return from it. As Marx throws away talk about prices as a proxy for understanding the real value added, we too must throw away the notion that capitalism makes money simply because it gets more money than it puts in. Tertiary finance latches on to this process in a very distant way, putting money into money that is somewhere backed by real value-adding processes. These financiers make money when the money they invest produces more money. The problem is that, because the link to real value-added process is so convoluted and, adding to that, the gambling economy of short-term trading practices, the M' that traders achieve is not easily traceable to any actual value created. Hence we can have toxic assets with no way to measure their actual value.

To better understand a bit of the range of tertiary finance practices and address one of its central self-defenses, we can look at speculative derivatives trading. To keep it simple, speculative derivatives trading operates by allowing investors to put money in actual goods and the returns that investors make come from the change in value brought about by other investors and market demand for that good. For example, I invest in the derivatives equivalent of a barrel of oil at $100. Five other people invest at increments of $105, $110, and so on. I then sell my derivative at the final $130 to the sixth person. I’ve made $30 because people were willing to pay $130 for a barrel of oil. (For those of you who know the technical dimensions of derivatives, I know I’ve cut out 99% of what actually happens for the sake of simplicity). While no more value was added to the barrel I bought and then sold, I still made money. The central rationale for this among economists and free market defenders is that this process helps the process of putting an accurate value on the good being traded. In essence, the actual value of the barrel I bought was $130, but the market did not know that until I sold it and, it was only because others bought it at higher prices (the proof that the barrel was worth more than the $100 I bought it for) that I could sell it for the more accurate value.

This accurate valuation hypothesis of the role of tertiary finance can hold water theoretically under the assumption that investors will not pay more than something is worth and will buy something when it is valued less than it is worth. Here we have the disjunction with the basic logic of capitalism. Tertiary profit is made when the estimated value increases. Primary profit increases when the actual value increases (primarily through productivity increases). (Note: increased market share, or selling to more people, does not constitute an increase in profit or value, only a redistribution of existing profit in Marx’s analysis). While there are many cases when tertiary profit increase occurs because primary profit increases, there is no reason to believe that this is actually what happens without a thorough business analysis. What this means is that the tertiary sector has an incredible leeway to make money without actually producing anything of value or contributing to the overall efficiency of the market.

The current recession is not the only time in which some have claimed that the profit businesses report were not based on any value created. Compare former U.S. Labor Secretary Robert Reich’s analysis of the 1980’s merger and acquisition bonanza with Gowan’s diagnosis of the present financial crisis. To save you some time, both argue that the large amount of profits generated were based on non-capitalist gains like artificially inflating and deflating market bubbles and taking government write-offs for merging and writing down sick companies. The lesson is that when we disconnect the capitalist motive for M' from the actual process of adding value to objects, we open ourselves up to diverting money to paper profits and a pure gambler’s game which are tangential to contributing to the production of real value.

What does this have to do with discerning good and bad finance? What I’ve implicitly argued and now explicitly state is that good finance is attached to real value, meaning that financial profit is generated by the creation of actual value. This does not necessarily mean that tertiary practices are bad, but they require much more conscientious review than primary or secondary finance (such as mutual funds, 401Ks, and the like). What is bad finance is the intentional attempt to make money by manipulating market values and disconnecting the value of a tradeable from the actual value which backs it. The CDOs that accumulated so many types of financial vehicles from so many sources that no one could trace them and that have melted our financial sector are criminally negligent at best. The second insidious form finance is that which makes profit from the loss of value. A good example of this would be predatory lending such as some forms of sub-prime mortgaging and many credit card policies. No, you cannot legislate consumers’ financial intelligence, but you cannot legitimate a business that financially generates and then profits from financial destruction. It usurps the creation of value and acts as a parasite on the capitalist system and our society as a whole.

There are two lessons that I believe can be taken away from a classical Marxist theory of finance. First, solid capitalist finance is linked to actual value. Second, finance disconnected from actual value contributes to the destructive and free-riding dimension inherent in capitalism. Though Marx’s vision of our ultimate evolution away from capitalism seems irrational now, I believe his underlying image of the economy is still useful in interpreting modern markets and capitalist enterprise and can contribute to a more ethically sound way of creating real value for our lives.


daiskmeliadorn said...

this was very helpful, thankyou! :)

Jason said...

Always a pleasure to share ideas