Can we rely on the Markets?

The mantra has always been to rely on the market to determine the price of commodities and with technology and other developments we now use markets to set the price of services both in the public and private sector.  But can we rely on the market any more? 

Recently there have been two stories that might cause us to to review the banking crisis that has threatened economies around the world. Most recently it emerges that oil prices have been in relation to price fixing on the oil markets that is forcing the price of petrol up at the pumps for UK motorists. (Read Telegraph story)

In June this year it emerged that Barclays and possibly other banks have been involved in fixing the LIBOR (London Inter Bank Overnight Rate). As a result they paid £290m to regulators in the UK and the US.

In both cases it is the potential for traders to manipulate the price or rate in what was assumed to be a ‘fair’ market. In the case of the oil market this is one that electronic handling trading and fixing benchmark prices across the market, the other relying much more on the integrity of traders to record trading correctly, in effect a much more traditional market.  However in both cases we can see that trading and market prices are more the manipulative hand of the traders than the Invisible Hand envisaged by Adam Smith.

With these cases in mind how can we review the banking crisis?  Derivative trading developed new financial products where their true risk or value could not be evaluated prior to purchase – in effect trying to commoditise goods that were ‘credence goods’ relying on the reputation of the traders such as Lehman Brothers who’s failure triggered the crisis.

When we look more closely we find that electronic markets became reliant on systematic trading using formula such as that developed by  Black, Scholes and Merton which supported the adoption of higher levels of risk or unknown levels of risk. Are systems such as this in effect preventing the market from operating as a free market?

Northern Rock failed because the LIBOR rate rose to a point that there was no wholesale margin for it to trade on.  This rise in rate was attributed to concerns that banks had hidden risk or what became known as ‘toxic dept.’ in their portfolios – on the assumption that LIBOR was set as if in a free market – clearly this is not the case.  So where there other actors at work at the time fixing the LIBOR to protect the interests of the bigger players?

The market if the main stay of the ‘free’ economy championed by politicians on the right and many economists – but can we really rely on this in he future or are we likely to see re-nationalisation of key services and state regulation of prices and rates in some markets?

Already the UK government is considering setting up a Business Bank so that business can access funds outside the current market place. (Telegraph 14th Sept 2012)

I guess we will have to wait and see banks and traders respond to these developments.

Sources and further reading:–2012_global_financial_crisis#Financial_institutions

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