How the Global Financial Markets Really Work: The Definitive Guide to Understanding the Dynamics of the International Money Markets (Times (Kogan Page))

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HOW THE GLOBAL FINANCIAL MARKETS REALLY WORK





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Praise for How the Global Financial Markets Really Work “An essential handbook for anyone hoping to understand the financial world of the 21st century.” William Kay, The Sunday Times ‘Money’ columnist, London “This book provides an easy-to-read and up–to-date overview of the players and products of the capital markets, explaining how and why things went so spectacularly wrong in the credit crunch.” Janette Rutterford, Professor of Financial Management, Open University Business School “An excellent introduction to financial markets. Wide-ranging, easy to read, and with a wealth of information for investors.” John Calverley, Head of Research, North America, Standard Chartered Bank, and author of When Bubbles Burst: Surviving the financial fallout “Alexander Davidson has provided a very useful overview of the structure and operation of the broad range of financial markets. This provides a framework in which the challenges and implications of the credit crunch can be explained.” Duncan McKenzie, Director of Economics, International Financial Services, London “A concise and readable commentary, particularly focused on making sense of recent events. Its scope is remarkably wide and the descriptions are well complemented by the glossary and other appendix materials.” Professor Stewart Hodges, Faculty of Finance, Cass Business School, London “Never has it been more important for all of us to understand how financial services work and this superb general guide deserves to be widely read. Alexander Davidson has done an excellent job in explaining how it all fits together and how the ‘City’ impacts the rest of society, and the world.” Lord Mayor of London, Alderman Ian Luder “The author provides a thorough analysis of the global financial markets and sets out in clear terms the interdependence of markets in the modern era. The book is a valuable aid for policymakers, campaigners with an interest in global financial markets, and students alike.” Mick McAteer, Director, The Financial Inclusion Centre, London

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HOW THE GLOBAL FINANCIAL MARKETS REALLY WORK The definitive guide to understanding international investment and money flows

Alexander Davidson

London and Philadelphia



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Publisher’s note Every possible effort has been made to ensure that the information contained in this book is accurate at the time of going to press, and the publishers and author cannot accept responsibility for any errors or omissions, however caused. No responsibility for loss or damage occasioned to any person acting, or refraining from action, as a result of the material in this publication can be accepted by the editor, the publisher or the author. First published in Great Britain and the United States in 2009 by Kogan Page Limited Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms and licences issued by the CLA. Enquiries concerning reproduction outside these terms should be sent to the publishers at the undermentioned addresses: 120 Pentonville Road London N1 9JN United Kingdom www.koganpage.com

525 South 4th Street, #241 Philadelphia PA 19147 USA

© Alexander Davidson, 2009 The right of Alexander Davidson to be identified as the author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN 978 0 7494 5393 0 The views expressed in this book are those of the author, and are not necessarily the same as those of Times Newspapers Ltd.

British Library Cataloguing-in-Publication Data A CIP record for this book is available from the British Library.

Library of Congress Cataloging-in-Publication Data Davidson, Alexander. How the global financial markets really work : the definitive guide to understanding international investment and money flows / Alexander Davidson. p. cm. Includes index. ISBN 978-0-7494-5393-0 1. International finance. 2. Investments, Foreign. 3. Money market. 4. Capital market. I. Title. HG3881.D3287 2009 3329.042—dc22 2009014889

Typeset by Saxon Graphics Ltd, Derby Printed and bound in Great Britain by Thanet Press Ltd, Margate

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T The T Times’ imes’ Guide to t the City Anthon J. Anthony J Evans E anss [email protected] [email protected] Europe ESCP Eur ope e is the oldest business school in n the world, founded in Paris in 1819 by Je Jean ean Baptiste Say Say.. The original vis vision sion was to unite the intellectual rig rigour gour of political economy with the e practical rrelevance elevance demanded byy businessmen, and the balance e between rigour and rrelevance elevance still drives the rresearch esearch agenda of tthe he school today today.. S ay w as o ne o he fifirst rst g reat e conomists, a nd h is understanding understanding o how Say was one off tthe great economists, and his off how individuals co coordinate ordinate their planning thr through ough th the he institution of market exchange e xchange h helped elped tto od define efine the the d discipline. iscipline. This This “Classical “Classical School” School” of of economics an and nd accompanying model of laisse laissez-faire ez-faire has since lost favour amongst som some me commentators and intellectuals intellectuals, s, but is little understood. However,, if you However yo ou talk to the entr entrepreneurs epreneurs and investors in nvestors that anticipated the current c urrent fifinancial nancial crisis crisis and and are are critical critical of of the the government government intervention intervention that that three free has followed, you will find thr ee important lessons lesso ons about fr ee markets. Firstly,, markets information.. It wass the short sellers trading on Firstly marketts reveal new information concerns were proven their concer ns about banks that wer e pr oven right, and the rregulators egulators who failed. failed A holistic appr approach oach to financial regulation reg gulation would rrealise ealise that no public agencyy can ever accumulate and act upon u the local and tacit across entire economy,, and wo would appreciate knowledge ac cross an entir e economy ould appr eciate the rrole ole that We markets can play in bringing this information to t light. W e could very discover bank’ss toxic assets quickly discov ver the extent of a bank’ a by allowing anyone with rrelevant elevant information to trade on it. This would w give potential whistleblowers heard. whistleblower rs a voice that would actually be hear d. Companies such as Koch Industri Industries es and Google have pioneer pioneered ed the t use of inter internal nal pr prediction ediction markets to all allow low executives to utilise the com combined mbined wisdom of their employees One employees. O of the key lessons is that the e people with private information ar re the ones who impr ove markett efficiency are improve efficiency.. Secondly ue comes through exchange he rreason eason that socialism has Secondly,, valu value exchange.. Th The led to econom mic chaos wher ever it has been tried t is because the marketeconomic wherever

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clearing price of a good is not merely a technical problem that can be solved through statistical modelling. Prices can only be established when subjective valuations combine and two parties actually trade. The quantitative analysts on Wall Street failed to realise this, since their models used current market prices as estimates of the value of an asset. However, we only find out the real value when that asset is sold, and if there is a systemic event that compels many banks to sell at the same time, this model will have been hopelessly optimistic. Thirdly, central banks are not market institutions. In the UK, our monetary system is centrally planned by a nationalised bank which holds a monopoly over the issuance of currency. Each month, a committee meets to set the Bank rate of interest; if they cannot set it any lower, they resort to directly expanding the supply through quantitative easing. If this were any other industry, it would be viewed as the Soviet-style planning board that it is, and we would be duly sceptical about its ability to intervene without creating wide scale misallocations of capital. Interest rates are not an arbitrary price of money - they are the devices that coordinate savings and investment. Manipulation of interest rates obscures the signal between consumers and producers, and when they are set too low people borrow too much. Many economists warned that central banks were creating too much credit, and that this would lead to an unsustainable boom, an inevitable credit crunch, and a subsequent recession. Many businessmen foresaw the crisis, and this is largely due to age-old economic truths about how markets operate. We are currently seeing policymakers blame the failures of laissez-faire to justify unprecedented amounts of intervention and indebtedness. The message of Jean Baptiste Say and the vision of what an economy would actually look like if markets were allowed to operate freely are more relevant than ever. Markets are not perfect, but they create more prosperity than any rival system. On this academics and businessmen can agree. Anthony J. Evans is Assistant Professor of Economics at ESCP Europe and Course Director of the Master in European Business (MEB) Programme in London. He is co-author of “The Neoliberal Revolution in Eastern Europe: Economic Ideas in the Transition from Communism” and has published research in a range of academic journals, trade publications and policy reports. His email address is [email protected].

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