How markets work

“Europe's financial markets are opening with a firmer bias Monday after the weekend's EU Summit, where some participants argue that progress was made towards addressing the euro-zone crisis.”

Wall Street Journal, 24th October 2011

Good one, Frau Merkel!

It has been pointed out that government politicians downplay market reactions to policy when they are negative and call attention to them when they are positive. Incredibly, opposition politicians seem to do precisely the opposite. That, my friends, is how politicians react to markets. It’s easily predictable and quite reassuring in a way. But can we predict how the markets react to policy?

Perhaps we can. Every time Eurozone leaders hold a summit and unveil a policy package to handle a crisis, the markets initially react positively. Traders buy and prices go up a bit. “It’s always a good opportunity for buying,” explained the well-informed interviewee on the Today programme yesterday, adding as an aside to the interviewer, “perhaps you’ve made money that way yourself, Evan [for it is he.]” When the big cheeses say they’ve solved the problem, buy shares! It’s such a simple formula, even simple BBC economics experts should be able to manage it!

Recession!

But wait. I thought ‘the markets’ carefully considered and analysed world events and reacted accordingly, like an infallible barometer made entirely out of money. The statement, “It’s always a good opportunity for buying” seems to belie this assumption. It suggests that fluctuations in ‘the markets’ actually depend less on rigorous analysis and more on convention.

Conventions are arbitrary rules. The rule here is, when Eurozone leaders reveal a bailout package, prices go up. Traders know this and therefore buy shares when this happens. The prices, consequently, go up. The words ‘self-fulfilling’ and ‘prophecy’ zigzag inexorably up into my consciousness like a red line on a profit chart.

At this point, a massively multiplayer online game (MMOG) begins. The rules of the game will be familiar to anyone who understands how to play ‘chicken’. The longer a trader stays in the game, the more money he (usually he) can make. But if the tide turns before he leaves the game, he could see the value of his shares plummet.

And that, dear readers, is how markets work. This is the ‘democracy of free markets’, as the interviewee on the radio put it. In a different interview about a month ago, Alessio Rastani said, “For most traders, we don't really care that much how they're going to fix the economy, how they're going to fix the whole situation - our job is to make money from it.” He may not have been the most representative or successful trader the BBC could have interviewed, but something about his words seems to make sense. Why should traders care how the economy will be fixed? What interest do the richest people have in the success of the wider economy, when in the current economic crisis chief execs can see their pay rise by almost 50%? Certainly not self-interest.

Alessio Rastani, 'not a hoax' says BBC

Maybe instead of the ‘democracy of free markets’, we should concentrate on the ‘democracy of actual democracy’, and maybe elected politicians should ask not what they can do for the markets, but what the markets can do for everyone else.