The lacking Trust

(Blog n°3)

Because financial exchanges are based on relationship implying the presence of human beings, feelings, intuitions and values, the gravity of such exchanges may be pushed into the background. Indeed, today’s review will focus on the idea that, just like during the 1920s, finance is a game. Of course, any game can be fun, occupy the children during a rainy afternoon, but it is also and most importantly a way, a tool to understand the way the human mind works. Such a knowledge would help to understand the levers of a subject as finance, where psychological actions are the very core of the exchanges. However, before trying to understand the players mind, perhaps should the game be firstly analyzed.

Essentially, the core point of a game is to find an equilibrium, a state where nothing can change. Even if the financial game cannot end, it still can reach a balance. According to V. Pareto (1909), such an equilibrium can only be optimal. Indeed, the players being rational individuals, they can only adopt the most perfect situation. An optimum such as defined by V. Pareto is a situation in which the well-being of one individual cannot be improved without reducing the well-being of the other participants.

This kind of optimum can exist in the financial market (if the shareholder’s wealth is considered as their well-being). Indeed, the Pareto’s optima could be assimilated with the capital market line: an optimal situation in which the profitability of a portfolio cannot be improved without increasing the volatility of the portfolio. This capital market line is a market balance, fixed by the offer and demand law, by the “invisible hand”, so theoretically, it is a Pareto optimum (that follows Pareto’s assumptions).

However, players could be victim of bias. The economist and mathematician J. Nash theorized such a phenomenon in 1950. According to his theory, another equilibrium can be reached in a similar game that the one presented by Pareto. However, this other equilibrium is not an optimal one in the terms determined by Pareto. The most famous example of this kind of situation is the prisoner dilemma. A fictional situation where the lack of trust between two persons is key: because two prisoners accuse each other, they are both condemned to a sentence that could have been reduced if they would have remained quiet. Nevertheless, the game forced them to denounce each other by rewarding such an act. This reward created this lack of trust.

Trust. Again, it is the core point of the whole economic system. Trust in prices, in money, in computers are conditions for the global financial functioning. Therefore, the actors of the market are potential prisoners. A slight doubt can create a situation in which the well-being of the participants is not optimized, in which the objective of an optimal shareholder wealth is missed.

However, all of these theories assume that participants are purely rational. This point remains controversial.

A risky game

(Blog n°2)

Last week's topic covered the first ever financial crisis, the Tulipomania crisis. While its effects were relatively restricted compared to a more recent crisis, it still asked the question of ethic in finance by noticing a gap between the actual value of the shares and their prices on the stock market. Such a gap did also exist during the 1929 American crisis, such as presented by the documentary 1929: The Great Crash. This relatively more recent example leads to ask about the mechanisms that conducted to the collapse of an entire economy.

Nevertheless, more than an economy, it is rather a whole culture that is involved in the financial exchanges at the end of the first World War. Therefore, both cultural and behavioral factors initiate this crisis.

• Firstly, common people are involved in the financial world by the state. Indeed, the US government (as the other belligerent governments) issues “liberty bonds” to raise funds for the war. By buying these bonds, US citizens are using securities for the first time and became quickly used to it.
• Secondly, the post-war situation allows the first consumption boom in the history. People become used to massively buy products and moreover, by credits. “Buy now, pay later” is the norm in terms of buying.
• Finally, the mentalities in Wall street evolve and see in the common people an opportunity to rise fund for the market. This was earlier considered as too risky, but the amounts of money owned by private individuals offer a great advantage to the stock exchange.

So, citizens begin to invest in the stock exchange. They buy shares as they were buying cars or sofas: by credit. A whole financial play culture emerges, based on “buying on margin” exchanges: borrowed money helped people to buy more shares. Fortunes are created, some new financial stars raised, becoming popular because of their stupendous wealth created in a few times.

However, this speculative movements implies an offset between the market prices and the actual values of the issuing companies. The market corrects itself on October 24^th, 1929, the “Black Thursday”. Despite the banks attempts to inject liquidities in the market to stabilize the prices, it finally collapses, leading to the bankruptcy of a huge part of the population.

Furthermore, the shares having been paid with borrowed money, the afraid banks ask the borrowers for cash, alternatively they would sell the shares owned by those people. The shares are sold, the prices collapse, so more shares are sold, leading to a vicious loss of value spiral, to the failure of two thousand banks in the year 1931, and to a major human disaster.

One more time, the analysis of a financial crisis highlights the fundamental link between the market and the rest of the society. The responsibility of this crisis was shared between the bankers, the politics, and the people. All of them suffered from the consequences of the crisis they initiated by their behaviors. Apart from the human and political crisis following this financial one, the biggest challenge remains in the lack trust initiated by such a phenomenon. Therefore, trust  will need a further reflexion.

The costly Tulip

(Blog n°1)

In the beginning of the 17th century, happens what is related as the first history financial crisis: The Tulip mania. Both a fashion effect and speculative investments cause a stupendous increase of the Tulips prices; these flowers become a luxury product within a few years. Regarding the figures that remain from this time, the prices were not reflecting the actual value of these flowers (notwithstanding their incredible beauty). The market validates this recognition by making the prices collapse in the year 1637.

This example illustrates the usual cliché about finance: greedy people exchanging securities for prices based on wind, rumors and assertions such as the global taste of a society for a special type of flowers.

The failures highlighted by this historical event reflect those gangrening the nowadays situation. Are the market prices still related to the actual shares values? The simple fact to be in measure to ask this question implies a possible defect in the global financial organization.  However, the point in this blog will not be to determine if whether or not there is such a difference between market and actual value of securities, simply because a blog is not the good format for such a study. These words are rather going to be focused on the consequences implied by the said phenomenon.

Back to basics: what is finance? It comes from the Latin fine: “end”. So essentially and etymologically, a funding has to deal with time: it can exist only when the whole amount of money is payed back. But if the market and the speculation price a share above its tangible value, there cannot be any repayment of the amount invested. This happened in the previous example of the Tulip mania: the prices collapsed with the demand just at the end of the fashion effect, the flowers owners lost fortunes because of this collapse.

In that case, the trust in a market tending to deviate from the concrete price of goods can be put into question. The market is supposed to help investors and entrepreneurs to meet each other. It is a tool aiming to improve projects realizations, and not to create fake value. This is why the incredible rationally-based and automatically-programmed exchanges can be as performant as possible, anyway they have to be based on human activities or, in other words the most random and chaotic events that could happen. Actually, this chaos needs trust to keep working, expanding and creating value.

Thus, the concrete projects prevail their finance simply because they precede them. However, finance allow the projects to exist. Because of this bilateral strength, trust muss be the base in such in relationship, otherwise the interests would not converge and nothing would be created. So, what is trust? From a human science point of view, it is a feeling including a subjective judgement, determining the base of a reliance relationship. Basically, finance is humanly centered. This is why ethic should be above the exchanges, this is why respect prevail: because Tulip price muss stay stable and relevant.