Neoclassical principle versus

Real world financial markets

Rhodes University, Economics 201 2010 Essay
“How do markets really work?”
Financial Markets
Motlatsi Molefe

Abstract
This assay analysis the ideology and model of the
neoclassical economist with reference to the financial
markets. Focusing ideally to the assumptions that assist in
simplifying the model. The model is then linked with the
real world economic situation and comparison is made
between the two. The findings are taken further in
explaining the recent global financial crisis. Aiming to
critique the application as neoclassical school of thought
and offer possible prevention tools. With the deregulated
market, the financial institutions have been creating
financial instruments aiming to hide risks born by their
heavy lending and making huge profits. At face value,
the solution is to regulate such tendencies and protect
consumers. A suggested policy will be outlined.

[511 words]

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Introduction

The recent global financial crisis has evoked a new interest in explaining
economic theories and how these can be put into practise to prevent similar
crisis. This essay seeks to analyse the relationship that exist between the theories
that explain the behaviours of markets and what and asses what happens in
the real world particularly the financial market. Knowing the gap between the
real world and conventional theories this will permit us to evaluating how far
form reality and how should they be further be developed in order to reflect
the real market dynamics. The fundamental question that seem to dominate
discourse on market is ‘to free the markets or to regulate the market.

The loanable fund Market under neoclassical view

The price paid for making a loan is the interest rate paid for the loan. The
equilibrium for loanable fund market occurs where supply and demand of
loanable fund market yield balance volume of funds and interest rate.
Demand for loanable funds is stimulated by government building up liquidity to
pay off it deficit budget (Barth, 2000:162) buy selling government securities to
the central bank. Later, the reserve bank exercise open market operations by
selling bonds in various forms to commercial banks. The implication of this is
that the government will stimulate demand for loanable funds. Holding other
things constant, this will have an upward pressure on interest rates. In a short
run interest rates will rise, suppose the assumption that the consumers and firms
are well informed and rational, the households will recognise an investment
opportunity in high interest rates and contribute their surplus disposable
income into the loanable market buy purchasing bond. Perpetual Bond price
is low when interest rate is high; therefore demand for bonds is high when
interest rates are high according to the model. According to Froyen (2008:
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119), investment by firms will fall considering the price (interest rate) of
borrowing is high. Figure 1 bellow illustrates the relationship between the
savings by households (which is function of real income), demand for
investment (which is function of interest rates).

Figure 1 Loanable fund equilibrium

For the above to hold, the market for loanable income must be subjected to
assumption that if markets are left free from any regulations so to self-adjust
(Froyen, 2008: 34). Wade (2009; 6) furthers these assumption by indicating that
the neoliberal idealism are seconded by “efficient market hypothesis” arguing
that will always clear to maintain an equilibrium point. In such market,
households and firms only act on the information in hand to make rationally
and independent decisions. When this model is transposed to real world
economics, many questions must be considered. Questions such as are people
really rational and independent, is every participant in the market well
informed?

A real world market

The American sub-prime mortgage bond market failure is attributed mainly to

neo-liberal school of thought that holds free markets are efficient and that
they always clear up after shock provided that certain assumptions hold (San,
2008: 6). This school of thought has resulted in the development of powerful
international financial institutions such as International Monetary Fund and
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World Bank. These institutions are funded buy wealthy countries and one can
never tell their impartiality when dealing with poorer nations (Kapur, 1998: 116).
According to Fox, (2009: 17) this has been evidence on the flow of capital from
poor country into wealthier country and when funds in a form of loads or
grants to poorer countries often followed by heavy regulations. IMF further
created sub institutions such as central banks that are responsible in controlling
interest rate. There for interest rate may never be determined market forces
but by the central banks. Deferent monetary institutions use intrust rate as an
instrument to fulfil various objectives. Some of which are: stimulate growth,
curve down unemployment and control inflation. Under such control, can one
say that the neoclassical theory still stands or why impose free market on other
markets while dictating regulations in other markets? The problems of such non
consistency was evidence in South Africa when the Workers unions called for
the Reserve bank to change their tactic in applying the country’s monetary
policy. The call was to let the interest rates fall, which is favourable for
investment that potentially creates jobs. This sentiment is shared by Bank for
International Settlement (BIS) in its report when stating that “monetary policy
have fuelled a giant global credit bubble” (Wade, 2009: 7). These institutions
have based their operations mainly on theory that is the main reason why they
do exist in the first place. The question that arises from that is, how big is the
gap between the hypothesis and the real world economics. To illustrate this we
look at the recent financial crisis that was characterised by market failure.

The hypothesis financial market versus reality

The origin of the global financial market has an underlying suggestion of its
cause. United States of America makers have always been embodied with
neoclassical ideology that imposed lax regulations (Wade, 2009: 12).
According to Elliott (2009: 35), the core cause the 2008 financial market crash
was poor macroeconomic policies that were embodied with high
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consumption, very poor savings, and expansion of financial institutions in the
pursuit of high profits. Banks lacked self-discipline and distorted information
regarding financial risk and asset pricing to their advantage (Elliott: 2009: 36).
This is a violation on the above-mentioned neoclassical assumptions that
participants in the market act rationally and that everyone is well informed
about the market. Banks generated information and derivatives that were not
backed by real assets (toxic funds). This was achieved by selling mortgage
bond in a form of financial instruments where more than one bond was
bundled after they were sold to households insecurely and later passed to an
unsuspecting investors, concealing high risk underlining this financial
instruments (Tiabbi, 2001). This inflated the bubble as long as the prices of
housing were rising, banks counted landing at subprime interest rate. That was
inconsistent from the bank side, once again violation the assumptions on
which they operated under. Rising property price meant that property was
considered a good investment and consumers were rational to act on the
information provided by the market. Information seems to be the main
lubrication in free market operation, without relevant information firms and
household cannot be consistent and rational. Rising property prices were
attenuated by market speculations based on previous periods, suddenly banks
were reluctant to issue credit, the wide spread lead even to short period
money markets (Wray, 2009: 9). Even bank were reluctant to lend each other
on overnight basis. This goes back to the issue of information, where banks
failed to trust one another. The effect does not fit the model since the shock is
caused by purely speculation.

Response and criticism

It is clear that markets left alone do not hold given that the core assumptions
that make up these neoclassical models are not easy to maintain. Capitalist
are tempted to speculation in order to fulfil their profit maximisation goal. Since
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these have more power over information than consumer, it is no firms’ best
interest to manipulate the information in order to prosper their aims. There is a
great need to return to a tighter regulatory model in financial market to
promote stability rather than speculation (Wray, 2009: 21). This has work in
countries like South Africa, where banks are prohibited from reckless lending by
enacting laws that regulate all financial institutions and protects consumer. The
free market has failed the financial market in a way that it is not consistent with
its core existence that is to offer everyone an equal opportunity to trade by
encouraging completion. The myth is that completion will maintain stable
market prices but failure of capitalist markets has proved otherwise.

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References

BARTH, RC., HEMPHILL, WL., AGANINA, I., 2000. Financial programming and policy. Washington:
IMF Institute

FOX, J., 2009. New world order. Time Magazine,173(7). February 16.

FROYEN, RT., 2008. Macroeconomics theories and policies. 9th ed. New Jersey: Person Prentice
Hall.

KAPUR, D.,1998. IMF: A cure or curse. [online]. Available at

http://www.jstor.org/stable/1149382?seq=3 [Accessed 1 August 20010].

TAIBBI, M.,1998. Bubble #3 The housing craze. [online]. Available at

http://www.rollingstone.com/politics/news/12697/64796# [Accessed 3 August 20010].

WRAYY, L.R. (2009). Money Manager Capitalism and the Global Financial Crisis. Working paper.
Kansas City: University of Missouri.

WADE, R. (2008). Financial regime change? New Left Review 53: 5-21

WADE, R. (2007). A new global financial architecture? New Left Review