Theorising Finance: From the Current Inflationary Spiral to Microfinance

The more one tries to objectively analyse some of the major economic challenges of contemporary economy, the more they are forced to conclude that the current prescription for overcoming these challenges is wrong. There seems to be an indulgent unwillingness on the part of various policy makers to deal with more fundamental structural issues that not only caused the crisis but continue to plague the global economy. The inflationary spiral in the Emerging economies seems to be a consequence of rampant financialisation that has climbed on to the bandwagon of shortages caused by a supply chain that may have become more obsolete. Add the consequences of nature’s fury and we have the broad contours of what may be a future crisis in food security. The seemingly relentless rise of financialisation has impacted economies of various hues, far beyond the shores of the more mature economies. Till recently, the conventional wisdom seems to have believed that financialisation will not have an adverse impact on the emerging markets, on the contrary, a number of observers seem to have believed that it would be beneficial due to general paucity of capital in most of the emerging markets. The recent inflationary spiral as well as some of the problems in some sectors of the increasingly financialised economy seems to indicate otherwise.

The post industrial-revolution production process requires an every increasing supply of money to be the means that would not only enable the production process but also convert profits into an easily mobile and socially acceptable form along with its commoditisation. The production process therefore entails Money to purchase Commodities and then reconverted to buy more commodities (or C-M-C) format . Broadly, this enables those who have no use value for what they produce (and/or their excess production) to exchange them for other commodities that have greater use value. Therefore, the fungibility of money is what gave it its essential characteristic. It is this quality (fungibility) of money enabled it to become the pivot on which contemporary industrial-service complex has been assiduously built. A general exchange of commodities becomes profitable only when the cost of this capital is low and is easily available and when money can be transferred over vast distances at short notice.

Commodities (especially those used in the production process) have an important characteristic: as they are consumed, they disappear from circulation. But money continues to circulate. Though over a period, some other commodity takes the place of commodity that has been consumed, in the short-term this creates a semblance of shortage, leading to prices to rise. In theory, the total quantity of money in circulation should be equivalent to the total amount of goods and services produced (or the aggregate price of the commodities). Money that is circulating can disappear only when the underlying asset (like say factories or companies) become economically unviable. In the case of financial assets, it can disappear only when underlying market value starts to decline. The bursting of a bubble are all excellent examples of how money can disappear.
The recent years have seen a major shift in the operational dynamics of finance. The financial sector’s (especially the USA from where global finance is mostly centred along with UK) profits and debts have increased exponentially over the last few decades. The debt outstanding in the financial sector has increased from US$504.91 billion in October 1979 to the present US$14.44 trillion by end of July 2010 after reaching a US$17.11 trillion by end of October 2008.

Corporate Profits in USA after Tax (in Millions of US Dollars)

Year	Total	Finance	Manufacturing
1980	166,352	14,805	55,217
1984	171,077	10,040	52,176
1987	192,658	23,072	48,720
1990	266,263	39,610	66,772
1995	466,458	83,509	112,440
1999	521,730	108,171	97,013
2000	507,379	106,474	91,788
2005	1,227,774	192,758	141,462
2006	1,349,453	171,148	195,519
2007	1,292,890	98,826	163,243
2009	1,061,818	32,294	59,366

The centrality of finance is best illustrated by the fact that during the period 1973 to 1985 the financial sector never earned more than 16% of domestic profits, in contrast in this decade, it has averaged 41% of all the profits earned by businesses in the U.S. In 1947, the financial sector represented only 2.5% of our gross domestic product. In 2006 it had risen to 8%. In other words, of every 12.5 dollars earned in the United States, one goes to the financial sector.

The above historical perspective enables us to understand the recent changes that have had a cascading effect on other aspects of the economy. To buy commodities, one need not posses actual commodities as in the past. Instead financial instruments provide sufficient exposure either exchange traded funds or even derivative instruments on exchange traded funds. These financialised commodity products means that non -consumption oriented fund flow now has a central part in the prices of commodities in the market place. Securitisation has only added to the allure of financialisation. Add in Quantitative Easing in the Western world with easy money conditions in China and India (where M3 has grown at an annualised rate of approximately 16-20 per cent) and you get an idea about the amount of money sloshing around.

Investing these large amounts is a problem. The very nature of finance is that it needs conducive conditions such as peace, tranquillity and more importantly sufficient clarity about the future returns over a number of years. Clarity on such issues not only enables greater availability of finance but also at a low cost. Institutional protection only enhances the possibility of finance to circulate freely thereby enhancing the attraction of particular countries/economies. There are two important changes that seem to be taking place. At one level we have a large segment of the economy being starved of capital due to economic problems in western world while those at the highest level of finance value chain have ever greater access to institutions that have an ability to create this money supply. This has resulted in large amounts of money looking for a better return, with some attempting to replicate the returns over the past few decades – a fallacy that they will realise soon. Unfortunately, the large institutions desperately require these larger return for a variety of reasons. Barclays Capital estimated that assets under management of commodity funds had jumped to US$224 billion by end of October 2009 (while in 2008, when oil was US$140, they amounted to US$270 billion). By end of 2010 Barclays estimated that the investments had jumped to US$360 billion. A EU report recently pointed out that institutional investors have increased investments in the commodity markets from 13 Billion Euro in 2003 to 170-205 billion Euro in 2008.

Global Speculation to Microfinance
Finance by itself does not produce anything but facilitates production of goods and services. The cumulative net result of this process has been that over the years, finance has been transformed into a global commodity due to the process of securitisation. Advances in computing technologies have vastly aided the mobility of capital, thereby reducing returns and forcing capital to take greater risks for smaller returns. The consequences of this have been that it has not only increased the capital resources available for lending, but it has also forced capital to move from the core of advanced countries to the periphery (emerging markets) as well as other asset classes. Lending practices have not only become less cumbersome but also more liberal with a growing focus on attempts to lend to those who in the past were considered to be risky borrowers (subprime, Microfinance, etc).

However, if large amounts of capital, (especially global capital), are to be invested or channelized, it would require efficient process where it can enter and exit relatively easily and where the payment and repayment mechanisms are transparent and easy. This transparency includes those in the realm of institutional framework, including property relations and legal structures vastly reduces their cost of operation. A good example is the case of the Indian stock markets. Once the stock markets were transformed through the introduction of screen-based trading, introduction of rolling settlement and de-materalisation of shares, billions of dollars of foreign capital started flowing into India. Hence, creating this channel is important. Local capital flows will have synchronised to national and global capital flows. It is pertinent to note that the government’s task of improving economic development will be easier if they facilitate this development. Historically, it is clear that these channels if not created and policed by the government will be created by private players.

It is precisely this channel for financial flows that are causing the inflationary spiral in food articles and problems in the sphere of microfinance. Microfinance has only one ‘innovation’ to its credit: it has deciphered a route that enables major financial institutions searching for additional returns to channelize their capital. The fact that this process of channelization speaks the language and the framework that global capital is comfortable with has helped matters for the indigenous microfinance companies.

One fact that has often been missed is that, unless the policy makers find a solution to financialisation, they may not be able to end the inflationary spiral. Enabling speculation without buying commodity, which hitherto were not possible without physical possession of the commodity, now enables people in different parts of the world to buy any commodity exchange traded funds. Financialisation has facilitated the process of thousands of investors, worldwide buying financial products that derive their value on other commodities (like Wheat, Cotton, copper, lead, etc) in quantities that they can never even dream of consuming even a fraction of what they buy in their lifetime, leave alone one year. That is exactly what is happening today and this is unlikely to change in the next year or two. While we lament the consequences of financial players pushing up prices or creating complications for the poor, it may be worth remembering the consequences when the financial herd stampedes out of a particular market segment.