Today I’m going to write about how economic theory views trade and how that relates to financial markets (stocks, bonds, etc.) The short answer is that things being exchanged on financial markets doesn’t really match the model that economists have in mind when they develop theories of trade, and that means some economic conclusions about trade are wrong when applied to financial trading.

Economists have an image in mind when they think about trade. They imagine that a baker has a bunch of bread, and a butcher has a bunch of ham. They trade some of the bread for some of the ham and then they can both eat ham sandwiches, and they are both happier than if they each had to eat bread or ham alone.

This model makes a few assumptions:

The goods being traded are valued for their own sake. They are being acquired to be consumed, not to be traded later for something else.

Everyone involved in the trade knows how much value they place on each of the goods or combination of goods.

Everyone’s knowledge is true about how valuable the goods are to themselves. This is a vitally important point!

Different people might value the same goods differently, but the valuation comes from the person desiring the goods for their own sake. The butcher and baker both know how much more they would rather eat a ham sandwich than bread or ham alone. They have true knowledge about how much they want the goods.

Each person’s desire for the goods is fixed a priori. Those desires will not be changed by anything that happens in the act of trading, and will not change after the trade is done.

If those assumptions are true, then you can conclude that any voluntary trade will create value. Each party to the trade looks at how much they value what they have before the trade and what they would have after the trade. If after is more valuable, they agree to the trade. If everyone agrees to the trade, then everyone must have more value after the trade so the sum of all the values must be higher after than before. Q.E.D.

Here’s the rub. Everyone has true knowledge about how much they will value what they will get after the trade. Before the trade the baker is thinking, “I would rather have both bread and ham than what I have now.”, and after the trade those desires are still true.

Imagine if instead, both parties stick something in a sack. The other party doesn’t know what’s in the sack they are trading for. They may have a belief about what might be in the sack, but that belief can be wrong. They agree to the trade believing that what’s in the sack is more valuable to them, but it turns out not to be what they thought, and they regret the trade. Their value goes down. In this case, the statement “everyone must have more value after the trade” no longer holds.

Now let’s look at financial markets. What kind of trading goes on there? Do people buy things that they value for their own sake in order to consume them? Generally not. Ok, there’s a little of that. On the commodities market companies like airlines buy fuel that they plan to burn in their planes, or meat packing companies buy pork bellies, etc. But even on the commodities market only a small percentage of trading volume is companies buying things that they will eventually take possession of and use, and on the stock and bond markets there’s essentially none of that. Most trading on financial markets is people buying something to try to sell it for more money later.

So these financial trades, do they satisfy the other assumptions of the economic model of trading? Do people have true knowledge about how much they will value what they are trading for after the trade is done? Are these desires for the trade goods fixed and will remain the same after the trade? No! They are trading for this thing hoping the price will go up after the trade. They don’t know if it will or not. They may have a belief about how the price will change after the trade, but that belief can be wrong. Financial trades are like trading for the mystery sack.

So a lot of conservatives advocate deregulating financial markets, and the argument they use to support that is “Any voluntary trade automatically creates value.” But that argument is false for financial trades!

Now, I’m not saying that financial markets have no use at all. What I’m saying is that the theory currently being used to intellectually defend our modern financial market system is broken, and some of what our modern financial markets are doing is hurting, not helping, the real productive sector of the economy. I’m pretty sure that zero-sum millisecond computer trading isn’t creating any value, and it’s bad for market stability.

We need to develop an intellectually sound theory of how financial markets actually work, and then use that to determine what kind of markets would be most economically beneficial.