*Why is the American economy in trouble? Consider the following scenarios.
Situation 1: The most basic aspect of economics is that Smith produces some product that others want. Perhaps he owns an apple orchard. Depending on how many people want those apples and how fast Smith can get his apples to a market, a price will be set at which people can obtain said apples. Generally speaking this type of commerce is dependent on the quality of the product; better apples will yield higher profits.
There is very little left to chance in these interactions. Because of this most people recognize that these transactions usually produce fair results.
Situation 2: One step removed from that basic building block of economics is the investment. Investments often take the form of stocks in a company. In this situation Brown gives money to Smith to help Smith produce better apples and thereby secure more profits. Of course by giving money to the apple operation, Brown will receive part of any profits.
The basic concept of owning stock or investing in a company is reasonable, but it allows for Brown to essentially profit from Smith’s labor. Brown, having harvested no apples, is able to pocket money from Smith’s expertise in apples. There is a bit of gambling in this scenario. Brown is betting that Smith will be successful. Most people believe that these transactions produce fair results.
Situation 3: One step further removed from a customer simply buying apples is the idea of mutual funds. In this situation Clark decides to invest in a fund that essentially bundles together a bunch of apple sellers. Clark is investing in multiple companies and seeing a profit as long as apple sales in general are profitable; multiple companies means that as long as apples as a product are doing well, that someone investing in apples (basically the concept of an apple mutual fund) will do well.
Mutual funds ramp up the “unfairness” factor. While Brown may invest in Smith’s company because he knows Smith produces a good product it is much less likely that Clark has any knowledge about the apple produces that the mutual fund is grouping together. If it questionable that Brown deserves a large portion of Smith’s profits, it is even less reasonable that Clark should profit from Smith and other apple producers. Clark is essentially gambling in a bigger way because by betting on a group of people Clark is hedging the bet. Mutual funds engender a bit of hostility from the general public.
Situation 4: Derivatives are investments on investments. Jones, for instance, could buy an option to buy Brown’s stock. Derivatives exist because there are not enough companies offering stocks to meet the demand of those who want to invest. So traders on Wall Street created, and continue to create, products that essentially have nothing to do with the underlying product. Jones is not betting on apples at all; Jones is betting on Brown’s ability to judge the probability of success of a company.
Derivatives and the profits they produce are extremely unfair. They produce wealth for people who have no interest in the actual sale of the product. Most people have very little positive to say regarding derivatives.
Derivatives are to be blamed for the housing bubble that led to the recent economic downturn. And if left to their own devices, Wall Street traders will continue to create derivatives based on different products and different industries and lead the American (and perhaps the global) economy back down the wrong road.
The answer is to ban derivatives. They are not a necessary part of any economy. And they contribute to creating dangerous investing practices in the original markets. And they are bets on people rather than bets on a good or service.
Michael Lewis in Joker’s Poker describes a scene in which traders are honing their craft by basically trying to out-bluff each other. The book is set in the 1980s when derivatives first became the hot new financial product. The derivative market as a branch of trading is based on bluffing. And the American economy should not be contingent on a bluff.
Trevor Brookins is a free lance writer in Rockland County, New York. He is currently working on a book about American culture during the Cold War. You can reach him at [email protected]