Neoclassical principle versus Real world financial markets

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

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.

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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:


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


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


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


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.


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

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