Vivian: And you don't make anything…
Edward: No.
Vivian: … and you don't build anything.
Edward: No.
For all the wealth Edward created as a private equity investor in the movie Pretty Woman, Vivian was puzzled by the notion of any economic activity that didn’t involve producing goods or services. Given the unrestrained speculation that precipitated the current economic crash, it is clear that production, not speculation, needs to lie at the heart of sustainable economic growth.
Every asset class – equities, bonds, commodities, currencies, real estate – has a true economic value that is based on its productive use. However, asset bubbles arise when speculative value outstrips economic value, that is, speculation becomes unhinged from production. As is the case in the current credit crisis, derivatives can fuel the unhinging. While derivatives are used to hedge the risk of losses on investments, it is their use as purely speculative instruments that pushes asset prices to unsustainable levels; levels which are not justifiable by their economic value. Broadly speaking, long-term investment decisions are based on the value that can be derived from the productive use of an asset and as such, investors are only prepared to pay what it is worth. On the other hand, short-term investments tend to be driven by speculation and consequently, such investors are prepared to pay the market price of an asset, regardless of its economic value.
One of the basic rules of trading is to be emotionally detached from investment decisions. However, the nature of speculative investment makes it highly susceptible to the human emotions of greed and fear, which lie at the heart of boom and bust cycles. Perhaps a key role of financial market regulation is to encourage long-term investments over short-term trades, keeping a leash on the market's tendency to get overblown by greed and imploded by fear.
A lot has been said about the sub-prime crisis, with US banks more than willing to give mortgages to people who could not afford them for the simple reason that they could parcel the mortgages up into complex credit derivatives and sell them to international investors. These investors did not buy the derivatives because they understood the structures or could identify their economic value, but because they were willing to gamble on making attractive short-term returns. In retrospect, investment strategies that focused on facilitating productivity and growth in the real economy could have avoided the financial famine we are currently contending with. Sure, the returns would be lower and the economy would be less flushed with cash but the growth would be sustainable and economic slowdowns would be less severe.
Financial services is one of the core engines of the real economy and its fulfilment of this strategic role will always be jeopardised by unchecked speculation. Every investment has a risk factor and as such, there is always a degree of speculation involved. However, sound investment decisions involve a clear understanding of the economic value of a product or service. Economic growth based on speculating on price movements can only have one outcome. Even Vivian would understand that.
