Man is a social animal. The 19th-century sociologist and philosopher Georg Simmel argued that trade and exchange is 'one of the purest and most primitive forms of human socialisation'. Last month, while travelling through West Timor, I was able to study first-hand how rural markets operate. I could not help wondering why so-called primitive markets such as these work so well when complex financial markets can be so dysfunctional.
Rural markets in West Timor are wonders of trade. Men and women converge on different villages on different days of the week. Everyone knows when to go to which village for these markets, which typically start at dawn and end by 11am. Economists would surely call this scene of bustling rural commerce a 'concentration of liquidity'.
As the late Stanford economist John McMillan argued, the market is a human construction - a tool. It has features to make it work smoothly: mechanisms to organise buying and selling; channels for information flow; laws that define property rights, and self-regulating rules that govern behaviour.
Most rural markets are much more complex than they appear. They sell everything needed for daily life and have their own hierarchies. The stalls of wealthier, established traders are sheltered and in the best locations, while poorer traders just spread their wares on the ground. Specialisation is evident even in this basic setting - there are designated places to buy textiles, fresh meat, vegetables or household goods. These markets also function efficiently as information exchanges. Prices differ depending on who you are and what you know.
In these markets, you can observe the entire range of business evolution, from simple production to wholesaling and final sale. Everything is designed for convenience and to reduce transaction costs.
The permeation of technology, like mobile phones and the internet, even into these remote rural areas, has accelerated the speed at which information travels through these markets. This means even lower transaction costs all round.
With rural markets now linked to global markets, the production and marketing game is changing beyond recognition. You see the effect of high transport costs clearly in rural markets. Here, locally produced goods are ludicrously cheap, but imported good are very expensive.
The study of modern, sophisticated supply chains enables us to appreciate that producers do not necessarily make most of their money in the product-to-consumer chain. The rule of thumb is that if a product costs US$1 to make, the distribution and transport costs may account for US$3 of the US$4 sale price. Common conceptions of innovation still focus largely on creating new products, whereas services or process innovation are probably much more profitable and add more value than is generally understood.
To illustrate, the global trade regime still has a 'hardware' focus, concentrating on physical trade rather than the more complex and less measured services trade.
Financial services have emerged as one of the most profitable businesses, certainly until the last financial crisis. For a time before the 2007 crisis, the return on capital in the financial sector was 20per cent per annum, significantly higher than for manufacturing and other real-sector businesses.
With the benefit of hindsight, we now know there were two major reasons for the large profits in finance. The first is that the physical cost of creating a financial derivative is almost zero, as it is an abstract product. For many, the reason to buy a derivative is to hedge and reduce risk. If a buyer believes that the hedge is useful, which it can be under specific circumstances, then he or she will be willing to pay a premium for it. A second reason is leverage. The greater the leverage, the larger the profits are for both lender and borrower. But there is a catch - it adds systemic risk to the entire market and can be fatal to the overleveraged borrower.
The FX Accumulator is a good example. It is a financial product that looks like a wonderful foreign exchange hedge that yields good profits for the speculator. However, many were not aware that, at certain price levels, the amount of margin called by the lender could be greater than the total assets held by the speculator. Thus, what appears to be a 'safe' hedge can turn out to be toxic, particularly when markets are volatile.
This raises the question of whether financial markets have evolved beyond the limits of social safety. University of Southampton professor Richard Werner was one of the first to point out that there are two aspects of credit creation - one that contributes to real-value creation and one that does not. Financial markets have evolved into highly complex systems that consumers and regulators do not fully understand. Increasingly, they contribute less to social utility and become systemically fragile.
As McMillan presciently pointed out, there are problems markets cannot address. 'Left to themselves, markets can fail. Viewed as tools, markets need be neither revered nor reviled - just allowed to operate where they are useful,' he said.
Rural markets arise from communities that have organised their commerce in such a way that reinforces social utility and stability. The Holy Grail of financial theory and practice in the world's advanced economies is to identify at what level of complexity financial markets exceed the limits of social stability.
Andrew Sheng is president of the Fung Global Institute