Windfalls that raise worries over markets

It may be the effect of spending the first part of this week in Russia, or it may be the news of the windfall gains of people who have money in Cheltenham & Gloucester rather than Halifax, but I'm becoming increasingly worried about the capriciousness of the market system.

In Russia wealth is being redistributed in an extraordinarily capricious way as the country makes its transition to the market economy. But it is a way that is an inevitable by-product of the process; in China the redistribution is highly capricious too. In the UK at least few people have been made poorer by changes of ownership such as privatisation, the conversion of building societies to quoted status, or the sale that is proposed in the case of C&G. Those who have gained have merely garnered additional cash to an uneven extent.

But those are just two random examples of something we all take for granted: the inherent unfairness of the market system. There are plenty of others. So while markets may be the least bad way of allocating resources - few people would now argue that politicians or civil servants consistently do better - it is sometimes difficult to feel comfortable with the results.

Just why financial markets should be so fickle is one of the main themes of a new book by Gordon Pepper, ('Money, Credit and Asset Prices', Gordon Pepper, St Martin's Press, pounds 40 ), former senior partner of the stockbroker W Greenwell, who left after it was taken over by Midland and became a professor at City University Business School. During the 1970s and the first half of the 1980s, he developed a monetarist approach to fixed-interest investment, which worked very effectively, enabling Greenwells to become one of the two or three best gilt market stockbrokers.

He has now taken these ideas further and refined them as a general theory of investment. In a nutshell, this is that in the short and medium term, markets are driven by liquidity - the balance between the supply of funds from savers and the demand for funds from borrowers - rather than by economic or company performance. Over the longer term, three to five years or more, economic fundamentals will determine investment performance. But meanwhile volatile markets will reward some and take from others.

Professor Pepper is not trying to provide a book that will enable people to forecast market movements and make their fortunes. Instead he is seeking to explain to people why markets behave as they do, and to modify the view of some academics who argue that markets are inherently efficient if they have all the available information.

There is much merit in anything that helps people to understand why markets behave as they do, but it is surely worth asking in addition whether there are structural weaknesses in financial markets that could be attacked, and hence their volatility reduced. This is a vast subject, going far beyond the scope of this book, but it might be worth listing three areas worth more attention.

The first would be whether it is possible to rebalance the participation in equity markets, giving a counterweight to the short-term performance ethic that drives them. Part of the answer might be to increase the proportion of individual shareholdings, to make markets more amateur, on the grounds that individuals trade less frequently than institutions and in any case ought to be prepared to take long-term views.

A second would be for the professionals to create more explicit long-term investment vehicles - funds that would perhaps be counter-cyclical in their investment strategy. One market solution to excessive volatility is to create counterweights.

A third would be to support other methods of ownership of commercial enterprises so that all the market economies' eggs were not in the publicly quoted company basket. We know that nationalisation does not work, but there are other forms of company ownership - partnerships, co-operatives, mutuals, private companies - that at least should be able to compete on a level tax basis with the quoted ones.

In other words, the fact that the last 10 years have seen the triumph of the market system should be a cause for celebration, but the starting point for reform. The fact that virtually every country in the world is privatising state industries and that successful mutual financial service companies like C&G are being subsumed in publicly quoted companies ought to be a spur.

If markets are seen to be excessively capricious, steps will be taken to make them less so, probably by a combination of taxation and legislation. The taxation will simply make the markets less efficient at their job, by distorting their decision-making, while on past form, any legislation will inevitably be badly designed and may well be ineffective. Better to acknowledge that there is a problem and look for market solutions, rather than political ones.