Paul Krugman always says the stock market is not the economy. It has always been a game, with frequent disparities between stock prices and actual company value. These days stock trading is done through computers. Computers also make possible many new financial “innovations” such as credit default swaps, and much more elaborate methods for option trading and market manipulation.
Hedge funds and much of the financial industry make much or most of their money not from actual investment in providing goods and services, but from financial manipulation. In essence they are parasites skimming money form the rest of the economy. The 2008 financial crisis showed what can happen when financial manipulation goes wrong. The hedge funds who were shorting Gamestop were doing a purely financial bet that Gamestop stock would go down. Such an effort from such big money can become a self fulfilling prophecy.
The people in r/WallStreetBets seem to be at least partly motivated by desire to punish the financial industry for its bloated influence on our country. I don’t blame them for that. These hedge funds and the people who own them are arrogant and believe their own hype about how their riches gained from parasitic finance are deserved.
At this point, playing the stock market game is beginning to be more and more like a computer game. Apps like Robinhood allow market activity with a click, and you have an arsenal of abilities like some video game character. In this case, getting a higher score translates not into some game virtual currency, but actual real world money. Of course, you can lose real world money.
But r/WallStreetBets has a cost. Gamestop as a company is not worth the inflated price that this game has produced. The result is a bubble in the stock of Gamestop and of other companies that have similar unexpected gains. This sort of Ponzi scheme can be very profitable if you get out before the bubble breaks. You can get hurt very badly if you don’t get out in time.
Now I am seeing claims that this stuff could have negative effects on the rest of the economy. Why would this be? Gamestop is a relatively small company whose fate should not matter for the economy as a whole. Even if you add in the other companies that have gotten involved it still should not threaten the whole economy. This can be explained by the idea of leverage. An investment has leverage if the upside or downside is disproportionate to the amount invested. For instance, if you borrow 90% of the money to buy something and it doubles in value, you make 10 times the money you invested. If it becomes valueless, you lose ten times the money you invested. The financial manipulations that are so common now can have negative leverage. A short play has unlimited downside, there is no theoretical limit on how much money you can lose if the stock you short goes up. The credit default swaps that powered the 2008 crisis had similar properties. I am not a financial expert on all the fancy financial instruments that are being used, mostly invisible to the general public. But the allure of upside leverage can put people in a position where you get a domino effect from downside leverage, One failure ripples through many other things. So if hedge funds lose billions on a short play, they might have to liquidate other assets, which could start other dominoes falling.
What is the lesson of all this? I think it is this: we have to do something to prevent financial structures where one failure can topple the whole structure. This means making the financial industry a much more boring game. We can’t have a situation where someone making a losing play in finance ends up with some people who were not playing the game starting to worry about being able to pay the rent. That’s what happened in 2008, it’s what happened in 1929, it could still happen to us in the future.