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Knaves & fools, contd
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Reading:  Robert M. Solow, an economics professor at MIT, in The New York Review of Books:

  "The financial system does have a useful function to perform, and that is to make the real economy operate more efficiently.  Some human institution has to collect a nation's savings and put them at the disposal of those who have productive ways to use them. Risks arise in the everyday business of economic life, and some human institution has to transfer them to those who are most willing to bear them."

All respectable commentators make statements of this kind.  I would be greatly interested in seeing them defended, because on the face of them, it seems to me, they are false.

Consider the stock market.  Is it actually a significant way of turning savings into capital?  It seems not, because (last I heard) the total net worth of U.S. corporations was about a hundred times the value of all their stock.  Where did the other 99% of their capital come from?  From the reinvestment of profits.  (It was Lester Thurow who revealed this secret to me, in a magazine article about 30 years ago.  I have never seen it mentioned since.)  The real situation, as far as I can guess, is the following:  A successful corporation is a source of wealth, and is consequently a political nexus in which managers, employees, customers, stockholders, and creditors bargain over how that wealth is to be divided among them.  (Those are, in general, overlapping sets of people.)  They have a common interest in keeping the goose alive, and competing interests in the apportionment of the golden eggs.  Among these groups, it is managers that have the greatest interest in reinvestment.  In successful corporations, that interest exceeds their interest, as employees and stockholders, in extracting personal wealth from the corporation, which, of course, they will also manage to do.  (If you are responsible for large sums of other people's money, you must pay yourself well to protect yourself from the temptation to steal.)

What, precisely, is that interest?  Partly, I suppose, it is a sporting interest: they are playing a game, and market share is their score.  Partly, it is fun to run a big machine, and more fun to run a bigger one.  (There was a wonderful article in the New Yorker in 1991, by Richard Preston, about the running of a small steel company.  You can't tell me those guys weren't having fun.  They needed to make a profit so they could go on making steel.)  Often, the business produces something useful, and it improves managers' self-respect to do it on a large scale or to improve its usefulness.  Often, the business produces something useless or pernicious, and it improves managers' self-respect to fancy themselves successful swindlers by selling it.  In any case, it seems to me, if you want to encourage investment, screwing around with the stock market is not likely to be useful.  What you want to do is alter the balance of political power within corporations, so as to increase the power of managers versus employees, customers, stockholders, and creditors, and, among the managers, to increase the power of  empire builders versus looters.  There are probably ways that the government could do that, within limits.

So, what use is the stock market?  Of course, when a company starts up, its founders buy stock in it, but not on the stock market.  They tap their own savings & labor, and hit up their friends & relations.  If the company is a success, they do get to use the stock market to enrich themselves by going public.  It is not clear, however, that that possibility is the most important motive, or the one that public policy should encourage.

Certainly, the stock market allows people to trade off risk against return, that is, to gamble.  But there are other institutions that do that at lower cost and with greater transparency.
 
Economists have often performed counterfactual exercises:  what if the Smoot-Hawley tariff hadn't passed, or if there had been no railroads in the U.S. in the 19th century?  Well, economists, what if there were no secondary market for stock in corporations?  What if stocks were like dentures, belonging only to natural persons, and buried with them?  I would be delighted to know what disasters would befall the market economy, and whether they would be worse than the ones we are used to.

 

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...the total net worth of U.S. corporations was about a hundred times the value of all their stock.

I can't see how this could possibly be true. A big factor in the dot-com bust was the observation that the companies on the NASDAQ could not have a net worth as great as the total value of their outstanding shares - one could make the argument for each individual company that they were worthy of their market cap, but collectively it was a mathematical impossibility. Exactly the opposite of the situation you suggest here.

Some human institution has to collect a nation's savings and put them at the disposal of those who have productive ways to use them.

This is a fantastically difficult job that should not be underestimated. Determining who has a "productive" way of using capital is the whole problem; the purpose of the financial system is largely to determine, first, who is not fraudulent, and second, who is not stupid, and third, who will actually be fortunate enough to enjoy a return on investment. This is not in ANY way a trivial problem and it's certainly worth billions of dollars to have the right answer.

What if stocks were like dentures, belonging only to natural persons, and buried with them?

Then it would be very difficult to raise money to pursue new ideas.

This seems like an unreasonably cynical take on investment, while I see it as (current crisis notwithstanding) a surprisingly efficient means of allocating capital. I mean, it only helped create the world's largest economy, not that this means anything...


> ...the total net worth of U.S. corporations was about a hundred times the value of all their stock.

>> I can't see how this could possibly be true. A big factor in the dot-com bust was the observation that the companies on the NASDAQ could not have a net worth as great as the total value of their outstanding shares - one could make the argument for each individual company that they were worthy of their market cap, but collectively it was a mathematical impossibility. Exactly the opposite of the situation you suggest here.

1. I should have been more precise. The contribution of a company's stock to its net worth is not its market price, but its price when issued. Further increases were not paid by investors to the company, but by speculators to other speculators.

2. FWIW, here is Thurow's actual assertion [Working Papers for a New Society III(4):69-70 (1976)]:
"In 1973, 71 percent of all U.S. savings by households, businesses, and government took the form of retained earnings and depreciation allowances by busineseses (the remaining 29 percent was government or household savings). If you subtract from total U.S. savings the investment resources that go into residential housing, then over 99 percent of all funds for investments in the real capital market were internally generated. If we accept the definition of standard economic theory that the real capital market is a place where the savings of the household sector are allocated to the business sector, then the United states does not have a real capital market. The household sector's savings are used basically to finance the direct investments of the household sector (housing), and the business sector is self-financing.
"The real capital market is even more atrophied than the lack of investments from household savings suggests. There is also very little long-term investment from one firm to another within the business sector...."
Either Thurow's analysis is fundamentally wrong in some way that I am not knowledgeable enough to see, or things have changed a lot in the last 30 years.

3. One can find the total capital accumulation of a company due to stock issues from its balance sheet. There has to be a line labeled "Stockholders' equity". About 1990 I happened to see such a balance sheet (belonging to a company one of my housemates was investing in), and sure enough, that line was only about 1% of its net worth. However, I have just looked up recent balance sheets for four corporations (Microsoft, IBM, Sprint Nextel, and JetBlue) on the Web, and it does seem that things have changed: their stockholders' equity is of the same order of magnitude as their net worth, sometimes more & sometimes less. (They are also heavily indebted; their net worth is the small difference between their assets & their obligations, which are of the same order of magnitude. I don't know what to make of that.)

Further increases were not paid by investors to the company, but by speculators to other speculators.

What does this mean? An increase in stock price generally (excepting bubbles) means that the company holds assets that investors think are of value, and a share is a claim to those assets. I mean, are you denying this? It's not that bubbles don't exist, nor that companies don't twiddle their books, but you seem to deny that the rubber ever meets the road when to my eyes it obviously does. It's not all that difficult to account for the value of most stocks.

then over 99 percent of all funds for investments in the real capital market were internally generated

Can you comment on what "internally generated" means? If he is saying that the market is becoming dominated by highly derived financial instruments that lack transparency, this is true, and it is arguably a problem, but it is also easy to come up with numbers that wildly exaggerate its scope.

>> What if stocks were like dentures, belonging only to natural persons, and buried with them?

> Then it would be very difficult to raise money to pursue new ideas.

How do you know?


I don't know exactly what you're advocating with the "denture" metaphor. Insofar as a stock is a claim to the assets of a company, what does it mean to "bury" them? Who holds the assets they represent after death - do they revert to the other shareholders through reduction in the number of outstanding shares?

If stocks could not be transferred, why would anyone buy them? Companies would have to get their money from other sources, and I can't imagine that eliminating a source of funding would make raising capital any easier. Where is the upside here?

All economic questions are party questions. It is almost impossible to consider them scientifically...

Economic questions are answered by the effects of the resulting decisions on your bank account. Seems pretty straightforward to me.

If Thurow is right, no one was doing that job 30 years ago... Investment decisions were made almost entirely within firms, with no recourse to financial markets.

WTF? While current finances are substantially more complex than in the past (thanks in part to computers) basically all financial institutions in existence today have been around in some form since the Middle Ages. How do you think companies raised capital before 1980?

I'm trying to be patient but there are so many things here that make no sense to me that I simply don't know where to begin.

I have just looked up recent balance sheets for four corporations (Microsoft, IBM, Sprint Nextel, and JetBlue) on the Web, and it does seem that things have changed: their stockholders' equity is of the same order of magnitude as their net worth

I would like a link to these balance sheets - after wondering why they would differ at all, I looked up the exact definitions of stockholder's equity and net worth expecting to find some difference I had not appreciated. But every source I have found says they are simply different terms for the same thing.


I have replied to this as a new posting, for reasons explained there.

> [Solow:] Some human institution has to collect a nation's savings and put them at the disposal of those who have productive ways to use them.

>> This is a fantastically difficult job that should not be underestimated. Determining who has a "productive" way of using capital is the whole problem; the purpose of the financial system is largely to determine, first, who is not fraudulent, and second, who is not stupid, and third, who will actually be fortunate enough to enjoy a return on investment. This is not in ANY way a trivial problem and it's certainly worth billions of dollars to have the right answer.

If Thurow is right, no one was doing that job 30 years ago, and it was not a problem. Investment decisions were made almost entirely within firms, with no recourse to financial markets. Different industries, and different firms within each industry, made different returns on their investments year after year, with no tendency to equilibrium. Somehow, market capitalism managed to produce a great deal of wealth while ignoring "the whole problem". If there has been a change, one is entitled to ask whether it is for the better or for the worse.

>> What if stocks were like dentures, belonging only to natural persons, and buried with them?

> Then it would be very difficult to raise money to pursue new ideas.

How do you know?

> This seems like an unreasonably cynical take on investment

1. Investment, in the economic sense, does not mean buying stock. It means buying tools of production.

2. All economic questions are party questions. It is almost impossible to consider them scientifically, because any answer will arouse ideological fervor and threaten pecuniary interests. I do not, myself, know whether the stock market is modestly useful or exceedingly valuable or a pernicious racket that cannot be gotten rid of. I do know that any statement you make on that subject will not be judged primarily according to the evidence (which may in fact be too scant for any reasonable conclusion -- the market may be too complicated to understand). It will be taken, first, as a sign of your religious affiliation (market worship or state worship), and second, as a political tool that may make the listener richer or poorer. For those reasons, I believe that extreme skepticism -- cynicism, if you like -- is a reasonable stance on economic questions for a person of independent mind.

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