Counter Economics

Are US capital markets fair? That is do they offer an equal, or roughly equal chance for individuals and companies to raise money?

There is a generally accepted view that stock is a good thing. The two most common concepts that are commonly used to promote the idea of stock ownership is that:

1. Stocks rise in value
2. Stocks allow companies to raise a quantity of capital at a cost they could not ordinarily raise without stock issuance

Good for Whom?

It is important to differentiate arguments for issuing stock vs. arguments for purchasing stock. The first argument above is an argument for purchasing stock. However, the second is actually an argument for issuing stock. However, strangely it is presented as an argument for purchasing stock. We fully evaluate this second argument in “Stock – An UnNecessary

Illusion?”

http://counterecon.com/2008/01/11/stock-an-unnecessary-illusion/

The benefit to companies large enough to afford investment bankers to take them public are undoubtedly high. Furthermore, the cost of capital for these companies is undoubtedly low. It does allow them to raise capital for projects and acquisitions that they ordinarily could not raise through other means. However, the questions is whether this is a good thing for the overall economy or even for free markets or even free society is a different matter. The simplistic argument that successful capitalist societies are based upon a “dynamic” stock market is questionable. Unlike most websites we believe the issue is debatable and the subject of this article.

Preferential Treatment for Big Companies Over Small Companies and the Individual

In a capitalistic society, individuals and companies supposedly have the ability to borrow money. Both individuals, small companies, medium and large companies are able to borrow money, however, they do so on very different terms. Small companies typically apply for loans at banks. Individuals can apply for loans for large collateral based loans to buy expensive items such as houses and cars, but are forced into higher interest loans for other loan needs. This type of borrowing includes credit card debt, which has high interest rates, and finance companies which specifically located their operations to Delaware and Iowa skirt with the law regarding their extremely high interest rate loans. What was once called “usury” (phenomenally high interest rates) is now simply considered good business. Once a company falls into the medium to large size category its capital raising options change. It can then issue stock in order to raise capital. Stock is a very interesting instrument and one that has changed through time (at least in the United States). An analysis of this change is important to understanding the modern stock market.

Promotion of Power Concentration

Once a company can issue stock interesting things begin to happen. Firstly the stock is rarely bought back by the company. The stock buyer may in most cases only sell the stock to another third party. In this way stock can be seen as a loan that is never paid back, or the closest thing there is to free money for companies (even though as pointed out in After the New Economy by Doug Henwood, only a small portion of a company’s capitalization is comes from stock issuance.) When stocks were first introduced in the US they typically paid a dividend, but that has changed as time as the emphasis switched to stock appreciation. Furthermore, companies continue to issue new stock on a yearly basis through providing stock options to their executives and employees which reduce the earnings allocated to the already existing stockholder base. This basic fact, that stocks are not paid back is either never, or exceedingly rarely discussed in conversations about stock in the United States. Much more frequently stocks are discussed as if they are a tangible item, something that should be owned and watched closely, and something that is essential to our standard of living and our economic system.

Medium vs. Large Companies

The US stock market is anything but democratic. Just as medium size companies have a capital advantage over small companies and individuals in that they can issue stock, large companies have advantages over medium companies because investors are typically willing to pay a premium as measured by the price to earnings ratio for the shares of large companies over medium sized companies. This well documented investor preference has resulted in unintended consequence of promoting mergers and acquisitions. That is companies are combined and re-configured not because it makes any sense for business reasons, but in order to be more attractive to Wall Street. No one on Wall Street, or an economist would say this of course, however this is a market distortion which allows the concentration of financial power to be rewarded. Companies hire and reward executives handsomely who understand how to manipulate this system, and investor relations is a big part of a company’s job. That is they spend resources that could be spent on improving the actual business on perception management and chicanery. This of course does not include the effort spent (wasted from a productivity standpoint) trying to look for short term ways to improve earnings. This leads to all types of counterproductive behavior like flushing inventory before the end of quarter and creating shell companies to put losses or expenses into.

Earnings Combination and Power Concentration

It has been known for some time that one of the fastest ways to provide constantly growing earnings to investors was to simply acquire smaller companies, for which investors would pay less for and subsume them into larger entities (for which investors would pay more for.) This has the secondary benefit of making earnings look like they are growing faster than they are. This means that many acquisitions were completed which did not necessarily make sense from a business perspective, but because they made sense from an investment perspective. General Electric followed this simple and non-value added approach to growth for decades. General Electric purchased companies it had no particular capability in managing simply to incorporate their earnings streams into the parent. Concentration of power in this way, while generally considered benign, in actuality leads to the promotion of concentration of power increasing the firm’s leverage vs. consumers, workers, government regulators and foreign firms. Why we have a system that encourages mergers for the sake of mergers and promotes so much wasted effort and fraudulent activities is not hard to understand. The system works very well for the system that created it. It just happens to work badly for 98% of the population who are considered irrelevan.

Note: (Concentration of power based upon the need for a business to be a certain size to have a certain scale to be successful needs to be differentiated from concentrations of power that are based upon financial particularities of our system. Large businesses always say they need more size to compete, however, when Exxon uses the same argument to merge with Mobile, its obvious there is something disingenuous about the argument. Secondly, merging firms often discuss their need to “compete” but never mention how their new size will affect the ability of companies smaller than them to compete.)

It is important to consider who it benefits and how loses from this system. It has been demonstrated that larger firms are less responsive to the needs of all of these groups, that their organizational structures tend towards higher bureaucracy and more political contributions which result in both lowered compliance with existing regulations and towards government based corporate welfare programs. These are generally considered undesirable outcomes and yet how these outcomes are directly related to our stock issuing and ownership system is never properly analyzed or understood.

Corruption of Compensation

Although stocks did not begin this way, they gradually evolved into a major method for executive and privileged employee compensation. For many years this compensation did not appear anywhere as an expense item on the company’s income statement or balance sheet. Many say that this had the effect of inflating earnings, and it certainly must have and continues to do so. Since then some minor changes to this way of accounting have been passed, but how stock options are expensed is still rather hazy. Who pays the costs for these stock options is relatively obvious, it is the existing shareholders who are diluted with these new stock issues. When new stock is issued the earnings per share goes down. In addition to earnings per share dilution, more supply of stock vs. an unchanged demand must lead to a lower price. In this way new stock issues can be seen as a skim off of the appreciation from existing shareholders. There have been many discussions on this and the honest way of managing options is straightforward: expense them on the balance sheet. However, the executive class is so corrupt in the US that they can not even agree to follow through on this basic point.

Fraud Incentive

Because executive compensation is so highly tied to share prices and because share prices are strongly correlated with financial statements, equities provide great incentives to falsify earnings. The public company audit profession attempts to mitigate against fraud, but it can only do so within limited constraints as has been demonstrated through history. Auditors have to balance maintaining their reputation vs. pleasing the companies that pay them for their audits. The US system could greatly reduce this conflict of interest by making audits paid for by shareholders or by the government, but they it chooses not to. Furthermore, accounting standards go up or down depending upon the incentives in the system at the time. When stock prices move towards historical highs, the financial incentives tilt towards pleasing audited companies which results in false financial statements being released with their signature. This has happened over and over in US history, it is a testament to Americans’ poor memory that they have not caught on to this fact. Private companies on the other hand, which compensate employees and executives with direct compensation have far fewer incentives to falsify their finances.

Note: The flip side to accounting fraud is investor fraud. This is described fully in the post Inaccuracy of Average Return, where the actual returns to investors from the stock market is explained. (Research shows that the stock market provides very different returns based upon the investors financial size. The returns are distributed very unequally, and the returns promoted by most financial publications are not available to average sized or below average sized investors.)

Arbitrage

By viewing the different terms available to four different types of entities (large company, medium sized company, small company and the individual) we can see significant inefficiencies in the US capital markets. This leads to the opportunities for arbitrage (buying in one area and selling in another at a profit). However, the arbitrage is between the capital markets for medium sized and large companies. That is it pays for larger companies buy smaller companies and then in effect reselling these earnings to investors at higher prices once the earnings are consolidated in the larger company. There is no real value added to society, it is simply responding to natural inefficiencies that are created in the market by our poorly designed system.

The Stated Purpose of Going Public is Misleading

The stated purpose of going public as presented by the financial media is to “raise money for growth.” However this leaves a few motivations out. They would include:

1. Gaining personal wealth for the executives and privileged employees at the company, and compensating them in a way that is not reported as reducing income.
2. Raising money that will never be paid back
3. Raising the public relations profile of the company

In would be informative for the public if the financial media might point out these less noble motivations when they describe the reasons for stock offerings. The fact that they don’t is reason to believe that they represent concentrated power interests and are spokesmen for them in return for advertising dollars.

Conclusion

The capital raising system we have designed is highly inefficient. Its inefficiency is demonstrated by the fact that companies can draw large amounts from the system by performing simple arbitrage. Furthermore, stocks create perverse incentives which include:

1. Falsifying earnings
2. Performing non value added business activities in order to meet earnings (i.e. flushing inventory from the system at the end of quarters)
3. Creating an incentive to consolidate companies and concentrate economic power
4. Removing money from the system in the form of fees to investment banking companies and hedge funds that could be put to better use in the real economy

None of these activities add to the economy and in fact they substantially detract from it. Our current capital system is not an enabler of of the underlying capitalist system but rather is a parasite on it.