Saturday, 9 January 2016

The Professor's New Clothes

There was some special pleading in City AM yesterday in an article titled Why financial markets matter for the real economy. His full paper his here.

He lays out the issue concisely enough:

Of course, real production requires funding. And so it’s clear that primary financial markets create value, by providing new capital to businesses. But the vast majority of activity occurs in secondary financial markets, where no new funds are being raised. Hedge funds, mutual funds, and other investors typically trade second-hand stocks and bonds, and do so among each other. Real companies are not involved, so surely they can’t benefit?

Although the answer is clearly 'no', he argues that the answer is 'yes'. It's worth reading the article in full just to see how threadbare his arguments are, but his logic boils down to this:

Many of the key drivers of a firm’s long-run value, such as its strategic positioning, are difficult to measure objectively. Like an efficient polling system, the stock price aggregates the information of millions of investors, each with their different viewpoints, and summarises them into a single number which can be used by anyone for free.

For example, a bank deciding whether to lend, a worker choosing which company to join, and a customer or supplier deciding whether to enter into a long-term relationship can use the stock price (in addition to other measures) to guide them.

It's clearly all nonsense (especially the bit about banks basing lending decisions on the share price!) and you will see why if you are prepared to consider the obvious alternative to having companies with quoted shares.

(Clearly, it's best if businesses are privately owned and that the profits accrue to the people prepared to invest in the business, we are agreed on that.)

That obvious alternative to plc's with quoted shares is a corporate ownership/financing model somewhere between a 'Limited Liability Partnership' and a 'building society'. Let's call it a 'deposit funded company' (DFC) for sake of argument.

A quoted plc raises money by issuing new shares for cash on the primary market. Investors get one vote for each share. Directors decide how much of the profits to allocate to general reserves and the rest is paid out as dividends. If the business makes losses, the shares go down in value.

If shareholders want to realise their investments, they can only sell their shares 'second hand' to subsequent investors on the 'secondary market'. This means that the directors of a quoted plc are largely insulated from their own bad decisions. They've got the shareholders' money with no obligation to return it. I know that theoretically a majority of shareholders could vote to sack them and replace them with new management, or vote for the company to be liquidated, but that hardly ever happens.

A DFC raises money in much the same way as a plc. Investors would deposit money into 'capital accounts' with them. Investors would get one vote for each £ average balance held in the period in question. Directors would allocate part of the profits to general reserves, and the balance would simply be credited to investor's accounts as interest or profit share, just like a building society or an LLP. If the business makes losses, this will be netted off with the general reserve and if the losses are huge, the difference will be deducted from 'capital accounts' like negative interest.

So far so good. The big differences are:

1. Investors in a DFC would realise their investment by withdrawing money from their accounts again - just like when you withdraw money from a building society account or when a partner leaves a partnership and is repaid his capital. That might be because they don't like the directors' decisions, because they want to spend the money or they want to invest elsewhere.

2. The amount an investor pays in to the business is broadly speaking equal to his share of the company's actual assets. If an investor buys shares second hand, what he is paying for is the value of future profits or dividends, which is usually (but not always) a much larger figure than actual assets but this figure is pure speculative guesswork, so fluctuates wildly and more or less at random.

3. Investor's total profit allocation in a year would be pretty much the same as the dividends they would have received, but expressed as a percentage of cash invested, it would be much higher than the dividend yield on shares.

4. The yield on a DFC account would be a very accurate reflection of how well or badly the actual business is doing. There is no smoke and mirrors, investors cash position would mirror the fortunes of the business very closely. Investors would look closely at the performance of the business and not be distracted by share price fluctuations. A DFC investor knows what return he is getting in near-cash, and he can compare that with previous years or with the return which other DFCs are paying. That is all be needs to know.

If you own plc shares, half of your total return is dividends, fair enough but these bear no relation to your pro rata share of the assets; it is more the case that the share price is a function of the dividends. And your share price gains or losses in a period bear little or no relation to your share of the assets, the business' actual performance or anything else 'real'.

5. If DFC investors are unhappy with directors' decisions, they will simply withdraw their deposits, so directors will get instant feedback on what 'the markets' want them to do. Or the whole thing will become much more democratic. Some directors might think it a good idea to branch out into new market or product XYZ but instead of just steaming ahead, they are more likely to ask investors to vote on whether they think it is a good idea.

If the business is in a real mess and too many investors want to withdraw at the same time, the directors will just have to put a stop on withdrawals for the time being. This is no different to trading in the shares in a company being suspended, or a quoted company becoming a private company again (private company shares are very illiquid).

6. With plc's, there is a primary market for companies to raise new capital, a secondary market for people to trade them later on and sporadic share buy backs.

With DFC's there is not even a need for a primary market, let alone a secondary one. The middlemen are completely cut out. Investors pay directly into and withdraw from 'the business'.

There would be no need for directors to stage gimmicky share buy backs when they run out of new things to invest in, because this would happen organically - if the DFC's business has run out of new things to invest in and is just accumulating surplus cash, then investors yields (expressed as a percentage of their account balances) will fall and they will withdraw funds to invest somewhere better, thus pushing up the percentage yield on the new lower account balances.

7. This will allocate real capital most efficiently. Ignoring risk premiums, investors will tend to withdraw and invest in such a way that each DFC is paying a very similar 'interest rate'.

8. It would also be a boost to employee share ownership. The value of plc shares depends on the company having the right workforce. So if an employee wants to buy shares in the plc he works for, he is paying for the value of his own future efforts - the harder he works, the higher the share price, which is a subtle form of debt slavery.

With a DFC, employees would rank the same as everybody else, if they invest in their employer, all they are paying for is a share of the actual assets used in the business, the same as a self-employed person having to pay for the assets he needs in his business, which is perfectly fair and reasonable.

9. There would be hardly any 'insider trading' or high frequency trading as there would be nothing to speculate on. This is entirely unproductive activity and their loss is proper investors' gain, improving returns to investors by a small margin. There would be little 'asset stripping', because it would be impossible to buy shares in a business at below net asset value. Investors would always be paying close to market value for the underlying assets.

What's not to like?


Random said...

The whole thing lacks the understanding that capital invested in a company is generally spent. There is no liquidity to repay 'capital' - which is why you have to sell capital shares in LLPs to another person. (And why you sell shares on a secondary market).

The problem with any corporation is the agency problem, and that the investors are just one of many contracting parties.

Shareholders don't own companies

There is an argument that corporations should be banned (or heavily taxed) for having credit balances in their current accounts. They should spend and borrow to keep them on the negative side of the system. Primarily to avoid the government suffering political pain of having the negative balance.

Random said...

Guardian article

"The MP for Croydon North also said the party had to “look too at a land use tax” to encourage owners to use land for socially beneficial purposes and put a stop to speculative land banking."


Bayard said...

"There is an argument that corporations should be banned (or heavily taxed) for having credit balances in their current accounts."

Presumably put forward by the same people who want to abolish cash and have negative interest rates on savings accounts.

Mark Wadsworth said...

R: "which is why you have to sell capital shares in LLPs to another person"

Well duh, that's the whole point - retiring partners do not 'sell their shares' to third parties. Neither do people with building society accounts 'sell their shares' to third parties. They just withdraw what they need and provided the business - LLP or building society - is well run and profitable, there will be others happy to invest in their place.

You ignore facts. Most businesses have a profit or return on actual capital of ten or twenty percent a year. So even if ten or twenty percent of DFC investors want to close their accounts each year and withdraw all funds, as long as the remaining members withdraw nothing, it will all be fine.

Remember the golden rule: always look at facts not unsubstantiated waffle or theory.

R, re The Guardian article, a dim light at the end of a long tunnel.

B, it sounds like a shit idea to me too. With the DFC model, it is quite clear who owns what. Few investors would want to invest surplus cash in a business which merely deposits surplus cash, they will withdraw it and put it in their own bank account, thus saving admin costs - the problem sorts itself out.

ThomasBHall said...

Mark- this is a really excellent piece and it deserves a lot wider circulation. Clearly, the problem comes back to people liking something for nothing- be it the lottery win on house prices or stock market "wins". Where do we push this seemingly insatiable desire to gamble/speculate without if mucking up the real economy?

Mark Wadsworth said...

TBH, thanks.

The problem is people's desire to get 'something or nothing'.

We had building societies, most of them became quoted plc's because their members voted for it. I had an account with Leeds Permanent BS then Halifax and did not vote for becoming a quoted plc, so I got £1,800 of shares which I sold on the first day.

People could not understand - no matter how many times I explained it to them - that the £1,800 is not free money, it is the net present value of the extra interest the bank will charge borrowers in future plus the reduction in interest which the bank will pay depositors in future.

And once it is a quoted plc, there is no incentive to convert back again because instead of owning x% of the shares worth £3,000 you would own x% of the company's assets worth £1,000.

The magic extra £2,000 'free money' vanishes again. That benefits future investors but not current investors.

Mark Wadsworth said...

TBH, so I fear the only way to encourage this is the brute force of taxation.

So unincorporated businesses, sole traders or partnerships, would pay zero% tax.
Those with limited liability but no share capital would pay (say) 7% - i.e. employees and members of an LLP, or my suggested DFCs.
Companies limited by shares would pay (say) 14% tax.
Companies with quoted shares would pay (say) 21% tax.

That might do the trick - by converting from quoted plc to DFC, although you lose the speculative/monopoly value of your shares, you have cut your tax bill by two-thirds. That makes corporation tax a voluntary tax, it is the price you pay for the privilege of having share capital and having your shares quoted.

Random said...

OK. I would just be very careful. There are therefore very good reasons why you can't 'withdraw' capital from a business - it's generally in stuff rather than cash. Where are the buffers in your system? Please go into more detail.

Lola said...

I think that the problem with share speculation (which is what in essence what we are railing about) is a function of other failures, not of the principle of limited liability businesses as such.

Those 'other problems' are (i) bad money, (ii) bad monetary policy (iii) bad tax policy (iv) an appalling situation with banks which are state sanctioned specially privileged cartelised suppliers of a monopoly product engaged in counterfeiting.

Much speculative stock investment is driven off the back of those failures. Consider that up until the early '60's stocks had a higher cash yield than bonds - as they were more risky. It took the insights of Ross-Goobey to divine that The Great Inflation needed by the welfare state would drive the stock price higher over time - pretty well regardless of the performance of the underlying business.

Without all these state engineered distortions stocks will return to their the 'natural' return, a high yield as a premium for risk.

The purpose of the secondary market would then be rational. It would enable existing owners to exist and new owners to buy. It may be that the existing owners want to invest elsewhere (for whatever reason - switching from stocks to bonds say to suit there own needs). The secondary market would then be introducing new cash.

Personally, I like the DFC idea. (LLP's are sort of there). And in a free market without all the egregious regulation we could just get on with it. But 'regulators' are part of the corrupt government/central bank/commercial FRB bank/bureaucrat nexus who benefit from the status quo.

As to differential tax rates - we are back to giving bureaucrats the licence to meddle - always, but always, a Very Bad Idea.

Lola said...

In re stock speculation by banks, something else has just occurred to me.

Generally I would prefer bankers to be directly accountable for their business decisions, i.e. 'ban' joint stock banks.

Now I have a principled objection to banning anything (well except murder, assaults on the person or theft, obviously). So I am not happy about banning joint stock banks.

So how about differential bank asset tax rates to reflect risk and accountability?

That is a joint stock bank would be subject to a BAT rate of say 3% whereas a bank structured in a way that made its owners and managers personally accountable, a Partnership say, would be taxed at only 2% on the basis that it was 'lower risk'?

Just a thought.

Mark Wadsworth said...

R. I have explained it in the article and again in the comments. S DFC is half way between a limited liability partnership and a building society. If you don't think it's possible then there's no point me trying to convince you otherwise.

Mark Wadsworth said...

L, agreed to most of your first comment up to this bit::

"The purpose of the secondary market would then be rational. It would enable existing owners to exist and new owners to buy"

The point is that the changes in the secondary market are not reflected by changes in the real world.

If you sell shares in Wax Candles plc and buy shares in Lightbulbs plc, that does not speed up the progression from candle light to electric light.

But if somebody withdraws his deposit from Wax Candles DFC and invests into Lightbulbs DFC, then that speeds up allocation of real capital from old to new technologies.

Mark Wadsworth said...

L: That is a joint stock bank would be subject to a BAT rate of say 3% whereas a bank structured in a way that made its owners and managers personally accountable, a Partnership say, would be taxed at only 2% on the basis that it was 'lower risk'?

Yes, exactly, the tax plan applies just as well to the BAT.

So unincorporated lender - no BAT.
LLP, DFC or BS - 1% BAT
Limited by shares but unquoted - 2%
Quoted plc bank - 3%.

Lola said...

MW. Oh but selling Wax Candles PLC (WCP) and buying Lightbulbs PLC (LPLC) does precisely speed up the change (or rather developement) from candles (four?) to electric light.

Consider. Mr Speculator Mr S who holds WCP which are paying a good divi as a mature business. But MR S thinks that the future is electric and he notices that LPLC is in the electric business. So he wants to sell WCP and buy LPLC. He needs a buyer. Now Mr Retired bloke looking for income (MRBLFI) quite likes WCP because it's paying a god divi and as he's an old boy only expects to enjoy that for say 5 years. And the 'market' has already worked out that that is about all the time it will go on for and the P/Y ratio reflects that and gives a PER of mayber 5. MRBLF buys with new money. Now MrS can go and buy LPLC from a prospect who does not think that electric is the future and is looking to invest in a start up in gas lighting.

Overall the tradeability of stock - all other things being equal and without all the statist distortions does introduce new money into new buisiness ideas at some point in the chain.

I reiterate, this is only distorted by the policy failures.

There is another advantage of a secondary market, especially in government bonds. It gets the price 'right' - as opposed to the inflated price at which the government sells them to its cronies.

And the secondary market permits well diversified portfolios to be built which reduce risk for small savers/investors - if you think that popular capitalism has a place. Personally, and based on my experience, many people would be happy with that, but not to the extent that they are currently forced into by financial repression.

Mark Wadsworth said...

L, yes, if we accept that companies have shred, then there has to be a secondary market, otherwise far fewer people would invest in the primary market. So the secondary market does have some advantages, as you outline.

You have explained the feedback between share trading and real businesses, but it is all very indirect.

The point is that with DFCs, the link between 'the markets' and 'businesses' is a lot more direct, hence quicker, cheaper and more effective.

Lola said...

MW. I don't think you can maintain that until it's been tried and market tested.
In other words, bring on DFC's and lets see what happens.
Fat chance of that with the horrible nexus between the FCA/Central Bank/banks/government/other vested interests.

Mark Wadsworth said...

L, yes I can, because it has been tried and tested.

Clearly, the current lot would never want it because half the people in the City would be superfluous to requirements and no possibility of pumping up artificial wealth of their mates (the already wealthy).