The Bear’s Lair: Engineering must beat financial engineering

Michael J. Dell is said to be bringing Dell Computer back to the stock market, at a valuation several times that at which it went private. GE has been thrown out of the Dow Jones Industrial Index, after a sorry saga of share buybacks, financial manipulation and forced asset sales. Tesla is unable to meet its production goals except for the occasional week, and must build automobiles in a tent to do so, yet its share price continues to defy gravity. All these stories have a single theme: financial engineering for the last two decades has paid very much better than actual engineering. For the health of the U.S. and other Western economies, this needs to be reversed.

Dell is the poster boy for the current financial engineering boom. Having made a fortune the old-fashioned way from starting a PC marketer in his college dorm room (though Dell Computer was always more of a distribution and marketing rather than engineering success), he decided that the size of the fortune – about $3.5 billion plus another $10 billion in outside investments – was insufficient. Also, it had taken a boringly long time – 29 years in all – to accumulate; after all Michael Dell at 48 wasn’t getting any younger.

Accordingly, in 2013 Dell took Dell Computer private, with the help of the private equity fund Silver Lake Technologies, for $25 billion, in a deal that was criticized by Carl Icahn for being carried out at too low a price. At that time, Dell claimed that he wanted to reboot Dell for the cloud computing era. In fact, he has done relatively little for the original PC company but has carried out a further series of leveraged buyouts. He bought the storage maker EMC for $67 billon, acquiring with it a controlling interest in the data storage center software company VMWare Inc., and funding part of the purchase with the sale of a VMWare tracking stock.

The combined group is mostly in slow-growing sectors of tech, so has not added much value, although VMWare has done well. Nevertheless, Dell is now proposing to go public on an enterprise value of $120 billion, buying back the VMWare tracking stock and ending up with 72% of a tech conglomerate, worth $35 billion, or ten times his original stake five years ago. Nice work, if you can get it, but created almost entirely with financial juggling in five years, unlike the original 29-year slog which created around a third as much wealth (since Dell’s outside investments presumably came mostly from Dell Computer payouts and stock sales).

The current spate of financial engineering began with the leveraged buyout boom in the 1980s, but it really accelerated after the Fed began keeping interest rates artificially low from 1995. Unsurprisingly, it has accelerated since 2009, as the Fed and other central banks have kept interest rates at unprecedentedly low levels for an unprecedentedly prolonged period – and anyway, probably not coincidentally, there has not been much of interest going on in the real “engineering” economy. It has been very difficult in the exceptionally sluggish and low-productivity-growth economy that the rich world has suffered since 2009 to build a major company based on real innovation and engineering skills. With financiers such as Silver Lake falling out of the trees at every crossroads, it is unsurprising that financial engineering has dominated the real kind.

This has happened before. When modern finance was invented, with the creation of the Bank of England in 1694 and the institutionalization of the government debt markets in the long wars that followed, there were not many ways to create a fortune by superior engineering. Abraham Darby, the builder of the first coke-fired pig-iron smelter at Coalbrookdale, Thomas Savery and Thomas Newcomen, inventors of successive steam engines, all died either bankrupt or in near-poverty.

Conversely financial engineering, given a sufficiently loose monetary policy and expansionary economy, was just about as easy as it is today. All it needed was a mechanism by which a bubble could be blown. The first was provided in Paris by the ingenious Scottish financier/fraudster/ Keynesian economist John Law, whose Banque Royale, founded in 1716, issued bank notes supposedly backed by the immense riches of France’s Mississippi colony. The Banque Royale issued both bank notes and shares, causing an immense wave of speculation which began to deflate in January 1720.

In London, where the country had been put onto the Gold Standard by Isaac Newton in 1717, there was less chance to create a “funny money” bubble, but the South Sea Company generated a scheme to buy up the National Debt, causing an equally large stock exchange bubble that peaked around six months later, in July 1720. Both Law and Knight, the Chief Cashier of the South Sea Company, escaped to Antwerp, in the Austrian Netherlands, with substantial portions of their fortunes intact (there were no extradition treaties between the Austrian Netherlands and either Britain or France).

In France, the Banque Royale’s notes became worthless, wiping out most of the savings of the French merchant class, and impoverishing the nation for the rest of the century. In London, the South Sea Company exchanged public debt for its shares, but Sir Robert Walpole arranged a partial bailout by the Bank of England, so the economic effects were less extreme. However, legislation passed during the boom, the Bubble Act, made it very difficult to establish a new public company, and almost impossible to get the benefit of limited liability. According to some economists, this legislation may have set the Industrial Revolution back fifty years. In any case it prevented another speculative bubble for another 105 years and directed savings into the public debt, where they were used to win several economically very profitable if lengthy wars against France.

By the time financial engineering was possible again in Britain, after 1825, various genuine engineers had made substantial fortunes, establishing the British industrial economy on a sound basis, and ensuring that at least until the end of the nineteenth century, industrial engineering would be given proper prominence even in the British economy. Eventually, however, an economically suicidal policy of unilateral free trade hollowed out Britain’s industrial capability, while making London the financial capital of the world. Consequently, Britain’s twentieth century saw many successful examples of financial engineering, while industry gradually atrophied.

The prevalence of financial engineering over real engineering can be put down to one simple cause: excess money creation. In 1716-20, Law’s Keynesian experiments in paper money allowed French finance to indulge in a riot of speculation and had some spill-over effect on the London market. In the U.S. and still more in Britain today, interest rates are being held down artificially, while broad money supply increases by 6% per annum, far more rapidly than nominal GDP. Hence, to re-focus the economies of the Western world on real engineering, we need to take away the funny money.

With money having been “funny” for more than twenty years, there are now structural incentives to favor financial engineering over the real kind. The plethora of private equity and hedge funds, all seeking financial engineering opportunities and somewhat disdaining real engineering opportunities because of their longer time frame are one such incentive — it is just easier to finance a quick-buck financial restructuring than a program of long-term structural growth. The stock options malaise is another such incentive; the payouts on successful stock options reward leverage and a fast deal, and that leverage itself makes long-term structural change very dangerous, because a couple of bad quarters can cause you to run out of money. Finally, asset prices that are high in relation to earnings make it relatively more profitable to manipulate assets rather than to produce organic earnings growth.

There are thus a few legislative and regulatory fixes for the problem. Raise interest rates and keep them soundly positive in real terms for the next decade. This will collapse asset prices; it will also put all the leveraged operations and hedge/private equity funds out of business. Problem largely solved, albeit at the cost of a lot of pain. Return to the pre-1978 prohibition on buying back Treasury stock. This will reduce the leverage in major U.S. corporations and eliminate the pernicious stock buybacks that worsen the leverage problem. Tax stock option gains as short-term; that will make them unattractive for management.

You could also usefully eliminate the leftist-imposed limit of $1 million on deductibility of non-incentive compensation to top management. That will return companies to paying decent salaries for a good job, with much less funny money on top (doing this will almost certainly improve the quality of accounting reports, since management will no longer need to fudge the accounts to achieve spurious bonus targets).

To prevent excessive financial engineering, the legislators of 1720 passed the Bubble Act, preventing new company formation for 105 years. We can avoid that extreme, while acknowledging that their Whig hearts were in the right place. But only when we have taken similar legislative and regulatory action, removing the excess incentives for financial engineering, will the U.S. and Western economies return to full health.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)