The merger between the New York Stock Exchange and the Deutsche Boerse, together with the SEC’s proposal to prevent money market funds from maintaining a stable $1 asset price per share are symptomatic of a worrying recent trend in global finance: the tilting of the playing field against individual investors of moderate means. This de-democritization of capitalism is very unhealthy; the global economic system will not work properly until it is reversed.
Many market commentators, used to an institutionally-dominated market, imagine that capitalism has always worked this way. The National Review blogger Reihan Salam, discussing the NYSE/Euronext merger, went so far to opine that “the death of the stock market is mostly good news.” He went on to opine that private equity funds could develop deeper and more long-term relationships with companies and thereby become more “value-added” shareholders through “relationship finance,” which he believes to be better at spurring innovation than the public markets.
When I hear the term “relationship finance” the old merchant banker in me twitches and I think back fondly to a vanished world in which banks fostered the growth of their clients with capital injections, remaining fully involved in their operations and steering them through the inevitable difficulties of business downturns. Then I wake up. Such a world had little or nothing to do with traditional merchant banking; it was the pattern of development in France, and to a lesser extent Germany and Japan.
The individual shareholder has been central to Anglo-American capitalism since before the time of Adam Smith. Smith regarded large companies as intrinsically corrupt and rent-seeking; he regarded the ideal form of capitalism as the small partnership in which all partners had unlimited liability and each was entitled to a share of the profits. By this means, Smith believed, the natural tendency of economic man towards rent-seeking and idleness would be thwarted by the vigilance of his partners.
In all but the few companies in which the founder still owns operating control, some outside force is needed to prevent management from looting the company. In the traditional Anglo-Saxon system, that force was exercised by individual shareholders, often quite substantial in terms of the overall company’s size. Those individual shareholders could then gain liquidity and when necessary cash for their own needs through a stock exchange listing.
This situation changed with the institutionalization of Western capitalism, from around 1960. The principal factor behind this was the rise of estate duties, set at exorbitant levels by President Hoover’s infamous 1932 tax bill, and not significantly alleviated since. This effectively prevented the survival of family companies and dissipated individual shareholdings, replacing them with the major institutional shareholders among the pension fund community.
With the rise of institutional shareholders, control over management was lost. Instead of major blocks of stock being held by tough-minded 82-year-old dowagers, they were held by middle level institutional bureaucrats, liable to lose their job if a CEO of a major corporation complained to their bosses. At that point, management’s looting became all too easy, which has resulted in the inexorable and apparently unstoppable rise in top management perquisites since about 1980.
Private equity funds are not a solution to this problem. Like institutions in general, their managers are not the owners of the money they manage, but are remunerated on the basis of reported profits, on a “heads I win, tails you lose” basis that incentivizes leverage and accounting game-playing. Their time horizons are generally much too short for any kind of strategic management, their knowledge of the industries in which their portfolio companies operate is limited, and nobody has ever properly addressed the exit question: If there is no public stock market, to whom should the private equity funds sell? To corporate behemoths – in which case why should not the corporate behemoths have bought in the first place, saving themselves the rents of private equity returns and possibly the depredations of amateur and short-termist private equity management? To other private equity funds – in which case what value can the second fund add that the first could not? In practice, the latter will frequently be the answer chosen – in which case the private equity business becomes nothing more than a chain letter scheme, destined to crash and burn the next time money becomes tight.
The exit problem of private equity ownership has never been properly addressed; it becomes more severe as public stock markets diminish in importance. Private equity funds are not set up to be long-term owners of companies and it’s difficult to see how they could be. They draw money from institutional investors with a third-party relationship with the fund, and their management consists primarily of hot-shots whose main concern is their next bonus, without any thought of long-term ownership.
Reducing the importance of stock markets would thus not produce a more efficient capitalism with long-term intelligent stakeholder owners; it would produce a rent-seeking capitalism in which private equity “owners” and management conspired to run companies purely for looting and short-term gain. Conventional venture capital remains a worthwhile means of nurturing new and innovative companies in the tech sector, but again there is a problem of exit. In any case, the return on venture capital funds since 2000 has been so abysmal that it seems difficult to imagine why new money might be drawn in to this sector.
“Relationship finance” as such does not really exist today. In France, the banks were all nationalized in the early 1980s, and the “banque d’affaires” with long term share stakes in its clients (as distinct from short-term Goldman Sachs-style speculations) no longer exists. In Japan, the troubles of the 1990s weakened the banks to such an extent that their industrial shareholdings have been much diminished, so the financial system has moved closer to the (possibly changing) US model. In Germany, the “mittelstand” of family controlled companies still exists and is indeed flourishing, but there bank relationships are dominated by debt rather than equity, which for medium sized companies usually remains in family hands. That’s an excellent economic model, but it bears no relationship to the one Salam seeks to encourage.
Having defended the existence of the Stock Exchange, one is forced to admit that it is failing badly in its primary task of facilitating liquidity for individual shareholders. The tax system’s bias against individual ownership is of course not the Stock Exchange’s fault. However in two other respects it has failed the economy. First, while the derivatives business was an interesting add-on when it first appeared in the 1980s, and seemed likely to add liquidity to the equities markets, it had already become apparent by the crash of 1987 that derivatives had become the tail that wags the dog, with bubbles and crises in the derivatives business impeding price discovery in the equity business, while derivatives traders, and more especially their quant-driven trading machines, had come to exert an altogether unhealthy dominance over the equities business.
Second, the “fast trading” operations whereby computers located next to the stock exchange seek to profit from their immediate knowledge of the trading flow, is nothing short of a gigantic insider trading scam, whereby the big brokers are able use their knowledge of trading patterns to extract rents from the market as a whole. In principle, as an insider trading operation, it should be illegal. In practice, it is impossible to make fast trading illegal without killing normal market-making practices. However at the very least it should be subjected to a Tobin Tax stiff enough to reduce its importance and the rents it obtains, returning the price discovery mechanism to genuine investors.
As for the money market fund proposal, that is a grotesque attempt by the banking lobby to de-legitimize money market funds as repositories of individual investor liquidity, thereby removing them as effective competitors to the bloated banking system. In an age where the banking system has become highly oligopolistic, we need to encourage all possible avenues of competition to it.
If the world’s stock exchanges wanted to improve the workings of capitalism, they would establish cross-trading platforms, on which stocks listed on any legitimate exchange could be traded on any other exchange – thus allowing individual investors to participate properly in the globalization that is changing their world. In practice, this is unlikely to occur – the Stock Exchanges and their insider dealing brokerage sponsors will make sure that national regulators prohibit it.
Other than this unlikely possibility, there is nothing to be gained for individual investors or the global economy by stock exchange mergers. Most likely, the only result for individuals from such mergers will be an increase in fees, as the global behemoths form a cartel. And, of course, a gigantic bill for another global financial bail-out when the trading strategies of the “too big to fail” behemoths go wrong.
As in other areas, the plethora of cheap money, expensive regulation and insider lobbying has produced a system which neither works properly nor provides a “level playing field” for investment. Reform is urgently needed – but unlikely in the short term.
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(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.)