Aside from the error identified by Shostak this morning, another error concerning financial markets is that they are systematically irrational – the very opposite error of the EMH.
Michael Kinsley, for example, condemns the stock market as a swindle. Kinsley admits that markets do well with commodities, but insists that markets fail elsewhere. “Capitalism is brilliant at setting the price of potatoes. But how good is it at setting the price of a large company … The free market in corporate shares doesn’t produce well-run companies?†Why does the stock market fail? It fails because there are different prices for individual companies on financial markets. According to Kinsley, the existence of leveraged buyouts and publicly traded companies mean that single companies have more than one price. This leads to a question: “the big question is this: Either the stock market is a fraud on the public or these deals that dominate the business pages are a fraud on the publicâ€.
The short answer to Kinsley’s question is simple. His question is misleading and therefore not worth answering. It is more important to explain why Kinsley simply does not understand the issue he is attempting to address. There are both theoretical and empirical reasons to ignore Kinsley’s attack on capitalism.
First, Kinsley is not at all clear about why markets price potatoes well. Is he talking about spot or futures markets for potatoes? Were Kinsley to visit a futures market and examine “the†price of potatoes, he would find different people bidding different prices for potatoes in the future. He would find speculators attempting to outguess each other about the future price of potatoes, and other commodities. Markets generate multiple prices for both companies and commodities, where futures markets are concerned. Therefore, if Kinsley is right about markets pricing companies wrong, he should also conclude that capitalism sets the wrong prices for potatoes and other commodities as well.
One of Kinsley’s misconceptions is that he fails to appreciate the importance of risk and uncertainty in markets, especially financial markets. Since future events are not known with certainty, people must speculate about future events. Rational coordination of production requires that we speculate about future economic conditions: how much will consumers want of different products, how much of each type of labor and capital will be available at a given date, how efficiently will labor and capital be used? Entrepreneurs compete for the use of labor and capital, and competition is, as Hayek noted, a process of forming opinions.
The facts that different people have different information and will interpret the information they have differently mean that we will all arrive at different conclusions regarding future prices. This is how futures markets are supposed to work for commodities. As for the stock market, investors are speculating about the future profits of different corporations. Different investors arrive at different conclusions about the future prospects of any corporation. This is not only a matter of the results that investors expect from any set of corporate plans, it is often a matter of what investors think a corporation’s strategy should be. Takeovers and leveraged buyouts are not simply a matter of what investors think a company is worth, given the way it is run.
Takeovers and LBO’s are about changing the way a corporation is run; they are about competition over the future course of business. For there to be one single price for a company would require either uniformity of opinion regarding the plans for a company’s future, or equality for the expected rate of returns on all conceived alternative business plans. Kinsley is holding the market for corporate shares to a standard that is both impossible and meaningless. His standard of a single price is impossible because the future is uncertain and we all have different opinions. His standard is meaningless because his way of thinking makes sense only in a world with no uncertainty and no change.
In a static unchanging world, we should be able to arrive at one price for every good and every organization. In a world of dynamic change we should expect different prices for the same good or organization. This is how the world really works, and Kinsley simply does not understand. There cannot be just one price for any future good, and there certainly cannot be just one price for a company, given that the relevant data concerns the goods that a company will produce, the future demand for those goods, and the efficiency of the implementation of a company’s future production plans relative to its rivals. Even the CEO of a corporation has to speculate about the future prospects of the company he likely knows better than any one else.
Of course, the fact that financial markets should produce multiple prices for the same thing does not automatically imply that the multiple prices are efficient. Kinsley does not have any evidence that stock markets really fail. He is merely speculating (as we all must do). However, his speculation is mere conjecture, rather than informed estimation. Scholars of financial markets have found that stock markets play a vital role in modern industrial economies.
Stock exchanges played an important role in the development of the industrial West. Initially, these stock exchanges were informal and unsophisticated. The London Stock Exchange developed in the eighteenth century. The stock market in Amsterdam emerged in the seventeenth century. The financial system of Belgium began in the fourteenth century, but the Brussels Stock Exchange opened in 1801. These early stock markets developed into sophisticated institutions with formal rules. These early stock markets in major cities began to direct capital investment throughout the West and in parts of Asia. Statistical studies indicate that the economic development of Belgium was driven by the development of Belgian financial markets, including the Brussels Stock Exchange. Financial development in Belgium began with the country’s independence in 1830, and was accelerated by the liberalization of the Belgian stock market in 1867. This pattern was paralleled in many nations. Statistical studies show that well-developed stock exchanges have enhanced long-run economic growth, increased capital investment, and raised productivity throughout the industrialized world.
The idea that stock markets are a swindle indicates a need for financial regulation. While journalists like Kinsley are entitled to their uniformed opinions, actual studies of financial markets show little need for regulation. Some evidence supports the case for liberalization of stock exchanges. Peter Henry (2003) finds that deregulating stock exchanges reduces capital costs and increases investment and per-worker productivity. Liberalized stock exchanges can also facilitate the adoption of new technologies in developing nations. Some distortions in the international financial system led investors to hold too much debt and too little equity (Henry 2006). The liberalization of stock exchanges has caused a shift from debt to equity holding during the 1990′s. This shift from debt to equity caused a short run increase in economic growth. Henry (2000) also finds that liberalizing stock exchanges can reduce the cost of equity capital by allowing risk-sharing between foreign and domestic investors.
Financial markets are important in capitalism because they redirect resources towards the satisfaction of the most urgent consumer demands. As Ludwig von Mises noted “it is above all necessary that capital be withdrawn from particular undertakings and applied in other lines of production … [This] is essentially a matter of the capitalists who buy and sell stocks and shares, who make loans and recover them, who speculate in all kinds of commodities†(Mises 1922 [1936] p121). A study by Borsch-Supan and Romer (1998) finds that competitive financial markets reinforce product market competition by cutting off funds to unproductive companies, but only in the face of competitive threats. Borsch-Supan and Romer also find that government regulation and ownership are important causes of low capital productivity, both directly and indirectly through limitations of competition. For example, the trade protection of the German and US auto industries and Deutsche Telekom enabled these companies to earn high profits, despite low productivity. Many less developed nations are now emulating the West by forming more sophisticated financial markets. One study (Agarwal 2001) of nine African nations indicates that stock exchange development has led to increased economic growth. Another study (Aragarwal 2007) of twenty-one developing nations shows that the development of stock exchanges increases private investment and economic growth. This study indicates that stock exchanges contribute to economic development by stabilizing productivity and liquidity shocks.
In his article, Kinsley claimed that Milton Friedman was wrong about capitalism and that John Kenneth Galbraith was right.
Nothing could be further from the truth. Galbraith was wrong about practically everything he wrote on economics. Milton Friedman correctly saw great merit in the free enterprise system, yet it was Mises and Hayek who understood the reasons for capitalism’s success most clearly. Mises recognized the importance of speculation in financial markets in theory. Hayek understood competition as it really is and should be: as a competitive discovery procedure. Numerous studies confirm the importance of free financial markets in practice. The attack that Michael Kinsley launched against stock markets proves only that he understands neither theory nor history in these matters.
Bibliography
Agarwal, Sumit. 2001 Stock Market Development and Economic Growth: Preliminary Evidence from African Countries Journal of Sustainable Development in Africa
Agarwal, Sumit. 2007 Stock Market Development and Economic Growth: Evidence from Developing Countries Working Paper
Atje, Raymond, and Boyan Jovanovic. 1993. Stock Markets and Development. European Economic Review 37: 632–640.
Caporale, Guglielmo Maria, Peter G. A. Howells, and Alaa M. Soliman. 2005. Stock Markets Developments and Economic Growth, the Causal Linkage. Journal of Economic Development 29 (1): 33–50.
Demirguch-Kunt, Asli, and Ross Levine. 1996. Stock Market Development and Financial Intermediaries: Stylized Facts. World Bank Economic Review 10: 291–321
El-Erian, Mohamed A., and Manmohan Kumar. 1995. Emerging Equity Markets in Middle Eastern Countries. Working Paper 94/103. IMF Staff Papers 42: 313–343
Greenwood, Jeremy, and Bruce Smith. 1997. Financial Markets in Development, and the Development of Financial Markets. Journal of Economic Dynamics and Control 21 (1): 145–181
Hayek, FA: 1948 The Meaning of Competition in Individualism and Economic Order
Hayek, FA: 1977 Competition as a Discovery Procedure in New Studies in Philosophy, Economics, and the History of Ideas University of Chicago Press
Henry, Peter. 2003 Capital Account Liberalization, the Cost of Capital, and Economic Growth The American Economic Review
Henry, Peter. 2006 Capital Account Liberalization: Theory, Evidence and Speculation CDDRL Working Paper
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Levine, Ross. 1991. Stock Markets, Growth, and Tax Policy. Journal of Finance 46 (4): 1445–1465
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Mohtadi, Hamid, and Sumit Agarwal. 2004. Stock Market Development and Economic Growth: Evidence from Developing Countries. Working Paper, University of Wisconsin–Milwaukee
Nieweburgh, Stijn van, Frans Buelens, and Ludo Cuyvers. 2006. Stock Market Development and Economic Growth in Belgium. Explorations in Economic History 43 (1): 13–38
Strigham, Edward. 2002. The Emergence of the London Stock Exchange as a Self-Policing Club. Journal of Private Enterprise 17 (2): 1–19
Strigham, Edward. 2003. The Extralegal Development of Securities Trading in Seventeenth-century Amsterdam. Quarterly Review of Economics and Finance 43 (2): 321–344
{ 16 comments }
Kinsley wrote a similar piece on Slate last November, and my jaw dropped at how mind-numbingly stupid it was. (like my reaction when people cite Stephan on IP) He was actually claiming that the stock market is a fraud because people bid different prices for the same security. The idea that maybe this reflects different people’s honest valuation of the good, and that this same thing happens with potatoes, never entered his head. In fact, investors’ evaluations are necessarily more honest because they suffer a financial loss if they’re wrong. How much doese Kinsley stand to lose if his judgment is in error?
It’s a swindle when you lose. Just like insurance when one of the exceptions to payout is proved. When the outcome is negative, the innocent merely have to claim ignorance and that the big meanies are to blame.
Having said that, it seems that little real analysis is done valuing stocks, even by those paid handsomely to do so. When the world was rocked by Worldcom and Enron it was inspiring to hear how analysts (in their own words) couldn’t be bothered to read all those boring footnotes to the financial statements. When the price of a stock is based on poor analysis, then all sorts of players can enter the process and inflate and conflate based on elements not tied to anything like discounted cash flow or asset based ROI, minty breath and good looks are all that are needed. Fortunately the market does correct itself, painfully, and when it does, the losers then cry over the decisions they have made.
Ownership of public companies is extremely attenuated, as the vast majority of investors simply own shares in a mutual fund which itself owns shares in various companies. The institutional investors are themselves the beneficiaries of government tax laws that drive Other People’s Money their way. I don’t see many fund managers concerning themselves with the minutiae of corporate governance, so managers and directors collude on all sorts of shenanigans.
With people like Kinsley, you have to always be suspicious of what they claim to accept about the goodness of capitalism. They don’t really accept it as good at all, but are smart enough to know that you can’t socialize the economy by claiming first that there is a justification for regulating the price of potatoes. For them, they see it is much better to start with a publicly less popular price setting mechanism, then, when you have control of that, you can move on to regulating the prices of other goods and services.
In other words, it is not that he doesn’t understand that the prices of potatoes and stocks are set by the same fundamental mechanism of price discovery, but rather, that he is attacking the one that it is more politically expedient to do so.
It could be that Kinsley is acting out of political expediency, but who knows? I am not a mind reader, and I prefer to assume genuine error over intellectual dishonesty. as for the idea that “managers and directors collude on all sorts of shenanigans”, this happens, but how often and to what degree? Enron and Worldcom were two of thousands of publically held companies- mere anecdotes. Stock market competition is pretty intense, and the evidence I cite indicates that efforts to remove stock market pressures from the picture just make matters worse. Stock market competition tends to eliminate swindlers like Ross Johnson and Ken Lay.
“In a static unchanging world, we should be able to arrive at one price for every good and every organization.”
Implied in this is that all market participants have exactly the same information, place exactly the same level of confidence and importance on each piece of information, are all equal in intelligence and preferences (time and otherwise). In other words, for one price to exist for a company, or anything, the world can’t have people who differ from each other; we must all be clones from one super human.
There is no such thing as the “right” price for anything. Prices are nothing but opinions. It’s really sad that a prominent writer/commentator lik Kinsley is so ignorant about basic economics.
Brad: “it seems that little real analysis is done valuing stocks, even by those paid handsomely to do so.”
Not a lot of real analysis is done because most people believe the efficient market nonsense. As Shostak writes, this should giver Austrians an edge in investing.
Successful investing requires sound business instincts and the ability to interpret financial statements. Economists of whatever school possess no particular insight in such areas.
Reactionary: “Economists of whatever school possess no particular insight in such areas.”
Austrian econ should give an investor an edge if you use the ABCT as a guide. As Shostak writes in “A Defense of Fundamental Analysis” capital intensive industries will do well in the early stages of a boom, while consumer goods will do best in the mid to later stages. Commodities do well in the later stages when inflation sets in. When the stock market has set new record highs, Austrians should be way of the collapse and either short the market, or get out and go to cash. In other words, Ausrians should be contrarian investors.
Kyosagi, author of the “Rich Dad Poor Dad” series, writes that long before the stock market peaked in 2000, most of the wealthy investors he knew had gotten out and invested in real estate and commodities because their prices had not risen in response to the money pumping of Greenspan. So as the market was collapsing on less savy investors, Kyosagi and his friends were surfing the rising wave of price increases in commodities and real estate.
Also, Kyosagi emphasizes buying low and selling high. It sounds simple, but most people buy high and sell low because the drive to follow the crowd is so strong. Kyosagi advices selling before the peak of any market, when everyone else is getting in, because you have to have cash to take advantage of the blue light specials when the market crashes. He sounds very Austrian to me.
“In a static unchanging world, we should be able to arrive at one price for every good and every organization.”
Implied in this is that all market participants have exactly the same information, place exactly the same level of confidence and importance on each piece of information, are all equal in intelligence and preferences (time and otherwise). In other words, for one price to exist for a company, or anything, the world can’t have people who differ from each other; we must all be clones from one super human.
I don’t think so; if a static world in which market participants have differing and incomplete information, etc., were possible, there would still be one price for everything (well, one price for each thing; different prices for different things, of course). There may be different prices in different markets for “the same thing”, but given that nobody can ever learn of them (that’s what it means to be a static world, after all – nobody can learn anything new!), they’re essentially different things (any overlap would be completely cleared up by arbitrageurs, so there could be no price differences between markets with shared participants, after accounting for transport costs, etc.)
it seems that little real analysis is done valuing stocks, even by those paid handsomely to do so. When the world was rocked by Worldcom and Enron it was inspiring to hear how analysts (in their own words) couldn’t be bothered to read all those boring footnotes to the financial statements.
Brad you are wrong. Some analysts suck but even for those of us who did all our homework, WorldCom was a surprise. First of all, the WorldCom situation was not as obvious as the Enron situation. Second, as an equity analyst, I spent 5 months researching WorldCom before I initiated coverage on the company just a few months before its fraud was exposed.
I read every single word the company published for the five previous years, built a giant model and reconciled every single one of their restatements (a massive task unto itself). To uncover WorldCom’s lie I would have needed non-public information to which I obviously didn’t have access.
However, the sheer number of restatements made me suspicious. I was a small analyst and Scott Sullivan brushed me off. When I couldn’t reconcile some of WorldCom’s capex numbers, I called him to find out why. His discomfort was palpable even through the phone. I was shocked at the change in personality. It seemed fishy to me. He didn’t have the numbers but he would find out and get back to me. Suddenly, my calls were taken right away, he was very attentive to my every question – except he could never get me those numbers. the whole thing stank.
I was under pressure from the director of research to launch (there were legitimate reasons for this). I wanted to launch with an “underperform” rating because I thought Sullivan was was lying about something and I didn’t think it was something small. After a long conversation with the director of research, it came down to having the proof. I couldn’t justify an underperform (basically a “sell”) rating unless I had something I could point to. If I didn’t have the proof, we would be publicly ripped to shreds and humiliated and Sullivan wasn’t about to pony up the goods. In the end, we launched with an outperform (buy) and the rest is history.
What I did find out is that the funds who were our clients and risked their own money also did this research. Some did a better job than others but most were well aware of all knowable issues. The point is, to know for sure if WorldCom was lying about its capex, I would have needed non-public information. Incidentally, the little discrepancy I found in the capex numbers paled in comparison to the actual fraud – so, for all my efforts I was unable to uncover enough in WCOM’s audited statements to give me a true picture of the extent of the fraud. The auditors really failed on this one.
Person should apologize for his inappropriate swipe at Stephan. In re the stock market, the open market for the paper tickets that purport to give you a defined interest in a corporation works just fine, considering the state interventions (SEC, etc). The real question is what the heck anyone is doing buying a share that gets you exactly two things at law: the right to vote (woohoo!) and the right to a proportional share of what remains of the entity after all creditors, employees, executives, board of directors, nephews and nieces of afrorementioned folks, attorneys and the government are paid when it is liquidated, usually under the aegis of bankruptcy court (hint: shareholders typically see nada).
Once again, the paper is fairly worthless but there is an active market that does an altogether decent job of rewarding the good and punishing the bad. I guess it is akin to international monetary trading. A canadian dollar ought to be as worthless as an american dollar, but isn’t. That’s because people still accept it has value, and so it does. One day that will end. And it will similarly end for our beloved public corporations.
Of course, this might just be the musings of guy who has bought high and sold low a few times too many.
Mr. Former Analyst: Great story.
Eh. I’d say any trader is really just playing a zero-sum game. Hope to buy low and sell high? Doesn’t that really mean you made profit by offloading a soon-to-be worthless security on some other lug? Indeed how does ‘hoping to buy low and sell high’ having anything to do with a better economy? To me it’s a little more like gambling. Some days you guess correctly, other days you don’t. Perhaps in a idyllic economy there’d only be private companies as true investors would have not only a stake in the company but have some managerial control such that they can make their investment grow rather play a game of pot luck.
TLWP,
No offense, but you show a complete lack of understanding of what traders do and why public markets exist.
Any trader just rolling the dice as you describe is soon a trader no more. Trading is definitely not a zero-sum game even though any individual transaction may be. A single trade may involve several transactions (or “legs”). For example, I’m happy to lose on the security I shorted as a hedge because I make my edge on the long leg but I did it with less volatility and the ability to hedge allowed me to do more size.
Public markets’ biggest contribution is liquidity and traders are willing to buy and sell frequently, providing that liquidity. If all companies were private, then it would be virtually impossible to take your initial investment out of a successful company to fund another one and you won’t know if you’re getting the best price because of the lack of bidders. Public markets allow people to monetize their investments quickly, making them more willing to make investments in the first place.
The share price is valued on a discounted cash flow basis – free cash flow/discount rate. If the cash increases of the hurdle rate decreases, the shares are worth more, if the the opposite happens, they’re worth less.
We get a better economy because liquidity gives people the confidence to invest, knowing that if they should need to monetize their investments quickly, they can. Companies can go to a liquid markets with millions of participants to fund expansions and new projects, helping the economy grow. If you’ve ever tried to fund a deal privately, you know how much more difficult it is.
The gambling part is really not knowing the future. Since knowing the future is impossible every trading decision carries that risk. But then, so does every decision, full stop. Lucky for us, the liquid markets also trade a plethora of securities to help us minimize risk too.
I’d say all those things make financial markets a pretty important part of both economic flexibility and growth.
RogerM,
Finance/accounting and economics are very different animals. Investing based on predicting the swings of ABCT is still way too macro, as Warren Buffett might put it. Otherwise, the Mises Institute could forego fundraising and instead focus on investments. As Mises himself noted, being an economist means talking about money while never having very much of it.
Cone to think of it, Mr. Kinsley seems to be good at putting certain ideas in the head. Such as:
“In regular economics, the subjective preferences of consumers are out there to see. In capital theory, though, they’re hidden, if included at all. Therefore, capital theory is a fraud.”
Yee-hah. No more sweatin’ over the textbook…
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