Monday, October 20, 2008

The Supercharged Stock Market

An Object Lesson in the Perils of Coercion


 

Imagine that a farmer comes to you for advice.

"My chickens keep dying," he complains, "and I have no idea why!"

"What do they die of?" you ask.

"Oh, the usual – diseases spread like wildfire, and they often get crushed to death – or just asphyxiate."

"Asphyxiate?" you reply, rather startled. "How so?"

"Well," says the farmer, "they never seem to be able to get enough air. I think that their lungs must be very weak."

"Where do you keep them?" you ask.

"Oh, in a shed of course. About 10' x 10'."

"And how many chickens are in the shed?"

"12,000."

Your jaw drops. "12,000! How on earth do you get 12,000 chickens into a shed?"

"Oh, at this point, I just jam them down the chimney, but it's really full. Nowadays, I have to use a broom stick."

"What? Who on earth told you to put 12,000 chickens in a little shed?"

The farmer blinks. "Oh, the guy who sells me the chickens, why?"

At this point, it would be fair to say that the mystery was solved. Complex theories about the lung capacity of chickens and the mystery of disease transmission would be quite unnecessary.

This analogy is very useful in helping understand one central reason why modern stock markets tend towards instability.

We all know how the government messes up the stock market through printing money, inflation, hyper-regulation, controlling interest rates, defense spending, deficit financing and so on – but there is another factor at work that is less obvious.

The Causes

As we all know, the stock market is designed to allow companies to raise money by selling shares to individuals. Individuals should ideally only invest in companies that they understand – investing in unknown companies or markets is more appropriately termed "speculation" rather than investment, and is generally indistinguishable from gambling.

Of course, there's nothing wrong with gambling, as long as you risk your own money, and at your own discretion. However, particularly since the Second World War, governments around the world have been increasingly forcing us at gunpoint to put our money into the stock market, much to the delight of money managers, corporate executives, stockbrokers – and politicians.

There are many examples of how we end up being forced to speculate. 401(k) plans only exempt current income from taxation if it ends up being invested – putting the money into your bank account or under your mattress will not save it from the tax man. The amount of money that 401(k) plans have herded into the stock market is truly staggering – rising from $105 billion in 1995 to over $14 trillion in 2005.

Of course, some of that money would have been invested even without 401(k) coercion, but how much? 10%? 20%? Half? Whatever the number, it is far less than what is currently being forced into the stock market through government regulation.

Let's look at some other sources. Hundreds of billions of dollars are currently being invested by unions – particularly in the public sector. The US teachers' union, for example, along with other non-profit groups, has an estimated $607 billion invested through 403(b) accounts. The very existence of these unions would be questionable in a free-market – there is almost no chance that they would end up as investment vehicles for their members' money. At present, however, trillions of dollars of forced union dues in state-protected monopolies are flooding into the stock market.

Let's not forget the surpluses of various government programs as well, such as unemployment insurance and some pension plans. This surplus, which is stripped from you at gunpoint, is also often invested in equities. Various government agencies also directly invest in companies – in Canada, the state agency HRDC recently had to write off over $5 billion in bad investments, out of an annual budget of over $70 billion.

The Effects

Around the world, governments are forcibly injecting trillions of dollars into stock markets. What are the effects of this "supercharging"?

First and foremost, it creates enormous instability in the stock market itself. Too much money ends up chasing too few stocks, creating a subtle shift in the concept of "value."

Ideally, "value" represents an actual and potential demand for goods and services. In a supercharged stock market, however, "value" tends to devolve into "whatever I can sell the stock for," which is a subtle but essential shift in perception. When the assessment of price becomes more based on the demand for a company's stock, rather the market demand for a company's products, a subtle and corrosive corruption enters into the equation.

When too much money sloshes around the stock market, chasing incremental and short-term changes in stock prices, the focus of chief executives begins to change. Rather than building corporate value for the long-term, they end up chasing stock prices in the short term. Since excess money jumps from stock to stock at a moment's notice, the temptation to misrepresent earnings and sales projections – as well as pursue short-term "pump and dump" strategies – becomes far greater. Executives who tell the truth about shortcomings often get punished; those who cover them up are all too often rewarded.

Skilful manipulation of a supercharged stock market thus creates rewards measured in the billions. Since enormous "value" can be rapidly created through the manipulation of perception, executives can become rich in months or years, rather than decades. The long-term value of "good character" thus goes down, while the short-term value of flashy marketing goes up. Executive salaries continue to rise, as the "value" they can provide increases. In 1970, US CEOs were paid28 times more than the average worker. By 2005, this had jumped to 465 times more.

Ambitious executives do not take very long to figure out that they are punished when they tell the truth, and rewarded when they prevaricate. Since "speculation" has largely displaced investment in the stock market, and the constant supply of additional capital is guaranteed through government coercion, an amoral feeding frenzy has taken over.

Naturally, the problems which arise from coercion are inevitably ascribed to voluntarism. State manipulation of the stock market is ignored; the resulting instability is invariably blamed on the free market – thus paving the way for additional (and ridiculous) regulations such as Sarbanes-Oxley. Executives can now be sent to jail for a single mistake by a single accountant – but no government executive loses his job over the slaughter in Iraq!

One reason that politicians like this setup so much is that it gives them enormous power over the financial sector, which has become largely dependent on the money that the government "sends" their way. If the government were to abolish 401(k) plans, for instance, and simply refrain from taxing the associated income, the financial services industry – one of many that depends on this violence – would largely collapse. Were we free to make our own investment decisions, the landscape of what is now currently called "stock market" would change almost beyond recognition.

Of course, this is highly unlikely to occur. Governments almost never reform themselves from within; they only change under the threat of fiscal collapse.

In other words, a whole lot more chickens will have to die before the farmer changes his ways.

3 comments:

Anonymous said...

Stefan, why do you keep talking about money being "forced" by 401(k) plans into the stock market? I've had a 401k account with four different companies and I was never forced to invest in stocks or even in the 401k plan. It's always been the employee's choice as to whether to invest in a 401K, and what to invest in. In particular, I have always had the option of investing in the equivalent of a money market mutual fund with a minimum guaranteed return.

molon labe said...

This post is wrong on so many points that I hardly know where to begin. I'll just pick some examples:

1) Despite what "we all know", the stock market is NOT "designed to allow companies to raise money by selling shares to individuals." This can be, and is, done alternatively through private placement markets. The real distinguishing feature of "the stock market" is the ability of investors to easily and cheaply sell to and buy from other investors. The volume of shares sold directly from companies to investors is miniscule compared to the volume of shares traded among investors.

2) While the 401(k) tax reg incents investing money in these accounts, there is no requirement to invest in stock market assets (or, for that matter, any risk-bearing assets). Thus, the entire argument that the government forces money in to the stock market falls apart.

3) Your further argument that money forced into the stock market is also forced into "speculation" is also false. Your distinction between "investing" and "speculating" is a difficult one to truly defend unless you literally mean that speculating only is investing in "unknown companies." If not, you must define just how much knowledge separates investing from speculating. If so, the number of 401(k) investors who directly invest in companies of which they know absolutely nothing must be close to, if not, zero. In either case, there is no compulsion to "speculate", irrespective of how you try to define the term.

4) An increased amount of money invested in the stock market does not, in and of itself, create "enormous market instability." In fact, most value theorists would argue the opposite: more invested funds create a more liquid market, which results in less volatiity.

5) I disagree that "value represents an actual and potential demand for goods and services." Assuming you're referring to the value of a firm, the question is so much more complex than this and includes costs of supply, volatility, etc.

6) The distinction you attempt to make between "uncorrupted" valuation of a stock and "corrupted" value is wrong. The only price investors ultimately and rightfully should care about is the value of the stock in the eyes of another willing buyer of the shares (i.e. "whatever I can sell the stock for."). Of course, the future performance prospects of the company are critically important inputs to this analysis but, at the end of the day, all that matters, and all that has ever mattered, irrespective of "super-charged" or limp stock markets, is the price of the asset one owns. This asset is not the company but a share in said company.

I'll stop here but could go into detail on many more points (e.g. the "too much money" changes CEO focus bit, the meaning of "building value for the long-term" vs. "chasing stock prices in the short term" piece, the "excess money" jumping from stock to stock thought, etc., etc., etc.).

Government is pernicious in so many clear ways but you've chosen the wrong angle from which to attack this particular tax policy. For example, a more legitimate case would be to analyze the 401(k) provision in the context of a tax system that confiscates money from citizens who choose to consume or maintain flexibility to consume rather than commit to long-term investment.

Michael said...

I found your podcasts somewhere after having an argument with some libertarians from my law school class. For the sake of making a good faith effort to have an open minded dialogue, I suffered through your pompous straw man arguments for a few hours but then I decided my time would be better spent filling out an application to work in the Obama administration.
I love the state!