Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Why Markets? (S1 E4)
Ever questioned the very existence of capital markets? Why do we allocate capital for risky uses through them? Join us as we dive into these mysteries with Edward Finley, a seasoned Wall Street investor and sometime Professor at the University of Virginia. Together, we'll decipher what constitutes the public good and explore how capital markets, through promoting risk taking, serve this greater cause. We'll unravel the concept of national wealth and the role it plays in the allocation of capital among productive uses. By the end of our chat, we promise you'll have a fresh perspective on the role of capital markets.
In the second half, we'll discuss how a blend of speculation, the separation of ownership and management, limited liability, and democratic institutions make it possible for capital markets to live up to their promise. We'll shed light on how speculation aids decision-making under uncertainty and fosters healthy innovation. Finally, we'll discuss how the interplay of economic efficiency, social justice, and individual liberty can lead to a better society, reflecting on the core economic theory by Keynes. So strap in and get ready for a thought-provoking journey into the world of capital markets!
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a Sumtime Professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment podcast. Here we explore topics and markets and investing that every educated person should understand to be a good citizen. Welcome to Core, episode 4 of the podcast. I'm Edward Finley. We're going to pick up now a topic that I think is a little bit more ephemeral and maybe a little more philosophical than what we've done so far. If you're only just now joining the podcast, I encourage you to go back and listen to Core Episodes 1 through 3, where you can learn about what the capital markets are, namely the money market, the bond market and the equity market, and all of which have as their role the job of allocating capital to risky uses. Today, we're going to ask what should be a fairly obvious question, it seems to me why capital markets? Why do we use capital markets? To provide capital for the purposes that we've just described, and I'm going to suggest a short answer. We do so because we think that capital markets increase the public good by promoting risk taking. Now I'm going to be the first to acknowledge that that sounds like a nice neat answer, and it may not be the nice, neat answer that you learned in your economics class, but I think it's a reasonably good answer and what I'd like us to do is take it apart and think about some of the weaknesses of that statement, but also some of its contours.
Speaker 1:Well, let's talk about the allocation of capital and the public good. So economists, when they try to measure the public good, use national wealth as a proxy for the public good. Then they would say higher national wealth implies wealthier and happier society. Is that really a good proxy? Are people really happier if they're richer? If labor earns less for its efforts than capital earns for its deployment, do you think that's a society in which people are happy? If we aggregate national wealth as economists, do we aggregate it? If all the gains in a society economic gains went to a small group of oligopolists and the rest of society did not earn any wealth, do we think that that society would be happier? They have higher national wealth, but it's all concentrated in a few people. Does it have to be with most people? Does it have to be with all people? It's just not clear whether that statement that I used earlier, that national wealth is a good proxy for public good, is right, but it's certainly a decent starting point, as long as we're aware of the limitations of what we said.
Speaker 1:Well, let's understand what the economists mean by national wealth. What they don't mean, which is important, is financial assets. They mean only productive assets, which, in an economy, consists of two things, essentially labor and capital. So, national wealth and whether we have more of it or less of it. Don't think of this as an idea of well, my portfolio has gone up in value. Or don't think of this as my bonds have gone up in value. Instead, focus and tend on just the value of labor and the value of productive capital. How do we think about it? Well, think about it this way Households earn money, usually from their labor, sometimes from their capital, and they make choices about what to consume.
Speaker 1:Today. Households balance sheets will consist of assets that they choose not to consume and to save for the future, and those assets can be either held as deposits in banks or invested in firms that engage in the production of income. The securities that are bought by households, therefore, their bank deposits, their equities, their bonds are going to be liabilities of those firms. The deposits at a bank are a liability of the bank because, if you want your money back, you got to give it back. If you invested in equity of a firm, that equity is a liability of the firm. If they liquidate, they've got to give you the money back. And so national wealth. When we aggregate the balance sheets of firms and households, it only consists of productive assets. The securities cancel each other out.
Speaker 1:Let me give a quick, simple example. If I'm a household and I have $100 that I hold on my balance sheet, I don't plan to consume it today, I plan to consume it in the future, and I take that $100 and I buy stock worth $100. So on my balance sheet I have an asset worth $100 and I don't have any liabilities. Well, now let's take a look at that firm's balance sheet. The firm will have taken the $100 in from me that's a liability on its balance sheet and then it will have productive assets that it buys with the $100. It will buy a factory, it will buy a machine to produce the things that it produces, and so those will be assets on its balance sheet. Now, if I'm computing national wealth and I aggregate my balance sheet and their balance sheet, what do you notice? Happens? The asset on my balance sheet, namely the $100 in equity that I have in the firm exactly cancels out the liability on the firm's balance sheet of $100 in equity that it took from investors.
Speaker 1:So when economists talk about national wealth and increased national wealth, don't think of portfolio assets. You're thinking instead only of their labor and productive assets. All right, well, if economists are saying that national wealth maximizing is really the key to figuring out whether a society is happier and by national wealth we don't mean stocks and bonds Then what role do stocks and bonds play and the markets in which they're traded? What is it? And what we can say of that is that stocks and bonds and the assets that we'll call in the aggregate capital market assets.
Speaker 1:Capital markets and capital market assets are the mechanism by which we allocate capital among productive uses, and therein is the strength of capital markets In terms of allocating the capital that we have as a society to productive uses. One way to do that is to use markets to allocate capital, and we think that they do a better job evaluating the risks and returns of allocating capital than any alternatives. But let's be clear there are alternatives. One could have a society with a central authority that determines how capital will be allocated in the economy. We've seen those historically. There are very few of them today, but we've seen them historically. Today, I would argue that some countries, like China, are a blended system. There's a central authority that plays a very serious role in the allocation of capital, but it does so within bounds, and they use markets as a complement to central authority to allocate capital.
Speaker 1:But let's just put our minds in a completely open place. We could decide as a society, to allocate capital via a lottery, so we know all of the capital we have available and when we say, well, what productive use is going to get it, we could just use a lottery. Well, we think that when you use capital markets to allocate capital to risky uses, you get better decisions than you would get with any other alternative. Banks, for example, that receive deposits from households make decisions about the creditworthiness of a borrower and, by implication, the merits of their business. And lots and lots of banks looking at the same possible risky use for its capital will, in the aggregate, we think, come to a very close estimate of how worthy that use is to gather the capital. Households will make decisions about the economic prospects of a firm's business when they buy either its debt or its equities, and they'll make those same decisions about the prospects of a bank when they decide whether to deposit their capital with a bank or not. Firms will decide how much leverage to employ in their business, that is, how much debt and how much equity capital to raise. And if firms make that decision and use too much debt, that they could put the firm in jeopardy, and if they make the decision to use not enough debt it could put the firm in jeopardy Overall.
Speaker 1:The operation of markets allows capital to be allocated based on the aggregate views of participants about the relative merits of the use of the capital. Here it can be useful to think about the merits in terms of what an economist known as Shumpeter described when he coined his phrase, creative destruction. By this view, all things being equal, capital will be allocated to assets that promise to pay greater risk adjusted returns. If a risky use doesn't promise to pay enough returns compared to a similar risk use, then that first risky use will not attract sufficient capital and it will likely fail. The overall views of the market about the broad economy will affect this decision all the time. It's not simply looking firm by firm and allocating capital on the basis of that risky use in a vacuum. If people believe the economy will contract, then they'll likely redeploy their capital away from the riskier uses and towards the less risky uses. Banks will become more restrictive in their lending practices and starve riskier uses of capital. Firms with riskier businesses will find the capital more expensive and that makes it harder for them to deliver a competitive return to other similar risky uses. And with all of those constraints in action, it means that the firms who aren't able to show that their risky uses will be rewarded will be out of business. They'll fail. And the breadth of all of this means that markets allow firms to raise more capital by allocating the risk differently to different investors.
Speaker 1:There's not a single way in which capital is allocated, and by broadening the amount of capital available for risky use means we can promote more innovation. Let's do it this way. Imagine If the only capital allocator available was a bank. Imagine if we had no debt markets and no equity markets. We'd just had banks and we all had capital on our balance sheets. All households have capital on their balance sheets. They deposit them with banks, and the only allocator of capital to risky uses is banks. Well, that would be a pretty narrow set of risky uses. Banks by their nature, have a set of incentives that make it very difficult for them to make decisions other than something that's secured by concrete plant equipment et cetera, and so the number of things available another number of innovations that could be made available in our economy would be greatly limited.
Speaker 1:But by increasing the number of ways in which we allocate capital, we therefore attract people with different appetites to risk. If we instituted a bond market, then they're gonna be what's the bond market do? Well, they have no upside participation by providing capital in the form of a bond, but they will earn a set coupon of interest that will be a fixed cost to the business and that will be a burden to the business. There are gonna be certain providers of capital who will provide capital only under those circumstances, or the issuance of equity. You share the upside, but it's with a lower cost to the business. So businesses would love to use equity, but it may not attract sufficient capital because there may not be enough people that appreciate that risk.
Speaker 1:What I wanna communicate here is that the way markets both allocate capital based on the decision among market participants about the potential returns relative to the risk, and then the aggregation of all of those in markets shouldn't be considered as something that is scientific or concrete, because it's not. Keynes pointed out long ago that markets function not so much by cold calculation of costs and benefits as they do by expectations of market participants. Here's a quote from Keynes's general theory of employment, interest and money, quote a monetary economy is essentially one in which changing views about the future are capable of influencing the quantity of employment. Our views about the future, those of us that possess capital and are allocating it, are just as important as very concrete measures of risk and return. Here's another quote from Keynes in the general theory, because when we talk about these views, we wanna understand them as being highly subjective and highly idiosyncratic. Keynes wrote, quote professional investment may be likened to newspaper competitions, in which the competitors have to pick out the six prettiest faces from 100 photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors as a whole. So Keynes goes on to say each competitor has to pick not the faces which he himself finds the prettiest, but those which he thinks likely is to catch the fancy of other competitors, all of whom are looking at the problem from the same point of view. Well, that suggests that when we're talking about capital allocation in markets, we don't wanna imagine that it is a pristine mathematical determination of risky uses and not risky uses, but instead it involves people's judgment, not only about the risk but about the perception that others in the market have of the risk.
Speaker 1:["the Risk of Risk"]. All right well. Markets, therefore I think we could make a safe argument that markets are a way to allocate capital among risky uses. I think I've made some decent arguments to suggest why that it's a better system than other alternatives, because, namely, it brings more capital into risky uses, both the fact that there are multiple forms of risk and that there are multiple ways in which capital can be allocated. Let's talk a little bit oh sorry, but we should also acknowledge that it's not a simple mathematical calculation, that it's not as concrete as one might want us to believe when thinking about how markets function Well. Let's talk, then, about some elements that help markets function well, and I might add, maybe they'll surprise you.
Speaker 1:["the Risk of Risk"]. The first element that I think is crucially important to the way markets function is speculation. Now, what I'm doing here is I'm really kind of taking advantage of a common use of a word and a technical use of a word, and throughout this podcast we're gonna find that this happens again and again. So I'll warn you now. There are just certain words that, in plain English, have a meaning that are not necessarily the meaning we want to imply in a very technical way. Speculation is one of them. When we in plain English say speculation, we think about mindless or dangerous risk taking, but when we're talking about markets and we're talking about economics, we mean when we say speculation, we mean making decisions under uncertainty, that we don't know what's going to happen. We're guessing, we're doing our best job at guessing and maybe, as Cain suggested, we're not only guessing about the likelihood of something being successful. We're guessing whether everybody else thinks it's likely to be successful.
Speaker 1:By promoting capital On the basis of risk and expected return, it means that speculation can take place and allow crazy ideas to be pursued. It's typically the case that the capital that gets allocated to the most risk seeking, the most crazy, innovative idea, is not going to be traded in public markets. The capital that comes to public markets is less risk taking than what? Than the capital that comes to private markets, and so the existence of private markets means that we might be able to allocate capital to really crazy uses. However, what did we notice when we talked about capital markets? The private markets are very small. The amount of capital available is simply far more limited than the capital available in public markets, and it won't allow a firm to reach the scale needed to be very successful. It might take a crazy idea and get it to the point where it might be able to approach public markets and get enough capital to be massively successful, but it will more likely disappear In private markets. The fundamental truth is that when we have capital allocated to such very risky ventures, the firms that don't prove themselves early will simply disappear. Successful firms will mature and when they're ready to reach that scale, they might be able to access public markets and make a giant success of the plan. So in a sense, speculation is really no different than what economists describe as price discovery in markets Just traders trying to guess what a stock is worth. It's making decisions in the face of uncertainty. That's speculation. It's just that there's so much more uncertainty when a market is private as opposed to when it's public. So speculation is a huge part of what makes a capital market economy work well.
Speaker 1:Second one separation of ownership and management. Well, we've identified the fact and maybe it's just an implicit bias that I hold that innovation is a really important thing, and we should want a society that constantly innovates. Healthy innovation, I think, is promoted by the separation of ownership and management. In my experience, shareholders are so risk seeking that they would otherwise take risks that would crash on a valuable business, but, on the other hand, management is so risk averse that they're likely to crush an otherwise valuable innovation, and so the balance struck by the separation of management and ownership in firms provides innovation to proceed, but not to proceed willy-nilly.
Speaker 1:Third limited liability. Well, recall that when we discuss the formation of firms, equity owners are not liable for any claims against the firm or against the employees of the firm for things that they did or things that they failed to do. It turns out that limited liability is a crucially important part of how capital markets can properly allocate capital to risky uses and promote innovation. Why anyone would commit capital to a firm if they were going to ultimately be responsible for the firm's liabilities? Think of uses where the probability of something bad happening is very small, but the harm that could be caused is enormous. Airlines why would anybody provide capital to an airline when planes were first invented and someone had the idea that we should fly people around the country in these bodies? No one would do it if shareholders could be liable for the harm. Drug companies Imagine the drug company that could attract capital where its shareholders would be liable if the drug unwittingly I'm not talking about bad actors here, but where the drug is unwittingly causing a problem. Ai Imagine if an investor in AI could be held liable for the harms committed by someone who uses the tool. By limiting liability to a firm's assets, investors are more likely to fund risky uses and thus, I think, promote innovation.
Speaker 1:The last point that I want to raise here as being a very important dimension of the functioning of capital markets may be the most surprising, but I think it is also the most important. That is, democratic institutions I'm using democratic here with a little d Governments. Systems might seem value neutral, but societies are not value neutral and markets are made up of the members of that society. So it's impossible for me to imagine that markets are value neutral. Tastes and preferences of households and firms depend a lot on the distribution of income and social status and education and so many other things, that accepting a market as value neutral is really to accept the current distribution of income or the current education as socially acceptable. That is to say, markets don't are not value neutral, but simply mirror the present distribution in a society.
Speaker 1:The second point to be made here is that market systems, if left to their own devices, are prone to maximize the returns on capital at the expense of the returns to labor. There's a great literature on this topic and there's a wonderful book by Pinkity that talks about this as well. The main point for you to take, I think, is that the nature of a capital system is that firms will always seek to pay capital providers before they pay labor providers, and that's a puzzle in economics because, honestly, it seems to me equally important that you have both inputs to run a firm. So it might make GDP go up, but it does so with significant economic costs the rise of inequality, the rise of income inequality, the rise of wealth inequality has very powerful negative effects on productivity and economic growth, and so a market system left to its own devices without any adjustment will increasingly become its own enemy.
Speaker 1:Here's another quote from Keynes, this time from his book the End of Laissez-Faire. Laissez-faire describes a period in economic history leading up to World War I, basically where governments took the view that it was not the role of government to interfere in markets, that markets should be left to their own devices. Many of the greatest economic evils of our time are the fruits of risk, uncertainty and ignorance. It's because particular individuals, fortunate in situation or abilities, are able to take advantage of uncertainty and ignorance, and it's also because, for the same reason, big businesses often allotter that great inequalities of wealth come about. And these same factors are also the cause of the unemployment of labor or the disappointment of reasonable business expectations or the impairment of efficiency and productions. Yet the cure Keynes told us quote lies outside the operation of individuals. It may even be to the interest of individuals to aggregate the disease.
Speaker 1:Keynes' point here is that people don't calculate their decisions in cold economic terms and calculate them in ways that the neoclassical economists would teach us they do. Instead, humans use forms of bounded rationality and they use views on things like morality and altruism, community conformity, in order to alter these views. These views, by the way, don't exist in a vacuum. We live in a world in which technology allows views to be transmitted instantaneously and greatly affect millions of people, more rapidly than it's ever been possible. And so simply allowing quote the market to work end quote will distort the social benefits of the allocation of capital. And it will distort it because it takes into account views that may or may not be relatable to what the economic goal is, but, more importantly, because they may be inconsistent with society's goals.
Speaker 1:Markets are creatures of local custom, norms and structures, and so we can't assume that quote market competition is a sufficiently broad frame to understand how they work best. It's naive, I would argue, to say we should just leave the market free to compete in any way that it likes. It doesn't make sense. Economies mirror biological evolution, and that shouldn't be so strange. Economies are made up of people and we are biological entities. Biological entities involve in a way that scientists call path dependent. It means how you start and the direction you're heading in has a lot more to do with what changes occur than anything else, and that path dependence is constrained by you guessed it previous conditions and inertia.
Speaker 1:Innovation doesn't occur simply because we use markets to allocate capital. It occurs because we're human, and as humans we seek innovation in order to respond to current conditions and current constraints. So the economy is really a subset of our biophysical systems in the planet. It depends on the natural environment. Our economy, markets, depend on the natural environment to provide resources, assimilate wastes and provide support to all of us. The typical assumption is that markets behave in linear ways, that people just compute costs and benefits and make decisions. But this ignores the way natural systems operate. They're not linear. Natural systems are very complex, with a range of thresholds and tipping points which can create really catastrophic change.
Speaker 1:To highlight this, john Kenneth Galbraith, another very famous economist, explained in his book the Affluent Society that a market's drive to maximize economic growth is really at odds with itself. Since the quality of life is not subject to market forces, economists would call it an externality. A market-based society would, galbraith argued, end up with dirty parks. Society would work longer hours if the parks were dirty. In fact, if the parks were not clean, they might work fewer hours because they don't have any pleasant way of spending their free time. And if parks are not clean and people work less, then the economy would suffer. But Galbraith argued the parks are not going to get clean unless someone makes the political judgment that they should be clean. A market is not going to cause that to happen. What he was doing is Galbraith is channeling Keynes' idea, first expressed shortly after World War.
Speaker 1:I quote the important thing for government is not to do things which individuals are doing already and to do them a little better or a little worse, but to do those things which at present are not going to happen, are not done at all. So, as a result, a feature of a strong market economy includes active involvement of government in many decisions about the allocation of capital, not because we don't trust the market to behave, but precisely because the market is not value neutral and we as humans are value creatures. Think about some of the things that government does, basic things that no one would really take issue with that affect the allocation of capital Our system of income taxation. In the United States we tax those with more income at a rate higher than those with less income. We also tax income earned from labor at a far higher rate than we tax income earned on capital. Those have very, very specific effects on the allocation of capital and it's a value judgment.
Speaker 1:It's not that we don't think markets work well or not work well. It's because we try to achieve another goal we limit the kinds of weapons that can be manufactured in this country and be sold. There's a great debate about guns in this country and it's a terribly important debate, but it's important to understand that the answer can't be just let the market function, because I might want a shoulder rocket launcher but I can't buy one, even if I wanted one. We restrict and in many, many places, prohibit prostitution, but why? Why should we not allow a person to sell their body for sex in a market system? Answer because we have a moral view. You could say the same about child labor, minimum wage and maximum hours laws.
Speaker 1:The point is that democratic institutions are very, very important in keeping in check the kinds of decisions that a capital system would make on its own. Now let's not imagine this is a crazy idea. We still leave a lot of really important decisions to the market alone. Genetically modified foods there are people with very strong views on this, but as of yet in the United States we don't restrict the market's behavior. The use of plastic in production Again very good and very compelling reasons, but we don't restrict the market from allocating capital in those ways.
Speaker 1:The division of profits between capital and labor here to 1975, there was a roughly equal split between firms excess income retained earnings as it was paid to shareholders in the form of dividends or paid to employees in the form of wages roughly equal split. Since the mid 1970s that has radically changed and now a vast majority something to the tune of 70% of the profits of a firm, after all of its expenses, are dedicated to owners of capital and 30% are dedicated to labor. We leave that up to the market to decide, but we don't have to. That's a notion that should be expelled from your mind. If you think that a podcast discussing markets and investing takes a view that there's just nothing to be done when markets drive to excess as they do, they're built to do it. Democratic institutions can check market behaviors and, in the end, protect them from their own inherent flaws.
Speaker 1:I'll finish with a very concise quote from John Keynes. In a piece entitled Am I a Liberal? He wrote the political problem of mankind is to combine three things Economic efficiency, social justice and individual liberty. That's it for the podcast. Thanks for listening. We'll see you next time. You've been listening to Not Another Investment Podcast hosted by me, edward Finley. You can find research links and charts at NotAnotherInvestmentPodcastcom. Don't forget to subscribe and leave a review of the podcast. Thanks for listening.
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