The End of Finance

Capital Market Inflation, Financial Derivatives and Pension Fund Capitalism

Jan Toporowski

• Publisher: Routledge
• Year: 2002
• Print ISBN: 9780415208819
• eBook ISBN: 9781134618279
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This volume develops an original critique of the belief that the present era of finance, where finance markets dominate contemporary capitalist economies, represents the best possible way of organising economic affairs. In fact, it is argued, the ensuing economic instability and inefficiency create the preconditions for the end of the dominance of finance. The End of Finance develops a theory of capital market inflation rooted in the work of Veblen, Kalecki, Keynes and Minsky, demonstrating how it disinclines productive activity on the part of firms, provides only short-term conditions that are propitious for privatisation and distorts monetary policy in the long-term. The author examines the role of pension fund schemes and financial derivatives in transmitting capital market inflation and provides a nuanced analysis of the contradictory role they play in the financial system. Capital market inflation is also examined in its historical context and compared with past inflations, in particular the South Sea and Mississippi Bubbles, which spawned the first financial derivatives, and the first privatisations. This broad historical vision allows us to see these forms of inflation as temporary and provisional in character.

Part I: The theory of capital market inflation

1 Capital markets and the real economy

1.1 ‘Outside’ finance and industry

Almost without exception, contemporary economic theory extols capital markets as the financiers and controlling mechanism of the capitalist system. The financial failures of government-owned enterprises and the less developed countries are commonly attributed to the absence of capital market constraints on their profligacy. This is epitomized in the standard textbook view of these markets:

The buying and selling of existing stock is important in ensuring that quoted firms remain efficient and seek to maximize their profits … The stock market encourages efficiency and profitability of firms and thereby benefits the economy in general … A well-developed stock market with a high degree of liquidity therefore helps to both increase the volume of new issues and their costs …

The performance of the stock market also has both a direct wealth effect on expenditure decisions and also an important confidence influence on economic agents. As the real value of shares rises, the wealth and usually the confidence of economic agents is raised, this encourages greater expenditure and investment which can reduce unemployment and contributes to economic growth. If the stockmarket is performing poorly this tends to lower agents’ wealth and confidence, and generally has an adverse impact on the economy.¹

But the most cursory historical research reveals that capital markets have only recently taken up their present role of financing capitalist enterprise. The theorist who identified capitalism with the development of markets, Adam Smith, makes only incidental mention of capital markets, obviously because in his lifetime their existence was still tenuous.² He was, moreover, sceptical about the usefulness of the joint stock system arguing that, without exclusive monopolies, it was suitable only for financing operations that

are capable of being reduced to what is called routine, or to such a uniformity of method as admits little or no variation. Of this kind is, first, the banking trade; secondly the trade of insurance from fire and from seas risk, and capture in time of war; thirdly the trade of making and maintaining a navigable cut or canal; and, fourthly, the similar trade of bringing water for the supply of a great city.³

The main condition for the development of equity (common stock) markets, the joint stock system of company ownership, did not become legal for industrial companies in industrialized countries until the 1860s. Even then, the key actual function of the capital market was not the creation of a market that would allow capital to be switched between companies, but the tapping of the wealth of the old, principally landed, upper classes, in order to provide finance for the enterprises needed to establish the new capital-intensive industries of the second half of the nineteenth century: railways, shipbuilding and public utilities, such as Smith’s water supply companies. In the British Empire and the Americas, this was done by the setting up of stock exchanges in which the wealthy were encouraged to keep their money capital, and through which trust companies and insurance funds invested long-term household savings. In this way, the problem of under-financing of entrepreneurs, first identified by the early nineteenth-century French utopian socialist thinker Claude Henri Saint-Simon, could be overcome.⁴

In the years that followed the 1860s, entrepreneurs refinanced their investments through those markets. However, where stock was issued to finance investment, for example in railways, this proved in general to be a highly speculative and frequently financially disastrous enterprise. In France and continental Europe, where a crédit mobilier system of banking developed under the influence of Saint-Simon’s ideas, banks have tended to provide more flexible forms of finance.⁵

The emergence of the joint stock system in industry, whether mediated through stock markets or banks, altered the capitalist system in a fundamental way. Under the previous system of entrepreneurial capitalism, the owner of an enterprise committed his finances fully to that enterprise. In a recession, the owner had no means of withdrawing his capital and hence was forced to continue to finance his company for as long as he had money or there was a reasonable hope of recovery. By contrast, in the rentier capitalism that was the outcome of the joint stock system, the owners’ risks are diversified. Through the capital market, those owners may more easily liquidate their interests in a company experiencing difficulties, providing there are buyers of their stock. If there are no buyers, then the shares are in effect suspended and the owners of such a company have to liquidate the company to retrieve their money. Thus the benefits of greater access to finance for companies that a capital market affords are offset to some degree by the weaker commitment of the owners to their enterprise.⁶ This increases the risks attendant upon capital market financing of fixed capital investment, and is the reason why ‘rational’ entrepreneurs occasionally ‘go private’ by buying out their less committed shareholders.

The analysis in this chapter does not, on the whole, distinguish between equity (common stock) and bond markets. When equity is sold in a capital market, the commitment of its owners to the economic success of their companies is, as we shall argue, impermanent: a fictional remnant of entrepreneurial capitalism prior to the establishment of capital markets. New financial market instruments, such as perpetual floating rate bonds, have blurred the distinction between the two types of financial paper and such instruments are frequently treated by, for example, bank regulators as equivalent, or near equivalent, to equity (common stock). Moreover, the degree to which companies continued to pay dividends on their equity even when making a loss during the slump of the 1930s, and the economic recessions of the early 1980s and the early 1990s, confirms that modern corporations in effect regard the shares that they issue as a liability.

Already in the 1930s Keynes had noted with characteristically eloquent disapproval the tendency to treat all securities as traded commodities rather than a long-term commitment to the enterprises issuing those shares.⁷ More recent moves towards centralized electronic share registration have been justified precisely on the grounds that this facilitates the rapid turnover of their ownership. Official bodies such as the UK’s Greenbury Committee on corporate governance may echo Adam Smith in lamenting the decline of corporate ownership to the status of merely holding financial claims on companies.⁸ But, in this respect, it has made corporate ownership indistinguishable from a company’s other financial liabilities.

For the two classes of capital market instruments to be fully equivalent, bonds need to have the facility to be ‘rolled over’ when they mature, making them effectively perpetual. Most financial centres are sufficiently efficient to allow companies this facility. Where they do not, or charge a punitive price for it, this of course makes common stocks less equivalent to bonds. But, such circumstances add to, rather than diminish, the capital market risks described below. Nevertheless, it is fairly realistic to assume that equity (common stock) bought and sold through capital markets is in practice, like bonds, a liability, albeit one on which a different pattern of payments is allowed.⁹ From the point of view of non-financial companies, the crucial distinction in corporate finance is between the internal funds of the company, and external bank and capital market finance which creates a liability against the company.¹⁰ In Part II, where the differences between the liquidity of equity (common stock) and that of bonds are examined more closely, it becomes apparent that these differences are more significant for investing institutions at times of capital market disintermediation than for industrial and commercial companies.

The link between companies and the capital markets in general (i.e., bond and equity markets), and the flow of finance into those markets, is the basis of capital market activity and values. The interaction of companies with the capital markets does not occur in any random way. Nor does it occur by means of arriving at a series of equilibrium positions in the capital markets that are determined by the productivity of real capital, as current finance theory maintains. In fact, this interaction depends on what the capital markets do for companies in the real economy, and what those companies do with the capital raised in those markets. These determine the flows of funds between the corporate sector and the capital markets. Such financial flows are the chief means by which the capital markets influence their listed companies.

Whereas neo-classical theory emphasizes the speed with which the price mechanism in capital markets operates to bring them (and by implication) the corporate sector into equilibrium, this chapter argues that in the real world capital markets are a factor that strains corporate sector finances and exacerbates disequilibrium in that sector. For this reason capital markets are used in practice to refinance the reserves and productive capital of companies, rather than as initial finance for new fixed capital investment. A consequence of this refinancing mechanism is that it causes extreme shifts in corporate liquidity over the period of the trade cycle.

1.2 Liquidity and capital markets

The conventional view is that the capital markets supply ‘factor services’ to the real economy, i.e., they collect up the savings of households and advance them to entrepreneurs as capital, in return for which entrepreneurs pay out of the operating profits of their companies dividends and interest to households in proportion to the capital advanced and the ‘riskiness’ of the enterprise.¹¹ An equilibrium is supposed to be achieved between the demand of entrepreneurs for finance and its supply by rentiers (holders of financial wealth) by some explicit, or implicit, auction of the finance available, in accordance with the market principles of supply and demand.¹²

However, in the process of actual financial intermediation no such auction actually takes place. Let us suppose that there is a new inflow of money into the capital market. This may be from a company taking over another company, and therefore purchasing the shares of the target company. It could also be from an individual financial investor with additional money (say from interest or dividend payments) which he wishes to invest in the capital market. He decides on the stock which he wishes to buy and instructs a broker on the purchase. But this money does not end up in the account of anyone raising finance on the stock market. It ends up in the account of a second financial investor who sold the first stock to the first investor. The second investor is then likely to use that money to buy another stock, from a third investor, who will then use the money to buy some third stock from a fourth investor. In the case of the money which a company might use to pay for a takeover, the shareholders of the target company will similarly find themselves with additional money, and less stock. They will therefore use that money to buy stock from a third set of stockholders.

In this way, the initial money inflow will circulate around the capital market until it is taken out by a final investor, or rentier, who wishes to use the money for some other purpose (say buying a holiday home), or by the government issuing a bond, or by a company issuing a stock or share. Market intermediaries, such as brokers or ‘market-makers’ have the function of balancing the potentially inconsistent sale and purchase orders of these investors with accommodating sales and purchases of their own stocks. An obvious feature of such financial circulation is that there is no ‘equilibrium’. Exchange continues until the liquidity put into the market is taken out or, if the initial transaction was a sale, until the money taken out of the market is replaced by a buyer putting liquidity into the market.

Even if the initial money inflow is eventually taken out by an industrial company, there is no auction mechanism to ensure that the funds obtained are applied to the most profitable projects in the real economy. The issue of new stock (the so-called primary market) is separated from the initial money inflow in time and in place by the many intermediary portfolio switches that eventually bring the money inflow to the company. The price or yield at which new stock may be issued, which we call the effective price,¹³ may depend on the liquidity of the market at the time of issue, but it is not likely to be applied in practice as a minimum required return on new industrial or commercial investment. Most stocks are issued to replace other stocks or debt. Others are used to replace the internal liquidity of companies, that has already been used up either in capital investment or, in a period of capital market inflation, on corporate restructuring (mergers and acquisitions). The yield or price of a new stock is in practice the price of internal liquidity, rather than the opportunity cost of fixed capital investment, whose return in any case varies over the business cycle. The remainder of this chapter examines the reasons why companies prefer to use finance to manage liquidity rather than to buy additional productive capacity.

According to the most common view of finance, entrepreneurs are supposed to take the money put into the capital market and employ it in their business, as a ‘factor’, like land or labour, to generate sales revenue.¹⁴ More specifically, entrepreneurs are supposed to use it to meet occasional working capital shortfalls or to purchase premises, plant and equipment (‘fixed’ capital). In this way, finance capital is supposed, by its own productivity, to generate additional profits.¹⁵

However, in business, working capital is usually more conveniently financed by bank short-term loans or overdraft facilities, or even bills and letters of credit. As for fixed capital investment, capital markets are inappropriate sources of finance for two principal reasons.

First of all, capital markets are inherently unstable, alternating between periods of liquidity in ‘bull’ markets when finance for enterprise is easily – perhaps too easily – raised and periods of illiquidity, when financiers tend to be over-cautious about advancing medium- and long-term funds for industrial and commercial enterprises. Broadly speaking, the liquidity of a long-term asset is the availability of a purchaser for it at a more than nominal price.¹⁶ Whereas bonds have an assured ‘residual’ liquidity when they are repaid, in the markets for equity or common stock the liquidity of stocks varies in proportion to the rate of change of securities prices. When equity prices are rising, there are plenty of buyers and sellers around wishing to cash in on capital gains. However, when prices are falling, buyers are more likely to seek alternative, more promising investments. Some sellers may become reluctant to realize losses on their investment, but even those wanting to avoid further losses by getting out of the market are likely to become ‘locked into’ their investment by an absence of buyers. In this way, the normal price mechanism that brings into equilibrium supply with demand breaks down because falling prices cause buyers to flee the market rather than stimulating their demand.

Capital markets normally fluctuate between this liquidity and illiquidity in association with the trade cycle. The markets are therefore likely to overcapitalize a company in a boom and they can shut off the flow of capital funds to that company in a recession. These swings between liquidity and illiquidity may be exacerbated by changes in monetary policy over the business cycle (see Chapter 3, section 3.2).

This has a crucial bearing on a company’s finances and any fixed capital investment programme that it may undertake. Such investment requires stable and assured finance. Over-capitalization will tend to leave a company with large financing costs, and the prospect of difficulties in meeting those costs out of its cash flow when the boom turns into recession. Although the issue of capital market instruments raises cash, that cash is the asset counter-part of the capital market liabilities. If the company buys other assets for that cash, the return on them must be at least as good as its payments commitments to the capital markets. There may appear to be many such opportunities in the boom, but they will almost inevitably bring reduced returns in a recession. If the proceeds of a capital market issue are retained as cash, i.e. banked, then the credit represented by the bank deposits remains the asset counterpart of capital market liabilities. But because it is on the company’s account at the bank, it is indistinguishable from internally generated funds, so that it is more likely to be used speculatively on ventures which bring little or no return, or used to service capital market obligations which cannot be ‘rolled over’ when the capital marke...

Table of contents

• Cover Page
• Half Title page
• Title Page
• Dedication
• Contents
• List of illustrations
• Foreword
• Introduction: Antecedents and methodology
• Part I The theory of capital market inflation
• Part II Ponzi finance and pension fund capitalism
• Part III Financial derivatives and liquidity preference
• Part IV Conclusion
• Notes
• Bibliography
• Index