Originally published November 3, 1986
WITH ITS characteristic penchant for triviality the daily press’ stories out the deregulation of British financial institutions (a.k.a. the Big Bang) have concentrated on the consequences, or lack thereof, for the traditional City of London man with his bowler and his tightly rolled umbrella. Will he be able to compete with Yahoos in shirtsleeves? Perhaps this is as it should be, since the consequences for the rest of the world are only as great as it allows them to be, and the rest of the world has already made its decision evident in Tokyo and Zurich and the Bahamas and New York and even in Chicago.
For a variety of reasons – some doctrinaire and some pragmatic – the world has already decided that international finance should not or cannot be regulated. Computers are too fast, and their ways too mysterious. While it would take you six months, together with fees to two teams of lawyers, premium to at least one title company and a half inch pile of paperwork, to induce your friendly banker to spring for a $50,000 mortgage, that same banker will transfer $50 million to an arbitrager in Hong Kong in the twinkling of an eye. He will have your notarized signature many times on all that paper to show for his deal with you; the Hong Kong deal will be recorded only as an electrical impulse in a computer.
The money may come back, via another blip, as the earth turns. In these circumstances, the pragmatic may well lie back and enjoy it. Margaret Thatcher’s Britain, which has now done this, and Ronald Reagan’s America, which would dearly like to do this, both also have doctrine to sustain them. Untrammeled finance, they believe, makes for liquidity, and liquidity encourages investment, and investment means production, and production means prosperity. They’re right on the first and last points.
The liquidity part of the story is limpidly clear. Give bankers and brokers and insurance companies their heads, and they’ll make your head swim. It is not, however, clear exactly what is liquid. A Singapore computer chatting up one in London doesn’t make it noticeably easier to sell a shirtwaist factory in Katmandu or a spare forklift truck in Trondheim. These things are as solid and stolid as they ever were, and are correspondingly unattractive to speculators; consequently, the new liquidity doesn’t stimulate the production of more of them.
International liquidity may make it somewhat easier to sell a large company, but this does not mean the sale stimulates the creation of anything new. There is no need to create a company in order to sell it; it is much easier to play with what is at hand.
International finance may make it somewhat easier for a large company to borrow large sums. Eurodollars are available, because of the lack of regulation, at a slightly lower rate of interest than domestic dollars. If the Reagan Administration gets its way, this differential will disappear (and if I had my way, it would not be available).
So what is left for international liquidity to do? It comes down to speculation in existing securities or in securities issued for the purpose of speculation. Back in THE NEW LEADER for April 19, 1982, Henry C. Wallich, a governor of the Federal Reserve Board, took me to task for not recognizing that liquid securities make everything liquid. “Eventually,” he wrote, “the money [resulting from a speculative coup] will find an outlet in directly productive new investment, unless it is consumed or hoarded.” I replied that there is a fourth possibility, which is by far the most likely – namely increased speculation. You have only to read the Wall Street gossip columns to know this is so. The economy may be essentially flat, yet day after day investors run from one takeover rumor to another; and if T. Boone Pickens squints his eyes, feverish attempts are made to discover the meaning.
The difference between Governor Wallich and me is by no means an idle one. If I am right, speculation will tend to pre-empt whatever money the banking system makes available, and productive industry will be starved. In addition, the very existence of a speculative market introduces a Catch 22. Because speculation encourages and thrives on running up the prices of securities, it will tend to reduce the earnings ratio of companies that attract its attention. A company that earns $5 a share has a price earnings ratio of 5 per cent if its stock sells for $100 a share; once the stock takes a modest run up to $125, its PE ratio will naturally fall to 4 per cent.
There are repercussions on Main Street and Commercial Street, too. When the company’s financial officer needs the usual line of credit to tide the firm over from the start of a production run to the time, a few or several months away, when income will start flowing from production, he has his regular lunch with the company’s friendly banker. The latter is unexpectedly cool and murmurs that in view of the falling PE ratio he’ll have to ask another half a point for the credit. The next day the principal stockholder, speaking for his sisters and his cousins and his aunts (their grandfather started the company), phones the company president all the way from his yacht in English Harbor, Antigua. He notes that many other stocks have a better PE ratio and wonders what can be done. Should he and the ladies mortify their family pride and sell out, or can the president somehow improve the picture?
Now, it is obvious that, in what are called real terms, the company is as good as it’s ever been and earns as much in dollars and cents as it ever did. The banker and the stockholder (who have contrary concerns) may even be bright enough to understand this, but they are also bight enough to see that they might make more money or safer money by lending or investing elsewhere. They have other options.
The company’s management has options, too, except they are more limited. They can try to increase income, a reduce expenses, or both. Increasing income isn’t the easiest thing to do. Sales can be improved by introducing new products, but that takes time and money, neither of which the company has enough of. Sales also can be improved, at least in theory, by cutting prices; but if the company has been reasonably well managed, its prices are already at the most profitable level.
That leaves the option of reducing expenses. This can certainly be done, and done quickly. Advertising campaigns can be trimmed or aborted; all it takes is a phone call to the agency. Production runs can be cut back and inventory allowed to run down. And of course people can be fired. In the long run-and in the situation we’re imagining, six months can be a long run-these cost-cutting measures may prove counterproductive. You have to spend a dollar to make a dollar; the absolutely perfect way to cut costs is to go out of business.
We don’t have to carry our story any further to see that, no matter how it comes out, bankers and stockholders have more options than do corporation managers and workers. The money that bankers and stockholders invest is more liquid than the sweat and tears the active people invest. Securities are more liquid than people. Workers and managers have personal commitments and can’t easily relocate even when jobs are available.
EVERY KIND of activity is risky, but the liquidity of securities reduces the risk involved in investing them. Liquidity also makes volatile trading possible, with sudden shifts of position to pick up a fraction of a point. Fortunes can be made very fast that way (see “New Ways to Get Rich,” NL, September 8). In contrast, it generally takes a lifetime to accumulate a modest retirement nest egg merely by working hard at producing something.
Traditional economists have built their theories on the notion that people are inherently or rationally or necessarily profit maximizers. I don’t myself hold with the notion, but I’m going to accept it here to meet the traditionalists on their own ground. On this ground, it is clear that a speculator who makes a killing in one speculation will look around for more of the same. Only a foolish profit maximizer would ever commit himself (or herself) to a “directly productive new investment,” especially one that required any hands-on productive work of him (or her). That is why the money growth the Federal Reserve Board has allowed since 1982 has gone into the run-ups of the securities and commodities markets, and not into what Governor Wallich called “brick and mortar.” Speculation is a problem, and it is not one that cures itself.
There are, to be sure, some economists who believe that speculation is actually beneficial. They base their arguments on Ludwig von Mises‘ dictum, “Action is always speculation.” To the extent that Mises meant what’s to come is still unsure, he was of course perfectly correct. Moreover, every business tries, within limits, to buy its inputs as cheaply as it can and to sell its outputs as dearly as it can, and so sometimes makes (or loses) a dollar on inventory. But this is not all that a business does. It adds value to what it takes in, and what it puts out increases the goods the rest of us can enjoy. Speculators or financial institutions attempt to increase price, but add no value. They avoid taking physical possession of and physically working with the things denominated in their bonds.
These are the people and institutions who will benefit from the Big Bang. Internationalizing Britain’s financial markets may give employment to a few hundred Yahoos in shirtsleeves, but it will do nothing for productive industry, either in Britain or anywhere else in the world. If we had any sense, we’d keep ourselves and our money out of it.
The New Leader