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Originally published December 29, 1986

JUDGING from newspaper reports, Professor James M. Buchanan of George Mason University won the Nobel Memorial Prize in Economics last October for discovering that politicians try to get re-elected, and that bureaucrats try to keep their jobs. This, you will admit, is a very great discovery and something that had not occurred to anyone else, before. How we got along until now, I can’t imagine; and how our new knowledge will change us, I can’t guess. It is reputed to be a powerful tool for prophesying, but it leaves me so breathless I haven’t the strength to wield it.

The professor is said to have come to his world-shattering notion as a result of studying economics at the University of Chicago, where he learned about Adam Smith and the invisible hand that produces results more socially desirable than those (if any) intended by profit maximizing economic men. However, declares the professor, the self-seeking of economic man is good, while the self-seeking of political man is bad. On the basis of this distinction, he joins (or leads a phalanx of) the radical Right that wants to do away with most government (except, perhaps, the Department of Defense), to deregulate everything, to require a balanced budget by constitutional amendment, and all the rest.

There is another distinction to be made: that between elective and bureaucratic officials. The elective is not all bad. On the positive side, “Persons or parties that seek to represent the interests of voters compete for approval or favor much in the manner as do the sellers of products in imperfectly competitive markets for private goods and services.” On the negative side, “Re-election prospects tend to keep the self-interests of politicians within the reasonable range of the median voter, but there is nothing to channel outcomes toward the needs of non-median voting groups.” (The professor is probably unaware of how ill the private producers of movies serve non-median curmudgeons like me.)

As for bureaucrats, they are all bad. “The bureaucracy can playoff one set of constituents against the others, insuring that budgets rise much beyond plausible efficiency limits.”

What Professor Buchanan says about politicians may well be true, yet it does not follow that the world of laissez- faire is free from questionable consequences. It is in the self-interest of a sharp fellow like the original Rockefeller to persuade suppliers to give him kickbacks, and it is in the self-interest of moneybags like the original Morgan to water stock. It is in the self-interest of surgeons to advise unnecessary surgery, and it is in the self interest of brokers to form pools in which suckers can take a bath while losing their shirts (see Junk Bonds and Watered Stock, NL, March 24, 1986).

I fail to see the public good that flows from these self-interests, or the public harm that flows from their regulation. I also note that the few public servants with their hands in the till don’t salt away as much in a lifetime as a corporate raider may in an afternoon. In short, a balanced-budget amendment might make some kind of sense if offered in tandem with a maximum-income-and wealth amendment.

The reason why Professor Buchanan favors the former and would be horrified at the latter is the doctrine that competition forces prices down. It stands to reason that it does, say traditional economists, because the best way to take business from your competitors is to underprice them. For the moment , let’s put to one side what every business man knows, namely that a more effective way to take business is to out-advertise and out-merchandise the competition: Don’t sell the steak, sell the sizzle. Politicians, too, know that this is the way to do it.)

Thus taking leave of the actual let’s explore the world of traditional doctrine, where competition forces prices down and down, until they hit cost and can go no lower this side of bankruptcy. Of course, when prices hit costs, there’s no room left for profit, and the profit system turns out to be profitless. Let’s put this paradox to one side, too and look more closely at costs.

One man’s cost is another man’s price. A firm’s labor costs are its workers’ prices (wages).A cost-conscious firm must try to get these costs down. It will also do what it can to buy its supplies – raw materials, partially finished goods, parts, whatever-at the lowest possible rates. To do this, it will stimulate competition among its suppliers, making them as cost-conscious as it is. Each cost-conscious supplier will then act as did the original firm. It will squeeze its own labor force, and it will hope to find its own suppliers competing among themselves. And so on. We have an infinite regress.

Adam Smith seemed to halt this regress by making the value of labor equal to the goods workers must buy in order to keep themselves going: the simplest food, the cheapest clothing, the minimum shelter-the bare necessities of life. The cost of labor cannot fall beyond the cost of these necessities, for the labor could not sustain itself; therefore their cost is the irreducible cost upon which the price system is based.

Yet these goods are produced, too, and produced exactly as other goods are. A firm producing them can reduce its prices by controlling its costs in the same ways other firms do. There is thus no minimum or final or “natural” price for the goods laborers must buy; consequently no determinate system of costs or prices or values. The regress continues.

But if the regress truly continued all prices under competitive conditions would approach zero, and so would all costs and all incomes. Somehow this bizarre situation never develops; somehow the regress stops.  How does it stop? In the only way a regress can stop: It never actually gets started.

THE SYSTEM does not follow the pattern traditional economics says it does. Prices are not forced down to costs, because firms, even when competing on the basis of price, do not set their prices in auction. As the late Sidney Weintraub showed, prices are set with a certain markup in mind; and

as the late Arthur Okun showed, firms also have a certain sales volume in mind. If the sales don’t develop, production is cut. A distress sale may be held, but seldom is an effort made to continue production by cutting price. On the other hand, in the happy case where sales are greater than expected, production is increased and profits pocketed, but price is not ordinarily altered.

Manufacturing firms act in this fashion because they are ongoing organizations. Their capital investment is such that a flow of income is more important to them than a sporadic killing, and steady customers more valuable than casual bargain hunters. They set their prices in the hope of maintaining that flow into the future, and they strive to build a reliable clientele on the basis of their own reliability in observing the industry’s customs-what Okun called the invisible handshake.

The most crucial point is that modern industrialists set their prices. Farmers set their production level and take whatever the market will pay them. Manufacturers are price setters and quantity takers: They set their prices and take whatever sales they can wrest from the market. Setting a price is an act of will.  It is a free act. It is determining, not determined. Like all acts, it is limited. It is an event in an actual, articulated world with a past and a future, not an imaginary world without time. You cannot effectively price your wares at a tenth of the going price or at 10 times the going price. Whatever price you set has consequences.

Price determination is not the only willful act in business. The decision to be a haberdasher instead of a bookseller is similarly willful. Determining the prices of shirts and ties is secondary and subordinate to deciding to be a haberdasher, and also to deciding what clientele one intends to attract, what kind of haberdasher one intends to be.

With willful acts we arrest the infinite regress. When we say, “This is what I offer,” “This is what I’ll sell at that price,” “This is what I’ll buy at that price,” we launch ourselves into the future: we progress, not regress. Accepting-seeking, rather-the consequences of our action, we declare our membership in, and responsibility to, the real world.

In conclusion, let me reward your perseverance in reading this far by allowing you to be among the first to hear of Brockway’s Paradox. Professor Buchanan (to get back to him) thinks that perfectly selfish competitors drive prices down to cost. But Brockway’s Paradox calls your attention to the fact that perfectly altruistic producers would also set their prices at cost. In physics, you’ d suspect an error in your observing or your reasoning if both freezing and heating caused water to boil. The solution to the Paradox? Economics isn’t about either selfishness or altruism; it is about right and wrong.

 The New Leader

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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

Originally published October 6, 1986

BERYL W. SPRINKEL has given up on monetarism, at least for now. He said as much in a speech recently and stirred some excitement because of who he is. Not only is he the possessor of the most striking public name since Orval Faubus ; he is the chairman of the Council of Economic Advisers and presumably talks things over with President Reagan, so what he says may foreshadow a shift in Administration policy.

Monetarism has had the great tactical advantage of massaging the egos of the wealthy, and especially of conservative bankers who serve the wealthy. It has as many definitions as it has definers, but all of them are based on the Quantity Theory of Money, a very old idea that treats money as simply another commodity. It then seems plausible to say that at any given moment a country has a certain quantity of money and a certain price level, at which, for example, a subscription to THE NEW LEADER costs $24 (and is a bargain).  Suppose that at midnight tonight President Reagan or Federal Reserve Chairman Paul A. Volcker or the Sugar Plum Fairy decreed that every dollar you have is hereafter worth two dollars. Would you now be able to buy two subscriptions, sending one to an intellectually needy friend?

Not likely. The first order of business at 275 Seventh Avenue tomorrow morning would be to raise the subscription price to $48. The same thing would happen throughout the economy, so that, subject to considerable slippage because of existing contracts, doubling the quantity of money would merely double the prices of goods and services.

The plausibility of the theory was great in the days when money appeared to be merely a physical object-gold, silver, seashells, or whatnot. But money never was merely a physical object (for reasons, I refer you to my book Economics: What Went Wrong and Why), and it certainly is not now. It is, as the late Professor John William Miller said in The Midworld, a functioning object. That is, it is an object, all right -a piece of metal, a piece of paper, a blip on a computer screen-but what matters is how it functions, not its physical composition. It is not simply another commodity; it is a standard or a control, as is, say, language or a yardstick. A language functions whether it is embodied in sound waves or marks on paper, and a yardstick functions whether it is made of maple or stainless steel. Of course, it doesn’t much matter what a hammer is made of, either, but a hammer is merely a useful tool (glue, or nuts and bolts, could do the job as well as nailing), while nothing can be built-space cannot be organized-without some measuring object.

This may sound pretty metaphysical, and it is, but I’m afraid we must go a step further in that direction. The Quantity Theory will acknowledge that, as a practical matter, it is difficult-indeed impossible-to count the amount of money a nation has. The very existence of the different quantities – M-l, M-2, M-3, and the rest – underlines the point. On the other hand, it is also impossible, as a practical matter, to count the number of electrons in a burst of energy. With electrons, however, it is possible to say that there is a definite number (despite our not knowing precisely what it is), that the number stands in some definite relation (which may also be unknown) to something else, and that therefore we can construct equations capable of yielding reliable predictions.

The trouble with money is that there is not ever a definite amount of it, just as there is not ever a definite number of thoughts expressed in language. Like language, money doesn’t even exist except as it is functioning. “If the coin be lockt up in chests,” wrote David Hume, ‘” tis the same thing with regard to prices as if it were annihilated.” What is true of coin is surely true of credit, the fundamental form of money.

This truth reveals itself in two consequences, one theoretical and one practical. The theoretical consequence is that the attempt to state the Quantity Theory in an equation (MV = PY) results in a sterile tautology. In words, the equation says that the quantity of money (M) times the velocity of its circulation (V) is equal to the general price level (P) times the goods produced (Y). For a fuller explanation I must again refer you to my book; but for present purposes it is enough to see that MV’=PY essentially says that the amount of money paid for goods is equal to the sum of the prices charged for them – which is not much to say.

Practical trouble comes when the attempt is made to use MV =PY as a guide to public policy. If your purpose is to increase production, you look at the equation and decide that all you need to do is to increase the money supply or speed up its circulation, at the same time holding the price level down. On the basis of historical studies that made his reputation, Professor Milton Friedman concluded that the economy could not sustain a steady growth faster than 3-4 per cent a year, that therefore the money supply should be expanded at that rate, and that any faster rate would be inflationary.

From Jimmy Carter’s appointment of Federal Reserve Board Chairman Volcker in 1979 until Beryl Sprinkel’s speech this summer, Milton Friedman was the guru of American economic policy (he is still a guru in GreatiBritain). These seven years have not been an unruffled calm. At the start, the prime rate jumped from just under 10 per cent to 15 per cent, and continued upward until it hit 21.5 per cent after the 1980 election. The inflation rate followed (note the emphasis, which we may examine another day), reaching about 13.5 per cent at the end of Volcker’ s first year in office. Then we had the deliberate depression of 1981-83, driving unemployment from a little over 6 million in 1979 to almost 12 million in 1983. Since that time we’ve had something called “recovery,” punctuated by happenings called “growth corrections,” with unemployment still over 8 million, even counting part-time dishwashers as employed.

During these seven years Friedman has steadily complained that his religion was hardly being tried, and that Volcker was a false prophet. For though Volcker’s policy has been to stop worrying about the interest rate and instead to control the money supply, he never has come close to bringing the yearly increase of M-1 or M-2 down to 4 percent. Consequently, Friedman has been in the comfortable position of taking credit for whatever has turned out well, while disowning whatever has gone wrong.

IN FAIRNESS, Friedman’s gospel has been more modest than that of his followers – a not unusual situation in the history of religions. He argues that because government does not handle money as well as profit-seeking individuals, it should do the barest minimum and should be constitutionally required to balance its budget. His argument in favor of a fixed rate of expansion in the money supply is basically that discretionary control by the Federal Reserve Board has been so awful, almost anything would be an improvement.

Nevertheless, the reasoning behind a low fixed rate of expansion is based on MV = PY: If the money supply expands faster than production, the price level must rise. If, however, the price level remains constant, a monetary expansion would necessarily expand production. For a considerable period now the price level has remained constant, or as near as doesn’t matter, while the money supply has been increasing twice or three times as fast as Friedman recommends. If the professor had his theory right, we should be experiencing the biggest boom in history. It seems the boom isn’t happening or about to happen, so Sprinkel has given up on monetarism.

What went wrong? Well, I’ll tell you: The monetarists have their metaphysics wrong. Money is not a commodity, it is a functioning object. You can’t count it; you use it to do your counting. Since you can’t count it, you can’t fit it into an equation. Beryl Sprinkel is gradually waking up to this fact-and, presumably, his boss is too.

Now, that’s dandy; better late than never, and all that. Except the awakening comes after a night that has destroyed forever the livelihood of millions of older men and women, and has condemned millions of younger men and women to a lifetime of hanging around street corners. It has made a few rich people very rich, and many poor people poorer than ever. It has deliberately stagnated the economy, with the result that in five and a half years the actual GNP has run roughly a trillion dollars less than potential GNP. Simultaneously, another trillion dollars has been taken out of the civilian economy by heating up the arms race. Finally, as a third trillion dollars has flowed into the stock markets, the rate of investment in productive enterprise has fallen.

So they goofed. So who’s perfect? The trouble is, none of this grief was necessary. As early as a speech Knut Wicksell made on April 14, 1898, it has been clear that banks don’t create money, business does. The textbooks continue to say banks create money by making loans, but Wicksell showed the initiative comes from businesses that want to borrow, not from banks that want to lend. Writers as various as Hayek and Keynes developed the idea, and businessmen have always known in their hearts that it is true. Only a fool or a knave borrows money simply because a bank wants to lend it[1]. The banking system can stifle an active economy with high interest rates, but it takes more than low rates to breathe life into a dormant economy.

What does it take? Good morale. Keynes talked of “animal spirits”; unfortunately the expression has the flavor of a biologically determined force that could be let loose if you changed your breakfast cereal. The neoclassical “Keynesians” (who try to press Keynes back into the mold of a classical economist) emphasize incentives to investment, like tax credits; regardless of the incentives, though, investment has languished.

Friedman has permitted himself the observation that rather than money, “The real wealth of a society depends much more on the kind of institutional structure it has, on the abilities, initiative, driving force of its people, on investment potentialities, on technology on all of these things.” Yet he would forbid corporations to concern themselves with the moral consequences of their business, to engage in unpaid public service, or to exercise charity. What is left? The naked bottom line. And what is the naked bottom line? Greed.

Morale is related to, but different from, morals. Greedy people are not necessarily immoral, just as self-sacrificing people are not necessarily moral. But the morale of greedy people is bad. Their universe is ungracious, ungenerous, constricted, pessimistic, often cynical.

As it happens, greedy people are in the ascendance in America today, and the fact of the matter is that the economy has gone just about as far as it can go on the greed standard. The economy is stagnant because its rewards are outrageously skewed in favor of those who already have more than they know what to do with[2].

According to the monetarist theory, these people should be putting their extra money into stepping up production, for the ultimate benefit of all. But they are not fools. Twenty-two per cent of the nation’s industrial capacity is already standing unused: What would be the sense of producing more things no one can buy? So the extra money goes into speculation, an activity that incidentally increases the cost of capital and further inhibits enterprise.

It would be pretty to think that, in giving up monetarism, the Administration will reverse itself and try to rationalize the distribution of income, thus incidentally increasing demand. But the probability is otherwise. Our morale has been so corrupted by the ideal of private greed that it will no doubt be decades before we enjoy again the eagerness with which we once faced the world.

The New Leader


[1] Editor’s note – or, based on the sub-prime lending bubble of the late 2000’s, an individual borrower as greedy as the Wall Street market makers intent on collateralizing fraudulent loans

[2] Editor’s italics…  sounds far too familiar in 2012

Originally published September 8, 1986

DURING THE last couple of years a new fungus has been welling in the dark of the financial moon – the securities futures market, or markets. The most prominent of these trades guesses about the future of the Dow-Jones Index. This trading is said to be similar to that on the commodities exchanges, where you can bet on the future price of sugar or platinum or pork bellies; but the similarity is merely superficial.

If I were crazy enough or shrewd enough to play the commodities markets, I’d go in for pork bellies, because that solemn game appeals to my sense of the ridiculous. The unit of trading is a contract to buy (or sell) 38,000 pounds of the stuff (which I suppose is a carload: a carload of book paper is 40,000 pounds) at a specified price at some future date. That’s a giggling amount of bacon to bring home.

As I write this, the price for next March is 63.4 cents a pound. Let’s say you purchase a contract to buy and, come March, the price is 73.4 cents a pound: You sell your contract at that price and pocket the difference, or $3,800, less a trifling brokerage charge and taxes. You don’t have to feed the pigs; you don’t hear them squeal; you never even put up any real money; and you can sell any time before if you think the price is right. You simply pick up a piece of change for guessing right. Of course, if you guess wrong, you take a bath in the trough.

The commodities markets are gambling dens for millionaires. Conscience stricken brokers (there are some such) claim that the trading stabilizes prices and so helps farmers plan. We don’t have to take this claim seriously to see that, in the end, someone winds up with some actual bacon to sell to someone else who has not been persuaded by Jane Brody to give up the ingestion of animal fats.

The stock market futures are something else. There, what is traded is the right to buy a bundle of stocks already a couple of markets away from anything you can get your teeth into. After all, the stock market itself is said to stabilize the cost of capital and help General Motors to plan production. Again, this is a claim we don’t have to take seriously.  And when we read in the business press that the securities futures market stabilizes the stock market, which stabilizes the cost of capital, we know we are in the land of make believe. Why not a market in options to buy futures, thus stabilizing the futures market?

Now, it is true that stock market futures have some slight appeal to people engaged in productive enterprise. Enterprisers deal with the future all the time anyhow. The local bookstore orders its Christmas stock in July; the publisher sent the manuscript to press in January; the printer and paper manufacturer have to order their machines years ahead.

It takes time to do business, and during that time the prices of things change unpredictably. If you contract today for a $10 million warehouse to be ready a year from now, you worry that by that future date the real estate market may have tumbled so that your competitor can buy one standing empty for $8 million and be in a position to underprice you. You may worry so much that you decide to hedge your bet by selling stocks short. Then if prices fall, the money you gain by selling short will offset the value lost on the warehouse. And if prices rise, the increased value of the warehouse will offset the money lost on the stocks.

Obviously, when you hedge a bet you narrow your possible gains as well as your possible losses; and you may be ready to do this because you want the warehouse to do business in, not to speculate with.

Since the stock futures market is an organized way of selling short, it is convenient for businessmen with heavy commitments they would like to hedge. Once the market is in operation, it offers a field day for big-time gambling on a sure thing. For various reasons, a gap will open from time to time between the futures market and the prices of the underlying stocks. When the gap is big enough (maybe only a point or two), arbitragers will buy in the cheaper market and sell in the dearer. It’s a riskless gamble, but you have to act fast, and you have to have access to an enormous amount of money to make the game worth the trouble and expense.

The gaps that open between the markets are not exactly the doings of the famous invisible hand. Those who run futures markets pride themselves on developing what they call “products” that will appeal to traders. (It would be hard to imagine anything less like a tangible product or more airy-fairy than the chits that are traded.) A successful “product”- one that has, as they say, a great deal of sizzle – is one that is extra volatile. The more volatile the markets, the bigger the possible gaps. The bigger the gaps, the more trading. The more trading, the more volatility.

Recently a vice president of the New York Stock Exchange, which usually pictures itself as sedate and conservative, talked pretty smugly during a TV interview about a new “product” the Exchange is pushing. It is called the Beta Index. Stocks that are highly volatile are said to have a high Beta characteristic, and the Beta Index is a weighted average of the 100 most volatile stocks on the Exchange. Beta Index futures, it is hoped, will be not only volatile but sizzling. There’ll be big gaps for sparks to jump.

Trading to take advantage of gaps is an old way of making money. It has a better claim than Marx’s elaborate analysis as the method of primitive accumulation that made capitalism possible. In The Wheels of Commerce, the second volume of his trilogy Civilization and Capitalism, 15th-18th Century, Fernand Braudel makes much of the fact that the first large Renaissance fortunes resulted from long-distance trade.

The money wasn’t earned in haulage; the function of distance was to open gaps in information, and consequently in prices, that enabled well-informed experienced traders to buy cheap and sell dear. Like the arbitragers of today, they used other people’s money: partnership funds, bank deposits, and ultimately credit, some of it not unlike junk bonds. Fortunes accumulated very fast.

What fascinates people about stock index futures is that the big trades are dictated by computers, and when they aren’t” down” they still have an aura of magic. It’s all done in seconds, as compared with months or even years a half millennium ago. On a recent day, some 40 million shares were traded in the last few seconds before the market closed. A brief four or five years ago, 40 million shares made a big day on Wall Street; on Black Tuesday in 1929, only 16,410,000 shares were traded. Today’s buy and sell orders are programed, which seems different from human agency (though programmers are presumably human). But the principle is the same. Also the same is the uneasiness aroused in the breasts of ordinary citizens by the extraordinary winnings of the traders.

THE UNEASINESS is certainly justified. The old curse (variously said to be Chinese, Jewish, or Hungarian) can be paraphrased to read, “May you live in volatile times.” Yet the stock Exchange itself could scarcely exist if it were not inherently volatile. It is disingenuous or ignorant to contend, as many do, that the market is an efficient way of valuing the nation’s industries. There is much fluttering in economic dovecotes if the GNP varies in a year as much as 2 per cent from its secular trend line, yet the stock market can rise or fall that much in a single session.

In a rational world, the value of a nation’s industries would be a function of what they produce. In the world of Wall Street, the nation’s industries are merely an occasion or an excuse for buying and selling pieces of paper. What is being valued is not the corporations that issued the paper but the traders’ guesses about what the Federal Reserve Board will do next. An offhand remark by Chairman Paul A. VoIcker will trigger a bigger rise or fall in the market than any conceivable news about actual production. Indeed, favorable news of production is likely to cause the market to fall, because it is thought likely to frighten VoIcker into tightening the money supply and raising the interest rate in order to try to exorcise the inflation banshee. Commentators will intone a few traditional homilies about the effects of high interest rates on industry, but what really matters is that a rise in the interest rate reduces the capitalized value of every income-earning asset.

The business press is fond of pointing out that everyone who guesses VoIcker is in a good mood is matched by someone who guesses he is in a foul mood. Otherwise there wouldn’t be any trading. The implication is the shaking and baking all evens out and doesn’t matter.

Unfortunately, it does matter. The New York Times estimates that $11 billion is now committed to the stock futures markets alone. This $11 billion, invested in “products” that neither are products nor produce products, is unavailable to productive industry. As far as enterprise is concerned, the stock futures markets have caused the money supply to fall $11 billion. An even more potent factor in the misuse of the money supply is the resurgent takeover wave, which must carry off upwards of $100 billion in its undertow.

Not so long ago, college endowment funds, pension funds and the like were invested almost exclusively in high-grade bonds. Bit by bit they all have been seduced into playing the market, where they are managed by “experts” with an eye to churning the accounts and so picking up a fraction of a point here or there, day after day. It can all add up, just as a vegetable market makes a tiny profit on sales but a tidy profit on investment by turning its inventory almost daily.

As the market has risen with the fall in interest rates, the results of this activity have been spectacular. Given the record, it will not be surprising if the managers of these funds are tempted by the stock futures markets, where the winnings can be two or three times those of the stocks themselves. As this comes to pass, more and more of our money will be frozen in nonproductive speculation. The resulting Ice Age will leave our industries, once a justifiable source of pride, high and dry.

The New Leader

Originally published July 14, 1986

LIKE THE Ancient Mariner, we war veterans have a glittering eye.  (I have seen mine reflected, dully, in my grandchildren’s eyes as they prepare to listen dutifully.) We could tell you a tale or two-and we will. Indeed, I will, here and now, tell you war story that has a lesson for us today and for tomorrow too.

Perhaps you were there. After all these years I may be off a bit on some of the details. If so, you can correct me. But I’m sure that I have my oral straight.

It was, as I remember it, in the fall of ’37. The battlefield was not on the banks of the Ebro but in Herald Square. Macy’s let loose a barrage advertising a special on the Modern Library: three volumes for a dollar. Skirmishing had been going on for months or maybe years but the price had rarely fallen below wholesale, somewhere around 50¢ (the list was 95¢). The big battles in the last half of ’36 and the first of ’37 were fought over Gone with the Wind, which, in spite of its $3.00 list price and an ordinary wholesale price of $1.80, sold as low as 49¢ in auto supply stores. It was the big loss leader: possible profits on Margaret Mitchell’s work were expendable as-Ion- as it lured in people to buy bigger-ticket items.

By the fall of ’37, practically everybody who wanted a copy of Gone with the Wind-and many who didn’t-had one. So Macy’s tried to effect a breakthrough with the Modern Library. The book section, then on the main floor, was mobbed. We rushed in from every point of the compass as soon as the doors opened. I still have my three books: The Education of Henry Adams, The Theory of the Leisure Class, and D.H. Lawrence’s The Rainbow (a novel, I’m ashamed to confess, that I’ve never been able to finish).

Did Macy’s tell Gimbel’s? No, but Gimbel’s was not caught napping. Its comparison shoppers were in the front line, rushing the news from 34th Street to 32nd Street as fast as it occurred. And of course, Macy’s spies were doing the same in Gimbel’s.

I was a well brought up young man; so after I had elbowed my way to the table and grabbed my three books, I waited patiently for a clerk. My good manners were rewarded. Twice, as I stood there, an assistant buyer rushed in (we smartly made way for her) and lowered the price-first to 31¢, then to 28¢, the price by the time I was waited on. Maybe I’d have done better at Gimbel’s.

I don’t know. Anyway, it was a good war. Even the most flaky Harvard philosopher would call it a just war. But it had repercussions. Booksellers for miles around were hurt, or thought they were, and screamed.

Some returned their stock of the Modern Library to Random House; some refused to buy Random’s new books; all urged Random to protect the Modern Library price under the new Fair Trade Act. (This law allowed producers of copyrighted, patented or trade-marked goods to follow a complicated procedure that would require every retailer to maintain list prices. The act has since been repealed, and it is conventional to denigrate it; constant readers will not be surprised to learn that there I go again, being unconventional.)

Macy’s moved quickly. They ordered in, on top of their usual heavy inventory, an extra $50,000 worth of the Modern Library. That was a lot of money in 1937. Random was delighted. But when the publisher started talking about price maintenance, Macy’s whispered that it would have to return all those books for cash. Random decided to bear those ills it knew, and continued to do so for another four or five years, until wartime shortages allowed it to call Macy’ s bluff and declare that it would take back any books Macy’s was ready to send. End of war story.

The moral is this: If you maintain a large inventory, you can force your suppliers to play the game according to your rules. And where can we put that lesson to good use? Ina word: oil. Oil is certainly the second most screwed-up topic in political economy. I’m not sure what is first. Probably the deficit, or maybe the defense budget. No matter; they’re all related.

Everyone knows you can’t run a war or a police action or even a defense without oil. It is the absolutely essential military resource. It is not surprising, therefore, that we have at least the outlines of a policy on oil, and that we’ve followed them for a long time. But if you tried to think the problem through, calmly and rationally, you would not guess what our policy is, not in a million years. For example,

President Eisenhower, who certainly did not regard defense frivolously, imposed a partial embargo on imported oil. Ike said (if you don’t believe me, you could look it up) this was a defense measure.

Its expected and intended and actual results were (l) to reduce the importation of foreign oil, (2) to let domestic producers raise their prices, and (3) to encourage domestic producers ( a.k.a. wildcatters) to explore for new oil fields and exploit existing fields more thoroughly, Now, you, being a sober citizen, will wonder how all this made America  stronger, and I will have to say that it had the diametrically opposite effect, for it caused us to use up our oil reserves faster than we might have otherwise. To be sure, the higher price of oil may have persuaded some people to conserve a bit; but the principal consequence was a draw-down of our reserves.

The crazy thing is, people are clamoring for us to do the same thing again. This time the alleged purpose isn’t national defense but deficit reduction. Of course, if your real aim was to reduce the deficit, you would put an extra excise tax on all oil. No one, however proposes this, because it would annoy a number of politically active oilmen.

Similarly, if you really wanted to make America stronger, you would import every ounce of foreign oil you could, now that the price is down. You would move, with more than deliberate speed, to fill up those salt mines (or whatever they are) where we started, back in the discredited days of Jimmy Carter, to accumulate a ready oil reserve. Before the oil glut, OPEC warned us that if we tried to fill those mines in order to reduce our dependence on them, they’d consider it unfriendly behavior and would respond by pushing up the price of oil, or maybe slapping a new embargo on us. Today, though, with pretty bad business and pretty good conservation world- wide, OPEC has so much oil it doesn’t know what to do. In addition, we have banks failing all over the West, and the growth of Houston, especially, is being corrected. So far, the only thing we have been able to think of is a trip for Vice-president Bush to explain to the Saudis that the people he represents hope that prices won’t fall too low.

ADMITTEDLY, filling those mines would cost real money, even at present oil prices, and everyone has been programm-rudmanned to worry about the deficit. But here is where the moral of the Herald Square war comes in. Just as Macy’s excessive inventory of Modern Library books inhibited Random House from fixing the price at 95¢, so if we had all our depleted mines (and all our storage tanks) brimming with oil, it would be difficult, if not impossible, for OPEC ever to spring another embargo on us.  Those full reserves would be a new declaration of independence for us. They’d make a quicker and more effective (and probably cheaper) contribution to national defense than Star Wars or nerve gas or re-commissioning obsolete battleships.

What’s more, buying that oil would be an investment in something useful for civilian as well as military life. At the minimum, it would be a guarantee that we would not have lines at the gas pumps until oil was really running out. Charging such investments to the current budget is nonsensical accounting (but that’s another story).

Filling our reserve capacity would also give us opportunities for a creative and hard-nosed foreign policy. Consider how the reduction of Arabian pressure on us would strengthen our position in the Middle East. And consider how we might distribute the orders for the oil: Naturally, we’d buy most from friendly countries that are heavily burdened with debt (much of it owed to us).

Thus we could help, first of all, Mexico, which is on the brink of lMF-sponsored chaos. Then we could think of Venezuela, one of the struggling South American democracies, and of Nigeria, one of the struggling African democracies (at least in ideals). In the Middle East we could favor countries willing to put a bit of pressure on Syria. The possibilities are very great. Prudent friendliness on our part could earn us friendly prudence on the part of many important nations.

So why don’t we do it? You know why. Even if we weren’t hung up on the deficit issue, even if the Administration and Congress could be gotten to see the light, the program would be stopped dead by influential senators and congressmen who are obligated to, or in fear of, 50-odd men who’ve made a killing in oil. You know these people would stop it, just as they’re now stopping tax reforms that might treat them like everyone else.

These 50-odd men are not the Seven Sisters of Big Oil. Exxon and the rest usually support what they do, and their support rivals the clout of any other industry’s lobby. But the initiative and most of the money comes from the independents. What makes these few men so powerful? They are wealthy-really and truly wealthy-and they don’t give a damn about anything except having their own way. Every one of them is capable of signing checks for hundreds of thousands without worrying about the bank balance. Every one of them can make maximum contributions to political action committees as fast as the committees are invented.  If you want a rundown on who they are and how they work, I refer you to The New Politics of Inequality by Thomas B. Edsall (one of the last books I edited, and a good one).

We’re not talking about merely Texas and Oklahoma. There are appreciable amounts of oil in 10 or more states, some of them very populous. That gives the oil lobby a bloc of, say, 20 senators and 50-60 congressmen it doesn’t have to worry about. Moreover, many of these legislators have accumulated seniority and the committee chairmanships that go with it.

In spite of all this, maybe the current economic difficulties of the oil states can give us a chance to get some of our own back. Suppose we said we’d fill up those reserves with true-blue American oil. Could they resist the temptation? We would lose the chance to do something useful in foreign policy. Still, we wouldn’t be doing something harmful to our national defense. And the existence of that ready reserve just might make the oil senators a little more respectful of the rest of us in the future.

The New Leader

Originally published May 5, 1986

 

 

 

 

 

 

 

 

BACK IN ONE of my early columns I threatened to say something about Marx’s theory of surplus value, and today I’m going to do it. If we keep our voices down, we may be able to make a few observations before the comrades accuse us of not commanding the literature and the Birchites accuse us of thinking.

Marx’s argument, stretching over Parts III, IV and V of Capital, turns on the notion that “The value of a day’s labor-power amounts to … the means of subsistence that are daily required for the production of labor-power. …” This is the exchange-value of labor-power and is what the worker is paid. But the use-value, or what the capitalist gets out of it, is very much greater (Marx usually estimates double), and the difference between the two is the surplus value the worker creates that the capitalist appropriates.

You will see at once that Marx has mixed apples and oranges. His workers sell their services at cost (apples), while his capitalist sells the product for whatever the market will bear (oranges). If both services and product were sold at cost, there would be no surplus value. If both services and product were sold at the market price, competition would theoretically force them back to cost, and again there would be no surplus value.

Competition doesn’t work as it is famed to do (see “Unthinkable Thoughts on Competition,” NL, April 2, 1984). In fact, today in the United States the sum of proprietors’ income, personal rental income, and personal dividend income is about 10 per cent of total personal income. (Were we to include personal interest income, the figure would jump to about 25 percent. From the point of view of an entrepreneur, though, interest is an expense, not part of a surplus. On the other hand, a large but undeterminable portion of proprietors’ income should be classified as wages rather than profit.)

Marx’s difficulty, which he shares with all economists of a materialist or realist persuasion, is that he wants to consider everything except cost as some unreal flim-flam. And he particularly wants the capitalist’s property to be a thing – a machine you can touch or land you can walk on.

Yet property is not and never has been a thing. It is, instead, a bundle of rights (see “Life, Liberty and Property,” NL, July 11-25, 1983). Different societies emphasize different bundles. Thus in the ancient world the household (the paterfamilias or patron, his family, his clients, his slaves) was the locus of power. Property was personal – by persons and in persons – and aspects of that arrangement survive to this day. In the medieval world, military power also a survivor – became crucial. In the early modern world, the factory came to the fore, and at present we are ruled by finance.

These distinctive emphases are close to what Marx meant by the modes (as distinguished from the means) of production. Although his need to see always in materialist terms skewed his analysis, he was insightful in recognizing that each society’s characteristic form of property engrosses the special rewards of the society and is protected by its legal and political organization. For this reason he noted at the start of the Grundrisse that J. S. Mill and his predecessors were wrong in claiming that an economy’s production of goods and consumption of goods are two different (and ahistorical) questions.

And for this reason he attacked Ferdinand Lassalle and the Social Democrats, who advocated “a fair distribution of the proceeds of labor.” In Critique of the Gotha Program [Marx] replied: “Any distribution whatever of the means of consumption is only a consequence of the distribution of the conditions of production …. The capitalist mode of production, for example, rests on the fact that the material conditions of production are in the hands of non-workers in the form of property in capital and land, while the masses are only owners of the personal condition of production, of labor-power. If the elements of production are so distributed, then the present day distribution of the means of consumption results automatically.”

There was a time – roughly the time of Marx’s life – when the material means of production did indeed dominate society. Factories were in the field (as Carey McWilliams said) as well as in buildings with smokestacks. Today, though the factories still exist, the ruling power is finance. The current observation, that we are moving from a production economy to a service economy, is true but superficial. There are no special rights attaching to service; there is, in our society, a special and encompassing bundle of rights attaching to finance, to money. Marx said money was a “purely ideal or mental” form of value. It certainly is, but it is not therefore imaginary or secondary or part of some sort of superstructure. This ideal form of value is now the ruling bundle of rights in our society. The owners of this bundle derive therefrom their claim to be entitled to the special rewards of the system.

Every system generates special rewards – rewards that go beyond what is necessary for the system’s day-to-day operation. How these surpluses are used is a question in macroeconomics (for a clear explanation thereof, I refer you to Profits and the Future of American Society by S. Jay Levy and David A. Levy). Why these surpluses are generated is a question in microeconomics.

More than that, it is a question in the philosophy of history. Since there is a present (otherwise, what are we doing?), there are both past and future, from which the present is distinguished. Whatever else you say about the future, you must say it is constitutionally unknowable. As Keynes concluded in his Treatise on Probability, “we simply do not know.” If we could know the future, it would then be the same as the present and the past.

A consequence of the unknowability of the future is the generation of surpluses or windfalls or profits. These cannot be contracted for (as wages and interest are); they are what is left over after all expenses are paid. Because what’s to come is still unsure, we can face the future with confidence only if we have sufficient resources to meet any eventuality. But what is sufficient for any eventuality is more than enough for most eventualities; and what is, most of the time, more than enough, becomes the surplus that every system generates if it is to survive.

Thus in the Middle Ages, the military power required to keep the peace in a given valley was much less than that needed to defend the valley from outside marauders. Yet even though the marauders appeared infrequently, the lord undertaking the valley’s defense had to have more than enough power for ordinary use. This surplus power took the form of a stronger and more magnificent castle, more and better equipped retainers, more impressive ceremonial displays, occasional forays to defend the domain by pushing its borders outside the limits of the valley, dynastic alliances with strategically placed peers … All of these emblems of power were at the same time the characteristic luxury or surplus goods of the society, and were exclusively enjoyed by those who wielded the power in the society.

SUCH INFLUENCE of the unknowable in our lives is pervasive. Thomas Hobbes saw it as the fear of death, which leads to “a perpetual and restless desire of power after power. And the cause of this,” he wrote, “is not always that a man hopes for a more intensive delight than he has already attained to, but because he cannot assure the power and means to live well … without the acquisition of more.” Or as Fritz Fischer has shown in a series of groundbreaking books, the leaders of pre-World War I Germany saw their options as “world power or decline.”

Likewise, it is often said that a business firm must expand or wither away. Even if it wants to stand pat, it cannot precisely anticipate its future business and so may find business booming and profits burgeoning. Alternatively, there is the risk that sales will be down and profits negative. Prudence dictates at least a defensive expansion – a drive for a larger market share, introduction of a new product, whatever. In any case, if expansion does result, its benefits accrue exclusively to the owners of the enterprise. It is an extra dividend or a capital gain.

The owners do not, however, necessarily accept the possible losses. The first sufferers are the firm’s workers, whose pay is cut, and some of whom are fired. Aside from the firing, it was not different for the underlings of an unsuccessful medieval lord. They were squeezed to rebuild the lord’s power, and this was reasonable because the lord – and the lord alone – maintained the peace. Without him there was anarchy, sometimes savagery. In the same way, without an ongoing enterprise, the workers have no jobs at all.

We are back in a familiar bind. If things turn out well, the owners of an enterprise get capital gains and other surplus or unearned income. If things turn out badly, the workers get fired. These outcomes are not inherent in any system, but the problem is inherent in every system, because it is inherent in life itself. The obvious solution is to unify society and make owners and workers the same people. Socialism does this, up to a point, but the dictatorship of the proletariat – that is, of the party – shows no sign of withering away. What is left? Well, if you have paid attention to previous lectures, you know that the answer is some form of employee ownership.

The New Leader

Originally published March 24, 1986

INTHE 1920s, bond salesmen were admired and envied. Later, when Wall Street laid its egg, they became butts of bitter jests (“Where are the customers’ yachts?” asked a book by Fred Schwed Jr.). In the end, they were objects of opprobrium and scorn. Today’s bond salesmen seem to be following in their grandfathers’ footsteps.

Salesmanship is now marvelously subtle, combining an ancient rhetorical device with an even more ancient childhood game. Long before Aristotle wrote his Rhetoric, Greek sophists found that an appearance of frankness could help them win a bad case; openly admitting a superficial weakness or two could get them good marks for sincerity. And since long before the sophists, children have known how to tempt their peers with the challenge, “I dare you.”

The device and the game are joined in the term “junk bonds.” The immediate connotation is of shoddy goods or a tangle of broken machinery, old plumbing fixtures and wrecked automobiles, partly hidden by a tumbled-down board fence as unsightly as what it pretends to hide. A secondary connotation is of junk mail, which almost everyone hates. The junk bonds metaphor boldly accepts both connotations and thus disarms criticism. No one, it winks, is trying to fool anyone.

At the same time, these negative connotations are modified by some that are at least ambiguous.  Those who send out junk mail presumably think well of it. Paraphrasing Abraham Lincoln, one might conclude that God must love churches and charities that raise money by mail, since He made so many of them. For another example, junk food is eaten by an awful lot of people, who apparently have a tolerance, if not taste, for it; and purveyors of junk food make an awful lot of money, something the purveyors and buyers of junk bonds hope to do, too.

In addition, the term admits risk and so suggests sport. I dare you to run the risks that may lead to a big killing. Are you big enough to afford such risks? You say that the capitalist system depends on risk taking: Do you dare put your money where your mouth is?

Yet just as a paranoiac may have real enemies, junk bonds may be really bad. They may not necessarily be bad for the new owners of the corporations that issue them or for the purchasers or for the underwriters, but they are almost invariably bad for the corporations themselves; they are also undeniably bad for the morale of our society (see “The Faith of Fiduciaries,” NL, December 24, 1984) and for the tax collections that support our society.

In spite of all the present hype, junk bonds are not new. Practically every railroad issued bonds at usurious rates – and ultimately paid the penalty. Neither are junk bonds the first securities of “less than investment grade” to be widely marketed in the United States. Most of our giant corporations – including many of those now being raided – were originally papered together with such securities. The chosen instrument was different, and the metaphor was different, but the results were similar. Stock was issued instead of bonds, and the stock was said to be watered like cheap whiskey.

In Other People’s Money, Louis D. Brandeis, later a Supreme Court justice, told how the United States Steel Corporation was formed in 1901: “The steel trust combines in one huge holding company the trusts previously formed in the different branches of the steel business. Thus the tube trust combined 17 tube mills, located in 16 different cities, scattered over 5 states, and owned by 13 different companies. The wire trust combined 19 mills; the sheet steel trust 26; the bridge and structural trust 27; and the plate trust 36 …. Finally, these and other companies were formed into the United States Steel Corporation, combining 228 companies in all …. ”

The tube trust, when it was put together a few years earlier, had been capitalized at $80 million. Half of that was common stock, and half of the common “was taken by J.P. Morgan & Co. and their associates for promotion services; and the $20 million stock so taken later became exchangeable for $25 million of Steel Common.” The tubes plainly held a lot of water, as did the other trusts that went into United States Steel. Nor was this all. The rest of Steel Common was watered in its turn, with nearly one-seventh issued directly or indirectly to the promoters.

Although Brandeis doesn’t give all the gory details, I would wager that at least half of the original 228 companies were enticed to sell out at greatly inflated (or pumped up) prices. Some of the others may have been squeezed a bit, but the total paid for the 228 was almost certainly far greater than their entire net worth. Once you add it together you have United States Steel, the first corporation capitalized at a billion dollars, and pretty close to half of it was water.

In Morgan’s time, high-flying corporations were overcapitalized. Currently they are undercapitalized, a.k.a. leveraged. The shift is a function of the tax laws, though you may read many an analysis of takeovers without coming across a mention of the part played by taxes.

When U.S. Steel was floated, there was no corporation tax. Since earnings were not taxed, interest paid on bonds was obviously not deductible. Interest was a fixed expense. Dividends, on the other hand, were not fixed (except for some on preferred stock). You paid dividends when you were flush; otherwise not.  Therefore a prudent company got its money from stock, rather than bonds. Today, with the corporation tax at 46 per cent (assuming a corporation pays any taxes at all), and with interest payments deductible, a clever company will issue bonds instead of stock, and a clever raider will happily issue junk bonds paying 14-15 per cent in order to buy up stock earning 5-6 per cent. (For reasons why no interest should be deductible, see “The Bottom Line of Tax Reform,” NL, November 26, 1984) After the deduction, the new load on the company is only about 6-8 per cent, and before it becomes oppressive, the raiders will be long gone.

That the debt will eventually become oppressive, there is usually little doubt. The interest payments will have to continue in bad times as well as in good. As profits fall or disappear, so will the benefit from deductibility. The corporation’s cash flow will be soaked up by the high interest. Even a sluggish cash flow can quickly lead to bankruptcy. Of course, bankruptcy may now be sought to break a labor contract, whereupon the company may become solvent again. Guess who’s left with the short end of the stick?

This result of undercapitalization is, you may be astonished to learn, not substantially different from the result of overcapitalization. How was the water in Big Steel paid for? As the man might say, there’s no such thing as a free drink. If the capitalization was half water, Steel’s earnings on its real assets would have had to be twice “normal.” Without a research assistant, I can only suggest the outline: First, the owners of the original 228 companies were well paid. Second, J.P. Morgan and his fellow underwriters were very well paid. Third, those who bought the watered stock received “normal” dividends. Fourth, the price of steel was not grossly exploitative (steel rails stayed at $28 per long ton for more than 10 years).

Here someone is sure to cut in with the claim that U.S. Steel was more efficient than its 228 components had been. Evidence for this is the fact that most of the 228 were shut down, while the surviving units were expanded. But if those shut down were inefficient, why were they bought in the first place? The competitive system is supposed to let inefficient companies die.

The case for technological efficiency is, if anything, worse. In 1911, 10 years after the emergence of U.S. Steel, Engineering News reported: “We are today something like five years behind Germany in iron and steel metallurgy, and such innovations as are being introduced  by our iron and steel manufacturers are most of them following the lead set by foreigners years ago.” (That might have been written yesterday.)

The question remains: Who paid for the water? Those who didn’t immediately answer “Labor!” will stay after class and be given a quick review of the effects of mass immigration, Taylor System management, and courts that issued injunctions against labor unions as conspiracies in restraint of trade.

THE Federal Reserve Board’s new rule limiting the use of junk bonds to 50 per cent of the price of a takeover may put a momentary hitch in a few raiders’ plans. And some say the present run-up of the stock market will put an end to takeovers by increasing the amount of money needed. The run-up, however, has been caused by the drop in interest rates, which increases the capitalized value of every income-earning asset. (An asset that earns $10 is worth $100 when the interest rate is 10 per cent, and jumps in value to $200 if the rate falls to 5 per cent.) For this reason, the bond market has been rising, too; the interest that investment-grade bonds must pay is falling-and so are the requirements for junk bonds.

Should President Reagan be successful in cutting corporation tax rates (as seems likely), the deductibility of interest payments will become less important and watered stock will tend to displace junk bonds in takeover schemes. In other words, look for an upsurge in new blue-sky issues. R.R. Palmer tells us in A History of the Modern World of an 18th-century promoter who issued shares in “a company ‘for an undertaking which in due time shall be revealed.” Does anyone doubt that if Carl Icahn made such an offering today it would be oversubscribed tomorrow? Whatever happens, the financing of the American economy will still be largely an incidental function of speculation, or as Keynes said, of running a casino.

My first “Dismal Science” column (NL, September 7, 1981) was entitled “Speculation Will Undo Reaganomics.” The title displays an innocence on my part. I did not imagine that the Reaganauts’ intention was to make paupers and millionaires. Speculation continues to have the effects I discussed; I still find it hard to believe that decent people think it’s grand.

Since the Civil War days of “Betcha Million” Gates and Jay Gould, speculation has resulted in American enterprises paying too much for capital. Andrew Carnegie observed in The Empire of Business (1902) that “railway managers today are … directed to obtain a return on more capital than would be required to duplicate their respective properties.” It matters little whether the capital is paid for with dividends on watered stock or with interest on junk bonds. Either way, it is the working man and woman-the people who put that capital to work – who do the ultimate paying.

The New Leader

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