18 March 2008

Is Wall Street Worth It? Part One

Inequality Is Driven By Wall Street

At the heart of the growing divide between the rich and everyone else in our society is Wall Street. While CEOs of big corporations make big money, the growth of a new class of American robber barons has not happened predominantly in the "real" economy. Instead, the incredible growth in the share of the national wealth owned by the top 1% of households in the American economy over the last decade or so has been driven primarily by financial professionals like investment bankers, hedge fund managers and private equity fund organizers.

Creating Economic Value v. Exploiting Legal Flaws

In a capitalist economy, there are basically two reasons that people get rich, which are not mutually exclusive. One is to add value to the economy. The other is to exploit a flaw in the legal and institutional framework of the economy for your own benefit.

Certainly, the Wall Street financial industry does contribute value to our society. The question is how much of its recent affluence is a result of value added to our economy, and how much is due to flaws in the system.

Collective Financial Action

Our society needs a thriving big business sector to survive. Fewer than ten thousand big corporations, out of tens of millions of businesses in the United States, produce the vast majority of the economic output that makes our way of life possible. Despite the fact that there are millions of individuals in the United States who are fabulously wealthy, only a few dozen have even remotely near the individual resources necessary to carry on the business of a large publicly held corporation. There is no one in all of the United States, for example, who is wealthy enough to self-finance an automobile manufacturing company, or a national grocery store chair.

One of the core purposes of Wall Street is to facilitate the collective action by the minority of people in the United States who can afford to own significant financial assets to meet the needs of American big business.

Alternative Sources Of Collective Action

The Anglo-American private investor driven model is not the only way to accomplish this end.

In Western Europe and in many of its former colonies, industrialization and the creation of a big business sector was driven largely by state owned enterprises in a mixed economy.

The Middle East has taken a similar approach with powerful monarches who control oil wealth substituting for Western style regimes.

The Soviet Union, its Warsaw Pact allies, China and its Asian communist allies, industrialized within the framework of socialist command economies.

While history appears to have favored the Anglo-American and Western European models over the communist model, communist countries have on the whole done better than Third World countries wracked with disorganization, war, autocratic cleptocracy, and often ill advised guidance from the international banking and economic development community.

Airbus, a conglomerate of airplane manufacturers seeped in the European tradition of state sponsored industrialization, recently beat Boeing, organized on a traditional Anglo-American capitalist basis, in a competition to see who could build a better air tanker for the United States military. And, the government dominanted banking sector of the Europe looks pretty good right now compared to its American counterparts.

Notwithstanding denunciatitions from a succession of U.S. Presidents, Castro's Cuba has outperformed most of its nominally capitalist neighbors on most measures of material well being, although it has paid a high price for this with a poiltically repressive regime.

China's economy, which is evolving market features within a communist framework, is growing its GNP by 10% a year and is an undisputed world economic powerhouse. You almost certainly own something made in China.

When Russia decides to get play hardball over its provision of natural gas to continential Europe, or OPEC decides to flex its economic might in the petroleum market, the world shivers.

Planning and Management

Wall Street does more than just make it possible to operate big businesses. Wall Street, collectively, self-interestedly, and in a decentralized manner, is the American answer to the Soviet Five Year Plan. Wall Street decides which business ventures deserve resources and which do not.

Interestingly, a lot of the planning takes place not in the glamorous stock market, but in the more staid bond market. Most publicly held companies make initial public offerings of common stock infrequently. For the most part, they get new money by issuing bonds which have to be repaid over time. This means that companies must continually issue new bonds to replace their old financing. If the market frown on a company, it will insist on higher interest rates for new bond issues. If the market believes a company is viable, it will snap up new bond issues for low interest rates.

While the formal democratic processes of large publicly held companies are laughable, the investor class, collectively, is also not without the power to discipline corporate management more directly. If the market loses confidence in a corporation's management, that corportion's share prices fall. Sometimes this happens dramatically, as it did in the case of Bear Stearns, which saw its market valuation which was about $20 billion in January of this year, collapse to 1% of the value in a matter of days this past week. In the wake of this collapse of confidence, J.P. Morgan Chase snapped up the company and has placed it under its, hopefully, wiser management. Not all takeovers are so dramatic, but the constant threat of a corporate takeover is the primary means by which Wall Street holds the management of large corporations responsible for their actions.

The Irrelevance of Statutory Law

A lot of what Wall Street does, however, is technical, obscure, or driven by tax law or regulatory schemes. Even people who really understand how a derivative trade or a hedge fund or a private equity firm creates wealth for its investors may be hard pressed to explain in anything more than a remote, trite, schoolboyish kind of way how their efforts create value in the larger economy. Mostly, those involved don't even try. On Wall Street, the transaction and personal gain are everything, and the players trust the system to get it right.

But, like law and customs generally of New York and Delaware and London that these financial sectors they call home, the legal and institutional framework of these financial sectors is anything but sleek. While no expense is spared on the latest computers and Ivy League trained experts to make the system run, the legal and institutional arrangements, as often as not, are designed to work in spite of, rather than in harmony with, the prevailing institutional and legal arrangements.

Securities dealers have abandoned the courts in favor of arbitration. They have circumvented rules on the transfer of stock by creating nominee corporations and brokerage accounts to hold it, they have an open call trading floor decades after it has become obsolete, they prefer elaborate master contracts to statutory guidance. They do multi-million dollar deals by phone calls or exchanging scraps of paper in a legal culture obsessed with getting things in writing. They adjudicate intra-corporate fights using procedures developed by English guys in wigs back when John Adams was a political player instead of the focus of the lastest HBO mini-series. The wizards that get it all done live in co-op apartments invented to address the absence of good laws on condominium ownership of property in New York State or rent controlled apartments in the most lassiez-faire oriented economy in the nation. The organize massive enterprises using business trusts that lacked almost all statutory recognition until recently, and do business in corporations with a shareholder democracy structure based upon in person shareholder's meetings with proxy voting and an elected board of directors accountable to those shareholders which is wholely at odds with how those corporations are actually run.

In the American financial sector, the workaround has been such a fine art that a good workaround to evade existing legal institutions is usually perferred to a purpose built legal entity.


Dex said...

great post. thanks, man.

Andrew Oh-Willeke said...

Your welcome. Nice to know that someone is reading.