As regular readers will know, I’ve been meaning to write about this for some time now. One of the reasons it has taken me so long is that I’ve had a lot of difficulty forming an opinion on the merits or otherwise of the Wall Street bailout. On the one hand, I can understand the outrage of the average American taxpayer, in as much as they are in a sense footing the bill for Wall Street’s excesses. On the other hand, I understand the desire to prevent a “freezing up” of the credit market, which would have disastrous knock-on effects for the entire economy—not just in the US, but in the rest of the world too. If the bailout package does in fact achieve this, then I guess it is a necessary evil. But it remains an open question as to whether it actually will help things anyway—indeed, it is possible it may even make things worse. Considering the continued volatility in the stock market since the bill was passed, it certainly doesn’t seem to have had any beneficial effect in the short term. Indeed, the announcement of this package and its bumpy ride through the US house of representatives seems only to have made the stock market even more nervous so far. Perhaps the mere fact that such a bill was announced and considered necessary by the US government has really only served to fuel investor nervousness, whereas if it hadn’t been announced, perhaps the stock market might have recovered on its own. However, the reality of the situation is that we really don’t know—the extreme unpredictability of the stock market is such that we can never be certain what the best course of action is in these matters. And herein lies the problem: the stock market does not seem to obey any sound and consistent rules of logic in its movements, which I think is the crux of the matter here.
Before the stock market, the rules of business were simple and logical: if the profits from the sales of your product or service made more money than you spent producing or delivering them, you made a profit. This meant following simple rules of trying to minimise your costs, while at the same time delivering a product or service that was of sufficient quality and desirability, so that you could sell enough of them to make money. Basically, having a successful business meant giving the customer what they wanted, at a price they were willing to pay, but which still allowed you to make a profit over what it cost to produce or deliver. Even today, many companies have grown into huge, multi-national businesses by staying private and following these basic principles. Perhaps the most famous recent example is Virgin, who expanded into all sorts of new markets from their humble origins as a record label, including starting an international airline, which must be of the most expensive businesses to run of all. They did this largely by giving the customer what they wanted, while cutting out the extras they didn’t, allowing them to deliver a cheaper product and service than their competitors, while still turning a profit. However, the stock market has turned a lot of these rules of business on their head.
For a public company, their primary responsibility is no longer to the customer—it is in fact to the shareholder, which is frequently in conflict with what’s good for their customers. It also means they have to put short term profit for their shareholders ahead of the long term good for their company. Take for example the common practice by public companies of reducing staff. This is one of the few things that is guaranteed to increase their share price, but it very often results in a reduction of service, which is bad for their customers. Even worse, they often end up replacing the staff they got rid of over time anyway, but it is obviously far more expensive to constantly turn staff over than to keep the ones they have, and once again, often results in a reduction of service, as their staff will be less experienced, and will have less well established relationships with their customers. Another example of this sort of thing is restructuring, which pleases shareholders, but often doesn’t produce anything of substance—I’ve lost count of how many public companies I’ve heard of closing branches in certain locations in the name of “streamlining” and “centralisation”, for example, only to open new branches in exactly the same locations later, in the name of “diversification” and “decentralisation”! Public companies partake in these sorts of charades because they know they’re the kinds of things that shareholders like to hear, but of course, this sort of thing only increases costs in the long term. A private company on the other hand simply determines their staffing levels on the basis of demand, and will determine whether to keep a branch open or not simply on the basis of how profitable it is.
But if private companies run so much better than public companies, then why do we even have the stock market in the first place? Of course, the original idea behind the stock market was to allow companies to grow more easily, by allowing anyone to invest in them. However, as examples like Virgin show, you don’t need to be a public company to grow into a huge, multi-national business. Indeed, given the way the stock market works in reality, it may actually be more a of a hindrance to a company’s growth than a benefit much of the time. This is because people (naturally) buy on good news, and sell on bad. But it is during the tough times that a company needs investment, so a lot of the time, when a public company really needs more money to invest in the future, the stock market actually drains it out of them, often running a company with perfectly sound business fundamentals into the ground. Take for example the case of RAMS home loans here in Australia: they were a very successful business as a private company, but they had the misfortune of going public two weeks before the current mortgage crisis started. Although they did have some exposure in this area, it was by all accounts not extensive enough to make them unprofitable. But the general bad sentiment toward home loan companies at the time drove their share price right down, putting this successful private company out of business within weeks of going public! Hence, public companies are under enormous pressure to constantly deliver good news to keep their share price up, even if they are in fact losing massive amounts of money (inevitably leading to such debacles as the Enron collapse).
Even worse, all too often stock traders don’t even focus on a company’s profitability, instead just being obsessed with growth. This is because a company that steadily delivers good profits without expanding doesn’t provide many opportunities to buy and sell shares, which is how stock traders make most of their money. They want the company to grow, even if it is at the expense of profits. A great example of this was the “dot.com bubble”—because the then relatively new internet market provided enormous opportunities for growth, stock traders invested heavily in it. Never mind the fact that most of these companies were actually losing money! Of course, this could not go on forever, so it eventually resulted in a stock market crash. When there isn’t enough real money to back up the profits businessmen are making, something eventually has to give. The current financial crisis is a more large scale version of much the same sort of thing: people borrowed amounts of money that were way beyond their actual capacity to repay, to generate profits for businessmen that in reality weren’t backed up by enough real money. And the really tragic thing is that it isn’t just the reckless businessmen themselves who eventually have to pay for this—because of the knock-on effects the share market has on the entire global economy, we all end up having to pay for its excesses. This is what caused the great depression, and is seriously threatening to do exactly the same thing now.
So what can we do about it? It seems to me that—given that the supposed advantages the stock market provides appear to be vastly outweighed by its proven disadvantages—the ideal solution may be to abolish the stock market entirely. But of course, it is difficult to see this happening in practice, and the short term effects for the global economy could be catastrophic (although to a large extent this could depend on how well it is managed). Sadly, it seems the reality is that we are stuck with the stock market for the foreseeable future, so the best we can do is try to control its excesses. Yet it seems to me that the kind of band-aid regulatory measures that are being talked about now will not do a good enough job. I think there needs to be fundamental changes to the laws governing the way public companies are run, and the liability of those companies and the people running them. It is beyond outrageous—indeed, beyond criminal—that business executives can run companies into the ground, then walk away with millions. Tying corporate salaries and payouts to company performance is a good start, but ultimately, I think what is required is that the people running public companies have to have far more personal liability for them. You can be damn sure they would do everything in their power to keep the company sustainably profitable if they knew that—were the company to go under—they would have to pay a large part of the bill themselves. Why should business executives be allowed to walk away from a failed company without having to take much financial responsibility for it, while their customers, employees and shareholders foot the bill?