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Essay on Flow of Funds Economics and the Equity Shortage

The Hidden Equity Shortage

Watson : "Is there any point to which you would wish to draw my attention?"

Holmes : "To the curious incident of the dog in the night time."

Watson : "The dog did nothing in the night time."

Holmes : "That was the curious incident."

Sir Arthur Conan Doyle

Like Sherlock Holmes in Conan Doyle's story, we should note the interesting fact that throughout the Great Stock Bubble of the 1990s, market experts did not attribute rising prices to a shortage of equities.

Instead, their explanation was simply that stocks had become more valuable.


This suggests that prices were rising faster than any plausible measure of intrinsic value.

An Unperceived Shortage

A reasonable explanation would be that prices rose because there were not enough of equities to go around.

Simply put, people came to the market wanting to buy more stocks than issuers would supply.

Economists proclaimed that price must be equal to intrinsic value.

Throughout the 1980s and 1990s, Americans listened to market professionals, academics, and politicians claiming that stock prices were rising because of improved productivity, low inflation, technological innovation, efficiency, and a Virtuous Cycle of good outcomes spurred by wise government policies.

Economists proclaimed an Efficient Market Hypothesis, saying that market price must be equal to intrinsic value.

If this were so, the real worth of stocks had to be increasing.

Most people thought the stock boom was not the result of inflation or an insufficient supply of stocks but instead was a natural outcome of increased worth being packed into each share.

People imagined increased worth being packed into each share.

It was as if in a market for bushel baskets, each basket contained one bar of gold in 1980 and three bars of gold in 2000.

Rising Prices, Rising Value?

During World War II, the price of sugar rose sharply and the government rationed the product.

Sugar prices don't rise because sugar is getting better.

No one claimed that sugar prices rose because sugar was getting better.

It was obvious this was not so.

People wanted sugar to put in their coffee and pancakes, but there was less sugar available because submarine warfare had interrupted ocean shipping and the government needed sugar to supply the armed forces.

Sugar prices rose because there was a shortage.

However, a 'shortage of equities' is rarely mentioned when talking about the stock market.

Some presume the supply of equities can be taken for granted.

One reason is that much of orthodox economic theory about capital market pricing deals with the supply of equities as an 'exogenous factor', which in plain language means that the supply of equities can be taken for granted or ignored.

Economists, rather than decrying a dearth of securities, proclaim the market is only a reflection of the considered judgment of rational, well-informed individuals who would not pay more for equities than they are worth.

Stockbrokers are happy to hire these economists as spokespersons for a New Era, because investment bankers know that rising prices mean larger year-end bonuses.

The Role of the SEC

The Securities and Exchange Commission, as the investors' watchdog, works under a theory that government should shield its gaze from the intrinsic value of stocks and avoid issuing opinions about the worth of equities.

The SEC does not concern itself about the worth of investments.

This is proudly called 'non-merit regulation'.

The SEC limits itself to observing trading, the safety of institutions, and the disclosure of 'material facts'.

If investors routinely buy equities at multiples of any reasonable worth, the SEC doesn't care as long as information needed to reach this conclusion is available.

There is an old regulator's adage that says, 'It's OK to sell smoke in a bottle, as long as it's labeled as smoke'.

The Shortage Went Unnoticed

One of the peculiarities of the stock market is that the asset traded is quoted in a vague unit – a 'share'.

A 'share' is not a defined standard, but only a legal idea about ownership of a corporation.

A share is a container of value of unspecified dimensions.

Corporation Alpha may have ten million gold bars represented by one million shares, while Corporation Beta might have the same number of gold bars represented by ten million shares.

Corporation Alpha might be quoted at ten gold bars a share, while Corporation Beta sells for one gold bar a share.

This does not mean that Corporation Alpha is worth more than Corporation Beta, although a careless investor might think so.

To say, 'Stock prices are rising' is like saying, 'Bushel prices are rising'.

Even saying, 'The price of IBM stock is rising', does not provide information about the intrinsic value of IBM shares.

A share is a container of unspecified dimensions.

It would be more useful to say, 'Current dividend yields on IBM stock are falling.'

It means even less when we set up indices of stock prices and constantly manipulate the way we calculate the averages, while the companies themselves adjust the perceived value of shares by reporting different earnings and dividends.

By focusing attention on the fuzzy idea of a 'share of stock', casual investors and many professionals lose a sense of intrinsic value.

Few people watch tickers of price-earnings ratios or dividend yields.

In tracking the commodity market, we follow prices of clearly defined items, like bushels of wheat of a certain quality or barrels of North Sea crude oil.

In the bond markets, we follow the current yield on specific bonds, or even categories of bonds, such as investment grade corporate debentures with ten-years to maturity, and this provides useful information.

However, in the stock market, few people watch tickers showing how price-earnings ratios or dividend yields change by class of stock.

After a while, stock investors easily confuse changes in intrinsic value with variations in market price and when this happens, a scarcity of equities passes unperceived.

What We Mean by 'Shortage'

To speak of a shortage involves the thought that people earning normal incomes should be able to afford a certain necessary quantity of whatever is lacking.

If we need fifty kilowatt-hours of electricity each month for a certain standard of living and the cost of electricity becomes so high that we cannot afford to buy this amount, we recognize a shortage and a problem.

There is demand for investments to transfer value from decade to decade.

In societies in which people need to amass wealth at one period in life, to spend in another, there is a demand for investments that transfer value safely and efficiently from decade to decade.

There may be a shortage of investments that do this effectively.

In Brazil, during the 1950s, inflation was running more than twenty percent a year, while usury laws banned interest of more than twelve percent on bank accounts.

Bank deposits were a dismal way to preserve savings over ten or fifteen years.

In those days, Brazil's stock market had not yet developed.

With a shortage of alternatives, Brazilians with savings turned to real estate as the best investment available.

Confused Ideas About Value

To sense the shortage of equities, we must have an idea of the intrinsic value of stocks.

If many people think the price of stock is too high to provide the income and safety needed to get through their retirement years, they may complain about a shortage of equities.

The Common Stock Legend clouded investors' minds as to value.

However, because of the three kinds of players that are active in the market , there is confusion about how stock values should be measured. (see: Three Faces of Value)

Americans did not speak of a shortage of equities during the 1980s and 1990s because they believed the Common Stock Legend.

The shortage of equities may become a topic for discussion when prices collapse and people realize that over-priced equities are a poor way to hold wealth.

Economic Blind Spots

In addition to uncertainty as to how stocks should be valued that fogs awareness of a scarcity of equities, economists give no guidelines as to the quantity and type of investment that is necessary for a good society.

No one knows for sure what 'savings' and 'investments' actually mean.

Instead, they chant the hollow tautology that savings equal investments, with both defined as income less consumption.

No one knows for sure what 'savings' and 'investments' actually mean.

U.S. government statisticians do not have a standard measure of savings.

Ambiguity partly resulted from flawed measurement, but mostly from conceptual squabbles about the meaning of savings, investment, income, and consumption.

Economists Pulling Levers

Economists generally say that the balance between savings and investment is determined by interest rates, the propensity to consume, and the marginal return on capital.

They assume that as expected returns on investments fall, people will be less inclined to save and will instead fritter money away on current consumption.

This is what is behind the basic strategy of the Federal Reserve Board that lowers interest rates in the hope of raising investment, consumption, and employment, while jacking up rates to dampen spending and inflation.

Millions of people believe that government fiddling with interest rates influences the level of economic activity and eagerly hang on to every word of the Federal Reserve Chairman.

The Fed's machinations are meant to give the masses a feeling that government can do something to control the economy.

The lag between a Federal Reserve interest rate decision and a measurable change in economic indicators varies so widely that the effectiveness of the Fed's actions is an open question.

Bankers eagerly jump on the Fed's bandwagon, because they can profit by change in any direction by adjusting the appropriate side of their balance sheets.

However, the broader impact on savings, investment, and consumption is less certain.

Nevertheless, the Fed's machinations give the masses a feeling that government can do something to control the economy.

If enough people believe that sacrificing virgins on the Capitol steps boosts economic activity, this might become the accepted practice, with the same outcome as jiggling interest rates.

Do Interest Rates Motivate Investors?

Demographics, wars, migrations, famine, plague, societal change, and projects of great leaders do more to influence investment than do interest rates.

The decision to save depends on many things other than expected investment returns.

The decision to save depends on many things other than expected investment returns.

Religious persecution encouraged early settlers to migrate to America from Europe, while a willingness to enslave other humans helped bring millions from Africa.

During the twentieth century, the size and unity of American families declined, while life expectancy increased, providing an incentive for increased saving, independent of interest rates or the expected return on capital.

Employment growth in the United States is attributed to small business, but most people do not open a sandwich shop, karate studio, or catering service because of the high expected returns.

Instead, the motives are usually personal – family custom, a lack of credentials or connections to gain employment in big business (or government), discrimination on the basis of race, national origin, sexual preference, or gender, the desire to be one's own boss, a reluctance to move to another city where opportunities are better, or the need to be near family, relatives, and friends.

Irrationality Triumphant

In the 1960s, thousands of Americans turned their backs on higher wages in large corporations to settle in hippy communes and make jewelry, weave rugs, manufacture waterbeds, or raise natural foods.

Some of these ventures, in time, turned into big business, but this was not necessarily the initial goal of the flower children.

During the nineteenth century, Americans went west and set up shop in rough frontier towns, not so much for the high returns on capital, as to flee creditors, arrest warrants, scandal, jilted lovers, or merely for adventure or to begin a new life.

The Pilgrims did not land on Plymouth Rock because of higher interest rates.

The Pilgrims who landed on Plymouth Rock were not drawn by high interest rates in the Massachusetts colony.

A man that establishes a surf board store on a beach in Hawaii is probably more driven by the opportunity to occasionally 'hang ten' than dreams of great wealth.

The Mormons did not trek across the Great Plains and found Salt Lake City in response to high returns on capital.

Most great endeavors of mankind have been unrelated to incentives to save: the pyramids of Egypt, the cathedrals of Europe, the American road system and the space program, the Nasca lines in the deserts of Peru, the structures at Teotihuacán near Mexico City, the Borobudur temple in Java, the colonization of the American West, the Brazilian hydroelectric system, the Great Wall of China, the Tennessee Valley Authority, and thousands of similar projects in the broad scope of human history.

Capital Costs and Investment

In Japan, where population aging has been extreme, savings have expanded and interest rates have dropped almost to zero.

On the investment side, in both the U.S. and Japan, the effective cost of capital has fallen, as retirement savings have increased.

In neither Japan nor the U.S., did reduced capital costs spur new investment.

However, in neither Japan nor the U.S., did reduced capital costs spur new investment.

In the U.S., corporations, on balance, reduced capital through buybacks that were designed to force stock prices upwards and give value to executive options, to the disadvantage of savers, technological progress, and future high-income employment.

In Japan, interest rates fell for a decade without luring the economy from a long recession.

In the U.S., throughout the Great Depression, interest rates stayed exceedingly low for a decade, without reviving the economy.

Savings Do Not Equal Investments

There is no reason to believe that savings necessarily equal investments, as the economists claim.

During the Internet phase of the Great Bubble, billions were transferred from well-intentioned savers into the pockets of slick stock promoters, venture 'capitalists', and the under-thirty founders of unprofitable and hare-brained schemes, and from there into the cash drawers of vendors of goods of conspicuous consumption or the tax authorities.

An 'investment' in tulip bulbs, antiques, or collectibles is really consumption.

Transfer of wealth from 401(k) plans that supported the capital gains of stock option fraudsters was neither savings nor investment.

An 'investment' in tulip bulbs, antiques, or collectibles is really consumption, as are often 'investments' in a vacation house or an entertainment center in the basement of the family home.

Investing in stock through mutual funds and 401(k) plans, at a time when corporations are reducing capitalization through equity buybacks, is clearly not savings induced by attractive interest rates or marginal returns on capital.

Speculation in porcelain figurines, Impressionist paintings, or baseball cards is not investment.

Buying stocks according to the Greater Fool Theory, in the hope of capital gain rather than dividends, is not consistent with the proposition of John Maynard Keynes who wrote that,

'when a man buys an investment or capital-asset, he purchases the right to the series of prospective returns, which he expects to obtain from selling its output, after deducting the recurring expenses of obtaining that output, during the life of the asset.'

( 'The General Theory of Employment, Interest, and Money', John Maynard Keynes.)

Who Has Seen The Invisible Hand?

Orthodox economic dogma asserts that when people are left to themselves, without government intervention, an 'invisible hand' of rational self-interest will guide them to invest in ways that are best for society, based on the highest expected returns of competing investments.

A completely free economy, of course, is nonsense and no society has ever succeeded with such a policy.

Even during the so-called laissez faire period of American history – the nineteenth century – major economic activity was triggered by massive government intervention in railroad finance and land distribution across the great prairies.

A completely free economy is, of course, nonsense. No society has ever had such a policy.

The Erie Canal exists because of the personal determination of Dewitt Clinton, the governor of New York, and the desire to make New York City the economic capital of the country, rather than the stimulus of higher marginal returns on capital.

During the nineteenth century, U.S. society benefited from government incentives for railroads, canals, and homesteading in the western lands.

Expansion of railroads spurred steel production, coal mining, and the stringing of telegraph lines across the continent.

In Singapore, after World War II, strong, wisely-directed government policies, transformed this small island into the world's most modern port, giving Singaporeans one of the highest living standards on earth.

In Brazil, in the twenty years following 1960, the government rationed, controlled, and directed scarce investment resources, successfully transforming an agricultural society into a major industrial power in one generation.

Essay: continued >

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