Chapter 1.8 - WALL STREET & THE GREAT INVESTMENT MYTH

CHANGING AMERICA'S MIND
Chapter 1 - Part 8


The Insatiable Demand that Became an Addiction

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The book is being published sequentially as it is written.


The financial markets of the world are places where people who have excess money (more than they require for current living expenses) put that money in an effort to gain the greatest possible return of interest for its use.  The concept is that the money is then used for productive purposes enabling a producer to make or grow more of something.  That “more” has a value and if it is sold at a profit, the ‘investor’ then takes a legitimate and appropriate cut for his part in making it possible.  Such excess money is also known as ‘capital’ which is ‘invested’ in hopes of achieving a ‘return’. 

Small businesses, family farms, and startups are certainly examples in which this concept is shown to be true.  It is also true, when corporations or governments raise needed capital by selling bonds.  But as I demonstrated earlier in the chapter, it is a myth when the ‘investment’ is not used for productive purposes.  If it does not help in making more of something that people need and therefore will buy, enabling the producer (distributor, retailer) to make a living and hopefully a profit, then where does this ‘interest’ or ‘return’ come from.  For that matter, even if it is used for productive purposes, but the demand is for an interest or return that is greater than the profit earned, where does it come from?

To attempt to answer that question, let’s consider the typical profit margins achieved by productive businesses.  First there are a host of successful retail businesses – department stores, hardware stores, grocery stores as examples - whose annual profits are seldom greater than 3-4%.  These are referred to as high volume, low margin businesses.  Farming and ranching, in good years, maybe yields 5-6%, but often the weather or falling prices result in losses instead.  Even in manufacturing and even with the best of lean manufacturing practices, the margins seldom exceed 9%; industry averages are usually closer to 6%.  Yet Wall Street financial markets consistently expect double digit returns; many of the financial instruments it sells are designed to yield as much as 30%.   So, if real businesses can’t earn that much, where does it come from?

Perhaps it can come from growth, you might conclude.  One of the articles quoted above, states that for business in general an 8.9% average revenue growth would be a record.  A business can only grow in one of two ways, it either offers products or services in a growing market or it gains a greater market share in an existing one.  Growth in mature highly competitive existing markets requires heavy expenditures for marketing and sometimes for incremental product enhancements.  Such expenditures cut into profits resulting in lower rates of return, not higher. 

Investment in high growth markets, on the other hand, usually follows the introduction of a totally new technology – think early days of television, personal computers, or the internet.  These are the realm of startups where entrepreneurs and venture capitalist achieve the high rates of return justified by their innovation and the high risks.  Such companies often achieve growth rates exceeding 100% and thirty percent annual profits or also common.  So perhaps a portion of Wall Street’s expected double digit returns come from these startups since some of the financial securities offered by Wall Street firms also bring money into these high growth markets.  The problem with this theory, however, is that there are a limited number of such opportunities so a much greater % of Wall Street’s money goes into the more speculative areas of betting for and against such companies. 

So again, I ask, how is it reasonable for the Wall Street Banks and financial funds to promise returns of up to 30%?  Where will this money come from?  It can only come from cost cutting in real businesses resulting in the off-shoring of jobs, cuts to R&D, the externalizing of costs at the expense of the environment, and other predatory means.  Or from using insider information to pick up the losses suffered by ordinary 401K holders.  That, I think, could be described as legalized piracy.

Welcome to the new age of finance capitalism.  In an article he presented to the Academy of Management at its 1998 San Diego Conference (foot note),  David Korten discussed finance capitalism, which as I understand it, can be described as the latest phase of capitalism following agricultural capitalism, industrial capitalism, and technological capitalism.  In those earlier phases of capitalism, wealth was created when a surplus beyond immediate needs was diverted from consumption into investments in buildings, machinery, and technological change.  Those investments also created jobs. 

The theory or logic of finance capitalism, Korten explains, is different in the following way.  “The key to rapidly and effortlessly increasing the wealth of a society” he writes, “is to convert ownership rights to its productive assets into freely traded financial securities.  These securities should then be placed under the management of professional portfolio managers who have a single-minded focus on shareholder return.  They will pressure the managers of the assets to squeeze every possible source of profit from the enterprise to inflate the share prices.  This increases the total market value of the society’s productive assets and thereby the total wealth of society.”

“Note the logical fallacy here,” he continues.  “The inflation of share prices puts more money in the hands of those who own the shares – more claims against society’s wealth – but it does not necessarily add a thing to society’s productive capacity or output.” … “It says nothing about – nor does it seem to care – where management gets the increased profits that the financial markets demand.” 

Perhaps Korten’s strongest indictment is that this theory’s proponents praise “finance capitalism and its underlying logic as the greatest invention since King Midas got the golden touch – a nifty way to create wealth without doing anything useful.”

Next this section continues - 

Footnote: Do Corporations Rule The World?  And Does It Matter?  David C. Korten; presented to the Organizations and the Natural Environment Section of the Academy of Management at the 1998 San Diego Conference on August 10, 1998.  Organization & Environment, Vol.11 No. 4, December 1998  389-398.  © 1998 Sage Publications, Inc.

Larry
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