Capitalism in decline as markets go soft

There’s no agreed definition of capitalism but most people would hazard a guess it’s about entrepreneurs.

There’s no agreed definition of capitalism but most people would hazard a guess it’s about entrepreneurs and business owners — people with real skin in the game — being left to their own devices. That’s a nice idea but it’s far removed from what our economies have become.

Take the stockmarket, which, especially in Australia, is starting to look a bit like a casino for unwitting gamblers than a mechanism to attract and allocate savings to new investments. Many see the benchmark S&P/ASX 200 index, which has just had its best annual return in four years, as a barometer of Australia’s economic and corporate success, but the number of firms choosing to list on exchanges has been declining, and the savings attracted and allocated via stockmarkets in general have been drying up.

The huge sums of cash that change hands daily on the ASX, more than $4 billion on average, have little to do with the investment decisions of the underlying firms or the creation of any new ones. Buying shares with a view to making a capital gain is a generous use of the term “investment”. It’s speculating, which is perfectly fine of course, but let’s not gild the lily. And this is before we even examine financial derivatives, whose value dwarfs the value of underlying assets they derive from.

The other thing people might volunteer about capitalism is a need for private capital, or savings, to power new business projects. Yet increasingly, business investment stems from retained earnings of existing firms, or is provided to newer firms “off market” by private equity and venture capital firms. Building factories and railways requires huge sums but the Apples and Googles of the world require very little capital.

“The social and economic function of the stockmarket is to provide equity capital to the Aus­tralian economy,” Credit Suisse’s Hasan Tevfik said earlier this year, pointing out year-to-date net issuance was only $1bn. Net equity issuance on the Australian market has dwindled to far below its average of about $40bn a year.

He’s not the only one to have noticed. The Reserve Bank in 2015 noted that non-resource firms’ net equity issuance has been “modest”.

“Net investment has continued to be funded mainly through internal sources, while the use of external finance has remained limited,” its economists noted. “Substantial net investment by resources companies has been funded primarily by operating cash flows, while external funding has been modest,” they added. It’s remarkable that even the resource boom, Australia’s biggest ever, needed little new equity issuance. The nature of share ownership has changed fundamentally too. When stockmarkets emerged shares were owned mainly by individuals, who took an interest in the management and success of their companies. Shareholders then were more powerful than the nebulous, dispersed groups of largely clueless people who “own” big listed firms today.

If capitalism is about having a tight link between ownership and control, that system died long ago.

The number of businesses and entities that stand between shareholders and management of the companies they own — custodians, asset managers, proxy advisers, consultants, bankers and traders — has become longer and longer, which inevitably makes the whole system more expensive. The entities who vote on company boards might have very different incentives and opinions from the shareholders they are meant to represent. The explosion of exchange traded funds, which allow “investors” to own shares that reflect the value of other shares, has only amplified this trend.

The volume of research provided for free by banks and asset managers, for instance, at great cost to those institutions, suggests its function might be closer to advertising than advice. While few investors have actively bought such advice, they are paying for it one way or another, be it though higher commissions or wider buy-sell spreads.

The British economist John Kay has cheekily suggested stockmarkets could be open as little as a day a month or year, to serve the actual purpose of amassing and allocating capital.

Such a reform would hurt financial services businesses that depend on transactions to make a living.

And what about price discovery and liquidity, you say? Price discovery and liquidity for whom, though?

Savers, investors and the ultimate businesses that receive their funds probably don’t need to know the price of shares every millisecond. Indeed, if investors were susceptible to irrational exuberance and fear, gyrations of market prices could destabilise the economy.

All major stockmarkets share these trends, but Australian listed equities are also affected by massive waves of compulsorily acquired savings, known as superannuation contributions, which wash over equity markets like clockwork.

This helps prop up equity values and naturally leads to an ownership pool far more likely to be ripped off than one in which individuals were consciously choosing to buy shares.

On top of superannuation, Australia’s market is almost uniquely characterised by dividend imputation, which encourages domestic investors to buy and hold stocks with higher dividends purely for tax reasons (although the push to slash company tax would cut these refundable tax credits, too).

Economists have long pondered a system just like the one we now have, where large corporations become responsible for the bulk of economic activity and their managers, along with politicians and bureaucrats, become the most powerful decision-makers in society. Senior managers in large corporations perform functions very similar to bureaucrats. And they weren’t especially optimistic about that development.