Thought du Jour

One of life’s paradoxes is that never have modern companies been so awash with cash, yet never have they been so active in capital markets. Apple last month raised $17 billion by selling bonds because it could, not because the company lacked cash to give its shareholders in exchange for stock. Apple has reserves of $145 billion stashed overseas, but would have to pay taxes on any money it repatriated. By borrowing money it does not need, Apple obtains a business deduction (payment of interest) and avoids payment of taxes on past profits.

British economist John Kay runs through the logic of this, and suggests that we are living in a non-capitalist world, even though we insist on calling the system by its old name.

In the 19th century, railroads raised funds from private investors to finance costly infrastructure. Later, large manufacturing corporations raised capital in much the same way.

But only a few businesses today, mainly utilities, have the capital-intensive character typical of those early days of industrialisation. …. [I]t is now relatively unusual for a business to own the premises from which it operates. Employees today generally do not know who owns the building in which they work, or the desk at which they sit. They do not know because it does not matter. Their boss tells them what to do, not because he owns the means of production, but because he has been appointed as the boss.

A modern company, such as Apple, is knowledge-based, outsources its manufacturing and has little need of any tangible capital at all. A new business will need investment to meet its initial operating losses but can expect to become cash generative at an early stage of its life. If the company seeks a public listing on an exchange, the likely purpose is to provide a liquidity event for early-stage investors, or to reassure employees that their options have value, rather than to raise money to expand the business. Facebook took in cash from investors because it could, while admitting that it had no particular use for it. We still use the word “capitalism” when we refer to the institutions of the modern market economy but it has become a misleading term.

John Kay, “Why business loves capital markets, even if it doesn’t need capital“, Financial Times, 15 May 2013 (ungated).

FT columnist John Kay explains, with a simple parable, how financial markets function.

In 1906, the great statistician Francis Galton observed a competition to guess the weight of an ox at a country fair. Eight hundred people entered. Galton, being the kind of man he was, ran statistical tests on the numbers. He discovered that the average guess (1,197lb) was extremely close to the actual weight (1,198lb) of the ox. This story was told by James Surowiecki, in his entertaining book The Wisdom of Crowds.

Not many people know the events that followed. A few years later, the scales seemed to become less and less reliable. Repairs were expensive; but the fair organiser had a brilliant idea. Since attendees were so good at guessing the weight of an ox, it was unnecessary to repair the scales. The organiser would simply ask everyone to guess the weight, and take the average of their estimates.

A new problem emerged, however. Once weight-guessing competitions became the rage, some participants tried to cheat. [snip]  Continued at the ungated link below.

John Kay, “The parable of the ox“, Financial Times, 25 July 2012.

On 4 January 2013 John Kay discussed the implications of this parable (which are not good!) with presenter Tim Harford on BBC Radio 4’s ‘More or Less’. Click here to listen to it.

John Kay has a wonderful column this week on lessons from the Cyprus bailout.

The combination of useless regulation, irrelevant regulation and state guarantees met the perceived needs of regulators and the industry itself by creating an appearance of activity while reinforcing the status quo. But the inevitable result was that the crises kept coming. ….

The principle of resolution should be that neither political democracy nor economic efficiency can tolerate institutions too big to fail. That requires realistic plans to break up struggling cross-border institutions and the capacity to impose losses on uninsured creditors as well as shareholders. Most of all, it demands recognition that, in banking as in the rest of the market economy, the normal fate of failed commercial institutions is to be wound up. ….

And, as a recent book by Anat Admati and Martin Hellwig explains, banks need more capital – lots more capital, not minimal provision based on a pseudoscientific calculation of risk-weighted assets. Neither regulators nor management can assess accurately how much a bank really needs. The only safe bank is one with more capital than it could possibly require. Like banks of old.

John Kay, “Bungled bailout heralds shift in attitudes“, Financial Times, 3 April 2013 (free access).

When will we ever learn? Crisis after crisis, and still no reform of the financial sector.

FT columnist John Kay thinks that comparing banks to casinos is unfair … to casinos. Casinos that fleece customers are shut down. Banks that fleece clients continue to operate, often with a government bailout.

[W]hat would happen if employees of a London casino were found colluding to rig games for the benefit of the house, and particularly themselves? The police would arrive in force, the company would lose its operating licence and senior management would be excluded from the industry.

We know this because it has happened. Twice. ….

These crackdowns provoked predictable warnings of regulatory overkill: no one would invest in the industry again; London’s tourism sector would be destroyed. Neither of these fears had substance. Las Vegas and Macau may be the glitziest gaming resorts, but the destination of serious gamblers today is London, where margins are slim but profits high and tables famously honest. One of the rules that keeps them that way is strict separation between the house and the punters: the bank’s interests are differentiated from and disclosed to the players. Another is that senior management and the company are unequivocally responsible for the behaviour of their employees. Of course, any large organisation will sometimes make a hiring mistake, and rectify it quickly. ….

Casinos attract greedy people with deficient ethics: the fear this engenders frames regulation, the obligations we impose on executives and the culture we expect from operating companies.

Perhaps banks should operate to standards as high as those of casinos. There are two main arguments for splitting the utility of retail banking from the trading casino. One is to stop croupiers gambling with house money; the other is the incompatibility of trading and banking cultures.

John Kay, “‘Not on my watch’: applies to banks and the navy“, Financial Times, 4 July 2012.

This column originally appeared in the Financial Times, 4 July 2012.

Market fundamentalists (“market evangelists”) do not view speculative markets in exotic financial instruments as a problem. On the contrary, they believe that financial markets provide social benefits, so product innovation and establishment of new markets ought to be encouraged. John Kay disagrees.

[T]his is persuasive argument only to those who have never heard the maxim “too much of a good thing”. No one should starve: that does not mean people should eat as much as possible. A country without a financial system would be – is – an impoverished place. It does not follow that the larger the financial system, the more prosperous the country.

A better response would echo the mantra of America’s National Rifle Association: guns do not kill people, people do. Derivative securities and other complex financial instruments can serve useful purposes. If they create instability it is because they are misused.

But should we, as the US would do, look for the solution in better people? Or should we, as most of the rest of the developed world does, think that if instruments are dangerous when abused their use should be tightly controlled? For many Americans, the fear of restrictions on the liberty of honest citizens is so strong that they are willing to accept the collateral damage of a high homicide rate and the incarceration of large numbers of bad young men. For Europeans, the loss of the ability to own a gun is a trifling price to pay for safer streets. There are similar transatlantic differences over the scope and merits of financial innovation.

John Kay, “Only market evangelists reconcile Jekyll with Hyde“, Financial Times, 6 June 2012.

There is much more in this superbly crafted column, which is not gated.