Irrational Finance

Two excerpts from Rational Irrationality: The real reason that capitalism is so crash-prone.

What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization. But, once his peers have entered the field, and are making money, his firm has little choice except to join them. C.E.O.s certainly don’t have much personal incentive to exercise caution. Most of them receive compensation packages loaded with stock options, which reward them for delivering extraordinary growth rather than maintaining product quality and protecting their firm’s reputation.

Here is another on financial innovation, which made me think of my bank post:

Limiting the development of those securities would stifle innovation, the financial industry contends. But that’s precisely the point. “The goal is not to have the most advanced financial system, but a financial system that is reasonably advanced but robust,” Viral V. Acharya and Matthew Richardson, two economists at N.Y.U.’s Stern School of Business, wrote in a recent paper. “That’s no different from what we seek in other areas of human activity. We don’t use the most advanced aircraft to move millions of people around the world. We use reasonably advanced aircrafts whose designs have proved to be reliable.”

11 replies on “Irrational Finance”

  1. The quest for market share and revenue has also taken its toll on the newspaper industry. Hearst and most other publicly traded media chains have expanded their holdings far beyond the point of profitability to satisfy shareholders’ demand for revenue growth. One study I read even described the “diseconomies of scale” that newspapers experience when they expand circulation beyond a certain point–say, 40,000 people. Meanwhile, the SF Chron currently circulates to about 400k, and has been losing upwards of $20 million a year or more since 2001!

    Makes me wonder what it is about public corporations and their addiction to bigger better faster more. Could the end of the stock market as we know it be on the horizon?

  2. @Rick – that’s fundamentally the problem with all public companies – they all have a mandate to increase shareholder value. Which is why the public and shareholders always makes such a big deal when earnings forecasts aren’t met.

    I think capitalism has some serious problems. Any system where you need a wizard behind a curtain magically turning the interest rate knob from time to time to keep the system from collapsing seems fundamentally broken. In fact, there are many safeguards in the system to prevent collapse, many of which go against the very principles of capitalism. For example, after the 1929 stock market crash, provisions are now in place such that the market can be arbitrarily suspended for a period of time to prevent a similar event. And while it may protect the system, it ultimately limits the ability of people to offload their shares in the event of an impending collapse.

    1. Duane: If your company doesn’t have a “mandate to increase shareholder value” you stay private. For going public and raising money must come at a cost of generating profits for investors. This is not a “fundamental problem of all private companies”, this is basic economic principles.

      And central bank interest rate planning and manipulation ARE NOT fundamentals of capitalism. These two elements of our economy share no links other than being simply what America is used to. You could probably argue that a strong central bank is more commonly associated with other economic systems like socialism than by capitalism, since a truely free market would allow interest rates to be set simply by market forces – the supply and demand of capital.

      The Fed will continue to point to this self-serving idealogue that capitalism is inherently unstable, in order to usurp additional power and control, meanwhile creating the underpinnings of more frequent and severe financial crises.

  3. It’s not that simple. You’re just assuming that the CEOs are who ignored the wisdom of everyone else when they dived off the subprime cliff. Totally not true. The government, small banks and private investors also slipped up.

    It’s not about compensation — it’s about how groups of people are sometimes morons, regardless of compensation. No economic system or financial system can reduce the impacts of collective stupidity.

  4. @Duane

    Absolutely correct. The primary goal of all public corporations is the increase in shareholder value. If they should make a good widget in the process, that’s just gravy.

    This sets corporations at odds with the continued good health of the system as a whole. To most capitalists this as a zero sum game. The game is grab your share and run.

    Let’s not forget that the most prosperous times in American history, 1945 to 1970 were achieved with more, not less, regulation than we have today.

  5. I know in these times this will be a contrarian opinion, but here goes:

    Markets only work when they are left to their own devices. When governments fiddle with them, they make a mess. If failing companies are allowed to fail, other companies learn a lesson. When big companies are given a pass by government, other companies learn to become too big to fail, too important to fail (Freddie Mac & Fannie Mae) or too politically connected to fail (GM & Chrysler).

    Rather than create numerous additional regulations, most of which will do more harm than good, beef up the SEC to enforce the good laws we already have, which would have helped prevent most of this current mess.

  6. In all this discussion about the hazards of capitalism, very few ever talk about the role our economic central planners (a.k.a the “Fed”) played in the current financial crisis. Cheap credit lead to over-speculation.

    Why are very few people talking about regulating the activities of the Federal Reserve? The amount of money they can release into the economy. For an organization that was supposedly established to stabilize the economy, they sure haven’t done a very good job. Our dollar is worth 95% less than it was since their inception. With every bust that follows a boom, more people fall victim to the whims of a system controlled by a few well-connected individuals.

  7. These are very thought provoking arguments. In theory, “the market” (aka investors) should be capable of judging whether a company’s valuation is low, high or reasonable. In reality, people lose and make money on these judgment everyday.

    I suspect that most investors fail to grasp the true dynamics of a company’s revenue stream, resulting in inflated valuations. People, like Warren Buffett, understand this and use the knowledge to accumulate vast amounts of long term, sustainable wealth.

    Rather than throw the baby out with the bath water, I can think of two things which would go a long way in correcting this behavior:

    1) Require schools to include basic finance/economics principles in their curriculum.

    2) Require that a measure of short positions are quoted next to every companies stock price.

    Even with a B.S. in economics and as a current business school student, there are many aspects of the equity markets that mystify me. However, common sense says that the above steps would go far in reducing similar crises.

  8. @Joel – I think the problem is that the markets are almost entirely speculative nowadays. Even when companies produce dismal financial results for several quarters, lots of people will continue to buy their stock hoping that things will turn around. The last company I was at lost money basically for six years straight, and yet people continued dumping their money into it and talking about what it steal it was.

    That’s why I’ve never understand the concept of speculative valuations for companies that haven’t even earned $1 yet — Twitter is a good example, last report I read valued it at 1.7 billion dollars. For what? Granted, you might be able to assign a dollar value per user if you thought it would be cheaper to buy those users instead of court them yourself in your business. But as a company with no revenue and no real business model, they shouldn’t really have a big valuation in the real world. If you were looking at buying a local business and saw a coffee shop that hadn’t earned a dollar since it opened, how much would you be willing to pay for it?

    @Jeff – you make some good points, and that leads into another area. The United States (and many other countries) aren’t really true democracies any more, they are more similar to plutocracies, where the wealth and control are kept by elite classes within the society.

  9. @Duane “I think the problem is that the markets are almost entirely speculative nowadays”…I appreciate the thoughtful response, so no offense, but I must say that I despise this statement.

    Every voluntary action a human being takes is based upon some expectation of future results; therefore every voluntary human action is speculative. The stock market is no different.

    Now, you may have different expectations of future results than someone else, but if you happen to be the one who is correct, that does not mean that the other person was the only one being “speculative.” It only means that they were wrong.

    You were both speculating. I understand the sentiment, but following this logic fails to give credit to those with sound judgment. In hindsight, we are all geniuses.

    I would like to say that we can regulate luck, another significant factor in success, out of the financial system, but by running state lotteries, government has already implicitly conceded that this is not possible. Besides, the biggest financial successes are the result of both luck and sound judgment.

    Perhaps we have differing definitions of the word “speculate” and this is causing a disconnect. If so, please correct me.

    In my earlier comment, I was just trying to point out some practical steps that could be taken to deflate some of the irrational exuberance that humans are prone to.

  10. @Rick, the “The quest for market share and revenue has also taken its toll on the newspaper industry. ”

    C’mon man, seriously? Do you really think disruptive forces like consumers getting their daily dose of news and media from free sources online is not the reason?

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