|It'sNo Gamble- The Economic and Social Benefits of Stock Markets|
Stock markets and the economy
FEW INSTITUTIONS ARE AS MALIGNED and misunderstood as the stock market. Financial markets in general are seen by many as a visible symbol of the greed and financial excesses of the 1980s - witness such popular books as Liar's Poker (Lewis 1989) and Bonfire of the Vanities (Wolfe 1987). Stock markets in particular are seen by some as speculative gambles at best and manipulated private clubs at worst. This latter view, espoused, for example, by Canadian writer Walter Stewart (1992), [The Golden Fleece vilifies Canadian stock markets. Analogous treatments of Wall Street are proffered in Elias (1971), Ney (1970), and Baruch (1971), among others. For a more sympathetic view of Bay Street, see Ross (1984).] gains prominence whenever evidence of market corruption gets media attention and lobbyists call for the imposition of stricter regulation. Others, such as international business guru Michael Porter (1992), blame the decline of North American competitivenesson myopic stock market investors who, the story goes, exert pressure on corporate management to pursue short-term profits at the expense of long-term strategic planning.
The purpose of this book is to look at how stock markets help economic growth and development, and to weigh the evidence about how well they discharge this function. We argue that stock markets are a vital intermediary in an industrial economy, facilitating the pooling of funds, the sharing of risks, and the transfer of wealth. Without them, resources would not flow to the most productive investment opportunities, and economic growth would suffer. Indeed, with trade barriers loosening around the world, a country's very economic survival may depend on well-functioning stock markets.
The following quote gives an indication of the range of tasks that the stock market is expected to perform:
Indeed, the stock market plays an important role in the daily economic life of this country. We hope to make a contribution toward a better understanding of how the stock market fulfils this role, and thus to foster a deeper appreciation of its economic importance. To accomplish this task, we draw upon a large body of theoretical literature and review the empirical evidence on the social benefits of stock markets. We pay special - but not exclusive - attention to the Canadian scene.
This book also attempts to correct some of the myths and misconceptions regarding the stock market. These myths have a powerful hold on people who criticize the stock market and on those who call for increased government regulation.
Stock markets are a zero-sum game; namely, what one person wins has to come at somebody else's loss. Walter Stewart (1992) is an important proponent of this view. He alleges that stock markets are merely a "crap game" in which the small investor is invariably cheated by those in the know. Table 1 demonstrates that investing in the stock market over long periods provides superior returns to investing in bonds, and that those returns are sufficient to beat inflation. As the economy grows, so does the total value of all the stocks outstanding. Some, of course, give better returns than others, and some decline in value. Moreover, some (mainly small) investors do get hurt by broker malfeasance (see chapter 7), but that does not invalidate the attractiveness of long-term investment in stocks, even for small investors. [We emphasize "long-term" returns here, because, as is well known, the stock market can be a dangerous place for investments in the short run (such as in October 1987)]
Click here to view Table 1: Capital Market Rates of Return in Canada, 1926-1993 (Percent)
Stewart supports his accusations with a litany of examples where small stockholders have been disadvantaged, and, as the "coup-de-grâce," refers to the existence of instruments such as the Toronto Index Participation Units (TIPs), a security which tracks the value of the TSE 35 Index:
None of these dice-rolling instruments has anything to do with bankrolling enterprise or participating in decision-making or, indeed, anything to do with anything but shouting, "Baby needs a new pair of shoes!" and praying not to roll craps. (p. 8)
While such prose is graphic and eye-catching, it unfortunately displays a simple-minded naivety regarding the operation of the stock market. The role of TIPs in allowing investors to hedge risk is explained in chapter 1.
The stock market is a source of economic instability. Supposedly, market volatility has increased with the growth of trading in so-called "derivatives" such as options and futures contracts. According to the critics, trading in derivatives has introduced to the market a "systemic" risk, meaning that the failure of one institution could bring down the entire financial system like a house of cards. Stewart (1992) dismisses derivative securities as mere "bets," and again shows a lack of appreciation of their role in reducing risks and thus facilitating economic development (which we explore in chapter 1).
People who "play" stock markets demand a quick return on their money and ignore long-term investments. Institutional investors are particularly maligned for their "bottom line" mentality. Michael Porter (1992) may have been partly right in criticizing the role of myopic investors in corporate strategic planning, but as we discuss in chapter 7, much of that kind of behaviour is changing as institutional investors take a more active role as "relationship investors," becoming long-term partners in the enterprise and taking a longer-term perspective.
Much financial system activity is mere "paper shuffling" that has nothing to do with the creation of real wealth. Critics often point to mergers and acquisitions and to "junk bonds" as prime examples of this allegation. We show in chapter 3 that mergers and acquisitions add to economic growth, and that junk bonds and other financial innovations are important contributors to this process. Corporate reorganization is part of the natural evolution of a company, and mergers and acquisitions serve to reduce inefficiency: the surviving company is usually better able to compete effectively than could the pre-takeover entities.
Stock market investors risk losing their money to firms that lie about their prospects when issuing new stock. A more realistic perspective is to view stock markets as a giant laboratory where investors try to find the best mix of stocks for their purposes. Finding this mix is expensive because the investor must research potential investments and weigh the information a company puts out about itself against his or her previous experience with the company. The stock market is driven by a search for information about which investments deserve a try, and which investments are likely to fail, and many companies specialize in collecting and selling information about investment prospects. We discuss the efficiency with which stock markets process such information in chapter 4.
Other myths and misconceptions about the stock market abound, and we debunk some of them throughout the book. We hope to leave the reader with a more informed opinion of the stock market, which will allow him or her to separate myth from reality.
We begin with a history of the development of stock markets and an examination of their structure and functions in chapter 1. We describe the creation of new market instruments such as derivative securities (so called because their value derives from that of an underlying asset), and examine objectively their role in fostering economic growth. Such objectivity has been largely absent from most media reports on derivatives. The central function of the stock market is to act as "middleman" between investors and public companies, and we describe its role in accommodating the different attitudes of individual investors to risk and their needs for a variety of forms of income, while at the same time ensuring that funds flow to the most profitable investment opportunities.
The stock market acts as a link between investors and company management. It allows managers to know what investors want and it allows investors to control their managers. Chapters 2 and 3 examine several aspects of the stock market's role in corporate governance. Chapter 2 focuses on the consequences of separation of ownership and control in shareholder-owned corporations (i.e., the managers of large companies tend not to be major shareholders, and they may have goals different from those of the owners), and on differential voting shares (i.e., shares with different voting power). Both of these features are frequently considered to work to the disadvantage of investors (particularly small investors). Managers are presumed to have motives different from those of the owners (investors), and, if left unconstrained, will manage a company in their own interests at the expense of the owners. We review the monitoring roles of the board of directors and institutional investors, and conclude that Canadian companies ae comparable to those in the U.S., but the ability of managers to pursue their own goals may place Canadian companies at a (shrinking) competitive disadvantage relative to Japanese and German competitors.
Differential voting shares pose a different problem. The conflict here is between different classes of shareholders, not between managers and shareholders (although there could be some overlap in these categories). One group of shareholders - one that holds a disproportionate number of votes per share - is able to wield power far in excess of its monetary stake in the company. Increasing institutional involvement in corporate governance is redressing a part of the power imbalance, as large institutional investors are taking a larger role at shareholder meetings and on boards of directors. The stock market also serves to redress the imbalance, as voting and non-voting (or lesser-voting) shares are priced at different levels, reflecting the value of different degrees of control.
Although the influence investors exercise through voting at shareholder meetings and through representation on boards of directors does constrain the behaviour of managers, considerable scope for managerial discretion remains, and some companies are undervalued because of managerial action or inaction. A class of investors, called "corporate raiders," specializes in identifying, or targeting, corporations whose market value and shareholder returns could be improved if existing management were replaced. These raiders are often maligned in the press but perform a vital disciplining function. Chapter 3 explains how they use the facilities of the stock market to engineer a takeover of target corporations - called a "hostile takeover" if opposed by incumbent owners and managers. In successful takeovers, the surviving company is often reorganized and streamlined, leading to its more efficient operation. The financial instruments used in the process include the much maligned "junk bonds" (low-grade securities with hgh degrees of risk). We discuss the role of the stock market in accomplishing takeovers and review the empirical evidence on the contribution of takeovers to the efficiency and competitiveness of the economy.
Chapter 4 explains the complicated concept of stock market efficiency. Efficiency has several meanings that critics of the stock market often confuse. We address two aspects of efficiency: does the market fairly price stocks (i.e., does price reflect value), and does the market do so at a reasonable cost (i.e., are transaction costs so high as to hinder efficient trading)? We conclude that Canadian markets are just as efficient as U.S. markets but may be less efficient than those of Japan and Europe. We also note the importance of investor confidence in the capital formation process: investors are loath to give their hard-earned money to strangers if they do not trust the process. Investor trust is the motivation behind much of the government regulation of the stock market, as we explore in chapter 7.
In chapter 5, we offer an additional perspective on the vital importance of stock markets in modern economies. We refer here to the spectacular development of stock markets in the former centrally-planned economies of eastern Europe, and in emerging markets elsewhere. There are, of course, questions and doubts, and we address them in our discussion of the comparative effectiveness of allocating financial resources through stock markets or through the banking system, which is the stock market's major competitor in financial markets around the world. In a broader context, this debate ties in with our analysis of corporate governance in chapter 2, and the relative merits of the "stock market-based" financial systems of Canada and the U.S. versus the "bank-based" systems of Continental Europe and Japan.
Chapter 6 tackles selected ethical issues related to the functioning of stock markets, including the morality of defensive measures in the face of hostile takeovers, the moral defensibility of insider trading (trades of stock by those with inside information, such as management, auditors, and lawyers), and the role of corporate social responsibility. All of these issues have been extensively - but not always objectively - treated in popular writings critical of the stock market. The market does a much better job of enforcing morality than many people think. We draw upon selected concepts in philosophy and ethics in an attempt to offer a framework for formulating an individual attitude toward this key institution of capitalism.
The book concludes with a discussion of public policy issues and stock market regulation. We consider the evidence on allegations of market failure and moral failure and evaluate the current system of self-regulation against the background of the market's performance and the imperative of investor confidence in the capital formation process. Drawing on the current regulatory reform of public utilities as an analogy, we determine that the restrictions placed on stock market activity should reflect underlying competitive conditions. Competition in this case means that all investors have equal access to accurate information on companies, with competitive activity taking the form of researching and processing information. Some (mostly larger) investors are better able to conduct such research than smaller investors, and some (mostly larger) companies have such information more readily available. As well, these larger investors tend to concentrate their investments in these larger companies. We recognize, then, tht there are two distinct types of market: the "upper tier" dominated by larger sophisticated investors, and a "lower tier" populated by small, less well-informed investors. We conclude that a revised, two-tier form of market regulation, with the upper tier largely unregulated, would probably best serve the goal of developing a competitive economy with a broadly-based participation of Canadians in the financing of its growth and the benefits derived from it.