Market for Corporate Control and Other Benefits of Capitalism

2018-04-12 11:07:13

Market for Corporate Control and Other Benefits of Capitalism



Recently I have been to a conference and met there a Belgian professor from Brussels. He was interested to learn about the life in Czech Republic (my home country, where the conference took place) and, upon learning that I now work in Kazakhstan, life in Kazakhstan, too. As we both were economists, our talk soon became about the economic situation: Is it possible to have a decent life in current global economic situation? Do people have jobs that give enough income? Are the living standards and the quality of life deteriorating as it is (according to him) in Belgium?

His opinion was that Europe goes down the road: Multinational companies have more and more power to evade (or write) country’s laws and, because of merciless pursuit of profits, exploit the employees (else they move the operations abroad). The weak or corrupt politicians can’t resist it, there is increasing economic inequality, the young generation is squeezed to the limits, trying to meet the ends with two jobs, or having none and living on welfare. He called for more protectionism, government regulation, and strong hand in dealing with what he called “market excesses” and “uncontrolled reign of multinationals”. He believed that the democracy and the markets are at odds and one with another often clash.

I would object. Democracy needs markets, and markets need democracy. Democracy and markets work together in creating progress and prosperity, and this prosperity, in a democracy, is shared by everybody. Yes, more gain those who know how to “game” the system and are willing to do so, less those who do not know or chose not to do so, but, in the end, it is difficult to find somebody who is universally worse-off, perhaps with the exception of former Communist party officials who lost their monopoly on power and now have to compete for success and happiness like everybody else. Let’s look at it more closely.

First, anybody can be an investor in the very multinationals he was criticizing; the “ruthless” capitalism is working for investors, increasing the value of their shares. He argued that it works for the minority (the rich) at the expense of the majority (the poor). I replied that I am definitely not a rich person, who inherited a castle and feudal lands from aristocratic ancestors, yet I can enjoy the financial returns on my investment equally well as them thanks to the existence of financial markets. Anyone can now invest in stocks (or other financial assets, such as through crowd funding) and enjoy the “capitalist’s” returns, as long as one produces savings, which of course is greatly assisted with high income, but also requires a discipline and moderation in consumption. Today’s technology such as online brokerage, and globalization, such as the creation of the single European space with free flow of capital (capital now flows with little restrictions globally) make investing by masses even easier. The markets are democratic because they do not ask who you are, who your father was, to which political, racial, or whatever group you belong, before you can invest. Money and markets are blind and largely anonymous, which is most of the time good, not bad. Investment is widely available through financial institutions (such as mutual funds) at competitive fees. Even if you are not an investor yourself, your bank deposits are used for investment, and you earn interest. The competition between financial intermediaries means they need to attract and retain clients, which means to offer attractive investment products: accessible, at fair cost and with fair returns on average.

He was not persuaded. He warned me about the stock bubble and unavoidable future crisis, which will be caused (as it was always the case) by the greediness of capitalists and will erase my profits (which is what I deserve!), but not only that, it will cost lot of taxpayers’ money (=poor people’s money) to bail out the failed banks (rich people). True, I said, financial crisis happens from time to time, yet, in the past one hundred years or so of public capitalism (marked by existence of corporations whose shares are publicly traded on the stock exchanges and thus available to any investor), anybody who invested into diversified equity (such as stock index) over a long enough period earned decent return on top of inflation and was able to increase his wealth. The bailouts (if performed in a transparent way and the public knows where the money goes and how much) are necessary cost to avoid even greater economic destruction that would come through contagion, and, in the end, the bailout money can turn out to be quite good investment, as the government buys an equity stake in troubled banks at discounted prices which can be sold later to the original or new investors when the crisis is over and the market valuations rebound.

Our conversation stopped there as the gentleman called me a neoliberal and muttered how come such people may still exist (we then changed the topic and still parted as friends). But I continue to be an ardent advocate of free markets, and will argue with people who see democracy (and well-being of common people) at cross with the markets.

Take the labor market. While it is true that capitalist will try to minimize wages (such as any other costs), at some point the capitalists also learn that creating an attractive environment for the workers, including good pay, is important for the success of the business. Such as people compete for jobs, employers compete for people, and as long as there is a free movement of workers and enough alternative employers (no slavery or monopoly), the resulting wages are competitive. Setting wages too low leads to lack of motivation to work; too high wages decrease competitiveness (and the motivation to run a business). Both are in the end counterproductive; as liberals would say, the markets are better left alone untampered.

But even those who do not participate in the labor force or are less fortunate in finding competitive wage benefit from capitalism indirectly: capitalism is the mechanism behind continuous innovation and improvement of our material world. The prices of products and services decline because of competition, new players appear on the market and offer the same products and services for lower price because of innovation (as they are produced more efficiently), or offer them for  the same price, but with higher quality. Here the most important thing is free competition and fair battle. Fair competition between players in the market is provided by democracy; in a non-democratic society the market is divided, there are players associated with the authorities who complicate the free battle or make it impossible. This slows down or stops the innovation process altogether, because the power of the market does not put pressure on the business connected with the authorities, and the businesses which are not connected with the authorities, are, at best, not allowed to develop, or at worst, are pressed upon and superseded. In a democratic society such situations are hardly possible: the press immediately writes about such attempts to do so, the opposition takes the case, you can ask various non-political, more or less objective institutions and independent courts for help. Justice, for the most part, does not depend on ties with the authorities, and the results of clashes of companies or businessmen in court depend more on the essence of the matter. And I am not mentioning fraud and confiscation: according to economists Daron Acemoglu and James A. Robinson, expropriation of property and “rent extraction” by the government (corruption) are the main reasons for the low level of development in many countries, as they write in their book “Why Nations Fail”.

This leads us to a very useful and often underestimated market mechanism: the battle of bidders for power over corporations in the market for corporate control, which fuels one of the most important processes – “creative destruction”.

The financial markets set value of financial instruments, such as shares, through trading (supply and demand), but not only that, they also help to weed out the bad (dumb or unscrupulous) company management. One of the great innovations of capitalism is a publicly traded joint stock company. Publicly traded company, unlike privately-held company, has better access to capital, since small shareholders can easily buy their shares, and in the total such people represent a huge amount of capital.

At publicly traded joint stock companies, the management is usually handed over from the owners to a hired team of professionals, who arguably create more value by making better decisions. However, the management has motivation to use their position for self-enrichment, i.e., benefit themselves rather than the owners (“principal-agent problem”). In privately-held companies (those whose shares are not traded on the public exchanges) it is impossible to render a conclusion whether the management performs well or not; in the end, it is a matter of subjective judgement of the owner (that is why the privately held companies are often owner-managed). In publicly traded companies, the share price is the indicator of the company’s success, and the managerial compensation can be (and often is) linked to it. Management who increase the stock price benefit from bonuses or through executive stock option plans; on the other hand, underperformance is visible from the low stock price (relative to some benchmark such as industry index, or price history).  If the management for whatever reason resists the owners and engages in value-destruction activities, such as wasting money on unimportant things or excessive frills (“corporate jet”)(this can happen when the ownership is diffused, i.e., each investor holds only a few shares and it does not make sense for him to occur monitoring costs), the dissatisfied owners start selling the shares, this drives their price down, the price becomes too low relative to the potential  and the company becomes a target for a hostile takeover or leveraged buyout by activist investors. My friend would argue that these are just instruments for speculation by capitalists. Perhaps, but equally or even more importantly these are also instruments enabling ousting underperforming managers and restructuring the company.

Thus the institution of the publicly-traded company and the stock market is not only important for enabling the access to funding and efficient cost of capital (efficient because of the competition between investors), but also provides an important management replacement mechanism. This is crucial for “creative destruction”, which is what capitalism is so good at. The progress and eventual prosperity comes from constant replacement of outdated products, business models, and people behind them with new, better ones, as was noted by Schumpeter. Investors such as Warren Buffet, Carl Icahn, or David Bonderman find underperforming, undervalued assets, acquire their control (buy them), restructure them, and resell them at higher price (or keep them for the dividends). Without the mechanism that prices the shares and enables their trading it would be impossible to evaluate management teams and replace underperforming ones. It is democratic mechanism and democratic process: anyone can participate; no one has the monopoly power over which projects, management teams etc. are good and bad.

The existence of publicly traded companies and the stock market is at the core of capitalism (together with the fundamental principle, which is untouchability of private ownership); the government of a reforming country needs to make it a priority to create such institutions, ensure that they function and are protected from power interests and lobbies.

Marek Jochec

Associate Professor of Finance and Academic Director of the MSF Program

Nazarbayev University Graduate School of Business

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