God is a Capitalist

Wednesday, January 8, 2014

Stockholders Rule

To the novice investor, the stock market and the real economy of the production of goods and services never meet. That is certainly to the mainstream economist for whom the stock market is a casino. But according to the great Austrian economist Ludwig Lachmann, the structure of production and the structure of a portfolio of securities are closely related:  “To understand how the two spheres of action interact is to understand how a market economy works.”[1] I guess that’s why mainstream economists don’t understand how a market economy works. 

Here are excerpts from Lachmann’s Capital and Its Structure on how the stock market directs the real economy through cash flows determined by capital gains and losses:

Three structures working as one

It would seem, then, that there are three kinds of structure: The Plan Structure based on technical complementarity, the Control Structure based on high or low gear of the company's capital [debt vs equity], and the Portfolio Structure based on people's asset preference. These three structures are not independent of each other. Whether a given production plan with its accoutrement of plant, equipment, raw materials, etc., is at all feasible depends inter alia on whether people are willing to take up the securities necessary to finance it, and this in its turn will depend on whether debentures, preference shares, or common stock are offered to them, and in what proportions. 

As long as success is achieved 'according to plan' the structural relationships remain undisturbed. Reserve assets neither increase nor decrease, operating cash balances and stocks are being replenished out of gross revenue. A steady yield stream in the form of money payments flows from cash balances to the holders of securities who, getting what they expected to get, will probably see little reason for changing the composition of their portfolios. The picture is that of stationary conditions with a 'steady income stream' flowing year after year, giving no incentive to anybody to modify his conduct.

Unexpected Success
If success is unexpectedly great problems begin to arise. The surplus profits ('surplus', of course, in the sense of: unexpected) have to be assigned to somebody. They may be used for higher dividends or be 'ploughed back' or serve to pay off debts. In the first case they will, in addition to giving higher incomes, entail capital gains to shareholders, and hence change the total value as well as the  composition of their portfolios. In the second case they will induce and make possible a new plan structure. In the third case they will modify the control structure. The decision will be made by the equity holders, but it is a well-known fact that the managers are as a rule able to influence their decision by withholding knowledge from them, by 'hiding' part of the surplus profits, in order to keep them under their own supervision. 
 Unexpected Failure
We now come to the case of failure. Temporary failure need mean nothing worse than a temporary drain on the reserves. If there were ample reserves to start with, a reduction of cash reserves may suffice to enable the firm to weather the storm. But where the money cushion is inadequate, or the failure severe, other steps will have to be taken. The balance of operating assets may be upset. It may become impossible to replace such assets as they wear out. Sooner or later the need for a reshuffle of operating assets will present itself. Such a reshuffle will almost certainly involve a need for more money, partly because, as we saw in Chapter III, the proceeds from the sale of old capital goods may not cover the cost of the new, and partly because the cash balance has to be replenished. Thus both expansion following on success as well as reconstruction following failure cause the 'demand for money’ to increase. But the conditions in which it is demanded, and the terms on which it is supplied, will differ in both cases. A successful enterprise will not ordinarily experience great difficulty in finding new money capital for expansion, though the new capital may alter the control structure.
Changes to the Control Structure
But financial reconstruction of an unsuccessful enterprise is a different matter, as the mere fact of the need for it transmits knowledge about the past performance of the management. Hence such reconstruction is usually postponed as long as is possible. A change in the control structure is now indicated. Whether or not the existing common stock is actually 'written down', its value will have declined, not as a result of any decline in 'asset preference', but as the result of events outside the control of the asset holders. It may be that debenture holders and other creditors have to take over the enterprise and to appoint a new management. Or, ultimately, they may even have to liquidate it. 

For our purpose in this chapter capital gains and losses are of importance mainly in that they reflect within the portfolio structure the success or failure of production plans, and thus record within one sphere the events that have taken place, or are about to take place, within another sphere. Their integrating quality is inherent in this function. Capital gains and losses modify the portfolio structure by affecting the relative values of the components of investment portfolios. If we wish to say that this structure is determined by relative preference for different classes of assets, we must nevertheless remember that such preferences are not given to us as a 'datum', but merely reflect other economic processes and their interpretation by asset holders.

From this rather fragmentary survey of interrelationships in the capital sphere we conclude:

Firstly, that changes in the size of reserve assets, and particularly of the cash reserve, serve as primary criteria of success and failure. Money flows, on the other hand, by regulating the size of cash balances, integrate the over-all asset structure and make for consistent capital change. As long as money flows regularly from cash balances to title holders in such a way as to leave cash balances undepleted, it indicates planned success. Where the flow increases, it drains off excess cash and records unplanned success. When the flow ceases altogether, it records failure. When it is actually reversed, when money flows from title holders into cash balances, it corrects the size of the latter by replenishing them.

Secondly, processes involving transmission of knowledge bring the various constituents of the asset structure into consistency with each other, modifying the control structure and the composition of portfolios. In these processes revaluation of securities by the market plays a vital part. Capital gains and losses are changes in asset values reflecting changes in other elements of the asset structure. 
The capitalist has ultimate control
All this has some bearing on the question of the location of entrepreneurial control in modern joint-stock enterprise [i.e., corporations owned by stockholders]. We hear it often said that in the modern industrial world the managers who make decisions about investment, production, and sales are 'the entrepreneurs', while capital owners have been reduced to a merely passive role. The 'separation of ownership and control' is the phrase used to describe this state of affairs. In fact the shareholder is already widely regarded as a mere rentier, dependent for his living on the exertions of the allegedly more active members of the enterprise, and unable to influence events. The calm and unruffled atmosphere in which most company meetings take place is offered as evidence for this thesis. If it were true it would of course obviate our concept of the control structure. If equity ownership has nothing to do with control and the making of decisions, the whole structural scheme we have presented would fall to the ground. 

In point of fact the manager and the capital owner are each active in his own distinct sphere, but their spheres of action are interrelated by virtue of mutual orientation. For either the other's action is a datum of his own action. The manager's plans concern operating assets. He operates and regroups them as his plans succeed or fail. The availability of new capital for expansion in case of success or reconstruction in case of failure is for him a datum. The capital owner's plans concern securities. He has to regroup them in the same way as the manager regroups his operating assets, and managerial decisions determine the scope of his operations as his decisions determine that of the manager. It is true that the modern shareholder rarely takes the trouble of opposing managerial decisions with which he happens to disagree at the company meeting. But this is so because he has a more effective way of voting against these decisions: He sells. 

We might then distinguish between the capitalist-entrepreneur and the manager-entrepreneur. The only significant difference between the two lies in that the specifying and modifying decisions of the manager presuppose and are consequent upon the decisions of the capitalist. If we like, we may say that the latter's decisions are of a ‘higher order’. 

Thus a capitalist makes a first specifying decision by deciding to invest a certain amount of capital, which probably, though not necessarily, exists in the money form, in Company A rather than in Company B, or rather than to lend it to the government. The managers of Company A then make a second specifying decision by deciding to use the capital so received in building or extending a department store in one suburb rather than another suburb, or another city. The manager of this local department store makes further specifying decisions, and so on, until the capital has been converted into concrete assets.

[1] All of the passages are from Ludwig Lachmann, Capital and Its Structure, Kansas City: Sheed Andrews and McNeel, Inc., 1978, 90-99.

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