Finance matters. We’re off to build a stock exchange, but first of all I’ll spend a little time explaining why financial markets matter. This episode explores how financial markets – a crucial mechanism for the distribution of wealth – are implicated in our present political malaise and looks at some of the ways that finance has squeezed us over the last three decades.
A famous philosopher once said – ‘It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.’ It was Adam Smith, of course, born not far down the road from me in Kirkcaldy, Scotland, and the father of modern economics. He once walked to neighbouring Dunfermline in his dressing gown, apparently, so deep was he in thoughts, musings like this, and ‘Nobody but a beggar chuses to depend chiefly upon the benevolence of his fellow-citizens.’
From those words, published in 1776, a whole global order has sprung. We can call it capitalism, and at its centre lies a strange entity, so much part of our lives that we simply take it for granted.
I’m talking about the stock exchange.
Hello, and welcome to this podcast.
My name is Philip Roscoe, and I teach and research at the University of St Andrews in Scotland. I am a sociologist interested in the world of finance and I want to build a stock exchange. Why? Because, when it comes to finance, what we have just isn’t good enough.
To build something – to make something better – you need to understand how it works. Sometimes that means taking it to pieces, and that’s exactly what we’ll be doing in this podcast. Over the coming episodes I will be revealing finance as you have never thought of it before. I’ll be asking what makes financial markets work? What is in a price, and why does it matter? How did finance become so important? And who invented unicorns? We will see that stock markets have places, and histories and politics. And we will come to understand just how influential stock-markets are in our everyday lives.
In this first episode I’m not going to do much building. Instead, I’m going to talk to you about why the world of finance really matters. I want to step back from the nitty-gritty of the project – we’ll see enough of that as we move along – and think about the role that financial markets play in society. You see, we can’t help noticing that things have changed in the last decade. Britain has fallen into disrepair. In the regions jobs have evaporated. In the cities casual work and portfolio careers have become the norm and it’s impossible to buy a house. Food banks are rife and one in five children lives below the poverty line. Brexit is looming, a howl of rage – as one commentator put it – against the state of the nation. I daresay swathes of North America and Europe feel much the same. But what has this to do with financial markets?
Well, the world has changed and financial markets stand at the heart of these transformations. They are not the only problem of course – but it is fair to say that finance is the mechanism on which global inequality pivots. Take risk. It’s everywhere in business, the other side of the coin from profits. The big question is who should carry it, and at the moment the answer seems to be the poor. Risk has been outsourced. It’s experienced as precarious employment, social exclusion, or plain, old-fashioned poverty, while financial markets – institutions that exist solely to manage risk – have pronounced themselves risk free. You can buy a bond rated triple A – as safe as the debt of the strongest governments – and still expect a return. Short-termism has prevented sustainable, long-term investment. At the same time, the rewards that supposedly come from taking risk – future profits – have been privatised among the financial elite, and they have done so through those same mechanisms that have shifted the risk itself: financial markets.
Sometimes finance goes stupendously and calamitously wrong, as in the financial crisis of 2008 – celebrating its tenth anniversary and still trailing a wake of austerity, Brexit and Trump. But here’s the rub: financial markets had sold us out anyway.
Global finance has transformed itself during the last three decades. During much of the 20th century financial markets were built around nation states and an economy that made tangible, concrete things. Their primary purpose was to allow investors to buy and sell stock, separating ownership of the firm from its day to day management by creating a new kind of product – the stock – and a market in which it can be traded – the stock-market. These markets evolved alongside the corporations of the twentieth century, their history overlapping but also self-contained. Financial markets supplied capital for companies and traded the bonds of governments that needed to raise money, whether to build hospitals or wage wars.
By the end of the 1990s, however, all this was slipping away, to be replaced by a global financial market that dealt in the knowledge economy and capital flows. I remember a glorious few years in the late 1990s when it looked as if the Internet could be the final democratising force in a decade of change. The Berlin Wall had fallen and we had enjoyed a decade of economic growth. The twin towers still stood, and the dotcom bull market promised that everyone could have a piece of the action.
This turned out to be an illusion. The Internet didn’t go the way we expected, for sure, but finance went even further off track. A utopian project sought to act out a vision of universal markets with every possible contract imagined and existent. This was free market thinking as a religion and the pointy-head, hedge fund quants with their Gaussian copulas were its apostles. Put simply, financial markets stopped trading in things we could, if not see, at least understand and imagine, and instead began to engineer new products so complex that even start traders couldn’t comprehend them. For a decade fortunes were made until with a crash and a bang, the whole thing came unravelled, and governments were forced to bail out these colossal banks lest they destroyed the basic economic structures that we need to live. I’ll spend some time talking about the crash later in this series, but for now let’s focus on its consequences. Ten years of austerity followed, and I think it’s fair to draw a straight line of cause and effect between those moments and the nasty, broken world we seem to be living in now. It hasn’t been bad for everyone, of course. Ironically, the more liquid and immaterial capital has become, the more solid and tangible its bridgehead cities must be. So London, New York, Frankfurt and Tokyo have become crowded with the towering glass cathedrals of global finance, visible anchors for the imaginary products they sell. No wonder you can’t buy a house there. Financial markets, as I keep saying, really matter.
We may remember the crisis of 2008 as spectacularly destructive, but in fact it is only one of a number. Markets imploded on ‘Black Monday’, 19 October 1987. The global financial order nearly collapsed in 1998 when Russia’s troubles with the rouble caused a melt-down among overstretched investors, and then the spring of 2000 saw the dot-com bubble burst. There is something in the genes of financial markets that leads to ‘excessive exuberance’, in the words of Alan Greenspan, the former Chairman of the Federal Reserve and free-market apostle whose own economic policy was responsible for much of that overexcitement. Going further back there was a prolonged downturn in the 70s, and the great crash of 1929. There was even a boom – and bust – trading the shares of dog tracks in post-war London.
These regular crises are just a spectacular manifestation of an more general trend towards inequality and exploitation. Thomas Piketty, rock-star economist, has shown that the gap between the haves and the have-nots is steadily growing.[i] His claim, that returns on capital are greater than growth, is an update on Marx’s classic insight that there is an inherent conflict between those who have to work for a living and those who generate income from investment in that work. For investors to gain a bigger share of the pie they must find ways of squeezing workers and for two decades financial markets have been at the centre of this process. This has involved a collective forgetting of the separation between stock ownership and management, and in its place the construction of new narratives of shareholder value and control. The idea that stock markets have single-handedly funded global corporations from the beginning and are therefore entitled to a disproportionate share of rewards and control is, in the words of anthropologist Karen Ho, a ‘neoliberal fairy story’.[ii] But it is persuasive enough. Short termism and a collective attempt to eradicate risk from investment has seen innovation decline and uncertainty – in classical terms the source of profits for any business – shipped out to employees. Uber is the most perfect example of this process: underneath the bluster and talk of disruptive, technological innovation is an attempt to drive every other taxi firm into bankruptcy through sheer force of capital and then use its monopoly to impose high prices on customers and harsh conditions on its workers.
Okay, let’s backtrack a little. The fundamental purpose of stock markets is to provide a market in the instruments of investment, be they stocks or bonds. Stocks are tiny fractions of a corporation, and owning them entitles you to a share of the profits distributed as dividends. Bonds are a kind of debt issued by governments and companies. They pay interest and at the end of the term you get your money back. We’ll revisit these in due course. But the very existence of these instruments shows that the secondary, related purpose of financial markets is to provide new capital for growth, or to facilitate this process by allowing investors to realise some of their profits and reinvest elsewhere. Stock markets are the interface between capital and firms; that makes them the link between the owners of firms and the people who work for those firms.
Money can flow both ways. It pours into companies to fund their growth, expanding into new markets, buying expensive assets, or developing new technology. Shareholders support growing firms through rounds of financing often known as ‘placings’, where new shares in the firm are issued to investors. Once firms mature, cash flows out again as dividends. Assuming that firms have a life-cycle and are truly profitable only in their comfortable but short-lived middle age, this pattern should repeat itself over and over, everyone benefiting in the process.
You might think this sounds like a generally beneficial process. How can these markets serve as instruments of inequality? In several ways. Towards the end of the 20th century capital –if you do not like this term you could say Wall Street, or investment funds, or the one percent – decided it wanted a bigger share of the pie. When that happens, stock-markets are the mechanism for putting on the squeeze. Money starts to flow out. Investment declines and executives will be pressured to increase dividends year on year, by squeezing employees and holding back from long-term investments or risky research and development. Stock markets mediate this pressure through aggressive shareholding tactics and short-term reporting cycles that force managers to deliver regular increases in pay-outs. Strategies such as takeovers and buyouts, while almost always destructive in the long term, are justified by the rhetoric of offering value to shareholders. Companies might use surplus cash to buy back their own shares, driving up the price and concentrating any future returns in the hands of remaining owners – those, of course, who can afford to pass up on a short-term bounty.
WE academics are culpable too. Sometime in the 1980s, a piece of academic know-how called ‘agency theory’ has passed into the common domain. I mentioned just now that stock exchanges are the interface between capital and firms, and therefore between the owners of firms – the shareholders – and the people who work for those firms. Note that I didn’t say ‘work for those shareholders’, because that isn’t the case, but that distinction is often overlooked. In 1976 two professors, from the Simon Business School at University of Rochester – Michael Jensen and William Meckling, suggested that owner-managed firms performed better than firms with salaried managers, and that they did so because in the case of owner-managers the interests of capital and management were neatly aligned. They therefore proposed that managers should be made owners – given a share in the firm. Fourteen years later, as these ideas were entering the mainstream, they penned an influential Harvard Business Review article subtitled ‘It’s not how much you pay but how’, suggesting how this might be done: chief executives should be granted the option to buy shares at knockdown prices if certain targets were reached. ‘On average, corporate America pays its most important leaders like bureaucrats,’ they blustered.
The complaint about being paid ‘like a bureaucrat’ is not a gripe that executives are paid as badly as bureaucrats, for by 1990 chief executives were paid vastly more than public servants; it is that bureaucrats are paid irrespective of the performance of their organisation. Max Weber, the father of sociology, saw this security of tenure as crucial to the disinterested performance of bureaucratic responsibility, but it did not cut it for Jensen and Meckling. ‘Is it any wonder then,’ they continued, ‘that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets?’ This was just what investment bankers, already committed to the maxim of “shareholder value’, needed to hear and the principle rushed into practice. [iii]
Agency theory provided the intellectual underpinning for a new class of super-chief executive, whose incentives are all too well aligned with those of their shareholding paymasters, committed to the ‘tough choices’ that will increase short-term earnings, often at the expense of long-term performance. Tough choices is a euphemism that too often means redundancies, squeezing suppliers and passing on uncertainty to outsiders; stock markets are the mechanisms through which these modern regimes of power are transmitted. Chief executives have become grossly overpaid, too, though without the compensatory effects that Jensen and Meckling promised when they lobbied so hard for a pay rise:
‘Are we arguing that CEOs are underpaid? If by this we mean “Would average levels of CEO pay be higher if the relation between pay and performance were stronger?” the answer is yes. More aggressive pay-for-performance systems (and a higher probability of dismissal for poor performance) would produce sharply lower compensation for less talented managers. Over time, these managers would be replaced by more able and more highly motivated executives who would, on average, perform better and earn higher levels of pay.’[iv]
I’ll read that again, missing out all but the crucial words:
‘Are CEOs underpaid? The answer is Yes. More able and more highly motivated executives would [assuming aggressive pay-for-performance systems] earn higher levels of pay.’
So there you have it.
But isn’t all this a means to an end – making more money for shareholders – that’s us – and thereby making the world a richer and better place? Don’t forget what I said before, though. It’s distribution that really matters. It turns out that not all shareholders are equal and future gains don’t get shared out equally. Take Silicon Valley’s ‘unicorns’ – startup firms worth over a billion dollars. Their extraordinary value comes not from profits but repeated rounds of financing at ever higher levels (again, I will explain this process later). If the everyday investor is only allowed in at a late stage, buying on the hype and paying accordingly, they will simply be funding the rewards already enjoyed by those already in the network who have been able to invest earlier on. It is an elaborate financial game of pass the parcel. At some point the music will stop and those left holding the parcel will unwrap it to find nothing inside, but by then the others will be long gone, their pockets stuffed with cash. Our contemporary economy is a chimera, a mirage, make believe. It’s a collective convention whereby everyone is better off if we agree that, yes, a loss-making online taxi-firm could be worth nearly a hundred billion dollars. A cynic might even see some kind of Ponzi scheme in the colossal valuations of the tech unicorns, and suspect that some entrepreneurs are more committed to capitalizing – cashing in – on a rhetorical strategy of global supremacy than actually squaring up to the Sisyphean labour of becoming the only taxi operator in the entire world.
Global finance is a con.
It’s not all bad news. There are green shoots of possibility emerging that may carry us into a better, fairer economy for the future. There is talk of ‘patient finance’ with connotations of fairness and long-term engagement. We see new market start-ups – there’s one near me in Scotland that’s talking about social impact and regional development, and I hope it comes to fruition. Perhaps I’ll be able to tell you more about it as this series progresses. Such moves seek to recover stock markets as mechanisms for social transformation, funding new ventures of all kinds. I think this is an endeavour worth pursuing.
In this podcast we’ll be working towards that goal, trying to imagine a finance fit for all. We need a new language to tell new stories of markets, to imagine designer markets that can offer us all kinds of future possibility, from radical technological innovation to new understandings of social organisation. We need markets that can facilitate growth, but growth of a kind fitted for the future.
And most of all, we need, as citizens, to really understand how finance works. We need to understand why markets have so much influence over politics and state. We should try and understand what those people sitting in skyscrapers in Canary Wharf or quiet offices in Mayfair actually do all day. We should think about the stuff that markets are made of: buildings, screens and wires. We need to understand the stories of markets; I’ve already sketched out some – the rights of shareholders and the laziness of bureaucratic managers and the myth of business as funded, even founded, on the efforts of finance – but there are others, about how finance is male, white and complicated, and out of bounds to the rest of us.
We could even think about prices. If prices contain information, as financial economists believe they do, how does it get there? Are some prices better than others? Why is it headline news if Apple’s share price goes down? What can we price, and when does it stop being okay to do so? As the philosopher Michael Sandel has asked, what can’t money buy?
So that’s where we are. In a society that’s broken, divided and unequal, financial markets are mechanisms absolutely at the root the trouble. But let’s hold onto them a little longer; let’s try and capture a little bit of that old, Enlightenment optimism about markets and their possibility. Maybe it’s misguided. Maybe we’ll discover that the best kind of market is no market at all. I don’t know. Let’s think of ourselves as twenty-first century financial engineers, examining this strange cyborg thing of people and wires and screens, stripping it down to figure out how it works and why it’s broken. Only when we have done that can we start to work out how to fix it.
That’s what this podcast is all about, working to build a finance that’s fit for purpose and fair for everyone.
I’m Philip Roscoe, and you’ve been listening to How to Build a Stock Exchange. If you’ve enjoyed this episode, please share! Tell your friends! If you’d like to get in touch and join the conversation, you can find me on Twitter @philip_roscoe or email me on email@example.com. Details are on the website. Please join me next time when we explore how stock exchanges telescope time and space, and wonder how you’d build one if you didn’t have computers…
[i] Thomas Piketty, Capital in the Twenty-First Century (Harvard University Press, 2017).
[ii] Karen Ho, Liquidated (Durham: Duke University Press, 2009).
[iii] The original paper is MC Jensen and WH Meckling, “Theory of the Firm: Managerial Behaviour, Agency Costs, and Ownership Structure,” Journal of Financial Economics 3 (1976). The ideas reached a broader audience through MC Jensen and WH Meckling, ‘CEO Incentives—It’s Not How Much You Pay, But How,’ Harvard Business Review (1990 May-June). For an account of Wall Street’s preoccupation with shareholder value see Ho, Liquidated.
[iv] Again, from MC Jensen and WH Meckling, ‘CEO Incentives—It’s Not How Much You Pay, But How,’ Harvard Business Review (1990 May-June)