Thursday, 3 September 2015

Speculation v Investment

Recently, I discussed the fact that many financial analysts are disoriented, because they have only been involved in the financial services industry for the last thirty years. So, they have only been involved during a thirty year period when global interest rates have been falling, and where, as a result, the prices of bonds, shares, property and other assets have been rising. The consequence is that the financial markets have become equated with the economy, when, in fact, they are two different things. By equating the two, it then becomes dangerous when central banks and governments act to prop up, or stimulate, the stock, bond or property markets, when they fall, in the mistaken belief that they are thereby acting to prop up, or stimulate, the economy. On the contrary, their actions to prop up the former, necessarily act to further depress the latter.

Stock markets may rise, because the economy is producing more profits, which can be paid out as dividends, which thereby justifies a higher price for shares. The higher price of the shares, arises, in that case, because the owners of other financial assets, such as bonds or property, sell them in order to buy shares. The higher price of shares is then the other side of a lower price for bonds and property, which reflects an overall rise in the rate of interest. But, they may rise simply as a consequence of speculation.

In that case, it is not higher profits that justify the higher share prices, but the prospect of higher share prices that encourages additional demand for shares, which pushes up share prices, which thereby becomes a self-fulfilling prophesy, which creates a bubble. In that case, rather than the yield on shares rising, relative to the yield on bonds, or rent on land, it will actually tend to be falling, precisely because the price of the shares is rising unrelated to any increase in profits or dividends. What it reflects is the fact that realised profits are going, not to the accumulation of productive-capital, so as to produce more profits, which would justify higher share values, but rather just to buy existing financial assets, thereby pushing up their price, and causing the yield to fall.

In fact, as the yield on shares drops, as a result of this, then it may also be the case, that the representatives of the shareholders try to prop up the yield on the shares, by diverting profits from additional investment in productive capacity, simply to the payment of additional dividends. This is the process of capital “eating itself”, that the Bank of England's Andy Haldane referred to lately. He commented that back in the 1970's, only about 10% of company profits, were used to pay out dividends, or other forms of return to shareholders, whereas today, the figure is more like 70%. Hillary Clinton, on the same day gave a figure of more like 90%, for US companies. In other words, the representatives of the shareholders on company boards, are promoting the interests only of the money-lenders to the business (shareholders) at the expense of the business itself. This confusion of the shareholders with the business, mirrors the confusion of the financial markets with the economy.

Consider the graph showing the yield on the US 10 Year Treasury Bond. A similar pattern exists for the US 30 Year Treasury Bond. Had you bought these bonds back in 1950, then you would have seen the value of those bonds fall steadily over the next 30 years. The price of the bond is inversely related to the yield on the bond, so that as yields rose, in a secular thirty year trend, up to 1982, this was also reflected in a similar secular fall in their price. Suppose, you had bought a 30 Year Bond, for $10,000 in 1950. It paid you $200 a year in interest, or 2%. If you held the bond to maturity, in 1980, you would indeed get your $10,000 back, but it would be worth much less, at that time, due to inflation. In the meantime, the bond continues to pay you only $200 a year in interest, despite the fact that all around, interest rates are rising.

Had you put your money into a savings deposit account, it might, during this period, have paid higher interest, certainly had you bought shares, the dividends you would have received, would have been greater. In fact, had you bought a US Treasury Bond, in later years, the interest paid to you, on those bonds, would itself have been higher, as the government had to offer higher rates of interest, on new bonds, in order to sell them, in a higher rate environment. You would then have had plenty of incentive to sell the bond you bought in 1950, rather than hold on to a depreciating asset, paying an increasingly uncompetitive rate of interest. But, precisely for those reasons, when you sold it, into the bond market, you would get less money for it, than you had originally paid for it. A buyer would only be prepared to pay for it, an amount that gave them a competitive rate of interest. For example, suppose you came to sell it in 1955, and the average rate of interest at that time was 5%. Then the $200 a year of interest would give a capitalised value for the bond of just $4000, i.e. 5% on $4000 equals $200. So, you would have lost $6000, or 60%, of your capital.

This effect does not just apply to bonds, as I have shown in the past. If the rate of interest rises from 2% to 5%, then the owners of shares will expect to make, on average, a 5% dividend yield on their shares, whilst landowners will expect to make, on average, a 5% rental yield on the value of their property. Shares or property that previously were worth £1 million, with a 2% average rate of interest, fall in value to just £400,000 when the rate of interest rises to 5%. That would only be countered, if the value of profits and rent rose. That in fact, is demonstrated by looking at the growth of the economy, and the rise in share prices during these two periods, between 1950-1980, and 1980-2012.

The rise in GDP can be seen as a proxy for the rise in profits. GDP measures the new value created by labour during the year, i.e. the consumption fund distributed as revenuewages, profits, rent and interest.

Adjusted for inflation, the Dow Jones did not recover the
1929 high until the 1960's, and it falls for 20 years between
1960 and 1980.  On this basis, the Dow is set to fall to
between 3000 - 5000.
If we look at the US, in 1950 its GDP was $294 billion. By 1980, it was $2788 billion, an increase of 848%. In 1950, the Dow Jones Index stood at 200, and by 1980 it had risen to 824, a rise of 312%. In other words, the rise in the stock market was only half the increase in GDP over the same period. The S&P 500 Index performed slightly better rising by 537% over that period, but still only just over half the rate of increase in GDP. In other words, the two effects can be seen here. On the one hand, over this period, interest rates are steadily rising, which forces down the prices of bonds and shares. On the other hand, the mass of profits is rising, which facilitates the payment of more dividends, alongside the accumulation of capital, to produce more profits, and this pushes share prices higher.  The other chart, which measures the Dow Jones in inflation adjusted terms, makes this even clearer.

US House prices corrected by 60% in 2008/9, along with those
in Ireland, and Spain.  The chart shows the extent of the bubble in
 UK property prices that is set to burst even more violently.
A similar thing can be seen in relation to property prices. That is best seen by looking at the change in constant dollar prices. In 2005 dollars, US GDP in 1950, was $2006 billion, rising to $5839 billion in 1980, which is a rise of 191%. US median home prices, measured in 2000 dollar prices, were $44600 in 1950, and $93,400 in 1980, which is a rise of 109%, or only just over half the rise in GDP.

This stands in marked contrast to the position between 1980 and 2012. During this period, GDP rose from $2788 billion to $15094 billion. That is a rise of 441%. But, the Dow Jones Index rose from 824 to 13593, a rise of 1549%. The S&P 500 rose by 1177%, during that period. In other words, during this period, when interest rates were falling, after 1982, stock markets rose by between three to four times the rise in GDP, whereas in the previous period, when interest rates were rising, but GDP and profits were rising, due to the post-war boom, GDP rose twice as fast as stock markets.

But, comparing the period 1980-2000, i.e. ahead of the 2000 Stock Market crash, the situation is even more clear. During that period, GDP rose by 257%, whereas the Dow Jones rose by 1323%, and the S&P 500 rose by 1261%. In other words, during this period, characterised by stagnation, and the repeated recessions of the early 1980's, and early 1990's, stock market indices rose by around four to five times the rise in GDP, demonstrating clearly the difference between the health of the real economy, and the performance of financial markets.

The connection, and inverse relation between the two is not accidental. The reason that interest rates rose during the period between 1950-1980, was that, as the economy went through a period of growth, it required the investment of additional productive-capital. Although the mass of profit rose during this period, the proportion of it that was required for reinvestment as additional productive-capital rose. In other words, the demand for capital rose relative to the supply, and this caused interest rates to rise. Companies either used internal funds from profits for this investment, so that these profits were not paid out as dividends, or thrown into the money markets, or else they had to raise capital, by issuing additional shares, or bonds, or by other forms of borrowing, which placed an increased demand on capital markets. To the extent that more shares or bonds were issued, this increased their supply, and so reduced their prices, again resulting in higher yields.

The higher rate of economic growth, and of productive investment was the cause of the higher rate of interest, and this higher rate of interest, thereby necessarily causes the capitalised value of financial assets such as shares, bonds and property to fall. But, the laws of capital, necessitate this situation, sooner or later, because each capital is ultimately driven by competition to have to invest in additional productive capacity.

Take the following example. Suppose I buy seeds to grow carrots and potatoes for £100. I then spend 100 hours growing carrots and potatoes, to feed myself. But, over time, I decide that I cannot really be bothered with this labour, and decide instead to let someone else do this work, whilst I will buy my carrots and potatoes from the shop. This is rather like what happened with the productive-capitalists, who gave up their active role in production, and became instead suppliers of money-capital. Although they could have had a greater return, in terms of profits, by investing their capital themselves, they chose the easier life of simply lending out their money-capital, in return for bonds and shares, upon which they took a low rate of interest.

But, now consider the situation whereby the price of carrots and potatoes in the shop continues to rise, rather like the price of bonds and shares has continued to rise. The price of carrots may at one time be relatively lower than that of potatoes, and vice versa, which will cause me to buy more of one than the other, but over time, the price of both continues to rise. At a certain point, the price of carrots and potatoes becomes so high, that I think, I'll go back to buying seeds, and growing my own.

There is some evidence that some capitalists, like Elon Musk, or Richard Branson have done that. Both have used their money not simply to buy shares in other companies, but to develop new industries, for example, in relation to space technology. In other words, rather than speculating in financial assets simply to obtain interest, or capital gain, they have invested in real productive-capital, with the intention of making profits. But, even if such capitalists do not do this, the laws of capital ensures that others will.

The interest that savers can obtain on savings deposits has fallen near to zero. One consequence of this has been to encourage speculation in other financial assets, such as the fad for buy-to-let landlords. But, for the reasons set out above, and as I have described elsewhere, that will lead to disaster, because rising interest rates will cause the bubble in property prices to burst even more violently than the bubbles in stock markets, because the property market is an illiquid market, where it is impossible to sell quickly, and so where a rush of sellers, with no immediate buyers, causes prices to fall even more precipitously. The bubble in one sphere, has simply promoted bubbles in others, as lenders have sought yield, or capital gain.

But, some of these savers will have used their potential money-capital, to actually create new businesses, i.e. to invest in actual productive-capital. The steady growth of peer-to-peer lending, where savers can lend to new businesses, so that the borrower obtains funds they might otherwise not have obtained, or obtains them at a lower rate of interest, whilst the lender obtains a higher rate of interest than they would on savings, is an indication of this.

In the UK, there has been a marked rise in the number of new companies being established. A lot of this is phoney; it is people who cannot get a permanent job, who have become self-employed as window cleaners, gardeners and so on, but some of it represents the actual creation of new capitals, because there are a range of new industries, with the potential for high profits, which offer the owners of these businesses much higher rates of return on their capital, than had they simply stuck it into the bank, or into a mutual fund. Some of these businesses, will succeed. They will grow, and they will come to challenge existing businesses, if not in the same line of business, at least in the sense that they will take consumption spending out of the market, which in turn will hit the profits of those companies that have not invested.

There will then be a situation whereby, the profits of existing companies will be squeezed as new capitals appropriate a portion of the newly created surplus value, and the dividend yields will get ever more squeezed. The attempts to keep these financial bubbles inflated, therefore, only delays the inevitable bursting of those bubbles, as interest rates rise, and the central banks and governments are acting contrary to the interests of the economy, in trying to keep those bubbles inflated. That they do so, simply reflects the extent to which they are under the influence of the owners of fictitious capital, just as the owners of that fictitious capital have appropriated to themselves powers, as shareholders to which they are not entitled.

We frequently hear shareholders described as the owners of businesses, but they are not. A shareholder merely provides money-capital, as a loan to a business, in return for a share certificate. The share certificate, merely entitles the shareholder to a dividend, which should be equal to an average rate of interest on the money-capital they have loaned. The whole point about a joint stock company is that, it represents socialised capital. That is the productive-capital is not privately owned. The productive-capital is owned by the firm itself as a legal entity, and the shareholders are entirely separate from this legal entity.

That was confirmed in a legal case going back to the 1930's.

"A company is an entity distinct alike from its shareholders and its directors.” (Shaw & Sons (Salford) Ltd v Shaw [1935] 2 KB 113 by Greer LJ.

As Marx puts it, this socialised capital is the property of the associated producers, i.e. the workers and managers of the business itself, and that is the case whether it is a joint stock company, or a co-operative. The decisions as to how much should be paid out as dividends, should be made by the company, on the basis of the appropriate market rates of interest, just as, indeed they should make decisions on the wages to be paid to managers and directors. But, the shareholders have appropriated rights to themselves, which they should not have. As increasingly, the professional managers of the business, the “functioning capitalists”, as Marx calls them, came to be drawn from the working-class, and to share its outlook, so the share owning capitalists sought to place, boards of directors above them, to represent their own interests as against the interests of the business.

These Boards of Directors, thereby appoint Chief Executives, and other Directors, whose role is not to further the interests of the business, but to further the interests of the shareholders, and in particular the large shareholders. They do so, by using the company's profits not for productive purposes, other than where this is vital to increase the returns to shareholders, but only to increase “shareholder value”, i.e. to pump up dividends, and other forms of capital transfer to shareholders. In return these executives are themselves given share options, along with astronomical salaries, unrelated to any value they might add to the company.

That fact, is highlighted by the difference in the salaries paid to these executives, and the salaries paid to managers by worker owned co-operatives. Yet, year after year, employee owned companies in general outperform FTSE 100 companies by around 10%.

In those societies where social democracy was stronger, for example, in Germany, this conflict was recognised so that the Boards of companies comprised not just the representatives of the money-capital, of stockholders, but also of the company itself. For example, the 1976 Co-determination Law, requires all German companies that employ more than 2000 people to have half of their supervisory boards elected by the workforce.

The fact that, Germany has the Co-determination Act, as part of a complex of social-democratic structures at workplace level, and that the current situation has provoked the responses from Clinton and Haldane, discussing the need for new corporate structures, is an indication that this contradiction between socialised capital and fictitious capital is a valid area of struggle between social democracy and conservatism. It should be seen in the context of Marx’s discussion of this socialised capital, including the joint stock company, as a transitional form of property.

This division between social-democracy and conservatism can also be witnessed in the difference of approach that developed at the height of social democracy in the 1970's, ahead of the conjunctural shift of the long wave cycle, and decline of productive-capital. That is to be seen not just in the 1976 Co-determination Act in Germany, but in the Bullock Report in Britain, which reported in 1977, under the Labour Government, of Jim Callaghan. Its proposals were more radical than in Germany. German co-determination provides shareholders still with the upper hand, because the Chairman is always a shareholder, and has a casting vote. However, the Bullock proposals would have enabled unions to directly elect the company management. In addition to worker and shareholder representation on the Board, it proposed a third “independent” component.

These proposals were a direct result of the social-democratic agenda that developed along with the Social-Contract, between the government, unions and big industrial capital. In the end, the proposals were never proceeded upon, as the Social Contract fell apart in the Winter of Discontent. At the same time, the EU developed its Fifth Directive On Company Law, which proposed a system of co-determination similar to that which exists in Germany.

It has not been acted upon, because, as in Britain the defeat of Labour in 1979, resulted in the rise of conservatism, with eighteen years of Tory government under Thatcher and Major, which promoted the interests of fictitious capital over productive capital, so similar dynamics developed across the EU as a whole.

In fact, the various social-democratic strategies of the time, such as the Alternative Economic Strategy, proposed in Britain, should be seen as the development of the kind of rational solutions that productive-capital required to resolve the contradictions it faced at the time, rather than any attempt to replace capitalism with socialism.

The rise of Jeremy Corbyn in Britain, and of Bernie Sanders in the US, along with the rise of Syriza in Greece, Podemos in Spain, and of other more traditional social-democratic forces in opposition to the conservative/Blairite forces that have dominated workers parties over the last thirty years, should be seen as a reflection, in the realm of ideas, of this change in material conditions.

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