Aside from the error identified by Shostak this morning, another error concerning financial markets is that they are systematically irrational - the very opposite error of the EMH.
Michael Kinsley, for example, condemns the stock market as a swindle. Kinsley admits that markets do well with commodities, but insists that markets fail elsewhere. “Capitalism is brilliant at setting the price of potatoes. But how good is it at setting the price of a large company... The free market in corporate shares doesn’t produce well-run companies?” Why does the stock market fail? It fails because there are different prices for individual companies on financial markets. According to Kinsley, the existence of leveraged buyouts and publicly traded companies mean that single companies have more than one price. This leads to a question: “the big question is this: Either the stock market is a fraud on the public or these deals that dominate the business pages are a fraud on the public”.
The short answer to Kinsley’s question is simple. His question is misleading and therefore not worth answering. It is more important to explain why Kinsley simply does not understand the issue he is attempting to address. There are both theoretical and empirical reasons to ignore Kinsley’s attack on capitalism.
First, Kinsley is not at all clear about why markets price potatoes well. Is he talking about spot or futures markets for potatoes? Were Kinsley to visit a futures market and examine “the” price of potatoes, he would find different people bidding different prices for potatoes in the future. He would find speculators attempting to outguess each other about the future price of potatoes, and other commodities. Markets generate multiple prices for both companies and commodities, where futures markets are concerned. Therefore, if Kinsley is right about markets pricing companies wrong, he should also conclude that capitalism sets the wrong prices for potatoes and other commodities as well.
One of Kinsley’s misconceptions is that he fails to appreciate the importance of risk and uncertainty in markets, especially financial markets. Since future events are not known with certainty, people must speculate about future events. Rational coordination of production requires that we speculate about future economic conditions: how much will consumers want of different products, how much of each type of labor and capital will be available at a given date, how efficiently will labor and capital be used? Entrepreneurs compete for the use of labor and capital, and competition is, as Hayek noted, a process of forming opinions.
The facts that different people have different information and will interpret the information they have differently mean that we will all arrive at different conclusions regarding future prices. This is how futures markets are supposed to work for commodities. As for the stock market, investors are speculating about the future profits of different corporations. Different investors arrive at different conclusions about the future prospects of any corporation. This is not only a matter of the results that investors expect from any set of corporate plans, it is often a matter of what investors think a corporation’s strategy should be. Takeovers and leveraged buyouts are not simply a matter of what investors think a company is worth, given the way it is run.
Takeovers and LBO’s are about changing the way a corporation is run; they are about competition over the future course of business. For there to be one single price for a company would require either uniformity of opinion regarding the plans for a company’s future, or equality for the expected rate of returns on all conceived alternative business plans. Kinsley is holding the market for corporate shares to a standard that is both impossible and meaningless. His standard of a single price is impossible because the future is uncertain and we all have different opinions. His standard is meaningless because his way of thinking makes sense only in a world with no uncertainty and no change.
In a static unchanging world, we should be able to arrive at one price for every good and every organization. In a world of dynamic change we should expect different prices for the same good or organization. This is how the world really works, and Kinsley simply does not understand. There cannot be just one price for any future good, and there certainly cannot be just one price for a company, given that the relevant data concerns the goods that a company will produce, the future demand for those goods, and the efficiency of the implementation of a company’s future production plans relative to its rivals. Even the CEO of a corporation has to speculate about the future prospects of the company he likely knows better than any one else.
Of course, the fact that financial markets should produce multiple prices for the same thing does not automatically imply that the multiple prices are efficient. Kinsley does not have any evidence that stock markets really fail. He is merely speculating (as we all must do). However, his speculation is mere conjecture, rather than informed estimation. Scholars of financial markets have found that stock markets play a vital role in modern industrial economies.
Stock exchanges played an important role in the development of the industrial West. Initially, these stock exchanges were informal and unsophisticated. The London Stock Exchange developed in the eighteenth century. The stock market in Amsterdam emerged in the seventeenth century. The financial system of Belgium began in the fourteenth century, but the Brussels Stock Exchange opened in 1801. These early stock markets developed into sophisticated institutions with formal rules. These early stock markets in major cities began to direct capital investment throughout the West and in parts of Asia. Statistical studies indicate that the economic development of Belgium was driven by the development of Belgian financial markets, including the Brussels Stock Exchange. Financial development in Belgium began with the country’s independence in 1830, and was accelerated by the liberalization of the Belgian stock market in 1867. This pattern was paralleled in many nations. Statistical studies show that well-developed stock exchanges have enhanced long-run economic growth, increased capital investment, and raised productivity throughout the industrialized world.
The idea that stock markets are a swindle indicates a need for financial regulation. While journalists like Kinsley are entitled to their uniformed opinions, actual studies of financial markets show little need for regulation. Some evidence supports the case for liberalization of stock exchanges. Peter Henry (2003) finds that deregulating stock exchanges reduces capital costs and increases investment and per-worker productivity. Liberalized stock exchanges can also facilitate the adoption of new technologies in developing nations. Some distortions in the international financial system led investors to hold too much debt and too little equity (Henry 2006). The liberalization of stock exchanges has caused a shift from debt to equity holding during the 1990’s. This shift from debt to equity caused a short run increase in economic growth. Henry (2000) also finds that liberalizing stock exchanges can reduce the cost of equity capital by allowing risk-sharing between foreign and domestic investors.
Financial markets are important in capitalism because they redirect resources towards the satisfaction of the most urgent consumer demands. As Ludwig von Mises noted “it is above all necessary that capital be withdrawn from particular undertakings and applied in other lines of production... [This] is essentially a matter of the capitalists who buy and sell stocks and shares, who make loans and recover them, who speculate in all kinds of commodities” (Mises 1922 [1936] p121). A study by Borsch-Supan and Romer (1998) finds that competitive financial markets reinforce product market competition by cutting off funds to unproductive companies, but only in the face of competitive threats. Borsch-Supan and Romer also find that government regulation and ownership are important causes of low capital productivity, both directly and indirectly through limitations of competition. For example, the trade protection of the German and US auto industries and Deutsche Telekom enabled these companies to earn high profits, despite low productivity. Many less developed nations are now emulating the West by forming more sophisticated financial markets. One study (Agarwal 2001) of nine African nations indicates that stock exchange development has led to increased economic growth. Another study (Aragarwal 2007) of twenty-one developing nations shows that the development of stock exchanges increases private investment and economic growth. This study indicates that stock exchanges contribute to economic development by stabilizing productivity and liquidity shocks. In his article, Kinsley claimed that Milton Friedman was wrong about capitalism and that John Kenneth Galbraith was right.
Nothing could be further from the truth. Galbraith was wrong about practically everything he wrote on economics. Milton Friedman correctly saw great merit in the free enterprise system, yet it was Mises and Hayek who understood the reasons for capitalism’s success most clearly. Mises recognized the importance of speculation in financial markets in theory. Hayek understood competition as it really is and should be: as a competitive discovery procedure. Numerous studies confirm the importance of free financial markets in practice. The attack that Michael Kinsley launched against stock markets proves only that he understands neither theory nor history in these matters.
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