Tuesday, February 3, 2009

The financial crisis: the road to deviancy

Most textbooks on corporate finance start off by defining the goal of business as the maximization of shareholder value. This apparently innocuous definition generated the deviant model of business that is causing many of today's financial problems.

On the traditional model, companies focus on creating better products or services and when they succeed, the stock market rewards them accordingly. But, modern finance theory holds that, all things considered, share prices are the best indicator of the value of a company, not the finance-independent, quality of the underlying assets. The reasoning behind this claim can seem compelling if certain theoretical assumptions are accepted - the main one being that markets are efficient (which means, in effect, that they reflect the status of underlying assets in their pricing). We will perhaps look at these assumptions, and the evidence that is commonly adduced in their favour, on another occasion.

Meanwhile, we should note that when managers started to believe that share price is king, many of them lost their traditional focus. At first, this showed up in a wave of mergers and acquisitions. Smart business people recognised that it is easier, quicker, and less risky to improve stock market performance by buying or teaming up with other companies than it is to develop new products/services or refine old ones. At this stage, a lot of social harm was done, not to mention the opportunity costs of putting resources into acquiring other resources rather than the creation of new or better ones. However, finance theorists put a shiny gloss on all of this. Even though many of the deals came unstuck, they still happily claim that all was for the best, that the market for corporate control made business more efficient, put resources in the hands of those who were able to make better use of them, and gave investors a better deal. Because so much finance-theoretical research is politically contaminated even though it shelters under the image of scientific objectivity, we will probably have to wait decades get a less biased account.

The next stage in deviancy came, when managers realised that the shortest route to wealth creation bypasses old-fashioned economic activity. It involves the direct manipulation of share price by creative accounting and financial wizardry. This takes us into Enron territory. But, don't think of Enron as a special case. Share price manipulation was widespread. It was aided by auditors who were incompetent and willing to turn a blind eye even when they were not. Finance theory also helped because it entailed that such tampering is impossible - the market will soon discover it and punish the share price accordingly. Not surprisingly there was a convenient political match-up here. Right-wing defenders of free markets were all too happy to take advantage of this theoretical blindfold, though naturally they did not wear it themselves. Many were too busy playing the manipulation game or taking backhanders from others who were were already doing so.

I've seen no data on this, but no doubt sophisticated investors, those who supposedly keep markets efficient, also took their eye off fundamentals, finding it more simpler and more lucrative to guess what others are likely to likely to invest in, to bet on the jockey rather than the form, as The Economist once put it (though in connection with CEOs).

I will talk about the final steps towards deviancy next time. Meanwhile here is a clue: Porsche's most recently recorded yearly profits before taxes were $11.6bn. Of these, only 12% came from making cars.

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