Attacking Free Enterprise?

It seems as though anyone advocating (1) the regulation of the derivatives markets, (2) the oversight of banking operations, and (3) the reduction of student loan rates is ATTACKING FREE ENTERPRISE… or at least that’s the impression given in the Romney advertising to date.  This might be just as good a time as any to explore what we mean by Free Enterprise in our capitalist system.

Let’s start with what Free Enterprise is NOT.  It is not a license to sell anything to anybody for any reason.  I am not at liberty to sell an unidentified liquid mixture labeled “baldness preventive” if it contains nothing but some water and lanolin. I am not at liberty to promote the sales of flammable pajamas for infants.  I am not at liberty to sell you portions of bridges I do not own.   In short, American Free Enterprise comes with some restrictions which prevent the greedy from exploiting the gullible.

If we move beyond the realm of quotidian consumer products, I am not free to sell you shares in the Reese River Steamboat Company — a river only in the Nevada sense of the term which has been known to flood, but is more often noted by small bridges along Highway 305.  I am not free to sell you my shares in Exxon-Mobil, Inc. because I don’t actually own any.  I am free to borrow some shares of XOM, and short sell them.  Here’s one of the best explanations of short selling I’ve seen so far:

“Assume you want to sell short 100 shares of a company because you believe sales are slowing and its earnings will drop. Your broker will borrow the shares from someone who owns them with the promise that you will return them later. You immediately sell the borrowed shares at the current market price. When the price of the shares drops (you hope), you “cover your short position” by buying back the shares, and your broker returns them to the lender. Your profit is the difference between the price at which you sold the stock and your cost to buy it back, minus commissions and expenses for borrowing the stock.”  [InvestorGuide]

Simple enough — you sell stocks you’re borrowing at a high price, and then buy them back at the newer lower price.  There’s a little rhyme which urges caution in these short sale transactions:  “He who sells what isn’t hizzen, Buys it back or goes to prison.”  There are, however, naked shorts — which do not come in boxer or brief forms — and in these transactions the seller doesn’t have the securities in hand.  The SEC has some serious rules to prevent short sellers from manipulating the market and artificially driving down prices, “requiring that short sellers and their broker-dealers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so.”   Back to, “He who sells what isn’t hizzen, Buys it back or goes to prison.”

I am not free to get information about a company that almost nobody else knows  and then use my knowledge to buy or sell Octopus Inc. shares accordingly.  People make frowny faces about “insider trading.” The SEC prosecutes.

In short, even in some of the most complex or technical kinds of financial trading, I am not free to satisfy my greed by taking advantage of  your gullibility.

Vultures and Ventures:   All business enterprises require financing.  The financing depends on the size of the enterprise.  Some individuals start companies by themselves, or by borrowing from family and friends.  Some get start up money from a local bank.  Some get start up funds from very big banks; some rely on Venture Capitalists.  The “venture” investors risk their money on enterprises which they believe will eventually thrive.  Some businesses make it — others don’t — Heaven Help ‘Em they are taking some serious risks.   Some firms  make it, like First Solar, others beset by Chinese “dumping” go the way of Solyndra. [CNN] So, what’s the difference between a Venture and a Vulture?

Vultures do perform a service.  In nature they are part of God’s Own Building and Grounds Department.  However, in financial realms they’re more like raptors than the much maligned Cathartidae.  There were plenty of raptors in the air in the 1980s, the era of the Leveraged Buyout. They’re still hunting.

In the classical leveraged buyout the takeover firm uses loans to accomplish the buyout of a smaller company, and then uses both the assets of the “acquiring company” AND the assets of the “acquired company” as collateral for the deal.   A private equity firm takes the acquired company “private” while it is re-organized and prepared to be offered once more as a “public” corporation.  This is the part wherein most of the bodies are buried.  Departments may be closed, factories shut down, management reorganized, pension funds offloaded, etc. The guiding principle here is Efficiency.

Now we have a problem, because “efficiency” to one person may not have the same meaning for another.  If one espouses the Shareholder Value school of corporate finance, then that company which maximizes value for the Shareholders is the Most Efficient Company.  The higher the share price the better the company.   Enter the issues:  Is this definition of efficiency really the best policy?

At bottom this is a management question.  If Octopus Inc. believes it can manufacture and market the best quality ink for ball point pens by purchasing the best quality ethylene glycol (another reason not to suck on your pen!) AND it takes its position as The Quality Manufacturer seriously, then it’s not really being efficient if the ingredients could be had more cheaply — at the risk of a slightly inferior product.  If Octopus Inc. were the target of Dewey Graspe & Grabbe, would it really be better “economically” should the new management be more “efficient” and procure inferior but cheaper ingredients?

If Octopus Inc. had a very low personnel turnover rate because it offered a good pension plan and paid the best wages in the pen manufacturing sector, and therefore had fewer “customer returns” due to dysfunctional pens, is it more “efficient” to reduce personnel expenditures by eliminating the company sponsored health plan or offloading the company’s pensions?  If we adopt the “efficiency” standard of the Shareholder Value School the answer is Yes.   If we apply another standard including the value of the company to its community, its reputation in the manufacturing sector, its contributions to the overall economic well being of its region — then the answer might very well be No.  Not only is the overall evaluation of a company problematic under the constrained definition of “efficiency” underpinning the Shareholder Value school, but there’s another glitch to be considered:  What’s the Value?

There’s a time and place to meander through the weeds of EMH (Efficient Market Hypothesis) variations, rational markets, and behavioral economics — and this isn’t it.   However, we do need to remember that the Shareholder Value school assumes that the higher the share value the “better” the company.   But, what factors inform the share value?

The stock market does place a price on the equities offered by any company, but does the price reflect the value?   What if our hypothetical Octopus Ink, Inc. has a current share price of $10 per share?  If it were to lay off 200 experienced workers and replace them with 150 inexperienced workers, and the “market” rewarded the firm by pricing the shares at $12, does the price increase really reflect more “value” in the company?

If the answer to the last question is something like, “Hmmm, could be, but maybe not…” then we need to assume that the value of a firm isn’t merely mathematical nor is it just a mirage created by social, cognitive, and emotional factors either.  Taking this one step further, if we aren’t ready to assign value based on price alone, then it’s difficult to argue that the Shareholder Value model is completely informative.  If it’s not completely informative then we’d be better off erring on the side of caution and not assuming that Shareholder Value is the be and end all of economic activity.

Re-enter the Raptors.  Let’s lay off the melancholy and  maligned vultures for the moment and concentrate instead on the private equity Raptors.  If an “efficient” economy is one in which shareholder value is the primary goal of investment, then we’re wedded to a system in which the equities markets determine how we evaluate our economic activities.  Wall Street takes over Main Street and reformulates it in its own image.

What we need to decide, and the election of 2012 is as good a time as any, is if we want to be a nation in which we know the price of everything, but have a more difficult time determining the value of anything.  This is not to attack the notion of “free enterprise,” but to establish the ground rules by which we conduct our transactions.

When freedom becomes license there is the least liberty.  If we minimize our vision of what is valuable by reducing it to a price tag bestowed by mathematical models or a Manic Mr. Market, then we have automatically reduced our economic horizons.  If our “free enterprise” tradition devolves into a free-for-all market in which the greedy are “free” to prey upon the gullible, then we will have exchanged our economic system for economic chaos.  No one would be so foolish as to equate chaos and liberty.

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