A Blog of the Global Justice Movement

Wednesday, March 7, 2012

Ye Olde Equity Shoppe

The guiding myth of "the stock market" is that "it" (as if there was only one) is somehow a leading indicator of economic health. If "the stock market" does well, the economy is going great guns. If there is a drop in the market, universal despair ensues at this sign that the economy is once again in a tailspin and about to crash and burn.

The fact is, however, that "the stock market" is no more an indicator of the general health of the economy than the market for secondhand clothing indicates how well Abercrombie and Fitch are doing. "The stock market" (hereinafter the stock market because we're tired of typing quotes just to make a minor point) is, essentially, a secondhand shop for existing corporate debt and equity — that is, after all, why it's called "the secondary market."

As for the myth that the stock market "allocates credit" for new capital formation, within the paradigm dictated by the mainstream schools of economics, every dollar spent in the market for existing shares is one dollar less available for new capital formation. This baffled analysts during the speculative boom leading up to the 1929 Crash, as they could not understand that money was being created for both new capital investment and speculation at a tremendous rate, not taken out of existing accumulations of savings for either purpose.

From a Just Third Way perspective, of course, we are fully aware that capital is not generally financed out of existing accumulations of savings. Money and credit (two forms of the same thing) is not a commodity with a price fixed by supply and demand, but a system of agreements that expands and contracts at need.

Further, even a casual glance at the rates of economic growth experienced for the past four hundred years demonstrates the basic fallacy of assuming that it is necessary to reduce consumption in order to finance new capital and increase production. On the contrary, the incredible growth experienced in the modern era was financed not by cutting consumption, but by increasing production — "future savings" rather than "past savings."

Dr. Harold G. Moulton, president of the Brookings Institution from 1916 to 1952, demonstrated this in his book, The Formation of Capital, published in 1935 to present an alternative to the Keynesian New Deal . . . which assumed as a given that all capital formation, new or otherwise, is necessarily financed out of existing accumulations of savings.

Given these basic facts about money, credit, banking and finance, we were pleased to receive a question about how purchases of new equity shares might be handled under Capital Homesteading. Our correspondent asked,

"Exactly what would be purchased with the credit to each citizen from the Federal Reserve? Is it shares of stock in one corporation? A sector of the economy? A mutual fund? Or a combination of the above? Will the proposed citizen purchasing be done through a separate exchange as opposed to the New York Stock Exchange or the American Stock Exchange?"

Here's how we answer that question:

In Capital Homesteading, "preference" will be given to people purchasing shares in the company in which they or members of their families work. This would not be a legal, but a "cultural" requirement. For example, just how committed are you to the family farm or business if you use your credit voucher to purchase shares in a competitor's farm or business instead of improving your own? People who don't want to buy in to the company usually "get suggested to resign" as they say.

Obviously such a purchase would not ordinarily go through the exchanges. Keep in mind that a stock exchange is, essentially, a "second hand shoppe" for existing debt and equity issues. Even IPOs — "Initial Public Offerings" — are not sold on the exchanges. Instead, they are "placed" with investment bankers who sell them to their clients. The brokers on the exchanges only buy and sell shares and bonds when the original people who bought them sell them. They can't usually sell a public offering back to the company or the investment banker that sold them to them, and usually end up going to some broker (either directly or through their own broker) who has a buyer.

In the current environment geared toward speculation instead of investment, of course, this encourages "flipping." We believe, however, that flipping will tend to diminish with Capital Homesteading and its emphasis on dividends rather than changes in the share value. (In the current environment, some IPOs get flipped several times in the first day, as speculators take a quick profit in response to rapid price changes.)

If an equity issue that is publicly traded on the exchanges includes full payout of dividends and the vote, then it would qualify for Capital Homestead credit. Where, after all, will the accumulated shares go when somebody dies and the heirs are already "full up"? The shares will likely be sold through an exchange to other people who need qualified shares, and the heirs take the money and recognize it as regular income.

The focus of Capital Homesteading, however, is on new share issuances, used to finance the annual "growth ring" of new capital. The exchanges are for trading existing capital, not floating new issuances. A company that is financing new capital will put together a new equity issue and "float" it. In the bad old days before Capital Homesteading, this will have meant finding a rich man to buy it, or an investment bank that could sell the securities to a rich man, institutional investor, mutual fund, and so on.

Under Capital Homesteading, although the details will have to be worked out — it can't be done before the legislation is written because the specific method or system has to conform to the law — absent a direct placement with its own workers, the company might either place shares directly with commercial banks that will then sell them to their customers for their Capital Homestead Account. This is probably a bad idea. We want to separate commercial from investment banking in all cases, not just for large or institutional investors.

That might mean, then, that new equity issues will be placed with an investment bank that serves as a "wholesaler," does due diligence, and provides a "catalog" of prospectuses to commercial banks which can then do their own due diligence and assist their customers in selecting shares for their Capital Homestead Accounts.

The commercial bank customer — the Capital Homesteader — makes the selection of shares. He or she then signs a note for the acquisition cost which the commercial bank accepts ("discounts") after receiving approval from the capital credit insurer — adding another level of oversight and due diligence.

The commercial bank then rediscounts the note at the local Federal Reserve. On accepting the note, the Federal Reserve issues a promissory note and creates a demand deposit in the name of the commercial bank. The commercial bank draws on this demand deposit to fund the demand deposit the commercial bank now creates in the name of the Capital Homesteader. The Capital Homesteader's demand deposit is immediately expended on the purchase of the selected shares. A check goes to the investment bank, which subtracts its fee and hands the money over to the companies that issued the shares.

To add another level of security, some people might organize Capital Homestead mutual funds of qualified shares. Companies would place their shares with investment banks, which would then place them with the Capital Homestead mutual funds. The investment bank would include the prospectus of the mutual fund in its "catalog" just as for a regular share offering, and shares of the mutual fund would be purchased through commercial banks the same as for regular Capital Homestead shares.

A possible scenario is that, in the initial stages of Capital Homesteading and where shares are not purchased in the company where a member of the family works, the preference will be for such mutual fund Capital Homestead shares instead of directly owned corporate or other equity. As people become more accustomed to and comfortable with ownership and the ownership culture is rebuilt (what Hilaire Belloc called "the restoration of property"), the preference will naturally shift to direct ownership of corporate and other equity instead of Capital Homestead mutual funds.

This is because a "smart" investor (or one with a "smart" adviser) will tend to do at least as well as a mutual fund — especially in the shares of the company in which he or she works — and not have to pay the fee that a mutual fund would charge. There would have to be a number of mutual funds to ensure competition and diversity, but as a major player, they would probably only be significant for twenty years or so, although there would always be a role for them, just as there will probably be for the ESOP, which we view as a transitional vehicle on the way to a Capital Homestead Act.

The stock exchanges will, of course, continue to function pretty much as today, although with a vastly increased customer base and volume of transactions. The difference will be that nobody will be under the illusion that these secondhand shops are the primary, productive market. The secondary market will still be important for determining risk and handling the transfer of existing equity and debt, but it will be seen as clearly ancillary to the primary market that really drives the economy.


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