I’m sympathetic to a lot of your complaints and find your overall narrative interesting (albeit not something I fully understand or buy). But most if not all of the pathologies you describe seem explainable under mainstream microeconomics (mainly using the concept of principle-agent problem), so I think I’d be more receptive to a version of this post where you didn’t claim otherwise.
I found myself trying to explain that you might lend some grain to a farmer, so they could plant it to grow more, pay you back with interest, and still have some grain left over. If this farmer did not yet have a grain repayment history, you might investigate other things like whether they had access to the land they said they did, whether they had a reputation among friends and neighbors for meaning what they said, and whether they had the knowledge and equipment to plant and harvest grain.
If you were an owner or investor of a bank, should you really prefer that lending decisions be based on the subjective judgement of loan officers? What if they decide to base their decisions in part on what maximizes their values instead of yours? E.g., demand kickbacks, make loans to their friends or allies, bias their decisions with political ideology, or just slack off when they’re supposed to be interviewing the farmer’s friends and neighbors.
Or consider the leveraged buyout example. A standard principle-agent problem in corporate governance is managers who prefer to hoard cash instead of returning profits to investors, with the investors not trusting the managers to use that cash in their interests (instead of the managers’ own interests) in the future. (That’s probably why the shares of such a company are trading at such a low multiple to its earnings that you can afford to buy them by issuing debt.) Leveraged buyout can be viewed as a solution to this problem.
From my perspective, the solutions to these problems offered by mainstream finance have their own serious downsides, but that’s exactly what you’d expect from a second best solution, as these solutions have to be.
Microeconomic ideology generally claims that this is because large corporations are more productive due to economies of scale. This may be true in some cases, but it is not generally the case. A local entrepreneur I know tells me that a well-run coffee shop in a well-chosen location can pay for itself (recoup the initial investment) within a year, while an investor in the stock market is doing well if they double their money in nine years. Another entrepreneur I know is planning to buy privately owned laundromats, package them into a publicly traded company, and sell it at 10-50 times the purchase price.
These are examples of publicly traded companies being valued at higher multiples than small businesses. This phenomenon is so well known or frequent that there’s a name for what the second entrepreneur is doing, “multiple arbitrage”. But again you don’t have to go outside of mainstream microeconomics to find explanations for this. Liquidity premium is one (relatively mundane) explanation, and I suspect principle-agent problem again applies here, perhaps because it’s easier (less costly) for a shareholder to monitor one big company for misalignment, and for the company to institute governance measures to try to ensure alignment, than the equivalent for n smaller companies.
But again you don’t have to go outside of mainstream microeconomics to find explanations for this. Liquidity premium is one (relatively mundane) explanation, and I suspect principle-agent problem again applies here, perhaps because it’s easier (less costly) for a shareholder to monitor one big company for misalignment, and for the company to institute governance measures to try to ensure alignment, than the equivalent for n smaller companies.
I would expect a liquidity premium to exist but I’d expect it to be much smaller than the size of opportunity I’m seeing—why do you expect to see one so large?
I don’t think the principal-agent problem explains anything here because large publicly traded corporations frequently have governance, financial structures, and operations that aren’t intelligible at all to casual investors. For example, I’ve taken courses in finance, accounting, and economics, and worked in financial services, and I have no idea how to evaluate Markopolos’s criticisms of GE, & compare this with their financial statements, because the latter are so vague. (Do you?) Nor was there a trusted intermediary whose evaluation methods I understood. (Can you recommend one?) In practice when I did own stocks I was relying on correlation with other investors—the government would try not to let us all fail at once—rather than any ability to meaningfully exercise oversight over centralized management.
The parenthetical questions are meant seriously, they’re not just rhetorical flourishes.
A standard principle-agent problem in corporate governance is managers who prefer to hoard cash instead of returning profits to investors, with the investors not trusting the managers to use that cash in their interests (instead of the managers’ own interests) in the future. (That’s probably why the shares of such a company are trading at such a low multiple to its earnings that you can afford to buy them by issuing debt.) Leveraged buyout can be viewed as a solution to this problem.
I understand this argument, it would be a perfectly logical reason for some leveraged buyouts to happen in some circumstances, but in practice many leveraged buyouts are a way to offload risk onto counterparties with less legible high-trust relationships with management, such as employees—e.g. in the airline bankruptcies—or consumers, who can’t use brandquality as much as they used to be able to because corporate decisions are made based on short-term numbers, and turnover means that the cost of eroded brand loyalty will be correlated across many companies and distributed across many people, and since the state won’t let large corporations in general fail all at once, we end up with bailouts. I recommended a book on the subject because I really can’t cover everything in the blog post, it’s long enough already and this sort of thing is very well documented elsewhere.
If you were an owner or investor of a bank, should you really prefer that lending decisions be based on the subjective judgement of loan officers? What if they decide to base their decisions in part on what maximizes their values instead of yours? E.g., demand kickbacks, make loans to their friends or allies, bias their decisions with political ideology, or just slack off when they’re supposed to be interviewing the farmer’s friends and neighbors.
I’d rather people investing on my behalf use objective profit-maximizing criteria, ideally with skin in the game, and that’s why it’s surprising that access to capital depends so much on the kinds of subjective factors you mention (checking whether someone has already been extended credit, whether they’re vibing the right way with VCs or bankers, whether they look like a normal borrower, and in the case I described, whether they took a class prescribed by the credit union) relative to economic considerations.
I have a close friend who was had a business bank account closed for avowedly discretionary reasons after a conversation with a banker where as far as I can tell the banker got spooked because he seemed like he had specific, creative plans that didn’t look normal. (Nothing illegal was discussed; they were thinking about something that might have attracted regulatory scrutiny, but they’d have been happy to negotiate or just look for a different counterparty for those transactions.)
An important case study here is Abacus Bank, the only bank to be prosecuted in relation to the 2008 financial crisis, as far as I can tell simply because they’re culturally decorrelated from other banks (small, ethnically Chinese, privately held). The prosecution didn’t work out, because Abacus hadn’t done any crimes.
I’m sympathetic to a lot of your complaints and find your overall narrative interesting (albeit not something I fully understand or buy). But most if not all of the pathologies you describe seem explainable under mainstream microeconomics (mainly using the concept of principle-agent problem), so I think I’d be more receptive to a version of this post where you didn’t claim otherwise.
If you were an owner or investor of a bank, should you really prefer that lending decisions be based on the subjective judgement of loan officers? What if they decide to base their decisions in part on what maximizes their values instead of yours? E.g., demand kickbacks, make loans to their friends or allies, bias their decisions with political ideology, or just slack off when they’re supposed to be interviewing the farmer’s friends and neighbors.
Or consider the leveraged buyout example. A standard principle-agent problem in corporate governance is managers who prefer to hoard cash instead of returning profits to investors, with the investors not trusting the managers to use that cash in their interests (instead of the managers’ own interests) in the future. (That’s probably why the shares of such a company are trading at such a low multiple to its earnings that you can afford to buy them by issuing debt.) Leveraged buyout can be viewed as a solution to this problem.
From my perspective, the solutions to these problems offered by mainstream finance have their own serious downsides, but that’s exactly what you’d expect from a second best solution, as these solutions have to be.
These are examples of publicly traded companies being valued at higher multiples than small businesses. This phenomenon is so well known or frequent that there’s a name for what the second entrepreneur is doing, “multiple arbitrage”. But again you don’t have to go outside of mainstream microeconomics to find explanations for this. Liquidity premium is one (relatively mundane) explanation, and I suspect principle-agent problem again applies here, perhaps because it’s easier (less costly) for a shareholder to monitor one big company for misalignment, and for the company to institute governance measures to try to ensure alignment, than the equivalent for n smaller companies.
I would expect a liquidity premium to exist but I’d expect it to be much smaller than the size of opportunity I’m seeing—why do you expect to see one so large?
I don’t think the principal-agent problem explains anything here because large publicly traded corporations frequently have governance, financial structures, and operations that aren’t intelligible at all to casual investors. For example, I’ve taken courses in finance, accounting, and economics, and worked in financial services, and I have no idea how to evaluate Markopolos’s criticisms of GE, & compare this with their financial statements, because the latter are so vague. (Do you?) Nor was there a trusted intermediary whose evaluation methods I understood. (Can you recommend one?) In practice when I did own stocks I was relying on correlation with other investors—the government would try not to let us all fail at once—rather than any ability to meaningfully exercise oversight over centralized management.
The parenthetical questions are meant seriously, they’re not just rhetorical flourishes.
I understand this argument, it would be a perfectly logical reason for some leveraged buyouts to happen in some circumstances, but in practice many leveraged buyouts are a way to offload risk onto counterparties with less legible high-trust relationships with management, such as employees—e.g. in the airline bankruptcies—or consumers, who can’t use brand quality as much as they used to be able to because corporate decisions are made based on short-term numbers, and turnover means that the cost of eroded brand loyalty will be correlated across many companies and distributed across many people, and since the state won’t let large corporations in general fail all at once, we end up with bailouts. I recommended a book on the subject because I really can’t cover everything in the blog post, it’s long enough already and this sort of thing is very well documented elsewhere.
I’d rather people investing on my behalf use objective profit-maximizing criteria, ideally with skin in the game, and that’s why it’s surprising that access to capital depends so much on the kinds of subjective factors you mention (checking whether someone has already been extended credit, whether they’re vibing the right way with VCs or bankers, whether they look like a normal borrower, and in the case I described, whether they took a class prescribed by the credit union) relative to economic considerations.
I have a close friend who was had a business bank account closed for avowedly discretionary reasons after a conversation with a banker where as far as I can tell the banker got spooked because he seemed like he had specific, creative plans that didn’t look normal. (Nothing illegal was discussed; they were thinking about something that might have attracted regulatory scrutiny, but they’d have been happy to negotiate or just look for a different counterparty for those transactions.)
An important case study here is Abacus Bank, the only bank to be prosecuted in relation to the 2008 financial crisis, as far as I can tell simply because they’re culturally decorrelated from other banks (small, ethnically Chinese, privately held). The prosecution didn’t work out, because Abacus hadn’t done any crimes.