The death of Milton Friedman has been an occasion for celebrating the magic of capitalism, and fair enough. Capitalism is pretty great, and Friedman was its feisty defender when that was far from a universally held view. But let’s not get carried away. There are things capitalism does not do well, and other things that masquerade as capitalism at work, and claim its virtues, but aren’t entitled.
Capitalism is brilliant at setting the price of potatoes. But how good is it at setting the price of a large company? To all appearances, the stock market is capitalism operating under near-laboratory conditions. Financial markets deal almost entirely in electronic blips. Supply and demand can chase each other around the world with no actual goods to get in the way, and prices can adjust constantly and instantaneously. Yet the prices set in financial markets are patently wrong.
That is not my opinion. Well, yes, it is my opinion. But it is not only my opinion. It is held by America’s financial leaders, though they don’t put it quite that way. Actually, it is close to a provable fact. The free market cannot be setting the right price for financial assets such as shares of stock, because often there are different prices with equal claims to be the product of free-market capitalism. They all can’t be right.
Since around World War II, company and union pension funds have been pouring money into publicly traded stocks. For the last generation, the government has been encouraging people, through tax and other incentives, to do the same with their savings. President Bush, of course, wanted to do likewise with Social Security revenues.
The Web site of the Securities and Exchange Commission, which regulates stocks, offers the conventional explanation of why publicly traded stocks are a good thing. They are good for individuals because they allow people to share in the growth of the American economy. They are good for society because, by creating a market and setting a value for corporate shares, they make it possible for corporations to raise money by issuing shares in the first place. Publicly traded companies have long dominated the American economy, and most Americans have money invested, directly or indirectly, in publicly traded stocks.
All of this depends, though, on the assumption that the stock market sets the right price for shares of big companies. But a whole separate part of corporate finance is based on the assumption that those prices are wrong. These special deals used to be called leveraged buyouts. Now they’re called “private equity.” The details are different, but the principle is the same. Private investors buy a company from its public stockholders. They have a letter from an investment bank saying the price is a fair one. They usually have the support of management, or they actually are the management. The public stockholders have little choice. But time and again—surprise, surprise—the investment bank turns out to be wrong. The company is actually far more valuable! (And any bank that can’t be counted on to get this wrong will not be in this profitable line of work for long.) Soon, the company is sold at a large profit, either to another company or back to the public.
So, free-market capitalism has decreed three different values for this company. One is set by the stock market: the value of all the company’s outstanding shares or “market capitalization.” One is what the private investors are offering—usually a bit more than the market cap. And one is what the private investors sell the company for a blink of an eye later—which is usually a lot more than the other two. Which of these numbers is the true capitalist price? Which one represents the most sublime interaction of supply and demand? Anyone? Anyone?
Defenders of this procedure say it’s not that the stockholders have been swindled. It’s that the company is actually far more valuable in private hands because managers—even the same managers as before—can manage far better without the constraints of public ownership, with its meddlesome stockholders and nettlesome regulations. Maybe so. But if these deals aren’t a swindle, then the stock market itself is a swindle. It does not maximize value for its working- and middle-class investors. The stock market leaves money on the table waiting for “private equity” to swoop down and pick it up. Furthermore, Milton Friedman was wrong, and the other famous economist who died this year, John Kenneth Galbraith, was right: The free market in corporate shares doesn’t produce well-run companies.
Many have asked how managers trying to buy a publicly traded company can possibly be trusted to represent the shareholders who are being asked to sell it. How can they even be trusted to run the company if they’re plotting to buy it with the argument that it can’t be well-run under current circumstances? There are other nice questions: Did these managers happen to mention that they could not perform their jobs adequately as heads of publicly traded companies when the stockholders hired them for the job? If public ownership is a concept so flawed that the only way a company can prosper is to go private, how do the private owners explain their decision to take it public again? And so on.
But 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. Which is it?