Thursday, 10 December 2015

An overview of finance theory under capitalism

The remarkable rise of financial markets in the first quarter of the XX century was followed by an increased interest in finance. Initially the emphasis was in security analysis, but since the 1950s its focus shifted towards portfolio theory, markets and new financial instruments such as derivatives.

Before the XX century, finance theory was mostly a branch of mathematics (actuarial calculus) dealing with the pricing of risk in fixed income securities (debt) based on the probabilities given by mortality and bankruptcy tables. Given the stable nature of such tables finance was not seen as ideological or having anything to do with the fundamental principles of capitalism.

However, following the rising issue of variable income securities (equity) by joint stock companies, finance theory become progressively the realm of accountants and lawyers dealing with the valuation of stocks on the basis of the calculation of future profits and the rights of each class of shares issued. These concerns were already at the core of the principles of capitalism (property rights and free markets), but remained largely non-ideological because of the nature of such valuations based on common sense forecasting of business profits and the growing prohibition of share manipulation. Such valuations were generally accepted as relevant to value firms.

Yet, this benign acceptance of security valuations came to an end following the 1929 stock market bubble and crash. During that period valuations were so much at odds with the corporate fundamentals that financial analysts had to look elsewhere for explanations.

The first attempt appeared in 1934 with the publication by Graham and Dodd of Security Analysis, a book that has gone through two major revisions but it is still seen today as the bible of financial analysis. The book covered many of the pitfalls of traditional financial analysis but did not cut with the tradition.

However, security analysts were not the only trying to find explanations for extreme volatility in market prices. Accountants responded by increasingly recording non-cash transactions in an attempt to find explanations and macro economists began explaining why arbitrage was not reducing such large departures from price equilibrium.

For this, both professions had to come up with new theories (not new facts) to explain past and current valuations. These theories had to draw on assumptions (subject to ideological bias) and could not be tested in a laboratorial sense.

These rival theories searched for supporters while special interest groups searched for theories that served their interest. Consequently, finance theory ceased to be a reasonably neutral instrumental tool to become a battle field of ideologies with an impact on the interpretation of the principles of capitalism, especially on the role of private property and the profit motive.

This process was fostered in the 1950s by the sudden interest in finance by macroeconomists with a tradition of competing schools of thought and doctrines.

Curiously, accordingly to Miller (1988), the Modigliani-Miller interest on the cost of capital had been awakened by listening to a paper presented by Durand (1952), the last preeminent scholar in the old finance tradition. Modigliani and Miller (1958) developed a general equilibrium model for a closed economy aimed at explaining the “determinants of aggregate economic investment”. By consolidating the accounts of the business and household services into a single balance sheet debt and securities no longer appear, thus proving the proof of their first proposition about the irrelevance of the capital structure.

This proposition had already been proved in finance theory by Durand (1952) for security valuations based on operating income rather than net income, which he did not consider a best approach to capitalization. He suggested that the businessmen’s interests were better served by the maximization of the present value of their investments rather than their profits, because the first took into account their time preference. Moreover, the cost of issuing debt or equity would have to consider the effects of increased leverage or equity dilution on investment value to assess the rate of return required on the investment to preserve shareholder’s value. That way, this required rate of return could be interpreted as an opportunity cost of capital.

Durand’s conclusion was that: “Given a method of security appraisal, the costs of raising capital can be both defined and measured. At the same time I have tried to show that there is at present no generally accepted system of appraisal; hence there can be no generally accepted system of measuring costs”.

In particular, Durand claimed that none of the two methods widely used in analyst’s valuations – capitalized net income or capitalized net operating income – was adequate or correct, when strictly interpreted. Not surprisingly, he was the first (Durand, 1958) to refute the Modigliani-Miller proposition on the grounds that it may apply to certain partnerships but not to corporations, since it neglected a fundamental principle of capitalism – limited liability. Later, Durand (1989) extended his critic to the static nature of a theory based on constant growth rates, by showing that “growth, when resulting from a premium rate of return in an imperfect market, will manifest itself in a premium stock price”.

Nevertheless, Miller and Modigliani (1961) extended their approach to the case of dividends to prove their second proposition about the irrelevance of dividends for firm valuation. Both propositions relied on pure capital markets and the possibility of creating so-called homemade leverage and dividends to create conditions for arbitrage between debt and equity that made structure irrelevant for valuation. These papers were necessarily controversial and triggered an unprecedented interest of macroeconomists in finance which extended also to econometricians and finance professionals.

This would create an new age in finance theory in academia. Given the rather complex and theoretical nature of the Modigliani-Miller approaches, it is still unclear why this happened so suddenly. Especially, since the greatest innovation with a practical use – Harry Markowitz (1952) paper on portfolio optimization - had remained forgotten for almost a decade.

It is nevertheless plausible to assume that the interest of company managers in encouraging a theory that would free them to use whatever capital structure they liked and to decide on how and when to return funds to the shareholders did not remain unnoticed. Likewise the replacement of profit by firm value maximization fade away the monitoring of their performance while justifying their growing compensation in terms of stock options .

In this new era of so-called modern finance, or new finance if we add behavioral finance, theory and practice became increasingly divorced. Contrary to tradition, practitioners began using complex academic theories to impress their marketing targets the same way salesman use super models to sell cars.

Thus modern finance theory became the realm of economists and econometricians, hiding their primeval ideological bias under a heavy use of complex modelling and econometrics.

Curiously, modern finance theory had begun in the right foot with Durand’s (1952) paper on the “Costs of Debt and Equity Funds for Business”, which questioned a proclaimed shortage of equity capital as the reason for the increased retention of earnings and borrowing.

Unfortunately, Modigliani and Miller (1958) reversed Durand’s conclusion and used the cost of capital concept to develop their model on the irrelevance of the capital structure on a firm’s value and the neutrality of dividend policy, by recurring to devices such as shareholder’s leverage and homemade dividends.

Despite the protests of Durand (1959), the Modigliani-Miller theory became fashionable among academics and was seized by managers to reclaim their long held desire to treat indifferently debt holders and stockholders. This fostered the idea (and reality) that managers select shareholders not the other way around, in order to maximize the owners value but that of an enlarged constituency ranging from employees to suppliers.

Combined with accommodating fiscal policies this “new ideology” justified an enormous rise in institutional investment and consequent facilitation of the rise of managerial capitalism. This fueled a number of potentially nefarious policies and political collusions. I address below some of these ranging from the abuse of the weighted average cost of capital to the attempts for (re-)privatization of money.

In conclusion, finance theory may not have had an impact as large as that of technology, but it was still significant. Its role has been mainly accommodating in explaining the trend for financialization and managerial capitalism. On the contrary, it has been lacking on exposing the excesses of financial deepening in finance-led capitalism. Since this is not always benign, one would expect more from financial theorists.

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