Wednesday, April 2, 2008

Manipulations of Capital

Manipulations of Capital

By Paul Fabra

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Let's begin with what serves as the devastating background to the drama being played out on financial markets in the United States first of all (but not only!). Every time the Fed lowers its interest rates, it weakens the dollar still further. Unlike his predecessor (and intercessor) Alan Greenspan, Ben Bernanke relies entirely on a cynical calculation. American monetary authorities' room for maneuver only appears as large as it does because they've transferred their main responsibility onto other people: safeguarding the dollar.

In short: if the Bank of China (we can understand why Bush goes to Beijing!) and the central banks of other emerging countries - among the first tier of which is the Bank of Russia - didn't buy up all the dollars that find no other takers on the markets at their present exchange rate, the Fed - unless it were willing to risk a dollar free fall - would not have its hands free to react as it does.

Among the consequences of the massive dollar purchases by foreign central banks - immediately reinvested in American government securities in New York - there are two designed to scramble market signals and deprive them almost completely of their regulating function - a world with neither compass nor anchor. First of all, these purchases supply enormous liquidity to the credit institutions of emerging countries (quickly spread onward throughout the globe). Hence, the coexistence of inflationary bubbles - with their impact on food stock and oil prices - along with formidable deflationary pressures (such as the accelerated deflation of real estate prices in the United States) that destroy liquidity.

Secondly, the value of short- and medium-term American Treasury bills (the categories purchased by central banks), already stimulated by private investors' "flight to quality," is powerfully reinforced that way, which mechanically translates into a reduction in the interest rate on those "products." As in the 1930s, soon governments only - beginning with the American government - will be able to borrow! Thus, they will be able to redeem rotten securities - the famous structured products that encumber the balance sheets of the multiform and opaque credit industry (banks, hedge funds, etc.). On the other side of the Atlantic, the "credit crunch" is spreading to other compartments of the market: first-tier mortgages (as opposed to "subprimes"), credit cards on which arrears are increasing....

However, we must also turn toward other perversions in particular to understand the ravages of the contagion. The rapid decline that has hit the particularly lucrative (up until June 2007) and burgeoning "private equity" sector is an edifying and highly significant example.

One of the most signal, if not the most crucial, services a market economy is able to perform is the determination of that eminently strategic variable called profit. The level of a whole national economy's investments depends upon it, as does the share of national revenue that goes to salaries. Now, in the system of a finance-dominated economy, the profits collected are disconnected from market data. That results from a power coup.

The vocabulary in use betrays this connection. Professors of economic science talk about the return investors "demand." That is the result of the now-universal assimilation of the notion of profit and the notion of risk. Each investor determines his risk level; the probability of a level of profit will derive therefrom. The economy is not, as a general rule, a casino (in spite of the dominant theory).

One method for varying the return on an investment somewhat to one's desire [1] is the discretionary use of the "leverage effect." As long as interest rates are low, it's advantageous for an investor to finance an investment by putting in the lowest possible amount of capital funds, with the major part of the investment having been supplied by an inexpensive loan. All the profit that exceeds the coast of reimbursing the loan goes to the capital holders who (by design, minimally) initially invested. The return per share is pushed to the maximum this way. Numerous investment societies function on the basis of such a "maximalization" scheme. One of the funds managed by this type of actor has just been rolled up. For every dollar of equity, it had $31 of debt. The key concept used to justify this type of arbitrage is the "cost of capital." Questioning its relevance as we've been doing here for fifteen years involves running the risk of never being taken seriously again.

But if one takes capitalism seriously - a regime in which the owner-shareholder carries the risk (in the strict and vital sense of the term) of the capital committed, in other words, assumes the success or the failure of the business - one cannot in any case talk about cost to designate profit. On the contrary, profit corresponds to the gain that comes to the shareholder in exchange for bringing the funds he has saved to the business. By definition, the funds thus put at the business's disposal cost it nothing. The business will only remunerate the shareholder in the event that its operation clears a surplus over the "inputs" used to offer a product for sale.

It is only from the perspective of a supposedly all-powerful manager that the remuneration of capital may be considered a cost in the manner of debt service. He will choose the appropriate dosage between the two resources. Even then, one must assume that for the business itself, equity financing is exactly the same as debt financing. Yet that's not true, absolutely not true, both from the point of view of the business and from the perspective of the economy in general. In the final analysis, economic growth is generated by the profit directly linked to capital. We'll talk about this some more later.

Peter Drucker wrote that the manager has no power, only responsibility. The authority invested in the manager is linked to his ability to assume that responsibility. The capital accumulated by a nation determines its ability to supply jobs and create wealth. In no case should managers be enabled to gamble with it.

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[1] On the condition (a condition the existence of which the present crisis has recalled) that the markets are running absolutely smoothly and operate "perfectly."

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