The Decline of the Stock Market

Felix Salmon has written a provocative piece arguing that stock markets are increasingly irrelevant to American capitalism. Reihan Salam has responded, arguing that a shift away from arms-length financing tools, like stocks, towards relationship-based lending, like private equity, could be a good thing:

I’m definitely on this matters, but I’ll just say that I think the death of the stock market is mostly good news. My admittedly crude sense is private equity firms do a fairly good job of allocating capital efficiently. We have evidence, from Nicholas Bloom and John Van Reenen in the JEP and elsewhere, that they have a managerial edge over publicly-owned and family-owned firms. As Amar Bhide argues in his wonderful new book A Call for Judgment, a case can be made that the U.S. has relied too heavily on arms-length finance rather than relationship finance, the approach taken by VCs that have deep, long-term relationships with the companies in which they invest. (Indeed, he argues that public markets in the U.S. suffer from excessive liquidity.) Our securities laws make relationship finance difficult if not criminal in many domains, and it is far from obvious that this has been good for the real economy.

Amar Bhide has written a good book, but I'm not entirely convinced. It's important to understand why stocks have become more important. If it were the case that companies on their own were choosing other financing options, this trend might be welcome. Rather, companies are instead frequently pushed away from the stock market by various worrying factors.

As Jeffrey Stewart argues, one such factor is new regulatory pushes (for instance, Sarbanes-Oxley) which have pushed the cost of listing higher to prohibitive levels. The whole market has also changed, possibly because of regulation, but also because of technology. Investment banks are perhaps less interested in underwriting new companies than in doing their own trading. Institutional managers are more interested in high-frequency trading among very liquid stocks than dealing with illiquid, new issues. Finally, there's an issue Felix has raised elsewhere -- that the tax code penalizes dividends and equity investments much more than raising debt, encouraging firms to stay away from equity. Overall, the stock market is less interested in deploying capital to entrepreneurial sectors of the economy than it is in making money on whether the tenth decimal place of a given price is correct.

It's true that Angel Investors, Venture Capitalist firms, and Private Equity have filled in the gap to some extent, particularly for tech firms. But even these financiers often require re-selling the company on a public exchange to cash out, so a poorly functioning stock market hurts them as well. The relationship funders rely on cooperating with arms-length finance too.

All these changes may make it harder for companies to get the financing needs they need as they grow up. Many companies around today -- Apple, Amazon, Microsoft -- went public very early on, and used that equity to finance future growth without giving up management. Yet new companies like Twitter or Facebook today rarely access the stock market until they get much larger. To an extent, venture capital funding may fill their early financing needs, though those backers may also be more likely to kill the company if it doesn't generate a quick, early return. You also need to be able to find such backers on a personal basis, rather than calling up some bankers and letting anyone buy your shares.

But the other alternative is selling out to a larger company, which seems to be one of the dominant next steps in the absence of cashing out through an IPO. This can frequently make capital allocation worse, to the extent big companies are bad at managing smaller companies they takeover. Many big companies, at least in tech, seem intent on buying out others simply to stifle competition.

A lack of easy access to capital markets also hurts incumbent firms that are already listed. Felix points to the high degree of corporate savings. In theory, companies should spend now if they have profitable projects, confident that the market will be able to meet any future capital needs. Instead, they are often opting to go for internal funding always. This can result in sizable capital inefficiencies over time.

You also need to think about the impact on investors. While the gyrations of the Dow may not have too much to do with real economic conditions, they certainly impact the 401(k)s of many individual investors. If the stock market remains a preserve of old, stagnant firms (missing Facebook, Twitter, and so forth); individual investors will miss out on the capital gains of a large sector of the economy, which will go instead only to a handful of connected insiders.

For an counterpoint to Amar Bhide, Anil Kashyap and others have a good book tracing Japan's financial evolution. I'll be blogging more on this soon, and am probably closer to Bhide than them. But they make some persuasive arguments -- Japan relied on a very equity-based system of financing pre-WWII, which worked very well; while the relationship style of banking that developed after the war resulted in substantial losses, particularly by the 90s.

It's hard to get a good sense of how much of this matters, particularly if you think that companies in general may need less capital to get going these days. But it certainly strikes me that lowering the capacity of the stock market to allocate capital was a particularly destructive move that has taken away an important financial choice for many companies. It's helpful that forms of relationship capital have filled in the gap in important ways. But surely it would be better to have both more venture capitalists, as well as a better functioning stock market.