The true lesson of capitalism

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One of the most basic distinctions in finance, with which any stockbroker or fund manager is intimately familiar, is that between equity (or shares), and debt. As the global economy teeters on the edge of a debt and banking crisis, with global debt more than 300 per cent of global GDP, the merits of equity is something that needs to be better understood.

Close up of hands checking financial trading data on smartphone in city street at night (Getty)With equity investment, the investor puts up the money without any guarantee they will get it back. That is, the risk is all on the person providing the capital. This is the opposite of debt investment, where the risk, as far as possible, is put on the person receiving the capital. They are asked to secure it against another asset — in Australia usually property — and are expected to make regular interest payments. In equity investment payments are only made, in the form of dividends, when the enterprise can afford it.

It might be expected that, because the risk is lower when lending than when investing in shares, that the returns from debt would be better. The opposite is the case. In the medium and long term, equities always outperform debt. Those fund managers and stockbrokers only buy debt securities to smooth out volatility in stock markets. It is generally thought that in the longer term they need to mostly buy shares to get good returns.

That much is well known. What is not as well known is why shares do so much better. Indeed, the question is almost never asked. Neither is the history of stock markets given much consideration. These things should be scrutinised, because they contain some important lessons.

For one thing, the development of equity capital is one of the main reasons that Karl Marx turned out to be wrong. His understanding of capital was principally as debt, and much of what he said about debt was not far off the mark. It is a form of enslavement, which is why it has been regularly banned for being usury, and it does lead to collapse. Debt payments routinely grow at a faster rate than the ability to pay, leading to more debt.

But that is not what happened in the north of England as it was industrialising. Possibly because access to the London banks was hard for the northerners to gain, there was the widespread creation of cooperatives, mutual funds, provident funds, that pooled capital, which was then invested as shares in the burgeoning industries, rather than as loans. Because there was a degree of financial democracy in these vehicles: one member, one vote, it did not lead to the inequities and social dislocation that Marx had predicted. The gains were shared.

It spread out from there to other English-speaking countries, including Australia. The clue is in the names: National Mutual, Colonial Mutual, Australian Mutual Provident Society, Manchester Unity. It is why having large stock markets was, and still mostly is, largely an English-speaking phenomenon (the exceptions are Japan, which was helped to do it by America after World War II, and China, which is mostly government owned). The idea may have come from the bourse in France, but it is the English speaking world that has developed it.

 

"There is a very big difference between debt capital and equity capital (shares), as we are probably going to find out very soon."

 

Two features of share investment are suggestive of why share investment is so superior. One is that there has to be a higher level of trust. Investors will only hand over their money if they trust the recipients. That trust in turn produces better commercial outcomes.

The other is that the repayments of the capital don't have to be made regularly as is the case with interest payments. They are only made when the enterprise can afford it. It gives the managers of the company more room to nurture the value.

When critics of capitalism explore its flaws, they usually assume that the 'capital' they are looking at is just one thing (usually share investment is dismissed as a form of gambling). That is wrong. There is a very big difference between debt capital and equity capital (shares), as we are probably going to find out very soon.

Shares can reprice without causing much damage, because people only lose when they sell. Stock markets act a bit like a shock absorber. That remains the case even when there is high speed trading in stock markets, which is a perversion of the original idea.

If debt reprices, however, the whole banking system is in peril; debt is inherently more fragile. As global debt reaches dangerous levels, we are likely to see that dynamic played out. The solution will be to look at boosting equity capital, perhaps even swapping failed debt into equity. Preferably it should be done in vehicles that have a degree of democracy, like mutual funds. That is the true lesson of capitalism.

 

 

David JamesDavid James is the managing editor of businessadvantagepng.com. He has a PhD in English literature and is author of the musical comedy The Bard Bites Back, which is about Shakespeare's ghost.

Topic tags: David James, equity, debt

 

 

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Existing comments

Global debt certainly is frightening, but even the best looking investments can fail, and fail spectacularly. Remember Long Term Capital Management that boasted two Nobel Prize-winning economists among its founders, but which lost $4 billion in a few weeks? And Amaranth Advisors, which lost $6 billion in a fortnight, including $100 million owned by the San Diego county pension scheme. Taking calculated risks is part and parcel of investing, but investors with gambling instincts, as Keynes warned, “Must pay to this propensity the appropriate toll.”
Ross Howard | 16 January 2019


The distinction between debt and equity capital is always a good one to be reminded about. This especially so when the subject is approached from the microeconomic direction of ‘mum and dad’ investors, as this article appears to be doing. However, given the bad press debt gets in this article, I think the article probably needs some counter-balancing points to be made, for example: 1. When approached from the macroeconomic direction, the great conservative economist Joseph Schumpeter emphasised how heavily capitalism relies on credit. He taught that the "the headquarters of the capitalist system" was the money market - the place where credit is allocated. "All kinds of credit requirements come to this market; all kinds of economic projects are first brought into relationship with one another, and contend for their realisation in it" (Thomas McCraw, Professor of Business History, Harvard Business School, quoting Schumpter in "Prophet of Innovation", Harvard University Press, 2007, p.74). 2. Also, at the macro level, it all depends on who is lending to whom. In cases such as entrepreneurial investing in new business enterprises, which Schumpeter has in mind, contrary to the point in the article, the risk is not “put on the person receiving the capital”. “The entrepreneur is never the risk bearer” Schumpeter argues. “The one who gives credit [the lender] comes to grief if the undertaking fails . . . . Even though [the entrepreneur] may risk his reputation, the direct economic responsibility of failure never falls on him [the borrower]” (ibid). 3. Another qualifier to the article is that debt and equity go together. Like 2 wheels on a bicycle, equity and debt are needed for a modern functioning mixed (government and business) economy to work properly. So, for instance, in the cases of the mutual funds developing in northern England, although they were primarily equity based, I’d be surprised if these organisations did not employ some debt as well. It’s a case of ‘both and’ rather than ‘either or’. The true lesson of capitalism is that it’s usually preferable (safer) to have considerably more equity than debt. The world at the moment has far too much debt relative to equity and, as the article points out, a rather severe correction to this imbalance is surely on the horizon.
Rex Graham | 17 March 2019


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