The Commission was founded in 1932 by Alfred Cowles III and Irving Fisher, two disgruntled
investors
who had just lost a fortune in the 1929 market crash.
Nitzan Bichler - 2012 - Capital as Power
Newton learned this lesson the hard way after losing plenty of money in the bursting of the 'South Sea Bubble'.
Two centuries later he was joined by no other than Irving Fisher, who managed to sacrifice his own fortune - $10 million then, $100 million in today's prices - on the altar of the 1929 stock market crash.
So just to be on the safe side, neoclassicists now agree that, although capi- talization does reflect the objective processes of the 'real economy', the picture must be augmented by human beings. And the latter, sadly but truly, are not always rational. Greed and fear cloud their vision, emotions upset their calculations and passion biases their decisions - distortions that are further amplified by government intervention and regulation, lack of trans- parency, insider trading and other such unfortunate imperfections. All of these deviations from the pure model lead to irrationality and end in mis- priced assets.
But not all is lost. Convention has it that there is nonetheless order in the chaos, a certain rationality in the irrationality. The basic reason is that greed tends to operate mostly on the upswing, whereas fear usually sets in in the downswing. 'We tend to label such behavioural responses as non rational', explains Alan Greenspan (2008), 'But forecasters' concerns should be not whether human response is rational or irrational, only that it is observable and systematic'. The regularity puts limits on the irrationality; limits imply predict- ability; and predictability helps keep the faith intact and the laity in place.
The boundaries of irrationality are well known and can be recited even by novice traders. The description usually goes as follows. In the upswing, the growth of investment in productive assets fires up the greedy imagination of investors, causing them to price financial assets even higher. To illustrate, during the 1990s developments in 'high-tech' hardware and software suppos- edly made investors lose sight of the possible. The evidence: they capitalized information and telecommunication companies, such as Amazon, Ericsson and Nortel, far above the underlying increase in their 'real' value. A similar scenario unfolded in the 2000s. Investors pushed real-estate capitalization, along with its various financial derivatives and structured investment vehi- cles, to levels that far exceeded the underlying 'actual' wealth. The process, which neoclassicists like to think of as a 'market aberration', led to undue 'asset-price inflation'. Naturally, the capitalization created by such 'bouts of insanity' is mostly 'fake wealth'. It represents 'fictitious value' and leads to inevitable 'bubbles'. 6 But there is nonetheless a clear positive relationship here: the irrational growth of 'fake wealth', although excessive, moves in the same direction as the rational growth of 'real wealth'.
? 6 For a typical analysis of 'bubbles', complete with the above jargon, see Janszen (2008).
180 Capitalization
The process is said to invert during a bust. This is where fear kicks in. The 'real' economy decelerates, but investors, feeling as if the sky is falling, bid down asset prices far more than implied by the 'underlying' productive capacity. A famous illustration is offered by the Great Depression. During the four years from 1928 to 1932, the dollar value of corporate fixed assets contracted by 20 per cent, while the market value of equities collapsed by an amplified 70 per cent (we have no aggregate figures for bonds). A similar 'undershooting' occurred during the 1997 Asian financial crisis, with market value contracting by 50 per cent in many cases, against a growth slowdown or a very moderate decline in the dollar value of the 'real' capital stock. Yet here, too, the relationship is clear: the irrational collapse of 'fictitious value', however exaggerated, moves together with the rational deceleration of 'productive wealth'.
This bounded irrationality is illustrated by the thin line in Figure 10. 3. Note that this series is a hypothetical construct. It describes what the growth of capitalization might look like when neoclassical orthodoxy is augmented by 'irrationality' and 'market aberrations'. The value for each year in the hypothetical series is computed in two steps. First, we calculate the deviation of the growth rate of the (smoothed) 'real' series from its historical mean (so if the smoothed growth rate during the year is 8 per cent and the historical mean rate is 6. 7 per cent, the deviation is 1. 3 per cent). Second, we add 2. 5 times the value of the deviation to the historical mean (so in our example, the hypothetical smoothed growth rate would be 2. 5 * 1. 3 + 6. 7 = 9. 95 per cent). The coefficient of 2. 5 is purely arbitrary. A larger or smaller coefficient would generate a larger or smaller amplification, but the cyclical pattern would remain the same.
This simulation solves the riddle of the fluctuating Tobin's Q. It shows how, due to market imperfections and investors' irrationality, the growth of capitalization overshoots 'real' accumulation on the upswing, therefore causing Tobin's Q to rise, and undershoots it on the downswing, causing Tobin's Q to decline.
And so everything falls into place. Tobin's Q averages more than 1 due to an invisible, yet very real intangible revolution. And it fluctuates heavily - admittedly because the market is imperfect and humans are not always rational - but these oscillations are safely bounded and pretty predicable. Capitalization indeed deviates from the 'real' assets, though in the end it always reverts back to the 'fundamentals'.
Or does it?
The gods must be crazy
It turns out that while the neoclassical priests were busy fortifying the faith, the gods were having fun with the facts. The result is illustrated in Figure 10. 4 (where both series again are smoothed as 10-year moving averages). The thick line, as in Figure 10. 3, shows the rate of change of corporate fixed assets
Fiction, mirror or distortion? 181
measured in current replacement cost. But the thin line is different. Whereas in Figure 10. 3 this line shows the rate of growth of capitalization stipulated by the theory, here it shows the actual rate of growth as it unfolded on the stock and bond markets. And the difference couldn't have been starker.
The gyrations of capitalization, instead of amplifying those of 'real' assets, move in exactly the opposite direction. It is important to note that we are dealing here not with short-term fluctuations of the business cycle, but with very long-term waves of roughly 30-year duration. Furthermore, the pattern seems anything but accidental. In fact, it is rather systematic: whenever the growth rate of 'real' assets decelerates, the growth rate of capitalization accel- erates, and vice versa. 7
This reality puts the world on its head. One could perhaps concede that 'real' assets do not have a material quantum - yet pretend, as we have agreed
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? ? ? ? per cent
? ? Market Value of Corporate Equities & Bonds (annual % change)
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Current Cost of Corporate Fixed Assets (annual % change)
www. bnarchives. net
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Figure 10. 4 US capital accumulation: which is the 'real', which the 'fictitious'?
Note: The market value of corporate equities and bonds is net of foreign holdings by US resi-
dents. Series are smoothed as 10-year moving averages. Source: See Figure 10. 2.
7 Given our rejection of 'material' measures of capital, there is no theoretical value in comparing the growth of the two series when measured in so-called 'real' terms. But just to defuse the scepticism, we deflated the two series by the implicit price deflator of gross investment and calculated their respective 'real' rates of change. The result is similar to Figure 10. 4: the two growth rates move in opposite directions.
? 182 Capitalization
to do here, that somehow this nonexistent quantum is proportionate to its dollar price. One could further accept that the dollar value of 'real' assets is misleading insofar as it excludes the invisible 'dark matter' of intangible assets (up to 80 per cent of the total) - yet nonetheless be convinced that these invisible-intangible assets follow the same pattern as the visible-tangible ones. Finally, one could allow economic agents to be irrational - yet assume that their irrational pricing of assets ends up oscillating around the rational 'fundamentals' (whatever they may be). But it seems a bit too much to follow Fisher and claim that the long-term growth rate of capitalization is driven by the accumulation of 'real' assets when the two processes in fact move in opposite directions.
And, yet, that is precisely what neoclassicists (and Marxists as well) seem to argue. Both emphasize the growth of real assets as the fountain of riches - while the facts say the very opposite. According to Figure 10. 4, during the 1940s and 1970s, when the dollar value of 'real assets' expanded the fastest, capitalists saw their capitalization growth dwindle. And when the value of 'real assets' decelerated - as it had during the 1950s and early 1960s, and, again, during the 1980s and 1990s - the capitalists were laughing all the way to the stock and bond markets.
Given this dismal record, why do capitalists continue to employ econo- mists and subsidize their university departments? Shouldn't they fire them all and close the tap of academic money? Not at all, and for the simplest of reasons: misleading explanations help divert attention from what really matters. The economists would have us believe that the 'real thing' is the tangible quantities of production, consumption, knowledge and the capital stock, and that the nominal world merely reflects this 'reality' with unfortu- nate distortions. This view may appeal to workers, but it has nothing to do with the reality of accumulation. For the capitalist, the real thing is the nominal capitalization of future earnings. This capitalization is not 'connected' to reality; it is the reality. And what matters in that reality is not production and consumption, but power. This nominal reality of power is the capitalist nomos, and that should be our starting point.
11 Capitalization
Elementary particles
But the past always seems, perhaps wrongly, to be predestined.
--Michel Houellebecq, The Elementary Particles
Capitalization uses a discount rate to reduce a stream of future earnings to their present value. But this statement is still very opaque and lacking in detail. Which earnings are being discounted? Do capitalists 'know' what these earnings are - and if so, how? What discount rate do they use? How is this rate established? Moreover, accumulation is a dynamic process of change, involving the growth of capitalization and therefore variations in earnings and the discount rate. What, then, determines the direction and magnitude of these variations? Are they interrelated - and if so, how and why? Are the patterns of these relationships stable, or do they change with time?
Academic experts and financial practitioners have saved no effort in trying to answer these questions. But the general thrust of their inquiry has been uncritical and ahistorical. Explicitly or implicitly, they all look for the philos- opher's stone. They seek to discover the 'natural laws of finance', the universal principles that, according to Frank Fetter, have governed capital- ization since the beginning of time.
The path to this knowledge of riches is summarized by the motto of the Cowles Commission: 'Science is Measurement'.
The Commission was founded in 1932 by Alfred Cowles III and Irving Fisher, two disgruntled investors who had just lost a fortune in the 1929 market crash. Their explicit goal was to put the study of finance and economics on a quantitative footing. And, on the face of it, they certainly succeeded. The establishment of quanti- tative journals, beginning with Econometrica in 1933 under the auspices of the Cowles Commission, and continuing with The Journal of Finance (1946), Journal of Finance and Quantitative Analysis (1966) and the Journal of Financial Economics (1974), among others, helped transform the nature of financial research. And this transformation, together with the parallel quan- tification of business school curricula since the 1960s, turned the analysis of finance into a mechanized extension of neoclassical economics. 1
? 1 For aspects of this transformation, see Whitley (1986) and Bernstein (1992).
184 Capitalization
Yet, if we are to judge this effort against the Cowles Commission's equa- tion of science with measurement, much of it has been for naught. While finance theory grew increasingly quantitative, its empirical verification became ever more elusive. And that should not surprise us. Finance in its entirety is a human construction, and a relatively recent one at that. Its princi- ples and regularities - insofar as it has any - are created not by god or nature, but by the capitalists themselves. And since what humans make, humans can - and do - change, any attempt to pin down the 'universal' regularities of their interactions becomes a Sisyphean task. Despite many millions of regres- sions and other mechanical rituals of the quantitative faith, the leading priests of finance remain deeply divided over what 'truly' determines capitalization. When it comes to 'true value', virtually every major theology of discounting has been proven empirically valid by its supporters and empirically invalid by its opponents (that is, until the next batch of data demonstrates otherwise).
But these failings are secondary. The 'science of finance' is first and fore- most a collective ethos. Its real achievement is not objective discovery but ethical articulation. Taken together, the models of finance constitute the architecture of the capitalist nomos. In a shifting world of nominal mirrors and pecuniary fiction, this nomos provides capitalists with a clear, moral anchor. It fixes the underlying terrain, it shows them the proper path to follow, and it compels them to stay on track. Without this anchor, all capital- ists - whether they are small, anonymous day traders, legendary investors such as Warren Buffet, or professional fund managers like Bill Gross - would be utterly lost.
Finance theory establishes the elementary particles of capitalization and the boundaries of accumulation. It gives capitalists the basic building blocks of investment; it tells them how to quantify these entities as numerical 'vari- ables'; and it provides them with a universal algorithm that reduces these variables into the single magnitude of present value. Although individual capitalists differ in how they interpret and apply these principles, few if any can transcend their logic. And since they all end up obeying the same general rules, the rules themselves seem 'objective' and therefore amenable to 'scien- tific discovery'.
This chapter completes our discussion of the financial ethos by identifying the elementary particles of capitalization and outlining the relationship between them. The storyline follows two parallel paths. One path examines the conventional argument as it is being built from the bottom up. The starting point here is the neoclassical actor: the representative investor/ consumer. This actor is thrown into a financial pool crowded with numerous similar actors, all seeking to maximize their net worth earmarked for hedonic consumption. For these actors, the financial reality is exogenously given. As individuals, there is little they can do to change it. And since the reality follows its own independent trajectory, the sole question for the actor is how to respond: 'what should I do to make the best of a given situation? ' As a result, although the market looks full of action, in fact every single bit of it is
Elementary particles 185
passive reaction. And since everyone is merely responding, the only thing left for the theorist to do is aggregate all the reactions into a single equilibrium: the price of the asset.
The other path in our presentation looks at capitalization from the top- down perspective of organized capitalist power. Here the question is not only how investors behave, but also how the ethos that conditions them has emerged and developed. Furthermore, although capitalists undoubtedly react to existing conditions, they also seek to change these conditions; and it is this active restructuring - particularly by the leading corporate and government organs - that needs to be put at the centre of accumulation analysis. The second purpose of our presentation, then, is to allude to these transformative aspects of the capitalist nomos. This emphasis provides the framework for the next part of the book, where we begin our analysis of capital as power.
Earnings
When capitalists buy an asset, they acquire a claim over earnings. This claim is the anchor of capital. 'The value of a common stock', write Graham and Dodd in the first edition of their sacred manual, 'depends entirely upon what it will earn in the future' (1934: 307). 'What is an issue in the purchase deci- sion', the book reiterates half a century and four editions later, 'is the future earnings that the investor will obtain by buying the stock. It is the ability of the existing assets and liabilities to create future earnings that determine the value of the equity position' (Graham et al. 1988: 553).
In Chapter 9, we provided a simple expression of this ethos, with capital- ization at any given time (Kt) being equal to the discounted value of a perpetual stream of earnings (E):
1. Kt=Er
Financial analysts, who customarily focus on individual stocks, similarly express the price of a share at a given time (Pt) as the present value of a perpetual stream of earnings per share (EPS):2
2. Pt = EPS r
These equations, although simplistic, point to a basic pillar of finance. Whether we look at overall capitalization or the price per 'share' of capital- ization, earnings have a crucial impact on the magnitude of capital and its
2 Equation 2 is derived by dividing both sides of Equation (1) by the number of shares (N), such that Pt = Kt / N and EPS = E / N.
? ? ? 186 Capitalization
pace of accumulation. All else being equal, the higher the earnings, the larger the capitalization; and the faster the growth of earnings, the more rapid the rate of accumulation.
This basic relationship is illustrated in Figure 11. 1. The chart plots annual data for the S&P 500 group of US-listed companies, showing, for each year, the average share price for the group along with its average earnings per share. Both time series are normalized with 1871 = 100 and are plotted against a logarithmic scale to calibrate the pattern of exponential growth.
The data establish two clear facts. The first fact is that, over the long term, capitalization is positively and fairly tightly related to earnings. During the 1871-2006 period, the correlation coefficient between the two series measured 0. 94 out of a maximum value of 1.
The alert reader may contest this correlation as deceptive, on the ground that capitalists discount not the current profits depicted in the chart, but the
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? ? ? ? Price
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1871=100
? ? ? ? ? ? ? Earnings per Share
? ? ? ? www. bnarchives. net
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1840 1860 1880 1900
1920 1940
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Figure 11. 1 S&P 500: price and earnings per share
Note: The S&P 500 index splices the following three series: the Cowles/Standard and Poor's Composite (1871-1925); the 90-stock Composite (1926-1957); and the S&P 500 (1957-present). Earnings per share are computed as the ratio of price to price/earnings.
Source: Global Financial Data (series codes: _SPXD for price; SPPECOMW for price/earnings); Standard and Poor's through Global Insight (series codes: JS&PC500 for price; PEC500 for price/earnings).
Elementary particles 187
profits they expect to earn in the future. And that certainly is true, but with a twist. Because they are obsessed with the future, capitalists are commonly described as 'forward looking'. They (or their strategists) constantly conjure up future events, developments and scenarios, all with an eye to predicting the future flow of profit. An Aymara Indian, though, would describe this process in reverse. Since our eyes can see only what lies ahead and are blind to what lies behind, it makes more sense to say that capitalists have the future behind them: like the rest of us, they can never really see it. 3
Now, imagine the uneasy feeling of a capitalist having to walk backwards into the future - not seeing what she is back-stepping into, having no idea when and where she may trip and not knowing how far she can fall. Obviously, she would feel much safer if her waist were tied to a trustworthy anchor - and preferably one that she can see clearly in front of her. And that is precisely what capitalists do: they use current earnings (which they know) as a benchmark to extrapolate future ones (which they do not know) - and then quickly discount their guess back to its 'present' value.
Their discounting ritual is usually some variant of Equation (2). Recall from Chapter 9 that this equation is derived on the assumption that earnings continue in perpetuity at a given level. Of course, with the exception of fixed- income instruments, this assumption is never true: most assets see their earn- ings vary over time. But whatever its temporal pattern, the flow of earnings can always be expressed as a perpetuity of some fixed average. 4 And it turns out that making that average equal to current profit (or some multiple of it) generates an empirical match that is more than sufficient for our purpose here. The tight correlation in Figure 11. 1 thus confirms a basic tenet of the modern capitalist nomos. It shows that the level and growth of earnings - at least for larger clusters of capital over an extended period of time - are the main benchmark of capitalization and the principal driver of accumulation.
The theoretical implication is straightforward: in order to theorize accu- mulation we need to theorize earnings. And yet here we run into a brick wall. As we have seen, both neoclassical and Marxist writers anchor earnings in the so-called 'real' economy; but since production and consumption cannot be measured in universal units, and given that the 'capital stock' does not have a
3 Most languages treat the ego as facing - and in that sense looking toward - the future. When capitalists speak of 'forward-looking profits' they refer to future earnings. Similarly, when they announce that 'the crisis is behind us' they talk of something that has already happened. The Aymara language, spoken by Indians in Southern Peru and Northern Chile, is a notable exception. Its words and accompanying gestures treat the known past as being 'in front of us' and the unknown future as lying 'behind us'. To test this inverted perception just look up to the stars: ahead of you there is nothing but the past (Nu? n? ez and Sweetser 2006; Pincock 2006).
4 The visual manifestation of this smoothing is rather striking. When analysts chart the past together with their predictions for the future, the historical pattern usually looks ragged and scarred, while the future forecast, like a metrosexual's smoothly-shaved cheek, usually takes the shape of a straight line or some stylized growth curve.
? 188 Capitalization
definite productive quantum, both explanations collapse. The only solution is to do what mainstream and heterodox theories refuse to do: abandon the productive-material logic and look into the power underpinnings of earnings. The remaining chapters of this book are devoted largely to this task.
However, before turning to a detailed power analysis of earnings, it is important to identify the other elementary particles of capitalization. The significance of these other particles is evident from the second fact in Figure 11. 1 - namely, that the match between earnings and capitalization, although fairly tight in the longer run, rarely holds in the medium and short term.
Sometimes the correlation is rather high. During the 1870s, 1900s and 1930s, for example, the annual variations in stock prices were very much in tandem with the ups and downs of earnings. But at other times - for instance, during the 1910s, 1940s and 1990s - the association was much looser and occasionally negative. Furthermore, even when prices and earnings move in the same direction, the magnitude of their variations is often very different.
These differences in scale are illustrated by the fluctuations of the price- earning ratio (or PE ratio for short), obtained by dividing share prices by their corresponding earnings per share. For the S&P 500 index, the PE ratio has fluctuated around a mean value of 16, with a low of 5 in 1917 and a high of 131 in 1932. These fluctuations mean that, if we were to predict capital- ization by multiplying current earnings by the historical PE average, our estimates could overshoot by as much as 220 per cent (in 1917) and under- shoot by as much as 88 per cent (in 1932). 5 Moreover, the deviations tend to be rather persistent, with price running ahead of earnings for a decade or more, and then reversing direction to trail earnings for another extended period. Finally, it should be added that the medium- and short-term mis- match between earnings and capitalization, evident as it is for the S&P 500, is greatly amplified at lower levels of aggregation. Individual firms - and even sectors of firms - often see their capitalization deviate markedly from their earnings for prolonged periods. Obviously, then, there is much more to capitalization than earnings alone.
Hype
Decomposition
The first qualification requires a decomposition of earnings. By definition, ex ante expected future earnings are equal to the ex post product of actual future earnings and what we shall call the 'hype' coefficient. 6 Using these concepts, we can modify Equation (1), such that:
5 When the PE is 5, the capitalization implied by a PE of 16 is 16/5 times its actual level (or 220 per cent larger). When the PE is 131, the implied capitalization is 16/131 times the actual level (or 88 per cent smaller).
6 For early, if somewhat nai? ve, attempts to understand hype, see Nitzan (1995b; 1996a).
? 3. Kt = EE = E * H rr
In this expression, EE is the expected future earnings (in perpetuity), E is the actual level of future earnings (in perpetuity), and H is the hype coefficient equal to the ratio of expected future earnings to actual future earnings (H = EE/E). Similarly for share prices:
4. Pt = EEPS = EPS * H rr
with EEPS denoting expected future earnings per share (in perpetuity), EPS signifying actual future earnings per share (in perpetuity), and H standing for the hype coefficient equal to the ratio of expected to actual future earnings per share (so that H = EEPS/EPS).
According to this decomposition, the capitalization of an asset (or of a share in that asset) depends on two earnings-related factors. The first factor is the actual, ex post future earnings. These earnings are unknown when the assets are capitalized, but they will become known as time passes and the income gets recorded and announced. The second factor - the hype coeffi- cient - represents the ex post collective error of capitalists when pricing the asset. This error, too, is unknown when the assets are priced, and is revealed only once the earnings are reported.
The hype coefficient, expressed as a pure number, measures the extent to which capitalists are overly optimistic or overly pessimistic about future earn- ings. When they are excessively optimistic, the hype factor is greater than 1. When they are exceedingly pessimistic, hype is less than 1. And in the unlikely case that their collective projection turns out to be exactly correct, hype is equal to 1.
So just to be on the safe side, neoclassicists now agree that, although capi- talization does reflect the objective processes of the 'real economy', the picture must be augmented by human beings. And the latter, sadly but truly, are not always rational. Greed and fear cloud their vision, emotions upset their calculations and passion biases their decisions - distortions that are further amplified by government intervention and regulation, lack of trans- parency, insider trading and other such unfortunate imperfections. All of these deviations from the pure model lead to irrationality and end in mis- priced assets.
But not all is lost. Convention has it that there is nonetheless order in the chaos, a certain rationality in the irrationality. The basic reason is that greed tends to operate mostly on the upswing, whereas fear usually sets in in the downswing. 'We tend to label such behavioural responses as non rational', explains Alan Greenspan (2008), 'But forecasters' concerns should be not whether human response is rational or irrational, only that it is observable and systematic'. The regularity puts limits on the irrationality; limits imply predict- ability; and predictability helps keep the faith intact and the laity in place.
The boundaries of irrationality are well known and can be recited even by novice traders. The description usually goes as follows. In the upswing, the growth of investment in productive assets fires up the greedy imagination of investors, causing them to price financial assets even higher. To illustrate, during the 1990s developments in 'high-tech' hardware and software suppos- edly made investors lose sight of the possible. The evidence: they capitalized information and telecommunication companies, such as Amazon, Ericsson and Nortel, far above the underlying increase in their 'real' value. A similar scenario unfolded in the 2000s. Investors pushed real-estate capitalization, along with its various financial derivatives and structured investment vehi- cles, to levels that far exceeded the underlying 'actual' wealth. The process, which neoclassicists like to think of as a 'market aberration', led to undue 'asset-price inflation'. Naturally, the capitalization created by such 'bouts of insanity' is mostly 'fake wealth'. It represents 'fictitious value' and leads to inevitable 'bubbles'. 6 But there is nonetheless a clear positive relationship here: the irrational growth of 'fake wealth', although excessive, moves in the same direction as the rational growth of 'real wealth'.
? 6 For a typical analysis of 'bubbles', complete with the above jargon, see Janszen (2008).
180 Capitalization
The process is said to invert during a bust. This is where fear kicks in. The 'real' economy decelerates, but investors, feeling as if the sky is falling, bid down asset prices far more than implied by the 'underlying' productive capacity. A famous illustration is offered by the Great Depression. During the four years from 1928 to 1932, the dollar value of corporate fixed assets contracted by 20 per cent, while the market value of equities collapsed by an amplified 70 per cent (we have no aggregate figures for bonds). A similar 'undershooting' occurred during the 1997 Asian financial crisis, with market value contracting by 50 per cent in many cases, against a growth slowdown or a very moderate decline in the dollar value of the 'real' capital stock. Yet here, too, the relationship is clear: the irrational collapse of 'fictitious value', however exaggerated, moves together with the rational deceleration of 'productive wealth'.
This bounded irrationality is illustrated by the thin line in Figure 10. 3. Note that this series is a hypothetical construct. It describes what the growth of capitalization might look like when neoclassical orthodoxy is augmented by 'irrationality' and 'market aberrations'. The value for each year in the hypothetical series is computed in two steps. First, we calculate the deviation of the growth rate of the (smoothed) 'real' series from its historical mean (so if the smoothed growth rate during the year is 8 per cent and the historical mean rate is 6. 7 per cent, the deviation is 1. 3 per cent). Second, we add 2. 5 times the value of the deviation to the historical mean (so in our example, the hypothetical smoothed growth rate would be 2. 5 * 1. 3 + 6. 7 = 9. 95 per cent). The coefficient of 2. 5 is purely arbitrary. A larger or smaller coefficient would generate a larger or smaller amplification, but the cyclical pattern would remain the same.
This simulation solves the riddle of the fluctuating Tobin's Q. It shows how, due to market imperfections and investors' irrationality, the growth of capitalization overshoots 'real' accumulation on the upswing, therefore causing Tobin's Q to rise, and undershoots it on the downswing, causing Tobin's Q to decline.
And so everything falls into place. Tobin's Q averages more than 1 due to an invisible, yet very real intangible revolution. And it fluctuates heavily - admittedly because the market is imperfect and humans are not always rational - but these oscillations are safely bounded and pretty predicable. Capitalization indeed deviates from the 'real' assets, though in the end it always reverts back to the 'fundamentals'.
Or does it?
The gods must be crazy
It turns out that while the neoclassical priests were busy fortifying the faith, the gods were having fun with the facts. The result is illustrated in Figure 10. 4 (where both series again are smoothed as 10-year moving averages). The thick line, as in Figure 10. 3, shows the rate of change of corporate fixed assets
Fiction, mirror or distortion? 181
measured in current replacement cost. But the thin line is different. Whereas in Figure 10. 3 this line shows the rate of growth of capitalization stipulated by the theory, here it shows the actual rate of growth as it unfolded on the stock and bond markets. And the difference couldn't have been starker.
The gyrations of capitalization, instead of amplifying those of 'real' assets, move in exactly the opposite direction. It is important to note that we are dealing here not with short-term fluctuations of the business cycle, but with very long-term waves of roughly 30-year duration. Furthermore, the pattern seems anything but accidental. In fact, it is rather systematic: whenever the growth rate of 'real' assets decelerates, the growth rate of capitalization accel- erates, and vice versa. 7
This reality puts the world on its head. One could perhaps concede that 'real' assets do not have a material quantum - yet pretend, as we have agreed
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15
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5
0
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1930 1940
1950 1960
1970 1980
1990 2000 2010 2020
? ? ? ? per cent
? ? Market Value of Corporate Equities & Bonds (annual % change)
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Current Cost of Corporate Fixed Assets (annual % change)
www. bnarchives. net
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? Figure 10. 4 US capital accumulation: which is the 'real', which the 'fictitious'?
Note: The market value of corporate equities and bonds is net of foreign holdings by US resi-
dents. Series are smoothed as 10-year moving averages. Source: See Figure 10. 2.
7 Given our rejection of 'material' measures of capital, there is no theoretical value in comparing the growth of the two series when measured in so-called 'real' terms. But just to defuse the scepticism, we deflated the two series by the implicit price deflator of gross investment and calculated their respective 'real' rates of change. The result is similar to Figure 10. 4: the two growth rates move in opposite directions.
? 182 Capitalization
to do here, that somehow this nonexistent quantum is proportionate to its dollar price. One could further accept that the dollar value of 'real' assets is misleading insofar as it excludes the invisible 'dark matter' of intangible assets (up to 80 per cent of the total) - yet nonetheless be convinced that these invisible-intangible assets follow the same pattern as the visible-tangible ones. Finally, one could allow economic agents to be irrational - yet assume that their irrational pricing of assets ends up oscillating around the rational 'fundamentals' (whatever they may be). But it seems a bit too much to follow Fisher and claim that the long-term growth rate of capitalization is driven by the accumulation of 'real' assets when the two processes in fact move in opposite directions.
And, yet, that is precisely what neoclassicists (and Marxists as well) seem to argue. Both emphasize the growth of real assets as the fountain of riches - while the facts say the very opposite. According to Figure 10. 4, during the 1940s and 1970s, when the dollar value of 'real assets' expanded the fastest, capitalists saw their capitalization growth dwindle. And when the value of 'real assets' decelerated - as it had during the 1950s and early 1960s, and, again, during the 1980s and 1990s - the capitalists were laughing all the way to the stock and bond markets.
Given this dismal record, why do capitalists continue to employ econo- mists and subsidize their university departments? Shouldn't they fire them all and close the tap of academic money? Not at all, and for the simplest of reasons: misleading explanations help divert attention from what really matters. The economists would have us believe that the 'real thing' is the tangible quantities of production, consumption, knowledge and the capital stock, and that the nominal world merely reflects this 'reality' with unfortu- nate distortions. This view may appeal to workers, but it has nothing to do with the reality of accumulation. For the capitalist, the real thing is the nominal capitalization of future earnings. This capitalization is not 'connected' to reality; it is the reality. And what matters in that reality is not production and consumption, but power. This nominal reality of power is the capitalist nomos, and that should be our starting point.
11 Capitalization
Elementary particles
But the past always seems, perhaps wrongly, to be predestined.
--Michel Houellebecq, The Elementary Particles
Capitalization uses a discount rate to reduce a stream of future earnings to their present value. But this statement is still very opaque and lacking in detail. Which earnings are being discounted? Do capitalists 'know' what these earnings are - and if so, how? What discount rate do they use? How is this rate established? Moreover, accumulation is a dynamic process of change, involving the growth of capitalization and therefore variations in earnings and the discount rate. What, then, determines the direction and magnitude of these variations? Are they interrelated - and if so, how and why? Are the patterns of these relationships stable, or do they change with time?
Academic experts and financial practitioners have saved no effort in trying to answer these questions. But the general thrust of their inquiry has been uncritical and ahistorical. Explicitly or implicitly, they all look for the philos- opher's stone. They seek to discover the 'natural laws of finance', the universal principles that, according to Frank Fetter, have governed capital- ization since the beginning of time.
The path to this knowledge of riches is summarized by the motto of the Cowles Commission: 'Science is Measurement'.
The Commission was founded in 1932 by Alfred Cowles III and Irving Fisher, two disgruntled investors who had just lost a fortune in the 1929 market crash. Their explicit goal was to put the study of finance and economics on a quantitative footing. And, on the face of it, they certainly succeeded. The establishment of quanti- tative journals, beginning with Econometrica in 1933 under the auspices of the Cowles Commission, and continuing with The Journal of Finance (1946), Journal of Finance and Quantitative Analysis (1966) and the Journal of Financial Economics (1974), among others, helped transform the nature of financial research. And this transformation, together with the parallel quan- tification of business school curricula since the 1960s, turned the analysis of finance into a mechanized extension of neoclassical economics. 1
? 1 For aspects of this transformation, see Whitley (1986) and Bernstein (1992).
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Yet, if we are to judge this effort against the Cowles Commission's equa- tion of science with measurement, much of it has been for naught. While finance theory grew increasingly quantitative, its empirical verification became ever more elusive. And that should not surprise us. Finance in its entirety is a human construction, and a relatively recent one at that. Its princi- ples and regularities - insofar as it has any - are created not by god or nature, but by the capitalists themselves. And since what humans make, humans can - and do - change, any attempt to pin down the 'universal' regularities of their interactions becomes a Sisyphean task. Despite many millions of regres- sions and other mechanical rituals of the quantitative faith, the leading priests of finance remain deeply divided over what 'truly' determines capitalization. When it comes to 'true value', virtually every major theology of discounting has been proven empirically valid by its supporters and empirically invalid by its opponents (that is, until the next batch of data demonstrates otherwise).
But these failings are secondary. The 'science of finance' is first and fore- most a collective ethos. Its real achievement is not objective discovery but ethical articulation. Taken together, the models of finance constitute the architecture of the capitalist nomos. In a shifting world of nominal mirrors and pecuniary fiction, this nomos provides capitalists with a clear, moral anchor. It fixes the underlying terrain, it shows them the proper path to follow, and it compels them to stay on track. Without this anchor, all capital- ists - whether they are small, anonymous day traders, legendary investors such as Warren Buffet, or professional fund managers like Bill Gross - would be utterly lost.
Finance theory establishes the elementary particles of capitalization and the boundaries of accumulation. It gives capitalists the basic building blocks of investment; it tells them how to quantify these entities as numerical 'vari- ables'; and it provides them with a universal algorithm that reduces these variables into the single magnitude of present value. Although individual capitalists differ in how they interpret and apply these principles, few if any can transcend their logic. And since they all end up obeying the same general rules, the rules themselves seem 'objective' and therefore amenable to 'scien- tific discovery'.
This chapter completes our discussion of the financial ethos by identifying the elementary particles of capitalization and outlining the relationship between them. The storyline follows two parallel paths. One path examines the conventional argument as it is being built from the bottom up. The starting point here is the neoclassical actor: the representative investor/ consumer. This actor is thrown into a financial pool crowded with numerous similar actors, all seeking to maximize their net worth earmarked for hedonic consumption. For these actors, the financial reality is exogenously given. As individuals, there is little they can do to change it. And since the reality follows its own independent trajectory, the sole question for the actor is how to respond: 'what should I do to make the best of a given situation? ' As a result, although the market looks full of action, in fact every single bit of it is
Elementary particles 185
passive reaction. And since everyone is merely responding, the only thing left for the theorist to do is aggregate all the reactions into a single equilibrium: the price of the asset.
The other path in our presentation looks at capitalization from the top- down perspective of organized capitalist power. Here the question is not only how investors behave, but also how the ethos that conditions them has emerged and developed. Furthermore, although capitalists undoubtedly react to existing conditions, they also seek to change these conditions; and it is this active restructuring - particularly by the leading corporate and government organs - that needs to be put at the centre of accumulation analysis. The second purpose of our presentation, then, is to allude to these transformative aspects of the capitalist nomos. This emphasis provides the framework for the next part of the book, where we begin our analysis of capital as power.
Earnings
When capitalists buy an asset, they acquire a claim over earnings. This claim is the anchor of capital. 'The value of a common stock', write Graham and Dodd in the first edition of their sacred manual, 'depends entirely upon what it will earn in the future' (1934: 307). 'What is an issue in the purchase deci- sion', the book reiterates half a century and four editions later, 'is the future earnings that the investor will obtain by buying the stock. It is the ability of the existing assets and liabilities to create future earnings that determine the value of the equity position' (Graham et al. 1988: 553).
In Chapter 9, we provided a simple expression of this ethos, with capital- ization at any given time (Kt) being equal to the discounted value of a perpetual stream of earnings (E):
1. Kt=Er
Financial analysts, who customarily focus on individual stocks, similarly express the price of a share at a given time (Pt) as the present value of a perpetual stream of earnings per share (EPS):2
2. Pt = EPS r
These equations, although simplistic, point to a basic pillar of finance. Whether we look at overall capitalization or the price per 'share' of capital- ization, earnings have a crucial impact on the magnitude of capital and its
2 Equation 2 is derived by dividing both sides of Equation (1) by the number of shares (N), such that Pt = Kt / N and EPS = E / N.
? ? ? 186 Capitalization
pace of accumulation. All else being equal, the higher the earnings, the larger the capitalization; and the faster the growth of earnings, the more rapid the rate of accumulation.
This basic relationship is illustrated in Figure 11. 1. The chart plots annual data for the S&P 500 group of US-listed companies, showing, for each year, the average share price for the group along with its average earnings per share. Both time series are normalized with 1871 = 100 and are plotted against a logarithmic scale to calibrate the pattern of exponential growth.
The data establish two clear facts. The first fact is that, over the long term, capitalization is positively and fairly tightly related to earnings. During the 1871-2006 period, the correlation coefficient between the two series measured 0. 94 out of a maximum value of 1.
The alert reader may contest this correlation as deceptive, on the ground that capitalists discount not the current profits depicted in the chart, but the
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10,000
1,000
100
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? ? ? ? Price
? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1871=100
? ? ? ? ? ? ? Earnings per Share
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? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? ? 1840 1860 1880 1900
1920 1940
1960 1980 2000 2020
Figure 11. 1 S&P 500: price and earnings per share
Note: The S&P 500 index splices the following three series: the Cowles/Standard and Poor's Composite (1871-1925); the 90-stock Composite (1926-1957); and the S&P 500 (1957-present). Earnings per share are computed as the ratio of price to price/earnings.
Source: Global Financial Data (series codes: _SPXD for price; SPPECOMW for price/earnings); Standard and Poor's through Global Insight (series codes: JS&PC500 for price; PEC500 for price/earnings).
Elementary particles 187
profits they expect to earn in the future. And that certainly is true, but with a twist. Because they are obsessed with the future, capitalists are commonly described as 'forward looking'. They (or their strategists) constantly conjure up future events, developments and scenarios, all with an eye to predicting the future flow of profit. An Aymara Indian, though, would describe this process in reverse. Since our eyes can see only what lies ahead and are blind to what lies behind, it makes more sense to say that capitalists have the future behind them: like the rest of us, they can never really see it. 3
Now, imagine the uneasy feeling of a capitalist having to walk backwards into the future - not seeing what she is back-stepping into, having no idea when and where she may trip and not knowing how far she can fall. Obviously, she would feel much safer if her waist were tied to a trustworthy anchor - and preferably one that she can see clearly in front of her. And that is precisely what capitalists do: they use current earnings (which they know) as a benchmark to extrapolate future ones (which they do not know) - and then quickly discount their guess back to its 'present' value.
Their discounting ritual is usually some variant of Equation (2). Recall from Chapter 9 that this equation is derived on the assumption that earnings continue in perpetuity at a given level. Of course, with the exception of fixed- income instruments, this assumption is never true: most assets see their earn- ings vary over time. But whatever its temporal pattern, the flow of earnings can always be expressed as a perpetuity of some fixed average. 4 And it turns out that making that average equal to current profit (or some multiple of it) generates an empirical match that is more than sufficient for our purpose here. The tight correlation in Figure 11. 1 thus confirms a basic tenet of the modern capitalist nomos. It shows that the level and growth of earnings - at least for larger clusters of capital over an extended period of time - are the main benchmark of capitalization and the principal driver of accumulation.
The theoretical implication is straightforward: in order to theorize accu- mulation we need to theorize earnings. And yet here we run into a brick wall. As we have seen, both neoclassical and Marxist writers anchor earnings in the so-called 'real' economy; but since production and consumption cannot be measured in universal units, and given that the 'capital stock' does not have a
3 Most languages treat the ego as facing - and in that sense looking toward - the future. When capitalists speak of 'forward-looking profits' they refer to future earnings. Similarly, when they announce that 'the crisis is behind us' they talk of something that has already happened. The Aymara language, spoken by Indians in Southern Peru and Northern Chile, is a notable exception. Its words and accompanying gestures treat the known past as being 'in front of us' and the unknown future as lying 'behind us'. To test this inverted perception just look up to the stars: ahead of you there is nothing but the past (Nu? n? ez and Sweetser 2006; Pincock 2006).
4 The visual manifestation of this smoothing is rather striking. When analysts chart the past together with their predictions for the future, the historical pattern usually looks ragged and scarred, while the future forecast, like a metrosexual's smoothly-shaved cheek, usually takes the shape of a straight line or some stylized growth curve.
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definite productive quantum, both explanations collapse. The only solution is to do what mainstream and heterodox theories refuse to do: abandon the productive-material logic and look into the power underpinnings of earnings. The remaining chapters of this book are devoted largely to this task.
However, before turning to a detailed power analysis of earnings, it is important to identify the other elementary particles of capitalization. The significance of these other particles is evident from the second fact in Figure 11. 1 - namely, that the match between earnings and capitalization, although fairly tight in the longer run, rarely holds in the medium and short term.
Sometimes the correlation is rather high. During the 1870s, 1900s and 1930s, for example, the annual variations in stock prices were very much in tandem with the ups and downs of earnings. But at other times - for instance, during the 1910s, 1940s and 1990s - the association was much looser and occasionally negative. Furthermore, even when prices and earnings move in the same direction, the magnitude of their variations is often very different.
These differences in scale are illustrated by the fluctuations of the price- earning ratio (or PE ratio for short), obtained by dividing share prices by their corresponding earnings per share. For the S&P 500 index, the PE ratio has fluctuated around a mean value of 16, with a low of 5 in 1917 and a high of 131 in 1932. These fluctuations mean that, if we were to predict capital- ization by multiplying current earnings by the historical PE average, our estimates could overshoot by as much as 220 per cent (in 1917) and under- shoot by as much as 88 per cent (in 1932). 5 Moreover, the deviations tend to be rather persistent, with price running ahead of earnings for a decade or more, and then reversing direction to trail earnings for another extended period. Finally, it should be added that the medium- and short-term mis- match between earnings and capitalization, evident as it is for the S&P 500, is greatly amplified at lower levels of aggregation. Individual firms - and even sectors of firms - often see their capitalization deviate markedly from their earnings for prolonged periods. Obviously, then, there is much more to capitalization than earnings alone.
Hype
Decomposition
The first qualification requires a decomposition of earnings. By definition, ex ante expected future earnings are equal to the ex post product of actual future earnings and what we shall call the 'hype' coefficient. 6 Using these concepts, we can modify Equation (1), such that:
5 When the PE is 5, the capitalization implied by a PE of 16 is 16/5 times its actual level (or 220 per cent larger). When the PE is 131, the implied capitalization is 16/131 times the actual level (or 88 per cent smaller).
6 For early, if somewhat nai? ve, attempts to understand hype, see Nitzan (1995b; 1996a).
? 3. Kt = EE = E * H rr
In this expression, EE is the expected future earnings (in perpetuity), E is the actual level of future earnings (in perpetuity), and H is the hype coefficient equal to the ratio of expected future earnings to actual future earnings (H = EE/E). Similarly for share prices:
4. Pt = EEPS = EPS * H rr
with EEPS denoting expected future earnings per share (in perpetuity), EPS signifying actual future earnings per share (in perpetuity), and H standing for the hype coefficient equal to the ratio of expected to actual future earnings per share (so that H = EEPS/EPS).
According to this decomposition, the capitalization of an asset (or of a share in that asset) depends on two earnings-related factors. The first factor is the actual, ex post future earnings. These earnings are unknown when the assets are capitalized, but they will become known as time passes and the income gets recorded and announced. The second factor - the hype coeffi- cient - represents the ex post collective error of capitalists when pricing the asset. This error, too, is unknown when the assets are priced, and is revealed only once the earnings are reported.
The hype coefficient, expressed as a pure number, measures the extent to which capitalists are overly optimistic or overly pessimistic about future earn- ings. When they are excessively optimistic, the hype factor is greater than 1. When they are exceedingly pessimistic, hype is less than 1. And in the unlikely case that their collective projection turns out to be exactly correct, hype is equal to 1.
