Doug Henwood's Wall Street - Book Report/Review Example

This research paper reviews Doug Henwood book "Wall Street" and compare his opinion the then years after the book was published. The paper will briefly present Henwood's explanation of the players, instruments and market models of the U.S. stock market. His opinion on the efficiency of the U.S. stock market will also be presented. Relevant theories from different economists will be presented and compared with Henwood's point of view in respective issues. Final section of the paper will review Henwood's idea of what to be done to fix the U.S. financial system. 1. Introduction: Today U.S. media is full of stories of permanent prosperity and stock market new records. Doug Henwood challenges these success stories in his book "Wall Street." He argues that the U.S. financial market does not provide either stable productivity gains or economic justice between rich and poor. 1.1 Stock market as a source of investment: The stock market is supposed to bring together cash-rich savers and cash-short investors. It allocates capital to its most needed outlets and thus advances everyone's prosperity. But the real stock market is not the major source of investment capital. Initial public offerings are often used to pay off loans from founding owners. Corporations also fund 95 percent of the cost of expansions internally from retained earnings. 1.2 The rich control the market to get richer quickly Wealth is not evenly distributed among the rich and poor. The rich who own most of corporate stocks control American firms. The wealthiest Americans hold the largest percentage of stock assets. In 1992, 1 percent of U.S. families owned 39 percent of corporate stocks. Even pension funds, 60 percent of U.S. workers have no pensions at all, and the richest 10 percent of U.S. workers control 62 percent of pension assets. U.S. firms must provide their stockholders most of their profit to retain their loyalty. Corporate management is a marketable commodity. Managements that don't deliver steadily increasing quarterly profits are subject to takeovers and reorganization. Stock market investors encourages short term over long term profit. Some companies make quick profits by firings and lay-offs of their employees. In the 1990s, profit growth was achieved by stagnation of wages while maintaining higher upper-management salaries with no intervention from unions or tax policy to better disperse the wealth (Buell 1997). 1.3 Mergers and Acquisitions vs. productive investment Henwood writes "Big corporations have more money than they know what to do with." Most of mergers and acquisitions did not foster long-term economic efficiency or even steady increase in profits. They spent $1.9 trillion buying each other out, about a third of what they spent on productive investment. Downsizing became the order of the day. Cuts in research and development that couldn't be justified in immediate terms were also mandated. 2. Stock Market Instruments: Modern financial markets are composed of several basic instruments which are quite old such as stocks, bonds, currencies, commodities, options, futures and others. In the following sections these instruments are reviewed. 2.1 Stocks The New York Stock Exchange (NYSE) is considered the "hub" of capitalism. The stock market is supposed to raise capital for real investment. Corporations sell large blocks of stock when they increase in size. Raised capital is small when compared with corporate buyouts and buybacks corporate. Ownership of stock represents ownership of productive assets in public corporations and claims to profit generated by those assets. Managers of public corporations decide how much profit to give to stock owners. They are hired agents who must please their stock owners by raising the stock price and increasing its return. In English-speaking countries, stock markets regulate how corporations are owned and run. This market style is sometimes called Anglo-Saxon. In Germanic countries, banks control interests and firms are not bought or sold on the open market. In Japan, banks and business partners such as suppliers and customers control interests and buying or selling of Japanese firms only emerges from this group (Henwood 1997). 2.2 Bonds and other credits The financial heart of capitalism is in the credit markets, covering simple bank loans to complex bond products. Unlike stock, most bonds give no claim of ownership on a firm's capital assets. On the other hand, corporations can skip dividend payments to shareholders, suffering only a blow to the stock price, but can not miss a bond interest payment which would result in bankruptcy. In a panic, money floods out of stocks and private bonds and into government securities, especially short-term ones. Interest rates on public debts act as a benchmark for the rest of the credit system (Henwood 1997:22). Liquid market in government debt with a central bank at its core is the base of modern financial systems. Central banks manage their domestic money supply through the purchase and sale of official paper. In 1952, federal debt exploded to reach 61% of GDP. That figure decreased over the next twenty years but started to rise again in 1980 to reach 47% in 1997. With the growth in Treasury debt trading in bonds and other Wall Street options increased. Government debt promotes the development of a central national capital market. Central banks also deal in their own papers. Public debt is a powerful way of assuring that the state remains safely in capital's hands. The explosion of federal debt increased the power of creditors to demand monetary policies to dampen the U.S. economy as it recovered in 1980s (Henwood 1997:24). 2.3 Trading Treasuries The market in U.S. government bonds is the biggest financial market in the world. Thirty eight major investment and commercial banks are the primary dealers of the U.S. government bond market with daily trading volume averaged $400-550 billion. Maturity of Treasury bills falls into three categories: from three months to one year, one year to ten, and bonds over ten years. Most trading occurs in the two- to seven-year range. The longer a maturity, the more possibility there is for something to go wrong such as inflation and financial panic so investors require higher return for bonds with long maturity periods. The Bank for International Settlements estimated that the average holding period for U.S., Germany, Britain and Japan treasury bonds and notes is one month (Henwood 1997:35). The Discount Rate is the interest rate charged by the Federal Reserve when banks borrow "overnight" from the Fed. The discount rate is under the direct control of the Fed. Only large banks borrow directly from the Fed, and thus get the benefit of the lower discount rate. The Federal Funds Rate is the interest rate charged by banks when banks borrow "overnight" from each other. The funds rate fluctuates according to supply and demand and it follows change in discount rate. The central bank controls short-term interest rates. In the U.S. federal funds rate is the short-term interest rate, which is what banks charge each other for overnight loans of reserves. When the Fed wants to repress the economy and raise interest rates, they sell part of their inventory of Treasury securities. Banks borrow from each other to cover their reserve level at the Fed. Intra-bank lending funds drive the funds rate up. To stimulate the economy, the Fed buys securities using money created out of thin air; this increases the supply of reserves, which lower funds rate. 2.4 Corporate Bonds The market for corporate bonds is starting to approach the U.S. Treasury market in size, but does not trade anywhere near as frequently. Much of the increased size was accounted for by the growth in asset-backed securities (ABS). Only the well known corporations are granted access to bond markets. Commercial paper (CP) is the short-term corporate unsecured debt of large firms, which is secured only on their promise and reputation. The development of the CP market has been a blow to banks and replaced the long-term associations between firms and their banks. 2.5 Derivatives Derivatives refer to a class of securities whose prices are derived from the prices of other securities like futures and options. A future is an agreement made by its seller to deliver a specific commodity and by the buyer to take that delivery on a specific date. Options contracts give buyers the right to buy or sell a particular asset before its expiration date. Holders of a future must take delivery of underlying commodity while holder of an option need not. The price of an option is affected by market interest rates, the time to maturity and historical price volatility. Higher interest rates, a longer time to maturity, and greater volatility tend to raise prices. 3. Players The 1933 Glass-Steagall Act forbids Commercial banks (CB) to play in the stock market. They were to use their depositors' money mainly to make business loans. As of 1995, the New York Stock Exchange has over 500 member firms, 10,450 banks and over 12,500 credit unions; in 1990, corporate America had 51,440,000 individual and hundreds of thousands of institutional shareholders (Henwood 1997:56). The best way to relate the financial players together is to examine the flow of money through the Federal Reserve's flow of funds (FoF) accounts. FoF divides the economy into five basic sectors: households, financial institutions, non-financial businesses, governments and the rest of world. Each of these entities saves, borrows, and accumulates physical capital with its own funds. All these flows must balance in the end. Flow of funds can be split into several categories: insurance and pension fund reserves; inter-bank dealings; bank deposits, stocks and mutual funds; credit market instruments such as bonds, mortgages, and consumer credit and loans (Henwood 1997:57). There are two ways of looking at FoF data, flows and stocks. Flows represent a sector's contributions and withdrawals from the capital markets during a quarter of a year. The size of one's bank account at the end of a year is the stock value; the year's deposits and withdrawals are flows. If the stock at the end of this year is larger than a year earlier, then the year's net flows were positive (Henwood 1997). 3.1 Who owes what to whom Financial market activity still involves borrowing and lending. As shown in Figure 1, most sectors have been busily borrowing from the credit markets. During 1952-1992, the main economic sectors where borrowing from financial institutions to drive the total debt/GDP ratio. The U.S. government was paying down its World War debt. Households were exploring consumer and mortgage credit; non-financial firms were gradually growing their businesses (Henwood 1997:59). Figure 1: 1952-1992 debt by sector relative to GDP1 For every borrower, there must be a lender. The manufacture of debt is the financial sector's main roles in life. Financial institutions are intermediaries, where the ultimate creditors and debtors are households. The distribution of household assets discussed below provides the true picture of who owes. In order to consume more than it produces, and invest more than it saves, the U.S. has turned to countries like Japan to satisfy its borrowers since the U.S. economy hasn't generate enough financial surpluses. Foreign claims on American borrowers exploded, from 1.4% of GDP in 1952 to 26.8% in 1997. Figure 2 shows the credit market debt where the U.S. moved from a net creditor position of 2.8% of GDP in 1952 to a net debtor figure of 20.2% in 1992. Figure 2: U.S. net credit market debt with rest of world in percent of GDP2 3.2 Households Households get most of their income from wages, salaries, investment income (interest and dividends) and transfer payments (like pensions, alimony, and welfare). This income pays for the necessities of life then the rest is saved. Most of household savings and investments are physical investment in housing and durable goods like cars and appliances. In 1997, households took on $404 billion in new debt at the same time they added $491 billion to their savings. House hold can be thought of as net providers of funds to the financial system since they put in more than what they took out. Home mortgages outstanding rose steadily from 14% in 1945 to 43% in 1997. This rise helped bring about the steady inflation in housing prices. Mortgage creditors were taking an ever-increasing share of personal income. The invention of home equity loan helped the rising trend of mortgage debt. Home equity load allowed people to borrow against the value of their house to finance college tuition, vacation expenses, and others. The increase in mortgage debt is not related to new capital formation but it suggests inflation and strains on personal housing budgets. According to (Henwood 1997:64), 30% of families with incomes under $10,000 had no financial assets at all and one in 10 American families had nothing in the bank (figure 3). The median assets of all families having assets were $13,100 compared to a median of $17,600 in debts, for the three-quarters of all households carrying debts. The decline in real hourly wages and the stagnation in household incomes, the middle and lower classes have borrowed from the very rich who have gotten richer. Figure 3: Household debts percent of income 1950-1997. Ownership of the real claims financial assets such as stocks and bonds is mainly packed in the richest one percent of households. Two million adults owned 42% of the stock owned by individuals, and 56% of the bonds, which is the productive capital and future profits of the U.S. (Kennickell and Woodburn 1997). 3.3 Non-financial Business Income to businesses is devoted to expenses and investments. If they need extra, they can borrow or sell stock to outside investors. Sharp managers will easily find investors while poor managers find it difficult. During 1952-1997, ninety two percent of total investment of business was paid by firm's own cash. During the 1990s, large corporations had several billion dollars in cash with no idea what to do with the money. During 1901-1996, net flow of new stock accounted to just four percent of non-financial corporations' exchange of funds. In the early years of the century, new stock offerings were equal to 11% of real investment. Recently, more stock has been retired than issued due to takeovers and buybacks. Net new stock offerings were -11% between 1980 and 1997, making the stock market, surreally, a negative source of funds (Henwood 1997:72). During 1946-1979, stocks financed five percent of real investment because firms were going public for the first time, not because existing ones were raising funds through fresh stock offerings (Flow of funds accounts). 3.4 Financial institutions The financial system exists to help households save and invest in most profitable ways. In 1991, finance, insurance, and real estate (FIRE) profits peaked at 47% of GDP. Real estate is included because residential investment account is a major section of total investment. According to the Bureau of Economic Analysis, in 1996, average earnings for FIRE workers were 39% above the national average. Security brokers are the highest paid within the financial system. On the other hand, real estate employees are the least paid of the FIRE community. "Real estate is based on milking wealth from land and tenants with the help of government tax breaks and infrastructure development." (Henwood 1997:80). 3.4.1 Banks, commercial and investment Old-style banking has taken a smaller role in the stock market. During 1950-1970, banks share of credit market debt has fallen from 28% to 19%. On the other hand pension funds doubled their share in the last forty years. Big banks don't have strong ties with big corporations anymore since they can borrow directly from the commercial paper market. Wall Street deals directly with both financial institutions and the general public of all wealth levels. At the peak of the Wall Street hierarchy lies institutions such as Morgan Stanley and Goldman Sachs who trade securities for themselves and their customer accounts who are very rich or huge institutions. Other firms, like Merrill Lynch, deal with the general public. 3.5 The Government The government is a major player in the financial market. It is a debtor with the issuance of public bonds and also spender and regulator without any use of federal regulations. Securities and Exchange Commission (SEC) governs the issuance and trading of securities. Public firms wishing to trade stocks or bonds must register with the SEC disclosing most of its information concerning securities in addition to annual and quarterly reports. SEC also keeps an eye on stock and over-the-counter trading. 3.5.1 The Federal Reserve (Fed) Fed is the most important government agency in the financial system. President Jefferson objected to the creation of an American central bank to avoid concentration of financial power. Fed consists of twelve district banks scattered around the U.S. 3.6 Styles of play Henwood classify people who trade in the NYSE as either traders or investors depending on how long they intend to keep their stocks. They usually use fundamental or technical analysis or a combination of both to analyze the value of stocks. Henwood points out that the secrets of success in the stock market involve market manipulation and use of inside information, and clever use of the press. This point of view even does not cover all the reasons in success in the stock market. Careful evaluation and prediction of performance of different sectors and businesses is the main reason why some investors outperform others. A number of monitoring systems watch out for suspicious activities within the market to avoid manipulation and illegal activities. 3.7 Multi-National Corporations (MNCs) In the 1990s, the decline in U.S. interest rates caused investors to direct their money towards Third World Countries. During 1990-1993, global investment in Third World Countries rose from 15% to 40%. Direct investments in Third World Countries were concentrated in South America, South East Asia and Eastern Europe. These investment flows were driven by the production strategy of multinational corporations (MNCs). The UNCTC (1991) calls the U.S., Western Europe, and Japan the Triad since they were three great sources of direct investment. UNCTC (1991) noted that each member of the Triad gathered a handful of poor countries to act as sweatshop, plantation, and mine: the U.S. has Latin America; the European Union has Eastern and Southern Europe and Africa; and Japan, Southeast Asia. Stephen Hymer (1979) mentioned that the growth of MNCs helped develop the global system. Shareholders and creditors showed interest in the global function of the system. 5. Market Models Henwood (1997:152) undermined confidence in the enterprise of conventional mathematical economics. He questioned theories about capital markets and noted that they fail to provide significant enlightenment. He examined three financial theories: Tobin's q, Modigliani-Miller theorem, and the efficient market hypothesis. He claimed all three theories were wrong. 5.1 Tobin Q Theory The first theory he reviewed was James Tobin and William Brainard theory of how the financial markets regulate investment. They defined q as the market value of a firm stock and its long-term debt divided by the value of its real capital. They advised firms to invest in the stock market when the value of q is higher than one and not to invest if it is below one. In figure 4, q and investment move together for the first half of the chart but they part at the middle. Q collapsed during the bearish stock markets of the 1970s, yet investment rose. In the bullish market, as q rose, investment didn't follow. In fact, since 1970, high q was associated with low investment and vise versa. Figure 4: Relationship between q value and Capital Expenditures3 5.2 Modigliani-Miller Theory (MM) Modigliani-Miller (MM) (1958) argued that it didn't really matter how a firm financed itself, with debt or equity. They preferred to rely on internal funds and to revert to loans and new stocks from the public investors only as a last resort only when profit from new operations is higher than interest of new investment. Gurley and Shaw (1955) claimed the differences between developed and undeveloped economies are the depth of their financial system. Banks connects savers and borrowers by acting as a repository for savings and a source of credit. They defined the financial capacity of an economy as a measure of borrowers' ability to absorb debt. 5.3 Efficient Market Hypothesis (EMH) Fama (1965a&b) argued that in an efficient world, the market price of a stock equals the right price. The right price of a stock is determined by its level of risk. Risk is defined as the volatility or variance of an asset's expected returns around its norm. He defined three Efficient Market Hypothesis (EMH); weak, semi-strong and strong. Weak EMH states that history of security prices says nothing about their future prices. Semi-strong EMH suggests that security prices adjust instantaneously to significant news (profits announcements, dividend changes, etc.). Strong EMH states that future news is already reflected in current prices of securities. An efficient market assumes theoretical conditions that there is no transaction cost in trading securities; information is disseminated equally among all market players who interpret them in a similar fashion. In the real world, commission and taxes makes buying and selling expensive. Similarly different players have access to different information which is interpreted in different ways. In 1991, Fama challenged his EMH theory and redefined efficiency as reflection of investor expectations about the future in prices of securities (Fama 1991). 6. Henwood's Idea of what is not to be done 6.1 Social Security privatization Henwood (1997) argues that the notion of private pension fund depends on an economic illusion. The stock market grows in line but not to exceed the economy growth rate. Dividends and capital gains are not re-invested since they are drawn to finance people's retirements. The Chilean pension system, oblige all employees to put 10% of their earnings into mutual funds to be invested in the stock and bond markets. Retirees are promised a poverty level pension check of $2 a day (Collins and Lear 1995). The Swedish wage-earner funds attempted to socialize ownership of corporations. Firms were required to issue new shares equal to 20% of their annual profits to funds. Fund managers started to trade stocks attempting to beat market averages. The funds never attracted popular support and was cancelled. The plan failed because business correctly saw the initial version as a challenge to capitalist ownership (Henwood 1997). 6.2 Democratizing the Fed It has been proposed to open up the proceedings of the Fed to the public and electing members of Fed board of governors. This would open up the Fed in a similar fashion like the Congress. Only the rich and powerful gain access to Congress. Televising congress procedures did not stop insults to democracy in the congress. Applying similar standards to the Fed should not produce better results. The U.S. fed appears less important when compared with central banks of other countries. The German central bank is the most independent among major central banks. The British central bank even though started as a private institution in the seventeenth century is the least independent European central bank. The independent German central bank has lead the German economy to outperform the English economy which is regulated by a less independent central bank. The Japanese central bank is even less independent than the British central bank, yet the Japanese economy outperformed the German economy. It is concluded that central bank independence is not the main factor determining economic success (Henwood 1997:307). The U.S. and U.K. runs a loosely controlled financial system, while Japan and Germany runs a tightly controlled financial system. The Japanese and German stock markets does not play an important role in investment and corporate finance. 6.3 Social Investment In the 1970s, a group of investors were concerned about the source of their profits. They demonstrated the desire to accomplish social goals along with making return on their money. For example, they cared to develop poor communities and fund environmental friendly technologies. In 1995, new promising strategies emerged such as community land trusts (CLTs) which are non-profit corporations whose members are elected. CLT acquires land then lease to individual families for long periods who build on that land. During 1979-1995, CLT had equity capital of $531,000 and had lent a total of $26 million (Community Investment Monitor 1995). Henwood (1997:315) was skeptical about these institutions and claimed these institutions often end up producing the results they meant to correct. In the U.S. a number of nonprofit organizations exist who embrace community development schemes. 6.4 Transforming corporations Henwood suggests the gradual termination of the role of the financial and governance in the stock market. Corporations should be publicly controlled by worker, community, customer and supplier. He considers the Japanese financial model of socialized ownership of large firms as a promising model. His financial system consists of publicly owned group of banks run by social principles instead of profit principles. These public banks answer to a central bank which is run on democratically agreed policies. Public banks would collect savings from households and lend them at lower rates of interest to corporate firms. The bank would supervise firm actions. 7. Conclusion Based on the analysis of the U.S. Flow of Funds (FoF) conducted by Henwood (1997), the stock market raises a small portion of the capital to be used by industrial and non-industrial corporations to conduct business. Most corporations use their profit to buy other smaller companies. The currently U.S. financial system widens the gap between the rich and the poor. The rich lend the poor to further invest their funds, while the poor have to borrow to support their life style. The financial institutions makes a lot of profit enabling the poor to borrow from the rich, making the rich more richer and the poor less poorer. The theoretically appealing structure of the U.S. financial system suggested by Henwood is technically and politically challenging to achieve. References Bernoulli, J. (2003). The Wizard of Wall Street: Did Mathematics Change Finance Zurich, Switzerland. Buell, J. (1997). Wall Street: book reviews. The Progressive, August 1977. Obtained on May 13, 2007 from http://findarticles.com/p/articles/mi_m1295/is_n8_v61/ai_19622666 Collins, Joseph, and John Lear (1995). Chile's Free Market Miracle: A Second Look. San Francisco. Community Investment Monitor. (1995). "Member Profile: Institute for Community Economics Revolving Loan Fund," Community Investment Monitor. Fama, E. (1965a). "The Behavior of Stock Prices," Journal of Business 37, pp. 34-105. Fama, E. (1965b). "Random Walks in Stock Market Prices," Financial Analysts Journal (September- October), pp. 55-59. Fama, E. (1991). "Efficient Capital Markets: II," Journal of Finance 46, pp. 1575-1617. Forelle, C. & Bandler, J. (2006). The Perfect Payday: Some CEOs reap millions by landing stock options when they are most valuable. Luck or something else The Wall Street Journal. March, 2006. Gurley, John, and Edward Shaw (1955). "Financial Aspects of Economic Development," American Economic Review 45 (September), pp. 515-538. Heartfield, D. (2004). Interview with Doug Henwood about After the New Economy. Obtained on May 12, 2007 from http://www.audacity.org/Book%20Review%2005.htm Henwood, D. (1997). Wall Street: How it works and for Whom. New York & London, Verso. Hymer, Stephen Herbert (1979). The Multinational Corporation: A Radical Approach (New York: Cambridge University Press). Kennickell, Arthur, and R. Louise Woodburn (1997). "Consistent Weight Design for the 1989, 1992, and 1995 SCFs, and the Distribution of Wealth," unpublished technical paper, Federal Reserve Board. Modigliani, Franco, and Merton H. Miller (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review 48 (1958). Rothbard, M. (1995). Wall Street, Banks, and American Foreign Policy. World Market Perspective. United Nations Centre on Transnational Corporations (1991). World Investment Report 1991: The Triad in Foreign Direct Investment (New York: United Nations). Read More