Magazine May 20, 2019, Issue

In Defense of Capital Markets  

A trader works at the New York Stock Exchange, January 8, 2019. (Brendan McDermid/Reuters)
Though no defense is needed

Mustering the courage to launch a public criticism of financiers these days doesn’t exactly require the grit of Dietrich Bonhoeffer or the bravery of a Navy SEAL. Today, the very terms “hedge funds,” “private equity,” “Wall Street,” and “investment banker” have a pejorative connotation. Critics of finance feel no need to distinguish between good actors and bad actors, and in fact the criticisms are hardly ever personalized; it is the capital markets themselves that have become unwelcome in our society, not just David Solomon or Jamie Dimon.

But establishing that finance is not popular does not tell us whether the critiques are right. One could argue that there is a track record of arrogance, excess, and combustion that has lent great sympathy to the cause of anti-finance. The financial crisis hardly created this impulse — Wall Streeters were not atop popularity lists before it — but the demonization reached a new level after Dick Fuld managed Lehman Brothers into bankruptcy and Jimmy Cayne’s Bear Stearns fell. The enduring conclusion that Main Street formed about Wall Street’s behavior before the financial crisis was that it had been reckless, greedy, and indifferent to the impact of its behavior as long as bonuses were paid. Adding to the crescendo of animosity, the TARP legislation carved into our consciousness the idea that the victim of the financial crisis (Main Street, in this broadly accepted narrative) was “bailing out” the perpetrator (Wall Street). If one had wanted to make finance hated for a generation, one hardly could have written a better script.

And while Wall Street (along with the NFL, the textile industry, clean energy, big oil, food and beverage, and youth soccer) has had its fair share of fat cats and disrepute, the public’s antagonism toward financiers is not attributable to a few bad apples. There is a hole in the public’s understanding of capital markets, and it explains the contemporary negativity about finance. So we must be very clear — there is no capitalism without capital markets.

That it is necessary to make an argument for financial markets is itself a testimony to the economic ignorance that has permeated our society. But let us state the obvious: While employment and rising wages are vital benefits of a business, they are not its objective. The objective is, rather, the delivery of a good or service to a customer who wants it. So while hampering businesses threatens jobs and wage growth, it also hampers the development and delivery of goods and services that make life better. Ergo, an attack on business is an attack on quality of life.

And any attack on the financial markets is an attack on business. I suppose one could make a list of businesses that, from cradle to adulthood, have been entirely self-funded. It will not be a very long list. Most businesses require capital to start, and most businesses do not generate cash until after they have started. American financial markets, without any provocation or encouragement from government, organically developed an entire industry known as “venture capital” over the last four decades. It has provided capital to countless technology start-ups that have changed the world. The financial terms were set by private economic actors and administered by risk-taking entrepreneurs and investors, and the sophisticated models in which such firms and investors interacted with developers, programmers, and proprietors were all the work of the invisible hand of American financial markets. 

The glory of venture capital in creating Google and Facebook can obscure the countless ways in which American financial markets have improved life outside of Silicon Valley and Wall Street. Small businesses seek debt- and equity-capital partners every day, whether to start up or to expand. Financial markets are the best way to price the risk accurately. Heavy collateral, significant streams of cash flow, and strong inventories tend to provide capital access at a lower cost; more-speculative, open-ended, less collateralized ventures tend to require greater cost of capital (in the form of equity). The existence of liquid, sophisticated financial markets — from conventional debt, to various categories of equity, to complex structures that perhaps combine features of the two — is part of the majesty of the American economy. Put differently, we do not have binary markets — one for high risk and one for low or no risk. The depth, complexity, and nuance of our free-enterprise system, along with advanced capital markets, has created a multitude of options for investors, borrowers, creditors, and every category of financial actor to access capital markets.

Efficient pricing of risk benefits not just investors and entrepreneurs but customers as well. Think of the downward pressure on borrowing costs that greater choice has brought to the debt markets. Relaxed debt-service obligations create greater profits for investors, lower prices for customers, or, as is actually the case, both.

A more sophisticated intellectual framework for finance, combined with the continuation of the Hamiltonian tradition in fervently seeking more evolved capital markets, has also created a division of labor that we all intuitively know works in every other business and sector. Company ABC now has the ability to shop for one set of terms in real-estate lending and another for its equipment-leasing needs. It can then turn to a different financial institution for its depository needs, and a different company still to ask for advice on mergers and acquisitions. At each link in the supply chain of financial advice, the development of sophisticated capital markets has fostered greater talent and placed it in more specialized silos. The benefits to the company, its employees, and its investors are hard to appreciate fully, as is the resulting competitiveness that has made American capital markets the envy of the world.

The common objection to all this is that the echelons of finance are no longer filled with those generating capital for business development or expansion, but rather those just pushing paper back and forth, resulting in no direct benefit to the entrepreneurs whose businesses are represented in the debt and equity securities. But this straw man is not taken seriously by anyone actually in the field of finance who can see the benefits of capital markets. It is prima facie true that hedge funds trading bond paper with another, and technological advances in high-frequency trading, appear to be adding no value to the economy. And yet no critic bemoaning the allegedly vast amounts of worthless economic activity has been able to explain why bid–ask spreads (the difference between what a buyer pays and what a seller gets) have fallen to the lowest level since they began to be measured. Prices of stocks and bonds — when purchased by mutual funds, exchange-traded funds, small investors, retirees, pension funds, and the whole gamut of regular people — include lower transaction costs, and are set in more-liquid markets, than ever before. If this is vulture capitalism, I’ll have more, please.

Lack of nuance and inability to make distinctions between key financial actors and roles are not mere ignorance. Hedge funds (asset managers trading their own capital, and often that of other highly accredited investors), private equity (an innovation in capital markets over the last 30 years that has revolutionized company access to capital for growth and strategic expansion), and investment banks (financial institutions providing advice on company strategy and structure, and, in many cases, access to capital markets) are distinct enough, and provide different enough services in financial markets, that the only purpose in blending them all together into some sinister Gordon Gekko caricature is to poison the well and relieve oneself of the burden of making or rebutting a specific argument.

American capital markets are the envy of the world, and rightfully so. Most important, sophisticated avenues of finance have served producers, consumers, job creators, job seekers, and investors for decades. Bad actors exist in financial services, just as bad actors exist in technology, consumer goods, and telecommunications. But to oppose capital markets is to argue for undermining the survival of our free-enterprise system. And perhaps critics of finance know that better than we think?

In This Issue

In Defense of Markets

Books, Arts & Manners

Sections

The Week

The Week

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