“Irrational Stock Exchanges” and the Wirecard Scandal: On the Blanket Suspicion of Financial Capitalism

Must everyone go crazy under capitalism? The collapse of the Wirecard company, the celebration of the stock market boom, and the increasing enrichment of investors alongside massively rising unemployment after the Coronavirus crisis all seem to put convinced advocates of the market economy on the defensive. But here we are, not so much dealing with capitalism as a whole, but with the aspect of it that regards securities, and, even then, only with a corrupted form of it.

What is the stock exchange system really all about? Many individuals pool their money to begin a large venture that they cannot do alone. Everyone participates proportionally, and there are two very special features that characterize public limited companies. One cannot return the shares but can only sell them to third parties; the company therefore always has its capital at its disposal, regardless of the life and private funds of the shareholders. However, the shareholder is liable for losses with his shares before the employees, lenders, and suppliers suffer losses. Nonetheless, he is only liable with his share, and does not have to pay more than that.

A place where such shares are exchanged—a stock exchange—therefore becomes a necessary establishment for a share system. Investors can get out, and new investors can get in. The company can also issue more shares on the stock exchange and take advantage of new opportunities with a surge in volume.

Stock Exchange Prices Are Not Accounting

Many see these stock exchange transactions through the lens of a blanket suspicion about such matters. However, in addition to the issue of the stock corporation’s durability, the shareholders need to be able to enter and exit the company, i.e. by share trading. The prices are formed according to supply and demand. They do not always reflect the daily equivalent value of the company balance sheets. Expectations for the future play a role, or the cash situation in the economy, or the general interest in the economy for fixed investments, with bonds being an alternative.

Derivatives have also emerged as a means of risk protection: one buys or sells only the right to shares in the future, with a small “insurance premium,” but with the leverage of profiting or suffering a total loss. The philosopher Thales of Miletus in the 6th century B.C. wanted to show that the rather ridiculed philosophers were good calculators and bought the right to all olive presses for the harvest season: he then set his price and profited.

Thus, the stock market is allowed to fluctuate, and it aggregates subjective expectations. It is not accounting. It is also reassuring that those who win or lose do not take it away from anyone. Rather, those who trade on the stock exchange attribute the prices to each other, often with only a few transactions, but also on dormant shares.

However, it remains a condition of all these forms of trading at the stock exchange that risk must not be removed. For players in this game, there is to be no protection to calm their nerves. The share system, correctly executed, realizes iustitia commutativa—the justice of exchange. The traders voluntarily admit to themselves what they believe is right.

All this forms a coherent architecture, and it has supported the upswing of modern economies. But architectures can crumble, and the latest model of this stock system suffers as a result.

Systematic Decadence and the Bonus Robber Barons

But let us first clear away the ruins of Wirecard—even the best-run private business enterprise, or the most socialist cooperative, would not be immune to straight up fraud with false documents. This unfortunately very human fact is concealed by the current condemnation of the auditors, of “capitalism,” and of the allegedly evil speculators. Wasn’t it the speculating and so often demonized short sellers who noticed that something was wrong at Wirecard and therefore bet on a price collapse? Instead of listening to them, the state financial supervisory authority banned short sales of Wirecard securities—an unforgivable intervention in the free market at the expense of unsuspecting investors who lacked the information provided by professional stock market speculators.

But quite apart from fraudulent machinations like that of Wirecard: there is a prior, almost systematic, decadence of corporations, who have split up into different stock companies instead of merging capital. It is just as strange when they buy up other stock corporations as shareholders. With such nesting, the original capital investors turn a big wheel and gain access to much more capital than they inject, because they control the minority shareholders of the nested companies. But they also take all the higher risks lightly.

Companies are going astray with capital reduction when they repay capital by buying back their shares. In doing so, they consolidate the profit on the remaining shares and hope to increase the value of these stocks—higher valuations thanks to less equity! But doing so also involves higher risks.

For almost a hundred years there has been debate about the problem of how to bring together the interests of the directors of the joint-stock company and its owners, the shareholders. The managers are involved on a daily basis, the shareholders meet once a year. With performance-dependent bonuses, the managers are expected to maintain interest in the company. However, these “compensations” do not come about on markets, but are decided by supervisory boards or bonus committees, who are themselves recipients of such payments that trend upwards. The bonuses become exorbitant and independent of success. In other words, a closed circle of people helps itself.

Employees are rarely involved as serious co-shareholders. Neither have the trade unions tried to implement this, nor do most companies go beyond a few employee shares that serve as a bonus.

The System Is Harmed by Government Intervention through Regulations and Central Banks

Two decisively decadent trends, however, stem from state intervention. On the one hand, the stock exchange supervisory authority, the banking supervisory authority, and stock market regulations everywhere have tried to eliminate the risks of shareholders: accounting is prescribed in detail, ordered to be audited, transparency is to be ensured with quarterly reports, with reporting of transactions, and with the possibility of legal action of all kinds. The result—behavior that is short-term oriented, ritualized and everywhere the same with companies, shareholders, and analysts. And everyone has the feeling that everything is safe because it is monitored.  If shareholders have a bad feeling, they do not make use of the complicated options for intervening. Instead, they sell their shares—love it or leave it. This certainly shifts power to the management.

The other decadent trend caused by intervention stems from the excessive policies of the central banks. On the stock market, prices are based on expected earnings per share. Investors compare other returns—for instance, the return on bonds—and capitalize on them: they use this to calculate the capital that one is prepared to give up for them. If the interest rate in an economy is 5%, you can pay twenty times as much for safe bonds, for example those issued by the state, and ten to fifteen times as much for shares, with their higher risk.

Since the 1980s, however, the central banks have been falsifying this calculation. They have been lowering interest rates continuously since 1982, and in the meantime, they are buying so many government bonds that their interest rates, as a basis for capitalization, have fallen to almost zero. As a result, investors, especially pension funds and insurance companies, are virtually forced to buy stocks, because they need income. Share prices have exploded since then, leaving the floor of ten to fifteen times the profits. Amazon shares sell at 150 times the profits, and even shares of sluggish companies like Henkel or Nestle sell at 40 times the profits.

The central banks have also eliminated the corresponding risk. Since the plunge of 1987, the U.S. Federal Reserve has provided liquidity and lower interest rates for every weakness, and since the financial crisis of 2008, all central banks have guaranteed it. As recently as last September and again in December, they immediately reached into the money box and calmed the situation when prices fell. Since the Coronavirus crisis, the U.S. and European central banks have explicitly declared that they will push down all interest rates once again, and for a long time, and will randomly buy up the debts of states and even companies.

The Price Explosion Resulting from Capitalization

At the peak of interest rates in 1982, 14% for U.S. government bonds, one only paid a rate of $700 dollars for a $100 yield. Today, at 1% interest, one could pay $10,000 to get the same return. This leverage has driven stocks for the last 38 years. Even Warren Buffet is not that brilliant, he just waited out that leverage.

Let us look back: if interest rates on government debt were back to normal at just 5%, as they were before 2008, then all stocks and bonds would collapse by half or less. The central banks can therefore no longer back away from its zero-interest policy. The stock markets are hopelessly distorted.

Consequences of Eliminating Risks

A consequence of all this is that risk is banished from the system of joint-stock companies.

• This explains the high share prices with rising unemployment and a weakening economy.
• It also explains why share prices always rise whenever there is a crisis—the state will run deficits, the central banks will finance it, and even more money rolls in. Every misfortune becomes euphoria in the stock market.
• It also explains the blatant concentration of wealth, since it is precisely the employees who have hardly been involved in productive assets, and who at the same time no longer receive interest as savers.
• Share buybacks increase share prices without the risks associated with reduced capital.
• A surge in stock sales by shareholders does not pose a risk for the management because everyone else buys in.
• Leverage acrobatics through derivatives becomes risk-free thanks to the central bank’s support of share prices.
• There are no consequences for the company’s high debts because the central bank reduces the price. Since the Coronavirus, some debts have even been guaranteed by the central bank.
• If prices only rise, thanks to the central bank guarantee, then the shareholder no longer looks at the real values, the earnings on the balance sheet, or even at dividends—the rising share price is already the total return on investment.

But some corrections or improvements can be considered, especially from a market economy perspective.

• The monetary distortions of the central banks must come to an end. That is now clear.
• If the joint-stock company as a legal person is to bundle many natural persons, why should it also buy up other legal persons? Without this occurring there would be less nesting, and less excessive risks and profits.
• If the joint-stock company is set up for the long term, shareholders might only be allowed to receive dividends and voting rights in the second or third year, or they could be given higher dividends and voting rights if the holding period were long. This would slow down the rapid turnover of purchases and sales.
• If employee advocates and leftists take issue with the concentration of assets, then they should at long last strive for a real ownership company, or even build up partnership companies, like the John Lewis Partnership in Great Britain (80,000 employees).
• The bonus robber barons disappear when the supervisory board lets three or four good candidates apply for the top jobs, then in a second round announces the lowest offer to all three or four and lets them make counteroffer. The market is also helpful in this regard.
• The authorities should not secure everything by rules, but it is necessary to make clear that everyone acts at his or her own risk.
• Modesty on the part of the stock exchange is also necessary. The distorted image that traders have of “efficient markets,” in which all risks are already priced in, is unrealistic. Behavioral economics is more realistic about “human” reactions.
• Very important: there is no prosperity without innovations that carry risk. Therefore, risk and profit must be possible. Justice of exchange (Iustitia commutativa) must be preserved.

Behavioral Economics

Compared to the doctrine of “efficient markets,” according to which all risks are always priced in, “behavioral finance” offers more realism: investors act in herds, they follow collectively or individually framed mentalities, they have asymmetric information, and markets are not always perfect or transparent. In short: it is inhuman to expect no mistakes from the stock market.

Translated from German by Thomas and Kira Howes