thoughts on investment

One narrative that's useful when you're thinking about questions relating to the economy is the one that supposes there are two groups concerned in any governance question: the governing and the constituent. It's important to recognize that this isn't the dichotomy most people imagine when they think about this idea -- it's not rulers and ruled. It's more like executives and shareholders. The endpoint of this discussion is speculation, but first some groundwork.

First, it's useful to go back to a basic model of what investment means. Imagine for a minute that I'm a plumber. Not only that I'm a plumber, but that I have worked closely with a plumbing contractor such that I understand both the running and the execution of the business. I can braze a pipe, I can make rational assumptions about the future cost of my basic materials, and I can handle HR and other side issues. I can do it all. But I don't have enough money to start my own firm. So I get as much together as I can, and then I go look for investors. To make it as simple as possible, I get one investor who pays for 51% of my new plumbing company. We'll call him Bob.

Now, what this guy owns is 51% of the assets of the company: the stock on hand, the tools, the building where the company is, and whatever cash assets or cash debts the company has. The value of his share of the company is equivalent to 51% of the liquidation value of the firm. So if I decided to stop being a plumber and we sold the entire operation, my partner would get 51% of the total net return. Bob's incentive to invest could be one of two things. One is that I don't plan to grow the firm. I'll pay myself a salary to be the plumber and the business manager of the firm, I'll pay the firm's bills, and the rest will be pure profit. That profit will be split between me and Bob 49/51 for as long as the firm continues to operate and, if the firm is in the red, Bob will be on the hook for 51% of the debt. The other possible incentive is that I will take the profit and re-invest it in the firm, such that the value of the firm -- the liquidation value -- increases over time. We'll have more stock on hand, we'll get a delivery truck, we'll get a bigger building, and we'll hire more people. Enlarging the operation will enlarge the profit which will accelerate the growth of the operation until we meet the market ceiling -- until we've done as much with the company as we can, given the size of the market. And during this process, the value of Bob's 51% of the company will increase hugely, without him actually having to do much beyond the initial investment.

In this scenario, I'm a technocrat. I'm the guy who knows what's going on. Bob's the guy whose money is at stake. Because he owns a majority interest in the firm, Bob theoretically has control of what the firm does -- including, incidentally, the option to fire me and hire someone else to run the firm. But Bob doesn't know anything about the plumbing business, or any of the rest of it. This isn't a judgment of Bob. Presumably he has his own business that he knows all about. But if Bob tried to run our company, he'd fuck it all up. Even though he owns a majority, he's sort of just along for the ride.

This is the basic governance question that comes up, in one form or another, pretty much everywhere. Lawyers know more about the law than we do; we want them to deal with it, but we hate and mistrust them. Politicians know more about politics; we want them to deal with it, but we hate and mistrust them. CEOs know more about business than we do; we want them to deal with it but... well, you see where this is going. The question is, how do you have experts run things without giving them too much power? Where do you draw the line between ownership -- or interest -- and control? The answers to this question tend to be doctrinal, but they're sort of tangential to the issue I'm trying to get at here.

The issue I'm getting at here has to do with the third reason Bob might want to invest in my plumbing company. Specifically, Bob might want to invest in my plumbing company because he believes I'll grow the business, he believes other people will believe I'll grow the business, and he believes he can make a profit selling his initial investment interest to one of those people on the premise that, since the business will grow, they'll pay more than the current value of the interest in anticipation of future value.

Speculation.

So the problem that comes up here arises when Bob sells his 51% for $100. Tom buys it at $100, goes to Helen and says he'll sell it to her for $105, because it'll be worth $110 by the end of the year. She buys it and tells Ed, who pays $115 for it, because it'll be worth $120 in two years. But then a weird thing happens. Nancy buys it for $120, because she thinks someone else will buy it for $125. Someone else looks at it, sees it's gone from $100 to $120 in a week and pays $125 for it, believing it'll sell for $130. Pretty soon that 51% is trading around town for $100,000 and, around that time, I have a bad month. The company loses money. Or maybe someone just makes the mistake of looking down. The price of the thing plummets until one day Rosanne buys it for $50.

Now, Rosanne has an interesting new option that nobody else has had. She just paid $50 for something that's actually worth $100. She can take her good investment and sit on it, in the hopes that the company will be profitable and the value of it will grow. OR she can order the liquidation of the company and make $50 right now. This is, by the way, basically the plot of the first Wall Street movie.

The fact that this scenario can occur has been pissing people off for hundreds of years and speculation is one of those things, like usury, that half-smart people have been railing against since the middle ages. Because, of course, speculation -- like usury -- is one of those basic engines that power the whole economy.

That doesn't mean regulation isn't a condition precedent to keeping the whole thing from blowing up in our faces.