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What are the causes for this attack? And last time we discussed the the perception of the common man. Why the common man, the person who doesn't know a lot of economics is not an intellectual. Why is he antagonistic towards financiers towards financial markets? And today we're going to talk about the intellectuals role. Because as we saw last time, the common man's ignorance is driven by guidance he is getting from the intellectuals. They are telling him what to look at and how to interpret the observations. So what is it that motivates the intellectuals? Or what are the philosophical roots of the attack? And I'm going to look at two. Now you could take any bad philosophy, I think, and work it out to the point to economics and come up with the same negative view of financial markets. I've chosen two that I think are very influential in the culture today. The first is Christianity. Now you might recall the view of Christianity of wealth. Remember it is easier for camel to pass through the eye of a needle than it is for rich man to get into heaven. Jesus throughout the money changes from the temple. So Christianity from early on has a negative view of wealth, of success, of money, of making money as a goal. And probably the earliest mention, or one of the earliest mentions because this actually goes back to the Greeks, one of the earliest mentions of an anti-finance attitude is the Christian's attitude to usury. If you go back to the early Christian writings all the way through Thomas Aquinas, usury is considered a sin. It is considered evil to be a usurer. A usurer is a person who charges interest on money that he's lent, any interest, any amount. The idea of making money from money is sinful and usurers in the early days of the church were persecuted and excommunicated. Now the Christians still needed to take out loans. They still needed financing for whatever little business activity was going on in the Middle Ages. So who did they turn to? Who did they turn to who could? The Jews. Because the Jews, according to at least my understanding of the Jewish religion, the Jews are prohibited from charging interest from other Jews, but they're not prohibited from charging interest from non-Jews, from infidels. So the Jews could lend money freely to Christians, and they did. Here was an entrepreneurial opportunity to make money. That's why in general they became merchants rather than landowners and went into agriculture, because they were prevented from those industries by law. But I would say that one of the original sources in Europe for anti-Semitism is this Christian idea that they were dependent financially on the Jews, and the Jews were committing a sin by lending the Christians money. Now the real sin under Christianity is to lend the money, not to borrow it. Paying interest is okay. It's just charging the interest that is evil. Now think about that means if I take the different kind of financial assets, the different kinds of financial instruments, I would divide them into three. One is money, and different types of money substitutes like checking and credit cards and so on. The second is equity. Equity is like stocks. It is, it gives you an ownership stake in your investment. Partnerships, preferred stocks, and stocks are types of equity. Finally, debt. And debt is the most prevalent financial asset. All bonds are debt, saving accounts in a bank, or debt. You are lending the bank money. Accounts payable that a company has is debt. All kind of commercial notes, commercial papers, most of the financial transactions in our economy involve debt instruments. Now what are the Christians saying? Christians saying this is evil. Can't do that. And the Jews are evil for doing it. If you look at world literature, you find a Jew as moneylender being portrayed as evil. These are the first instances of financiers being portrayed as evil. Just some of the more popular ones, Shakespeare, the merchant of Venice, Shylock, the Jewish moneylender is portrayed as a money grubbing sleazy moneylender. And Dostoevsky, I'd like to read you a short quote after Dostoevsky's The Brothers Karamazov. It was well known too that the young person had, especially of late, been given to what is called speculation and that she had shown marked abilities in the direction. So the people began to say that she was no better than a Jew. It was not that she lent money on interest, but it was known, for instance, that she had for some time passed in partnership with old Karamazov, actually invested in the purchase of bad debts for a trifle, a tenth of their nominal value, and afterwards had made out of them ten times their value. What was she investing in? Junk bonds. These are junk bonds. No different from the junk bonds in the 80s. So already in the days of Dostoevsky, about a hundred years ago, junk bonds were considered something really bad and really evil that speculated and Jews dealt it. So a lot of animosity, a lot of animosity, especially among the common man and within the conservative movement, on the right. And as we'll see, a lot of the persecution of financiers in the 1980s originated with Republican conservatives, not with the left. So a lot of antagonism on the right, on the Christian right, and among common people towards financiers, I think has its origin in Christianity's view of wealth, of finance, of usury. Usury being one of the cornerstones of finance. You can't charge interest and debt, financial markets do not exist. The second set of ideas, the second philosophy is Marxism, which among intellectuals in our culture is a dominant philosophy. Not in its pure form, but definitely in its subtleties. According to Marx, productive activity and manual labor are one and the same. So the only productive activity in an economy is making things with your hands, which of course excludes finance completely. Finance is not productive. It is just dividing up the pie, dividing up the cake, as we saw in the quotes in a previous class. This is the doctrine that underlies much of the condemnation of financiers, much of the condemnation of businessmen in general. They're not productive, they don't add anything. All they do is divvy up the pieces. The focus for the Marxist is on manufacturing jobs, on making things, on the perceptual level. According to Marx, any profits that the financiers might make, just like any profits that the businessman might make, are, what's the word he uses, exploitation. It's not earned, they've exploited it, they've basically stolen it from the workers. This is money that really belongs to workers and the financiers have stolen it, or the businessman have stolen it. In a pure Marxist world, there's no role for financier. They don't need it. Now modern intellectuals are not that extreme in their views, in their Marxism. They realize that you need financial markets, but they view financial markets as parasites. You know, just like in biology, you have those little fish that pick the food out of the whale's teeth. The despicable, the sleazy, you really don't want to think about it, but they kind of need it. They're necessary evils. And that's our finances perceived. It's a necessary evil. Yeah, you need to somehow convert those savings into capital. But we wish we didn't have to deal with it. We wish we really didn't have to do it. Capital markets should be, according to this theory, just transferring people saving to labor. Because, again, businessmen don't really have a role under this theory. So the real producers of labor and financiers are just the conduits, the neutral conduits of this capital. And then you can see if that's all they do, they're just parasites moving the money around. And it seems like a very simple thing to do. Then, of course, you can't explain how somebody like Michael Milken could make $500 million in one year. That was a salary, I think, in 1986. And nobody can make $500 million in just transferring cleaning the whale's teeth. There's no way parasites should make those kind of profits. Now, to quote one of my favorite leftist intellectuals, Robert Reich, our Secretary of Labor. Robert Reich talks, and I quote, about a brain drain from product to paper. So there's a brain drain. The smart people are going from making things from the product to shuffling papers, financiers. All they're doing is moving things around. Quote again from Reich, our best minds are increasingly drawn to the pie-dividing professions of law and finance and away from the pie-enlarging professions like engineering and science. So all financiers do is they take the cake, you remember the cake from the first class? They take the cake and they slice it up and they deviate up. And some people, they give small slices and other people, they give large slices. And, of course, they are collecting the crumbs. So they don't do anything to enlarge the pie, they just divide it. And this is straight out of Marx. There's no productive role for financiers. It's all in the labor. The laborer made the pie and all the financiers doing is dividing it up. Again, a complete parasite with the role equivalent to a parasite in nature. Nothing beyond that. Something incredible has arrived at Disney California Adventure Park. Darling, I want action. We're going big. Elegance. And we're going fast. Speed. Predacoster is here and now open at Pixar Pier at Disney California Adventure Park. Bring your super family and your friends and come celebrate Friendship and Beyond at Pixar Fest before it ends September 3rd, only at Disneyland Resort. Attractions and entertainment subject to change without notice. Now, underlying both the Christian view and the Marxist view is, of course, in ethics, altruism. Remember that the profit motive, the idea of making money, is essentially an expression of egoism. It's an expression of selfishness. You don't make money for other people. You're making money for you. Companies seek profits for themselves, for their shareholders, not for society. So an altruist views the making of money as something selfish, something bad. Now this, I think, is true to a large extent with financiers. Financiers, and take, for example, speculators in the stock market, are clearly seeking profit for themselves. There's no other motive for them to trade. It's very hard for a financier to hide behind a product, like many CEOs do, unfortunately. They say things like, yeah, we're making profits, but we're investing all the money in R&D so we can have products which will benefit society. That is their explanation. If you listen to a drug company's CEOs, you know, when they're about to be regulated, this is the justification for making profits that they use. Now, that is close enough to the perceptual level that people can deal with. Now, financier to make that argument would have to explain the role of financial markets and why it is that if they do their job well, then companies can then make products that benefit society, and that's too complicated. So it's too far removed on the perceptual level for them to even attempt to hide behind the product to make an altruistic argument. So what does somebody like Michael Milken, how does he defend himself in court? He says, well, with all the money that I made, I gave a lot to charity. And he did. So he uses an altruistic defense, but he can't connect it to the product. He can't connect it to his profession. And that's why I think altruists go after financiers more than they do after businessmen. For example, if they went after Bill Gates, and they do go after Bill Gates, but not to the extent they went after Michael Milken. If they went after Bill Gates to that extent, then most people would say, well, you know, how bad can Bill Gates really be? I'm using his product, they're pretty good. I would pay 50 bucks for this. So if he may, if he is making money on this, there's some justification, because yeah, I'm getting some value from it. But what value did I ever get from Michael Milken? I got nothing from it. Again, it's too far removed from that perceptual level that people can identify with. Now again, just to make real this altruistic view, I'm going to quote again from Robert Reich. He just has some of the best quotes on this topic. And I quote, profitable companies may contribute to a good society, but ultimately the end is not profits. Let's not simply say profits are good without understanding that there are social consequences here that have to be traded off. Profits are very important, but they're not the only important thing. And he continues, by some measures AT&T did precisely what it ought to have done, but the fundamental question is whether society is better off. So this is complete altruism. Somehow, and of course who's going to tell whether society is better off? Robert Reich. I mean, who else would? Now, consider how he phrases these sentences. It is amazing to me because he always says something positive and then something negative about exactly the same thing. He says, by some measures AT&T did something good, but we should consider the bad things. Or he says, let's not just say profits are good because there are also these consequences. He does this continuously implying, and he actually says this explicitly sometimes, implying that he's actually for free markets, but we have to consider other things as well. He's epistemologically, he's trying to, he's confusing people. He says nothing that you can pin him down to in any of these quotes. Just a final horrifying one, again from Robert Reich, the ones I've given you up till now were from this year from a Harper Magazine interview. This one's from 1989. The bankers and lawyers who helped Argyon Nabisco move out of equity and into debt late last year earned about one billion dollars for their efforts. This sum exceeds the total amount devoted by the United States in all of 1988 to the search for a cure for AIDS. Now those two are connected, right? There's a relationship there. Now what's he trying to do? Why is he doing that? He's trying to imply that that million dollars that went to the financiers could have gone to help AIDS patients. These financiers are taking money away from research to help AIDS patients. These evil financiers are responsible for these people dying ultimately. So you can see how altruism is everywhere in their arguments. Because the standard is always somehow maximizing social benefit. Of course they can never define what that means and it ultimately comes down to what the powerless to be think it has, it should be. Now what does they go? What is the intellectual goal, intellectual's goal in attacking the financial markets? I think today they are out to destroy whatever remnants of a market economy we have. Putting themselves in a position to control the economy. People like Robert Reich are power lusters. They want control. So they want to destroy the market economy. They want to destroy those people who profit from it. They ultimately want to destroy achievement. Now how are they trying to do this? Or first by perpetuating ignorance? We saw last time what kind of nonsense they are teaching people who watch their news, people who go to school, people who are interested in finding out what is actually going on here. Part of it's just in the terminology they use. As soon as you put junk together with bonds, you create the perception that there's something wrong here. There's something awful. A hostile takeover. Second way they do this is by demonizing, discrediting the successful financiers and other businessmen. Denying that they're productive. Denying that they provide any kind of benefit. By doing that they create the illusion among people that they're socially useless. These people they do something that's completely useless. Now once people are convinced that a certain profession or certain group of people are useless it is a very short way, a very short step to go from that to criminalizing the activity that they are performing. So if you look at the 1980s the first step was to talk about how unproductive financial markets were. Not only were they not productive, they were destructive. They were causing the United States to be less productive and less competitive with Japan and Germany and other countries in the world. One step after that was to go after these financiers. Once you established an atmosphere of these people don't do anything, well if they don't do anything productive how can they make so much money? They must be doing something illegal, they must be doing something bad. And that's how they got most of the financiers in the 1980s. Now why are they going after finance in particular? And again I think they go after finance more than they do after other types of businesses. First because it's intangible. It is far removed from the perceptual level. It is difficult to understand. The productive role of financial markets is not self-evident. Secondly it is very visible. People hear about these big deals. They hear about the amount of money the financiers are making. They see the stock market going way up or way down. They also take advantage of the historical animosity that Christianity has rooted in our culture towards financiers and in the general sense of mystery that many people have with regard to money and where money comes from and how do you really make money from money? What is this whole notion of interest? Where does it come from? Some people talk about money as a almost as a mystical experience. It's something they don't understand, they can't comprehend and therefore it is something that is easy to pervert. So if you combine a field that is relatively abstract, intangible, removed from the perceptual level with a high visibility and some of the people making lots of money, historical animosity, you've got a mixture here that makes finance easy to attack, very attractive for the intellectuals and of course as we've seen it is at the heart of our economic system. If you destroy it, you destroy the economic system. Free markets, whatever bits of capitalism we have left would stop functioning without financial markets. Any questions? Do you think that the intellectuals who are out to destroy the financiers actually understand that financial markets and institutions are at the heart of the free market economy? I think many of them do and if they don't they're just evading on a massive scale and then they're using other reasons. So I think somebody like Reich has to be evading on a massive level. He's not an idiot, he is well educated. You just have to open your eyes and look. If you're above the perceptual level you don't need that much information. If you live in that world, if you study economics and you investigate, puts a little bit of research into seeing what Wall Street does to figure out what's going on here. So it is not innocent. It's either they know it and they're fighting it anyway because of Marxist ideals or whatever. Other reason or they are evading it. They are blocking it out. So I don't think any of this is innocent. Do you think they really believe that it's a zero sum game or is that just a facade they set up to make the argument easier to present to the public? Again, I think it depends on who. I think some people clearly believe it's a zero sum game and as we'll see when we talk about the stock market, again it takes even one additional step of abstraction to understand that it's not. At least some of it it's not. But some of it is clearly enlarging. Just the ability to transfer capital from savings into capital to transfer money from saving into capital. Just that process is clearly pie and lodging. How could you form companies without that? How could businesses expand without that? And they have to be evading that. They have to be evading again on a massive level in order to in order to truly believe that. So again, I think it's either evasion or some other form of corruption where they understand it and they're fighting it anyway. Some of it is more subtle. Some arguments might be a little bit more subtle and more complex and they really don't understand. But again people like Robert Reich are no idiots. He's a real altruist. He is and he's he's very explicit about it but he's very clever in how he presents himself because he always makes the point of saying I'm for capitalism but or I'm I like AT&T. I don't think they did anything wrong but you know he so he tries to make few people feel comfortable that he's a very tolerant guy. He's not an extremist. He doesn't really want to go after them. And it's amazing and you probably noticed this. Those of you who've seen him on on tv with Dr. Peacoff on on the comedy channel. And when every time he's put in a corner the way he diffuses the argument is by making fun of himself. So make a short people joke. He does this at every opportunity he can. He'll tell a joke about short people. You know he's about that time. And that diffuses it and he gets people sympathy and he plays these cards so cleverly that you get the sense that he knows exactly what he's doing. Okay. What are the ramifications? What are the ramifications of these attacks? Or we get a general disrespect in large segments of the public. For finance, for financiers, for the activities involved. They really don't believe this is productive. You know I think I told you when I tell people I teach a course in finance and ethics they say isn't that a contradiction in terms? That's the normal response that I get even some of my students who take the class come into the class at least thinking that. Some of them believe the class thinking that's it. As a consequence of this finance is ripe for regulation, for heavy regulation, and financiers are ripe for persecution. During the 1980s successful financiers were one could say were systematically persecuted by people like Rudolph Giuliani. Case after case, which Michael Milken is only the most visible. Wall Street professionals were arrested, their lives ruined, the assets seized under the RICO Act, the Racketeering Act which was passed in order to fight what? Organized crime. So the RICO Act is being used to fight organized crime and Wall Street. Many of these cases were later thrown out of court because there was absolutely no evidence to convict these guys. Yet this took five, six years of appeals and by that time their professional careers were ruined. Many of the assets were seized by the governments. They got no return on those assets for many years. So lives were ruined. And a book I highly recommend that gives you a detailed description of this as payback which is available just across the corridor. Payback by Daniel, I think it's Fischl, official. I'm not sure how you pronounce it. It's an excellent analysis of the witch hunt you could call of these financiers during the 1980s and the political motives of the people prosecuting them. Ultimately all this leads to less growth, a decrease in the productivity of labor and a decrease in the standard of living for everybody. Financial markets become less efficient. Some of the best financiers are taken out and put in prison. They are heavily regulated and they just don't work as well as they could. And as a consequence they don't serve their productive role as well as they could and therefore as we've seen if they function correctly they increase the productivity of labor. They increase the standard of living. Well they can't do that so whatever increases we have are much slower than the other ways would be. So all these roadblocks have a real effect on all of our standard of living. Okay we have finished for now at least the section on the attack on financial markets. We're going to move on now to a concrete example of the productive role of financial markets and I'm going to use as the concrete example the stock market. So we're going to talk about the productive role of the stock market and then tomorrow we're going to take one specific function of the stock markets and we're going to talk about corporate restructuring. But what role the stock market has in restructuring corporations and whether that is a productive role or not. Now there are any questions on what we've completed up to this point? Any correlation between the attacks on the financial financiers and the stock market? Because you said it happened a lot in the 80s. Yes October 19th 1987 was the day the stock market crashed but dropped 25% during that day. This is not directly the persecution of financiers but it's related. That same day the final passages were being written the final formulations were being made and new regulations that were supposed that both the House Banking Committee and the Senate Banking Committee were working on to regulate the activities of financiers with regard to takeovers and leveraged buyouts. I believe that is no accident. That is a market part of the rise of the stock market during the 1980s can directly be attributed to takeovers LBOs to those kind of financial activities. Both House and Senate in 1987 were considering major legislation that will block that and the market I think responded by declining by 25% or more if you take a few days together if you take the 17th or the 16th and the 19th together. By declining and it is interesting that the legislation was wiped off the books. It never went got out of committee after the market dropped. It was in a sense the market sending a very strong message to the politicians don't touch this. Now as we'll see the legislation got passed elsewhere the state's picked it up and now we've got massive anti-takeover legislation in the state but the federal government never touched that. So it's not direct but it is it's an indirect effect not only that but if you look at the collapse in the junk bond market in 1989 collapse in the junk bond market is a direct link to the destruction of Drexel. Drexel was the company that Milken worked for which the government destroyed and the persecution of Milken. If Milken and Drexel had been healthy had been allowed to do what they do best the junk bond market would not have collapsed in 1980. Now there's some other causes which we'll get to later in the course but there's no doubt that these persecutions had dramatic effects on financial markets and financial activity and they're still having to this day. That is the kind of activity that we're not seeing in financial markets today is that the direct consequence are the fact that Milken went to jail and people like Milken went to jail and therefore that kind the kind of things that Milken was doing which were good are not being done today because nobody will touch it. Okay any other questions? Yeah. Only if you can answer without taking too much time is it possible to briefly explain how you've done how they work what they do? I will in the next class of the class after that when I talk about takeovers I will talk about junk bonds. This stock market okay to talk about the stock well it's first what are stocks? What is a stock? Anybody? An ownership claim okay so stock is a claim against the assets of a company that's a special kind of claim right because it's not like a partnership claim. What makes it different than a partnership? Legally what is it what makes it different? Why do we have corporations and partnerships? What is the limited liability? So distinctive feature about stocks is the fact that they are an ownership claim that provides the owner with limited liability what that means is that if the corporation goes bankrupt and it owes a lot of money the debtors cannot come to the stockholders demanding payment. You are not liable beyond what you paid for the stock so you can lose the all the value of the stock they can't come out of your personal assets they can't come after your personal assets for example in a partnership if the partnership goes bankrupt and it owes a lot of money you are responsible for paying those debts back as a partner so stock is an ownership claim which provides the owners with limited liability okay stop by any of the 133 Los Angeles area O'Reilly auto parts stores where you'll find everyday low prices on the parts you need to keep your vehicle at its best our guaranteed low prices ensure you're always getting our best deal in fact we'll match any auto parts stores price on any like item O'Reilly auto parts better parts better prices every day now what's a stock market yeah it's a place in which stocks are bought and sold and you can have a physical location for a stock market like the new york stock exchange where if you see pictures people run around selling and buying or you can have it on a computer in a network without a physical location like Nasdaq which deals in smaller companies where you buy and sell on computers you you say I want to buy IBM at 52 somebody wants to sell you the computer matches the trades so the stock market allows the selling and buying of stocks now what role what productive role does this serve why is it important that we have stocks and we have a stock market I think it's very easy and cheap to transfer ownership okay why is that important why do we carefully can transfer ownership because the one that gets it is the is the cheapest and the most efficient person to use it let's say like I would be more efficient in running this company so I would be the better person to run it so it's very easy to just buy the stock instead of going through a big deal of contracts and I don't know whatever it consumes a lot of time in there money it makes the buying and selling of stock a relatively easy efficient low-cost transaction yeah that makes it easy to get out of non-probable ventures and into more probable okay so again it makes it easy to to execute the trade now but again look a little bit more fundamental why do we care yeah it also offers a great deal of capital that otherwise wouldn't be available okay so it the primary function here is to allow corporations to raise large amounts of capital in a very efficient way by selling stock now we'll see how the other things you've said fit into that in a few minutes now how does this done how does a corporation sell the stock to a large number of people what financial institution is involved in that and setting that up in that transaction what underwriter underwriter uh investment banks investment banks do the underwriting of stocks what does an investment bank do it buys the stock let's say Netscape wants to go public they buy the stock from Netscape and then they turn around and they sell it to the market that's what an underwriter does Netscape has access to a very large amount of capital and it has many owners now that capitalists come from lots of people yeah why don't Netscape sell it directly why do that uh yeah primarily because the underwriter has a market but it is possible for a company to sell it on the stock when you can do that but an underwriter has a customer to buy the stock underwriter makes the process more efficient and they do two things one they have access to the market they have cheap easy access to the market to different investors they can call them up they recommend the stock in addition the underwriter has the expertise to go to Netscape check their books check their products and say this company is worth $12 a year so that when they when uh when you the investor wants to buy want to buy the IPO the initial public offering of Netscape the the the stock of Netscape you're not buying it from Netscape directly and you don't know how they came up with the figure but you're buying it from an intermediary who specializes in pricing these things right they actually have a fiduciary duty to price them right and under common law you could sue them if they if they have breached that fiduciary duty if they'd not done they'd do diligence in inspecting the company and making sure that this was an appropriate price for them so they serve as an intermediary so they help Netscape on the one hand and they help you the investor on the other hand by providing you with a reliable source of information about that company through the price that they provide the price they put on the stock so stock markets allow companies to raise large quantities of money through issuing through issuing stock now let's see what role in the actual market has to play in this right because most transactions in the stock market do not involve raising capital most transactions in the stock market involve you selling a stock to me and the transaction involves the two of us it doesn't involve Netscape anymore so why does the fact that we can trade make it easier for Netscape to raise the capital in the first night so what we want to what i want to do now is go over some of the other roles that the stock market have and then integrate them all into this primary function of the ability to raise capital so let's look at some of the additional functions and then integrate them all back okay one of the things that was mentioned was that stock market allows for liquidity now what do we mean by liquidity means that we can sell the stock when we need money so i can make an investment in IBM and not be worried about getting a return on my investment over the next 50 years if i need the money earlier i can sell the stock i'm almost guaranteed that there will be somebody in the market if the price is appropriate that will buy the stock for me not only that but i can do this at a very low cost very very easily think of what would happen if you had an individualized contract with IBM that is you bought an ownership directly from IBM there was no secondary market there was no stock market so you had a contract saying that you own 5% of IBM now you want to sell it so you have to put an ad in the paper announcing that you have the 5% and would somebody like to buy it and then you'd have to sit down with that person and showing the books of IBM and try and value the contract and you would haggle you know you would you would have to start negotiating what the appropriate price is this is all incredibly costly you'd have to have a lawyer president to make sure that the contract between the two of you was appropriate that he couldn't sue you afterwards very complicated transaction versus i call my broker up and i say sell my stock in IBM at $25 and as soon as the market price hits $25 you've sold and if it doesn't you don't sell you can adjust your price it's very easy very simple very efficient it adds to the likelihood that you would want to be an investor in IBM so if IBMs try to raise capital by issuing individualized contracts that were not tradable it would be very difficult for them to raise that capital the fact that they that the stock market exists that this liquidity exists allows IBM initially to raise that capital what else does it do it allows the entrepreneurs people who initially invested the money in the in startup companies to take their profit relatively early in the in the life of that company give you an example again let's let's take Netscape remember that the one of the people who founded Netscape was an entrepreneur in founding Netscape he was also one of the managers and he provided the capital think he invested $50 million in Netscape of his own money now if there was no stock market if he could not sell stock easily on the market he would say okay i've got $50 million today i expect profits of Netscape to be x i will get a percentage of those profits for the next 50 years and over those 50 years i will make money is it worth my wallet to invest $50 million right now in this venture versus i put $50 million right now into the venture if the product is successful we'll go public i will be able to take out all those future profits i will be able to get in five years by selling my stock to the public so now i get $500 million an investment of $50 million upfront okay so it allows the entrepreneur to cash out now what does this do two things one it encourages entrepreneurs to invest because they know that the investment horizon now is not 50 years not 20 years or 10 years but if the product is good if the company is profitable the investment horizon is much shorter secondly it provides additional capital because what's this entrepreneur going to do with the $500 million that he got now from the from the sale of the stock he's going to reinvest that $500 million in some other company so he's going to now introduce new companies so think if you think of venture capitalists let's say they have a pool of $100 million and they decide i'm going to put 10 million in in 10 different companies and i know that usually nine of them fail and one succeeds so i need that one to succeed a lot for me to do this now i know that i will receive this return which has to be very very large in order for me to make this investment over 20 years the likelihood of making that investment is relatively small versus in three years i'll be able to take out $100 million or $200 million he has to make a profit here right he started with a hundred so he takes out $200 million on this investment now there's $200 million available in this venture capital fund to be divided up into new entrepreneurial ventures and now he can put 20 million into 10 different ventures or 10 million into 20 different ventures so the fact that they can go public makes it more likely for these entrepreneurs to invest or these these venture capitalists to invest stop by any of the 133 Los Angeles area O'Reilly auto part stores where you'll find everyday low prices on the parts you need to keep your vehicle at its best our guaranteed low prices ensure you're always getting our best deal in fact we'll match any auto parts stores price on any like item O'Reilly auto parts better parts better prices every day hi it's jamie progresses number one number two employee leave a message at the hey jamie it's me jamie this is your daily pep talk i know it's been rough going ever since people found out about your acapella group mad harmony but you will bounce back i mean you're the guy always helping people find coverage options with the name your price tool it should be you giving me the pep talk now get out there hit that high note and take mad harmony all the way to nationals this year sorry it's pitchy progressive casualty insurance company and affiliates price and coverage match limited by state law going public selling shares to the company of selling shares to the public also allows for the conversion of fixed assets like plants and equipment into cash if you want it to the reverse of a mortgage remember we talked about a mortgage how that how if you wanted to buy a house and there were no mortgages you'd have to save for 30 years and then you'd buy the house and with a mortgage now you can buy the house now and pay it off over 30 years this is a way that you have a house and you want to take money out of the house and you can do that today with uh you can get home equity loans well this is the equivalent what you do is you've got big plant lots of equipment and you have ideas for other other ventures you want to go on or you want to expand well one source of capital is tied up in these fixed assets a way to make that liquid is to sell stock in those assets now you have more capital to make further investments okay an additional role that stock markets will play the fact that stocks are denominated in small units they give you very small pieces of corporate ownership allows lots of investors to buy stock it inked what yes but that wasn't the point i was getting to but but you're right i'll get to that in a little while by allowing lots of investors to get into it it allows for an increase in the pool of money available so if if you had to privately buy a stake of ownership from IBM they probably wouldn't talk to you unless you had 10 million 100 million dollars to do it with now if you have a hundred bucks you can buy a piece of IBM so almost everybody in the economy becomes a potential provider of capital everybody in the economy becomes a potential capitalist which increases the amount of capital available for production makes possible the formation of very large corporations it's no accident that the largest businesses in the world are publicly owned corporations or corporations that have sold stock it is hard to raise the billions and billions of dollars that would be needed in order to fund these corporations by issuing bonds or by getting money for private investors it is much easier much more efficient much more likely to be able to raise that kind of money from the millions of investors out there IBM has millions of shareholders so each one has to just put a hundred dollars in and it's already a huge amount of money now this also allows for something that we call this in finance a separation of ownership and control it allows stockholders to own the company but they don't have to manage it they can hire professional managers to do their job for them so small investors can now benefit from owning large businesses without having to worry about managing those large businesses something that they don't have the talent to do or not interested in doing they can delegate that responsibility to professional managers whose expertise is doing that specific job so if you want it enhances the division of labor so it provides another means or provides a means for small investors to benefit from the productive capacity from the profits of large businesses in the economy and as a result it is again another means by which we're converting savings of lots and lots of people into capital to be used by the producers one more rule stock market allows us to value corporations by buying and selling these stocks a price is set for them a price which is the estimate which is the best estimate of the best minds that are monitoring this company so we have financial analysts and we have investment bankers looking at this company speaking to the managers looking at the products looking at the competition saying this company's worth about 45 and trading based on that information and by trading based on that information they move the stock price to what in the context of their knowledge is the value of that company it is often the best or it is the best value that we have for a company these are professionals that are motivated by what what motivates them to get it right profits they are motivated by the profit motive they are looking for stocks that they think are underpriced and by buying those and making money moving that price up and looking for stocks that might be overpriced and by selling them moving them down to to the right price now this is very useful information it is useful to managers useful to the managers of the company it is telling the managers financial markets the people are trading in these markets believe that i'm doing a good job the price of the stock is going up or they think i'm doing a bad job now maybe i'm overlooking something maybe they are seeing something that i am not saying maybe i'm doing something wrong we've used a host buggy industry as an example stocks of the host buggy company are declining fast use the manager you know you're making good product sales are picking up they're fine there's no problems what am i missing and it forces you to look around and aha there's a new industry being formed which is in direct competition with me automobiles it forces the manager if the stock is declining to look to see what is going on why is this happening it is a potential source of important information or if the price is going up it tells the manager the market thinks i'm doing a good job the market thinks i have good growth opportunities i should continue in this path i should continue making the kinds of investments that i am making now this doesn't make the manager in any way second-handed a second-hand this is an additional source of information from specialists into the market that he isn't into the activities that he is involved in so they provide information to managers they also the price and the movement and change in the price also provides information to other capitalists in allocating their capital and deciding which companies to invest in and which not to invest in so a falling price in the buggy whip industry tells you well you know maybe that's not the industry to be building a new plant in or to be heavily investing in this is this is a sign that this is probably an industry in decline and maybe i should look to invest in something that's going to be profitable in the future so falling price is telling the markets is telling other capitalists to telling managers that the prospects are not good for the future for whatever reason what does that do let's say you're in a company you're in a company where the price of the stock is falling and you want to expand it makes it very expensive for you to go out and raise capital because if the price is low in order to get a given amount of capital you have to issue lots and lots of shares the lower the price the more shares you have to distribute in order to raise a given amount of capital which makes capital very expensive for you makes you think well you know i can't really do this or maybe i shouldn't expand and that's good because companies with declining stock prices are probably either poorly managed during declining industries and we don't want them to make investments we want capital to be moving away from them into more profitable profitable ventures so bad companies make fewer investments because the cost of their capital is increased firms that are doing well their stock price is rising the number of shares they have to issue for a given quantity of capital is smaller the cost of capital is lower high stock price lower cost of capital which means they're more inclined or it's easier and cheaper for them to raise capital which is good these are good firms we want them to be making capital investments so the movement of stock prices is also going to determine the investment policy of the firm itself in a way in a positive way in a way that adds to productivity now moving to stock price also provides information to other participants in the economy for example let's say you are a supplier i think we gave this example of a you're a supplier of goods to the host buggy firm and that you observe their stock price declining and now you have to negotiate a new agreement with them are you going to give them 90 days credit or just 30 days credit well you're going to be a lot more careful and you're dealing with them you're going to say well you know the market thinks this company is a little shaky maybe they'll go bankrupt i don't want to get stuck with a lot of debt again what does that do it raises the cost of capital for that company not just in the stock market but in other markets as well in credit markets or if you're the bond market if the company's coming to you and wants to issue bonds and raise money that way you say well the stock price is really declined i'm going to demand a higher interest rate because you are more risky company there's a higher probability that you will go bankrupt now at least that is the information i'm gleaning from the stock market so it raises the cost of capital for these firms not only in a stock market but everywhere now there's something else that a low that a declining stock market does because you could say well why should a manager care let's say i'm a manager of a company a company's doing fairly well cash flows are coming in and i don't expect to make any large investment i don't need to raise capital for another five years so i don't care what my stock price does i'll just continue doing what i'm doing what's going to happen if the stock market is declining in a free market somebody will say the assets of this company are not being utilized this these managers are not doing a good job the lower the price of the stock the easier it is to take the company over so if you don't pay attention to the information being provided to you by investors in the stock market if you are not alert to the to what's going on in your environment if you become a bad lazy manager then the lower stock price provides an incentive to other managers to come in and kick you out and try and do a better job so let's say you're managing assets that if utilized efficiently and correctly would result in a stock price of twenty dollars but the stock price right now is ten dollars because you're a lousy manager and you haven't been noticing what's going on around you somebody's going to buy the stock at ten dollars going to accumulate a large a large position kick you out put in good managers who do the job appropriately stock price will rise to twenty and they have made a nice return on the investment if the stock price was just random then you couldn't do that because it wouldn't reflect the fact that you were doing a good job so again the profit motive keeps managers on their toes if they don't do a good job the consequence of that is a declining stock price which makes it cheap to take them over which means they lose their jobs so it provides incentives lower stock prices provide incentives of changes in corporate control replacing poor managers with good managers and we'll as we'll see this is a lot of what was going on in the 1980s and we'll see why why is it that there was so many bad managers in the 1980s and us corporations okay now to leave this point about reducing risk a stock market allows us not only to own a stock of IBM relatively easily but it allows us to own a little bit if we want a little bit of lots and lots of companies we call that diversification so we can buy some high tech and some banking stocks and some agricultural companies and some home building companies and diversify ourselves across almost the entire economy now what does diversification do for us why why is the diversification of value it reduces risk now how does it do that well let's say the high tech industry is doing poorly one year why in a in a normal economy some other industries probably doing okay so our losses from the high tech are canceled out by a gains from a different industry think about it this way if you could own a little bit of every asset in the economy if you could completely diversify what would the return on your investment be the growth of the economy exactly it would be exactly equal to whatever the economy was growing because you owned a little bit of everything the more you diversify the more closely you match with the growth of the economy and the less risk you're taking on the risk you're taking on is whether the economy will grow or not but you're not taking any risk associated with any individual company so for example somebody who's very risk averse who's afraid of risk doesn't like taking on risk can still own stock in Netscape which is a high tech very very risky company why because they could own 5 000 other stocks as well therefore they are completely diversified their fate is not going to be determined primarily by Netscape but by the performance of the economy in general yet they have now provided capital to Netscape these are people who otherwise would never give money to Netscape would never provide that capital Netscape so suddenly you've increased the amount of capital available through high risk ventures by allowing for diversification very risk averse people own and lots of people own mutual funds mutual funds own very high risk stocks yet because of the the diversification the mutual fund itself is not risky we are almost out of time now so you can see that all these functions integrate into the primary function of raising the capital if there was no liquidity people wouldn't want to own the stock the company would have a hard time raising the capital if prices in the market did not reflect the value of the company again you wouldn't want to own the stock if the prices in the stock market were random right we're just arbitrary you won't want to own the stock because you wouldn't know when to buy and when to sell and what it meant and when you bought it what does this reflect i'm not you're not buying anything real you're just buying a random series and nobody would buy what makes it attractive is that if this company does well you will make money that that doing well will be reflected immediately in the price of the stock so the fact that it provides information the fact that it provides liquidity the fact that it provides diversification all make possible the primary function which is the raising of capital from many many individuals thus increasing the pool of capital available for business it is only because of the existence of the secondary market the stock market where you trade and securities with one another the companies can ultimately raise money directly from investors okay so let's stop there and we'll finish our discussion of stock market next time and go on to corporate restructuring i will see you tomorrow this course continues with lecture four do you promise to love each other for richer and poorer i do i do i now pronounce wait if you'd like things to be more richer than poorer you should open an account at westcom it's a member owned not-for-profit financial co-op that gives you low rates on loans and credit cards and great savings yields you hear what i'm saying i do i do too westcom the best bank for you may not 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