Michael Kinsley has a new piece in Slate this week purportedly offering “proof that the stock market is irrational.” As the someday-to-be-author of a book tentatively titled The Myth of the Rational Investor (due out early next year, if I get cracking on the rewrite), I ought to agree with him. But I just can’t bring myself to. Maybe it’s because he unfairly disses my buddy Milton Friedman. Or maybe it’s because, after dumping on the stock market for 900 words, he offers no plausible alternative.
Kinsley bases his argument on the current boom in private equity, and the fact that the private equity guys are almost always able to resell the companies they buy for more than they paid for them.
The details are different, but the principle is the same. Private investors buy a company from its public stockholders. They have a letter from an investment bank saying the price is a fair one. They usually have the support of management, or they actually are the management. The public stockholders have little choice. But time and again–surprise, surprise–the investment bank turns out to be wrong. The company is actually far more valuable! (And any bank that can’t be counted on to get this wrong will not be in this profitable line of work for long.) Soon, the company is sold at a large profit, either to another company or back to the public.
So far, so indisputably true. And Kinsley is right to say that this state of affairs casts some doubt on the efficient market hypothesis, the theory that the stock market always accurately reflects all available information about the companies traded on it. If the market is efficient, he asks, how can the same company sell at three different prices depending on who happens to be doing the buying and selling?
Actually, you can make an efficient-markets argument to explain the price discrepancy, as scholar Michael Jensen has been doing for the past quarter century: Private-equity-owned companies (a.k.a. leveraged buyouts) avoid a lot of the conflicts between owners and managers that plague publicly traded companies. The owners (the private equity guys) are clearly in charge, and therefore their companies are run better, and worth more. Kinsley allows that this might be true, but then argues:
[I]f these deals aren’t a swindle, then the stock market itself is a swindle. It does not maximize value for its working- and middle-class investors. The stock market leaves money on the table waiting for “private equity” to swoop down and pick it up. Furthermore, Milton Friedman was wrong, and the other famous economist who died this year, John Kenneth Galbraith, was right: The free market in corporate shares doesn’t produce well-run companies.
I wasn’t aware that Friedman had ever claimed that it did. He was not a believer in the efficient market hypothesis, at least not in the extreme version of it that held sway at the University of Chicago Graduate School of Business (and a lot of other business schools) in the 1970s and 1980s. As he put it to me a couple of years ago:
We all know the market is not efficient in a descriptive sense. But that doesn’t mean that the efficient market is not the best approximation if you don’t have anything else to use.
And that’s really the key. In our current system of stock-market-driven capitalism, corporate insiders make out like bandits, investment banks skim millions for themselves, and private equity firms profit repeatedly off the mispricing or mismanagement of public companies. Yet, somehow or other, stock market investors have made more than 10% a year since 1926.
That doesn’t necessarily mean they will in the future–but I also wouldn’t be surprised if a lot of the private equity deals being closed these days go sour, too. There’s just too much money flowing into the sector for all of it to be invested wisely. Over time, though, private equity will continue to serve as a useful alternative to the inevitably conflicted management model of the publicly traded company. And without the public equity markets, the private equity guys would never be able to cash in. It’s a symbiotic relationship.
Is it also a messy, wasteful way of doing things? You bet. Got a better alternative? Galbraith never did, which is why he will go down in history as a brilliant critic with few constructive economic ideas of his own (Thorstein Veblen with much better table manners) while Friedman’s legacy lives on in policies and institutions that affect our lives every day.
As for Kinsley, he’s still the cleverest political pundit of the past couple of decades (in print, not so much on Crossfire). But he had a seriously wrongheaded piece about stock option accounting in Slate a few years ago, and now this. Maybe it’s time for him to take his business commentary private. (This should, of course, dramatically increase its value, enabling him to charge much more per column when he takes his opinions public again in a couple of years.)