All that Glitters is not Gold: Not All that is Called Investment is Investment

When I first studied economics in university, I came across in my economics textbook the statement that savings equals investment, or S = I. This statement puzzled me at the time, but it was only many years later that I understood why it is wrong.

There are several widely-held misconceptions about the stock market. One of them, which I have mentioned elsewhere, is the notion of “market capitalization” – the belief that a company’s financial or monetary value can be calculated by multiplying the total number of the company’s shares by the price at which a very small portion of those shares were recently sold. A more accurate name for this simple but highly misleading mathematical sum would be the company’s “speculative value,” since the price at which some of those shares are sold at any given time often has little to do with its monetary value, as this is calculated by accountants.[1] Furthermore, many stock market investors seek quick monetary gains by buying and selling stocks, and so their actions are more in the nature of speculation rather than long-term investment. The assumption made by those who buy and sell stocks and glibly repeat phrases like a company’s “market capitalisation” is that the price at which a small percentage of the company’s shares were recently sold is also the price of all the company’s shares. This generalization from a usually miniscule sample to the whole is not at all justified.

Another widely-held misconception is that when one buys a company’s stock, one is contributing money to the company, which will be used to increase its production or profitability. In most cases, however – in fact, in more than 99% of all stock market transactions – none of the money that is paid for the shares actually goes to the company. So where does all this money go? Very simply, it goes to the previous owner of the shares, while a small percentage is taken by stock brokerages and other financial companies as payment for the services they provide to stock traders, such as enabling them to buy and sell shares of stocks on various markets, which means helping owners find buyers for the shares they want to sell, and helping buyers find owners who want to sell shares of the stock they want to buy.

It is important, therefore, to distinguish between primary and secondary sales of stocks. Primary sales of stocks occur when a company sells shares of its stock to others. It is only in these sales that the money that is paid for the shares actually goes to the company. In all subsequent sales of the company’s shares, which I will call the “secondary stock market,” absolutely none of the money that is paid for the shares goes to the company. The stock market transactions that take place daily in markets around the world consist almost exclusively of secondary sales of companies’ stocks. In other words, none of this money goes to the company, and therefore these transactions cannot be called investment, in the economist’s narrow sense of capital formation.

There is a confusion about the word “investment” that needs to be clarified. When people buy shares of a company’s stock, they believe they are investing because they hope to make money from their purchase. Seen from their perspective, these kinds of transactions can be considered as investments.[2] But seen from the company’s perspective, these transactions are not investment, since the company receives none of the money that is paid for its shares in the secondary stock market. But generally no distinction is made, both by economists and others, such as government tax agencies, between these two fundamentally different kinds of transactions. This has led to the widespread belief among stock market participants that they are contributing money to a company whose stock they buy whenever they buy its shares, and therefore they are investing in that company, in the economist’s sense of helping it to grow. In reality, what they are doing when they buy stocks is placing a bet that the price of the company’s shares will go up, whether in the near or long-term future. The speculative nature of stock market transactions is clearly shown in the case of short-selling, where the person shorting a company’s stock is making a bet that its price will go down.[3]

As economic historian Alfred Chandler has written, apart from railroad companies, which resorted to the financial market in New York to finance costly railway expansion in the nineteenth century, in the past, the great majority of companies, including those that eventually became the dominant companies in their respective industries, generally financed their expansion through profits or from borrowing money from banks. Economist Paul Ormerod makes the same observation:

In America and Britain, industrial companies obtain only a tiny fraction of the money they need for business investment from the stock markets; most of it comes from profits or from borrowing.[4]

Today, many IPOs, or initial public offerings of stocks, which are primary sales of stocks by the company’s founders or original owners to the public, are regarded as a way for the company’s founders, owners, or executives to cash in on the company’s success, rather than as a means of expanding and developing the company. Interestingly, a new business model has arisen that didn’t exist in the past or was not as prevalent, which is to develop a company until it becomes profitable, and then sell shares in the company for a large amount of money to the public or to a large, existing company. What this has done is to externalize research and development. In today’s extremely rapidly changing world, this practice does makes sense, as it has become more difficult to predict in what direction technological development will progress, as well as how consumers’ preferences will change.

No one would argue that gambling in casinos, buying lottery tickets, or betting on the outcome of horse races or sporting events is a form of investment. All that occurs in these transactions is that the money that is wagered by the gamblers is redistributed among different individuals: some people win while others lose, while those who operate the gambling enterprises take a portion of the money that is wagered by the gamblers. The same is true of the secondary stock market, which comprises the bulk of all stock market transactions. Another similarity is that both of these industries create jobs and, in places where gambling is legal, tax revenue.[5]

So why do stock market prices rise over the long term? This is due to an increase in the total amount of money that is spent on buying and selling stocks. Similarly, a lottery jackpot also increases when there are more people who buy lottery tickets. In an economy that is constant expanding, that is, where the total output, and therefore people’s real wealth, is constantly increasing, there will be more money available for various activities, one of which is buying stocks.

As we have seen, stock market purchases, which in recent decades are taking up a greater and greater share of people’s savings, are not investment in the sense of capital formation, which is the economist’s definition of “investment.” The same is true of another significant use of people’s savings, namely home mortgages. People deposit their money in banks to keep it secure and possibly to make money in the form of interest. Banks then use the deposits in various ways to make money, one of which is to lend it to people who want to buy a house or some other kind of residence. In the case of already existing residences, when a bank lends the new owner money to purchase the residence, all that happens is that the residence is transferred from one person to another, while a large sum of money is transferred in the other direction. Again, no new capital has been created, and therefore these kinds of transactions do not qualify as investment in the economist’s sense of the word.

Back in the early 1980s, when financialization began to gain steam, commercial banks in the United States provided almost as much in loans to industrial and commercial enterprises as they did in real estate and consumer loans; that ratio stood at 80 percent. By the end of the 1990s, the ratio fell to 52 percent, and by 2005, it was only 28 percent. Lending to small business has fallen particularly sharply, as has the number of start-up firms themselves. In the early 1980s, new companies made up half of all US businesses. By 2011, they were just a third, a trend that numerous academics and even many investors and businesspeople have linked to the financial industry’s change in focus from lending to speculation.[6]

Between 1979 and 2011, as employment in UK manufacturing fell from 6 million to just under 2.5 million, its output stagnated while financial services output trebled. Meanwhile, British banks aren’t even lending to British industry: in the decade before the crash just 3 per cent of banks’ net cumulative lending in the UK went to manufacturing, while three-quarters went to home mortgages and commercial real estate. ‘They have lent not for any productive purpose at all,’ said Professor Karel Williams, author of a groundbreaking 2009 study of the financial sector in Britain’s economy.

This is the finance sector working for itself and inflating asset prices in an unstable way. The story the industry itself is telling is a story about social contributions which presents finance as the goose that lays the golden eggs. When you look at it, none of it stands up to empirical scrutiny … If you check the figures and put them in context, the net social contribution is negative.

Britain and the US, the two leaders of modern global finance, are now among the most unequal societies in the developed world. In Britain 0.3 per cent of the population owns two-thirds of the land; in famously unequal Brazil 1 per cent of the population owns only half of the land.[7]

The economists’ claim that savings equals investment is another example of their sheer laziness: rather than going out into the world and actually measuring the total amount of investment that takes place by asking companies how much investment they did in the past fiscal year, they resort to the mathematical trickery of defining investment as being equal to savings, even though this is very far from being true. To say that savings always leads to investment is like saying that sexual intercourse always leads to pregnancy, or that all wheat is necessarily turned into bread: W = B, where W is defined as the total quantity of wheat and B is the total quantity of bread produced in the world. All we can say in these cases is that sexual intercourse may lead to pregnancy, and that wheat may be turned into bread, but there are several intervening steps that must take place for the event or transformation to occur. Similarly, all we can say about savings is that they may be turned into investment, but not all savings – especially the considerable part that is used to buy stocks in the secondary stock market – actually become investment in the sense of capital formation.

Apart from those who work in the financial industry, who may profit greatly from financial activities, because the gains that are made from the many different kinds of financial speculation do not in any significant way benefit a country’s economy, and in fact may starve other sectors of money, which money could be used more productively by creating jobs, this kind of speculation should be taxed in order to increase government revenue and discourage this kind of selfish and occasionally reckless behaviour. The primary concern with this course is that a decline in stock market prices can affect people’s confidence. Because of the highly misleading habit of multiplying the number of shares one owns by the most recent price at which a very small percentage of the company’s shares were sold, a decline in stock prices will lead their owners to think they are less wealthy, which may lead them to adjust their spending or other financial decisions accordingly.

The mere fact that such a measure would be unpopular and fiercely opposed by those who would lose by it is no reason not to implement it, for decades of reduced taxes on speculative financial gains and weakened government regulation in the United States and elsewhere have increased the power of both the financial sector and the extremely wealthy to the point where they can pose a threat to the stability of both a country’s and the world economy. These sectors and their dominant companies are comparable to fiefdoms which are zealously protected by those who profit from them, but this does not mean that everything they do is beneficial for society or even sensible, as is believed by those ideological fools known as laissez-faire or free-market capitalists.

[1] This figure, which in the past was regarded as the true measure of a company’s worth, is almost never mentioned in financial discussions today, having been eclipsed by the erroneous term “market capitalisation,” which, if the truth be told, is nothing more than a collective delusion, or a figment of investors’ imagination, which in turn is due to their collective greed.

[2] There is an important asymmetry in the corporate stock ownership model: when a publicly-owned corporation makes a profit, it is legally obligated, by its terms of incorporation, to share some of that profit with its owners; but when the owners make money by selling their shares at a higher price than they paid for them, which gain has been mistakenly called a “capital gain” rather than what it really is, namely a “speculative gain,” they are not obliged to share any of that gain with the company, even though the increase in the price of the company’s stock is usually dependent on its financial performance, which in turn depends on the company’s workers.

[3] Large investors or investment funds may sometimes try to ensure this result by spreading rumours about the company or its performance, or by selling a large quantity of its shares, which practices clearly constitute market manipulation.

[4] The Death of Economics by Paul Ormerod, p. 175. John Wiley and Sons, New York, 1997.

[5] The majority of those who buy stock shares are betting that their price will go up, just as those who bet on the outcome of a horse race are betting on which horse will win or place in the second or third spot. Unlike buyers and sellers in the secondary stock market, however, those who bet legally on horse races actually do contribute to the maintenance of some of the horses, since the purses offered in each race to the owners of the winning horses are taken from the bets placed on the races, which purses help to pay for the horses’ food, grooming, shelter, training, and medical attention. Thus, horse race bettors contribute more to the maintenance and success of the most successful horses than the great majority of stock market speculators do to the success of the companies whose stocks they buy and sell, since, except for primary stock sales, none of the money which they pay for their shares actually goes to the company.

[6] Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar, Introduction. Crown Business, New York, 2016.

[7] Treasure Islands: Tax Havens and the Men Who Stole the World by Nicholas Shaxson, chapter 12. Vintage, London, 2011.