We have been led to think of the economy in financial terms: the stock prices of the largest companies, their quarterly earnings reports, trends in GDP, mergers and acquisitions, central bank money-printing and the prices of homes. This phenomenon is a reflection of the expansion of the financial sector of the economy – the investment banks, the brokerage houses, the stock markets, the hedge funds and the ETF platforms. But when the financial sector expands, it does so at the expense of the productive economy. More and more smart and talented people are engaged in trading certificates and designing derivatives and fewer and fewer are engaged in production of real goods and services.
Financialization makes the case that business and management are all about driving stock prices up, conducting arcane financial maneuvers like manipulating debt offerings, and finding new ways to trade financial instruments. It even has its own ideology: maximizing shareholder value.
For example, the notion of stock buybacks has become popular among the high-flying companies of this financialized age. Apple is a prime example. There are years in which Apple has spent more than 100% of its net earnings on buying back stocks from shareholders, thereby providing those individuals with a major cash bonus. Of course, a significant group to benefit from this action are those members of management who hold stock grants or stock options, which they buy back from themselves at a high return.
Stock buybacks are self-serving stock price manipulation.
As Professor William Lazonick has pointed out, very famously in an article in Harvard Business Review under the title Profits Without Prosperity, but also in many books, papers, and an open letter to the SEC, this action of stock buybacks undermines capital formation – companies spend their earnings on stock buybacks that help share traders, and underinvest in the capital that makes workers more productive and generates value for customers. Financialization in the form of maximizing shareholder value through dividends and share buybacks has distorted the true purpose of the firm, which is to facilitate value for customers, earn cash flows in return via the customers’ willingness to pay for that value, and to reinvest the earnings (cash flow minus cost) in more capital to facilitate more customer value.
Since it is so lucrative to manage a company that’s traded on a stock exchange, this form of financialization has led to a second-order distortion. Start-up businesses funded by venture capital and private firms seeking to monetize their growth by sprinting toward an IPO, i.e. for their stock to be traded on an exchange. The business model is to grow at a fast pace, at the expense of maturing a business model, or refining the value proposition through customer feedback. These companies “burn cash” – i.e. make operational expenditures far in excess of cash flow from sales to customers – in order to establish a price for their privately traded shares that could be translated to be a successful IPO. Examples like Uber, WeWork and Peloton show the many ways this financialized approach can fail, when growth is not underpinned by true customer value creation.
The True Entrepreneurial Ethic.
The greatest damage that financialization has done to capitalism is to distort our views of the entrepreneurial ethic that underlies the system. Many young people think that capitalism is exploitative and cynical, which is not an irrational view when confronted with corporate executives who award themselves stock grants and then implement stock buybacks to cash in on the stocks they awarded themselves.
The reputational damage to free market capitalism is worsened by the association of the term “entrepreneurship” to the burn-cash-in-a-dash-to-IPO tactics of startups and Silicon Valley unicorns. Their behavior is not that of entrepreneurs. True entrepreneurship is the identification of a market opportunity defined as an unmet customer need: a customer’s unease about the status quo, the feeling that things could somehow be better than they are, without a specific idea of how to realize that betterment. The entrepreneurial business is the one that comes up with the welcome new way to relieve that unease, and to actually make the customer’s life better, as defined by their own subjective evaluation. If the entrepreneur gets it right, and does so better than any competitor in the eyes of the customer, then they trigger a willingness to pay for value received. Willingness to pay becomes cash flow, and if the cash flow is greater than the entrepreneur’s cost, there is profit to be reinvested in capital for more and even better services in the future. The ethic is to serve customers, and to accept the rewards of the market for doing so.
If the owners and managers of the entrepreneurial firm get rich, it’s from an abundance of customer satisfaction, not from stock manipulation through share buybacks. They’ll accumulate capital, because capital is defined as assets that produce customer value. The more customer value they facilitate, the greater the value of the entrepreneur’s assets. That’s why entrepreneurial businesses reinvest most of their business’s profits to create more capital value in the future.
This entrepreneurial “flywheel” (as it’s characterized at the very entrepreneurial business known as Amazon) can be a virtuous cycle: serve more customers with more and better offerings, receive more cash flow, and reinvest the profits in new capital formation in order to serve more customers in better ways. Entrepreneurship raises all boats, and does so through the explicit purpose of serving customers’ needs.
The financial sector and the stock traders and stock sellers who think of business only in financial terms do entrepreneurial capitalism a great disservice.