Re: dilution and risk

[Shann Turnbull <sturnbull@mba1963.hbs.edu>]

Dear Ownership Group

Point 1 of Charles Upton's posting diverts the debate from a valuable
feature of ESOP's and a process of self-financing economic development.  

Point 1 assumes that it is the employees who have to accept the risk of
financing business expansion.  Many ESOPs are designed so employees need
neither utilise their own funds to obtain an equity interest or become
exposed to the liabilities incurred to finance the issue of new shares to
the ESOP trust used to finance expansion of the business on their behalf.
In such situations the employee is in a no lose situation to make
irrelevant the statement of Charles Upton that "Optimal portfolio theory
requires diversification".

By definition all "viable" business expansion must become self-financing.
This allows any credit used to finance the expansion to be paid back to
eliminate any credit risk.  The pay back of any bank loan used to finance
business expansion also allows the banking system to cancel the credit to
reduce the volume of money and credit in the banking system.  The credit
risk during the "payback period" is either assumed by the existing
stockholders and/or an ESOP loan insurance facility as envisaged in the
Industrial Homesteading proposals.  The existing stock holders accept the
incremental risk with the view that their aggregate risk is reduced by
greater employee involvement.

ESOPs designed in this way provide a more direct way of converting bank
credits into industrial equity than that described by Harold G. Moulton in
his 1935 book on "The formation of capital".  Moulton described how the
credit risk of loans obtained from commercial banks to finance new share
issues were accepted by investment banks at the beginning of the century in
the US.  This was before the Federal Reserve had been formed or the Glass
Stegal Act introduced.

Consistent with "Optimal portfolio theory" the Investment banks averaged
their risks through the economy and over time by holding new stock issued
by many corporations until the business expansion created appreciation in
the stock so they could liquidate their holdings on the stock market.
Moulton described this as the "around about method" of capital formation.
The Japanese converted credit into industrial equity at the beginning of
the century through what they described as "overloaning" and averaging
their risks through a Zaibatsu with its diversified interests.  Both
techniques avoid the need for foreign credits and so the need for foreign
loans or even a World Bank.  They provide an example of investment
financing savings rather than savings financing investment described in my
attached opinion article "Savings from Investment" published by the
Australian Financial Review as 'Theorists Confuse Savings Debate',  p.13,
January 10th, Sydney, 1996.

Self-financing ESOPs, CSOPs, and USOPs provide a technique for countries to
internally finance much of their industrial development.  This would
accelerate their economic growth as they would not have to export income to
foreign bankers in the form of interest payments.  This is why the World
Bank should stop draining wealth from the poor countries to make rich
countries richer by teaching the poor countries how to finance their
development internally and avoid financial colonisation.

My article published as "Theorists Confuse Savings Debate" follows

                       Savings from investment

                          Shann Turnbull*

The debate over national savings has been captured by opinion makers who do
not understand that all procreative investments must create savings by
increasing productivity.  The best way to increase national savings is to
increase the value of procreative investments rather than forcing people to
forgo consumption by contributing to their superannuation or through other
means.

Any government action which encourages people to forgo consumption will
reduce the demand for goods and services.  As demand is reduced, the
incentive to invest to expand the economy will diminish.  A contrary
development process is established requiring a step backwards in
consumption to create investment to go forward.  It is also contrary
because the money saved by forgoing consumption is more likely to be used
for financing government debt, speculation in property, or other
investments which do not expand output, income and savings.  

Theorists have confused the debate by assuming that all savings are
automatically channelled into investments which expand output.  The only
type of investment which can expand output are those which become
procreative.  These investments produce sufficient income over their
operating life to generate values surplus to that required to pay for their
cost.  

The formation of procreative assets creates the only way in which nature
can be made to yield her resources more abundantly without requiring people
to work harder or longer.  The productivity of procreative assets counters
inflation.  By generating surplus values they increase national income to
permit savings to rise without the need to forgo consumption.  

The higher standard of living may be reflected in a better quality of life
through investments in environmental protection, collectables or consumer
durables such as cars, household goods, houses, sporting and recreation
facilities.  Investment in these consumption assets absorb surplus values.
They reflect rather than produce higher living standards.

The savings debate has been confused because policy makers do not
distinguish between procreative and consumption assets.  The confusion is
created by economic text books no longer identifying procreative assets and
by economists defining investment as being identical to savings in the form
of forgone consumption.  Confusion is compounded by commentators who do not
distinguish between investments which create new assets and those which
simply finance the transfer of their ownership.  

Confusion also arises from the word "capital" being used in misleading
and/or ambiguous ways.  The word can be used to describe many things
including money, credit, paper assets like government debt, paper claims to
real assets like corporate equity, total assets of a corporation, or
physical assets which may or may not be procreative!

In political terms, the formation of procreative assets allows economic
gains to be achieved without the pain of forgone consumption.  In economic
terms a virtuous circle is created of increased consumption generating new
investment to raise both incomes and savings.  Investment, income,
consumption and savings can all be increased together to create a confluent
development process.

The formation of procreative assets should never be constrained by the
availability of finance.  This is because all procreative assets must be
self-financing.  The banking system can be used to bridge their payback
period.  Even if consumer demand does not increase, procreative assets can
reduce the current account deficit through their output being exported or
by substituting for imports.  As Australia has under-employed labour,
materials and know how, customer demand is the only limitation for
accelerating economic growth.  Forcing people to forgo consumption becomes
counter productive.  

Neither foreign loans or foreign equity investments are required to
generate economic growth if we adopt monetary and fiscal policies to
facilitate the formation of appropriate procreative assets.  However, if
our policy advisers do not understand the difference between consumption
and procreative assets then they will see a level playing field and resist
initiating policy changes.  

Policy initiatives to create economic gains without political and social
pain would provide a compelling basis for electing our next government.
The question is do we have politicians who are not captive of muddle headed
theorists?

                               oooOOOooo
                               646/100595

*Shann Turnbull is author of Democratising The Wealth of Nations.

Ph: 02/9328-7466B; 9327-8487AH; Fax: 02/9327-1497 e-mail:
sturnbull@mba1963.hbs.edu

At 04:05 AM 21/10/1999 , you wrote:
>Dear Ownership Group,
>
>This discussion is becoming more productive (at least from my perspective).
>I would agree with Charles Upton's points below as they are consistent with
>my perspective on capital ownership:
>Points 1 & 2 seem to illustrate the trade-off for employees; this is exactly
>why I focus on risk-return decision behavior; 
>
>Point 3 seems plausible that ownership structures should vary, but I'm not
>sure anyone knows how yet;
>
>Point 5 begs the question: so, what explains all the inaction? It has been
>claimed that it is largely insufficient credit. If one wants to understand
>why lending is not forthcoming, I don't see how you can ignore the risks
>associated with ESOP transactions. Bankers and former owners don't want to
>assume these risks and therefore refuse to lend without a kicker. Finance
>theory is as important as economic theory here.
>
>Ellerman identifies the main problem as the diverging interests of employee
>and non-employee shareholders in ESOP firms.  
>That seems quite plausible for mixed ESOPs (and not being an ESOP expert I
>hadn't considered it, but that's why I belong to this group) and his
>analysis make sense to me, but in general I ask myself why I'm so willing to
>support stock option dilution in the companies in which I am a shareholder?
>Even without tax benefits.
>Is it because as a shareholder I am willing to concede the productivity
>benefits of employee ownership incentives and what's good for them is good
>for me as an owner? 
>Perhaps then it is necessary to make a strong empirical case for ESOP firms
>on the productivity side to address this potential conflict in mixed ESOPs.
>I don't believe Kelso's only contribution is that he finagled a way to pull
>the wool over non-employee shareholders with a ESOP contrivance - I just
>don't believe shareholders are or ever were that clueless. 
>
>However, on an important related issue, I'm convinced that CAPM theory is
>fundamental to understanding the differences between employment and
>ownership and all the various stakeholders in between--in effect the entire
>ownership/capital structure. It is residual claimancy and subordination that
>determines how the risks and returns to the business are distributed. Thus,
>it's not some special productivity distinction between capital vs. labor
>that counts - it's the ex post distribution of returns that matter. The fact
>that this distribution is largely determined by the ex-ante risk preferences
>and loss aversion of agents is exactly the point. The success of the firm,
>either through increased actual or expected cash flow accrues to residual
>claimants (the owners) and perhaps trickles down to other stakeholders.
>Considering Ed Wolff's research into the determinants of wealth and income
>inequalities, the maldistribution of productive financial assets is exactly
>the problem I am hoping to address here.
>
>As an aside to Keith Wilde's summary, I don't view this as a debate between
>economists and non-economists - I can't really make that distinction...
>
>
>Regards,
>Michael Harrington
>
>
>-----Original Message-----
>From: Charles W. Upton [mailto:cupton@kent.edu]
>Sent: Tuesday, October 19, 1999 7:40 AM
>To: ownership@cog.kent.edu
>Subject: Re: Yes, the Earth is Round
>
>
>Actually the earth is pear shaped. 
>
> Ellerman makes several good points, the key one being that economic theory
>is being ignored and mischaracterized in this debate.  Several points are
>worth making:
>
>1.  Optimal portfolio theory requires diversification.  An individual
>thinking of how to hold his or her accumulated financial wealth would
>generally be well advised to avoid holding shares in his own company.  The
>covariance between his or her human capital, both firm specific and non
>firm specific is just too high.  
>
>2.  The reason to hold capital in the firm for which you work must
>therefore be found in incentives and minimizing monitoring costs.  When you
>own the firm, you may be underdiversified, but at least you are playing
>with your own money, which certainly focuses the mind.
>
>3.  At the same time, monitoring costs will lead to different structures
>for different employees in a firm and for different industries.  It may
>make sense for a dentist to own the practice, rather than work for a dental
>conglomerate, say, but does it make sense to cut the hygenists in for a
>piece of the action?  And, why is the structure which is right for one
>industry right for all industries?  Clearly it isn't.
>
>4.  Remember, the Soviet system was, in theory, 100% ESOP'ed (with
>apologies for killing the English Language).  And we know what a paradygm
>of economic efficiency that was.  
>
>5.  Finally, Ellerman is quite right.  Taxes drive a lot of activity, and
>the tax subsidy to ESOP's explains a lot of the action.
>
>
>Charles W. Upton
>2324 Exline Circle
>Hudson OH 44236
>
>Department of Economics
>Kent State University
>http://www.personal.kent.edu/~cupton
>

Shann Turnbull
P.O. Box 266 Woollahra, Sydney, Australia, 1350
Phone: 02 9328 7466 office; 02 9327 8487 home
Fax: 02 9327 1497 home & office.  Mobile 0418 222 378
Outside Australia, replace first "0" with "61" after international access code
Life long E-mail: sturnbull@mba1963.hbs.edu
http://www.mpx.com.au/~sturnbull/index.html