Needing relief from medieval churches and cutesy cafes on a trip to Prague a few years back (O.K., and a tax break), I paid a call on the Prague Stock Exchange, tucked in a blocky, Soviet-style building off the main drag. I climbed a few flights of poorly lit stairs and entered a dour, dusty-musty office. I didn’t expect John Thain clapping with happy C.E.O.s at the opening bell, but heck, this place might as well have been a D.M.V. I started pining for stained-glass windows again. Nonetheless, I learned more in the next 20 minutes about how the world works than I had in the last 20 years sweating on Wall Street as an analyst and running a hedge fund.
Back home, everything on Wall Street is beyond complex: Men in funny sports coats grunting and littering the floor of the New York Stock Exchange. Dow Jones industrial averages rising and falling in seeming random correlations to sunspots or something. Million-dollar bonuses to traders younger than that Rolling Stones T-shirt in the back of your closet. Derivatives. Rate hikes. Credit swaps. Sub-prime loans. Discounted free cash flow. Man, this stuff is harder than Chinese arithmetic. I craved for a simple explanation on what it all meant. It was right in front of me.
There in the Prague office I spoke with a nice chain-smoking gentleman in an ill-fitting suit who was no doubt a district member of the Party a decade earlier. I quickly learned that, duh, there is no Prague Stock Exchange, not physically anyway. It’s just a bunch of computer servers sitting in a backroom that match trades all day. O.K., I get that. But how is it that the Czech Republic has stocks to trade in the first place? One day the government owns every business, bloated with beer-breath bureaucrats, and bleeding money if they ever bothered to check. And then one day, boom, the Berlin Wall falls, Prague is wrapped in Velvet, and the next, you have capitalism? Tricky transition.
To pull this off in the Czech Republic, as well as in other former Soviet satellite states, authorities handed out vouchers, chits really — an equal number to each citizen — that could be traded in auctions for shares of companies, including banks, oil refineries, phone service providers, electric utilities, auto manufacturers and others. Or you could just sell the chits to someone else, which plenty of people did around Christmas time.
From Prague, a high-speed data line to the Frankfurt Stock Exchange was set up, and foreign money slowly came in to buy shares of Czech companies. It took a few years, but as trading increased, the value of each company was set by its profits and prospects for growth, and the market eventually transferred ownership from Party to proletariat, from all to y’all. My host smiled and said, “Then with magic, companies start make money, they cut — how you say — fat?” he grabbed his belly, “and stock go up and they get more money to grow.” How cool. It was like being present at the creation.
Strip away all the glitz of Wall Street — CNBC’s daily “well, Maria, the market’s up because there were more buyers than sellers”— and you get Prague, so simple that it can be boiled down to three thoughts, mega-maxims that I’ve subsequently written on my forehead (backwards so I can read them in a mirror) with an indelible conceptual Sharpie. I use them every day. Cancel those night classes – here’s two years of B-school in a nutshell:
- Profits lead to increased living standards.
- Money sloshes around the globe seeking its highest risk-adjusted returns.
- The stock market allocates precious capital to companies it thinks can maximize profits and starves those that it thinks can’t.
In other words, the stock market is democracy’s half-evil, half-angelic henchman, whose tool is more carrot than stick. The tenets of capitalism’s dead economists — from Adam Smith’s “invisible hand” to Joseph Schumpeter’s “creative destruction” and Gordon Gekko’s “greed is good” — are powerful concepts. But it’s the stock market that makes them a reality and carries out the dirty work. No five-year plans. No individual or bureaucrat controls the economy. Instead, over time, the collective not-so-invisible hands of investors end up funding the companies with the best prospects and destroying those that aren’t worthy. Just by driving stock prices up and down.
Greed is a deadly sin for good reason, but why are profits always linked with greed? Consumer outrage against profits is legendary — windfall oil profits, overpriced drugs, ESPN on premium cable. I’m the first one to get annoyed when I get charged $5 for a Coke at the ballpark, knowing that what I am holding in my hand is 10 cents worth of syrup and sugar mixed with water and ice. The esteemed economist Navin Johnson best sums it up in the economic primer “The Jerk,” starring Steve Martin:
Navin: Frosty, I’m no good at this.
Frosty: Aw come on Navin, you’re doing fine.
Navin: I’ve already given away eight pencils, two hula dolls and an ashtray, and I’ve only taken in 15 dollars.
Frosty: Navin, you have taken in 15 dollars and given away 50 cents worth of crap, which gives us a net profit of 15 dollars and 50 cents.
Navin: Ah! It’s a profit deal!
Despite its negative place in our culture — thanks Ebenezer — 99 and 44/100ths percent of the time, profits aren’t motivated by greed. Gordon Gekko was just a trader with a bad ’80s hairdo; ignore him and his clones in today’s private equity business. Profit not only tells you if a project is worth doing, the profit motive has been a giant carrot for centuries and is what drives innovation and productivity and, yup, increases standards of living.
James Watt, a University of Glasgow flunky, studied latent heat and tinkered for years until he came up with a more efficient steam engine, selling off two-thirds of his future invention to venture capitalist Matthew Boulton in exchange for capital to fund his work. The whole thing was set up to make money. And make money it did. Watt’s steam engine was originally built to pump water out of flooded mines, replacing the horses that would walk around in circles running a manual pump. Boulton and Watt charged one-third of the annual costs of the horses. A few horses were out of a job, and a lot more miners were hired.
Decent biz, but Boulton and Watt plowed their profits back into scores of innovations, and their steam engine ended up powering jennies and yarn pullers and looms, displacing entire villages of cottage workers, who later were employed in the very factories that eliminated their jobs. Say what you will about industrialization and soot and Mary Poppins chimney sweeps, men’s life expectancy in England jumped from 35 to over 55 from 1800 to 1900, and kept rising to its level of 80 years today. Wealth from industrialization led to better food, better medicine, better science. Yes, it also led to bizarre Victorian morals and robber barons and all the ugly mutations of concentrated wealth, but for my dollar, it beats waking up at 5 a.m. and milking the chickens.
Think of a world in which we all do each other’s laundry. We all get paid, but no wealth is created. Until you get the bright idea of hooking up an oxen to a wheel and invent the agitation cycle. Woo-hoo. All of a sudden you own the laundry concession. Someone else owns farming or omelette-making, etc. More work is done with fewer people. The economy grows and people, no longer washing clothes all day, see their standard of living rise. Wealth is created. Economists like big words like productivity (output per worker hour), but you get the idea – if there are no profits, there is no wealth, no cancer drugs, no microbreweries, no progress. Really.
Productivity creates wealth. Consumers are willing to pay more than cost for a product or service because it has value and would probably be more expensive to make or do themselves. Searches via Google are more productive than wrestling with Mr. Dewey’s decimal system at the library. Except for the profits of government-mandated monopolies — you know, phone, cable, electric, cellular, Congress — most profits are driven by some form of productivity. Finding the next wave of these profits is the giant pain in the assets of investing.
But this is not just about ledgers and hedgers – economics drive policy. Democracies have embraced profits for a reason. Totalitarian systems rarely recognize individual ownership of property, so the only way to increase wealth is to steal it from someone else, invade your neighbor, roll tanks (into Prague as it turned out, or Poland, Nanking or Kuwait). The thinking that “the pie isn’t growing, just get a bigger slice” in the end loses out to productive economies that increase the size of the whole cherry pie.
Profits really do increase our collective standard of living, not just that of the fat cats who make the profits. But hey, what about the stock market’s role? Or those other two mega-maxims on my forehead – something about sloshing and starvation? Oh yeah . . . I’ll get to those in my next post.
Link to Andy Kessler's Website
