Book Notes

Wall Street: How it Works and for Whom
By Doug Henwood
New York: Verso, 1997
372 pp.; $25.00

Money and financial markets matter. That is one of the central arguments of Doug Henwood's Wall Street, and the financial crisis now collapsing the economies of East Asia and dramatically altering the fortunes of more than 300 million people in Indonesia, Thailand, South Korea, Malaysia and the Philippines provides conclusive proof of the argument's validity. But while they matter enormously, Henwood charges, financial markets hardly deliver on their basic promise: allocating capital to socially desirable investments by searching for the most profitable outlets.

A simple fact illustrates the basic point: money poured into the stock market does not go into corporate investments in plant and machinery, except (sometimes) in the occasional new stock offering. Once GM has sold a share of stock, every subsequent swap involves only the transfer of money between stock buyer and seller -- the buyer is not giving any new money to GM to invest in new fuel efficiency technology, or anything else.

From 1952 to 1995, Henwood shows, nearly 90 percent of corporate investment was financed from internal assets -- and the stock market contributed a relatively small share of the financing of the remaining 10 percent. Those companies that need more outside financing -- primarily small and new businesses -- are generally unable to tap into the stock market, and must resort to banks instead.

"In sum," he writes, "big corporations, the ones with easy access to the public (non-bank) capital markets, have more money than they know what to do with; small ones, who invest most of what they earn, don't find a generous reception in the capital markets."

This is a simple insight, but one of extreme importance. It underlies Henwood's persuasive contention that financial markets do not contribute to social well-being.

That thesis is buttressed by a second contention: financial markets do not do a very good job of what they are most celebrated for accomplishing -- assigning proper value to corporate assets.

While financial theory (and Wall Street PR) is governed by variants of the "efficient market hypothesis" -- which holds that financial markets rationally and nearly instantaneously incorporate all available information into stock or currency prices, Henwood paints a much uglier picture. The markets are dominated by young kid traders playing with computers who tend to do what everyone else is doing. They make the same mistakes people make in psychological experiments on predictions: they tend to be overconfident, to extrapolate the past into the future and to give too much weight to new information.

If there are any "rational" people who fail to succumb to these human infirmities, it doesn't much matter, because they still must try to anticipate what the other "irrational" people who affect the market are going to do.

On these matters, Henwood stands with John Maynard Keynes, who "argued that asset prices are powered by wild swings of temperament, the volatile judgments of an ignorant herd, and [that] these noisy signals guide real investment." He approving quotes Keynes' comment that the game is one of "the third degree where we devote our own intelligences to anticipating what average opinion expects the average opinion to be."

Unfortunately, there are serious consequences to market biases and incompetence. "The stock market isn't just about prices," Henwood writes, "it's about the control of whole corporations, which are bought and sold, combined and liquidated, often on purely financial considerations through the mechanisms of the stock exchange. So the judgments of an ignorant, greedy and excitable mob do have considerable real world effects."

The financial markets demand short-term returns, which puts pressure on corporate executives to slash costs -- and often jobs -- even at the expense of long-term corporate health. Mergers and acquisitions which cannot be justified in productive terms but yield immediate financial advantage to some section of the market are encouraged. And long-term investment is discouraged.

All of these problems have worsened in the last two decades, as the world of finance has gained increasing influence and power over corporate management. For Henwood, empowered shareholders are a bad thing -- they encourage all the worst tendencies of unfettered capitalism -- so he bemoans the growing assertiveness of institutional investors in recent years.

Henwood makes these arguments in a book often written in scathing and sarcastic tone. While the argument is seamless, the book is effectively divided into two parts: a discussion of how Wall Street works (at least in the domestic economy); and a review of theoretical literature that purports to explain Wall Street behavior and the role of finance. The first section should be of extraordinary value to those who want to gain insight into the "black box" of Wall Street activity. Parts of the second section, at least, may be overly theoretical for readers without some prior familiarity with the works discussed.

Wall Street concludes with a short "what should (not) be done" chapter that Henwood acknowledges is little more than an outline. But in a few pages he shreds the idea of social security privatization with plain common sense, mocks the pretensions of the socially responsible investment movement and even puts a damper on populist attacks on the Federal Reserve (which he supports but argues cannot ultimately succeed without a broader effort to restrain the power of financial capital).

As affirmative calls, he urges capital controls, taxing wealth and imposition of a financial transactions tax -- not on the political agenda of the moment, for sure, but well worth placing there.

-- Robert Weissman