To: Website fans
From: Jude Wanniski
Re: Financing the Voyage to "India"
Most of you know I have the highest regard for Professor Reuven Brenner, who was Robert Mundell's personal choice to occupy the Petty Chair of Management at McGill University in Montreal. What I'm sending here is the equivalent of Mozart dashing off a piano sonata after lunch. It was simply a Reuven posting on the www.metamarkets.com website of Don Luskin, a Polyconomics client, who himself is pushing the frontiers of the Internet. If you take the trouble to read this, you will know a lot more about the boom in the Internet stocks -- and what could slow it down. Reuven actually has taken the trouble to learn how Columbus managed to finance his voyage to "India" in 1492, which produces striking similarities to the New World now opening up to us.
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Reuven Brenner, January 25, at http://www.metamarkets.com
Warren Buffet said that "On the final exam [for a business valuation course], I'd probably take an Internet company, and [ask], "How much it is worth?" And anybody that gave me an answer, I'd flunk " In spite of such warnings, this piece gives an answer, which also puts both financial valuation and implications for monetary policy in a broad context.
How Do You Finance Companies with High Fixed Costs?
One feature of many industries is that one must incur relatively high fixed costs before being able to come up with a commercially viable product or service. However, once one experiment turns out to be a commercial success, the marginal cost of supplying the product or service is negligible. This is a feature of some Internet companies, as well as phone and drug businesses too, and, in the past, was a feature of the airline and hotel businesses. Once a seat or room is available, one can rent them at low price to cover for the cost of the temporary use. But such low price cannot be charged for all rooms and seats all the time, since it does not cover the fixed costs.
So how does one finance companies with high fixed costs? To illustrate one option let us go back in time and see how Columbus financed his expedition to the Indies, as a result of which he stumbled on the Americas. While Columbus built the ships for his expeditions -- the fixed costs necessary to launch the enterprise -- only very vague estimates could be made about their potential value. The reason is that at this stage:
- Nobody knew if Columbus would manage the crossing (recall, he and investors expected to arrive to India);
- Nobody knew how many ships would arrive;
- Nobody knew what would be the cargo carried eventually on the ships: Gold? Spices? Textile?
- Nobody knew how long would the trip last? What about storms, fogs, rogue waves?
Looked upon from the investors' point of view, if there were shares in the company building the ships, they would fluctuate wildly with every rumor, about the joining and departure of captains and potential captains and crew in particular. Dangerous business.
Who will pay for the fixed costs of building the ships? Who paid for Columbus' expeditions? In his case it was Isabella, Queen of Spain. Yet, in spite of initial enthusiasm, she and her husband, Ferdinand, vacillated -- until competition for financing Columbus appeared on the horizon. Columbus first tried to raise money from King John II of Portugal. Though at first taken with Columbus enthusiasm -- good promoters have always been a necessity in this business -- at the end he gave him a small credit only because he found Columbus to be a "big talker," boastful and too full "of fancy and imagination." Columbus and his brother Bartholomew then spent seven years raising money for their Enterprise of the Indies. Henry VII of England was not interested. Charles VIII of France was not interested initially either, though he changed his mind. It was this change of mind of her rival that led Isabella to then decide to finance Columbus' expedition -- which did not come cheap. Though in his first voyage he used three small caravels, in the second he already had an armada of 17 vessels and 1,200 men (no women).
Briefly: kings and queens picked up the bill for the fixed costs, induced by both the entrepreneur's enthusiasm, expectations of vague riches and -- most important -- when potential competition for financing appeared on the horizon. That was the straw that led Isabella to her bet.
Today's economic theories, concerning financing of enterprises where large fixed costs must be borne first, are still rationalizations of this ancient form of financing. The so-called Hotelling-Lerner solution calls for large fixed costs to be financed through taxation. But Ronald Coase (Nobel Prize winner in economics), in his Marginal Cost Controversy back in 1946, finished the article with these questions: "Are these costs to be borne out of taxation? Or should they be borne by consumers? If the analysis in this article is accepted, these would seem to be the next questions to be examined."
Economists have not picked up these questions since, most continuing with their models of praising marginal cost pricing, and failing to integrate either financial markets or broader issues into their analyses, accepting that taxes, taxes and more taxes are the solution. But let us go back to Coase's questions: How can industries which requires large fixed costs be financed? What are the alternative to taxes?
One solution, as Coase pointed out more than 50 years ago, is to charge different customers different prices -- something that is done on the Net, and done in the past in the airline and hotel business. Those putting higher value on accessing information pay more for it, and obtain stock information, for example, 20 minutes before those who want the pricing information for free.
Is there another alternative? There is. Financial markets can finance voluntarily part of the fixed costs (and, as the enterprise comes into better focus, the aforementioned multi-part system of pricing can do the rest). How does that happen?
The answer is "irrational exuberance."
Evangelical entrepreneurs appear -- be they Columbus and his brother, or in our times the "Steve Jobs's and Jeff Bezos's" ("evangelical entrepreneurs" are the missing elements from economic and financial analyses). They, together with the financial press, analysts and participants in information markets surrounding financial markets, succeed to drive people into frenzy, and provoke competition to finance their ventures. They do so in part by appealing to the same strategy that Columbus pursued in the 15th century: evangelical drive and a skill to use "information" markets to create competition for funds.
"Frenzy" -- or Alan Greenspan's "irrational exuberance" -- allows the entrepreneurs to get access to cheaper financing, necessary to pay for the fixed costs. However, there is a fundamental difference between Mr. Greenspan's and much of the financial press' skeptical approach toward such exuberance and the one outlined here. Mr. Greenspan and the press view the resulting "overvaluation" of stocks as dangerous. The perspective presented above -- looking at ways in which societies finance a new venture, where large fixed costs must first be incurred before there is any cargo in sight -- views it as the private solution for financing large fixed costs. It allows enterprises to raise money voluntarily through financial markets instead of having to rely on taxation, be it by kings or democratically elected governments. True, stock prices in the particular sector will eventually fall. While it lasts, the cheaper access to credit allows entrepreneurs to experiment.
Indeed, Wall Street is the new king on the block -- though a far more democratic one than the titled ones of the past. In the past, kings committed follies, without allowing capital markets to be democratized. Today, financial markets are democratized -- and so are follies. But these "follies" finance fixed costs voluntarily. If such "follies" are outlawed or someone pours cold water on them then, if a society giving voice through "public opinion" still wants to make this investment, these same costs would be financed either through taxation, or complex price schemes. However, if competition bureaus are suspicious of the latter, then raising money through taxes is the only solution. Yet the burden of taxation on a society is always bigger than the burden of losses borne by volunteers in financial markets. Let your people be exuberant: It is a temporary stage. And while it lasts, it brings about great public benefit.
Monetary Policy and Financial Markets
Once the nature of the cargo to be carried becomes clearer, frenzy disappears and more solid evaluation are done. However, the process described above refers to a situation where people have no idea either of the cargo to be carried, or how long the trip lasts. As a result, the value of the ship is pure speculation. This is the stage at which most Internet companies are today. Money is spent on fixed costs and experiments, 90 percent of which may not lead to a commercial successful venture. This is the stage to which the vague "human capital arbitrage" calculation, summarized next, would apply.
Before showing how that approximate calculation is made, let consider implications of these arguments for monetary policy, since Mr. Greenspan and the financial press have focused so much of his attention to the possible link between stock prices and his policies. As long as financial markets pour money into the fixed costs of building ships or infrastructure, which nobody knows just when and how their use may lead to a commercial success, the Federal Reserve Chairman looking at "productivity" figures would find very little increase, if any. On the contrary, he could even measure decline. For, resources are allocated to building ships. Yet the enterprise does not bring in any revenue. Only costs. Revenues will start rising only once the ships sail and carry cargo. If properly measured, the flow of capital toward building ships should be neither inflationary nor deflationary, that is, should have no effect on price levels.
How much money will flow to shipbuilding? The answer depends on people's expectations. If they expect that the ventures will be eventually very profitable, people will forgo present consumption, display patience, and invest more in the ventures. People spend less on consumption, and save more. With open capital markets, this means that the increased savings is global, not necessarily in the country where the ships are built. Savings flow toward captains and crew, as well as equipment necessary to build the ships. These employees and builders of "human capital" in the process, forego incomes, and are ready to accept options in the enterprise as part of their compensation.
What happens if suddenly expectations change, and people now believe that sailing is a waste, that there is no continent behind the horizon, and building the ships was a big mistake? Or, what would happen today if suddenly people thought that the Internet is not such a revolutionary technology as claimed, and they cannot see too many opportunities for commercial successes? Money would stop flowing to the new industries, the stocks in these companies would crash, and less wealth would be expected to be created. This happens because people now realize that much effort and capital were wasted, and must be written off (the changed expectations bring about instant depreciation of the ships).
With this change, the crew and captain are returning to the "traditional" sectors. Since they are now asking for wages rather than options, measured salaries may go up. Since there is no reason for people to display the same increased patience as before and save more expecting riches from the sailing ventures, and unless monetary policy is tightened, there will be inflationary pressures.
If this is a central banker's perception of the sequence of events, and if the economy is not adhering to a monetary standard (say, gold), he will then absorb what he perceives to be the unwanted liquidity, leading to a temporary increase in interest rates. The problem with the scenario above is that from the aggregate numbers that either Mr. Greenspan or any central banker, would be looking at today -- price indices, wage indices, productivity levels etc. -- they cannot infer if what is unfolding in the economy is indeed the aforementioned sequence of events.
It is possible that Mr. Greenspan reads the data, sees no increase in productivity, and tightens monetary policy. If this happens to be the case, then, by his own actions, he is turning misperception based on macro-economic fads into reality. For, by tightening, he brings about the drop in the stock price, which then brings about less investment in shipbuilding. He diminishes the "frenzy" which is necessary to sustain financing fixed costs of a new industry, and through this action, slows down entrepreneurial ventures. The government then steps into the void. It's art, not science, to manage monetary policy today between sustaining the right amount of frenzy and preventing inflation when the frenzy diminishes.
Let us turn now from these broader observations to narrower ones, concerning valuations of pioneering enterprises, with large fixed costs.
How to Value New Companies Through Human Capital Arbitrage
How can one put a value on companies at the first stage, when they incur fixed costs, but there is no clear idea what will this enterprise actually sell or when? To make any valuation of any business, one needs a benchmark. Presently all Internet calculations, take an arbitrary company's valuation as benchmark and compare all evaluation relatively to that. This is circular and arbitrary.
There is only one way to put a number on enterprises at the stage when fixed costs are incurred but nobody quite knows what will make the venture a commercial success. These businesses draw on "intellectual capital." Say that one knew what was the respective entrepreneur's or executive's compensation at an established, traditional company. He now jumps ship to a dot.com, where he is offered a compensation based on lower salary, but also stock options. He accepts. If one has sufficient observations, a calculation based on Órbitrage of "human capital" allows one to find the expected value of the option, and thus of the expected stock price. True, this calculation has flaws.
Recall, in light of the aforementioned discussion on how people can -- and should be -- driven into a frenzy, people may overestimate the chances of this enterprise to succeed. It is also possible that some people are already comfortable enough, and are just looking for an adventure. In this case the calculation would not lead to a meaningful figure.
Nevertheless, when human capital is the only asset backing some ventures, calculation based on human capital arbitrage is the only game in town.