Created: 2000-03-04
Last Modified: 2000-03-04
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Discussion of the Role of Private Equity Capital

J. Bradford DeLong

March 2000

Over the past century and a half the pendulum has swung back and forth between two different systems of equity finance, call them the Anglo-American decentralized market-based system and the Germano-Japanese centralized bank-based system.

The Anglo-American system has many advantages: that risk is spread because equity ownership is widespread and diffuse; that information is public because it is largely revealed through prices in relatively thick high-volume financial markets; that corporate results reported according to accounting standards are important channels of information transmission. But the Anglo-American system also has the disadvantage that monitoring and controlling firm managers often falls between the cracks.

The Germano-Japanese system--what Bo Cutter calls "bank capitalism"--has the advantage that monitoring and controlling firm managers is very definitely the business of the unified institutions that hold and issue equity and have long-term close relationships with operating firms. The Germano-Japanese system has the disadvantage that information is harder to see and harder to learn: there is more of a difference between insiders and outsiders.

Now this opposition can be overstressed. There are powerful elements of both systems in all economies. But it is real. And over the past half century opinion has been excessively volatile, swinging back and forth from overemphasizing the advantages of one to overemphasizing the advantages of the other. Think of American attempts to restructure Japanese finance in the Anglo-American mode in the aftermath of World War II. Or think of Michael Jensen's claims that the leveraged buyouts of the 1980s would move the U.S. toward the Germano-Japanese system and be the wave of the future. Or think of the dour declarations two years ago that the Korean economy could not recover unless it dismantled its Germano-Japanese-style system of equity finance--so vulnerable to "crony capitalism" and replaced it with an Anglo-American style system.

Yet all these predictions have been awry. Japanese finance was not restructured, at least not fundamentally--yet the Japanese economy after World War II boomed. The LBO boom of the 1980s was a temporary phenomenon, not a sea-change to a new world. And the Korean economy is recovering very rapidly in spite of the failure of the Korean government to obay the ukases of the IMF.

At the moment the Anglo-American model is riding high. The reasons that it is riding high are in large part sound: the Germano-Japanese system is vulnerable to crony capitalism; that system is fundamentally unfair to "outsiders"--and hence has a hard time raising funds that are not channeled through the gatekeeping institutions of finance capitalism.

But I am not as sure as Bo Cutter is that the worldwide integration of equity markets is leading to a wave that inherently strengthens the market-based, decentralized wing of equity finance. For the Anglo-American system has vulnerabilities too.

We know what those vulnerabilities are. The NASDAQ 100's P-E ratio is 100. The S&P 500's P-E is 31. Some people say that these high price earnings ratios exist because investors have recognized that stocks are no riskier than bonds, and hence have bid up stock prices until the expected real rate of return on stocks is the 3 percent or so expected on bonds. These people are wrong: investors are holding stocks because they expect the future to be like the past--expect the next year at least to deliver the double-digit real equity returns seen in every year over the past decade.

I believe that either the NASDAQ portfolio holders are realistic--and that the new companies will take immense market share and profits away from old companies over the next two decades--or the S&P portfolio holders are realistic--and that old companies will successfully surf the technology wave. And I believe that both cannot be right: some large component of the global stock market today is way overvalued.

So I predict that a decade from now there will be someone sitting here who will talk about the benefits of patient capital, the advantages of relationship equity, the unproductive distortions introduced into the world economy by the froth on the wave of overoptimistic equity investment at the turn of the millennium, and our renewed appreciation of the virtues of the Germano-Japanese system whereby the corporate decisions that are made are those that boost informed investors' and analysts' views of the fundamentals of the business rather than those that boost tomorrow's stock price.

And then, of course, the pendulum will swing yet again...

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Professor of Economics J. Bradford DeLong, 601 Evans Hall, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax

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