Hyper Valuation and Wealth Extraction – A Major Pitfall of Modern-Day Capitalism

It is absurd to try and be semantically exact when discussing matters relating to economic systems such as capitalism. A major reason for this absurdity is due to economic systems being socially constructed phenomena littered with convoluted terminology that defy easy explanation. One cannot simply provide an ostensive definition of value or capitalism so any discussion about them will always suffer from a degree of dispute. This piece, therefore, cannot pretend to be an all-encompassing account. It will, however, attempt to give some tangible notion to the reader about these two important ideas, especially value, for a functional purpose. This prerequisite is necessary to help elucidate a major pitfall that currently undermines the health of modern-day capitalism. This pitfall is hyper valuation and wealth extraction.

Capitalism is an economic system that focuses on the production of goods and services for consumption. There are many variations of the ideal capitalist system. For instance, laissez-faire capitalism wants little to no regulatory or governmental oversight where private individuals freely produce and consume goods and services. At the other end of the spectrum, you have state run capitalism, where the nation state manages and organises the production of goods and services for consumption. Irrespective of these variations in capitalism itself, the production of goods and services occurs due to two fundamental reasons. The first is that they have value for people consuming so there is demand. The second, is the producer can extract surplus value by providing the good or service with labour and capital (machinery, buildings, land etc.) to the consumer at a value which is higher than the cost of production meaning there is impetus to supply. To capture this value for the producer a mechanism of value exchange was needed. This mechanism is of course monetary exchange. Historically, money was primarily represented with coinage. These coins were principally made of gold or silver or a mix of these two metals called electrum. Nowadays value, although captured by various markers of its worth, is still represented and exchanged with denoted banknotes and coinage.

How is this value denoted by money determined?  

Historically, there was an awareness of value emanating from consumption and production. This is initially seen with the mercantilist logic that pervaded the world since the time of Aristotle (384 BC-322 BC). Mercantilism places emphasis on selling more to others than buying (obtaining a trade surplus by producing more than consuming) to accumulate monetary wealth. This logic is summarised well by the former director of the East India Company Sir Thomas Mun (1571-1641) when he states, “sell more to strangers than we consume of theirs in value”.[1]  What is clear with mercantilism is that there is value in both the production and consumption of goods and services. It is, however, better to sell more than you buy to have a value surplus. This is the heart of mercantilist value thought. Where this value came from though, at this stage, was under theorised right up until the rise of the physiocrats. The first attempt to find a formal theory of economic value came from François Quesnay (1694-1774) in his seminal work Tableau économique which provided the foundation of economic physiocracy. Quesnay argued that land was the source of all value.[2] His basis for this idea was that nature itself produced the new things that have value; “grain out of small seeds for food, trees out of saplings, and mineral ores from the earth from which houses and ships and machinery were built”.[3] Effectively, this theory linked the determination of value to nature, the primary source of capital needed for production.

As industry developed rapidly in the eighteenth and nineteenth centuries so did formal economic value theories. The most famous proponents of these new theories came from Adam Smith (1723-90), David Ricardo (1772-1823), and Karl Marx (1818-83). Each of these writer’s contribution to value theory deserves consideration. However, for functional reasons, I am only going to outline the theory of value proposed by Smith in his masterful economic tome The Wealth of Nations. In this work, Smith derives value from adding up the costs of production. He starts by noting that labour would make up the entire cost of production in an early society hunt as there is no private ownership of land and the capital required isn’t complex; “If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for, or be worth two deer”.[4] He goes on to note that this measure of value is insufficient for the more complex production processes and property ownership patterns of capitalism. In addition to the labour input of value, you also have the potential profit opportunity for the producer; “in the price of commodities, therefore, the profits of stock [capital] constitute a component part altogether different from the wages of labour”.[5]  What Smith painstakingly and convincingly conveys to the reader is that the worker is paid by the hour of labour while the capitalist is paid by the amount of capital and the length of time that the capital is engaged in that production process. In addition to these two inputs of value, there is also a third potential input opportunity for wealth extraction via renting capital to the production process. An example Smith presents is land, “As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed.”[6] The real value then, of any good or service, will be the sum of the labour and capital cost, the profit derived by the producer from exchange, and potentially also the value extracted by renting capital to be used in production.

At this point, the reader should notice that the above theories of value from Quesnay and Smith focus on the production side of capitalism to try and provide a rational basis for where exactly the value of money is derived. The physiocrats like Quesnay saw the source of value in nature whereas the great economist Adam Smith saw it stemming from labour, capital, and in some cases rent (all three inputs on the production side). Although we do not have time to give an idea of the work of Ricardo and Marx here, it is worth noting that their great contributions to value theory were also squarely rooted in the production side. It was not until the advent of neo-classical economic theory that there was a renewed focus on the demand side of capitalism to explain the basis of value.

William Jevons (1835-1882), Carl Menger (1840-1921), and Leon Walras (1834-1910) all developed new theories of value that were rooted in the demand side of capitalism. A paradox discussed by Adam Smith about the difference in value between diamonds and water was a big driver of their neo-classical economic work. The paradox stems from the fact that while water overall is more useful for survival than diamonds, the latter is worth more than the former when exchanged. Smith provided a solution to this paradox by suggesting that the costs of production were higher to produce diamonds than to produce water, so the producer needs to charge a higher price to get profit. This was a large part of Smith’s contention that value was derived from the production side of goods and services. The above three neo-classical theorists all separately disagreed and argued instead that the demand side of capitalism was critically important in determining value. A major tool of their work was marginal utility analysis. Value for the neo-classical school is aligned with utility, an idea originally introduced within the theory of utilitarianism by philosophers Jeremy Bentham (1748-1832) and John Stuart Mill (1806-73). Utility is basically a gauge of pleasure or happiness. As Menger notes in his Principles of Economics, “utility is the capacity of a thing to serve for the satisfaction of human needs”.[7] In essence, people get happiness or pleasure through the marginal use of goods and services. The more happiness or pleasure they get the higher the overall utility of the goods and services. As diamonds are scarce and beautiful, people derive a lot of happiness and pleasure by consuming them. Diamonds therefore have high utility. As water is plentiful when needed to satiate thirst, once that thirst is quenched, its marginal utility declines rapidly for the consumer. Essentially, for these theorists, value is linked to utility derived from consumption. Producers only produce to satiate demand.

At this juncture, we can see the history of formalised value theory initially tried to explain where money gets its value in the production side of a capitalist system whereas over time the theory shifted towards the demand side to find an explanation. Modern value theory looks to find a basis for the value of money in both sides of this capitalist equation. The most famous proponent of this harmonised value theory is arguably Alfred Marshall (1842-1924). The impact of time was crucial for Marshall in understanding the source of value. His assessment is divided into four time periods. First, the market period where time is so short supply is fixed, as there is no time to increase labour or capital output. Second, the short-run period where time is in enough supply that firms can change their production somewhat but cannot vary long term capital requirements like their office building. Third, the long-run period where value is determined by both supply and demand. Finally, the secular period where technological advancement and population demographics influence the supply. For Marshall, a proper comprehension of the influence of time and the interdependence of production and consumption variables would resolve the controversy over whether it was the cost of production or utility which determines the value of goods and services. It took hundreds of years for formal economic theory to provide a theoretical basis of value rooted in the demand and supply of goods and services even though it was intuitively understood far earlier by mercantilists.

To reiterate, it is impossible to do justice to these ideas about value in an essay like this. As noted earlier, you cannot provide an ostensive definition of capitalism or value. An overview and explanation of historical value theory is necessary, however, to show the reader that the value of money has been historically rooted in the consumption and production of actual goods and services that are demanded and supplied in the real economy.

How does hyper valuation and wealth extraction occur within such a system?

Surely, if goods and services are highly valued by consumers there is a rational reason for this, like the economics profession is often at pains to tell us. The production side will also be able to meet this rational demand and the net consequence will be capitalist economic growth that benefits all. This is the ideal capitalist scenario that many of us are familiar with. Sadly, this ideal theory is not largely applicable to our modern economic reality. Instead, hyper valuation and wealth extraction is rife within the capitalist system and it is a major pitfall to the system’s long-term viability. It is now time to explain to you why this is the case. Our starting point is banks and financial markets, and their relationship with capitalism.

Financial markets, along with banks, were originally justified to help producers and consumers match up more efficiently in the real capitalist economy. The logic for wanting better connections between producers and consumers was to stimulate economic growth (more production and consumption of goods and services) by directing surplus money (deposits) into the production of goods and services that are in higher demand within society than the suppliers can match with their own current enterprise. The original aim was to establish optimal market equilibriums between the supply and demand of goods and services through the utilisation of deposits. Banks and financial markets, although not generating value themselves, were justified because they helped more value generation in the real economy by enabling more production and consumption with value redistributive services. This is key to note. As the world became more globalised in the late 20th century, there was also a greater need to help businesses deal with more value related future volatility, as there were more businesses with higher stores of accumulated profit with financial activity in numerous geographic locations. The most pertinent of these volatilities were foreign exchange rate risk, interest rate risk, and inflation rate risk. Banks and financial institutions again stepped forward to help the real economy by first designing financial instruments, effectively complicated insurance and speculation products, and secondly, by allowing these financial instruments to be exchanged in financial markets. The logic was that banks and financial institutions could charge a premium to businesses to assume these risks and then repackage this risk into insurance and speculative products like derivatives, which they could then sell in the financial market space. Effectively, the justificatory logic was that the risk faced by individual businesses in the real economy could be assumed by banks first and then sold into financial markets. This risk mitigation, in theory, would help businesses focus on their production leading to more economic growth and prosperity.

These specific banking and financial services, however, failed dramatically with the financial crash in 2008. There have been many explanations provided to account for the causes of this crash. I cannot, once again, do justification here. There are though, three important and clearly identifiable contributory causes rooted in what we have discussed above. The first is that loans (debt) principally created the value that fuelled more production and consumption in the real economy as opposed to deposits (credit). It was not until after the crash that “the Bank of England admitted that loans create deposits and not vice versa”.[8] Surplus cash was not being principally redirected to productive uses but rather loans were created to be put to productive use. The second is that the logic behind the risk mitigating protection offered by products like derivatives was majorly flawed. As Mazzucato notes, “derivatives capacity to transfer and defray risk really only exists at the individual level. At the aggregate level, the individual risk is merely transferred to other intermediaries in the form of counterparty risk”.[9] Essentially, the risk isn’t negated with derivatives but merely moved elsewhere. The risk should only be assumed by entities with the sufficient liquidity (available money) and capital buffers to survive that risk becoming material. The third is that too many banks, financial institutions, and private individuals assumed too much risk way beyond the requisite buffers they would need to swallow the prospective risk if it ever materialised. We are all familiar with the story of people getting mortgages for houses they could not afford if their source of credit dried up. Effectively, these people consumed more than they should have by taking on too much debt. Most people are less aware that the same logic was also applicable to numerous large economic actors in the financial market space as well. For example, AIG required a bailout of $85 billion in 2008 because it assumed too much debt it could not pay in the event of materialised risk.[10] This debt was largely assumed through the over selling of a derivative product called a credit default swap (CDS). A seller of a CDS will compensate the buyer in the event of a particular debt default. AIG had credit default swaps worth over $500 billion prior to getting this bailout.[11] $78 billion of these CDS instruments were on multi-sector collateralized debt obligations (CDO), a security largely “backed by debt payments from residential and commercial mortgages”.[12] When mortgages went unpaid, AIG simply did not have the money to pay out on the CDS instruments they had sold.  They could not honour their debt commitments like mortgage holders. The story is the same. The flaw in the system was overconsumption fuelled by taking on excessively risky debts. The consumption and growth in the run up to the crash came primarily from the riskier stimulation of debt not the more stable stimulation of credit.

From 2008 until present, the banking and financial sector has been subject to a whole host of new regulatory requirements which are helping to minimise the risk associated with derivatives and debt fuelled lending. There have been genuine improvements made with EMIR and MiFID regulations, and the Basel III accords. Sadly, the excessive risk taking has not stopped. It has merely moved to the shadow banking sector. Shadow banks are “diverse financial intermediaries that carry out bank-like activities but are not regulated as banks”.[13] Many of these intermediaries do not exist to fuel production by redirecting surplus credit (deposits) or mitigating risk for a fee but instead to make “money from moving existing money around”.[14] Their principal aim is to help engineer and extract value from incorrect valuations that arise from the continuous churning of valuations within market spaces.  Essentially, they want to engineer or find hyper valuation, either hyper over valuation or hyper under valuation, so they can profit by undercutting the perceived over valuation or profit by pumping the perceived under valuation. This value is not coming from the consumption or production of goods and services which is where historically economists, as we noted above, have rightly attempted to base the source of value. Instead, it comes from the incorrect hyper valuation of financial instruments. This is problematic especially when there is information and power asymmetries in the market space among participants. There are many sharks (large hedge funds etc.) devouring small fish (private investors) with their power (greater money and risk tolerance) and superior market knowledge and information.

There are many examples of this type of hyper valuation and wealth extraction in action in the market space. Most cryptocurrencies and their exchanges are prime examples. Bitcoin was worth $952.46 a share in December 2016. Four years later, the share value of Bitcoin was worth $27,768.84 a share. This increase in value came entirely from the demand and supply of Bitcoin itself. Its main use value for consumers is its expected future value. It has not been widely accepted in numerous jurisdictions as a means of exchange and there is also a multiplicity of similar cryptocurrencies that offer the same service. Those making money on it, are making money because other people are willing to purchase it at a higher price then they did. There is nothing profitable about Bitcoin otherwise. It is a zero-sum game. For every winner (wealth extractor) there is a loser (wealth enabler). This is the same perverse logic that creates value in a Ponzi scheme. It is not just cryptocurrencies that suffer from this hyper valuation. Share prices in businesses are also often far removed from reality. Tesla’s share price at the end of 2019 was $86.08 a share. At the end of 2020, the share price was $705.67 a share. Tesla made a loss of $862 million in 2019. It made its first ever annual profit in 2020.[15]  As Forbes note, “Tesla trades at about 15 times its projected 2021 revenue and about 175 times its projected earnings”.[16] A company’s share price should be driven by its current and future estimated production of goods and services to meet levels of consumption (current and future estimated profit). This is clearly not the case with Tesla. A company, that made its first ever profit in 2020, should not be estimated to be worth more than the next nine most valuable car manufacturers combined.[17] People have made money from their Tesla shares because others were willing to buy them at a higher price. They have not made money from Tesla’s profit derived from production. It is another prime example of hyper valuation and wealth extraction. As Shaxson reminds us in his excellent book The Finance Curse: How Global Finance is Making Us All Poorer, there is always someone “exerting power in markets – usually in order to extract supersized profits”.[18] The sharks have been feasting and getting fat. The small fish are merely getting eaten.

There are countless other examples of this sort of hyper valuation and wealth extraction in financial markets in recent years. This is sadly, however, not the only source of this pernicious problem. The other major way it occurs is through share buy-backs which “are a way of transferring money from a corporation to its shareholders”.[19] They are a way of paying out dividends where a company buys some of its own shares from existing shareholders. This automatically “boosts earning per share” as the share price increases from being bought.[20] In 2014, William Lazonick examined 449 companies listed in the S&P 500 index and “found that between 2003 and 2012 share buybacks constituted 54 per cent of their collective earnings”.[21] These earnings stem from a business inflating their share price through buying back their own shares. This value increase has nothing to do with the underlying profitability of the business. It stems from the business pumping up its own share value. Microsoft during this period had a net income of $148 billion. Its repurchasing during this period accounted for $114 billion.[22] It makes little sense that share buy-backs are allowed. If shares are undervalued, it is up to the market to decide based on actual business profitability and production not the business itself. Lots of upper end management have their renumerations tied to the performance of the company’s share price. The moral hazard is clearly there for misuse and sadly this has obviously occurred at an alarming pace over the last decade.

How does this impact you?

The processes of engineered hyper valuation by powerful economic actors and hyper valuation through share buy-backs have led to massive wealth extraction by a few of value that is not actually being produced in the real capitalist economy. This is largely contributing to the massive wealth inequality that is exploding upwards in the western world. As Thomas Piketty notes, if change continues at this pace “the upper decile will be raking in 60 percent of national income by 2030” in the USA.[23] The more recent prognoses is even more stark, as the House of Commons library suggests that “if trends seen since the 2008 financial crash were to continue, then the top 1% will hold 64% of the world’s wealth by 2030”.[24]  Shadow banking now accounts for half of financial assets in the world, having grown faster over the past decade than mainstream banks.[25] In the Republic of Ireland, the size of shadow banking was almost €5 trillion in 2019 according to the Financial Stability Board. This value is fourteen times the size of the actual Irish economy most of us operate within. As Shaxson notes, “this game isn’t just about the big players taking a bigger share of the pie; the pie has actually shrunk as workers have lost purchasing power and thus found themselves less able to buy goods, sapping demand” for productive output.[26]  Hyper valuation and wealth extraction is contributing to massive wealth inequality and is taking investment away from the productive economy. We must collectively be cognisant of this fact and do everything in our collective power to remedy this situation. There are solutions. We can tighten regulations in the shadow banking sector and tax this wealth extraction more heavily to make it less desirable. Tax breaks should also be given to actual productive businesses that create goods and services of actual real value to consumers. There needs to be a re-evaluation of what constitutes value. If enough of us demand this change hopefully there will be a will to produce it. We cannot allow this major pitfall to be fatal. We must enact change.

[1] Mun, Thomas, England’s Treasure by Forraign Trade, MacMillan (1865), pg. 7

[2] Mazzucato, Mariana, The Value of Everything Making and Taking in the Global Economy, Penguin (2018), pg. 29

[3] Ibid

[4] Smith, Adam, An Inquiry into the Nature and Causes of The Wealth of Nations, Metalibri (2007), pg. 41

[5] Ibid, pg. 42

[6] Ibid, pg. 43

[7] Menger, Carl, Principles of Economics, Ludwig van Mises Institute (1976), pg.119

[8] Mazzucato, 2018, pg. 116

[9] Ibid, pg. 126

[10] https://www.reuters.com/article/us-aig-bailout-trial-idUSKCN0HO02F20140929

[11] https://insight.kellogg.northwestern.edu/article/what-went-wrong-at-aig

[12] Ibid

[13] Mazzucato, 2018, pg. 135

[14] Ibid, pg. 135

[15] https://www.forbes.com/sites/alanohnsman/2021/01/27/tesla-notches-first-full-year-profit-aided-by-270-million-fourth-quarter-net-income/?sh=5998cfc022f6

[16] https://www.forbes.com/sites/greatspeculations/2020/12/21/will-highly-overvalued-tesla-stock-see-a-correction-after-sp-inclusion/?sh=578e376f725a

[17] https://www.cnbc.com/2020/12/14/tesla-valuation-more-than-nine-largest-carmakers-combined-why.html

[18] Shaxson, Nicholas, The Finance Curse: How Global Finance Is Making Us All Poorer, The Bodley Head (2018), pg. 82

[19] Mazzucato, 2018, pg. 163

[20] Ibid, pg. 163

[21] Mazzucato, 2018, pg. 164

[22] Ibid, pg. 163

[23] Piketty, Thomas, Capital in the Twenty-First Century, Harvard University Press (2013), pg. 294

[24] https://www.theguardian.com/business/2018/apr/07/global-inequality-tipping-point-2030

[25] https://www.irishtimes.com/business/financial-services/state-s-5tn-shadow-banking-world-will-be-in-the-spotlight-after-covid-19-1.4440755

[26]Shaxson, 2018, pg.90