In recent years there has been no subject with more tentacles into diverse economic phenomena than the large capital gains recorded over the last two decades in stocks, and more recently, housing. Capital gains have implications for consumption, savings and growth, associated implications for social insurance, and even international trade. (1)
The largest part of any explanation of large capital gains must certainly put at center stage the manic hypothesis, most humorously discussed over decades by John Kenneth Galbraith ( 1961;1994), and dissected most recently, in its psychological dimension by Robert Shiller (2005). Manic asset psychosis develops when, for whatever reason, an asset class acquires some tenable reason for earnings' gains, which in turn, motivate investors to jump in generating capital gains that persuade others--now the size of a herd--to follow. Losing sight of earnings, the herd, running madly in a deeply leveraged gallop inevitably run off the cliff, when for whatever reason bad news starts to spread or when some of the herd moves off in another direction. The New Economy hype of the 1990s, so adequately described by Shiller, and so nicely captured by Alan Greenspan's term, "irrational exuberance," exemplifies the manic situation completely. More recently, the rapid rise in housing prices to income and rents suggests at least the possibility of another manic psychology associated with still another bubbly asset class.
The manic hypothesis of capital gains involves feedback loops of demanding herds. It is a "demand" hypothesis that requires some explanation--exogenous to the manic "hypothesis itself--of the "origins" of whatever prospective earnings the herd eventually loses track of.
In contrast, the present essay inquires into the "supply side" of recent bubbles by examining institutional and historical factors that tend to further the phenomena of capital gains surrounding stocks and housing--the two main asset classes of households. The thesis advanced here is that the production of recent bubbles has root causes in the fundamental shake-ups in the industrial and financial structures and the decline of new investment prospects, particularly in the "Old" economy of manufacturing and trade. These shake-ups and the decline in new investment prospects have led to an expansion in the relative valuation of existing capital stock as measured by those same investment prospects. By using a simple model and a new conceptual measure of the capital stock, I show below that the recent increase in the distributive share accruing to capital has also expanded the relative valuation of the existing capital stock. I argue that this expansion of relative valuation has driven an increase in mergers, acquisitions, share repurchases and debt that both represent and are collateralized by the expanded valuation of the existing capital stock. I show below that mergers and share-repurchases were major factors in expanding the equity bubble of the 1990s, and I estimate that roughly a third of the equity bubble was driven by mergers alone.
Expanding the valuation of existing capital is equivalent to lowering its rate of return as measured by cash returns. Given a risk premium between equity and bonds, such an expansion of equity valuation will tend to lower interest rates as well, because equity and loan capital compete. In addition, the expanded valuation of equity allows for increased leverage by corporations. As financial interests acquire capital gains through a successive decline in interest rates, a further demand for bonds is generated, lowering interest rates even more. Such lowering of rates will in turn expand capital valuation as prospective streams of earnings become discounted at lower rates. But such expanded capital valuation again lowers the rate of return, feeding back into capital gains in the bond market and encouraging the growth of the financial sector. I argue that this expansion of the financial sector has been a major factor in driving down long-term interest rates as the expansion of the financial sector has required a net influx of new borrowers. Lately, these new markets have been particularly apparent in real estate. As the decline in rates has constituted the main "fundamental" behind lower payments per mortgage dollar, relative capital valuation helps explain how the stock bubble spilled over into housing. The groping of the financial sector after expanded markets also explains the continuing deterioration in mortgage underwriting, the parking of more mortgages into government-sponsored entities as a protective shield, and the increasing dangers of a sudden upward shift in long-term rates.
The plan of the essay is as follows: it first examines mergers, share-repurchases and debt in the context of relative valuation theory, and then shows how such equity and debt expansion has fundamentally altered the financial environment concerning capital gains, interest rates and housing.
Merger theory that has any claim to generality must take into account two anomalous facts. The first is that mergers tend to come in waves that, without exception for over one-hundred years, fall in line with stock market expansions, which make target acquisitions expensive. The second is the preponderance of evidence that acquiring firms fail to generate effects of synergistic profitability at levels significant enough for them to be detected.
The stock market-merger connection, noted initially by Ralph Nelson's famous study on merger waves (1959), has lately been revisited by others. The proponents of a finance-dominated theory of mergers stress the role of investment-banking promoters (Du Boff and Herman 1989) and the role of over valued acquirers using their stock as currency or collateral for takeovers (Shleifer and Vishney 2003). Gort (1969, 628) and Shleifer and Vishny (2003, 297) also argue that booms create a wider divergence of valuations that generate mergers. Taken collectively, these understandings may explain some of the merger activity in booms, but they involve certain asymmetries that undercut their explanatory power. High stock valuations allow stock to be utilized as currency and collateral for takeovers; yet stock booms also make targets expensive. Indeed, according to q theory, higher target prices should make new investments more attractive than the merger route to growth. Yet, in booms the merger/new investment ratio goes up (Medlen, 2003, 979). As Mueller (1977, 318) argued against Gort (1969) and as Lambrecht (2004, 42) has recently noted, it is far from certain that booms drive diverse valuations any more than downturns. Indeed, stock market contractions typically are far more severe over a shorter time period than expansions of equity during booms.
The second anomalous fact about mergers concerns the lack of evidence that mergers are profitable. This fact begs the question: why then are mergers carried out with such frequency and with such large levels of capitalization? Theories that encompass efficiencies surrounding shifts in corporate governance (Jensen 1986) find at least some evidence in the early 1980s for increased profitability, although by the late 1980s a third of the leveraged buyouts defaulted (Homstrom and Kaplan 2001, 128). Theories that rely on industry shocks, such as the recent deregulation surrounding telecommunications and financial services, point to a tendency of merger actors to cluster around particular industrial settings (Mitchell and Mulherin 1996). Such theorizing understands mergers, largely on an ad hoc basis, with particular historical periods giving rise to distinct merger characteristics--conglomeration in the 1960s, leveraged buyouts in the 1980s, New Economy acquisitions in the 1990s. The lack of demonstrated profitability of these acquisitions, however, still begs the question: why are they carried out? Some like Roll (1986) and Morack, Shleifer and Vishny (1990) suggest that empire building and hubris play a role, but such theorizing ignores the possibility that empires might well be built through internal investment.
This lack of evidence of profitability extends over eighty years. In summarizing numerous studies from the 1920s to the late 1960s, T. F. Hogarty (1970) said that the one major difference in the studies surrounds the question of "whether mergers have a neutral or negative impact on profitability" (389). This characterization largely summarizes the studies since 1970 as well. In one recent large study encompassing a sample of 12,023 acquisitions by public firms from 1980 to 2001 (Moeller, Schlingemann and Stulz 2004), the researchers found "the average dollar change in the wealth of acquiring-firm shareholders when acquisition announcements are made" was negative (202). Other recent studies are, at best, inconclusive on the question of profitability.: Yet this lack of demonstrated profitability is the most important piece of evidence surrounding the limited internal investment prospects of acquiring firms. For if acquirers could build up firms profitably through internal investment, certainly they would choose this route, even if such building required more time.
Relative Valuation and Low Internal Growth Prospects
The acknowledgment that managers have a choice between mergers and internal growth has encouraged theorists, at least since the 1920s, to look for merger motives in the limited internal investment potential of acquirers. Noting the absence of any demonstrable synergies surrounding the conglomerate wave of the 1960s, Dennis Mueller (1969) concluded that only a "growth" motive could explain the "irrational flurry" of conglomerate activity (644). Growth, however, could be obtained through internal expansion. Mueller's answer was that the mature firm was likely to acquire funds faster than could be profitably invested (646). In other words, mergers were promoted by internal growth limitations. In the...