2.4 The nancial system and resource allocation

A different illustration is provided by securities markets, the market for ordinary

company shares, for example. The shareholders of a rm are its legal owners and

they appoint the Board of Directors who in turn give general direction to a rm and

appoint its managers. Taking control of a rm thus requires either ownership of, or

inuence over, at least 50 per cent of the ordinary shares. In a takeover battle, this

is the target for the ‘predator’ rm. Clearly, the higher the price of a rm’s shares,

the more costly it is to buy 50 per cent. Thus, other things being equal, a high share

price provides an element of security against takeover, while a low share price may

invite predators.

In theory, the price of a company’s shares should reect the ‘fundamental value’

of the rm. As we explain in Chapter 6, this means that the price should be deter-

mined by the prots that the rm can earn from its assets. As above, the level of

prot is seen as some indicator of the value which society places on the rm’s

activities. Low prots, and a low share price, indicate that the rm is not providing

goods or services which people want particularly strongly, or that it is not doing so

efciently. In these circumstances, it could be argued, it might be a good idea if the

rm were taken over (by another rm with high prots and a high share price) and

reorganised into a more valuable productive unit. In these circumstances, a takeover

is one way of bringing superior management expertise to a poorly performing rm.

It might be uncomfortable for the management (and workers) of the rm being

taken over, but there would be a sound economic rationale. Notice though that the

rationale depends critically upon share prices. For the process to work correctly, a

company’s share price has to accurately reect the performance of its underlying

assets. If the predator rm has a high share price for reasons not associated with its

assets’ performance, there can be no guarantee of superior management. Equally,

if the target rm has a low share price for reasons which have little to do with its

economic performance, this may be no indication of poor management expertise. So

far as getting the best management resources to places where they are most needed,

the results of takeovers in these circumstances will be a lottery.

A further consequence of mispricing can be seen in the cost of capital to a rm.

Imagine a rm whose capital structure is nanced entirely by the issue of ordinary

shares. If the rm wishes to expand by raising new capital, the rate of return to

existing shareholders tells us the rate that will have to be available on the new

shares. The shareholders’ return, in other words, is the rm’s cost of capital. As we

shall see in Chapter 6 (eqn 6.14), this rate of return varies inversely with the price

of the shares. Thus, a rm whose share price is ‘high’ can raise new funds more

cheaply than when the price is ‘low’. (Think of this as the difference between the

number of pounds that the rm can buy in return for a given dividend payment.)

With a low cost of capital a rm may be encouraged to expand, while if capital is

costly it may be deterred. As we said above, provided that the price of shares reects

the ‘fundamentals’ of the business, a ‘high’ or ‘low’ price conveys a signal to the rm

that will ultimately benet society. But if the price has nothing to do with a rm’s

earnings and therefore nothing to do with the utility that consumers derive from

its products, rms may be encouraged to expand or contract with no corresponding

benet to the community at large.

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Chapter 2 • The nancial system and the real economy

An extreme example of this was provided by the ‘dot.com’ boom of 2000, when

investors queued up to buy internet businesses which were being oated on the

stock exchange with no earnings history at all, and no prospect of making a prot

for some years. When the otation of Lastminute.com was announced in March

2000 the response was so enthusiastic that the issuing bank revised the offer price,

raising it by 67 per cent. While companies like Lastminute.com found investors ght-

ing to supply it with funds, the prices of utility companies (water, gas, electricity, etc.)

were depressed to the point that some lost their position in the FTSE-100 index. How

much of investors’ capital was to be wasted in this craze became apparent a year

later. As one broker later said, with the benet of hindsight: ‘We all invested in a

few [dot.coms]. You look at it now and think you must have been a bit crackers...’

(10 March 2001, Financial Times).

So far, we have considered several ways in which the nancial system can con-

tribute to the functioning of a developed economy. In recent years, however, there

has been a growth of interest in the way in which nancial systems may contribute

to the development of low-income countries. Clearly, a less-developed country should

benet from a nancial system which encourages lending and borrowing in the

same way that a developed economy should benet. There should be more saving

and investment, less consumption and a higher rate of economic growth (as we

described in section 2.3). But in many low-income countries we nd that govern-

ments impose many restrictions on the functioning of the nancial system and even

interfere directly in its working. This is a situation that has come to be known as

‘nancial repression’. A common example of such interference is a ceiling (or ‘cap’)

on interest rates to hold them below the market clearing level. Sometimes this is

done in the misguided belief that by keeping the cost of borrowing articially low,

rms will be encouraged to borrow and invest and so raise the level of productivity.

Sometimes, however, it is simply a way of making it cheaper for the government

itself to borrow in order to nance a large budget decit. Whatever the reason for

such a cap, the effects on investment and growth are usually negative for two reasons:

one fairly obvious, the other more complex.

To understand the rst problem, we have to visualise a diagram rather like

Figure 2.1a but with only a single supply curve. Instead of the rate of interest

settling where the demand and supply curves intersect, a rate of interest below the

market-clearing rate is imposed. There is an excess demand for funds. (This low rate

of interest encourages rms to borrow for investment, but it discourages lending.)

Since rms can only borrow what is lent, the low price has only succeeded in limiting

investment.

The second problem begins with the excess demand. The standard test of a worth-

while investment project is that its rate of return should equal or exceed the cost

of capital. With a low rate of interest, the threshold test is set very low and there

are potentially many protable projects amongst which the limited funds must be

allocated. Furthermore, many of these potentially protable projects will have low

rates of return (equal to or just above the low rate of interest) indicating that they

have low productivity and will contribute little to increasing the economy’s rate of

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