What is Cost of Equity? – Meaning, Concept and Formula
February 12, 2025
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Joseph Stiglitz is one of the most renowned economists of our time. He once criticized the current economic system after the great recession of 2008. He said that the current system is skewed in favor of the rich. This economic system is no longer capitalism. It is a strange combination of capitalism and socialism wherein profits are distributed amongst private individuals whereas losses have to be borne by taxpayers. At that time, it seemed like a one-off incident. However, since then, there have been several cases wherein losses generated by private companies had to be borne by taxpayers. This has created a situation wherein moral hazard is now the norm. In this article, we will have a closer look at the socialization of losses.
The typical story involves a company which is a part of the sunshine industry of that nation. For instance, the United States is famous for having some of the best financial institutions in the world. On the other hand, India is famous for having some of the best information technology services companies.
One of the companies in these industries grows too big by taking reckless risks. For a long time, these risks pay off. Also, there is no internal mechanism of control since many of these companies are no longer run by founders. Instead, they are run by managers who are rewarded according to the profit they make. This prompts them to take even more risks. As long as the going is good, the managers make a lot of money in the form of bonuses. However, as soon problems begin to appear, the managers are the first ones to jump ship. They have better information than everyone else since they are inside the system. Also, once they are out of the company, they aren’t really responsible for the results.
Hence, by the time, the bad news becomes public, these managers are already out of the company after encashing their stock options and bonuses. This is when the market goes into a frenzy. The stocks of these companies are hammered by the market. The end result is that shareholders stand to lose a lot of wealth. Ideally, shareholders should be allowed to lose money since they are the ones responsible. However, shareholders start lobbying the government stating that if their company falls, they will not be the only one going down. Since these firms are huge in size, a lot of other banks and firms have exposure to them. Hence, the fear of a contagion runs wild in the market, and this brings stock prices to crashing lows.
In the end, the government is forced to intervene to stop the bloodshed under the guise of “protecting the small investor”. The government provides loans or equity money to these firms at a time when nobody else will. In a capitalist system, firms that make a mistake must fall and be replaced by better firms. However, in this strange hybrid system, firms which make mistakes are allowed to thrive using public money.
The bottom line is that the same story is playing out over and over again in different parts of the world. It is high time that the governments decided to abandon this “too big to fail” narrative. Capitalism is the best economic system known to man. However, if the rules of the game are not followed correctly, the results can be disastrous.
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