Freeman

ARTICLE

Risk and Profit versus Security

MAY 01, 1978 by KENNETH MCDONALD

Mr. McDonald Is a Toronto writer on economic and political subjects.

This article Is reprinted, by permission, from the Winter 1977 issue of The Business Quarterly pub­lished by the School of Business Administration, the University of Western Ontario, London, Canada. All rights reserved.

From the moment of birth, life is a risky business. The search for secu­rity is instinctive. Where the par­ents sought it in religion the chil­dren seek it in the state.

Because they do, the state has grown, its growth fueled by reve­nues that increase every year. The transfer of wealth from individual hands, which created it, to public hands which merely redistribute it, achieves another kind of redistri­bution: the number of consumers is increased; the number of pro­ducers diminished.

The process is cumulative. Tax-funded services which people regard as "free" are partaken of liberally on that account. Nor are they recog­nized as an element of compensa­tion. Rather does the mounting tax deduction from the pay packet cause demands for more pay. But pay must come from wealth, the sum of which is declining.

Underlying the whole process is the most insidious tax of all: infla­tion. The lack of political courage to tell the truth, to reveal the absence of a free lunch, impels politicians either to borrow money or to enlarge the amount of it in circulation. Whichever device is resorted to—often both at the same time—the future is mortgaged to pay for the present.

Indexed pensions, whose projected growth to astronomical figures alarms every self-respecting ac­tuary, are sops to a people whose currency inflation must destroy.

At 7 per cent annual inflation, 1977′s modest $15,000 salary would grow to $58,000 in 1997 on cost of living allowance alone. If a further 7 per cent were added each year for merit pay or fringe benefits, it would grow, by 1997, to $201,000. Not wal­lets, but wheelbarrows.

As more and more power—the power to distribute wealth—is transferred to the state, people look increasingly to the state as a source of investment.

State Ownership in Britain

An advanced stage of the process may be witnessed in Britain, where a state-owned National Enterprise Board was formed in 1975 to rescue major enterprises that had fallen into decline as a result of the state’s encroachment. How insidious the process may be judged by the fact that The Economist, hardly a radical journal, records the development with a perfectly straight face.

A report in the issue of May 7, 1977, concludes with this sentence: "Intervention leads to ownership but much of it—inevitably under any government, let alone one eager to save jobs at almost any price—is riskier than a commercial company should be expected to undertake."

Risk, upon which was founded the commerce that took Britain to greatness, is now, in her decline, too risky to undertake.

The welfare state, which seeks to conceal the realities of death and misfortune, must cushion the risks that attended the creation of the wealth it has dissipated.

Canada, which is said to be trail­ing Britain by a scant five years, is scattering the seeds of a National Enterprise Board of its own. Ven­ture Investment Corporations pro­mise rain to end the equity drought.

Not that VICs are bad in them­selves. Within a too-pervasive state they offer investors the incentive of relief from the state’s tax burden. But it is because the state has in­truded too much that the relief must be offered. VICs are a palliative, not a cure. The vehicle their initials remind us of will not carry us very far.

Just as a compost heap turns a garden’s residue into food for more produce, so must the wealth creat­ing process turn its own residue to the creation of more wealth.

Its residue is profit.

How profit is used, and of what it consists, are bones of perennial con­tention. Politicians of every stripe have worried them to death. For special interest groups who would shift the blame for their own depre­dations, profit is the scapegoat.

Some are prone to regard it as a surplus, as a bag of money that the owner of a business takes away to spend on him—or herself—while the wage earners count out their pen­nies for bread.

Others look at a business in isolation. The financial results for one year, or one quarter, are pasted on the wall like specimens in a labora­tory. It is as if they had stopped a film on one frame and were trying to determine, from that frame, what had happened before and what would happen next.

But (except by going out of busi­ness) the business cannot be stop­ped. Every minute of the twenty-four hours, seven days a week, it is ticking away.

Interest costs on borrowed finan­cial capital (bonds and debentures); dividends on equity capital(shares of common stock); costs of wages, of vacation pay, of future pensions for those working and of past pensions for those retired; costs of machinery that is wearing out and must one day be replaced; costs of raw material or other supplies needed to make the product; costs of transpor­tation, of heat and light and power; costs of telephone and mail; costs of accounting; costs of interpreting and adhering to government regula­tions; costs of calculating and pay­ing out taxes to three levels of gov­ernment; costs of research into bet­ter ways of making the product and of developing new ones; costs of ad­vertising and sales. It never stops.

The Urge to Be Independent

Think of the process as a film, with people working in offices, or operating machines, or standing be­fore drawing boards, or selling the product to customers, and there is no sequence where someone walks out the door carrying a bag marked "surplus."

Yet there is a residue, something left over, a margin of some sort. Otherwise the process would stop.

Does everyone engaged in the business—owners, employees, investors—give a little more than they get back? In a way, they do. They give energy, and initiative, and ingenuity and, no doubt, some enthusiasm. They provide part of the economic energy that keeps the film turning, the business going. But not all of it.

Where did the rest come from?

It stemmed from the urge to be independent that is present in every person who has the idea for a busi­ness. Call him or her Smith.

Smith was convinced the idea would work. Whether a product or a service, it could be sold. There was a niche for it in the market.

To get it to market, Smith needed money (the financial capital) in order to acquire the office and office equipment, or the buildings and machinery (the productive capital) to start the thing off.

Smith was prepared to take a risk, but not many Smiths have either enough savings of their own, or enough of anything in the form of collateral to borrow the money—the risk capital.

Banks are not in the business of taking risks. They have a responsi­bility to their depositors. Govern­ments are not supposed to take that sort of risk, either, because they have a responsibility to taxpayers. Unfortunately that does not always stop them from trying.

Someone, or a number of people, had to be found who would be will­ing to put up the risk capital to get Smith started. From their own ex­perience in business they would ex­amine Smith’s idea and if they thought it would work, and if they thought Smith was a sensible per­son, they would put up the money.

We are back at risk.

Knowing that out of ten chances eight might fail and only two suc­ceed, they must be assured of suffi­cient return from the two successes to make up for the failures. The return may be a long time coming.

The function of equity money is to carry the risk during the critical period from conception through business plan and start-up to profit­able operation. During that period the equity investors get no return on the money they risk. But they have one vital quality which no chartered bank or government department or indeed government agency could in­ject: it is their own money at risk and they have a very intimate and personal reason for wanting the business to succeed. That quality is balanced by another: a readiness to cut losses and stop, which govern­ments lack because there are always political reasons for pouring good money after bad.

A curious feature of new ventures is that the instigators—the Smiths—turn to debt financing rather than equity. Possibly they feel more comfortable dealing with a bank. Banks are in the business of making people feel comfortable about borrowing from them. No doubt that is why they inhabit such splendid buildings.

But to secure a loan there must be collateral. Usually it is the building, or the machinery, or both—the pro­ductive capital that the business needs to function. Later, the busi­ness will need more money to tide it over between getting the orders, making the products and getting paid for them. It is at that critical point, when there is no more collat­eral, that many businesses either fail, or are taken over by an estab­lished competitor.

Yet the reason many owner man­agers give for preferring debt over equity is a reluctance to surrender, or even to share, ownership.

Risk-Taking by Individuals—A Dying Art

But the people who are willing to take a chance on backing them—the equity investors—must also be as­sured of at least an even chance of a return on the money they’re prepared to risk. Otherwise they won’t risk it. That is the crux of our prob­lem. The misconception of profit has become so widespread, and the sup­porters of government planning have been so influential, that risk-taking by individuals is a dying art.

Instead of risk-taking being en­couraged, it is discouraged. In an age when the schools and colleges are training Canada’s young people for pensionable jobs in public or pri­vate bureaucracies, anyone who takes risks is regarded as a freak. The atmosphere, the social pres­sures, not least the tax system, all are opposed to risk-taking.

Without equity, the main source of creating wealth and jobs is drying up.

Those who advocate central planning of the economy are drawn by the mirage of state-fed security. Central planning and risk-taking are poles apart. The more the state plans, the harder it is for individuals to make plans of their own.

To make them, they need to know, in advance, what the ground rules are. Smith, and the equity investors who would put up the money, need to know, in advance, what the costs will be during the crucial period between starting up the business and reaching the break-even point at which revenue draws level with expenditures and begins to draw ahead. That period might be as short as one year or as long as five depend­ing on the size and complexity of Smith’s business.

In a time of stable prices, of low taxes and, consequently, of a low level of state intervention in the economy, estimating costs during. that period would be relatively straightforward—little more than a projection of current costs against the estimated rise in business vol­ume. Today, however, prices are un­stable. Quality and availability of labor are serious problems, taxes are high—all resulting from state intervention. Worst of all is the un­certainty.

Clearance Procedures

So many powers have been dele­gated to regulatory boards and commissions of one kind or another that it is impossible to forecast. One thing is certain. Smith’s planned ac­tivity would have to be cleared with planning boards in any or all of the three levels of government. At each step the decision would be based not on broad rules laid down by parlia­ment but on variable rules which, in the opinion of the inspectors or commissioners or regulators, were appropriate to the circumstances at the time of application.

Even if Smith and company over­came the first field of hurdles, quite likely they would find themselves opposed by environmentalists or other publicity-seeking special interest groups, often subsidized by the state, whose ambition is to oc­cupy center stage at every opportu­nity.

If profit is both spur and fuel, if profit is to supply the economic energy to keep the system going, it must be open to all corners. Other­wise its essential ingredient—the limitless supply of human inge­nuity—will be shut out.

Yet what do we find? Profit is recycled within a closed system. The banks and other financial institu­tions which depend on a safe return to protect their depositors’ and their own investments will invest their funds safely, i.e. in the country’s leading, well established enter­prises. Most of them are regulated, to varying degrees, by the state. Their return is limited by taxation and inflation. If it should appear to rise above a "reasonable" figure in any one period the enterprises will be attacked from all sides.

The Final Security

Institutional investors, the enter­prises they invest in and draw re­turns from, the governments which control them both—all three are engaged in a ritual dance from which the individual investor is excluded.

At those modest rates of return he cannot afford to enter the game. But without his contribution of energy, of enthusiasm, of willingness to risk and to wait, the game will slow down, as it has slowed down, until it is not a game at all, but a funeral procession.

Death, which shares its certainty with taxes, is also the final security. The search for security, which gives rise to taxes, drives away the risk which accompanies all creation.

The generation of risk capital is no different from any other genera­tion. It must come from its own kind.

 

***

What Pulls Up Wages

Though labor is a commodity, the price of which is subject to supply and demand, it is a unique commodity. It enters into every kind of produc­tion, and as productivity increases, the workman shares in the increase.

The hope of profit in new and growing industries forces employers in those industries to bid up for labor. This force has caused them to bid millions of people from off the farms, from out of depressed areas and out of domestic service, and even from across the Atlantic. The best and the most new jobs are normally found with the most optimistic employers who have the strongest hope of profit. And it is such labor markets that over the decades have steadily lifted wages.

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May 1978

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