Understanding Equity
This post will focus on equity, identifying what qualifies financial assets as equity, and the strengths and weaknesses of equity as a financial tool.
Compared to trying to analyze “money”, which can mean different things to different people in different contexts, describing equity is relatively straightforward. We can avoid confusion by replacing the vague term “money”, with the explicit asset we are talking about: bank balances, central bank balances, cash, or bonds, for example.
The technical financial definition of equity: assets - liabilities, is somewhat misleading. The key principles of equity are flexibility and fairness. Equity adapts to the state of the equity issuing entity. Describing equity as “assets minus liabilities” simply asserts that it’s a protocol for distributing the “leftovers” under accounting norms. But this isn’t the only consideration when designing adaptive equity claims. This is especially important when when assets and liabilities are ongoing and unresolved, and claims must be exercised without disruption or dissection. (Contrast this with forensically resolving equity claims, which involves killing a living entity, taking it apart, measuring it precisely, and divvying up the loot.)
I will address the definition of equity and related normative issues in more detail later on.
Even more challenging than definitions and explanations of financial terms like equity and money, are philosophical theories of value. The title of this publication is “Costs and priorities”. “Priorities” is closely related to concepts of “value”, so theories of value is something this publication must address. Other posts hint at some ideas which I may explore more in future posts. By using the word “priorities”, I hope to shift the focus from “value”, as an abstract quality we try to quantify, to “values”, which highlights the existence virtual entities performing resource programs according to features of their ontological classification.
Lesson 1: All Financial Assets are Claims.
The first thing we must understand is that all financial assets are claims.
For those familiar with chartalism, this should not be a surprise.
Claims Explained through Patents
As a personal note, I first learned about the the concept of claims while working for my dad as a technical artist creating patent drawings.
Patents specify claims to cover inventions. The patent gives the patent holder an exclusive legal right to make and use an invention for a period of time. If someone uses an invention without licensing their use with the patent holder, the patent holder can use their legal claim to litigate the infringer for damages in the form of financial reward.
Patent claims come in two types, independent and dependent claims.
Independent claims must qualify as an invention. This is determined by various legal criteria, such as that it must not be obvious to one of ordinary skill in the art.
Dependent claims specify variations to the core invention, that the patent holder also wants to cover. By including dependent claims, you explicitly identify variations covered by the inventive idea, improving patent coverage.
Dependent claims can serve as a fail safe in case the independent claims are not found to meet the criteria of an invention or are otherwise disqualified. Combinations of independent and dependent claims, then serves as replacement for the original independent claim, according their dependency relations, provided each combination meets relevant criteria.
While the patent application process involves evaluating patentability of the invention disclosed and the claims specified, and amending the claims and disclosure to satisfy the patent office, these legal issues are ultimately resolved in a court of a law through patent litigation.
Patents highlight the importance of adaptability and process.
Other Examples of Claims
If you own deed to land or a title of a car, those are also legal claims. I can’t think of a counterexample to this statement:
All financial assets are claims.
Whether a lottery ticket or “buy one get one free” coupon, all financial assets are claims.
The Conceptual Advantage of Describing Financial Assets as Claims
Describing financial assets as claims offers conceptual advantages.
“Claims” highlights process. Legal process is an important aspect of many financial relations, but it is not the only process we must examine.
Social and political processes are also key aspects of financial relations. Beyond that, other “processes” of interest might be biological, ecological, historical, cosmological, or other words with suffix “-al”.
By concerning ourselves with process, and not just the numerical representations we create to describe expectations in our interactions, we explicitly identify the way our relations are resolved. In essence, it’s a reality check on accounting. We must verify that the numbers we use in accounting are valid representations of history and our programmed responses to accounting information are sustainable normative practices.
Unfortunately, there’s more to explore here than can be covered in one post. Let’s move on. In the rest of the post, I will define equity and explore the unique strengths and potential weaknesses of equity as a tool for organizing financial relations.
What is Equity?
The word Equity sounds like Equal. In equity relationships, all share holders have equal claims, per share.
What Equity is NOT.
People complaining about wealth “inequality”, are alarmed by the exponential differences in personal claims to wealth enjoyed by some people compared to others, when all these claims get converted into dollar values. This way of looking at inequality accepts prices and holdings as a valid description of social outcomes. To quantify inequality financially is to de facto accept relative prices and differences in personal claims to resources as a valid way to measure social justice. What makes a simple, carefree, basic lifestyle better or worse than a lavish one with lots of financial authority/responsibility?
I would suggest that converting all financial claims into a single unit degrades the depth and usefulness of the huge body of information we call accounting, which we use to manage our relationships. Our activities are bounded into certain spheres. When a CEO acts on behalf of a corporation, they are acting in a completely different sphere, with different applicable laws and social expectations, than when they act as an individual.
In my view, the price information revealed through exchange of resource claims provides less direct insight than explicit political considerations in managing resources. How do we design our resource claims? What roles do various entities perform? What is the rationale behind these political relations and legal rules? Social justice is achieved not by an equivalence of roles and equality in holdings, but by creating appropriate and fair political and social relationships.
In some contexts, social justice requires personal equality, but in others it does not. Every citizen gets an equal vote. Every citizen should have an equal opportunity to work for basic resources or receive those if not able. When a prosperous society forces people to work like serfs and live like paupers, social justice is not being fulfilled. When ANY society excludes people from the opportunity to work or contribute, in a way commensurate with their aptitudes and interests, and providing just compensation in return, social contracts are broken. These issues are of much higher priority, in my view, than deciding whether lavish expressions of personal wealth enjoyed by financially successful are appropriate. (Personally, I’m okay with lavish wealth, as long as it doesn’t emit a lot of carbon dioxide into the atmosphere or crowd out higher priorities like basic resource needs).
Certainly, there may be problems in the ways we create boundaries between resource spheres. Perhaps the roles we create in capitalism, such as worker, owner, contractor, shareholder, regulator, enforcer, legislator, judge, and voter, are fundamentally defective or poorly implemented. But unless you have specific suggestions to improve on these roles and relationships, attacking capitalism won’t yield positive change.
In exercising equity, process is of critical importance. The shares themselves may be fungible, but the share holders all find themselves in different positions with different goals and constraints. This will be important when we discuss the weaknesses of equity.
Advantages of Equity
The main advantage of equity is flexibility. When equity is used properly, the exercising of claims is always adapted of the current state of the equity issuing entity.
Fairness is an essential goal of equity. Equity claims should not give one shareholder an unfair advantage over another. The powers and privileges afforded equity holders should reflect mutual interests.
When you trade stock, shares often come with voting rights or dividends. These are benefits that can be granted to share holders which, in general, don’t compromise the position of other claim holders.
The process should ensure that when people exercise their claims, it is unlikely to disrupt or hurt the equity issuing entity, or negatively affect the other share holders.
There’s a ton of legal nuance to how all this works in practice, so I suggest you investigate in greater detail.
Failing Gracefully
Compared to other financial tools, equity facilitates “graceful failure”. Because the value of claims is flexible, as the equity issuer experiences successes and failures, the market price of these claims(if they can be exchanged) may adjust.
Compare that to a savings account at a bank. Banks use opaque processes designed to simplify the interface for users. This is why banks can fail dramatically. This is why the public has to carefully regulate banks and hold them to detailed standards.
Based on my description of equity above, fiat currency qualifies as equity. When we talk about inflation, it is a tool for graceful failure. It allows us to adjust the claims of existing savings to adapt to the current domestic capacity of the economy. This avoids dramatic failure. This is why we don’t need to worry so much about the quantity of the national debt, so much as what its distribution might tell us about problems in political and fiscal processes.(Did equity holders make contributions commensurate with their current holdings? If not, we might want to take a closer look at resource rules and fiscal process.)
Currencies can still fail dramatically, because generally, the state is the last line of defense against social disintegration. As social problems compound, running a business becomes more difficult, and less reliable, and people will depend on the state more for saving money, and directing productive programs, until the point that it fails.
But with proper awareness of currency operations, and by focusing on the priorities necessary to maintain political efficacy, states can overcome existential threats and maintain the efficacy of currency as a tool for directing and rewarding participation in social efforts.
Weaknesses of Equity
The job of a bank accepting deposits is straightforward. Accept a deposit, then redeem it for the same thing in the future. We permit them operational flexibility so long as they honor this arrangement.
Equity, on the other hand, is more socially involved. If participants don’t have equal information, and operations aren’t transparent, then fairness gets compromised.
This great potential for social and political confusion is one of the great weaknesses of equity, and why it is so important that participants are informed, aware, knowledgeable, savvy, and can trust each other.
