About a month ago, NPR’s podcast planet money aired an episode on shorting the stock market, and specifically, the very first short in the stock market. This may be one of my very favorite episodes they’ve ever done, for two reasons. The first reason is that it represents the beginning of a very interesting (albeit dangerous) phenomenon in the stock market. The second is how signaling gave birth to many of the features of the modern stock market. This second part is interesting, and I’d like to give some explanation as to how it works, and then, how it birthed many features of the stock market today.
‘Signaling’ is how people or corporations on two different ends of some transaction communicate with each other, when there isn’t perfect information present. A firm does this by offering some information or deal that would be difficult, or costly to fake. The classic example of this is a product warranty. A company makes some promise about the functioning of a product over a given period, and if that product breaks, then the company has to replace it, or somehow reimburse the customer. This is a great deal for some company who manufactures very durable items, and not such a great deal for a different company whose products are of a lower quality. This is because the lower quality firm would have to replace broken items at a faster rate, and so we would expect that the first, higher-quality firm would be willing to offer a bigger warranty, because it would be cheaper for them to do so. Thus, the consumers who are willing to pay extra for a higher quality item have some way of both limiting the risk to themselves, and simultaneously interpreting which products are actually of a higher quality.
This episode of planet money was primarily interested in the world’s first short of the market, but it also touched briefly on one other aspect of stock markets today: dividends. Before I get into that, however, I want to briefly summarize the events that led to the final conclusion. Isaac Le Maire was a merchant for the Dutch East India Company, and he starts the story in conflict with his employer. Somehow, he ended up thrown out of the spice giant, speculation pointing towards some impropriety with company money. As revenge, he schemed a way to short company stocks, and then set about sabotaging the Dutch East India company’s reputation. Shorting, without explaining its precise mechanisms, is essentially betting that the price of a stock will fall. If Isaac’s plan worked, he would have been phenomenally rich, and the Dutch East India Company, much less so.
So Isaac hired a number of people to go around, and claim that the company had lost a shipment at sea, that the cargo had been water damaged, and that they were in really big trouble because of it. There was no evidence to back this claim up, but since the company could do nothing to contradict these rumors, aside from spreading more rumors, their stock price began to sink. They had no way of verifying the state of their ship, and certainly no expedient way, so they had to rely on their believability. This is what is called ‘cheap talk,’ and basically represents a signal with no cost to the signaler. If, for instance, someone went to an interview, and their resume consisted of ‘I’m awesome’ on it, the chances of their potential employer accepting this fact and hiring them on the spot are pretty slim, given that there is no proof to back that claim. Similarly, the Dutch East India Company stating ‘we’re fine’ in response to the equally unfounded rumors that they had a shipment lost at sea was not sufficiently convincing. So, the Dutch East India Company did what many companies today do: produce a dividend to give to stockholders. Of course, it was maize not money that was paid out, but the effect was the same. If the company HAD in fact lost a ship at sea, losing what product they had in storage would have been crippling, and thus that dividend would be unwise and not pay off for them in the long run. This single action, through being convincingly costly to the company, was able to reinvigorate their stock, and put Mr. La Maire into quite a bad spot.