Via Nathan Cedric Tankus, here is a recent JPKE article by Kevin Capehart on a 1990 lecture by Minsky that uses Trump as a case study of asset market bubbles in the 1980s. The lecture is fascinating, and not just as an odd historical artifact.
Here is what Minsky says about Trump:
One of the puzzles of the 1980s was the rapid rise in the financial wealth of Donald Trump, author of The Art of the Deal… Trump’s fortune was made in real estate. Many large fortunes have been made in real estate, since real estate is highly leveraged. Two factors made Trump somewhat unique — one was the he developed a fortune in the period of high real interest rates, and the second was that the cash flows on most of Trump’s properties were negative.
Trump’s wealth surged because the market value of his properties — or at least the appraised value — was increasing faster than the interest rate. Trump obtained the funds to pay the interest on his outstanding loans by increasing the draw under what in effect was a home equity credit line. The efficiency with which Trump managed these properties was more or less irrelevant — hence Trump could acquire the Taj Mahal in Atlantic City without much concern about the impacts on the profits of the two casinos he already owned. Trump was golden — he had a magic touch — as long as property prices were increasing at a more rapid rate than the interest rate on the borrowed funds.
The puzzle is that the lenders failed to recognize that the arithmetic of his cash flows was virtually identical with that of the developing countries [discussed earlier in the lecture]; in effect Trump was Brazil in drag. In the short run Trump could make his interest payments with funds from new loans — but when the increase in property prices declined to a value below the interest rate, Trump would become short of the cash necessary to pay the interest on the outstanding loans.
The increase in U.S. real estate prices in the 1980s was regional, and concentrated in the Northeast and in coastal California. … Real estate prices dipped in the oil patch, climbed modestly in the rust belt, and surged in those areas that benefitted from the rapid increases in incomes in banking and financial services — sort of a derived demand from the financial success of Drexel Burnham. In effect, those individuals with high incomes in financial services — and with the prospect of sharp increase in incomes — set the pace for increases in real estate prices.
Trump’s cousins were alive and well and flourishing in Tokyo, Taipei and Seoul especially in the second half of the 1980s. The prices of equities and real estate were increasing because they were increasing…
In any market economy the price of real estate will tend to reflect both its rental return and the rate of return on the riskless bond. … The price of land rises and the price of land sometimes falls — the relevant question is whether the anticipated increase in the price of land is sufficiently higher than the interest rate on bonds to justify a riskier investment.
….
The key question is why so many varied bubbles developed in the last several decades. The most general answer is that sharp changes in inflation rates and interest rates led to extremely volatile movement in asset prices. And once these price movements begin, then on occasion momentum may develop and feed on itself — at least for a while.
So in Minsky’s version of The Art of the Deal, there are three things you need to get rich like Trump. First, be an investor in NYC and New Jersey real estate in a period when land prices are rising rapidly there relative to the rest of the country. Second, be highly leveraged. And third — and this is critical — convert your equity to cash as quickly as possible to protect yourself from the post-bubble fall in prices. Picking the right individual properties doesn’t matter so much, and managing the properties well doesn’t matter at all.
In this analysis, the repeated bankruptcies of Trump-controlled properties don’t undermine his claims of business success, nor are they just an incidental footnote to it; they are an integral part of how he got so rich. Because the flipside of extracting cash from his properties through “what was in effect a home equity credit line” is that there was less equity left for the entity that actually owned them.
The trick to making money in an asset bubble is to cash out before it pops. Doing this by selling at the peak is hard; you have to time it just right. It’s easier and much more reliable to cash out the capital gains as they accrue; that just requires some way of moving them to a different legal entity. The precedent for Trump, in this reading, would be the utility holding companies that played such a big part in the stock market boom of the 1920s and were such a big target for regulation in the 1930s. Another parallel would be today’s private equity funds. To the extent that the funds cash out via so-called “dividend recapitalization” (special dividends paid by the acquired company to the PE fund) rather than eventual resale, an acquired company that doesn’t end in bankruptcy is money left on the table. It’s interesting, in this context, to think about Romney and Trump as successive Republican nominees: They may embody different cultural stereotypes (prissy Mormon patriarch vs womanizing New York vulgarian) but fundamentally they are in the same business of financial value extraction.
A few things elsewhere on the web, relevant to recent conversations here.
1. Michael Reich and his colleagues at the Berkeley Center for Labor Research have a new report out on the impacts of a $15 minimum wage in New York. It does something I wish all studies of the minimum wage and employment would do: It explicitly decomposes the employment impact into labor productivity, price, demand and labor share effects. Besides being useful for policy, this links nicely to the macro discussion of alternative Phillips curves.
2. I like Susan Schroeder’s idea of creating a public credit-rating agency. It’s always interesting how the need to deal with immediate crises and dysfunctions creates pressure to socialize various aspects of the financial system. The most dramatic recent example was back in the fall of 2008, when the Fed began lending directly to anyone who needed to roll over commercial paper; but you can think of lots of examples, including QE itself, which involves the central bank taking over part of banks’ core function of maturity transformation.
3. On the subject of big business’s tendency to socialize itself, I should have linked earlier to Noah Smith’s discussion of “new industrialism” (including my work for the Roosevelt Institute) as the next big thing in economic policy. Eric Ries’ proposal for creating a new, nontransferable form of stock ownership reminded me of this bit from Keynes: “The spectacle of modern investment markets has sometimes moved me towards the conclusion that the purchase of an investment [should be] permanent and indissoluble, like marriage, except by reason of death or other grave cause… For this would force the investor to direct his mind to the long-term prospects and to those only.”
4. In comments to my recent post on the balance of payments, Ramanan points to a post of his, making the same point, more clearly than I managed to. Also worth reading is the old BIS report he links to, which explicitly distinguishes between autonomous and accommodative financial flows. Kostas Kalaveras also had a very nice post on this topic a while ago, noting that in Europe TARGET2 balances function as a buffer allowing private financial flows and current account balances to move independently from each other.
5. I’m teaching intermediate macroeconomics here at John Jay, as I do most semesters, and I’ve put some new notes I’m using up on the teaching page of this website. It’s probably mostly of interest to people who teach this stuff themselves, but I did want to call attention to the varieties of business cycles handout, which is somewhat relevant to current debates. It’s also an example of how I try to teach macro — focus on causal relationships between observable aggregates, rather than formal models based on equilibrium conditions.
There are two new papers up at the Roosevelt Institute, building on my Disgorge the Cash paper from last spring. The first, analytic, paper, written by me, attempts to respond to some of the most common criticisms of the idea that shareholders’ lust for payouts is holding back business investment — that investment is doing just fine actually; that payouts are just reallocating capital to its most socially valuable uses; and that there’s no legitimate grounds to challenge shareholder rule over corporations. The second paper, written by Mike Konczal, me, and my former student Amanda Page-Hongrajook, lays out a policy agenda, in the canonical ten points, for rolling back the shareholder revolution.
We released the reports at an event in DC last week with Mike, me, Lynn Stout, and Heather Slavkin of the AFL-CIO, headlined by Senator Tammy Baldwin. Based on my brief conversation with her, Senator Baldwin seems genuinely interested in this stuff. So hopefully, if nothing else, we’ll be able to continue pestering the SEC about shareholder payouts.
There was a nice writeup of the analytic paper by Jeff Spross at The Week; there were also pieces in the Huffington Post and at Bloomberg View. I was on NPR’s Marketplace, very briefly, off this stuff this morning; I’ll be on Bloomberg TV Wednesday afternoon, hopefully for longer.
A common response to concerns about high payouts and the short-term orientation of financial markets is that money paid out to shareholders will just be reinvested elsewhere.
Some defenders of the current American financial system claim this as one of its major virtues — investment decisions are made by participants in financial markets, rather than managers at existing firms. In the words of Michael Jensen, an important early theorist of the shareholder revolution,
Wall Street can allocate capital among competing businesses and monitor and discipline management more effectively than the CEO and headquarters staff of the typical diversified company. [Private equity fund] KKR’s New York offices … are direct substitutes for corporate headquarters in Akron or Peoria.
But while private equity funds do indeed replace exiting management at corporations they buy shares in, this form of active investment is very much the minority. The vast majority of “investment” by private shareholders does not directly contribute any funding to the companies being invested in. Rather, it involves the purchase of existing assets from other owners of financial assets.
Suppose a wealthy investor receives $1 million from increased dividends on shares they own. Now ask: what do they do? Their liquidity has increased. So has their net wealth, since the higher dividends are unlikely to reduce the market value of the shares and may well increase them. The natural use of this additional liquidity and wealth is to purchase more shares. (If the shares are owned indirectly, through a mutual fund or similar entity, this reinvestment happens automatically). But this purchases of additional shares does not provide any funding for the companies “invested” in, it simply bids up the prices of existing shares and increases the liquidity of the sellers. Those sellers in turn may purchase more shares or other financial assets, bidding up their prices and passing the liquidity to their sellers; and so on.
Of course, this process does not continue indefinitely; at each stage people may respond to their increased wealth by increasing their cash holdings, or by increasing their consumption; and each transaction involves some payments to the financial industry. Eventually, the full payout will leak out through these three channels, and share prices will stop rising. In the end, the full $1 million will be absorbed by the higher consumption and cash holdings induced by the higher share prices, and by the financial-sector incomes generated by the transactions.
Now, not every share purchase involves an existing share. But the vast majority do. In 2014, there were $90 billion of new shares issued through IPOs on American markets — an exceptionally high number. By comparison, daily transactions on the main US stock markets average around $300 billion. Given around 260 trading days in a year, this implies that only one trade in a thousand on an American stock exchange involves the purchase of a newly issued share. And that is not counting the many “stock market” transactions other than outright share purchases (closed-end mutual funds, derivative contracts, etc.) all of which allow income from shareholder payouts to be reinvested and none of which provide any new funding for businesses.
External financing for businesses is much more likely to take the form of debt than new shares. But here, again, we can’t assume that there is any direct link between shareholder payouts and funding for other firms. Corporate bonds are issue by the same established corporations that are making the payouts. Meanwhile, smaller and younger firms, both listed and unlisted, are dependent on bank loans. And the fundamental fact about modern banks is that their lending is in no way dependent on prior saving. There is no way for higher payouts to increase the volume of bank lending. Banks’ funding costs are closely tied to the short-term interest rate set by the Federal Reserve, while their willingness to lend depends on the expected riskiness of the loan; there is no way for increased payouts to increase the availability of bank loans.
New bonds, on the other hand, do need to be purchase by wealthowners, and it is possible that the market liquidity created by high payouts has helped hold down longer interest rates. But many other factors — especially the beliefs of market participants about the future path of interest rates — also affect these rates, so is hard to see any direct link between payouts by some corporations and increased bond financing for others. Nor do new bonds necessarily finance investment. Indeed, since the mid-1980s corporate borrowing has been more tightly correlated with shareholder payouts than with investment. So if payouts do spill over into the bond market, to a large extent they are simply financing themselves.
Defenders of the financial status quo suggest that it’s wrong to accuse the markets as a whole of short-termism, since for every established company being pressured to increase payouts, there is a startup getting funded despite even when any profits are years away. I certainly wouldn’t deny that financial markets do often fund startups and other small- financially-constrained firms; and these firms do sometimes undertake socially useful investment that established corporations for whatever reason do not. And in principle, shareholder payouts can support this kind of funding both directly, as shareowners put money into venture capital funds, IPOs, etc.; and indirectly, as higher share prices make it easier to raise funds through new offerings. But the optimistic view of shareholder payouts not sustainable once we look at the magnitudes involved. It is mathematically impossible for the additional funds directed to new firms, to offset what they drain from established ones.
Again, IPOs in 2014 raised a record $90 billion for newly listed firms. (Over the past ten years, the average annual funds raised by IPOs was $45 billion.) Secondary offerings by listed firms totaled $180 billion, but some large fraction of these involved stock-option exercise by executives rather than new funding for the corporation. Prior to an IPO, the most important non-bank source of external funding for new companies is venture capital funds. In 2014, VC funds invested approximately $50 billion, but only $30 billion of this represented new commitments by investors; the remaining $20 billion came from the funds’ own retained profits. (And there is some double-counting between VC commitments and IPOs, since one of the main functions of IPOs today is to cash out earlier investors.) Net commitments to private equity funds might come to another $200 billion, but very little of this represents funding for the businesses they invest in — private equity specializes, rather, in buying control of corporations from existing shareholders. All told, flows of money from investors to businesses through these channels was probably less than $100 billion.
Meanwhile, total shareholder payouts in 2014 were over $1.2 trillion. So at best less than one dollar in ten flowing out of publicly-traded corporations went to fund some startup. And this assumes that shareholder payouts are the only source of funds for IPOs and venture capital; but of course people also invest in these out of labor income (salaries are a significant fraction of even the highest incomes in the US) and other sources. So the real fraction of payouts flowing to startups must be much less. There simply isn’t enough room in the limited financial pipelines flowing into new businesses, to accommodate the immense gusher of cash coming from established ones. Apple alone paid out $56 billion to shareholders last year, or nearly twice total commitments to VC funds. Intel, Oracle, IBM, Cisco and AT&T together paid out another $70 billion. [1] It’s hard to understand why, if finance is able to identify such wonderful investment opportunities for its cash, the management at these successful technology companies is unable to. You would have to have a profound faith in the unicorn hunters at Andreesen Horowitz to believe that the $1 billion they invested last year will produce more social value than $10 or $20 or $50 billion invested by established companies — or an equally profound pessimism about the abilities of professional managers. If this is what people like James Surowiecki really believe, they should not be writing about the dynamism of American financial markets, but about whatever pathology they believe has crippled the ability of mangers at existing corporations to identify viable investment projects.
[1] These numbers are taken from the Compustat database of filings by publicly traded corporations.
In a previous post, I pointed out that if capital means real investment, then the place where capital is going these days is fossil fuels, not the industries we usually think of as high tech. I want to build on that now by looking at some other financial flows across these same sectors.
As I discussed in the previous post, any analysis of investment and profits has to deal with the problem of R&D, and IP-related spending in general. If we want to be consistent with the national accounts and, arguably, economic theory, we should add R&D to investment, and therefore also to cashflow from operations. (It’s obvious why you have to do this, right?) But if we want to be consistent with the accounting principles followed by individual businesses, we must treat R&D as a current expense. For many purposes, it doesn’t end up making a big difference, but sometimes it does.
Below, I show the four major sources and uses of funds for three subsets of corporations. The flows are: cashflow from operations — that is, profits plus depreciation, plus R&D if that is counted in investment; profits; investment, possibly including R&D; and net borrowing. The universes are publicly traded corporations: first all of them; second the high tech sector, defined as in the previous post, and third fossil fuels, also as defined previously. Here I am using the broad measure of investment, including R&D, and the corresponding measure of cashflow from operations. At the end of the post, I show the same figures using the narrow measure of investment, and with profits as well as cashflow.
For the corporate sector as a whole, we have the familiar story. Over the past twenty-five years annual shareholder payouts (dividends plus share repurchases) have approximately doubled, rising from around 3 percent of sales in the 1950s, 60s and 70s to around 6 percent today. Payouts have also become more variable, with periods of high and low payouts corresponding with high and low borrowing. (This correlation between payouts and borrowing is also clearly visible across firms since the 1990s, but not previously, as discussed here.) There’s also a strong upward trend in cashflow from operations, especially in the last two expansions, rising from about 10 percent of sales in the 1970s to 15 percent today. Investment spending, however, shows no trend; since 1960, it’s stayed around 10 percent of sales. The result is an unprecedented gap between corporate earnings and and investment.
Here’s one way of looking at this. Recall that, if these were the only cashflows into and out of the corporate sector, then cash from operations plus net borrowing (the two sources) would have to equal investment plus payouts (the two uses). In the real world, of course, there are other important flows, including mergers and acquisitions, net acquisition of financial assets, and foreign investment flows. But there’s still a sense in which the upper gap in the figure is the mirror image or complement of the lower gap. The excess of cash from operations over investment shows that corporate sector’s real activities are a net source of cash, while the excess of payouts over borrowing suggests that its financial activities are a net use of cash.
Focusing on the relationship between cashflow and investment suggests a story with three periods rather than two. Between roughly 1950 and 1970, the corporate sector generated significantly more cash than it required for expansion, leaving a surplus to be paid out through the financial system in one form or another. (While payouts were low compared with today, borrowing was also quite low, leaving a substantial net flow to owners of financial assets.) Between 1970 and 1985 or so, the combination of higher investment and weaker cashflow meant that, in the aggregate all the funds generated within the corporate sector were being used there, with no net surplus available for financial claimants. This is the situation that provoked the “revolt of the rentiers.” Finally, from the 1990s and especially after 2000, we see the successful outcome of the revolt.
This is obviously a simplified and speculative story. It’s important to look at what’s going on across firms and not just at aggregates. It’s also important to look at various flows I’ve ignored here; cashflow ideally should be gross, rather than net, of interest and taxes, and those two flows along with net foreign investment, net acquisition of financial assets, and cash M&A spending, should be explicitly included. But this is a start.
Now, let’s see how things look in the tech sector. Compared with publicly-traded corporations as a whole, these are high-profit and high-invewtment industries. (At least when R&D is included in investment — without it, things look different.) It’s not surprising that high levels of these two flows would go together — firms with higher fixed costs will only be viable if they generate larger cashflows to cover them.
But what stands out in this picture is how the trends in the corporate sector as a whole are even more visible in the tech industries. The gap between cashflow and investment is always positive here, and it grows dramatically larger after 1990. In 2014, cashflow from operations averaged 30 percent of sales in these industries, and reported profits averaged 12 percent of sales — more than double the figures for publicly traded corporations as a whole. So to an even greater extent than corporations in general, the tech industries have increasingly been net sources of funds to the financial system, not net users of funds from it. Payouts in the tech industries have also increased even faster than for publicly traded corporations in general. Before 1985, shareholder payouts in the tech industries averaged 3.5 percent of sales, very close to the average for all corporations. But over the past decade, tech payouts have averaged full 10 percent of annual sales, compared with just a bit over 5 percent for publicly-traded corporations as a whole.
In 2014, there were 15 corporations listed on US stock markets with total shareholder payouts of $10 billion or more, as shown in the table below. Ten of the 15 were tech companies, by the definition used here. Computer hardware and software are often held out as industries in which US capitalism, with its garish inequality and fierce protections of property rights, is especially successful at fostering innovation. So it’s striking that the leading firms in these industries are not recipients of funds from financial markets, but instead pay the biggest tributes to the lords of finance.
Dividends
Repurchases
Total Payouts
APPLE INC
11,215
45,000
56,215
EXXON MOBIL CORP
11,568
13,183
24,751
IBM
4,265
13,679
17,944
INTEL CORP
4,409
10,792
15,201
ROYAL DUTCH SHELL PLC
11,843
3,328
15,171
JOHNSON & JOHNSON
7,768
7,124
14,892
NOVARTIS AG
6,810
6,915
13,725
CISCO SYSTEMS INC
3,758
9,843
13,601
MERCK & CO
5,156
7,703
12,859
CHEVRON CORP
7,928
4,412
12,340
PFIZER INC
6,691
5,000
11,691
AT&T INC
9,629
1,617
11,246
BP PLC
5,852
4,589
10,441
ORACLE CORP
2,255
8,087
10,342
GENERAL ELECTRIC CO
8,949
1,218
10,167
2014. Values in millions of dollars. Tech firms in bold.
It’s hard to argue that Apple and Merck represent mature industries without significant growth prospects. And note that, apart from GE (which is not listed in the the high-tech sector as defined here, but perhaps should be), all the other members of the $10 billion club are in the fast-growing oil industry. It’s hard to shake the feeling that what distinguishes high-payout corporations is not the absence of investment opportunities, but rather the presence of large monopoly rents.
Finally, let’s quickly look at the fossil-fuel industries. Up through the 1980s, the picture here is not too different from publicly-traded corporations in general, though with more variability — the collapse in fossil-fuel earnings and dividends in the 1970s is especially striking. But it’s interesting that, despite very high payouts in several big oil companies, there has been no increase in payouts for the sector in general. And in the most recent oil and gas boom, new investment has been running ahead of internal cashflow, making the sector a net recipient of funds from financial markets. (This trend seems to have intensified recently, as falling profits in the sector have not (yet) been accompanied with falling investment.) So the capital-reallocation story has some prima facie plausibility as applied to the oil and gas boom.
In the next, and final, post in this series, I’ll try to explain why I don’t think it makes sense to think of shareholder payouts as a form of capital reallocation. My argument has two parts. First, I think these claims often rest on an implicit loanable-funds framework that is logically flawed. There is not a fixed stock of savings available for investment; rather, changes in investment result in changes in income that necessarily produce the required (dis)saving. So if payouts in one company boost investment in another, it cannot be by releasing real resources, but only by relieving liquidity constraints. And that’s the second part of my argument: While it is possible for higher payouts to result in greater liquidity, it is hard to see any plausible liquidity channel by which more than a small fraction of today’s payouts could be translated into higher investment elsewhere.
Finally, here are the same graphs as above but with investment counted as it is businesses’ own financial statements, with R&D spending counted as current costs. The most notable difference is the strong downward trend in tech-sector investment when R&D is excluded.
Readers of this blog are familiar with the “short-termism” position: Because of the rise in shareholder power, the marginal use of funds for many corporations is no longer fixed investment, but increased payouts in the form of dividends and sharebuybacks. We’re already seeing some backlash against this view; I expect we’ll be seeing lots more.
The claim on the other side is that increased payouts from established corporations are nothing to worry about, because they increase the funds available to newer firms and sectors. We are trying to explore the evidence on this empirically. In a previous post, I asked if the shareholder revolution had been followed by an increase in the share of smaller, newer firms. I concluded that it didn’t look like it. Now, in this post and the following one, we’ll look at things by industry.
In that earlier post, I focused on publicly traded corporations. I know some people don’t like this — new companies, after all, aren’t going to be publicly traded. Of course in an ideal world we would not limit this kind of analysis to public traded firms. But for the moment, this is where the data is; by their nature, publicly traded corporations are much more transparent than other kinds of businesses, so for a lot of questions that’s where you have to go. (Maybe one day I’ll get funding to purchase access to firm-level financial data for nontraded firms; but even then I doubt it would be possible to do the sort of historical analysis I’m interested in.) Anyway, it seems unlikely that the behavior of privately held corporations is radically different from publicly traded one; I have a hard time imagining a set of institutions that reliably channel funds to smaller, newer firms but stop working entirely as soon as they are listed on a stock market. And I’m getting a bit impatient with people who seem to use the possibility that things might look totally different in the part of the economy that’s hard to see, as an excuse for ignoring what’s happening in the parts we do see.
Besides, the magnitudes don’t work. Publicly traded corporations continue to account for the bulk of economic activity in the US. For example, we can compare the total assets of the nonfinancial corporate sector, including closely held corporations, with the total assets of publicly traded firms listed in the Compustat database. Over the past decade, the latter number is consistently around 90 percent of the former. Other comparisons will give somewhat different values, but no matter how you measure, the majority of corporations in the US are going to be publicly traded. Anyway, for better or worse, I’m again looking at publicly-traded firms here.
In the simplest version of the capital-reallocation story, payouts from old, declining industries are, thanks to the magic of the capital markets, used to fund investment in new, technology-intensive industries. So the obvious question is, has there in fact been a shift in investment from the old smokestack industries to the newer high-tech ones?
One problem is defining investment. The accounting rules followed by American businesses generally allow an expense to be capitalized only when it is associated with a tangible asset. R&D spending, in particular, must be treated as a current cost. The BEA, however, has since 2013 treated R&D spending, along with other forms of intellectual property production, as a form of investment. R&D does have investment-like properties; arguably it’s the most relevant form of investment for some technology-intensive sectors. But the problem with redefining investment this way is that it creates inconsistencies with the data reported by individual companies, and with other aggregate data. For one thing, if R&D is capitalized rather than expensed, then profits have to be increased by the same amount. And then some assumptions have to be made about the depreciation rate of intellectual property, resulting in a pseudo asset in the aggregate statistics that is not reported on any company’s books. I’m not sure what the best solution is. [1]
Fortunately, companies do report R&D as a separate component of expenses, so it is possible to use either definition of investment with firm-level data from Compustat. The following figure shows the share of total corporate investment, under each definition, of a group of six high-tech industries: drugs; computers; communications equipment; medical equipment; scientific equipment other electronic goods; and software and data processing. [2]
As you can see, R&D spending is very important for these industries; for the past 20 years, it has consistently exceed investment spending as traditionally defined. Using the older, narrow definition, these industries account for no greater share of investment in the US than they did 50 years ago; with R&D included, their share of total investment has more than doubled. But both measures show the high-tech share of investment peaking in the late 1990s; for the past 15 years, it has steadily declined.
Obviously, this doesn’t tell us anything about why investment has stalled in these industries since the end of the tech boom. But it does at least suggest some problems with a simple story in which financial markets reallocate capital from old industries to newer ones.
The next figure breaks out the industries within the high-tech group. Here we’re looking at the broad measure of investment, which incudes R&D.
As you can see, the decline in high-tech investment is consistent across the high-tech sectors. While the exact timing varies, in the 1980s and 1990s all of these sectors saw a rising share of investment; in the past 15 years, none have. [3] So we can safely say: In the universe of publicly traded corporations, the sectors we think would benefit from reallocation of capital were indeed investing heavily in the decades before 2000; but since then, they have not been. The decline in investment spending in the pharmaceutical industry — which, again, includes R&D spending on new drugs — is especially striking.
Where has investment been growing, then? Here:
The red lines show broad and narrow investment for oil and gas and related industries — SICs 101-138, 291-299, and 492. Either way you measure investment, the increase over the past 15 years has dwarfed that in any other industry. Note that oil and gas, unlike the high-tech industries, is less R&D-intensive than the corporate sector as a whole. Looking only at plant and equipment, fossil fuels account for 40 percent of total corporate investment; by this measure, in some recent years, investment here has exceeded that of all manufacturing together. With R&D included, by contrast, fossil fuels account for “only” a third of US investment.
In the next post, I’ll look at the other key financial flows — cashflow from operations, shareholder payouts, and borrowing — for the tech industries, compared with corporations in general. As we’ll see, while at one point payouts were lower in these industries than elsewhere, over the past 15 years they have increased even faster than for publicly traded corporations as a whole. In the meantime:
Very few of the people talking about the dynamic way American financial markets reallocate capital have, I suspect, a clear idea of the actual reallocation that is taking place. Save for another time the question of whether this huge growth in fossil fuel extraction is a good thing for the United States or the world. (Spoiler: It’s very bad.) I think it’s hard to argue with a straight face that shareholder payouts at Apple or GE are what’s funding fracking in North Dakota.
[1] This seems to be part of a larger phenomenon of the official statistical agencies being pulled into the orbit of economic theory and away from business accounting practices. It seems to me that allowing the official statistics to drift away from the statistics actually used by households and businesses creates all kinds of problems.
[2] Specifically, it is SICs 83, 357, 366, 367, 382, 384, and 737. I took this specific definition from Brown, Fazzari and Petersen. It seems to be standard in the literature.
[3] Since you are probably wondering: About two-thirds of that spike in software investment around 1970 is IBM, with Xerox and Unisys accounting for most of the rest.
Are shareholder payouts a tool for reallocating capital from large, established corporations to the newer, smaller firms with better prospects for growth? If so, we should see this reflected in the investment figures — the shareholder revolution of the 1980s, and the more recent growth of activist investors, should be associated with a shift of investment away from big incumbent firms. Do we see this?
As a simple test, we can look at the share of corporate investment accounted for by smaller and younger firms. And the answer this exercise suggests is, No. Within the corporate sector, there is also no sign of capital being allocated to new sectors and smaller firms. The following figures show the share of total corporate investment accounted for by young firms, defined as those listed for less than five years; and by small firms, defined as those with sales below the median sales for listed corporations in that year. [1]
The share of investment accounted for newer firms fluctuates between 5 and 20 percent of the total, peaking periodically when large numbers of new firms enter the markets. [2] The most recent such peak came in tech boom period of the late 1990s, as one might expect. But the young-firm investment share shows no upward trend, and since the recession has been stuck at its lowest level of the postwar period. As for the the share of investment accounted for small firms, it has steadily declined since the 1950s — apart from, again, a temporary spike during the tech-boom period. Like the investment share of newer firms, the investment share of small firms is now at its lowest level ever.
We come to a similar conclusion if we look at the share of investment accounted for by noncorporate businesses. Partnerships, sole proprietorships and other noncorporate businesses accounted for close to 20 percent of US fixed investment in the 1960s and 1970s, but have accounted for a steady 12 percent of fixed investment over the past 25 years. So the funds flowing out of large corporations sector are not financing increased investment in smaller, younger corporations, or in the noncorporate sector either.
This is not really surprising. Smaller and younger businesses are mainly dependent on bank loans, and shareholder payouts don’t increase bank lending capacity in any direct way. More broadly, it’s hard to see evidence that potential funders of new businesses are liquidity-constrained. Higher payouts presumably do contribute to higher stock prices, and perhaps marginally to lower bond yields, but any connection with financing for new businesses seems tenuous at best.
In any case, whatever the shareholder revolution has accomplished, there does no seem to have been any reallocation of capital to smaller, growing firms. Capital accumulation in the United States is more concentrated in large established corporations than ever.
[1] Data is from Compustat, a database that assembles all the income, cashflow and balance sheet statements published since 1950 by corporations listed on US markets. I’ve excluded the financial sector, defined as 2-digit NAICS 52 and 53 and SIC 60-69. Investment is capital expenditure plus R&D.
[2] I suspect the late-80s peak is an artifact of the many changes of ownership in that period, which are hard to distinguish from new listings.
With my colleagues at the Roosevelt Institute, I’m working on a long-delayed followup to the Disgorge the Cash paper.
One of the issues we are addressing is this: Aren’t higher shareholder payouts just a way of channeling funds from mature, slow-growing firms to fast-growing sectors that need capital? This has always been one of the main arguments in support of the shareholder revolution. Michael Jensen:
With all its vast increases in data, talent, and technology, Wall Street can allocate capital among competing businesses and monitor and discipline management more effectively than the CEO and headquarters staff of the typical diversified company. KKR’s New York offices and Irwin Jacobs’ Minneapolis base are direct substitutes for corporate headquarters in Akron and Peoria.
Can the data shed light on the claim that high shareholder payouts are just a way that capital markets reallocate scarce funds from stagnant established firms to up-and-coming innovators?
One line of evidence against this claim is presented in my original Disgorge paper, though not explained as clearly as it could have been. As the table below — reproduced from the paper — shows, the correlations of investment with profits and borrowing have weakened not just at the level of the individual firm, but for the corporate sector as a whole. If markets were mainly reallocating capital from the industries of yesterday to the industries of tomorrow, we would expect an inflow of funds into the corporate sector to be associated with a rise in investment somewhere, even if not in the firms that initially received them. But this is not the case — or at least, it is less the case than it used to be. The weakening of the aggregate relationship between cashflow from operations and borrowing, on the one hand, and investment, on the other, suggests that higher payouts from one business are not translated into more investment funding for another.
Now I want to present two more lines of evidence that point in the same direction.
First, we can compare sources and uses of funds for corporations in general with the same sources and uses for corporations in high-technology industries. Second, we can look at smaller and younger firms specifically, and ask if they account for a higher share of investment than in the old days of managerialism, when investment was more internally financed. In the next two posts that’s what I’ll do.
The OECD has just released its new Business and Finance Outlook for 2015. A lot of interesting stuff there. We’ll want to take a closer look at the discussion of the problems that low interest rates pose for pension funds and insurance companies — I’ve thought for a while that this is the most convincing form of the “reaching for yield” argument. But what I want to talk about now is the OECD’s apparent endorsement of the “disgorge the cash” thesis.
Chapter 2, “Corporate Investment and the Stagnation Puzzle,” has a very interesting discussion of shareholder activism and its effects on investment. The starting point is the puzzle that while participants in financial markets are willing to accept unprecedentedly low returns, the minimum returns on new investment projects remain high, as evidenced by depressed real investment despite sustained low interest rates. I think this apparent puzzle is, precisely, a rediscovery of Keynes’ liquidity premium. (Perhaps I will return to this in a subsequent post.) There are a number of ways to think about this, but one dimension is the pressure corporate managers face to avoid investment projects unless the returns are rapid, large, and certain.
Stock markets currently reward companies that favour dividends and buybacks and punish those that undertake more investment … which creates higher hurdle rates for investment.
Here in one sentence is the disgorge the cash argument.
Private sector companies in market-based economies allocate capital spending according to shareholder value. Earnings may be retained for capital spending and growth, but only if the return on equity exceeds the cost of equity. If this is not the case then … they will choose to use their operating cash flow in other ways (by issuing dividends, carrying out cash buybacks…) … and in the limit may close plants and shed labor.
The bolded sentence is puzzling. Is it description or prescription? (Or description of a prescription?) The rest of the section makes no sense if you think either that this is how corporate investment decisions are made, or if you think it’s how they should be made. Among other reasons, once we have different, competing discount rates, the “return on equity” no longer has a well-defined value, even in principle. Throughout, there’s a tension between the language of economic theory and the language of concrete phenomena. Fortunately the latter mostly wins out.
The last decade has seen the rising importance of activist investors who gain the support of other investors and proxy advisors to remove management, to gain influential board seats and/or to make sure that company strategy is in the best interest of shareholders… The question arises as to whether the role of such investors is working to cause short-termism strategies [sic] at the expense of long-term investment, by effectively raising the hurdle rate… Activists… favour the short-term gratification of dividends and share buybacks versus longer-term investment. Incumbent managers will certainly prefer giving in to shareholders desire for more ‘yield’ in a low-interest world to taking on the risk of uncertain long-term investment that might cause them to be punished in the share market. …
To test this idea, an index of CAPEX/(CAPEX + Dividends & Buybacks) was created for each company, and the following investment strategy was measured: sell the highest quartile of the index (capital heavy firms) and buy the lowest quartile of the index (Dividend and Buyback heavy firms). … Selling high capital spending companies and buying low CAPEX and high buyback companies would have added 50% to portfolio values in the USA, 47% in Europe, 21% in emerging economies and even 12% in Japan (where activists play little role). On balance there is a clear investor preference against capital spending companies and in favor of short-termism. This adds to the hurdle rate faced by managers in attempting to undertake large capital spending programmes — stock market investors will likely punish them. … it would be fairly logical from a management point of view to return this cash to shareholders rather than undertake uncertain long-term investment projects… The risks instead would be born more by host-country investment in capacity and infrastructure.
This is a useful exercise. The idea is to look at the ratio of investment to shareholder payouts, and ask how the stock price of the high-investment firms performed compared to the high-payout firms, over the six years 2009 through 2014. What they find is that the shares of the high-payout firms performed considerably better. This is important because it undermines the version of the disgorge argument you get from people like Bill Lazonick, in which buybacks deliver a short-term boost the share price that benefits CEOs looking to cash in on their options, but does nothing for longer-term investors. In Lazonick’s version of the story, managers are on one side, shareholders, workers and the rest of society on the other. But if high-payout firms perform better for shareholders over a six-year horizon (which in financial-market terms is almost geologically long term) then we have to slice things differently. On one side are shareholders and CEOs, on the other are us regular people.
The other thing that is notable here is the aggregating of dividends and buybacks in a single “shareholder payout” term. This is what I do, I think it’s unambiguously the right thing to do, but in somequarters for some reason it’s controversial. So I’m always glad to find another authority to say, a buyback is a dividend, a dividend is a buyback, the end.
Another way to see these two points is to think about so-called dividend recapitalizations. These are when a private equity firm, having taken control of a business, has it issue new debt in order to fund a special dividend payment to themselves. (It’s the private equity firm that’s being recapitalized here, not the hapless target firm.) The idea of private equity is that the acquired firm will be resold at a premium because of the productive efficiencies brought about by new management. The more or less acknowledged point of a dividend recap is to allow the private equity partners to get their money back even when they have failed to deliver the improvements, and the firm cannot be sold at a price that would allow them to recoup their investment. Dividend recaps are a small though not trivial part of the flow of payments from productive enterprises to money-owners, in recent years totaling between 5 and 10 percent of total dividends. For present purposes, there are two especially noteworthy things about them. First, they are pure value extraction, but they take the form of a dividend rather than a share repurchase. This suggests that if the SEC were to crack down on buybacks, as people Lazonick suggest, it would be easy for special dividends to take their place. Second, they take place at closely held firms, where the managers have been personally chosen by the new owners. It’s the partners at Cerberus or Apollo who want the dividends, not their hired guns in the CEO suites. It’s an interesting question why the partners want to squeeze these immediate cash payments out of their prey when, you would think, they would just reduce the sale price of the carcass dollar for dollar. But the important point is that here we have a case where there’s no entrenched management, no coordination problems among shareholders — and Lazonick’s “downsize-and-distribute” approach to corporate finance is more pronounced than ever.
Back to the OECD report. The chapter has some useful descriptive material, comparing shareholder payouts in different countries.
[In the United States,] dividends and buybacks are running at a truly remarkable pace, even greater than capital expenditure itself in recent years. There has been plenty of scope to increase capital spending, but instead firms appear to be adjusting to the demands of investors for greater yield (dividends and buybacks). … [In Europe] dividends and buybacks are only half what United States companies pay … While there is no marked tendency for this component to rise in the aggregate in Europe, companies in the United Kingdom and Switzerland … do indeed look very similar to the United States, with very strong growth in buybacks. … [In Japan] dividends and buybacks are minuscule compared with companies in other countries. …
Here, for the US, are shareholder payouts (gray), investment (dark blue), and new borrowing (light blue, with negative values indicating an increase in debt; ignore the dotted “net borrowing” line), all given as a percent of total sales. We are interested in the lower panel.
from OECD, Business and Finance Outlook 2015
As you can see, investment is quite stable as a fraction of sales. Shareholder payouts, by contrast, dropped sharply over 2007-2009, and have since recovered even more strongly. Since 2009, US corporations have increased their borrowing (“other financing”) by about 4 percent of sales; shareholder payouts have increased by an almost exactly equal amount. This is consistent with my argument that in the shareholder-dominated corporation, real activity is largely buffered from changes in financial conditions. Shifts in the availability of credit simply result in larger or smaller payments to shareholders. The OECD report takes a similar view, that access to credit is not an important factor in variation in corporate investment spending.
The bottom line, though the OECD report doesn’t quite put it this way, is that wealth-owners strongly prefer claims on future income that take money-like forms over claims on future incomes exercised through concrete productive activity. [1] This is, again, simply Keynes’ liquidity premium, which the OECD authors knowing or unknowingly (but without crediting him) summarize well:
It was noted earlier that capital expenditures appear to have a higher hurdle rate than for financial investors. There are two fundamental reasons for this. First, real investors have a longer time frame compared to financial investors who believe (perhaps wrongly at times) that their positions can be quickly unwound.
From a social standpoint, therefore, it matters how much authority is exercised by wealth-owners, who embody the “M” moment of capital, and how much is exercised by the managers or productive capitalists (the OECD’s “real investors”) who embody its “P” moment. [2] Insofar as the former dominate, fixed investment will be discouraged, especially when its returns are further off or less certain.
Second, managers … operate in a very uncertain world and the empirical evidence … suggests that equity investors punish companies that invest too much and reward those that return cash to investors. If managers make an error of judgement they will be punished by activist investors and/or stock market reactions … hence they prefer buybacks.
Finally, it’s interesting what the OECD says about claims that high payouts are simply a way for financial markets to reallocate investment spending in more productive directions.
It is arguable that if managers do not have profitable projects, it makes sense to give the money back to investors so that they can reallocate it to those with better ideas. However, the evidence … suggests that the buyback phenomenon is not associated with rising productivity and better returns on equity.
Of course this isn’t surprising. It’s consistent with the academic literature on shareholder activism, and on the earlier takeover wave, which finds success at increasing payments to shareholders but not at increasing earnings or productive efficiency. For example, this recent study concludes:
We did not see evidence that targets’ financials improved… The targets’ leverage and payout, however, did seem to increase, suggesting that the activists are unlocking value by prompting management to return additional cash to shareholders.
Still, it’s noteworthy to see a bastion of orthodoxy like the OECD flatly stating that shareholder activism is pure extraction and does nothing for productivity.
UPDATE: Here’s James Mackintosh discussing this same material on “The Short View”:
[1] It’s worth mentioning here this interesting recent Australian survey of corporate executives, which found that new investment projects are judged by a minimum expected return or hurdle rate that is quite high — usually in excess of 10 percent — and not unresponsive to changes in interest rates. Even more interesting for our purposes, many firms report that they evaluate projects not based on a rate of return but on a payback period, often as short as three years.
[2] The language of “M and “P” moments is of course taken from Marx’s vision of capital as a process of transformation, from money to commodities to authority over a production process, back to commodities and finally back to money. In Capital Vol. 1 and much of his other writing, Marx speaks of the capitalist as straightforwardly the embodiment of capital, a reasonable simplification given his focus there and the fact that in the 1860s absentee ownership was a rare exception. There is a much more complex discussion of the ways in which the different moments of capital can take the form of distinct and possibly conflicting social actors in Capital Vol. 3, Part 5, especially chapter 27.
I have a working paper up at the Roosevelt Institute, as part of their new Financialization Project. Much of the content will be familiar to readers of this blog, but I think the argument is clearer and, I hope, more convincing in the paper.
