is there a credit crisis?

OECD: Activist Shareholders Are Bad for Investment

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 some quarters 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.

OECD_fig — 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.

The Cash and I

Martin Wolf in the FT the other day:

The third challenge is over the longer-term sources of demand. I look at this issue in terms of the sectoral financial balances – the balances between income and spending – in the household, business, external and government sectors. The question, then, is where expansion will come from. In the first quarter of this year the principal offset to fiscal contraction was the declining household surplus.

What is needed, as well, is a big swing towards surplus in the US current account or a jump in corporate investment, relative to retained profits. Neither seems imminent, though the second seems more likely than the first. The worry is that the only way to balance the economy will be via big new bubbles. If so, this is not the fault of the Fed. It is the fault of structural features of the domestic and global economies…

This is a good point, which should be made more. If we compare aggregate expenditure today to expenditure just before the recession, it is clear that the lower level of demand today is all about lower consumption. But maybe that’s not the best comparison, because during the housing boom period, consumption was historically high. If we take a somewhat longer view, what’s unusually low today is not household consumption, but business investment. Weak demand is about I, not C.

This is especially clear when we compare investment by businesses to what they are receiving in the form of profits, or, better cashflow from operations — after-tax profits plus depreciation. [1] Here is the relationship over the past 40 years:

Corporate Investment and Cashflow from Operations as Fraction of Total Assets, 1970-2012

The graph shows annualized corporate investment and cashflow, normalized by total assets. Each dot is data from one quarter; to keep the thing legible, I’ve only labeled the fourth quarter of each year. As you can see, there used to be a clear relationship between corporate profitability and corporate investment. For every additional $150, more or less, that a corporation took in from operations, it would increase capital expenditures by $100. This relationship held consistently through the 1960s (not shown), the 1970s, the 1980s and 1990s.

But now look at the past ten years, the period after 2001Q4. Corporate investment rates are substantially lower throughout this period than at any earlier time (averaging around 3.5% of total assets, compared with 5% of assets for 1960-2001). And the relationship between aggregate profit and investment rates has simply disappeared.

Some people might say that the problem is in the financial system, that even profitable businesses can’t borrow because of a breakdown in intermediation, a shortage of liquidity, an unwillingness of risk-averse investors to hold their debt, etc. I don’t buy this story for a number of reasons, some of which I’ve laid out in recent posts here. But it at least has some certain prima facie plausibility for the period following the great financial crisis. Not for for the whole decade-plus since 2001. Saying that investment is low today because businesses can’t find anyone to buy their bonds is merely wrong. Saying that’s why investment was low in 2005 is absurd.

(And remember, these are aggregates, so they mainly reflect the largest corporations, the ones that should have the least problems borrowing.)

So what’s a better story?

I am going to save my full answer for another post. But regular readers will not be surprised that I think the key is a shift in the relationship between corporations and shareholders. I think there’s a sense in which the binding constraint on investment has changed from the terms on which management can get funds into the corporation, from profits or borrowing, to the terms are on which they can keep them from going out, to investors. But the specific story doesn’t matter so much here. You can certainly imagine other explanations. Like, “the China price” — even additional capacity that would be profitable today won’t be added if it there’s a danger of lower-cost imports entering that market.

The point of this post is just that corporate investment is historically low, both in absolute terms and relative to profitability. And because this has been true for a decade, it is hard to attribute this weakness to credit constraints, or believe that it will be responsive to monetary policy. (This is even more true when you recall that the link between corporate borrowing and investment has also essentially disappeared.) By contrast, household consumption remains high. I have the highest respect for Steve Fazzari, and agree that high income inequality is a key metric of the fucked-upness of our economy. But I don’t think it makes sense to think of the current situation in terms of a story where high inequality reduces demand by holding down consumption.

Consumption is red, on the right scale; investment is blue, on the left. Both as shares of GDP.

As I say, I’ll come back in a future post to my on preferred explanation for why a comparably profitable firm, facing comparable credit conditions, will invest less today than 20 or 30 years ago.

In the meantime, one other thing. That first graph is a nice tool for showing how a Marxist thinks about business cycles.

If you look at the graph carefully, you’ll see the points follow counterclockwise loops. It’s natural to see this as cycles. Like this:

Start from the bottom of a cycle, at a point like 1992. A rise in profits from whatever source leads to higher investment, mainly as a source of funds and but also because it raises expectations of future profitability. That’s the lower right segment of the cycle. High investment eventually runs into supply constraints, typically in the form of a rising wage share.[1] At that point profits begin to fall. Investment, however, continues high for a while, as the credit system allows firms to bridge a growing financing gap. That’s the upper right segment of the cycle. Eventually, though, if profits don’t recover, investment will follow them downward. This turning point often involves a financial crisis and/or abrupt fall in asset values, like the collapse of tech stocks in 2000. This is the upper left segment of the cycle. Finally, in the lower left, both profits and investment are low. But after some time the conditions for profitability are restored, and we move toward the right and begin a new cycle. This last step is less reliable than the others. It’s quite possible for the economy to come to rest at the lower left and wobble there for a while without any sustained change in either profits or investment. We see this in 2002-2003 and in 1988-1991.

(I think the investment boom of the late 70s and the persistent slump of the early 1990s are two of the more neglected episodes in recent economic history. The period around 1990, in particular, seems to have all the features that are supposed to be distinctive to the current macroeconomic conjuncture. At the time, people even called it a balance-sheet recession!)

For now, though, we’re not interested in the general properties of cycles. We’re interested in how flat and low the most recent two are, compared with earlier ones. That is the structural feature that Martin Wolf is pointing to. And it’s not a new feature of the post financial crisis period, it’s been the case for a dozen years at least, only temporarily obscured by the housing bubble.

UPDATE: In comments, Seth Ackerman asks if maybe using total assets to normalize investment and profits is distorting the picture. It’s a good question, but the answer is no. Here’s the same thing, with trend GDP in the denominator instead:

As you can see, the picture is basically the same. Investment in the 200s is still visibly depressed compared with earlier decades, and the relationship between profits and investment is much weaker. Of course, it’s always possible that current high profits will lead an investment boom in the next few years…

[1] Cash from operations is better than profits for at least two reasons. First, from the point of view of aggregate demand, we are interested in gross not net investment. A dollar of investment stimulates demand just as much whether it’s replacing old equipment or adding new. So our measure of income should also be gross of depreciation. Second, there are major practical and conceptual issues with measuring depreciation. Changes in accounting standards may result in very different official depreciation numbers in economically identical situations. By combining depreciation and profits, we avoid the problem of the fuzzy and shifting line between them, making it more likely that we are comparing equivalent quantities.

[2] A rising wage share need not, and often does not, take the form of rising real wages. In recent cycles especially, it’s more likely to combine flat real wages with a rising relative cost of wage goods.

That Safe Asset Shortage, Continued

Regular readers of the blog will know that we have been having a contradiction with Brad DeLong and the rest of the monetarist mainstream of modern macroeconomics.

They think that demand constraints imply, by definition, an excess demand for money or “safe assets.” Unemployment implies disequilibrium, for them; if everyone can achieve their desired transactions at the prevailing prices, then society’s productive capacity will always be fully utilized. Whereas I think that the interdependence of income and expenditure means that all markets can clear at a range of different levels of output and employment.

What does this mean in practice? I am pretty sure that no one thinks the desire to accumulate safe assets directly reduces demand for current goods from households and nonfinancial businesses. If a safe asset shortage is restricting demand for real goods and services, it must be via an unwillingness of banks to hold the liabilities of nonfinancial units. Somebody has to be credit constrained.

So then: What spending is more credit constrained now, than before the crisis?

It’s natural to say, business investment. But in fact, nonresidential investment is recovering nicely. And as I pointed out last week, by any obvious measure credit conditions for business are exceptionally favorable. Risky business debt is trading at historically low yields, while the volume of new issues of high-risk corporate debt is more than twice what it was on the eve of the crisis. There’s some evidence that credit constraints were important for businesses in the immediate post-Lehmann period, if not more recently; but even for the acute crisis period it’s hard to explain the majority of the decline in business investment that way. And today, it certainly looks like the supply of business credit is higher, not lower, than before 2008.

Similarly, if a lack of safe assets has reduced intermediaries’ willingness to hold household liabilities, it’s hard to see it in the data. We know that interest rates are low. We know that most household deleveraging has taken place via default, as opposed to reduced borrowing. We know the applications for mortgages and new credit cards have continued to be accepted at the same rate as before the crisis. And this week’s new Household Credit and Debt Report confirms that people are coming no closer than before the crisis, to exhausting their credit-card credit. Here’s a graph I just made of credit card balances and limits, from the report:

Ratio of total credit card balances to total limits (blue bars) on left scale; indexes of actual and trend consumption (orange lines) on right scale. Source: New York Fed.

The blue bars show total credit card debt outstanding, divided by total credit card limits. As you can see, borrowers did significantly draw down their credit in the immediate crisis period, with balances rising from about 23% to about 28% of total credit available. This is just as one would expect in a situation where more people were pushing up against liquidity constraints. But for the past year and a half, the ratio of credit card balances to limits has been no higher than before the crisis. Yet, as the orange lines show, consumption hasn’t returned to the pre-crisis trend; if anything, it continues to fall further behind. So it looks like a large number of household were pressing against their credit limit during the recession itself (as during the previous one), but not since 2011. One more reason to think that, while the financial crisis may have helped trigger the downturn, household consumption today is not being held back a lack of available credit, or a safe asset shortage.

If it’s credit constraints holding back real expenditure, who or what exactly is constrained?

Tell Me About that “Safe Asset Shortage” Again

From today’s FT:

US Junk Debt Yield Hits Historic Low

The average yield on US junk-rated debt fell below 5 per cent for the first time on Monday, setting yet another milestone in a multiyear rally and illustrating the massive demand for fixed income returns as central banks suppress interest rates.

Junk bonds and equities often move in tandem, and with the S&P 500 rising above 1,600 points for the first time and sitting on a double digit gain this year, speculative rated corporate bonds are also on a tear. … With corporate default rates below historical averages, investors are willing to overlook the weaker credit quality in exchange for higher returns on the securities, analysts said. … The demand for yield has become the major driver of investor behaviour this year, as they downplay high valuations for junk bonds and dividend paying stocks.

“Maybe the hurdles of 6 per cent and now 5 per cent on high-yield bonds are less relevant given the insatiable demand for income,” said Jim Sarni, managing principal at Payden & Rygel. “People need income and they are less concerned about valuations.”

In other words, the demand for risky assets is exceptionally high, and this has driven up their price. Or to put it the other way, if you are a high-risk corporate borrower, now is a very good time to be looking for a loan.

Here’s the same thing in a figure. Instead of their absolute yield, this shows the spread of junk bonds over AAA:

Difference between CCC- and AAA bond yields

See how high it is now, over on the far right? Yeah, me neither. But if the premium for safe assets is currently quite low, how can you say that it is a shortage of safe assets that is holding back the recovery? If financial markets are willing to lend money to risky borrowers on exceptionally generous terms, how can you say the problem is a shortage of risk-bearing capacity?

Now, the shortage-of-safe-assets story does fit the acute financial crisis period. There was a period in late 2008 and early 2009 when banks were very wary of holding risky assets, and this may have had real effects. (I say “may” because some large part of the apparent fall in the supply of credit in the crisis was limited to banks’ unwillingness to lend to each other.) But by the end of 2009, the disruptions in the financial markets were over, and by all the obvious measures credit was as available as before the crisis. The difference is that now households and firms wished to borrow less. So, yes, there was excess demand for safe assets in the crisis itself; but since then, it seems to me, we are in a situation where all markets clear, just at a lower level of activity.

This is a perfect illustration of the importance of the difference between the intertemporal optimization vision of modern macro, and the income-expenditure vision of older Keynesian macro. In modern macro, it is necessarily true that a shortfall of demand for currently produced goods and services is equivalent to an excess demand for money or some other asset that the private sector can’t produce. Or as DeLong puts it:

If you relieve the excess demand for financial assets, you also cure the excess supply of goods and services (the shortfall of aggregate demand) and the excess supply of labor (mass unemployment).

Because what else can people spend their (given, lifetime) income on, except currently produced stuff or assets? If they want less of one, that must mean they want more of the other.

In the Keynesian vision, by contrast, there’s no fixed budget — no endowment — to be allocated. People don’t know their lifetime income; indeed, there is no true expected value of future income out there for them to know. So households and businesses adjust current spending based on current income. Which means that all markets can clear at a various different levels of aggregate activity. Or in other words, people can rationally believe they are on their budget constraint at different levels of expenditure, so there is no reason that a decline in desired expenditure in one direction (currently produced stuff) has to be accompanied by an increase in some other direction (safe assets or money).

(This is one reason why fundamental uncertainty is important to the Keynesian system.)

For income-expenditure Keynesians, it may well be true that the financial meltdown triggered the recession. But that doesn’t mean that an ongoing depression implies an ongoing credit crisis. Once underway, a low level of activity is self-reinforcing, even if financial markets return to a pristine state and asset markets all clear perfectly. Modern macro, on the other hand, does need a continued failure in financial markets to explain output continuing to fall short of potential. So they imagine a “safe asset shortage” even when the markets are shouting “safe asset glut.”

EDIT: I made this same case, more convincingly I think, in this post from December about credit card debt. The key points are (1) current low demand is much more a matter of depressed consumption than depressed investment; (2) it’s nonsense to say that households suffer from a shortage of safe assets since they face an infinitely-elastic supply of government-guaranteed bank deposits, the safest, most liquid asset there is; (3) while it’s possible in principle for a safe-asset shortage to show up as an unwillingness of financial intermediaries to hold household debt, the evidence is overwhelming that the fall in household borrowing is driven by demand, not supply. The entire fall in credit card debt is accounted for by defaults and reduced applications; the proportion of credit card applications accepted, and the average balance per card, have not fallen at all.

What Is Business Borrowing For?

In comments, Woj asks,

have you done any research on the decline in bank lending for tangible capital/investment?

As a matter of fact, I have. Check this out:

Simple correlation between borrowing and fixed investment

What this shows is the correlation between new borrowing and fixed investment across firms, by year (Borrowing and investmnet are both expressed as a fraction of the firm’s total assets; the data is from Compustat.) So what we see is that in the 1960s and 70s, a firm that was borrowing heavily also tended to be investing a lot, and vice versa; but after 1985, that was much less true. The same shift is visible if we look at the relationship between investment and borrowing for a given firm, across years: There is a strong correlation before 1980, but a much weaker one afterward. This table shows the average correlation of fixed investment for a given firm across quarters, with borrowing and cashflow.

Average correlation of fixed investment for a given firm.

So again, pre-1980 a given firm tended to borrow heavily and invest heavily in the same periods; after 1980 not so much.

I think it’s natural to see this change in the relation between borrowing and investment as a sign of the breakdown of the old hierarchy of finance. In the era of the Chandler-Galbraith corporation, payouts to shareholders were a quasi-fixed cost, not so different from bond payments. The effective residual claimants of corporate earnings were managers who, sociologically, were identified with the firm and pursued survival and growth objectives rather than profit maximization. Under these conditions, internal funds were lower cost than external funds, as Minsky, writing in this epoch, emphasized. So firms only turned to external finance once lower-cost internal funds were exhausted, meaning that in general, only those firms with exceptionally high investment demand borrowed heavily; this explains the strong correlation between borrowing and investment.

from Hubbard, Fazzari and Petersen (1988)

But since the shareholder revolution of the 1980s, this no longer really holds; shareholders have been much more effective in making their status as residual claimants effective, meaning that the opportunity cost of investing out of internal funds is no longer much lower than investing out of external funds. It’s no longer much easier for managers to convince shareholders to let the firm keep more of its earnings, than to convince bankers to let it have a loan. So the question of how much a firm borrows is now largely independent of how much it invests. (Modigliani-Miller comes closer to being true in a neoliberal world.)

Fun fact: Regressing nonfinancial corporate borrowing on stock buybacks for the period 2005-2010 yields a coefficient not significantly different from 1.0, with an r-squared of 0.98. In other words, it seems that the marginal dollar borrowed by a nonfinancial business in this period was simply handed on to shareholders, without funding any productive expenditure at all. This close fit between corporate borrowing and share buybacks raises doubts about the contribution of the financial crisis to the downturn in the real economy.

The larger implication is that, with the loss of the low-cost pool of internal funds, the hurdle rate for investment by nonfinancial firms is higher than it was during the postwar decades. In my mind this — more than inequality, tho it is of course important in its own right — is the structural condition for the Great Recession and the previous jobless recoveries. The downward shift in investment demand means that aggregate demand falls short of full employment except when boosted by asset bubbles.

The end of the cost advantage of internal funds (and the corresponding erosion of the correlation between borrowing and investment) is related to the end of the collapse of the larger post-New Deal structure of financial repression that preferentially channeled savings to productive investment.

UPDATE: I should clarify that while share buybacks are very large quantitatively — equal to total new borrowing by nonfinancial corporations in recent years — they are undertaken by only a relatively small group of firms. For smaller businesses, businesses without access to the bond market and especially privately held businesses, there probably still is a substantial wedge between the perceived cost of internal and external funds. It is quite possible that for small businesses, disruptions in credit supply did have significant effects. But given the comparatively small fraction of the economy accounted for by these firms, it seems unlikely that this could be a major cause of the recession.

Credit Cards and the Corridor

I don’t know if most people realize how much credit card debt fell during and after the Great Recession. It fell by a lot! Credit card debt outstanding today is about $180 billion, or 21 percent, lower than it was at the end of 2007. This is a 50 percent larger fall than in mortgage debt in percentage terms — though the fall in mortgages is of course much bigger in absolute dollars.

This fall in credit card debt is entirely explained by the drop in the number of credit card accounts, from about 500 million to 380 million. The average balance on open credit card accounts is about the same today as it was when the recession began.

The obvious question is, is this fall in consumer credit due to supply, or demand? Are banks less willing to lend, or are households less eager to borrow?

Here’s some interesting data that helps shed light on this question, from the Fed’s most recent Quarterly Report on Household Credit and Finance.

The red line shows the number of credit card accounts closed over the preceding 12 months, while the blue line shows the number opened. So the gap between the blue and red lines equals the change in the number of accounts. The spike in the red line is mostly write-offs, or defaults. I’ll return to those in a subsequent post; for now let’s look at the blue and green lines. The green line shows the number of inquiries, that is, applications for new cards by consumers. The blue line, again, shows the number issued. As we can see, the number of new accounts tracks the number of inquiries almost exactly. [1] What do we conclude from this? That the fall in the rate at which new credit cards are issued is entirely a matter of reduced demand, not supply. And given that balances on outstanding credit cards have not fallen, it’s hard to avoid the conclusion that banks’ reduced willingness to lend played little or no role in the fall in consumer credit.

Of course one figure isn’t dispositive, and mortgage debt is much more important quantitatively than credit card debt. But Dean Baker has been making a similar argument about mortgages for several years now:

the ratio of applications to [home] sales has not risen notably in this slump, indicating that the inability of potential homebuyers to get mortgages has not been a big factor in the housing downturn.

As a matter of fact, after reading that post (or one of Dean’s many others making the same point), I tried to construct a similar ratio for credit cards, but I wasn’t able to find the data. I didn’t realize then that the Fed publishes it regularly in the household credit report.

Needless to say, the ratio of applications to contracts is hardly the last word on this question, and needless to say there are plenty of more sophisticated attempts out there to disentangle the roles of supply and demand in the fall in borrowing. Rather than get into the data issues in more detail right now, I want to talk about what is at stake. Does it matter whether a fall in borrowing is more driven by the supply of credit or the demand for it? I think it does, both for theory and for policy.

One important question, of course, is the historical one: Did the financial crisis straightforwardly cause the recession by cutting off the supply of credit for nonfinancial borrowers, or were other factors more important? I admit to being agnostic on this question — I do think that credit constraints were dragging down fixed investment in the year or so before the recession officially began, but I’m not sure how important this was quantitatively. But setting aside the historical question, we also need to ask, is the availability of credit the binding constraint on real activity today?

For monetarists and New Keynesians, the answer has to be Yes almost by definition. Here’s DeLong:

There is indeed a “fundamental” configuration of asset prices–one that produces full employment, the optimal level of investment given the time preference of economic agents and the expected future growth of the economy, and the optimal division of investment between safe, moderately risky, and blue-sky projects.

However, right now the private market cannot deliver this “fundamental” configuration of asset prices. The aftermath of the financial crisis has left us without sufficient trusted financial intermediaries … no private-sector agent can create the safe securities that patient and prudent investors wish to hold. The overleverage left in the aftermath of the financial crisis has left a good many investors and financial intermediaries petrified of losing all their money and being forced to exit the game–hence the risk tolerance of the private sector is depressed far below levels that are appropriate given the fundamentals… Until this overleverage is worked off, the private marketplace left to its own will deliver a price of safe assets far above fundamentals … and a level of investment and thus of employment far below the economy’s sustainable and optimal equilibrium.

In such a situation, by issuing safe assets–and thus raising their supply–the government pushes the price of safe assets down and thus closer to its proper fundamental equilibrium value.

In other words, there is a unique, stable, optimal equilibrium for the macroeconomy. All agents know their expected lifetime income and preferred expenditures in that equilibrium. The only reason we are not there, is if some market fails to clear. If there is a shortfall of demand for currently produced output, then there must be excess demand for some asset the private sector cannot produce. In the monetarist version of the story, that asset is money. [2] In DeLong’s version, it’s “safe assets” more generally. But the logic is the same.

This is why DeLong is so confident that continued zero interest rates and QE must work — that it is literally impossible for output to remain below potential if the Fed follows its stated policy for the next three years. If the only reason for the economy to be off its unique, optimal growth path is excess demand for safe assets, then a sufficient increase in the supply of safe assets has to be able to get us back onto it.

But is this right?

Note that in the passage above, DeLong refers to a depressed “level of investment and thus of employment.” That’s how we’re accustomed to think about demand shortfalls, and most of the time it’s a reasonable shorthand — investment (business and residential) generally does drive fluctuations in demand. But it’s not so clear that this is true of the current situation. Here, check this out:

We’re looking at output relative to potential for GDP and its components; I’ve defined potential as 2.5 percent real annual growth from the 2007Q4 peak. [3] What we see here is investment and consumption both fell during the recession proper, but since 2010, investment has recovered strongly and is almost back to trend. The continued output gap is mainly accounted for by the failure of consumption to show any signs of returning to trend — if anything, consumption growth has decelerated further in the recovery.

You can’t explain low household consumption demand in terms of a shortage of safe assets. The safest, most liquid asset available to households is bank deposits, and the supply of these is perfectly elastic. I should note that it is possible (though not necessarily correct) to explain falling consumption this way for the early 1930s, when people were trying to withdraw their savings from banks and convert them into cash. The private sector cannot print bills or mint coins. But classical bank runs are no longer a thing; people are not trying to literally hoard cash; it is impossible that a lack of safe savings vehicles for households is what’s holding down consumption today.

So if we are going to explain the continued consumption shortfall in DeLong’s preferred terms, households must be credit-constrained. It is not plausible that households are restricting consumption in order to bid up the price of some money-like asset in fixed supply. But it is plausible that the lack of trusted financial intermediaries makes investors less willing to hold households’ debt, and that this is limiting some households’ ability to borrow and thus their consumption. In that case, it could be that increasing the supply of safe assets will provide enough of a cushion that investors are again willing to hold risky assets like household debt, and this will allow households to return to their optimal consumption path. That’s the only way DeLong’s story works.

It’s plausible, yes; but is it true? The credit card data is evidence that, no, it is not. If you believe the evidence of that first figure, the fall in consumer borrowing is driven by demand, not supply; continued weakness in consumption is not the result of unwillingness of investors to hold household debt due to excess demand for safe assets. If you believe the figure, investors are no less willing to hold consumer debt than they were before the recession; it’s households that are less willing to borrow.

Again, one figure isn’t dispositive. But what I really want to establish is the logical point: The shortage-of-safe-assets explanation of the continued output gap, and the corollary belief in the efficacy of monetary policy, only makes sense if the weakness in nonfinancial units’ expenditure is due to continued tightness of credit constraints. So every additional piece of evidence that low consumption (and investment, though again investment is not especially low) is not due to credit constraints, is another nail in the coffin of the shortage-of-safe-assets story.

So what’s the alternative? Well, that’s beyond the scope of this post. But basically, it’s this. Rather than assume there is a unique, stable, optimal equilibrium, we say that the macroeconomy has multiple equilibria and/or divergent adjustment dynamics. More specifically, we emphasize the positive feedback between current income and expenditure. For small deviations in income, people and businesses don’t adjust their expenditure, but use credit and and/or liquid assets to maintain it at its normal level. But for large deviations, this buffering no longer takes place, both because of financing constraints and because true lifetime income is uncertain, so people’s beliefs about it change in response to changes in current income.

In other word’s Axel Leijonhufvud’s “corridor of stability”. Within certain bounds (the corridor), the economy experiences stabilizing feedback, based on relative prices; beyond them, it experiences destabilizing feedback based on the income-expenditure link. Within these bounds, the multiplier is weak; outside them, it is “strong enough for effects of shocks to be endogenously amplified. Within the corridor, the prescription is in favor of ‘monetarist,’ outside in favor of ‘fiscalist’, policy prescriptions.”

I’m going to break that thought off here. The important point for now is that if you think that the continued depressed level of real economic activity is due to excess demand for safe assets, you really need evidence that the expenditure of households and businesses is limited by the unwillingness of investors to hold their liabilities, i.e. that they face credit constraints. And this credit card data is one more piece of evidence that they don’t. Which, among other things, makes it less likely that central bank interventions to remove risk from the balance sheets of the financial system will meaningfully boost output and employment.

[1] For some reason, inquiries are given over the past six months while the other two series are given over the past year. This implies that about half of all inquiries result in a new account being opened. The important point for our purposes is that this fraction did not change at all during the financial crisis and recession.

[2] To be fair, you can also find this story in the General Theory — “unemployment develops because people want the moon,” etc. But it’s not the only story you can find there. And, I would argue, Keynes really intends this as a story of how downturns begin, and not why they persist.

[3] Yes, it would be more “correct” to use the BEA’s measure of potential output. But the results would be qualitatively very similar, and I don’t think there’s nearly enough precision in measures of potential output to make the few tenths of a point difference meaningful.

LATE UPDATE: Here is a similar graph for the previous recession & recovery.

The Financial Crisis and the Recession: Two Datapoints for the Skeptics

One of the most dramatic features of the financial crisis, for those who were following it obsessively in the autumn of 2008, was the near-freezing up of the commercial paper market. Commercial paper is short-term debt sold in markets rather than advanced by banks. It’s mostly very short maturity — days, weeks or months, not years. It’s generally cheaper than other forms of financing, but firms that rely on it need to be able to borrow more or less continuously. Doubts about their financial condition, or even the suspicion that other lenders might have doubts, can quickly push them up against their survival constraint. This is what happened to a number of financial institutions — most spectacularly Lehman Brothers — in the third quarter of 2008. The breakdown in the commercial paper market was one of the things that convinced people the financial universe was imploding, and taking the real economy down with it.

The story, implicit or explicit, was that the suddenly reduced or uncertain value of financial assets, and the seizing-up of the interbank markets, left banks unable or unwilling to hold the liabilities of nonfinancial businesses, i.e., to lend. These businesses found themselves unable to finance new investment or even routine operations, leading to the Great Recession. This is essentially the same story that Milton Friedman told (and Peter Temin, among others, criticized), about the Great Depression, but it’s also more or less the consensus view of the 2008-09 crisis among New Keynesian economists. For example:

A large decrease in the value of asset holdings of financial institutions resulted in dramatic intensification of the agency problems in those institutions … Credit spreads widened and credit rationing became widespread. The diminished ability to finance the acquisition of capital goods resulted in huge cutbacks of all types of investment.

The same story was widespread in the business journalism world, with people like Andrew Ross Sorkin writing, “Commercial paper, the workaday stuff that lets companies make payroll, was suddenly viewed as radioactive — and business activity almost stopped in its tracks.” Most importantly, this was the view of the crisis that motivated — or at least justified — the choice of both the Bush and Obama administrations to make strengthening bank balance sheets their number one priority in the crisis. But is it right? There are reasons for doubt.

Data from FRED.

See, here’s a funny thing. I haven’t seen it discussed anywhere, but it’s very interesting. The commercial paper of financial and nonfinancial firms, normally interchangeable, fared quite differently in the crisis. Up til then, both had tracked the federal funds rate closely, except in the early 90s (the last by-general-agreement credit crisis) when both had risen above it. But as the figure above shows, in the fall of 2008, right around the Lehmann failure (the arrow on the graph), an unprecedented gap opened up between the interest lenders demanded on commercial paper from financial versus nonfinancial companies.

The implication: The state of the interbank lending market isn’t necessarily informative about the availability of credit to nonfinancial firms. It’s perfectly possible that lots of big banks had made lots of stupid bets in the real estate market, and once this became known other banks were unwilling to lend to them. But they remained perfectly willing to lend to everyone else — perhaps even on more favorable terms, since those funds had to go somewhere. The divergence in commercial paper rates is hardly dispositive, of course, but it at least suggests that the acute phase of the financial crisis was more of a problem for the financial sector specifically than for the economy as a whole

Second. Sorkin calls commercial paper “the workaday stuff that lets companies meet payroll.” This kind of language was everywhere for a while — that the financial crisis threatened to stop the flow of short-term credit from banks, and that without that even the most routine business functions would be impossible.

One of the central political-economic facts of our time is that public discussion of the economy is entirely dominated by finance. The interests of banks differ from those of other businesses on many dimensions; one of them is banks’ dependence on short-term financing. Financial firms are defined by the combination of short-term liabilities and long-term assets; they need to borrow every day; that’s why they’re subject to runs. The fear of not being able to make payroll if you’re cut off, even briefly, from financial markets, is perfectly reasonable, if you’re a bank.

But if you’re not?

In fact, short-term debt is large relative to cashflow only for financial firms. Nonfinancial firms don’t finance operating expenses through debt, only investment. (And inventories and goods-in-progress, which are largely financed by credit from customers and suppliers, rather than from banks.) From Compustat:

Short-term debt as a fraction of total debt

Sector	Median	Mean
FIRE	0.56	0.55
Non-FIRE	0.16	0.23

Short-term debt as a fraction of cashflow

Sector	Median	Mean
FIRE	7.53	15.1
Non-FIRE	0.35	0.71

Short-term debt as a fraction of revenue

Sector	Median	Mean
FIRE	0.78	1.64
Non-FIRE	0.04	0.08

(FIRE is finance, insurance and real estate. Short-term here means maturities of less than a year. Cashflow is defined as profits plus depreciation.)
This isn’t a secret; but it’s striking how different are the financing structures of financial and nonfinancial firms, and how little that difference has penetrated into public debate or much of the economics profession. For the median financial firm, losing access to short-term finance would be equivalent to a 70 percent fall in revenues; few could survive. For the median nonfinancial firm, by contrast, loss of access to short-term finance would be equivalent to a fall in revenues of just 4 percent. Short-term finance is just not that important to nonfinancial firms.
So, the breakdown in short-term credit markets was largely limited to financial firms, and financial firms are anyway the only ones that really depend on short-term credit. I don’t claim these two pieces of evidence are in any way definitive — I’ve got a long paper on this question in the works, which, well, won’t be definitive either — but they are at least consistent with the story that the financial crisis, on the one hand, and the fall of employment and output, on the other, were more or less independent outcomes of the collapse of the housing bubble, and that the state of the banks was not the major problem for the real economy.

EDIT: For the life of me, I can’t get either graphs or tables to look good in Blogger.

What Does a Credit Crunch Look Like?

What doesn’t it look like? Krugman has a picture:

His point here is right, for sure: Business investment is being held back by weak demand, not lack of credit. Would Tufte approve of that graph, tho? (It looks like one of those images of disk usage you get when you defragment your hard drive.) And more importantly: Why does it start in 1986?

It’s an arbitrary date, and an especially weird one to pick in this context, because of what happens if you go back just a couple years. You call that a credit crunch, mate? Now this is a credit crunch:

See that spike over on the left? That’s a country full of businessmen screaming as Papa Volcker stomps on their necks. (To be fair, it’s their workers he was mainly interested in strangling, but the credit squeeze for business was no less real for that.) And that’s what a credit crunch looks like.

Credit and car sales

Here’s another one for the file on credit availability and the downturn: How much has tighter financing contributed to the decline in car sales?

The conventional view is that auto sales, like other categories of consumer spending, have been sharply and directly reduced by the financial crisis. From today’s Wall Street Journal:

The hardest-hit markets since the crisis were ones at the heart of the financial problem — the “securitization” markets where loans for everything from mortgages to credit-card debt get sliced up and repackaged into complex securities.

The size of the market for securities backed by loans tied to homeowners’ equity has shrunk more than 40% since the second half of 2007. The market for securities backed by auto loans has shrunk 33%…

These securitization markets provided as much as 50% of consumer lending in the years leading up to the crisis, says Tim Ryan of the Securities Industry and Financial Markets Association, a financial-industry trade group. “Without [the securitization markets], it’s very difficult to replicate the amount of money moving into the economy,” he says.

I’ve been skeptical about this story in general, but let’s see how it holds up in this case. (Click the graph to make it readable; I’m still figuring out the mechanics of blogging.)

The top panel shows the real interest rate on new car loans, the second shows the average loan-to-value ratio, and the bottom shows monthly auto sales in millions, at a seasonally-adjusted annual rate. (Source: Table G.20 from the Flow of Funds; BEA via FRED.) The vertical lines mark business cycle peaks. To make the argument clear, here are the same graphs for just the past two years. The gray area in this one shows when the “Cash for Clunkers” program was in effect.

We see a few things here. First, while auto financing clearly did get tighter as measured both by interest rates and loan-to-value (the latter is a measure of credit availability), the decline in sales started first. Sales were already falling by the end of 2007, while there’s no sign of tighter credit until August 2008. So while the collapse of the secondary market for securitized auto loans may indeed have caused lenders to tighten their standards, it’s not clear that this was a major factor in reducing sales. Further evidence on this point: Auto credit tightened just as much in 2003-04, with no effect whatever on sales.

Second, while lending standards relaxed this past spring (the bailouts worked), easier credit didn’t get people into the dealerships. The spike in sales this summer was all about cash for clunkers; once that ended, sales collapsed, even though interest rates remained extremely low and credit availability, as measured by the loan-to-value ratio, remained fairly high (lower than in the 2000s, but similar to the 90s.) Interestingly, dealers seem to have tightened credit standards during the period of heightened demand in July and August; in this case, the real dog was wagging the financial tail.

So as far as cars go, we can conclude: The credit crisis may have contributed to the decline in real activity, but it wasn’t the sole or the decisive cause. And now that sales have collapsed, there’s no reason to think that credit conditions are what’s holding them down. If you want to support the auto industry, give people money to buy cars (or retrofit car factories to build windmills). Don’t try to revive the market for securitized auto loans.

Getting it wrong on credit conditions

I’ve been obsessed for a while with the idea that credit availability is a much smaller factor in the current downturn than is widely believed — that the focus on bank balance sheets as a key constraint on output and employment is a symptom of the intellectual capture of economic discussions by Wall Street.

Here’s a perfect example from the generally good Gretchen Morgenson of the Times. Morgenson writes:

All that debt overhanging consumers and organizations is the pivotal reason we are still seeing a free fall in bank lending. And small businesses, which account for half of all jobs in this country, are taking the brunt of this credit contraction. Smaller banks are especially worried about their own balance sheets and aren’t making loans. This puts small businesses important engines of growth squarely on the brink.

In its survey, the [National Federation of Independent Businesses] asks small businesses how easy it is for them to get loans. The most recent data shows that credit tightness peaked earlier this fall the worst levels in 23 years, Mr. Shepherdson says. Although credit continues to remain troublingly hard for small business to come by, that phenomenon is a largely untold story.

So let’s take a look at what that NFIB report actually says. Yes, on p.12-13 it reports that the net percent reporting easier credit conditions was -14 percent in October, compared with just -4 percent five years ago; in July, the percent saying they had satisfied their borrowing needs over the past three months bottomed out at 29%, with 10% saying their borrowing needs were not satisfied. (The balance didn’t need to borrow.)

But!

Turn to p. 14 and you see that the interest rate paid by small business on short-term loans was 6.0%, down from 9.5% in May 2007. On p.6, we learn that of the half of small business owners who report lower earnings this month, 62% say it’s because of reduced sales and another 8% to price cuts; only 13% cite rising costs, including labor, materials, taxes, and regulatory costs as well as finance costs. And then on p. 18 they ask small biz owners what is their most important problem. Sales, 33%; taxes, 22%; government regulation, 11%; competition from big business, 6%; and finally financing, tied with cost and and quality of labor at 4%. Compare this to the early 80s, when nearly 40% cited financing as their single most important problem.

Here’s how the NFIB itself summarizes these findings:

Overall, loan demand remains weak due to widespread postponement of investment in inventories and record low plans for capital spending. In addition, the continued poor earnings and sales performance has weakened the credit worthiness of many potential borrowers. This has resulted in tougher terms and higher loan rejection rates (even with no change in lending standards), and there is no rush to borrow money … It sounds like the Administration thinks the reason small firms are not hiring is that they are not able get credit. Although credit is harder to get, ‘financing’ is cited as the ‘most important problem’ by only four percent of NFIB’s hundreds of thousands of member firms. … Record low percentages cite the current period as a good time to expand, more owners plan to reduce inventories than to add to them, and record low percentages plan any capital expenditures. In short, the demand for credit is in short supply and failing to understand the more major problems facing small business leads to bad policy. … What small business needs is customers.

Gretchen Morgenson is one of the better business reporters out there, as far as I can tell. So how could she take a report that explicitly says that credit availability is not a major problem for small businesses and turn its findings around 180 degrees? And of course, this has implications for the shaping of policy. The NFIB’s story leads to the conclusion that what’s needed is government action to raise final demand. But in Morgenson’s version, it turns into an argument for further capital injections into the banking system instead. That’s how strong is the intellectual hegemony of finance. Stories that don’t end with the moral “… and so banks need more money” just do not get told.