naked capitalism

John Authers of the Financial Times provides an update on corporate cash-hoarding. In brief, it’s getting worse due to probably-warranted executive nervousness about business prospects. As Authers puts it:

Corporate chieftains the world over have lots of cash, and want to hold on to it. It is a critical symptom of a new Age of Anxiety, as the corporate world tries and fails to convince itself that the global financial crisis has blown itself out. As Richard Dobbs, head of the McKinsey Global Institute, puts it: “Companies are uncertain about where the world is going to go. Until they are sure, they don’t want to pay the money out.”

In their drive for efficiency, companies have gone for operating too lean. There are two elements to this tale. One syndrome is well known, the now-infamous big company short-termism, which can easily come at the expense of longer-term results. But there is a second, related, but less well recognized aspect, that of operating with fewer buffers against risk. You see it in all sorts of practices: whittling down supplier networks to fewer companies (so as to gain more bargaining leverage over then) to just-in-time inventory to outsourcing (reliance on a partner reduces flexibility and responsiveness).

And as we wrote some months ago, we’ve hit the point where capitalists are no longer playing their proper role. The intuitive understanding most people have of how a proper economy works is that households save and businesses invest. But that is not how it has worked for quite some time. The time of onset varies by country, but in most advanced and emerging economies, the business sector has been a net saver too, in many nations for over a decade. And as Authers observes, that pattern has gotten even worse among big companies in the wake of the financial crisis:

According to Credit Suisse, the free cash flows of non-financial companies in the biggest four developed economies now account for 4.3 per cent of gross domestic product. This is double what it was a decade ago, and a record. Yet the share of gross domestic product going to investment is its lowest in decades, at about 16 per cent.

Where did the cash come from, then? Companies moved arguably too aggressively to cut costs in the wake of the Lehman shock. That created unemployment, but left far more cash on their books once the recovery started. Big companies have no problem accessing the cheap financing available from governments and central banks – unlike consumers and smaller companies, which must contend with the tighter standards being imposed by lending officers on the ground.

In China, companies pay less in dividends than their US counterparts, and save even more. But the resurgence of Chinese demand has generated cash elsewhere. Miners and natural resources groups in particular are awash with cash thanks to a resurgence in commodity prices that looks unsustainable.

In the US, small businesses somewhat offset the tight-fistedness of larger companies, but not by enough to make the business sector a net spender after the 2001-2002 recession. And this new pattern, of corporations as savers, has serious implications.

If you look at an economy from an accounting perspective, you can see why this pattern is dangerous. As we noted in July,

What happens when corporations on balance are saving, and households in aggregate try to save too? Families and individuals typically tighten their belts and bolster their bank accounts in bad times; the tendency is even more acute now, since many are trying to pay down borrowings, which is a form of saving,

If households and corporations are both saving, it must be balanced by the other two sectors of the economy, the government sector and the import/expert secto. In other words, the foreign and government sectors must spend more cash than they are taking in. In lay terms, that means running a trade surplus and having the government incur budget deficits.

Therefore, when both domestic households and the corporate sector are saving at the same time, then you need to have a VERY large trade surplus, a very large government deficit, or some combination of the two. There is no other way to square this circle – anyone who tries to tell you otherwise does not understand double entry book keeping, which the West has used for at least the last five centuries with some success.

And what if a government embarks on an austerity program in the face of private sector efforts to deleverage? Income growth will stall, and if the austerity program is large or sustained long enough, falling household wages and business profits can result.

That result might not sound bad, since lower wages and prices would make US goods more competitive abroad. But in economies suffering from a debt hangover, as incomes fall, it becomes even harder to make payments on outstanding loans. Defaults and bankruptcies cascade through the financial system, leading to even more reluctance to borrow and lend. In other words, the result of Austerian fiscal policies, is deflation – falling wages and prices – which can easily snowball into a depression.

This is why deficit spending, particularly on long-term investments, as Martin Wolf stressed, is sound in a deep recession or near depression. The problem is this policy was abused in expansionary periods and has gotten an undeserved bad name. The fact that antibiotics are overprescribed is no reason to refuse them if you have a gunshot wound. Yet the public has been conditioned to make a similar type of rejection in the economic realm. We are seeing the results in Ireland, where strict adherence to an austerity program has resulted in a nearly 20% fall in nominal GDP, making debt/GDP ratios worse, the exact opposite of the goal of this exercise. A far better policy is to write down and restructure bad debt, something creditors routinely do (think the US Chapter 11 process).

But bondholders have somehow gotten themselves in the position where they are refusing to share in collective pain, even though their investments were risk capital and they should be subject to the consequences of poor decisions. Instead, the losses have been shifted to taxpayers and ordinary savers (who are suffering due to negative real interest rates, another salvage operation for bank stock and bondholders). And the public at large has been steamrolled with Austerian logic, which again is the doing of….bond vigilantes!

As general Phyrrus said, “One more such victory shall utterly undo me.” But our leaders seem unable, as Phyrrus was, to keep proper stock of the true costs of their successes.