It’s surprising how the media and academia refuse to take notice of well-established phenomena that are inconsistent with the ideology about how our present order works. Of course, the ideology serves to justify the operation of our current regime, so one can see why those in positions of influence would not want unflattering stories to become mainstream. Nevertheless, one would hope expect to see robust minority opinion on questions like whether “shareholder capitalism” works as advertised. Yet even though the media often laments big business short-termism, it typically fails to point out obvious implications of the sustained fixation on quarterly earnings, as opposed to longer-term performance.
This short post based on a Roosevelt Institute study, explains that reliance on a rosy-colored view of how capitalism works explains why policies meant to stimulate growth are mainly goosing the value of equities.
Mind you, this general line of thinking is hardly new. We described this phenomenon in a paper for the Conference Board Review in 2005. Its thesis:
If you’ve visited a grocery store recently, it’s hard to miss the cover of Men’s Health, featuring buff young men, with their chiseled biceps and rock-hard abs, the seeming embodiment of fitness and vitality. Yet these poster boys for hearty living seldom achieve their “cut” through a wholesome process. While a lucky few, in the bloom of their youth, come by their six-packs naturally, the great majority go through a process of “dieting down” that is neither healthy nor sustainable. The typical regime is twelve weeks of rigorous dieting, combined with cardiovascular and weight work-
outs, resulting in the loss of muscle along with fat. And the use of steroids, stimulants, and diuretics is not uncommon. Even then, Men’s Health airbrushes some photos.
Just like these sculpted lads, corporate America takes extreme measures to look great for the end-of-quarter shoot. But the problem in the business world is that public companies are “dieting down” all the time, starving their businesses of needed investment and engaging in short-term expediencies.
Even worse, the belief that it is reasonable to try to meet an unhealthy standard has infected the business psyche. Body dysmorphia, a distortedly unflattering perception of the body, occurs when people are dissatisfied and preoccupied with their appearance. Examples include teen- age boys who use growth hormone to achieve a muscular look, along with growing numbers of men and women afflicted with eating disorders.
Like individuals who identify with an unattainable standard of perfection, Big Business increasingly suffers from corporate dysmorphia. Corporations deeply and sincerely embrace practices that, like the use of steroids, pump up their performance at the expense of their well-being.
Or as we wrote for a New York Times op-ed with Rob Parenteau in 2010:
The normal state of affairs is for households to save for large purchases, retirement and emergencies, and for businesses to tap those savings via borrowings or equity investments to help fund the expansion of their businesses.
But many economies have abandoned that pattern. For instance, IMF and World Bank studies found a reduced reinvestment rate of profits in many Asian nations following the 1998 crisis. Similarly, a 2005 JPMorgan report noted with concern that since 2002, US corporations on average ran a net financial surplus of 1.7 percent of GDP, which contrasted with an average deficit of 1.2 percent of GDP for the preceding forty years. Companies as a whole historically ran fiscal surpluses, meaning in aggregate they saved rather than expanded, in economic downturns, not expansion phases.
The big culprit in America is that public companies are obsessed with quarterly earnings. Investing in future growth often reduces profits short term. The enterprise has to spend money, say on additional staff or extra marketing, before any new revenues come in the door. And for bolder initiatives like developing new products, the up front costs can be considerable (marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors). Thus a fall in business investment short circuits a major driver of growth in capitalist economies.
Companies, while claiming they maximize shareholder value, increasingly prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or engage in financial speculation. They turn their backs on the traditional role of a capitalist – to find and exploit profitable opportunities to expand his activities…Rather than blindly marching to Austeria, we need to set fiscal policy to the task of incentivizing the reinvestment of corporate profits in business operations rather than games at the casino.
And the notion that companies have an obligation to “maximize shareholder value”? That is an economic theory that has gone mainstream. It most assuredly is not a legal theory. As we wrote in 2013:
If you review any of the numerous guides prepared for directors of corporations prepared by law firms and other experts, you won’t find a stipulation for them to maximize shareholder value on the list of things they are supposed to do. It’s not a legal requirement. And there is a good reason for that.
Directors and officers, broadly speaking, have a duty of care and duty of loyalty to the corporation. From that flow more specific obligations under Federal and state law. But notice: those responsibilities are to the corporation, not to shareholders in particular…Shareholders are at the very back of the line. They get their piece only after everyone else is satisfied. If you read between the lines of the duties of directors and officers, the implicit “don’t go bankrupt” duty clearly trumps concerns about shareholders…
So how did this “the last shall come first” thinking become established? You can blame it all on economists, specifically Harvard Business School’s Michael Jensen. In other words, this idea did not come out of legal analysis, changes in regulation, or court decisions. It was simply an academic theory that went mainstream. And to add insult to injury, the version of the Jensen formula that became popular was its worst possible embodiment.
So while it’s good to see the Roosevelt Institute taking up this important message, it’s simultaneously revealing that what ought to be obvious by now is instead treated as novel.
By David Llewellyn-Smith, founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. Originally posted at MacroBusiness
We all know that the RBA has been pushing a line for years that the missing link in the Australian recovery is business investment owing to poor “confidence”. I’ve railed against that any number of times noting that the actual problem is structural in that our competitiveness is shot owing largely to the consecutive booms in banking and mining. From the Roosevelt Institute comes another piece of the structural puzzle:
This paper provides evidence that the strong empirical relationship of corporate cash flow and borrowing to productive corporate investment has disappeared in the last 30 years and has been replaced with corporate funds and shareholder payouts. Whereas firms once borrowed to invest and improve their long-term performance, they now borrow to enrich their investors in the short-run. This is the result of legal, managerial, and structural changes that resulted from the shareholder revolution of the 1980s. Under the older, managerial, model, more money coming into a firm – from sales or from borrowing – typically meant more money spent on fixed investment. In the new rentier-dominated model, more money coming in means more money flowing out to shareholders in the form of dividends and stock buybacks.These results have important implications for macroeconomic policy. The shareholder revolution – and its implications for corporate financing decisions – may help explain why higher corporate profits in recent business cycles have generally failed to lead to high levels of investment. And under this new system, cheaper money from lower interest rates will fail to stimulate investment, growth, and wages because, as we show here, additional funds are funneled to shareholders through buybacks and dividends.Key Findings
• In the 1960s and 1970s, an additional dollar of earnings or borrowing was associated with about a 40-cent increase in investment. Since the 1980s, less than 10 cents of each borrowed dollar is invested.• Since the 1980s, shareholder payouts have nearly doubled; in the second half of 2007, aggregate payouts actually exceeded aggregate investment. Today, there is a strong correlation between shareholder payouts and borrowing that did not exist before the mid-1980s.• This change in corporate finance, associated with the “shareholder revolution”, means there is good reason to believe that the real economy benefits less from the easier credit provided by macroeconomic policy than it once did.
“There has been a major change in the upper middle-management layer of most corporations. In the old days, which certainly I believe in, the standard organisation was that equity went into a company, and if you owned that equity after 20 years’ hard work you made a lot of money if you were successful.
About 10 or 20 years ago this all changed. All of a sudden these people on good salaries who hadn’t taken the risk, who hadn’t built the corporation, they said to themselves: ‘I’d like to be rich. I’d like to have equity in the company but I don’t want to buy it.’ And a whole new set of instruments evolved out of America, which then infested the rest of the world, certainly the Western world, where executives became owners but with no risk.
[At that point] capitalism as we know it changed. It is not capitalism because the risk has gone. The executives have the upside and no down-side. That is the problem.”
What does it mean when Rodney Adler makes more sense than the Reserve Bank of Australia?
“how are present order works”
have edits, will travel
i will only add (as i’m sure you reinforce over and over), that the original social contract of korporations being formed ONLY if they benefited the public at large -NOT just owners/shareholdesr- has gone the way of the dodo…
(not to mention being of ‘limited duration’; so, what we end up with are immortal, immoral, fictitious legal entities (now more powerful people than actual people!), that have -relative to 99.99% of real people- infinite resources… gee, how *did* we end up in this mess ? ? ? *snort*
so, we not only have skewed the benefits to be arrogated exclusively by the korporations, we have eliminated virtually ANY regard for korporations serving the public interest AT ALL… (never mind paying taxes…)
Sorry re the typos. I composed this in great haste because a post that was supposed to have been provided was missing, and I did this on little sleep before having to run to the airport.
#1. A bunch of CEO’s with their shirts off on the cover of a magazine would be a good visual metaphor for the ugliness of corporate ethics.
#2. A bunch of as***les have succeeded in carving their dog-given right to sit around and rearrange tokens in exchange for extra tokens in stone.
Who needs food, shelter, or companionship, when you’ve got the markets? Money can always buy these things, right?
Hooray for economics!
#1 is a bad mental image, perhaps worse than corporate ethics, that I may not able to delete from my mind.
Yes, capitalism has changed. Then, what those superich do with their money if not investing in their own business? A lot of it is going to private equity firms and is inflating the internet bubble with every PE manager hoping to nurse their own google-amazon-facebook etc and obtain stratospheric benefits in very short periods. That’s why I complain with Wolf Richter when he blames the Fed or other central banks for lowering real interest rates when he writes about the internet bubble. This piece combines well with the view that the bubbles migth be driven by inequality rather than low real interest rates. Apart from internet start-ups, and few other operations like fracking, corporate investment seems to be diminishing. This is not to say that low real interests influence investment decissions but just to say that the causality migth come another way.
‘We need to set fiscal policy to the task of incentivizing the reinvestment of corporate profits in business operations.’
Consider a developed-country future in which population declines are expected. This is already happening in Japan, Italy and Russia, among others.
There would be very little need for any net corporate investment, beyond that needed to replace worn-out capital. And some capital (e.g., shopping malls) would even be abandoned for lack of demand.
Returning capital rather than reinvesting it is a rational response to a ZPG future, and it’s a more nuanced response than simply demanding ‘MOAR investment.’ Investment without return wastes resources.
True if ones’ focus were strictly financial. The sticky part is the socio-political. How much of economics deserves to be pure finance, and how much socio-political? There’s the basic conflict.
The reasoning is correct, but then all logical consequences must be consistently followed.
In particular, there should be a truly massive increase in the taxation of distributed profits, or in retained but not reinvested profits.
After all, corporations and shareholders clamoured for reduced taxation because it would lead to more investment and hence growth, did they not? So if the justification no longer applies, the reverse policy must apply…
Huh? You assume no innovation and no benefits to it.
Moreover, you assume no pressing needs. Just for starters are in desperate need of greatly reduced energy use, through conservation (which does not need to be at the expense of out, the waste is tremendous), much more investment in public transportation.
What does it mean when Rodney Adler makes more sense than the Reserve Bank of Australia?
Rodney is not an economist, so naturally makes more sense.
Imagine that you are the executive manager of a big publicly traded company and want to do the right thing, which would be . . . to find and exploit profitable opportunities to expand . . . activities…
Mr Market looks at that and goes haywire, saying stuff like “where is my money”, “how dare you take my money”, “investing for the future is taking away my money for today’s lunch”.
Mr Market goes for lunch and after a half dozen martinis, glowers at the executive that wants to do the right thing and declares “I will punish you by cutting your stock price in half, which means your executive payout will be cut in half, and the board’s payout will be cut in half, and you will die from a horrible slow financial death”.
The executive snaps out of it, and realizes that doing the right thing would be wrong.
Gosh, why does your comment bring the image of Carl Icahn whinging on about Apple needing to do ‘share buybacks’ come to mind…?
The topic of this post needs a lot more discussion and visibility IMVHO. But then, I tend to side with the people who actually make stuff – which is damn hard to do – rather than those like Icahn who obsess on ‘the financials’, rather than future productivity.
Why is this a problem? Lack of investment by corporations creates opportunities for individuals, I won’t use the word entrepreneurs, to create new businesses and bring fresh ideas into the economy. I smile every time I see companies like Yahoo, IBM, Xerox, HP, collapsing due to their lack of investment in the future.
Also, does anyone join a large corporation to “change the world” anymore? Many of those I’ve met in my career have been more focused on milking the cash cow than doing good work.
The overwhelming amount of basic research has been funded by government, and the next biggest investor is large corporations because they have the access to cheaper capital and ought to have the risk tolerance. The idea that small businesses make meaningful investments is an illusion.
You are confusing investment with innovation. They aren’t at all the same thing. Virtually all measures to increase the activity of an existing business requires investment. So not investing is tantamount to long term-liquidation. So you are basically saying you are fine with corporate executives looting their companies by levering them up and liquidating them.
And your view of innovation is also simplistic. Bell Labs and Xerox Parc, two of the greatest incubators of innovation, were both large entities. The auto industry was forced to be innovative in pollution reduction (catalytic converters and other measures) as a result of regulation.
We should ask, then, whether the large institutions are all that good at innovating. My experience would indicate that they are, generally, not. The history of the giants of the Technology Industry seems to support my intuition.
On investment as a cost of maintaining the position of the business, I totally agree. Not investing is, as you say, bad. Not investing and squandering cash on equity buy-backs is
As I said, look at Bell Labs. Or the creation of the DARPAnet, Or the Manhattan Project, which spawned ton of innovations. Most innovation is collaborative and involves taking ideas and technology and building on them. The Thomas Edison image of an innovator as an isolated individual is out of date. While it is true that a large majority of big organizations are not innovative, to say that they all aren’t is inaccurate. Japanese companies, for instance, make a fetish of kaizen, which is constant small innovations in process and product. And I hate to say it, but look at Wall Street. Firms there are constantly innovative, but not in our best interest.
Your case is further supported by the the findings of Robert Axtell on the growth of firms.
“Firm size matters. The corporations that attract and retain productive workers grow while others collapse”
Axtell, R. L.Zipf distribution of U.S. firm sizes. Science 293, 1818 – 1820 (2001).
Larger firms are larger because they have attracted more talented people that band together for economies of scale in talent build-up. Larger firms have grown large not because they maximized profit margins but because they attracted and retained the most productive workers. Thus lack of investment in large firms delay the process of innovation by disbanding the talented.
Note the language in the last paragraph from the quote by Parenteau, “Companies, while claiming they maximize shareholder value, increasingly prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or engage in financial speculation.”
Companies do not decide to do anything, the executives of companies decide to do things, like decide to pay themselves exorbitant bonuses. Similarly with banks; banks did not engage in fraud, the employees of bank, individual people engaged in fraud. As banks have become vehicles for the enrichment of the executives, so have any other types of companies.
The solutions are to be found not in punishing companies, but in punishing and changing the incentives for individuals.
“Yes, capitalism has changed”
I disagree. Capitalism never changed, but the available energy to society did. As society cascades back to lower amounts of energy available, capitalism will look just like it did in late 1800’s until the new deal. The new deal was only implemented for two reasons as far as i can see. The country was either going to have a revolution and how would you convince millions of people to fight a war for you if they can’t feed themselves? When the mirage of recovery is finally toss into the trashbin, we’ll see if the elites can bring themselves to create a new new deal, or if they think they can hold their ill gotten gains by force.
If capitalism means that the change of rules in favor of thieves are a normal part of it then you may be correct. For me, however, it is at least partially centrally planned crony capitalism at work mainly enabled by central banks with their deranged monetary policies.
Tell me when world energy use actually starts going down …
There is plenty of energy. Current human energy usage is less than 1% of the total solar energy that hits the planet. So, energy use should go up to alleviate human suffering in the world. We need to stop digging up buried solar energy and start using present solar energy, kinetic energy, gravitational energy, and heat from nuclear decay (aka solar and wind, tidal, part of geothermal, and the rest of geothermal, respectively)
Considering the treatment of Occupy and the growth of the industrial private prison complex, it appears to be the latter.
It always struck me as economists bearing quite a bit of the blame for the change in the way corporations compensated executives. I remember as a grad student in economics in the 1980’s reading articles (I think it was from the Chicago school people) about how bureaucrats, including in business, had their own motives, and how their incentives should be tailored to meet the needs of the organization. Compensation in the form of stocks was always a “remedy” for corporate “agents”. Keynes was right, defunct economists have more power than we want to believe. Unfortunately.
Investments are more often than not done to reduce costs. The most common (& most obvious to execs) cost is the cost of wages for the employed peons. Improved efficiency -> Fewer employees & if many corporations do the same then also -> higher unemployment -> poor wage growth. All of that leads to lack of demand. (situation could be mitigated if the myth – new jobs will always, from now until the end of time, replace the ones that have been automated away – was true)
Also, while some investments have been done to increase supply of goods (services to less extent) the increase has led to overcapacity. Now we have a situation with overcapacity and few execs want to invest if there already is overcapacity of production into the market. That would be true even if the execs did not solely focus on their own personal short term gains – maximise shareholder value.
The rather singe-minded focus on making capital investments more profitable by lowering the cost (interest) of investment is at best ill-advised and at worst it is …..
The way forward is to increase the relative bargaining strength of the average employee. There are several ways of doing so, however, none of them will come without a cost to people who are currently doing well in the current system.
Corporate greed is killing humanity.
Nice theory but I have a question. If the executives who are paid exorbitant bonuses by shareholders are paying the shareholders special dividends from, among other things, their financial speculation, who is it that is going to change the incentives. The set up as I see it is, “I’ll scratch your back if you’ll scratch mine”. These problems keep reminding me of the old saying: “Those that can won’t and those that won’t can.” (Hint – Those that can are our elected leaders and, of course, that brings up another set of bad incentives, doesn’t it?)
Please click through to the our older post. We provided remedies.
Do you recall a memoir from the early ’70’s entitled “The Gospel According to the Harvard Business School”?
The last line is precious, if I recall it correctly: “The maximization of corporate profits is the reason why God has created the Earth.”
Now there’s an economic theory for you.
The burden of bad ideas ….
There is no consumer protection agency in the marketplace of ideas ….
What university economist would submit to economic regulation in the marketplace of ideas? It furn out that their criticisms do not apply to what they themselves are doing …..
It’s caveat emptor all the way. in the marketplace of ideas….
Frankly, I believe we have an excellent current example of “stuff the shareholders”, and starve the corporations in the oil patch. Over on ZH I read a list of oil boom companies that are in severe financial distress. Well, some of these are startups, one might expect the margin on their cash flow to decline with oil prices. But where are those “rich” majors? It would appear there may be a fire sale. I read another piece that showed that total shareholder payout, including stock buy-backs, was a huge fraction of profit. Like them or not, it would seem much smarter business for big oil to use savings rather than borrowing to conduct exploration and development. Big oil it would appear, has drunk the Koolaid.
“it’s simultaneously revealing that what ought to be obvious by now is instead treated as novel.”
Revealing, yes. Novel, not so much
“It is difficult to get a man to understand something, when his salary depends upon his not understanding it!” Upton Sinclair
Recently I have been wondering a bit about the economy of scams and the more I think about it, the more I wonder whether economies might be going through periods in which scammers prevail. Take, for instance, ancient roman soldiers. Many of them were promised great rewards under the guise of plots of land for participanting to military efforts. Obviously, an ancient Roman living in comparatively miserable condition, would probably take that bait. But the odds are half of your army will never return, which prevents a lot of land from being distributed in the frist place. Then you redistribute to survivors, who maybe attempted to produce a little more produce than subsistance farming could. One bad year and they are saddled in debt, so they must sell the land for a misery to the landed elite (big farming). The remaining survivors try to sell in the marketplace, only to find their produce to cost too much, whereas the landed elite (also thanks to armies of slaves, imported these days for a pittance and known as mexicans et al) were able to sell their produce at a lower price, maybe even at a loss to force small land owners to sell them their small lot. Eventually, the luckyest soldiers, who managed to survive, kept running their mini-farm, realize after 10-15 years it all was a big, big scam, known as the “long scam”.
The idea that companies are unduly short-termist is indeed not new. But even with that well recognized, hardly anyone points out the obvious result of large-scale underinvestment and lower growth.