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?