Sunday, November 23, 2014

Wallets Wide Shut

NEWPORT BEACH, CALIFORNIA – Some economists, like Larry Summers, call it “secular stagnation.” Others refer to it as “Japanization.” But all agree that after too many years of inadequate growth in advanced economies, substantial longer-term risks have emerged, not only for the wellbeing of these countries’ citizens but also for the health and stability of the global economy.

Those looking for ways to reduce the risks of inadequate growth agree that, of all possible solutions, increased business investment can make the biggest difference. And many medium-size and large companies, having recovered impressively from the huge shock of the 2008 global financial crisis and subsequent recession, now have the wherewithal to invest in new plants, equipment, and hiring.

Indeed, with profitability at or near record levels, cash holdings by the corporate sector in the United States have piled up quarter after quarter, reaching all-time highs – and earning very little at today’s near-zero interest rates. Moreover, because companies have significantly improved their operating efficiency and lengthened the maturities on their debt, they need a lot less precautionary savings than they did in the past.

However one looks at it, the corporate sector in advanced economies in general, and in the US in particular, is as strong as it has been in many years. Non-financial firms have achieved a mix of resilience and agility that contrasts sharply with prevailing conditions for some households and governments around the world that have yet to confront adequately a legacy of over-leverage.

But, rather than deploy their abundant cash in new investments to expand capacity and tap new markets – which they have been very hesitant to do since the global financial crisis erupted – many companies have so far preferred (or have been pressured by activist investors) to give it back to shareholders.

Last year alone, US companies authorized more than $600 billion of share buybacks – an impressive amount by any measure, and a record high. Moreover, many companies boosted their quarterly dividend payouts to shareholders. Such activity continued in the first two months of 2014.

But, while shareholders have clearly benefited from companies’ unwillingness to invest their ample cash, the bulk of the injected money has been circulating only in the financial sector. Little of it has directly benefited economies that are struggling to boost their growth rates, expand employment, avoid creating a lost generation of workers, and address excessive income inequality.

If advanced economies are to prosper, it is necessary (though not sufficient) that the corporate sector’s willingness to invest match its considerable wallet. Six factors appear to pose particularly important constraints.

First, companies are concerned about future demand for their products. The recent economic recovery, as muted as it has been (both in absolute terms and relative to most expectations), has been driven by the experimental policies that central banks have pursued to sustain consumption. Now, with the US Federal Reserve beginning to withdraw monetary stimulus, and with growth in emerging countries slowing, most companies are simply unable to point to massive expansion opportunities.

Second, with China such an influential driver of global demand (both directly and indirectly through important network effects), the outlook for the world’s second-largest economy has a disproportionate impact on projections of global corporate revenues. And, as China’s excessive domestic credit growth and shadow-banking system attract increased attention, many companies are becoming anxious.

Third, while companies recognize that innovation is a key comparative advantage in today’s global economy, they are also humbled by its increasingly winner-take-all nature. Successful innovation today is a lot less about financing and much more about finding the “killer app.” As a result, many companies, less convinced that “normal” innovation yields big payoffs, end up investing less overall than they did before.

Fourth, the longer-term cost-benefit analysis for would-be investors is clouded by legitimate questions about certain operating environments. In the US, many companies expect major budgetary reform; but they are not yet able to assess the impact on their future operating profits. In Europe, politicians are aware of the need for major structural reforms, including those required to solidify regional integration; but companies lack adequate clarity about the components of such reforms.

Fifth, the scope for risk mitigation is not as large as financial advances would initially suggest. Yes, companies have more hedging tools at their disposal. But the ability to manage downside risk comprehensively is still limited by incomplete longer-term markets and public-private partnerships that cannot be sufficiently leveraged.

Finally, most corporate leaders recognize that they owe a large debt of gratitude to central bankers for the relative tranquility of recent years. Through bold policy experiments, central bankers succeeded in avoiding a global multi-year depression and buying time for companies to heal.

But, working essentially alone, central banks have not been able to revamp properly the advanced economies’ growth engines; nor do they have the tools to do so. Though many corporate leaders may still be unable to grasp the precise threats, they seem uneasy about the longer-term collateral damage implied by running modern market economies at artificially repressed interest rates and with bloated central-bank balance sheets.

The good news is that each of these constraints on investment can – and should – be addressed; and recent US business investment data suggest some progress. The bad news is that it will take a lot more time, effort, and global coordination. In the meantime, the corporate sector will only gradually take on more of the heavy lifting. That will be enough to keep the advanced economies growing this year; unfortunately, it will not be enough to attain the faster growth that their citizens’ wellbeing – and that of the global economy – urgently requires.

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    1. CommentedLuis de Agustin

      The article’s title suggested reference to the usual culprit for lack of growth – damp consumer spending, whereas Mr. El-Erian appears to make the case for capital formation and investment as key to growth. To the extent, this is so in the author’s opinion, the macro prescription is sound.

      In a recent presentation on how economies really function from the POV of the underlying thrust of this argument, David Ranson, Wainwright Economics, summarizes the investment environment we live in vs. the one we’re told we live in, that is, an economy organized around capital vs. spending that fuels and thrusts the growth engine forward.

      Ranson begins by positing just about the only point we’ll all likely agree on - that no one should believe everything they hear from Washington and the media, especially when it comes to the way the economy works. Apart from this, it’s an argumentative slugfest – among gentlemen of course.

      Journalists depend on the economics profession to explain it all to them, and economists in turn tend to depend on the consensus of their colleagues rather than do their own homework.

      The disadvantage of doing one’s own homework is that the results may be inconvenient. Economics is a politically contentious field, and different interpretations suggested by those who challenge the consensus get an inadequate hearing.

      According to Dr. Ranson, the world we’re told that we live in goes like this:

      Employment is increasing, unemployment is falling, and inflation is very low. The economy is driven by spending, and since businesses and consumers cannot always be relied on to do their part, government spending is all the more important.

      Deficit spending causes government debt to grow, but that can be paid for by increasing tax rates. If government spending is insufficient, monetary stimulus may also be necessary with the help of Federal Reserve control of interest rates and the money supply. Extremely low interest rates make it easier for people to get credit so as to boost their spending.

      When the Fed buys back the government’s bonds it’s called quantitative easing. This helps the economy in two ways; it reduces federal debt and puts money into circulation, and that further encourages the private sector to spend.

      In a nutshell, it’s all about spending.

      Ranson submits that the world we actually do live in is much more this way:

      Employment should be judged relative to the working-age population, and in that sense, it has not recovered at all from the great recession despite five years of economic growth (using ratio of employment to working-age population, full-time equivalent employment is down from a 2007 58% high to 53%). If you include all those who have left the labor force, unemployment is static at best – and actually rising among young people.

      Inflation has been high for more than a decade, although it has decelerated in the last year or two.

      Spending does not drive the economy. Spending would be impossible without income, there can be no income without the employment of labor and other resources, employment cannot be sustained unless it results in output, and there will be no output unless producers know that they can sell it. What this means is that spending, income, employment and output are all just features of a functioning economy, and the relationship among them is circular.

      What drives the economy is capital, including both financial capital and human capital. Government spending merely subtracts from private spending, dollar for dollar. Washington cannot sustainably gain revenue by raising tax rates. That’s because the ratio of revenue to GDP is almost constant regardless of marginal tax rates on the highest incomes. Higher marginal tax rates mean a smaller GDP, and therefore less rather than more federal revenue. Artificially low interest rates inhibit saving, banking and lending, leaving borrowers no better off than they were before.

      The Fed can print money and buy bonds, but it’s banks that control the money supply. The only way to boost the economy is to boost the willingness of capital to put itself to work.

      In a nutshell, it’s all about capital.

      Luis de Agustin

    2. CommentedG. A. Pakela

      The before tax cost of capital is too high at both the corporate level small business. Moreover, high tax rates on lower and middle income individuals are also too high, reflected in lower participation rates across the board. The same revenues could be attained by lowering tax rates while simultaneously reducing exemptions. The CBO studies show that the average all-in tax rate across each income quintile is far lower that the top marginal tax rate applied to that quintile. This suggests that the only purpose for the high marginal tax rates is to support exemptions. If the tax rate on future income streams generated by new investment was lower, companies would have a greater incentive to take on the risk of new investment instead of buying back share. And for those of you who think that such a policy would amount to corporate welfare, consider the fact that pension plans, 401ks and IRAs are dependent upon future corporate profitability.

    3. CommentedJoshua Ioji Konov

      When mentioning Globalization as the reason for the bulking up profits and inequality I would suggest to stop seeing investment into a close market approach and look beyond into a Global marketplace where the investment is done: to make investors and company invest into a particular US market could happen only if the ROI is advanced to others? Well, deregulation, low taxation, no consumer protection and business laws are those that attract investment that are far off some in emerging markets, and most important the ever expanding Chinese market where the government has lifted consumption..., factors that attract investors. It is not about responsibility but only ROI.

    4. CommentedCharlie Liu

      It is interesting that when valuating the recent m&a activities in the tech space, a metric often used is $/user, which shows why Instagram and Whasapp are good bargains. To extrapolate that metric to economic sense, maybe instead of "labor" we should use "consumer" in the growth model. The assessment of "labor" productivity is vague, as a lot of the techies are self-taught (especially as some are "dropouts").

    5. CommentedUsha Abramovitz

      To conclude, it is the Central Banks who have created and sustained the problem. The big companies will not invest because they are concerned about future demand. The companies that can create the demand have their hands tied.

      Enough with the failed Supply Side policies.

    6. CommentedUsha Abramovitz

      To continue, in fact the developments of the last five years and the 'stagnation' in large sized companies just goes to prove and identify who are the real risk takers, the innovators, the drivers of our economies. The mammoth corporations have been focused on their bottom line, laying off workers as an easy way to boost profits (and their bonuses). These increased profits with fewer employees is then mistaken for increased productivity rather than what it really is, i.e. worker redundancy. Obviously, this is not a dynamic that can be sustained. There is a break-even point for employee retrenchment!

    7. CommentedUsha Abramovitz

      Sir, small and medium business are considered to be primary growth and job creating sectors of most any economy. Your article has completely failed to consider these and ignored the fact that these very businesses have been hard pressed to obtain the credit and the liquidity that they need for their operations, to innovate and to build/expand. The last five years have seen Central Banks and governments focus on keeping the TBTF banks afloat, while ignoring these core demand generating sectors! With this approach, the Central Banks have basically skewed the markets and created dangerous imbalances that could take years to correct.

    8. CommentedFrank Aten

      "Net" debt of corporations since 2008 is up 18%. It's not just about's about NET

    9. CommentedJoan Miro

      As Thomas Picketty has noted, the share of capital returned to the workers (those who create it) during the period 1930-1970 was an aberration due to a variety of unique factors. These include a deep distrust of markets and millionaires due to the depression, the destruction of infrastructure during ww II and need for rebuilding, high progressive tax rates, powerful unions and labor parties, and a broad acceptance of keynesian and social welfare economic policies. Almost all of this has been reversed and the ration of capital returned to labor continues to decline.
      Many writers on this site, like El-Arian, seem to think that more equal distribution of wealth and income will happen because the economy needs the extra aggregate demand. But investors don't respond to what the economy needs; they respond to their own interests, namely, the largest possible return. They've been getting that in spades, but it's never enough. Capitalism is doing exactly what it is designed to do: take the wealth from those who create it through their labor and shift it to those who do no actual work.

    10. CommentedProcyon Mukherjee

      Close to $ 2 Trillion is the cash on hand for the S&P 500 and another $1 Trillion is sitting as commercial bank excess reserves in the Fed’s liability side of the balance sheet waiting for opportunities; the productive use of cash is strangely found in the buy-back programs, which has no other impact but to raise the prices of stocks, while all other prices stay tamed to make any meaningful inflation a rarity. While moving cash to investments that would have produced goods and services in the current context would have sparked off inflation, perhaps it could have been a solution that would not have augured well with the financial system, but those outside this system would have seen a fresh lease of hope.

    11. CommentedPaul Mathew Mathew

      Mohamed --- you need to read Zero Hedge..... because you've not got the facts straight:

      Corporations Have Record Cash: They Also Have Record-er Debt, As Net Leverage Soars 15% Above Its 2008 Peak

      There is a reason why activism was the best performing hedge fund "strategy" of 2013: as we wrote and predicted back in November 2012 in "Where The Levered Corporate "Cash On The Sidelines" Is Truly Going", US corporations - susceptible to soothing and not so soothing (ahem Icahn) suggestions by major shareholders - would lever to the hilt with cheap debt and use it all not for CapEx and growth, but for short-term shareholder gratification such as buybacks and dividends. A year later we found just how accurate this prediction would be when as we reported ten days ago US corporations invested a whopping half a trillion in buying back their stock, incidentally at all time high prices.

      Putting aside the stupidity of this action for corporate IRRs, if not for activist hedge fund P&Ls, another finding has emerged, one that was also predicted back in 2012. Because in addition to still soaring mountains of cash, corporations have quietly amassed even greater mountains... of debt. In fact, as SocGen reveals, net debt, or total debt less cash, has risen to a new all time high, and is now 15% higher than it was at its prior peak just before the financial crisis!