Evaluating the "excess" in the US corporate financial balance
In a NY Times op-ed, Rob Parenteau and Yves Smith reminded us that the private sector financial balance is a function of the household financial balance and the corporate financial balance. They concluded the following regarding excess corporate saving:
So instead of pursuing budget retrenchment, policymakers need to create incentives for corporations to reinvest their profits in business operations.
In my view, it’s not that simple (not that passing this type policy would be easy at all). As I illustrate below, firms, like households, are in a deleveraging cycle, where corporate excess saving is likely to persist for some time. (Note: US total corporate financial balance, excess saving if the balance is positive, is roughly undistributed profits minus gross corporate domestic investment)
In their NY Times article, Rob and Yves cite a 2005 JP Morgan study, “Corporates are driving the global saving glut”. In that study, JP Morgan argues that the global saving glut has been driven largely by G6 excess corporate saving, and to a lesser extent emerging economies. In the US, positive corporate excess saving persisted through the latest print, 2010 Q2.
The illustration above plots the total corporate financial balance as a percentage of GDP. I calculate the Total Corporate Financial Balance (TCFB) as in the JP Morgan study, which is the residual of the national accounting identity of the Current Account Balance minus the Household Financial Balance minus the Government Financial Balance. According to this measure, the TCFB was roughly +3% in 2010 Q2, or about +1% above the 2008-2010Q2 average (2.1%).
About the same time as JP Morgan published their research, the IMF and the OECD were wondering why global TCFBs were rising. Several factors are attributed the upward trend in the first half of the 2000’s, including (this is not a complete list of factors):
- Repurchase of stock shares relative to dividend payouts
- The falling relative price of capital goods dragging nominal investment spending as a share of GDP (see Table 3.2 of the OECD publication)
- The overhang of leverage build in the 1990’s
- Rising profits via falling taxes and low interest payments (especially in other OECD economies)
Although firms likely worked out much of the debt overhang from the 1990’s, the debt accumulation spanning the second half of the 2000’s was precipitous.
It’s very unlikely that the excess corporate saving will fall anytime soon, as non-financial business leverage is high just as household leverage is high. Total non-financial business debt peaked in 2009 Q1 at 79.5% of GDP and is now trending downward, hitting 74.9% in 2010 Q2.
If history is any guide, then the “excessive” borrowing spanning 2005-2008 will take some time to repair. Spanning 2002 to 2004, the non-financial business sector dropped leverage 2.5% to 64%. If this 2-year period of de-leveraging indicates an “equilibrium” level of leverage, then non-financial businesses are likely to run consecutive financial surpluses (excess saving) in order to reduce debt levels by another 11 percentage points of GDP for a decade more.
If firms run excess saving balances, then they’re not investing in future profitability via capital expenditures nor increasing marginal costs, like wages and hiring, relative to profit growth. So while it is true that some fiscal policy should be targeted directly at investment incentives (Rob Parenteau and Yves Smith article), these measures may prove less effective since the non-financial business sector’s desire to “save” and repair balance sheets is high.
I leave you with one final chart to inspire more discussion: a breakdown of the total corporate financial balance into its two parts, financial-business and non-financial business.
The financial balances in illustration 2 are computed directly from the Flow of Funds Accounts, Table F.8, rather than taking the residual as calculated in illustration 1. Thus, the total corporate financial balance will not match that in illustration 1.
The point is simple: the small drop in excess saving in total corporate financial balance in illustration 1 is stemming from the financial side. The non-financial corporate sector continues to raise excess saving by investing retained earnings into liquid financial assets relative to capital investment.
Fiscal policy should be targeted at the high desired saving by the corporate and household sectors alike. The idea is to pull forward the deleveraging process by “helping” households and firms lower debt burden via direct liquidity transfers (lower taxes or subsidies, for example). Only then will healthy private-sector growth resume.
Good post, Rebecca.
This is probably correct: “It’s very unlikely that the excess corporate saving will fall anytime soon, as non-financial business leverage is high just as household leverage is high.”
I see no basis for which many private enterprises would significantly ramp up capital spending in the near term absent remarkable, though unlikely, consumer and business demand growth. Yes, some of spending can be pulled forward with a few policy changes, but that doesn’t necessarily change the long term outlook.
I suspect that a lot of enterprises were shocked when credit froze up in 2008. This was not supposed to happen by modern economic theory, which held that when you need to borrow you can. So enterprises are reacting by keeping enough cash to tide them thru another credit freeze up. One wonders why companies where operating in a mode where they had to borrow to make payroll, as was often stated during the freeze up. So they got their wakeup call, and have decided to change their behavior in the future. I suspect its a permant increase in cash positions to protect themselves from the wild markets.
The Great Pretending
I find it troubling that there aren’t any meaningful reports and Federal/credit industry data being provided to the public which would explain the potential loss of economic activity and consumer demand due solely to previous excess credit availability and utilization which will not come back as part of the ongoing economic recovery plan. The lower level of credit availability and utilization will result in a net drop in economic activity, and that should be factored into the big picture, complete with data and explanations.
Ignoring this issue is all part of the Great Pretending. Instead, we have economists and journalists arguing over cyclical and structural unemployment. It’s a ridiculous exercise in light of the impact that reduced credit will have on the U.S. economy.
There is no sustainable plan in play to deal with the long term job losses and loss of economic activity due primarily to the previously high levels of credit availability that affected the U.S. economic from 1994-2007. There has been no attempt by the Government or private economists to my knowledge to release publicly available data which indicates the anticipated drop in consumer demand and also the number of jobs that were previously supported by higher levels of credit availability and utilization. The credit industry knows the new credit formulas, and the Federal Reserve has the capability to determine the potential losses. Where are the related projections?
There is also the continuing matter of the effects of U.S. trade policy. Yet, there are no major changes being pursued on that front.
Let’s see how the leadership of this nation handles the net loss in consumer and business demand over the next five years. Perhaps later, some will begin to grasp the level of GDP loss that is resulting from U.S. trade policy and lower levels of credit consumption. And no, the answer is not an endless stream of Federal stimulus and other Government expenditures. That approach masks the problem, but doesn’t solve it. The problem will not go away.
The U.S. economy is facing two overriding issues, one driven by U.S. trade policy, and the other driven by lower availability of credit and lack of related consumption.
It’s time to lay all the cards on the table and understand where we are.
Bravo Rebecca. Nice work. Thanks for sharing
Why are non-financial corporate savings rising? Because their expenses (labor and interest) are falling. Have corporations increased capital expenditures? Yes, along with inventory rebuilding it’s about the only demand there’s been. Can corporations find uses for all their profits? No; once they’ve empire built (M&A) and maximized stock options (share buybacks) there’s nothing for them to do but increase their dividends — what? increase dividends? Pulease!
There is nothing to do to decrease corporate savings short of increasing consumer demand.
Economists, especially those in government and academia, have been looking in their 1950s econ books trying to verify if there is such a thing as the consumer running into his/her credit limit. There is not, ergo, the confusion.
Ever since I went into the working world I thought it strange that 50 year old companies did not have their own savings accounts yet. I found that they did either have short term credit lines from banks or more recently they access short term money markets. The most common reason they give for this is that they are financing the gap between accounts receivable and accounts payable. They don’t mention financing payroll, because that sounds bad.
But that is all short term credit. Long term credit is another animal.
Of course as Cedric suggested one could generate balances, so that one did not have to factor the accounts receivable. Just save up enough money, to ride the balance. This was because the efficient marketeers said that holding cash was inefficient. 2008 proved the efficent group stupid, because they assumed that there would never be any more panics. So if I were a CFO I would want to run the company so I could ride the AR on my cash balances rather than borrowing them even short term. Given how little short term money earns, its still cheaper than borrowing short term. In addition since its not obvious that today there is a lot to invest in that will give better return than avoiding the short term debt, it makes sense.
On a related point, there are a couple of articles out (FT and WSJ) citing the rise in risk in corporate debt, a Bloomberg piece citing the reveleraging of US corporations to buy back record amounts of equity (so pushing up debt/equity ratios) and a NYT piece reporting that investment banks are underperforming in part because IPOs have fallen off. So yes, corporations have been through a period of deleveraging, but there may be a change underway. The change is aimed at reducing equity relative to debt, rather than at investing in expansion or productivity improvement. The good news is that there is also a push underway to roll over the mountain of corporate debt due to mature in the next 2 1/2 years (Iincluding lots of junk, now that junk spreads are narrow). Roll-over risk is down, while other risk factors are apparently on the rise, and most everything that is going on remains on the financial side of operations.
one might argume that the consumer running into his credit limit was precisely what happened in 1929.
why do you feel there is no credit limit? that seems an extreme claim.
the most difficult bubbles to clean up are those that occur in non productive assets and are funded by debt. (like this one – real estate driven by mortgages) they stay with us because the debt lingers, but the assets don’t drive any gorwth.
after an internet or a railroad bubble, at least you still have productive assets to aid in the next expansion. if they were funded by equity, so much the better as all the pain gets taken at once.
this one is going to be with us for a long time. it s exactly the kind of bubble you don;t want.
Maybe I wasn’t clear. I think there is a credit limit. I was making another one of my sarcastic remarks about economists in general. Or at least how it took the entire decade untire the light slowly dawned, except for a few that are now considered prescient.
ahh, got it. i misunderstood.
do you happen to have some of those links…I read some but have posts stacked up on other things. If so, could you send a few. Thanks, Dan
The market for junk is heating up. I’d call it the “search(or stretch) for yield”, but this article spins it as improving economy, which always boosts junk. They will get killed in a double dipper tho.
“Investors rush into junk bonds”
What is the matter with all you progressive posters? Sure, Rebecca’s made a great post, but are all of us just going to lie down and die for the next ten years? that’s what may happen under current public policy. What about public works, public works, and more public works, which everyone (except Republican legislators) agrees are sorely needed? Despite inevitable waste, adequate public investment should get private debt down a helluva lot faster.
That would be a no-brainer if Obama was starting with the national debt/gdp that FDR had, but we are nowhere close.
However, I think the USG could make loan guarantees on low risk private infrastructure projects that are of a low risk variety. This doesn’t cost the government anything, provided the project doesn’t completely fail. We do not have a shortage of private capital. More like a shortage of good low risk places to invest it. One example I know of where they did this is guaranteeing the loans of a utility that is building a new Gen 3 nuclear power plant. This cut 100 of millions of the plant life cycle cost, as well as providing the financing to get things going. The same sort of thing could be done with airport/air traffic modernization, and all those other infrastructure areas where attention has been lacking.
Forget cap and trade and just fix the problems. We know where they are. We don’t need Wall Street traders to find them for us.