Do Businesses Borrow to Invest in Productive Assets? Does the Business-Interest Tax Deduction Encourage That?
J.W. Mason at The Slack Wire gives us a telling and trenchant analysis of that question:
Short answer: They used to, but not any more. The correlation in the U.S. between fixed-capital investment and a) debt levels and b) change in debt levels has been vanishingly small since the late eighties.
…in the 1960s and 70s, a firm that was borrowing heavily also tended to be investing a lot, and vice versa; but after 1985, that was much less true.
It’s gotten really bad lately:
Regressing nonfinancial corporate borrowing on stock buybacks for the period 2005-2010 yields a coefficient not significantly different from 1.0, with an r-squared of 0.98.
As CEOs and their cronies have moved from being business-runners to financial arbitrageurs,*
…the marginal dollar borrowed by a nonfinancial business in this period was simply handed on to shareholders, without funding any productive expenditure at all.
This goes far in explaining an amazing fact about Dell, recently revealed by Floyd Norris:
It has spent more money on share repurchases than it earned throughout its life as a public company.
This is not an anomaly. Floyd pointed out to us some time ago that:
From the fourth quarter of 2004 through the third quarter of 2008, the companies in the S.& P. 500 — generally the largest companies in the country — reported net earnings of $2.4 trillion. They paid $900 billion in dividends, but they also repurchased $1.7 trillion in shares.
As a group, shareholders were paid about $200 billion more than their companies earned.
Floyd’s post is aptly titled “Easy Loans Financed Dividends” (and buybacks).
I would take issue with one seemingly judicious caveat in JW’s piece:
It is quite possible that for small businesses, disruptions in credit supply did have significant effects.
Based on one piece of evidence that I’ve cited repeatedly, not so. Here from December 2009 (follow “Related Links” for more discussion and evidence):
Small businesses consistently put financing and interest rates at the very bottom or near-bottom of their lists of business constraints. That has been true for many years [almost three decades now…], it was true throughout the recent crisis, and it remains true at this very moment.
It really makes a fellow wonder: given all the (sensible) talk about ending the mortgage interest deduction for homeowners, why we aren’t hearing a similar quantity of talk about ending all interest deductions — especially the money-funnel sweetheart deal for the rich that is the business-interest deduction?
Anyone thinking we’ve become a Great Stagnation, or wondering why?
* JW describes that shift from businessperson to financial prestidigitator more fully (emphasis mine):
In the era of the Chandler-Galbraith corporation, payouts to shareholders were a quasi-fixed cost, not so different from bond payments. The effective residual claimants of corporate earnings were managers who, sociologically, were identified with the firm and pursued survival and growth objectives rather than profit maximization. Under these conditions, internal funds were lower cost than external funds, as Minsky, writing in this epoch, emphasized. So firms only turned to external finance once lower-cost internal funds were exhausted, meaning that in general, only those firms with exceptionally high investment demand borrowed heavily; this explains the strong correlation between borrowing and investment.
But since the shareholder revolution of the 1980s, this no longer really holds; shareholders have been much more effective in making their status as residual claimants effective, meaning that the opportunity cost of investing out of internal funds is no longer much lower than investing out of external funds. It’s no longer much easier for managers to convince shareholders to let the firm keep more of its earnings, than to convince bankers to let it have a loan.
Cross-posted at Asymptosis.
I believe that pre about 1980’s, share repurchases were not legal, except to fund stock options. Executives found it was easier to increase earnings per share by buying back shares than by investing in new products or plants.
This becomes an interesting counterpoint to The Economist latest cover story about the dearth of innovation.
The whole “shareholder value” BS has fathered many sins, IMO. Short-term focus, only looking to the next quarter (I believe the birth of the IRA and 401k, the snookering of Joe Main Street into thinking he, too, could be stock-trading millionaire, along with the whole lower-cost trading revolution, fueled much of the short-term myopia, since capital gains wasn’t traditionally such a big deal), explosive CEO pay, more mergers and takeovers. Why invest in new technology or whatever, when it’s cheaper to buy it “off the shelf”? There are so many things it seems to this country girl have gone wrong with the whole investment world, it’s ridiculous.
So, shareholders get money back from large and successful corporations.
What do shareholders then do with that money?
Invest it in other businesses perhaps?
Possibly even new ones?
The problem with this system is what?
The problem, Tim, is that the expected return shareholders require to commit their capital to a new business, is higher than the return managers require to invest a firm’s returned earnings in a new project. So the hurdle rate for new investment is higher in the new system than in the old, so we get less of it. So we cannot get to full employment without asset bubbles (which both inflate expected returns and boost consumption demand).
Share buybacks are simply a way of liquidating the company. They are the opposite of investment for a variety of reasons. Anyone who knows accounting knows this. As a shareholder, I’ve taken advantage of buybacks. Then I wait for the bounce back and sell out. They are not usually a good sign for the long run.
The problem is that wages have been stagnant since 1980, so there is no expanding market to drive a return on investment. The best way to make money during such a period is liquidation. As Rhett Butler noted in Gone With The Wind, you can make slow, hard money building an empire, but the way to get rich quickly is to liquidate one.
(We may be seeing some interesting action soon. Even at last year’s stock price, the numbers looked good for a liquidating take over of Apple. The recent media driven share price drop suggests that others have recognized the opportunity. I wouldn’t be surprised by a take over in the next year or two. The US tech industry is the last game going for serious dismantling.)