(h/t The Other McCain)
When distilled to its core, the purpose of a business is to provide for the economic well-being of its owners. A business might have a particular method of generating revenue, such as next-day shipping or providing home mortgages or making soft drinks, but at its core the purpose of a business is to make money for its owners.
Don’t tell that to Yves Smith, author of “Econned: How Unenlightened Self-Interest Undermined Democracy and Corrupted Capitalism” or to Bob Parenteau, head of a global financial advisory firm named MacroStrategy Edge. Their recent Op-Ed in the New York Times asks the question: Are Profits Hurting Capitalism?
My unequivocated answer is, “Hell no!”
It seems Parenteau and Smith are concerned that corporations in most of the developed world are not investing in themselves at a pace that the two of them feel is necessary to achieve economic growth. The two men seem to think that because corporations are focused on quarterly earnings reports and stock dividend rates, they aren’t focusing enough on their future.
Over the past decade and a half, corporations have been saving more and investing less in their own businesses. A 2005 report from JPMorgan Research noted with concern that, since 2002, American corporations on average ran a net financial surplus of 1.7 percent of the gross domestic product — a drastic change from the previous 40 years, when they had maintained an average deficit of 1.2 percent of G.D.P. More recent studies have indicated that companies in Europe, Japan and China are also running unprecedented surpluses.
The reason for all this saving in the United States is that public companies have become obsessed with quarterly earnings. To show short-term profits, they avoid investing in future growth. To develop new products, buy new equipment or expand geographically, an enterprise has to spend money — on marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors and so on.
There’s a problem with Smith and Parenteau’s analysis: Capital Expenditures largely do not show up on Profit-and-Loss statements (aka P&L) until after the capital investment is finalized. The two focus so much on the P&L that they say nothing about the other major financial statements, the Balance Sheet and the Statement of Cash Flows. If a company invests in a new program today that will take five years to build, the balance sheet and cash flow statements are affected immediately, but the expense will not be reported on the P&L until the 3rd Quarter of 2015!
So while I agree that the focus on quarterly earnings reports can be short-sighted, Smith and Parenteau show in their writing a clear misunderstanding of basic financial accounting. For both Smith and Parenteau it shows that they are either incompetent in their professional positions as financial analysts or that they are hiding information that might be pertinent to the reader. Either way, the two men’s assessments become immediately suspect.
In fact, a relatively quick internet search about Parenteau reveals he attended Williams College, which does not have a business school. While he attended nearly 30 years ago, the school today does not offer a single course in accounting, though it does have one economics lecture listed in its catalog for “Corporate Finance”. In other words, Parenteau’s entire experience as an economic analyst is likely based on pure economic theory (probably–though not certainly–Keynesian, since it is the most commonly taught in America and the type taught at Williams College) and “on the job” training. Smith’s is almost more insulting since he has been a banker and attended Harvard Business School. Both men should know better how to react to an analysis based on an incomplete set of financial statements.
I would be far less critical on this point had the two men so much as mentioned the other financial statements, but the words in their Op-Ed are lacking.
I went looking and I found the JP Morgan report that Smith and Parenteau use as reference for their article. Rather than an indictment of corporations choosing to give out bonuses and dividends, as the two men suggest, the report indicates that:
The shift in the corporate sector’s desire to save was in response to earlier excesses; to equity market bubbles in the G6 economies and to excessive capital inflows in the emerging economies prior to various crises. The healing process involved the restoration of profitability and the restructuring of balance sheets. [emphasis theirs]
In other words, the increased savings wasn’t short-sighted move towards increased valuation, but rather a correction of prior short-sighted behaviors. The report does suggest that increased corporate savings iswas unprecedented and iswas slowing the economy in the early 2000s, but hardly for the reasons that Smith and Parenteau suggest. Nor is the report even relevant to today’s economic outlook, since the most recent data in it is now more than five years old. The increased economic growth experienced immediately preceding and following through the two years after the report’s release are indicative that increased savings are not a predicate to immediate economic decline.
Further, the symptoms that Smith and Parenteau describe show a clear economic myopia of their own: Their belief that economic growth is driven primarily by large corporate investment. In a few paragraphs, I’ll explain how their viewpoint is more short-sighted than Corporate America’s quarterly earnings reports.
Businesses grow in a reasonably predictable pattern. They are born, then they grow, then they mature, they decline, and eventually they die. These stages are well documented in business literature, though rarely are the stages talked about in general practice, and never are they mentioned in the press. Still, the stages are real and important to understanding the nature of capital growth.
A business is born when an entrepreneur invests money and time and resources in a new venture. That entrepreneur then works hard to grow their business, buying new equipment and hiring additional employees. After a time the business matures into a slow-growing but still profitable enterprise. At some point, the business declines as it suffers a loss of market share, profitability and its ability to adapt to new priorities. Eventually, the business dies when it is bought out by another firm or liquidates through bankruptcy.
It can help to think of these stages as being similar to stages in the human life span: Birth, Growth (childhood and adolescence), Maturity (adulthood and middle age), Decline (old age) and Death.
Unlike a human being, though, companies can move back-and-forth between the three middle stages. A company in decline can be revitalized into a mature company, or a mature company can regenerate its entrepreneurial spirit and become a growth business. A growth company can even skip maturity and move straight into decline.
By and large, Corporate America and Corporate Europe are not filled with growth companies. Rather the companies traded on the stock markets (and from whom JP Morgan would obtain financial data) are either mature or in decline. In the stock markets, for every Google, Facebook or other growth company there are dozens or perhaps hundreds of General Motors, Coca-Colas and other mature or declining companies.
Right now, there is a great deal of uncertainty in the marketplace. The economic outlook is still very unstable. In this environment, a mature or declining company investing capital in new plant and equipment is taking a tremendous risk. They must either borrow or spend their cash reserves on the speculation that the economy will grow. If the economy grows, the investment will make money. If it doesn’t, the investment will lose money. With the current bleak economic outlook, is it any wonder corporate executives aren’t investing in new plant and equipment?
All of this has absolutely nothing at all to do with quarterly profits or simple accounting, as Smith and Parenteau claim. Rather it is a self-preservation mechanism: Squeeze productivity, increase profits and generate cash until the economy begins to rebound.
Meanwhile, corporations are generating large amounts of cash and has to figure out what to do with it. The company’s managers can do several things with this cash, among them: They can invest this money in improvements to existing facilities to increase safety, reduce costs or for other reasons; they can also buy out other businesses or they can return the profits to the company’s owners in the form of dividends. There are other options but these three are among the most common. Smith and Parenteau seem to take issue with the last one, however, and this is their folly.
Rather than incur such expenses, companies increasingly prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or engage in purely financial speculation. But this means they also short-circuit a major driver of economic growth.
In the minds of Smith and Parenteau, issuing dividends and bonuses is irresponsible. These companies should be investing in themselves! They should be growing! They should be expanding and hiring new employees! If they don’t, we all lose!
Here’s an example: Imagine it’s 1910. You own shares in the world’s largest, most profitable buggy-whip manufacturer. This corporation makes whips, bridles and reigns for horse and buggy makers the world-over. But people have begun to buy those new-fangled horseless carriages, or automobiles, in record numbers. Sales of buggies are flattening. Should that corporation invest in new plant and equipment? Clearly not! This business is mature and on the precipice of decline! It would be irresponsible to invest in new plant and equipment unless the company can learn to make parts for automobiles.
So instead of investing in a declining industry, the responsible corporate manager will either invest in a new, growing industry or give the profits back to you, the shareholder, so that you can instead spend or invest that money elsewhere. Often, that comes in the form of investment in new businesses.
So the corporate managers who sustain profits in a declining market get a share of those profits. That’s a reward for good management and it shouldn’t be eschewed as corrupt or unethical. The shareholders take their dividend payments and the corporate managers take their bonuses and both invest in new, growing businesses. Or perhaps they make improvements to their homes or take a vacation to Aruba. It doesn’t really matter, because whatever they do with it is likely to be more productive than what the corporation that paid those dividends and bonuses could do with it. Even if that shareholder spends the money on creature comforts like imported water and luxury automobiles, it is still more productive than investing in a declining business.
In economics, we call this “creative destruction”. That is, as one business declines toward death, the resources are returned to its owners invest in new businesses, creating new business growth. It is a slow and often painful process, one that politicians are often far too quick to interfere in so as to curry favor with the dispossessed workers of the declining firms.
Smith and Parenteau’s view only makes sense if we perceive that because a corporation exists today, it must therefore continue to exist into perpetuity. That is the view of politicians, who hate to see bankruptcies and the resulting job losses inevitably resulting from them. And indeed, Smith and Parenteau declare that government is the answer to the economic ills they perceive:
Another problem for the economy is that, once the crisis began, families and individuals started tightening their belts, bolstering their bank accounts or trying to pay down borrowings (another form of saving).
If households and corporations are trying to save more of their income and spend less, then it is up to the other two sectors of the economy — the government and the import-export sector — to spend more and save less to keep the economy humming. In other words, there needs to be a large trade surplus, a large government deficit or some combination of the two. This isn’t a matter of economic theory; it’s based in simple accounting.
Forget trade deficits or surpluses. The United States has been running consistent trade deficits for decades, yet our economy continues to grow. Why? Because the money we spend in foreign economies is invested back in our economy! So while we might be buying cheaper goods from China, India and Bangladesh, they are buying our government bonds and investing in American-owned businesses. And since it seems unlikely that the trade deficits will abate, Smith and Parenteau declare the answer to be (ta-da!) MORE GOVERNMENT! The same bailouts that didn’t do anything to sustain the economy or slow the recession in late 2008 and early 2009 are now suggested as the cure-all to prevent renewed economic recession in 2010!
Government, for better or worse, is not an effective or efficient mover of money. Government tends to spend money on programs that are politically imperative, rather than investing that money where it will do the most economic good. That is why the “stimulus” money tended to go toward civic works programs by state and local governments and large corporations (who had the political connections to get the money) rather than small, growing businesses where jobs and economic growth are largely created, and from whose owners most of the money was taxed or borrowed anyway. Hence why the TARP and Stimulus bills failed entirely at their stated goals of increasing the liquidity of the financial markets and keeping the economy from dropping into a deep recession.
Add to this the government bureaucrats who got to decide where all the “stimulus” would be spent. This extra layer makes government not an investor, but a “middle-man”. All those bureaucrats have to be paid after all, and they are better paid these days than in the private sector. Add again the fact that the government has no cash reserves: Rather, the government must borrow or tax money out of the economy before spending it, or risk inflation by unilaterally printing more dollars.
So instead of increasing the flow of money, all the government does is add an extra step and syphon off a portion for itself and its employees. In other words government spending is, for the most part, a net loss for the economy. Government spending is almost never investment, it is just spending. The exception is generally in infrastructure where highways, bridges and airports facilitate commerce, or in education where an educated workforce is capable of greater economic activity. Even some regulation of dangerous activities like mining can be helpful. Of course, spending more dollars on bad schools and “bridges to nowhere” or enacting unnecessary regulations do more actual harm than good.
Smith and Parenteau have hooked-on to a major economic fallacy: That if the private sector economy is saving, the public sector must spend to maintain economic growth. But as we can see from above, deficit spending by government is actually counter-productive, and corporate savings leads inevitably to new venture investment.
Perhaps because Smith, Parenteau and JP Morgan all make their living by offering their services to large, publicly-traded corporations, they might be dis-inclined to see the benefits of investing profits in new ventures and privately owned businesses? Perhaps because “stimulus” is so often directed at those large corporations, Smith and Parenteau see reduced government spending as bad for their myopic view of business?
The answer, as economic history has shown us again and again, is not “MORE GOVERNMENT SPENDING!!” as Smith and Parenteau suggest. The answer instead is to limit government spending and to reduce economic barriers like taxes, regulation and trade restrictions. The current administration is doing neither of these things, and Smith and Parenteau advocate moving us further in the wrong direction.
Cut taxes. Cut even more spending. Reduce deficits and stop enacting new, ever more expensive programs, regulations and mandates. Let Capitalism do on its own what it is more than capable of doing without the tinkering of the economic nit-wits in Washington, Tokyo, London and Berlin. When that happens, Smith and Parenteau will surely be pleased to see an increase in the “Capital Investment” line of corporate P&Ls.