At The Wall Street Journal’s 2017 CEO Council meeting, Gary Cohn—then the director of the White House National Economic Council—spoke to the Trump administration’s tax reform efforts. “We want companies to invest back in the economy,” he said, “not give money back, or sit on money because they don’t think there’s anything to do with it.”
Moments later, the Journal’s John Bussey turned to the audience and asked for a show of hands: “If the tax reform bill goes through, do you plan to increase investment, your companies’ investment, capital investment?” In the crowd of over 100 top corporate executives, only two or three hands could be seen rising on the C-Span recording.
“Why aren’t the other hands up?” Cohn asked through nervous laughter, before the moderator deftly changed the topic.
Opening with the transcript of this exchange, a new report from Senator Marco Rubio, “American Investment in the 21st Century,” suggests it knows the answer to that question. But in a compelling shift from the usual Republican focus on taxes and regulation, it points the finger squarely at over-financialization and the notion that corporations exist to maximize returns to their shareholders.
Shareholder primacy, the report argues, “tilts business decision-making towards returning money quickly and predictably to investors rather than building long-term corporate capabilities, reduces investment in research and innovation, and undervalues American workers’ contribution to production.”
Take the disappointing trend in U.S. net private domestic investment, which averaged about 8 percent of GDP between 1947 and 1990. Since the Great Recession, it’s averaged about half that. Meanwhile, the median share of assets held in the form of property, plants, and equipment by S&P 500 companies has steadily fallen since the mid-1980s, from a high of about 35 percent to just above 10 percent today.
Enter the era of intangible assets—branding, software, intellectual property—or what the economists Jonathan Haskel and Stian Westlake have dubbed “Capitalism without Capital.”
In this new economy, the classic conception of businesses as net borrowers breaks down. The corporate sector instead accumulates financial assets relative to non-financial assets. The report supports this with a graph illustrating the decline in borrowing and increased lending-for-profit by blue-chip companies like Apple and UnitedHealth. As investment in non-financial assets weakens, businesses start to look more like banks than productive enterprises.
That leaves the federal government as “investor of last resort,” with a dramatic increase in net borrowing to prove it. “There must be a borrower,” the report notes. “The sectoral balances described above are an accounting identity that must sum to zero.” But given the government’s limited ability to centrally plan production, public investment (and unfunded tax cuts) are at best a partial solution.
Does “shareholder primacy” really explain the contemporary dearth in private investment? According to Rubio’s report, the shareholder model biases value creation to the short-term, which in turn favors financial engineering over investment in “real” long-life assets. This can be seen in the “$1 trillion in share buybacks” authorized by corporations in 2018, “the highest figure on record.” It’s an argument that echoes left-of-center think tanks like the Roosevelt Institute, but it’s not without problems.
For example, the report makes much of the fact that “the average ratio of shareholder payout to corporate profits from 2008-2017 was 100 percent.” Yet new research shows that “accounting for both direct and indirect equity issuances, net shareholder payouts by all public firms during this period totaled only 41% of net income.” This is well within the historical norm, and actually low relative to the stock market’s current capitalization.
Share buybacks, in particular, are essentially benign. They take place when a firm with limited new growth opportunities returns its excess cash (like from a windfall tax cut) back to investors to be reinvested elsewhere. This is why, as Matthew Klein has shown, aggregate share repurchase agreements rise and fall in direct proportion to aggregate capital expenditures. Known as the “free cash flow hypothesis,” the economist Michael Jensen influentially argued that manager-controlled firms waste excess cash on empire building and other low or negative return projects, rather than return capital to shareholders. A number of lines of research bear the hypothesis out, including the finding that high cash-flow businesses face more challenging audits.
The Rubio report disputes this standard neoclassical story. It cites an NBER working paper that found that companies with high growth potential mysteriously switched from raising capital to repurchasing shares after 1996. Yet the study’s method for classifying high-growth potential firms, a high Tobin’s Q ratio, has problems of its own. A high Tobin’s Q means a company has a high market valuation relative to the book value of its assets—a useful indicator of future expected growth. But what should be counted as an asset is not always clear, and as discussed above, intangible assets have exploded in importance since the IT revolution.
While the study’s authors attempt to incorporate intangible assets into their analysis, the proxy they use is imperfect. More recent work by Germán Gutiérrez and Thomas Philippon finds that intangible assets can explain up to a third of the measured investment gap, with the remainder explained by increased firm concentration and the growth in common ownership via index funds. Consistent with the study Rubio cites, these same firms also use “a disproportionate amount of free cash flows buying back their shares.”
This helps make some sense of the timing, given the massive growth in index funds beginning after 1996 and the coincident emergence of superstar tech firms in the 2000s. But if true, it also makes share buybacks a symptom of diffuse ownership and superstar firms, rather than a cause of capital misallocation or an indictment of the shareholder model, per se. Moreover, the value of share buybacks is highly concentrated in only a handful of intangible sectors. As Bloomberg recently reported, “20 companies accounted for more than a third of cash spent on repurchases last year,” mostly in tech and financial services. Apple alone accounted for 14 percent of the total.
Rubio has put forward legislation to tweak the way buybacks are taxed in order to encourage companies to reinvest their cash internally. But this makes little sense within his broader critique of intangible capitalism. If it worked as intended, it would cause the likes of Apple and Wells Fargo to overinvest in more useless apps and financial engineering, or raise the wages of their already highly paid knowledge workers. The sectors suffering from stagnant or even declining productivity growth, like utilities and construction, barely make use of repurchase agreements at all.
On the issue of short-termism more broadly, the obvious counter-examples of Amazon and Tesla prove shareholders can be patient and forward looking, particularly when a business’s strategy is communicated upfront. Ditto for the enormous valuations of many tech startups, often with low or zero revenue. Indeed, the empirical evidence for the corporate sector being short-termist on average is surprisingly thin. The short life of intangible assets like software further suggests some degree of increased short-termism is not just expected but appropriate, and more an effect of capital-free capitalism than its cause.
None of this is to paint a rosy picture of U.S. corporate governance or to deny that we have an investment problem. The point is simply that Rubio’s focus on shareholder primacy is somewhat of a distraction, rooted in a mistaken nostalgia for the managerialism of the early-to-mid-20th century.
Interpreting the last 40 years of economic history is all the more challenging due to how many major events occurred around the same time. The 1980s shareholder revolution, for example, took off in the years following the hugely consequential demise of Bretton Woods. The sudden adoption of free-floating exchange rates allowed countries around the world to liberalize their capital accounts while maintaining independent monetary policies. The resulting wave of globalization led to the U.S. dollar’s privileged role as the global reserve currency, denominating two thirds of all foreign reserves and nearly 90 percent of foreign exchange trades. As banker to the world, it’s thus not surprising that the United States became host to the world’s financial services industry.
Being the global reserve currency comes with significant benefits, like the ability to unilaterally impose financial sanctions. It also means deficits and the cost of capital matter a lot less than under standard economic models. Foreign countries and multinationals depend on U.S. treasuries as safe and highly liquid assets. With an aging population and a growing global middle class, savings have come to dramatically outstrip investment, pushing down global interest rates and encouraging excess leverage.
To take full advantage of the bottomless demand for U.S. sovereign debt, we could have financed massive public investments in infrastructure and R&D. Instead, the Clinton administration passed budget surpluses and, in 1995, adopted an explicit strong dollar policy. As peripheral countries pursued export-led development growth through currency depreciation, U.S. multinationals shifted from domestic investment to international arbitrage, offshoring much of America’s manufacturing sector. For the “tangible” production that remained, capital goods were often cheaper to import from China. As Brad Stetser notes, “the China shock for capital goods lasted until at least 2012.” Rising industry concentration followed, not because of lax antitrust enforcement, but because smaller, less productive firms struggled to compete on a global stage.
Stable inflation during the “Great Moderation” compounded financialization. Shielded from inflation risk, creditors—including the business sector—increased lending like never before. With the Treasury and Federal Reserve keeping a lid on the supply of U.S. dollars, global savings shifted into mortgages and financial derivatives, engineered to appear as safe as sovereign debt.
The American model of corporate governance no doubt played a role in all this. Nonetheless, the massive structural changes brought on by financial globalization and tight U.S. monetary policy do a far better job of explaining the facts. Multinationals shifting production to China may have been focused on maximizing shareholder value, for instance, but that doesn’t explain why those returns were so preternaturally high in the first place.
Fortunately, despite this one dead end, the Rubio report still gets most of the pieces of the puzzle right. And on its more general concern for the state of American investment, it should be applauded for venturing outside the usual Republican orthodoxies about the nature and causes of the wealth of nations. In context of America’s broader abdication of industrial policy, lowering the corporate tax rate was never likely to generate the productivity renaissance imagined by the likes of Gary Cohn. Cohn may as well have stood timidly before the country’s top CEOs and asked them, in Jeb Bush fashion, to “Please invest.” In fact, that’s almost exactly what he did.
Samuel Hammond is the director of poverty and welfare policy at the Niskanen Center. Follow him on Twitter @hamandchesse.