Seeking Alpha
Small-cap, macro, value, momentum
Profile| Send Message|
( followers)  

Summary

  • Business investment is low, despite record corporate profits, cash balances and low interest rates.
  • Part of this is a sectoral shift from high capital intensive manufacturing to lower capital intensive services.
  • But it is reinforced by a shift in categorical income distribution from wages to profits.
  • This creates a negative feedback loop and threatens to lock the economy into a low growth equilibrium.

Many observers agree that business investment (or, if you like, capital formation), is running very low.

(click to enlarge)
The more important issue is why it is so low. Companies are sitting on record profits and mountains of cash ($1.5 trillion in the US, $7 trillion worldwide), and interest rates are at rock bottom in many places, like the US. Most economists would argue that capital formation is a negative function of interest rates, that is, lower interest rates leads to higher capital formation.

This is simply because the internal hurdle rate for considering investment projects becomes lower so more investment projects become more attractive, and the cost of capital is lower as well. The strength of the relation (the elasticity of investment demand) is probably not very high, but nobody argues lower rates reduces investment.

Until now. With (considerable) amazement we read the rendition of ZeroHedge:

We also identified what in our view was the primary reason for this misallocation, which said simply, is the Fed's monetary policy which forces corporate executives to focus on short-term gratification of shareholders via prompt return of cash instead of reinvestment into the business - a critical requirement to assure top-line stability and growth.

Now, in Austrian economics, "artificially" low interest rates (we'll come back to the issue of whether rates are artificially low or not) leads to over-investment and "misallocation" of capital, that is, investment into projects that would not be profitable under "normal" circumstances.

But for some reason not quite spelled out, over-investment turns out to be in "short-term gratification of shareholders," rather than re-investment into the business. So the Austrian (or at least the ZeroHedge) position seems to be that below "normal" interest rates lead normally to over-investment, but for some reason, this time not to productive over-investment, that is capital formation.

This is only one reason we have so much trouble with Austrian economics; it's so elliptic that anything seems to go, and normal positions (low interest leading to over-investment) can easily be turned into something with diametrically opposite consequences (low interest rates leading to over-investment in share buybacks, but a dearth of capital formation).

And all that without much (if any) of an explanation. The interesting question remains: why is capital formation so low? While ZeroHedge argues that capital formation is low because of monetary policy, UBS (quoted in the same ZeroHedge article) has it the other way around:

If developed economies are to ever wane themselves off their dependency on monetary and fiscal policy stimulus, private sector capital spending must push up a gear or two.

They blame low capex on (non-US specific) policy uncertainty:

In a recent survey of UBS company analysts over half (54%) believed that fiscal, monetary or euro membership uncertainty is delaying investment planning

This is certainly plausible, but at least for the US, low capital formation is anything but a recent phenomenon:

Since 1980, U.S. investment as a percentage of GDP was sliced in half, from nearly 24 percent to 12 percent, leaving the United States 174th in the world. The result was a dearth of real value added products and productivity. [Moneynews]

Part of that can be explained by a secular trend in the make-up of the US (and many other advanced) economy. Rising productivity shrinks manufacturing as a percentage of GDP, so the economy becomes less capital intensive over time. But still, with record profits and cash stacks, record low interest rates, and the best companies can think of to do with their bounty is share buybacks?

Feedback loop?

Are there no worthwhile investment projects generating returns above the meager cost of financing? This lack of investment is slowing down the economy in multiple ways:

  • Less new production capacity is created.
  • Old production capacity gets extended life and less new modern capacity gets built, leading to an older capital stock and a slowing pace of adoption of new production technology.
  • Companies are looking for other ways to boost the bottom line.

The latter could actually create something of a negative feedback loop. Two mechanisms stand out:

  • An emphasis on cost reductions, squeezing wages and employment
  • An emphasis on share buybacks and dividends,

Together, these forces shift income from wage earners to shareholders, that is, from people with a low propensity to save to people with a high propensity to save. This is likely to have important economic consequences. A good example here is Wal-Mart (NYSE:WMT):

Wal-Mart spent $7.6 billion last year buying back shares of its own stock - a move that papered over its falling profits. Had it used that money on wages instead, it could have given its workers a raise from around $9 an hour to almost $15. [Robert Reich]

Wal-Mart employees earn close to the minimum wage (which is so low that a disproportionate amount of their employees are on some form of tax funded additional benefits). In an economy, which is still suffering from a demand deficiency, which group do you think will spend more of that $7.6 billion, Wal-Mart employees if they would get such a pay rise, or the Wal-Mart shareholders getting the benefit of the buyback?

We're not arguing in favor of a rise in the minimum wage here (Wal-Mart could easily handle that, but other smaller companies might struggle); we're merely pointing out that the present institutional makeup of US capitalism might generate some feedback loops which make it stuck on a lower equilibrium growth trajectory than necessary.

That feedback loop would run something like this: many companies don't see much need to expand capacity (despite record profits, cash balances, interest rates) because of tepid demand. Instead of increasing the top line, companies focus on increasing the bottom line, costs are squeezed, wages and employment suffer (median wages have trailed productivity growth for decades), but company profits and shareholders win out.

Since companies and shareholders are spending much less of their income than wage earners (especially low wage earners), the original tepid demand is reinforced, giving companies even less reason to expand production capacity.

In fact this feedback loop could partly explain a phenomenon first described by Larry Summers as 'secular stagnation,' the inability of the US economy to get overheated even in the midst of an asset bubble. At the core, this points to a structural demand deficiency (not just as the result of deleveraging after a credit-infused asset bubble has imploded).

While a decreasing capital intensity of production and a world savings glut are important factors here, the shift in categorical income distribution should not be overlooked, at the minimum, because it's entirely consistent with the facts (stagnant wages, rising profits, tepid business investment, record buybacks, etc.).

And the US economy becomes ever less capital intensive due to the ongoing shift from manufacturing to services, bigger parts of it become like Wal-Mart. Fairly low tech, not growing much (if at all), hugely profitable, but mostly at the expense of squeezing cost and wages, and shifting much of the proceeds to shareholders. And, most importantly, this way is locking the economy in a low growth equilibrium.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The Wal-Mart Economy