Short-termism: steady on now

A lot of recent economic problems have been put down to short-termism. Many accounts of the financial crisis held that loan originators and mortgage investors knew they were taking on a lot of risk, but were under pressure from "quarterly capitalism"—the need to present a strong bottom line to investors every financial quarter. Many people ascribe some of "secular stagnation"—slow growth around the world since the financial crisis, and persistently low interest rates—to an unwillingness of firms to invest for the long run in their business, choosing to give the money back to their stockholders through buybacks and dividends instead.

But both of these are wrong. Far from being short-termist, US investment bankers were so convinced their own banks had good financial strategies that they invested heavily in their own firms. And they weren't alone: practically everybody—regulators, ratings agencies, government-sponsored enterprises and banks—believed that US housing was on the up. The investment turned out to be foolish, but it was ignorance and poor guesswork, not inevitable upshot of bad bets.

And there is no reason why society should always do new investment through existing firms. Would it have been better to try and invent smartphones through existing camera companies like Kodak? Would on-demand video have turned out better if Blockbuster, not Netflix, had been the first big player? There is a reason that young entrepreneurs and start-ups have grown to dominate some businesses, creatively destroying older players in the process. Young firms are nimbler and more flexible and manoeuvrable.

This is why buybacks and dividends—ways that firms return money to shareholders—are not necessarily any bad thing, or any indication of worrying short-termism among business. It doesn't necessarily mean lower investment overall; mostly that investment will just be happening in different places.

Now to some extent, this is just conjecture: it makes sense that households would switch investment from one venture to another when companies divest cash. But a new paper from Charles Wang at Harvard Business School, and Jesse Fried at Harvard Law, strongly supports my thesis with empirical data. (Hat tip to Jose Ricón's wonderful third links post for bringing the paper to my attention.)

Wang and Fried look at the capital flows data—the huge outflows from S&P 500 firms to their shareholders that worry so many commentators—and find that these are balanced by gigantic flows into investment, but in other ways and areas. As well as buying some stock back, firms issued more. They also funded investment with new borrowing. On top of that, stockholders used much of the cash coming out to invest in non-S&P 500 firms.

During the period 2005-2014, S&P 500 firms distributed to shareholders more than $3.95 trillion through stock buybacks and $2.45 trillion through dividends. But S&P 500 firms absorbed, directly or indirectly, $3.4 trillion of equity capital from shareholders through share issuances.

We show that while S&P 500 firms are net exporters of equity capital, public firms outside of the S&P 500 are net importers of equity capital. During the period 2005-2014, they absorbed $520 billion of equity capital, or about 16% of the net shareholder payouts of S&P 500 companies.

Public firms engaged in approximately $800 billion of net debt issuances, equal to 32% of the $2.50 trillion in net shareholder payouts. When a firm borrows $X and issues a dividend of $X, there is no reduction in the firm’s assets.

What's more, Wang and Fried caution that even this much smaller number likely does not represent firms missing out on investment opportunity due to a self-destructive urge to give their owners money. 

Firstly, net income, the denominator in this equation, is calculated after R&D spending—but firms spend a huge sum on that (around the size of 25-30% of net income itself) before we get to this point. Simply including R&D may balance the scales entirely. Secondly, firms do not need to spend out of cash, and can easily—and often do—issue more equity or debt. Thirdly, cash in the hands of investors does not all go into consumption—it may go into IPOs, private equity, venture capital, or crowdfunding.

The paper is devastating to the simplistic case that buybacks, driven by myopic short-termism, hurt growth, which should always have seemed silly. In 1900 should we have worried if Standard Oil gave money to its investors, because they might just consume it all, and not invest in the companies of the future? Capitalism proceeds by constant entrepreneurial rearrangement of the structure of production—big existing firms are sometimes as bad at picking winners as the government.