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Wednesday, 17 September 2014

Bonus culture springs a Keynesian trap

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What if animal spirits in the business sector aren’t so much low as totally changed? Cash hoards are huge at corporations in the US and Britain, an economic puzzle which does much to explain why growth is so low and joblessness so high.

James Saft, Reuters Columnist

Conventional explanations posit that corporate chieftains are failing to invest because they are, depending on your prejudices, overly bound by regulations, worried about uncertainty, simply not seeing demand or confident that it will rise to meet new supply.

The trick, according to this line of thinking, is to raise animal spirits in the business community. How one does this, again, depends on your prejudices, with some arguing that stripping away regulation will help while others believe that deficit spending could jump-start investment.

Venerable economist Andrew Smithers, of asset allocation adviser Smithers & Co, has looked at the issue closely in Britain and argues that compensation targets have fundamentally changed how corporations behave and that the unwillingness to invest, twinned as it is with a penchant for buying back stock, arises from a bonus regime which values short-term profit growth in extreme and distorting ways over growth and sustainability.

If he is right, the implications are huge, making deficit spending a less productive way to break the cycle of low investment, low growth and high rates of unemployment. And though this goes beyond Smithers’ argument, theoretically the same thing would be true about monetary policy. If companies are passing on investment because it simply doesn’t pay for executives, cutting rates and buying bonds will be less effective than assumed.

Corporate cash held onshore by US nonfinancial companies is now US$1.728trn, a decline from Q1 of US$21.5bn but still hugely up on recent years and near to an all-time peak

“We fully support the use of fiscal policy to prevent depression but, because of the change in corporate behaviour, fiscal policy cannot now sensibly be used to engineer recovery,” Smithers writes in a note to clients.

“The intended net savings surplus of the business sector is not today a cyclical problem which will disappear when ’entrepreneurs recover their animal spirits’ but a semi-permanent structural one.”

Corporate cash held onshore by US nonfinancial companies is now US$1.728trn, a decline from Q1 of US$21.5bn but still hugely up on recent years and near to an all-time peak.

Uncounted, and uncountable, trillions are also likely held offshore by US corporations. In Britain, corporations effectively ran deficits from 1987 to 2001, at which point behaviour changed abruptly with large surpluses the norm since.

British companies had a cash flow surplus of 6% of GDP in 2011, and did so while keeping corporate leverage at relatively high levels, even compared to output, something which implies they were not simply responding to weak demand. Remember too that profit margins are at historically high levels, implying again that we need to look beyond straight economics to explain corporate behaviour.

Who get paid and how

So why might executives be passing up on investments which carry a high chance of paying off? In short, because that is not what they get paid to do.

Compensation structures, and levels, have changed fundamentally over the past two decades, with a much higher proportion of pay in shares or share options. Those options in turn are linked to metrics of profitability, such as earnings per share, return on equity or return to shareholders. All of these metrics can be gamed by insiders, and most of the ways in which they are gamed involve deferring long-term good in order to look good on a quarter-by-quarter basis over a period of two or three years.

This has, very likely, raised the bar considerably for what is considered a worthwhile risk in terms of capital investment or expansion into new markets.

Earlier work by Smithers has tied compensation to increasing volatility in profitability at corporations, with the presumption being that there is good reason for new executives to set the bar low so that they can be sure of making their option targets later. Falling average tenure in the top executive suite only exacerbates all of these forces. Why invest for the long term when you won’t be part of it?

Remember too, this is often not in the best interest of shareholders, who rightly hate profit volatility and who also can be left holding the bag when companies which under-invest lose market share over time.

In short, corporate behaviour in the English-speaking world has changed, and without outside influence, can’t be counted on as much to play its traditional role in taking an economy out of recession or a malaise. With the household sector unlikely to take up the slack, this implies that fiscal deficits won’t be as effective but will be far more persistent, raising a host of risks.

Shareholders, policy makers and taxpayers, therefore, have a common cause and should work together to reform how and for what executives are paid.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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