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Sunday, 22 October 2017

Intangible capital

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Jim Saft on slow growth and the knowledge economy.

James Saft

James Saft

Reuters Columnist

Corporate cash hoarding may simply be an unintended consequence of the rise and rise of the knowledge economy.

If true, this may help to explain not only why companies see fit to pile up mountains of cash, but also why the recovery and job growth are so weak.

A study published by the Federal Reserve in September tied the growth of cash on corporate balance sheets to the rise of so-called intangible capital, things like intellectual property or the processes and experience that allow a company to deliver a good or service.

For whatever reason, companies are simply happier piling up cash, or using it to buy back shares, than to build out new capacity.

 “Using a new measure, we show that intangible capital is the most important firm-determinant of corporate cash holdings. Our measure accounts for almost as much of the secular increase in cash since the 1980s as all other determinants together,” Antonio Falato and Jae Sim of the Federal Reserve and Dalida Kadyrzhanova of the University of Maryland write. 

The rise of cash holdings by companies has been remarkable, and a huge puzzle.

US corporations now hold almost three times the amount of cash they did in the 1970s. A variety of explanations has been suggested; from the idea that companies are holding more cash offshore to skirt taxes to accusations that executives won’t make long-term investments because their own pay is tied so closely to quarter-to-quarter profit measures. Those may be true in part, but not the entire story.

Whatever the explanation, the economic impact of all this cash sitting around is large. In an old-fashioned industrial-age economic cycle companies moved strongly to invest coming out of recessions, reacting to the high profit margins which recovering demand drives. That investment, in turn, drove hiring, spending and a virtuous cycle of growth.

This time round, however, while investment has recovered somewhat, it has done so only slowly and still lingers near where it would usually bottom out in past recessions.

For whatever reason, companies are simply happier piling up cash, or using it to buy back shares, than to build out new capacity.

The paper’s authors find a very tight relationship between this cash build-up and the equally remarkable rise of intangible capital. Intangible capital is, broadly speaking, all of the things which allow a company to successfully compete and deliver a good or service but which, unlike a loom or a building, can’t be touched. Much of this, like research and development, both uses technology and is driven by technology.

The collateral problem   

The rise of the Internet and computing has led to a corresponding rise in intangible capital. Whereas intangible capital was equal to only about 5% of net corporate book assets in 1970 it has skyrocketed to about 60% by 2010.

If company investment won’t lead to full employment, then we’ll need something like a housing bubble or a social media bubble to get people back to work.

Having more of your value invested in and represented by intangibles creates some problems. For one thing, unlike a factory building or a piece of machinery, you can’t pledge intangibles as security against a loan. That makes borrowing more expensive or even, if a company is in distress, impossible. It follows then that firms with high levels of intangible capital, which is just about everyone, would hold more cash in order to keep their options open, either for investment or acquisitions or simply to weather the inevitable storms.

In many ways this theory fits in well with the broad facts of the past 15 years. You might argue that the unusually loose monetary policy which produced first the dot-com bubble and then the housing one was in part a reaction, intentional or not, to a world in which companies are investing less and behaving more cautiously. If company investment won’t lead to full employment, then we’ll need something like a housing bubble or a social media bubble to get people back to work. And with companies less willing to borrow, more of the weight of growth depends on getting households to borrow, be it for houses or cars or college degrees.

A troubling thought is that with the rise of 3D manufacturing, with its emphasis on intellectual property, intangible capital will only become more important. That implies that the cash hoarding and investment drought will only get worse.

One partial potential solution might be to make it easier for firms, perhaps through banking regulation, to borrow against their intangibles. That might encourage them to keep less cash on hand and invest more. It also, of course, might lead to banks going bust when they find it impossible to measure, much less seize and liquidate, the intangibles pledged against a loan.

In any event, it doesn’t seem like this is a problem which can be solved by low interest rates, no matter how many times we try.

(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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