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Monday, 18 December 2017

The incentive gap

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  • James Saft

Jim Saft sees a battle of conflicting incentives… and the economy suffers.

Households are borrowing like it’s 2008 but businesses simply won’t play along.

That gap, between households which once again are taking on debt and businesses which can find nothing better to do with record profits than hand the money back to shareholders, is at the center of our economic malaise.

Understand the working behind this and you may be able to parse not just why everything from art to wine is fetching record prices but why employment and conventional inflation remain mired at unacceptable levels.

First, let’s describe what’s happening.

On the one hand we have data released last week from the New York Federal Reserve which seems to show that, far from deleveraging, households are now avidly adding to their debts.

US household debt jumped by US$127 billion in the third quarter, the biggest increase since the first quarter of 2008. The increase was across the board, as Americans went into greater debt to buy everything from houses to cars to schooling. Household debt is now growing faster than both GDP and disposable income, returning to the pattern which drove both economic growth and serial bubbles in the last decade.

Rather than responding to high profit margins by investing and competing, (executives) seem happy to milk their cows without adding much to their herds.

But, while corporate profits are at a post-war peak compared to GDP, business investment, which has recovered a bit from its steep recession decline, is still about where it was during the recession before last.

Think of this as a battle of conflicting incentives.

On one side stand households and investors who are responding to the very strong liquor which the Federal Reserve is putting in the punch. By buying up bonds and keeping rates low, the Fed encourages risk taking and drives prices for assets – real and financial – higher.

That’s leading to record prices for everything from art to social media companies to Manhattan real estate. This isn’t just a phenomenon for the rich, though the rich do get the cream. Real estate is going up fairly strongly in a wide variety of markets, as are the stocks owned in so many people’s retirement funds and accounts.

On the other side are corporate executives, who don’t seem to have read their economics textbooks. Rather than responding to high profit margins by investing and competing, they seem happy to milk their cows without adding much to their herds.

Since business investment, and the loans used to generate it, are key to growth, this leaves us with an economy which never quite takes off, leaving employment and inflation at potentially damaging levels.

Road to recovery?

Economist Andrew Smithers argues, convincingly, in his new book “The Road to Recovery: How and Why Economic Policy Must Change”, that much of this investment drought is down to executive incentives.

Smithers contrasts the early 1970s with today. Then companies invested about 15 times more in new equipment and ventures than they returned to shareholders via dividends. Now the ratio is less than two. As recently as the 1990s, this number was as high as six.

Why? The change toward ever greater executive pay, doled out in share options which are highly sensitive to short-term stock price movements, has changed how CEOs behave.

That, in combination with the market obsession with making quarterly earnings targets, has resulted in a corporate landscape in which legitimate long-term projects can’t get a hearing because they are not in the best interest of those making the decisions. Why fund a project which will only bear fruit when you, the CEO, are out of office and no longer getting huge yearly allocations of shares?

That’s the real irony here – monetary policy is trying to get households to behave ever more foolishly because companies are living as if only today and next quarter matter.

Both groups are arguably responding by making increasingly poor decisions about how to allocate their funds.

Tucked away in the Fed household debt report was the fact that, while student debt is surging, so is student debt delinquency. A total of 11.8 percent of all student loans are now 90 days in arrears or more. That means more student loans are now in delinquency than existed in total in mid-2001.

That’s a reflection of the increasing desperation of young people who, faced with a bleak job market, try to stay in school to either acquire new salable skills or wait out the recovery.

But with business investment low, that recovery seems forever delayed.

Former U.S. Treasury Secretary Larry Summers recently argued that this state of affairs is in part a function of demographics – that some economies have reached the point where only bubbles can produce enough juice to bring unemployment satisfactorily down.

It may well be that, rather than bubbles, what is needed is effective control of corporations by their owners rather than by top staff.

(At the time of publication, Reuters columnist 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.jamessaft@jamessaft.com)

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