Companies—both here and abroad—have accumulated billions. How do we get them to spend it?by George Magnus / May 24, 2016 / Leave a comment
On 21st May, Shadow Chancellor John McDonnell spoke at a State of the Economy conference organised by the Labour Party. His talk was a wide-ranging pitch about “we can start to transform how capitalism in Britain works,” and how Labour could become a credible alternative government. He also stated, in a rather threatening way, that the UK’s “giant corporations are sitting on giant cash piles—perhaps up to £700bn.” He went on to note that “instead of investing money productively, creating new jobs and opportunities, our corporations are hoarding cash.”
McDonnell is certainly right that UK companies are sitting on a mountain of cash. According to Bank of England economists Katie Farrant and Magda Rutkowska, over the last decade, private non-financial companies in the UK have been accumulating a higher proportion of cash on their balance sheets than before, and the estimated total at the end of 2014 was about £500bn. As a share of GDP, corporate cash has risen from about 20 per cent in 1987 to about 30 per cent today.
But McDonnell got other facts wrong. According to the National Income Accounts, UK companies have been investing at a rate of about 6-7 per cent per year since the financial crisis—a rate faster than GDP growth—in spite of the retrenchment in financial services and the oil industry. Moreover, labour market data shows that the UK has the highest level of employment on record.
McDonnell has a point, but it should have been delivered in a more considered fashion, for three reasons. First, the build-up in cash on corporate balance sheets is something that’s been going on for some time. Second, it is a global phenomenon. Recent estimates put the cash reserves of US non-financial companies at $1.7 trillion, a third of which is accounted for by just five tech giants: Apple, Microsoft, Alphabet (Google’s parent company), Cisco and Oracle. Moody’s, the credit rating agency, issued a report last year suggesting that 672 major European companies were together holding about €870bn at the end of 2014. And the worst offenders are in Japan, with listed companies sitting on about $2.2 trillion, or some 40 per cent of GDP.
Finally, the “hoarding” of cash is an emotive term, suggesting that companies are up to no good. This masks a deeper, underlying problem: the elevated levels of corporate savings (of which cash is an important but not the only part), especially in relation to investment. Historically, it’s been the other way around: companies are usually net borrowers. They tend to invest more than they save, and finance the difference by borrowing from banks or in capital markets. What we need to ask is why their behaviour has changed? And what should be done about it?
Since the financial crisis, companies have also been borrowing a lot of money, taking advantage of rock-bottom borrowing rates and the cheapness of capital. That makes sense. But why are they generating so much idle cash and why do they borrow money to put it back in the market where returns are so low? That makes no sense. It burns a hole in the company’s pockets, so to speak.
We don’t really know. Some people argue that companies are saving a lot and investing less because they are uncertain about the future. Yet the decline in the investment rate (as a share of GDP) in many western countries pre-dates the financial crisis and hasn’t recovered well, while companies have increased their payouts to investors through dividend payments and share buybacks. If companies were that cautious, they probably wouldn’t have rewarded investors in this way.
“Governments could change the tax code to penalise retained profits, encouraging firms to distribute them or spend them.”
Others argue that high cash holdings reflect the absence of worthwhile or profitable investments. Their detractors say quite the opposite, namely that if the outlook was bleak, and we have reached the end of innovation, then there would be no point hanging on to cash. Or maybe, companies use cash to adjust to business cycle ups-and-downs, as they used to adjust inventories, but in modern production models, the latter are much smaller than they used to be. They might need more cash for tax claims and litigation, for example, or for collateral in complex financing arrangements. As it is, companies are being rewarded for saving—that is, high stock prices and high cash piles co-exist.
Another, more thoughtful explanation is that modern technologies tend to conserve capital rather than create it: for example, consider the impact of Uber on sales of cars, of Amazon on warehousing and shopping centres, and of Airbnb on hotel construction. And tech companies do account for a high proportion of the cash owned by private companies. Whatever the reasons, no one thinks the cash piles are going to diminish anytime soon.
So what should be done to make companies run them down, which would boost spending in the economy? Governments could change the tax code to penalise retained profits, encouraging firms to distribute them or spend them. They could tighten up the tax treatment of debt, to disincentivise companies from borrowing, especially to finance share buybacks. Joining the narrative about tax havens, they could use the tax system to make it harder for companies to avoid tax as they do under current regulations. But these measures treat the symptoms not the causes of high corporate savings.
In his speech, McDonnell said that the solution is to change ownership structures. Hitting out at “those responsible for running [companies] who are paying themselves obscene amounts of cash,” he made a pitch to bring employees and workers into management, increase the size of the co-operative sector, and encourage more community or collective ownership in new business models. But these proposals don’t even begin to address the reasons for high corporate savings.
There may be cases where ownership changes might work and where they would be socially beneficial. But if we want capitalism to work better, the first thing to do is to look at the corporate governance system. At present, it rewards executives for short-term share price performance, which leads to bad outcomes for the executives themselves, the companies and society. Companies need to be seen to be socially responsible as well as successful. Longer-term incentives, clawbacks, bigger payouts to shareholders (who should be more empowered over executives), wider employee share participation, and higher employee compensation could all be part of new arrangements.
The missing piece remains how to get the investment rate up, especially since new technologies, low fossil fuel prices and labour costs, and the rising number of older citizens may be pulling it down. If private sector capital spending stagnates or doesn’t rise up to address these challenges, we may yet have to look to government capital spending, and regulatory and fiscal support for private investment, unfashionable as it now is.