Monday, 18 February 2013

The Price of Safety

In my latest feature "The price of safety", co-written with Frances Coppola, we take a look at an issue I have been closely following over the past few years - the economic impact of corporate cash hoarding. To my mind the story is a crucial one to help explain why more than five years since the start of the financial crisis Western economies are still struggling to achieve meaningful growth.

For me the key to understanding this point is an appreciation of sectoral balances. The concept was eloquently summarised by Martin Wolf in 2011:

"If the government wishes to cut its deficits, other sectors must save less. The questions are 'which ones' and 'how'. What the government has not admitted is that the only actors able to save less now are corporations."

Since the onset of the crisis executives of cash-rich firms (along with a number of commentators) have argued that they have good reason to build up capital buffers. Macro threats such as the eurozone crisis, heated debates over the federal budget in the US and a possible hard landing in China have all been offered as sources of existential risk.

When I first looked at the issue I was tempted to accept this analysis. The overwhelming desire for safety in the face of these risks appeared both to explain rising cash reserves and below inflation yields on government debt instruments. In effect management of businesses running a cash surplus were focused solely on downside protection even at the medium term cost to profitability and the wider economy.

Yet Andrew Smithers, head of Smithers & Co, had a different interpretation. He noted that while cash reserves were indeed high so too were corporate debt levels. With interest rates at historic lows profitable businesses found an extremely cheap source of financing in debt markets and appeared to be using them to fund, among other things, large scale share buybacks and dividend payments. Smithers says buybacks alone were equal to 3% of UK GDP in 2011.

Unsurprisingly equity investors have broadly supported these moves with many actively agitating for them. Some have even filed law suits to that effect.

While I understand their motivation, I think the argument that companies should simply hand their reserves back to investors or reduce the stock of risk-absorbing equity may well be misplaced. This is because in large part these capital stockpiles have been built on businesses slashing their capital investment. The lack of organic investment may be part of the explanation for falling productivity and over the medium term could also have serious consequences for the profitability of these firms (even if the trend can temporarily be masked by a boost to investor returns through buybacks).

Falling manufacturing profitability, as show by the ONS chart below, could suggest that this squeeze is already starting to happen. It might also demonstrate that corporates are having to try to protect margins by bleeding existing assets to a greater extent and leaning on suppliers - neither really offering a long term solution.


Furthermore, while the private sector remains focused on its search for safety the public sector in the UK is attempting to cut spending in an effort to improve the longer term trajectory of government finances. This is helping to drive a toxic cycle whereby fears of the impact of government cuts on demand can be used as a pretext for increasing capital buffers - or as Wolf puts it: "The government's - not surprisingly, unstated - policy is to demolish corporate profits."

In "The price of safety" we conclude that although it may not be the government's intention to undermine aggregate demand, nor the private sector's desire to hold back economic growth (although with large and growing debt piles they may have some motivation to keep interest rates low!) the lack of investment is nevertheless having that effect. Frances writes:

"It is unreasonable of the private sector to withhold risky investment in potentially productive activities themselves and refuse to allow government to do so. If private investors will not take risks, and the government cannot for fear of upsetting private investors, the economy is doomed to stagnation."

For me, this is an excellent summary of the game of chicken that has been initiated. Ultimately either the private sector will have to balk at falling profits or the government become shy of driving output lower if we are to break free of the current economic malaise. On current signals from both sides it seems that realisation may take some time yet.



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