Wednesday, February 25, 2015

Articulating my confusion: Shareholders vs. the real economy

Here's an article by Lydia DePillis based on a study by J.W. Mason. Excerpt:

The years since the recession have given firms even more of an incentive to dispense cash rather than invest in growth: The Fed’s policy of keeping interest rates low has made credit cheap, and with weak consumer demand, high-yield investment opportunities have been scarce. So instead, companies have been borrowing in order to buy back stock, which boosts their share price and keeps investors happy — but doesn’t give anything back to the world of job listings and salary freezes, where most of us still exist.

DePillis (and/or Mason) blames the rise of a "shareholder-above-all philosophy" for the more-cash-to-shareholders trend. The article's headline (which was probably not written by DePillis) is blunt: "Why companies are rewarding shareholders instead of investing in the real economy."

We might call this partial equilibrium reasoning. Shareholders are not modeled explicitly. Firms can use their earnings in one of two ways: hire people, or make payouts to shareholders. Since shareholders are not modeled, the latter means throwing money outside of the economy. We might as well be setting it on fire. Regular folks like you and me will never see that money--all those corporate profits just disappear.

In general equilibrium, those shareholder payouts go somewhere. If the shareholders invest the money in companies (or loan the money to someone else who invests in companies), then this is just a roundabout way of doing what DePillis wants. The money might not be staying inside the firm that earned it, but it will find its way into some other firm. The fact that the reallocation happened suggests that the funds are more productive in the second firm than they would have been in the first firm, unless some sort of policy is distorting things.

Another alternative is that the shareholders spend the money. That boosts aggregate demand, right? Maybe DePillis and the other people who don't like what's happening here don't think more demand is good for regular workers.

But maybe the shareholders don't invest or spend the money. They put the cash under their mattress and it does nothing. That may be the case, but it would be very odd in light of the argument that all this flow of cash is happening because shareholders have become so powerful. Dictatorial shareholders demand that firms give them the cash, so that said shareholders can... do nothing with it.

So I don't understand the story, but the notion that money going to shareholders is money lost from the economy is fairly popular. I would like to see that modeled. In any case, the recommendation at the end is that politicians should have more power over credit allocation, which would not surprise Arnold Kling.


16 comments:

  1. I suppose the real critique they're making there implicitly is that instead of firms investing their earnings in either higher wages for employees, or expanding capacity (which would likely involve hiring more workers and possibly wage rises), they're kicking the money out to shareholders instead. And since shareholders are concentrated near the upper end of the income spectrum already, it means that firm behavior is mostly helping the rich to become even richer with little visible income gains to the rest of the population.

    Granted, that money gets invested back outwards, generating more economic activity which in turn can lead to more jobs overall (and eventual income rises as the unemployment rate shrinks), but it's less direct.

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  2. I don't know about overall, but I just selected the option to "reinvest" all dividends. Don't most? Yes that is very indirect -- I won't be "spending" that "money" back into the economy until retirement, decades away.

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  3. >> Dictatorial shareholders demand that firms give them the cash, so that said shareholders can... do nothing with it. <<

    No, more like they demand the cash so they can purchase condos in Knightsbridge/Midtown Manhattan, art, structured financial products, etc, all of which provide superior returns to investing in the real economy (for now).

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    1. Condos are not part of the real economy? Doesn't somebody have to build them?

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    3. Ryan, that's like saying structured financial products are part of the real economy because somebody has to print out a physical stock certificate. The embedded labor costs are in the $1-200/sf range, and the condos themselves sell for $5-10K/sf. Condos in these markets are positional goods with very low labor intensity relative to asset prices.

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    4. Wow. Look, if you're going to claim that money that goes into the construction industry isn't sufficiently "real economy," then this is going nowhere. Your standard for what counts as "real" is absurd.

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  4. Your implicit model apparently assumes that only one firm is buying back shares. When it becomes the norm for corporations to buy back shares, then money "invested" in the stock market is not about investing in the real economy. It is about taking a punt that the process of buying back shares will raise prices enough to make the "investment" worthwhile in terms of capital gains.

    I don't think that Mason is implying that this model is sustainable over the long-run, since it seems likely that asset price growth without real economic growth to support it will sooner-or-later lead to a dramatic fall in asset prices.

    So it seems to me that your critique is a result of the macroeconomist's habit of working with models where finance doesn't matter, so every use of money is either genuine investment or consumption.

    The decision not to model adverse feedback loops and their sustainability over the short run impacts macroeconomists' ability to understand the macroeconomy. (Literature that may be helpful for understanding these dynamics: Adrian and Shin, Geanakoplos, search model of money (start with Williamson and Wright's handbook article). )

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    1. "Your implicit model apparently assumes that only one firm is buying back shares. "

      No, it doesn't. General equilibrium concerns matter regardless of how many firms are doing it.

      "So it seems to me that your critique is a result of the macroeconomist's habit of working with models where finance doesn't matter, so every use of money is either genuine investment or consumption. "

      I understand that it's fun to bash macroeconomists, so I'm glad you got that out of your system. In any case I am not suggesting that finance doesn't matter. I'm suggesting that the money from buybacks goes somewhere. Maybe it goes into other financial assets, but those have a seller who will do something with the money. More broadly, what I'm asking is for the people espousing the finance-as-black-hole model to explain themselves better. Owners of financial assets are people. What do they plan to do with the money they get?

      It looks to me like the main point of your comment is to complain about macro. I'm very familiar with Adrian and Shin, Geanakoplos, money search models, etc. I learned about those things in graduate macro coursework, among other places.

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    2. Sorry I obviously wasn't clear enough. If you understand adverse feedback loops, then I don't get what your problem is with Mason's model.

      Imagine a world where the funds from buying back the shares get reinvested in the stock market (for capital gains), where the firms that receive the funds are engaged in buybacks not investment. While there's no question that this kind of a feedback loop is not sustainable over the long run, where's the confusion about this as a short-run phenomenon which may or may not lead to adverse economic consequences when unsustainable phenomenon comes to an end.

      (Sorry about the tone. Macro without feedback loops/money/finance is something I've never gotten my head around.)

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  5. Buying shares has little to do with capital investment. The only effect is relatively weak and indirect, in that a higher share price can make borrowing easier (shares as collateral). Retained earnings can do the same thing by reducing borrowing needs. Paying the CEO 300-500 times average employee pay is an obvious theft of employee pay. As a national trend where many corporations are buying back shares, sound similar to the 'fallacy of thrift' problem. Sooner or later, the pumped up asset prices will have to adjust downward.

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  6. "So instead, companies have been borrowing in order to buy back stock, which boosts their share price and keeps investors happy".

    So cash is *not* distributed to shareholders: bonds are sold at low interest rates and the funds obtained used to do share buybacks, boosting the price of stocks. If the shareholder does not sell the stocks they still represent wealth but there are no taxable gains.

    Share buybacks are done for another reason: to keep total shares issued fairly constant when options are given to executives. It is likely that some share buyback activity is done to keep the share price rising but that much of it is done to distribute generous packages to executives in the company.

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  7. Not all shareholders are rich. I'm an expat teacher with about 95 k in my portfolio, blue chip large cap. I don't sell when Apple gives dividends, I buy and hold till I retire. I get emails to vote on the boards._.That's a joke. Most of the companies have hordes of cash and barely pretend to care about shareholders. It is timing.If you got in 2008 you did well.

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  8. This analysis leaves out the obvious case. The money goes to raising the share price. Yes, someone else gets that money, but that money just goes again into raising other share prices. It's perpetual motion.

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    1. The alternative is that it goes into raising real estate prices in London and Manhattan.

      This is not as weird an idea as it might sound. Look at Maxwell's equations describing the nature of light. There is an electric field that vanishes as it stimulates a magnetic field and the magnetic field vanishes as it stimulates an electric field. What actually exists? That's a tough question, but it moves at the speed of light.

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  9. The returns on my financial investments generally go back into other financial investments. I would be surprised to find this is not largely true on average.

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