A Discussion of the Phenomenon and some Pragmatic Solutions to Realigning Corporate America’s Investment Spending to a Long Term Time Horizon
Much debate during our current election cycle has focused on America’s economic footing after emerging from the 2007 financial crisis. Specifically, many presidential hopefuls are criticizing Wall Street and Corporate America for their excessive greed in seeking profits at the expense of the average working-class American. From Hillary Clinton’s economic plan that chastises the “tyranny of today’s earnings report”, to Bernie Sanders’s calls for a more equitable distribution in wealth and even Donald Trump’s remarks that he will go after “those hedge fund guys”, it is evident that the issue of curbing greed amongst Corporate America and Wall Street is a topic that will receive extensive coverage in the upcoming months leading up to the 2016 Presidential Election.
While the idea of curbing excessive greed is divisive and useful for a politician to rally public political support, these accusations only provide a cursory look at the problem that underlies Corporate America and America’s Political Economy. One of the fundamental problems that concerns me is a lack of long-term investment spending on the part of America’s largest corporations and a coinciding increase and emphasis in spending on short-term financial engineering mechanisms like stock buyback’s and in a few cases some seemingly speculative M&A activity. In the short run, these financial engineering mechanisms serve to boost a company’s margins and potentially its stock price without necessarily helping the particular company establish a more prosperous and successful future. If we continue to allow Corporate America to retain such a short-term investment focus and outlook, it can have drastic effects on America’s future economy. Economic growth comes from investment spending because it leads to innovation, which increases a nation’s production capabilities. As public spending on R&D as a percentage of overall GDP has continuously dropped for decades (a problem that also must be addressed) it is imperative for not only the American government to invest more in our economy’s future, but for our nation’s largest corporations to do so as well.
William Lazonick, in his article published in the Harvard Business Review, “Profits Without Prosperity”, addresses the issue of disparity in economic gains between Corporate America and the average American since the 2007 financial crisis. Lazonick looks at the 449 companies that were publicly listed on the S&P 500 from 2003 to 2012 and finds that 54% of their earnings were spent on stock buybacks and another 37% of their earnings were spent on dividend payouts, leaving a very small amount of earnings to be spent on investments in improving a company’s productive capabilities (1). He asserts that much of the reason why corporate America has been rewarding its shareholders and executives so handsomely through stock buybacks and dividends is that these financial engineering mechanisms enrich corporate executives who are largely paid in stock compensation and options. Interestingly, the impetus for tying executive compensation to stock options was to incentivize company executives to make business decisions that would promote a company’s productivity and thereby encourage economic growth (Big picture article). The idea that executive compensation aligns an executive’s interest with the interest of shareholder’s and thereby encourages economic growth largely came from the intellectual contributions and philosophies of the Chicago school of economics in the 1970s and 1980s.
Milton Friedman, one of the most influential economists of the 20th century and the intellectual leader of the Chicago school of economics, advocated for shareholder primacy in his seminal essay published in 1970 entitled “The Social Responsibility of Business is to Increase its Profits.” Friedman declares that the “primary responsibility” of “a corporate executive” is to act as “the agent of the individuals who own the corporation.” To Friedman, an executive who focuses on spending corporate money on social responsibility objectives, like hiring unskilled workers to fight poverty, is unjustly reducing the returns of stockholders who provide the capital to start a company (2). Friedman utilizes an extreme example here to argue for why a corporate executive’s only responsibility should be the accumulation of profits for his or her shareholders and thus ignores an executive’s responsibilities to the corporation’s other important stakeholder—its employees. While I do not agree completely with Friedman’s idea that an executive’s ultimate goal should be the maximization of profits, the notion that shareholder considerations should weigh considerable importance for a company executive when making a business decision is reasonable. Friedman’s ideas were later expanded upon by other economists, most notably Michael Jenson and William Meckling, who argued for tying executive compensation to stock options in order to align the interests of corporate executives and their shareholders (3).
Although the ideas of shareholder primacy called for creating greater economic efficiency and growth, the same ideas when taken to their extreme have had a detrimental effect on corporate America and the American economy. It is telling that Laurence Fink, the CEO of the world’s largest asset manager BlackRock, is concerned with the current buyback frenzy: “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies… Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks” (4). Below is a graph that shows how since 2009 a majority of stock buybacks has been financed with cash raised from corporate debt.
This is concerning because the entire reason why the Federal Reserve lowered interest rates to historical lows in 2008-2009 was mainly to encourage businesses to invest in the American economy in order to increase employment and future economic growth. However, much of the debt taken on by our largest corporations has been spent on buybacks that artificially inflate a company’s value without helping the American economy or even necessarily the future growth of the business in question. Under normal circumstances, a buyback does not necessarily increase a stocks price as the total amount of shares can decline in proportion to the decline in a company’s earnings as cash is spent on the buyback. However, when debt is used to fund a buyback it almost guarantees an increase in earnings per share as the total amount of shares declines in a greater proportion than the decrease in earnings (6).
Furthermore, this excessive financial engineering has affected the average American worker. The graph below shows the relationship between real compensation per hour since 1947 and real output per hour since 1947
As we see gains in productively from 1947 to around the mid 1970s resulted in a coinciding gain in worker compensation. Conversely, around the mid 1970s when the ideas of shareholder primacy began to come into fruition, we see a divergence between worker compensation and productivity. It is important to note that a part of the above divergence is a result of factors like globalization that have outsourced labor overseas. Nevertheless, the emphasis on rewarding shareholders and executives with stock compensation also explains the divergence between worker compensation and productivity. As more and more capital is channeled towards increasing stock buybacks and dividends, less capital is spent on reinvesting in a company’s workforce through training programs and in rewarding the typical worker with a wage increase. Here we can see part of the reason for why the real median household income has not increased since the early 1980s and for why the average CEO of a public company in 2003 made 500 times their average employee versus 140 times their average employee in 1984 (7)
Despite the concerning trend in corporate America towards shunning long-term investment spending in order to promote short-term financial engineering mechanisms, there are pragmatic solutions to this problem that support both the shareholder and stakeholder business ideologies. Below are three practical solutions that I believe could encourage corporations to increase their long-term investment spending without ignoring the expectations of their shareholders
We must pass legislation that emphasizes long-term capital expenditures and investment metrics to make up a portion of CEO compensation, while de-emphasizing short-term profitability metrics in executive compensation. If this is done, executives will be more incentivized to invest capital in employee training programs and R&D expenditures versus short-term financial engineering mechanisms. Furthermore, short-term profitability metrics still should comprise a part of an executive’s compensation as these metrics are important to the corporations shareholders, and it would be immoral to ignore these important stakeholders.
We must offer greater tax credits to business expenditures on R&D and corporate trainee programs. As many advocates of the shareholder primacy ideology argue, an executive’s ultimate responsibility is to seek corporate profits. If we offered greater tax credits for long-term investment expenditures this would make long-term investment expenditures more profitable in the short-run. Furthermore, by including tax credits on corporate trainee programs it would encourage our largest corporations to continually reinvest in their workers, which won’t only increase a corporation’s productivity, but also increase the wages of their workers overtime because these workers would become more skilled.
We must pass laws that make labor a permanent fixture in corporate boardrooms. Again, collective labor is an important stakeholder in any corporation and their opinions and concerns should be recognized as equal to that of a primary shareholder’s.
A Final Note on Buy-Backs:
Some people who want to see a shift away from shareholder primacy ideas call for the outlaw of stock buybacks. I frankly think this idea is ridiculous. Stock buybacks, when not done excessively, serve a great purpose and provide value. First off, when a corporation performs a buyback it is a signal to the market from the corporation’s leaders that they are optimistic about their business and believe it is undervalued. During times of financial panic when stock prices can drop irrationally because of unwarranted fear, stock buybacks are an effective tool for any corporate executive to relieve people’s fears about his/her company. Second off, as I already have alluded to, corporate executives must be judged and rewarded in part based on profitability measures. It is important for a corporation to generate profits and when a corporation has excessive capital and there are no attractive long-term investment opportunities a buyback is an efficient use of excess capital.
Lazonick, William. "Profits Without Prosperity." Harvard Business Review. N.p., 01 Sept. 2014. Web. 23 Oct. 2015.
Friedman, Milton. "The Social Responsibility of Business Is to Increase Its Profits, by Milton Friedman." The Social Responsibility of Business Is to Increase Its Profits, by Milton Friedman. N.p., n.d. Web. 23 Oct. 2015.
Bartlett, Bruce. “Is the Only Purpose of a Corporation to Maximize Profit?” The Big Picture, N.p., 13 May 2015.
Stout, Lynn A. The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public. San Francisco: Berrett-Koehler, 2012. Print. 18.
Lazonick, William. "Profits Without Prosperity." Harvard Business Review. N.p., 01 Sept. 2014. Web. 23 Oct. 2015.
Mauboussin, Michael J., and Dan Callahan. "Disbursing Cash to Shareholders." Editorial. Shareholderforum.com. UBS, 6 May 2014. Web. 23 Oct. 2015.
Stout, Lynn A. The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public. San Francisco: Berrett-Koehler, 2012. Print. 18
The opinions expressed in this article are the author's own, and do not represent the views of the Review at NYU, aside from its belief that the free exchange of ideas is crucial to university discourse.