My favorite pet story is the economy is awash in “buggy whip profits”. Many businesses that currently generate free cash flow will be either outsourced or computerized in the future, but it is clear that investment in such firms is not profitable.
This is consistent with the productivity dispersion recently discussed on MRU and also with the large share buybacks made by mature firms.
Because our financial system cannot intermediate these funds towards the really innovative firms, the result is high asset prices and low interest rates.
My thoughts:
1. I love the phrase “buggy whip profits.”
2. There are those who say that the corporate raiding of the 1980s helped move capital out of lazily-managed firms and into better uses.
3. There are those who say that Michael Milken’s junk bonds helped move capital into forward-looking industries, such as the early cell phone networks.
4. As economists, we really do not know much about how financial intermediation works. As you know, I think of households as wanting to hold short-term, riskless assets and firms as wanting to issue long-term, risky liabilities, with intermediaries doing the opposite. But how can we tell if and when there is variation in the ability of the financial system to “intermediate these funds toward really innovative firms”?
Economists might be blind to this problem because they see capex as generally a good thing, but capex from a company trying to defend a declining franchise is usually wasted. That’s why Investors are always imploring companies to manage decline and for cash flow instead of trying to turn around a terminal business. A good example right now is Outerwall, the company that runs the Red Box video rental boxes in your local 7-11, and is trying to defend the franchise by expanding into recycled cell phones. How many tech companies will spend down their remaining franchise value by trying to get into selling cloud services? You might think of the capital locked in these companies as stranded capital, not the same as stranded assets.
Managers, looking for something else to mange, using other peoples’ money.
The largest of which is .. Apple? All advantages eventually dissipate and maybe sooner than later and maybe this is amassing assets for future options, and maybe success is expected to be more ephemeral than before. The large buybacks are just offsetting even larger internal and external issuance though. It may be they prefer the option value and to let others to take the risk whether due to the psychology and fear of risk or immaturity of technology.
There is a huge hole in this theory, you have to simultaneously believe that there is investment going on that will cause the computerization or outsourcing to come to pass but also believe that the financial system isn’t proving for that funding. The Buggy Whip metaphor is telling. For built his first car prototype in 1896, started his first company (that failed quickly), introduces the Model T in 1908, and went to full on assembly line production in 1913. Total sales of the Model T didn’t break a quarter of a million until 1914. It took 20 years of Ford’s involvement in the Auto industry to spell doom for the buggy whip along with numerous innovations and adaptations and countless other attempts at automobile start ups raised capital and went bust in that time.
Is the Ford reference to dated? Amazon was founded in 1994 didn’t turn a profit until 2001 and surpassed Walmart by market cap only in 2015. Along the way they acquired dozens of other net startups that had raised their own capital, and wouldn’t have been able to expand this quickly without them.
It would indeed be a strange world where investors are fearful of a future that isn’t being actively funded.
1. We are under counting the number of financial institution. One thing to consider is that big mature firms that are involved in technical innovation may now be the new financial intermediators. Apple, Google, Facebook, Microsoft, etc. because of their special monopoly-ish character, are able to sell corporate bonds near the risk-free rate (I think sometimes even a little less!). They know the tech industry and business better than banks. It looks like they are sitting on a bunch of idle cash, but they are also sitting on a bunch of liabilities, so it’s really like there is an internal financial sector company. It is like inside Google (or ‘alphabet’) there is “Google, the tech company” and also “The Bank Of Google” which they use for both buyouts and takovers outside the house, but also for capital allocation to different risky projects they can perform in-house.
2. A huge and I think under-estimated confounder in all of this is the coincidental timing of various demographic phenomena like the bulge in baby-boomer age-cohorts and the timing of the entry of women into the workplace.
Let’s say not just your population, but all across the developed world, has a huge and growing bulge in the population ratio of retired people (with a dramatic increase in the ratio of old-to-young) who also happen to own (or have claims against) most of the invested savings and wealth in the world.
Retirees aren’t getting income from producing marketable value. For them to consume, they must in aggregate sell off their assets.
When there are lots of young people, compared to old people, in an era of quickly rising wages, then middle-aged people begin to hold more of the wealth, and they must invest their savings someplace new.
When those people get old, however, and there are few young people in an era of stagnating wages, then the old people hold most of the wealth and need to offload it, then this off-loading can satisfy all the demand for saving from current workers. That is to say that most savings behavior is channeled into merely transferring the ownership of existing investments instead of channeling new wealth into new investments.
I don’t know how big a deal it is, but it seems plausible to me that it could be a significant contribution to the problem.
Whoops, I meant to add it a part about the retirees being forced to sell out assets when yields fall too low and dividends can no longer sustain their consumption. And those dividends and rates are very, very low right now, so they have to sell-off because they can’t live off the interest.
This is the best explanation for low real rates:
http://bankunderground.co.uk/2015/07/28/drivers-of-long-term-global-interest-rates-can-changes-in-desired-savings-and-investment-explain-the-fall/
Do you believe in markets? if you do, then you have to assume the stock/capital markets will figure this all out and force businesses to make correct decisions.
One example is Exxon. it is basically self liquidating. it realizes that over the very long term the oil and gas business is like the buggy whip business, and uses a large percentage of its profits to buy back stock. The stark market recognizes this makes Exxon a good stewart of their money and so rewards Exxon with an above average P/E multiple. Hess, which was a bad stewart had an hedge fund buy a big chuck of stock and force change. Markets works, and notwithstanding the interests of management they force companies to do the right thing. To the extent you do not believe this, vote for Bernie and renounce any and all libertarian thoughts.
The issue isn’t getting the money out of exxon in my opinion (and the CFO of exxon has the tools to do this relatively well) but more figuring out how to get it into the right innovative tech firms without getting fooled by pets dot com. On average, the return to venture capital is low historically, but organizations like Y Combinator earn very impressive returns. My interpretation of this is that almost by definition, innovative firms are the ones whose business model is difficult for a bank credit analyst to understand using conventional methods.
In equilibrium, if an uninformed wealthy investor has just received a large payout from their stock portfolio, the only natural thing to do is for them to purchase more stock (or bonds of course) and bid the price up if they are rich enough to already buy most everything they want. If they started funding tech companies themselves which had not already IPOed, they would get the leftovers the smart guys never touched.
Maybe I misread this blog, but I see it (and am personally fairly sympathetic to, even if I’m probably one of the more lefty ones here) strongly in the libertarian tradition of imperfect markets, particularly imperfect financial markets, but even more imperfect government which is too poorly informed and too corrupted to have a good chance to improve on the market outcome.
An economic history paper I quite like, making a related point about the industrial revolution in the UK : http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2611159
that the high tech entrepreneurs of the time were funded almost exclusively by reinvested profits and that the financial sector was unable to channel the wealth of the old nobles to them despite very high marginal returns on capital.