Why do businesses borrow money and issue stock? We know what the answer should be: to finance investment. Here you are, with extra income and no current need for it; over there is someone with a great business plan but no funds to carry it out. The job of finance is to hook you two up — to intermediate — to put your unwanted funds into her unfunded project. For a small fee, of course.
Economics textbooks all assume this is how finance works. So does economic policy. The reason we think that central banks can control aggregate demand, is that we think making it easier for businesses to borrow will boost their investment spending. And that in turn will lead to higher incomes and employment.
In the real world, though, things aren’t so simple. For one thing, investment is not the only thing businesses borrow for.
The link between corporate balance sheets and investment is the focus of my current work, including a just-published paper for the Roosevelt Institute Financialization Project. My argument is that the relationship between corporate sources and uses of funds has evolved historically, and now looks quite different from the textbook story. Today, there is little reason to think that easier credit for corporations will have a major effect on investment or on real economic activity. Instead, changes in the availability of credit for the corporate sector mainly show up as changes in the money flowing out to shareholders as dividends and share repurchases.
You can find the paper itself here. There are good discussions of the results in The Washington Post, Time magazine, and The Week. I wrote about the larger implications of this change in the online political journal The New Inquiry. I’ve also written a great deal on the topic on my blog.
Here are the key points from the working paper:
Over the past six years, the Federal Reserve has taken extraordinary steps to increase the flow of credit to corporations, yet the recovery has been anemic at best. While corporate borrowing returned quickly to its pre-recession levels, the recovery of real investment spending has been sluggish.
This disconnect between corporate borrowing and real investment is an important difference between the U.S. economy of today and the postwar period. A firm in the 1960s that borrowed a dollar would invest about 40 cents of it. Since the 1980s, less than 10 cents of that dollar is invested.
Over the same period, shareholder payouts have nearly doubled; by the second half of 2007 aggregate payouts actually exceeded aggregate investment.
This change in corporate finance is associated with the “shareholder revolution” in corporate governance of the 1980s, which fundamentally transformed the relationship between corporations and financial markets.
The delinking of corporate investment from financing poses a serious challenge for monetary policy. The central bank’s efforts to boost lending will have no effect on output or employment if they only encourage greater shareholder payouts rather than greater spending on real goods and services. Since the beginning of the Great Recession, macroeconomic policy has focused on restoring the health of the financial system, in the hope that increased lending and easier credit will help boost the economy and bring about full employment. But there is good reason to believe that the real economy benefits less from easier credit than it once did.
And here is paper’s key figure:
What this shows is that in the 1950s, 1960s and 1970s, if a given corporation borrowed a dollar more in a given year than other similar-sized firms, you could safely predict that it was investing 30 cents more in that same year. But this relationship weakened abruptly in the early 1980s; over the past three decades, corporations that borrowed more had essentially the same level of investment as ones that borrowed less. At the same time, a new relationship emerged, that did not exist at all before the 1980s: The corporations with the heaviest borrowing were now the ones paying the most out to shareholders. The conclusion of the paper: It appears that finance is no longer an instrument for getting money into productive businesses, but instead for getting money out of them.
I should add that when I first started working on this project, as part of my dissertation at the University of Massachusetts, this was not what I expected to find. Just the opposite: My goal was to show empirically how much the financial crisis of 2008-2009 had contributed to the fall in business investment in the United States. There was a well-established literature on testing the importance of credit constraints for investment, so it seemed like it should be straightforward to apply it to the Great Recession period. But I found myself baffled and frustrated because no matter how I sliced the data, I couldn’t find evidence for substantial credit constraints at all, let alone a a sufficient tightening to explain the dramatic fall in investment in the recession. I pored over the classic empirical papers on credit constraints, trying to understand why they found such clear evidence for a cashflow-investment link that I wasn’t seeing at all. Finally I realized, it wasn’t me, it was the data. The key papers in the empirical literature on credit constraints and investment were largely written in the 1980s, drawing on data from the 1960s and 1970s. The problem, as I discovered, is that the relationships between corporate sources and uses of funds were not the same in that period as in more recent decades.
This is an experience everyone in heterodox economics has had at some point. When you can’t make what you see in front of you match up with what ought to be there, it may not mean you’re doing something wrong. It may mean there’s something wrong with the world.