Wednesday, January 23, 2013

What Is Business Borrowing For?

In comments, Woj asks,

have you done any research on the decline in bank lending for tangible capital/investment?

As a matter of fact, I have. Check this out:

Simple correlation between borrowing and fixed investment

What this shows is the correlation between new borrowing and fixed investment across firms, by year (Borrowing and investmnet are both expressed as a fraction of the firm's total assets; the data is from Compustat.) So what we see is that in the 1960s and 70s, a firm that was borrowing heavily also tended to be investing a lot, and vice versa; but after 1985, that was much less true. The same shift is visible if we look at the relationship between investment and borrowing for a given firm, across years: There is a strong correlation before 1980, but a much weaker one afterward. This table shows the average correlation of fixed investment for a given firm across quarters, with borrowing and cashflow.

Average correlation of fixed investment for a given firm.
So again, pre-1980 a given firm tended to borrow heavily and invest heavily in the same periods; after 1980 not so much.

I think it's natural to see this change in the relation between borrowing and investment as a sign of the breakdown of the old hierarchy of finance. In the era of the Chandler-Galbraith corporation, payouts to shareholders were a quasi-fixed cost, not so different from bond payments. The effective residual claimants of corporate earnings were managers who, sociologically, were identified with the firm and pursued survival and growth objectives rather than profit maximization. Under these conditions, internal funds were lower cost than external funds, as Minsky, writing in this epoch, emphasized. So firms only turned to external finance once lower-cost internal funds were exhausted, meaning that in general, only those firms with exceptionally high investment demand borrowed heavily; this explains the strong correlation between borrowing and investment.

from Hubbard, Fazzari and Petersen (1988)

But since the shareholder revolution of the 1980s, this no longer really holds; shareholders have been much more effective in making their status as residual claimants effective, meaning that the opportunity cost of investing out of internal funds is no longer much lower than investing out of external funds. It's no longer much easier for managers to convince shareholders to let the firm keep more of its earnings, than to convince bankers to let it have a loan. So the question of how much a firm borrows is now largely independent of how much it invests. (Modigliani-Miller comes closer to being true in a neoliberal world.)

Fun fact: Regressing nonfinancial corporate borrowing on stock buybacks for the period 2005-2010 yields a coefficient not significantly different from 1.0, with an r-squared of 0.98. In other words, it seems that the marginal dollar borrowed by a nonfinancial business in this period was simply handed on to shareholders, without funding any productive expenditure at all. This close fit between corporate borrowing and share buybacks raises doubts about the contribution of the financial crisis to the downturn in the real economy.

The larger implication is that, with the loss of the low-cost pool of internal funds, the hurdle rate for investment by nonfinancial firms is higher than it was during the postwar decades. In my mind this -- more than inequality, tho it is of course important in its own right -- is the structural condition for the Great Recession and the previous jobless recoveries. The downward shift in investment demand means that aggregate demand falls short of full employment except when boosted by asset bubbles.

The end of the cost advantage of internal funds (and the corresponding erosion of the correlation between borrowing and investment) is related to the end of the collapse of the larger post-New Deal structure of financial repression that preferentially channeled savings to productive investment.

UPDATE: I should clarify that while share buybacks are very large quantitatively -- equal to total new borrowing by nonfinancial corporations in recent years -- they are undertaken by only a relatively small group of firms. For smaller businesses, businesses without access to the bond market and especially privately held businesses, there probably still is a substantial wedge between the perceived cost of internal and external funds. It is quite possible that for small businesses, disruptions in credit supply did have significant effects. But given the comparatively small fraction of the economy accounted for by these firms, it seems unlikely that this could be a major cause of the recession.


  1. Swedish economists Rudolf Meidner and Gösta Rehn used to claim that a decrease in corporate profits actually increased investment through a sort of income effect. According to the theory, managers who saw dwindling profits would respond by trying to expand the business, similar to how a worker might work harder when income goes down to make ends meet.

    I don't know to what extent this theory has been empirically verified, but Sweden had record levels of growth during the time the Rehn-Meidner model was in effect.

    I wonder if you could make a similar claim about stock prices. High stock prices implies lower required returns and nice bonuses for managers, which would make managers complacent. This would explain the investment boom of the 70s, it was really a terrible decade for stock prices.

    If true, it would add even more weight to the idea that the way to get investment going is to encourage internally funded investment, not to channel even more money to the stock market.

    One obvious idea right out of the Rehn-Meidner playbook is to put a larger burden of taxation on corporate income, which opens up possibilities to encourage investment from retained earnings via various tax incentives. The usual objections about tax incidence don't apply since the purpose is not to reduce after-tax profits.

  2. A "great moderation" of "average correlation" perhaps? Da-ring-a-ding-a-cha-cha-cha.

    I am uncomfortable with phrases like "the breakdown of the old hierarchy of finance" and "the shareholder revolution of the 1980s" when they are prefaced by graph evaluations like "So what we see is that in the 1960s and 70s, a firm that was borrowing heavily also tended to be investing a lot, and vice versa; but after 1985, that was much less true."

    What I see in the graph is accelerating downtrend from 1960 to a bottom (1985-1990).

    Also, your table hides what may well be a similar downtrend, by compressing 1960-1984 into just one value, and 1985-2010 into just one value.

    The "loss of the low-cost pool of internal funds" seems to me the same thing as the "deep, and lasting, decline of the rate of return on capital investment since the end of the 1960s" noted by Robert P. Brenner

    As I see it, In the 1950s, about 60% of corporate profits came from real production, and the rest from finance. During most of the Great Inflation, the ratio was 50-50. Today, about 25% of corporate profits come from real production. Three quarters comes from finance.

  3. This is basically LBOs, isn't it? Borrow a ton of money to buy the shares, dump it on the operating company, squeeze it for cashflow to make payments on the debt, and certainly don't invest anything as that's a waste of money that could be used to pay down the debt. When you flip the deal, your turn comes from the fact you get 100% of whatever it sells for on your 10% or whatever equity.

    Structurally, it de-couples borrowing and investment. David Stockman's beatdown of Rmoney looks more and more on point.

  4. Alex,

    The LBO connection is right, I think. But what we've seen, as with the larger set of corporate finance innovations of the 1980s, is the evolution of the exceptional to the routine. In the LBO era, converting a large part of a firm's borrowing capacity into immediate cash for finanancial claimants generally took a change in control and was often strongly resisted by incumbents. Now, it's standard practice.

    Dumenil and Levy have a nice discussion of this in The Crisis of Neoliberalism: "During the 1980s the disciplinary aspect of the new relationship between the capitalist and managerial classes was dominant ... after 2000, ... managers had become a pillar of Finance." Today, the "financial facet of management tends to overwhelmingly dominate” and "a process of 'hybridization' or merger is under way."

  5. These are some mighty weird leftist arguments. Let's acknowledge that corporate governance circa 1960 allowed management to use excess cash flow for their own benefit to try to grow the firm. The benefit has to come in greater compensation from nominally greater profits in the future, rather than metrics like return on investment or share price. However, they clearly did not act in the interest of shareholders in doing so. The revolution of the 80s was to align interests between managers and owners (p.s. this is always the case in privately held or LBO companies where they become one and the same).

    It seems that you don't like this because it means that less wasteful capital investment is happening and wasteful capital investment happened to lead to "some" employment at least temporarily. Hence, modern cures include corporate taxation and incentive schemes with huge deadweight losses that make that wasteful capital spending look attractive to corporation and make the temporary employment and deadweight losses permanent. Your only problem is competitive global markets and trade, which tend to reward the efficient.

    1. Please define "wasteful capital investment" and the time period involved.

  6. "This close fit between corporate borrowing and share buybacks raises doubts about the contribution of the financial crisis to the downturn in the real economy."

    I'm not getting the purport of this claim. Why is increased corporate leverage, (and declining "real" investment), not a contributing cause to the financial crisis and the corresponding economic downturn?

    Further, doesn't the short-term leveraging of corporate productive "assets" amount an increasing extraction of rents from prior investment, at the expense of investment in future production possibilities? And is that somehow unrelated to dis-investment from the domestic U.S. economy, in favor of lower productive investment costs abroad, (for a number of reasons, but especially by "playing" FX rate differentials)?

  7. Dumenil as well as Levy have a nice discussion on this within the Situation regarding Neoliberalism: "During the 80s the disciplinary part of the fresh romantic relationship between your capitalist and managerial classes ended up being dominating ... right after The year 2000, ... managers had become a principal involving Financing.Inches These days, the particular "financial facet of administration tends to completely dominate” as well as "a process of 'hybridization' or perhaps merger will be under way.In .

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