Western capitalism is in bad shape. A decade has passed since banks and financial houses began to crumble and took Western economies to the brink of collapse, but economic growth on both sides of the Atlantic remains weak. It is still determined more by governments and central banks than the animal spirits of entrepreneurial capitalism. It is hardly a consolation that the U.S. economy performed somewhat better than Europe’s when investment as well as new firm creation is muted, real employment levels remain low, and people feel that their economic prospects have improved little. The past ten years have been a lost decade and, unfortunately, many people in the West do not believe the next one will be much better.
Capitalism cannot be blamed for all these problems, but it does not require much imagination, or belief in the Marxist school of history, to see how economic developments before and after the crisis that started in 2007 have fed political revolt. In both America and Europe, people are angry about their poor income growth, and they indict the “one percent” or “the establishment” for pursuing policies that benefit the rich at the expense of the middle class. They feel that the age of cost-cutting McKinsey consultants, cheap capital, and Wall Street financial engineers brought prosperity to the professional classes, but that, as a result, everyone else’s expectations were revised permanently downward. The revolt comes from both the Left and the Right, but the underlying premise is shared: capitalism hasn’t been working for me!
The economics of current political anger clearly connects with the way capitalism has evolved over the past fifty years. Capitalism has gradually been losing its dynamism and has become detached from the spirit of creative destruction that impressed such different economic thinkers as Karl Marx and Joseph Schumpeter. While there is always a cycle of ups and downs for individual sectors or the economy as a whole, the trend has been one of falling productivity growth and corporations that are less patient in how they plan or strategize to make money. Western economies have been gradually losing their ability to grow productivity and expand prosperity by smarter combinations of labor, capital, and technology. There was a productivity spurt in the late 1990s and early 2000s—mostly because of higher capital expenditures in information and communication technology, leading to more technology adaptation. But it did not last for long, and never changed the trend of declining growth. Despite the much-discussed revolution in robotics, big data, machine intelligence, and more, the Western capacity for innovation-led productivity growth has continued to fall—and has recently been close to zero.
That is not surprising for those who have followed the balance sheets of corporate America and Europe. For a long time, businesses have gradually invested less of their revenues. Their total investment represents a smaller share of gross domestic product today than in previous decades. Real expenditures on research and development (R&D) in corporate America have been on a downward trend since the 1960s, with Europe on a similar course. If businesses were preparing for a new innovation boom, the share of revenues that is spent on R&D would have gone up, but it has not. While there has been a lot of capital available for managers who seek to make their way in the world by buying other firms and consolidating markets, there has been much less of a readiness to plow money into competitive strategies based on radical innovation.
Corporations borrow more money today than ever before because the cost of capital has been relatively low for a long time. But there is nothing to suggest that all the new balance sheet capital has been used to expand productive assets or improve capacity for long-term value generation. America’s corporate sector has rather been a net contributor of capital to the rest of the economy for more than a decade. In the 1970s and 1980s, according to the Organisation for Economic Co-operation and Development (OECD), the U.S. business sector was borrowing around 15–20 percent of the value of its productive assets. When the financial crisis hit in 2007, that had already changed: the business sector was lending 5 percent of the value of its productive assets to the rest of the economy.
Firms, therefore, have not just borrowed more—they have also saved more. Balance sheets have been propped up by soaring liquid assets: between 1979 and 2011 the ratio of cash to total assets went up from 9 to 21 percent. In the past decade that cash has been needed to keep up the valuation of firms. Under pressure from investors, companies have handed back money to shareholders at a rate that is disproportionate to their revenue and income growth. Dividends and share buybacks have repeatedly hit all-time highs, and in 2013 the Economist calculated that “38% of firms paid more in buy-backs than their cashflows could support, an unsustainable position.” With all that circulation of credit and cash, large nonfinancial enterprises have increasingly come to operate as savings institutions that make money by simply lending their capital at rates that are higher than the cost of the capital they borrow.
We do not have to go much further in order to understand the economics of political anger. This is what it is all about. Western “money-manager capitalism,” to use a term coined by the late Hyman Minsky, has changed the patterns of incentives and rewards in the economy, leading to stagnation in productivity and wages by reducing the capital investment that supports their growth. This capitalism has unfairly skewed the rewards to investors versus labor because, with corporate capital allowed to be idle, money has flowed to those seeking rents and skimming the cream off the money-circulation machine—and not to the entrepreneurs, to those taking risks, or to those providing better productivity. Firms are increasingly focused on safe, “risk-free” forms of profitmaking. Neither investors nor competitive markets have forced them to spend more capital and energy on long-term investment and innovation. Capitalism has become a “safe space” for firms that want to shield themselves against market disruption—an economic system characterized by competitive and innovative change that is too slow, rather than too fast, for economic opportunity to grow. While corporate leaders advertise their outsized appetite for innovation and disruption, the reality is that, for several decades, they have been protecting themselves against these forces of competition and have become complacent.
The Color of Capitalism Is Grey
If there is one character that represents the gradually shrinking dynamism of Western capitalism, it is the capitalist—or rather that character’s increasing absence. What really separates today’s Western capitalism from that of fifty years ago is the infrequent presence of real capitalists in the world of commerce. That is quite something for an economic system that, functionally, is about one thing alone: the ownership of firms.
Those running Western capitalism today are not really entrepreneurial capitalists but asset managers and financial institutions such as pension funds and sovereign wealth funds. They are third-party intermediaries, managing other people’s money, and have cut the link between ownership on the one hand and corporate control and entrepreneurship on the other. Because of their growing role, the color of capitalism has become grey. No one knows anymore who really owns firms: owners are known unknowns. In some cases, ownership by third-party intermediaries can have little effect on business decisions, but quite often it creates incentives that are in opposition to all the principles typically associated with entrepreneurial capitalism.
Take an institution like Vanguard, which last year owned close to 7 percent of the S&P 500, an index for the five hundred largest firms by market capitalization listed on the New York Stock Exchange and Nasdaq. It is also the single largest shareholder in General Electric. Therefore, to get an idea of how the biggest owner of General Electric wants its investee to deliver a good return to all its shareholders, it is first necessary to figure out who owns Vanguard. That, however, is easier said than done. Vanguard is not investing its own money. It just represents Vanguard’s different funds, and the company, which pioneered the market for mutual index funds, operates—like other funds—on a principle of diversified allocation of capital. Hence Vanguard does not necessarily hold stocks in General Electric because it has an idea for how to make a successful company even more successful.
Who are Vanguard’s twenty million savers that collectively are the biggest owner of GE? It is impossible to say, of course, but quite a number of them are not direct savers—they are beneficiaries of employers and others that have invested in pension plans. Even if we descended the stairs to the ground floor of savers, the group would be too large to ask what they want to do with their intermediated ownership of GE. Clearly, they are not putting their savings in Vanguard funds because they want an ownership role in GE. Nor are they expecting Vanguard to act as a controlling or entrepreneurial owner.
Yet Vanguard is not a bad asset manager. On the contrary, it is a company that has delivered good returns to its customers. But it is also an institution with such significant holdings in so many companies that it illustrates how the relationship between owners, the firms they own, and their managers has changed. Ultimately, when the identity of an owner is unknown, it is equally impossible to know what the owners want. When companies are principally owned and controlled by owners whose agendas are at best arcane, capitalism turns grey. It is not enough to know that investors simply desire good investment returns and, if the company cannot generate sufficient returns, investors will leave. While it is true that investors tend to be happy as long as companies make good money, it is not the desire to make money that determines whether an owner is successful or not. Money can be made in many different ways. For a company to thrive, owners with diverse interests have to be aligned with the success of the company. Often they clearly are not. Many investment funds, for instance, have significant ownership in competing firms. They are not investing in any one of these firms because they have an idea about how that company will beat all of its competitors; they are just spreading risk. Vanguard, of course, is not alone. The biggest shareholders of most listed companies in America and Europe are funds that invest on the basis of portfolio risk management.
The development of grey capitalism started forty years ago and has accelerated as institutions have been entrusted with a larger part of our savings. In 2013, natural persons owned only 40 percent of all issued public stock, down from 84 percent in the 1960s. And if we take all issued equity, the trend has been even more pronounced. In the 1950s only 6.1 percent of all issued equity was owned by institutions but, in 2009, institutions held more than 50 percent of all equity. The OECD estimated that, in 2013, insurance companies, pension funds, and investment funds administered $93 trillion of the world’s assets—five times the size of America’s gross domestic product.
Perhaps this rapid pace of recent decades will not persist, but there is a compelling reason to believe that Western capitalism will continue in this direction. Savings will need to increase as more people get closer to retirement—and, as they save more, they need more investment advice and more managers to oversee their savings. For that reason, the change from capitalist owners to institutional owners is logical. Nor will institutional owners’ growing role in the future be the result of irrational acts. The growth of these institutions is a direct reflection of the growing demand from savers with a desire to grow their assets but little knowledge of how to do so. Just like other sectors, the world of investment runs on the economies of scale and specialization, and rather than having laymen investing their savings, it is obviously better for them to use the service of professional asset managers.
But the shift from capitalist ownership to institutional ownership has undermined the ethos of capitalism and has created a new class of companies without entrepreneurial and controlling owners. Contrary to some expectations, that has not created new space for free-wheeling and entrepreneurial managers to act on their own judgment instead of following the instructions of owners. Rather, managers are subject to a growing number of rules and guidelines designed for and by risk-averse owners with little knowledge about their investees. These owners have no other option than to outsource ownership to corporate managers.
by Fredrik Erixon and Björn Weigel , American Affairs | Read more:
Image: uncredited
Capitalism cannot be blamed for all these problems, but it does not require much imagination, or belief in the Marxist school of history, to see how economic developments before and after the crisis that started in 2007 have fed political revolt. In both America and Europe, people are angry about their poor income growth, and they indict the “one percent” or “the establishment” for pursuing policies that benefit the rich at the expense of the middle class. They feel that the age of cost-cutting McKinsey consultants, cheap capital, and Wall Street financial engineers brought prosperity to the professional classes, but that, as a result, everyone else’s expectations were revised permanently downward. The revolt comes from both the Left and the Right, but the underlying premise is shared: capitalism hasn’t been working for me!
That is not surprising for those who have followed the balance sheets of corporate America and Europe. For a long time, businesses have gradually invested less of their revenues. Their total investment represents a smaller share of gross domestic product today than in previous decades. Real expenditures on research and development (R&D) in corporate America have been on a downward trend since the 1960s, with Europe on a similar course. If businesses were preparing for a new innovation boom, the share of revenues that is spent on R&D would have gone up, but it has not. While there has been a lot of capital available for managers who seek to make their way in the world by buying other firms and consolidating markets, there has been much less of a readiness to plow money into competitive strategies based on radical innovation.
Corporations borrow more money today than ever before because the cost of capital has been relatively low for a long time. But there is nothing to suggest that all the new balance sheet capital has been used to expand productive assets or improve capacity for long-term value generation. America’s corporate sector has rather been a net contributor of capital to the rest of the economy for more than a decade. In the 1970s and 1980s, according to the Organisation for Economic Co-operation and Development (OECD), the U.S. business sector was borrowing around 15–20 percent of the value of its productive assets. When the financial crisis hit in 2007, that had already changed: the business sector was lending 5 percent of the value of its productive assets to the rest of the economy.
Firms, therefore, have not just borrowed more—they have also saved more. Balance sheets have been propped up by soaring liquid assets: between 1979 and 2011 the ratio of cash to total assets went up from 9 to 21 percent. In the past decade that cash has been needed to keep up the valuation of firms. Under pressure from investors, companies have handed back money to shareholders at a rate that is disproportionate to their revenue and income growth. Dividends and share buybacks have repeatedly hit all-time highs, and in 2013 the Economist calculated that “38% of firms paid more in buy-backs than their cashflows could support, an unsustainable position.” With all that circulation of credit and cash, large nonfinancial enterprises have increasingly come to operate as savings institutions that make money by simply lending their capital at rates that are higher than the cost of the capital they borrow.
We do not have to go much further in order to understand the economics of political anger. This is what it is all about. Western “money-manager capitalism,” to use a term coined by the late Hyman Minsky, has changed the patterns of incentives and rewards in the economy, leading to stagnation in productivity and wages by reducing the capital investment that supports their growth. This capitalism has unfairly skewed the rewards to investors versus labor because, with corporate capital allowed to be idle, money has flowed to those seeking rents and skimming the cream off the money-circulation machine—and not to the entrepreneurs, to those taking risks, or to those providing better productivity. Firms are increasingly focused on safe, “risk-free” forms of profitmaking. Neither investors nor competitive markets have forced them to spend more capital and energy on long-term investment and innovation. Capitalism has become a “safe space” for firms that want to shield themselves against market disruption—an economic system characterized by competitive and innovative change that is too slow, rather than too fast, for economic opportunity to grow. While corporate leaders advertise their outsized appetite for innovation and disruption, the reality is that, for several decades, they have been protecting themselves against these forces of competition and have become complacent.
The Color of Capitalism Is Grey
If there is one character that represents the gradually shrinking dynamism of Western capitalism, it is the capitalist—or rather that character’s increasing absence. What really separates today’s Western capitalism from that of fifty years ago is the infrequent presence of real capitalists in the world of commerce. That is quite something for an economic system that, functionally, is about one thing alone: the ownership of firms.
Those running Western capitalism today are not really entrepreneurial capitalists but asset managers and financial institutions such as pension funds and sovereign wealth funds. They are third-party intermediaries, managing other people’s money, and have cut the link between ownership on the one hand and corporate control and entrepreneurship on the other. Because of their growing role, the color of capitalism has become grey. No one knows anymore who really owns firms: owners are known unknowns. In some cases, ownership by third-party intermediaries can have little effect on business decisions, but quite often it creates incentives that are in opposition to all the principles typically associated with entrepreneurial capitalism.
Take an institution like Vanguard, which last year owned close to 7 percent of the S&P 500, an index for the five hundred largest firms by market capitalization listed on the New York Stock Exchange and Nasdaq. It is also the single largest shareholder in General Electric. Therefore, to get an idea of how the biggest owner of General Electric wants its investee to deliver a good return to all its shareholders, it is first necessary to figure out who owns Vanguard. That, however, is easier said than done. Vanguard is not investing its own money. It just represents Vanguard’s different funds, and the company, which pioneered the market for mutual index funds, operates—like other funds—on a principle of diversified allocation of capital. Hence Vanguard does not necessarily hold stocks in General Electric because it has an idea for how to make a successful company even more successful.
Who are Vanguard’s twenty million savers that collectively are the biggest owner of GE? It is impossible to say, of course, but quite a number of them are not direct savers—they are beneficiaries of employers and others that have invested in pension plans. Even if we descended the stairs to the ground floor of savers, the group would be too large to ask what they want to do with their intermediated ownership of GE. Clearly, they are not putting their savings in Vanguard funds because they want an ownership role in GE. Nor are they expecting Vanguard to act as a controlling or entrepreneurial owner.
Yet Vanguard is not a bad asset manager. On the contrary, it is a company that has delivered good returns to its customers. But it is also an institution with such significant holdings in so many companies that it illustrates how the relationship between owners, the firms they own, and their managers has changed. Ultimately, when the identity of an owner is unknown, it is equally impossible to know what the owners want. When companies are principally owned and controlled by owners whose agendas are at best arcane, capitalism turns grey. It is not enough to know that investors simply desire good investment returns and, if the company cannot generate sufficient returns, investors will leave. While it is true that investors tend to be happy as long as companies make good money, it is not the desire to make money that determines whether an owner is successful or not. Money can be made in many different ways. For a company to thrive, owners with diverse interests have to be aligned with the success of the company. Often they clearly are not. Many investment funds, for instance, have significant ownership in competing firms. They are not investing in any one of these firms because they have an idea about how that company will beat all of its competitors; they are just spreading risk. Vanguard, of course, is not alone. The biggest shareholders of most listed companies in America and Europe are funds that invest on the basis of portfolio risk management.
The development of grey capitalism started forty years ago and has accelerated as institutions have been entrusted with a larger part of our savings. In 2013, natural persons owned only 40 percent of all issued public stock, down from 84 percent in the 1960s. And if we take all issued equity, the trend has been even more pronounced. In the 1950s only 6.1 percent of all issued equity was owned by institutions but, in 2009, institutions held more than 50 percent of all equity. The OECD estimated that, in 2013, insurance companies, pension funds, and investment funds administered $93 trillion of the world’s assets—five times the size of America’s gross domestic product.
Perhaps this rapid pace of recent decades will not persist, but there is a compelling reason to believe that Western capitalism will continue in this direction. Savings will need to increase as more people get closer to retirement—and, as they save more, they need more investment advice and more managers to oversee their savings. For that reason, the change from capitalist owners to institutional owners is logical. Nor will institutional owners’ growing role in the future be the result of irrational acts. The growth of these institutions is a direct reflection of the growing demand from savers with a desire to grow their assets but little knowledge of how to do so. Just like other sectors, the world of investment runs on the economies of scale and specialization, and rather than having laymen investing their savings, it is obviously better for them to use the service of professional asset managers.
But the shift from capitalist ownership to institutional ownership has undermined the ethos of capitalism and has created a new class of companies without entrepreneurial and controlling owners. Contrary to some expectations, that has not created new space for free-wheeling and entrepreneurial managers to act on their own judgment instead of following the instructions of owners. Rather, managers are subject to a growing number of rules and guidelines designed for and by risk-averse owners with little knowledge about their investees. These owners have no other option than to outsource ownership to corporate managers.
by Fredrik Erixon and Björn Weigel , American Affairs | Read more:
Image: uncredited
