A stream of disheartening economic news last week, including flagging consumer confidence and meager private-sector job growth, is leading experts to worry that the recession is coming back. At the same time, many policymakers, particularly in Europe, are slashing government budgets in an effort to lower debt levels and thereby restore investor confidence, reduce interest rates and promote growth.
There is an unrecognized problem with this approach: Reductions in deficits have implications for the private sector. Higher taxes draw cash from households and businesses, while lower government expenditures withhold money from the economy. Making matters worse, businesses are already plowing fewer profits back into their own enterprises.
Over the past decade and a half, corporations have been saving more and investing less in their own businesses. A 2005 report from JPMorgan Research noted with concern that, since 2002, American corporations on average ran a net financial surplus of 1.7 percent of the gross domestic product — a drastic change from the previous 40 years, when they had maintained an average deficit of 1.2 percent of G.D.P. More recent studies have indicated that companies in Europe, Japan and China are also running unprecedented surpluses.
The reason for all this saving in the United States is that public companies have become obsessed with quarterly earnings. To show short-term profits, they avoid investing in future growth. To develop new products, buy new equipment or expand geographically, an enterprise has to spend money — on marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors and so on.
Rather than incur such expenses, companies increasingly prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or engage in purely financial speculation. But this means they also short-circuit a major driver of economic growth.
Some may argue that businesses aren’t investing in growth because the prospects for success are so poor, but American corporate profits are nearly all the way back to their peak, right before the global financial crisis took hold.
Another problem for the economy is that, once the crisis began, families and individuals started tightening their belts, bolstering their bank accounts or trying to pay down borrowings (another form of saving).
If households and corporations are trying to save more of their income and spend less, then it is up to the other two sectors of the economy — the government and the import-export sector — to spend more and save less to keep the economy humming. In other words, there needs to be a large trade surplus, a large government deficit or some combination of the two. This isn’t a matter of economic theory; it’s based in simple accounting.
What if a government instead embarks on an austerity program? Income growth will stall, and household wages and business profits may fall.
That result might not sound bad for the United States, since lower wages and prices would make American goods more competitive abroad. But falling incomes make it even harder for people to make payments on outstanding loans. And if defaults and bankruptcies cascade through the financial system, credit becomes tighter still. Ultimately, there is a danger that deflation — falling wages and prices — will snowball into a depression.
So instead of pursuing budget retrenchment, policymakers need to create incentives for corporations to reinvest their profits in business operations. One way to do this would be to impose an aggressive tax on retained earnings that are not reinvested within two years. Another approach would be a tax on the turnover of corporate financial investments that would raise the cost of speculating with profits, rather than putting them into the business.
At the same time, the federal government must continue to encourage investment in the economy — ideally by creating incentives for investments in national priorities, like new energy technologies.
The entrepreneurial pursuit of profitable growth has been the vital engine of prosperity since the Industrial Revolution. Yet corporate executives are being rewarded for myopia and speculation, undermining the very operation of capitalism. We need tax and regulatory policies to counter this destructive development, along with wider recognition that government deficits, when they counteract corporate savings, are necessary and salutary.
Yves Smith, the author of the blog Naked Capitalism and Econned: How Unenlightened Self-Interest Undermined Democracy and Corrupted Capitalism and Rob Parenteau, the head of a global financial advisory firm and the editor of The Richebächer Letter.