Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

But rent-seeking is not limited to the financial sector. It has pervaded non-financial industries as well – through the pressures that financial-sector profitability, exaggerated by monopoly power and implicit public guarantees, place on the corporate governance of non-financial firms. If investors can expect a certain return by putting their money into a fund, spreading the risks across a wide range of money-making instruments, they will only sink the same funds into one industrial project if it offers a much higher return. The return on financial-sector investment sets a minimum for the return on ‘real’ fixed investment, a floor which rises as financial operations become more profitable. Non-financial companies that cannot beat the financial investors’ return are forced to join them, by ‘financializing’ their production and distribution activities.

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Financialization of the Real Economy

On the face of it, shareholder value is the dumbest idea in the world.

Jack Welch, former General Electric CEO, 2009 1

Finance’s extraordinary growth into an economic colossus over the past thirty years has not been confined to the financial sector; it has also permeated companies in the broader economy, such as manufacturing and non-financial services. The financialization of the real economy is in some respects a more extraordinary phenomenon than the expansion of the financial sector itself and is a central social, political and economic development of modern times.

In exploring this phenomenon, I will look chiefly at the US and the UK, where financialization tends to be most advanced. As we have seen, businesses such as manufacturing and non-financial services have often been classed as the ‘productive sector’, unambiguously creating value, whereas finance is often a cost of doing business, and only contributes to value creation rather than creating value by itself. More loosely, the productive sector is often called ‘the real economy’.

It’s a truism to say that the modern corporation is among the most important forces in the economy. In 2015, the 500 largest public US companies (those listed on a stock exchange) employed almost 25 million people worldwide and generated revenues of over $9 trillion. In the same year, the 500 largest UK companies on the stock market had more than 8 million employees and their total annual turnover was well over £1.5 trillion. 2What’s more, many of the largest companies at the forefront of innovation in the economy are publicly listed; to these we must add the many companies that are privately owned but controlled by financially minded owners such as private equity (PE) or venture capital (VC). The decisions these corporations take, particularly capital allocation, are critical to value creation.

This is why it is so important that we understand the huge extent of the financialization of the productive sector. In the 2000s, for example, the US arm of Ford made more money by selling loans for cars than by selling the cars themselves. Ford sped up the car’s transition from physical product to financial commodity by pioneering the Personal Contract Plan (PCP), which allowed a ‘buyer’ to pay monthly instalments that only covered the predicted depreciation, and trade up to a new model after two or three years rather than paying off the balance. Adopted by most other auto-makers, and with the additional merit of being bundled into securitizations and resold on financial markets, PCPs drove car sales to record levels, alarming only the final regulators, who wondered what would happen if (as with houses in 2008) cash-strapped contractees walked away from their vehicles and handed back the keys. Over the same period GE Capital, the finance arm of the enormous General Electric (GE) group, made around half of the whole group’s earnings. 3Companies such as Ford and GE contributed heavily to the sharp rise in the value of financial assets relative to US GDP in the quarter-century after 1980.

Lending money to customers to buy your cars does not necessarily mean that you are extracting value to the extent discussed in the previous chapter. But, as we shall see, financialization more generally can profoundly affect how companies behave. The strongest evidence of how financial value can damage real economic value can be found in the widespread practice of share buy-backs by public companies listed in the US and UK.

THE BUY-BACK BLOWBACK

Share buy-backs are a way of transferring money from a corporation to its shareholders. The company buys some of its own shares from existing shareholders. As a pure matter of finance and economics, these transactions are just like money paid out as dividends: shareholders receive, and the company pays out, the same amount. The only difference is that dividends are paid out evenly to all shareholders, while buy-backs give cash only to those who want to sell; and, what’s more, buy-backs avoid any penalty taxes imposed on dividends by governments that want more profit reinvested.

A switch from dividends to buy-backs can, however, make a big difference to executive pay, because (unlike dividends) they reduce the number of shares. This automatically boosts earnings per share (EPS), which is one of the key measures of corporate success. Buy-backs typically increase the pace of EPS growth – a measure which is often used to determine just how exorbitant the rewards of senior executives will be. So bosses prefer buy-backs to dividends. Two basically equivalent measures have been made to diverge, unless accountants adjust the share count to ensure that identical transactions have the same effect on the reported results. But bosses are hardly likely to prod them to standardize their measures of corporate payouts. 4

Shareholders also seem impressed by rising EPS, preferring not to notice that buy-backs remove just as much cash as dividends from the funds available for investment. They also seem to ignore the fact that companies are more likely to buy back shares when the price is high than when the price is low, 5despite the inefficiency of this market timing.

In any case, the numbers are striking. In 2014 the American economist William Lazonick chronicled the scale of share buy-backs in the top US companies in recent years. 6Between 2003 and 2012, 449 companies listed in the S&P 500 index deployed $2.4 trillion in buying back their own shares, mostly through open-market purchases. That sum constituted 54 per cent of their collective earnings. Add in dividends, which took out a further 37 per cent, and only 9 per cent of profits were available for capital investment. Over the same period, the ten biggest re-purchasers in the US shelled out a staggering $859 billion on share buy-backs, equivalent to 68 per cent of their combined net income. As illustrated in Figure 21 below, seven of those companies committed more than 100 per cent of their net income to buy-backs and dividends.

Until recently, few investors seemed to grasp the scale of these disbursements. While regular dividends are often used by shareholders as a source of income – which is why shareholders get so upset when they’re cut – buy-backs, on the other hand, are often considered special payments. This ignores their status as an active choice not to invest to create long-term value.

Some investors are finally waking up. In March 2014, Larry Fink, the CEO of Blackrock, one of the largest institutional investors in the world, wrote to the CEOs of the S&P 500 companies about excessive profit distributions. Observing that too many companies ‘have cut capital expenditure and even increased debt to boost dividends and increase share buy-backs’, Fink stated that while ‘returning cash to shareholders should be part of a balanced capital strategy’, such a practice could, ‘when done for the wrong reasons and at the expense of capital investment … jeopardize a company’s ability to generate sustainable long-term returns’. 7