America’s spending on physical capital, including buildings and machinery, is declining as a percentage of its total production. Economists have offered a number of explanations for this trend. For example, one might expect this to happen as the technology and service sectors get larger relative to other, more physical-capital-intensive sectors such as manufacturing. In addition, firms are devoting an increasing fraction of their investment to “intangible capital” such as research and development, intellectual property, branding, and organization. And whatever the mix of causes ultimately turns out to be, it might have important implications for economic policy.
Thus, I was interested in reading a recent report from Senator Marco Rubio entitled “American Investment in the 21st Century.” Unfortunately, the report is both poorly reasoned and filled with left-wing talking points.
While the report cites some of the relevant economic literature on the declining share of physical-capital investment, it does so only to establish the empirical trend — not to explore the trend’s causes. Instead, the report tries to explain the trend in investment by appealing to a balance-sheet approach of the economy: a comparison of the financial liabilities and financial assets of particular types of firms.
When the value of a firm’s financial assets exceeds the value of its financial liabilities, the firm is a net lender; if the opposite is the case, the firm is a net borrower. Prior to the 21st century, non-financial firms were net borrowers, while households and financial firms were net lenders. However, in recent years, non-financial firms have become net lenders as well. The report refers to this as the “financialization” of the economy and argues that it is a problem. Why? For one thing, firms used to use their net-borrowing position to invest in physical capital, which they can no longer do as net lenders. For another, in the economy as a whole, total financial liabilities must equal total financial assets — meaning that if financial firms, non-financial firms, and households are all net lenders, there must be some borrower.
This analysis is nonsense. It amounts to reasoning from an accounting identity. It is not the sort of thing that one would find in mainstream economic textbooks, for good reason.
It is true, by definition, that the aggregate value of financial assets must equal the aggregate value of financial liabilities. Determining who holds those assets and liabilities and how those holdings have changed over time might pose interesting research questions, but it certainly does not provide any answers.
Anyone investigating this topic should ask the following questions. Why have these firms gone from being net borrowers to being net lenders? Is this a genuine change in behavior or an artifact of the accounting? Is this a temporary change or a permanent change? How would we know? Is government borrowing the cause, the effect, or a passive response? What if firms are simply relying less on borrowing and more on retained earnings to finance investment? Is that picked up in the accounting? Is there evidence that this change in firm financing is causing a decline in investment in physical capital? None of these questions are asked because the entire analysis is not an exercise in economics, but merely an exercise in accounting.
Again, economists have a number of plausible explanations for the decline in investment, and a report sorting through these explanations and exploring their policy ramifications would be welcome. But it is unclear how an accounting exercise based on U.S. firms can explain this phenomenon — especially when the decline in physical-capital investment is not confined to the U.S.
Nonetheless, the report persists. Why have firms changed their behavior? According to the report, the answer is simple. I’ll quote directly from the report:
It has been accepted as economic law since the 1970s that returning value to shareholders is the primary function of business activity. This theory, which we will call “shareholder primacy theory” in this section, is not a law of nature, but a system of preferences, or as William Lazonick has called it, an ideology. It is a theory based on a certain set of beliefs about what economic value is, how it is created, and who has what claims to it. Nothing about it guarantees that capital will be deployed to the productive ends described in the previous section.
This claim is hard to parse. First, we are told that returning value to shareholders is an economic law. Then we are told it’s a theory. Then we are told that it is a system of preferences or an ideology. Finally, we are told that this law/theory/ideology is to blame for declining investment in physical capital.
The difficulty of determining whether the primacy of shareholders is a law, a theory, or an ideology is indicative of the main problem of the report, whose authors are confused about where the ideology lies on this issue. The idea that firms are responsible to their shareholders is self-evident. The conventional critique is that firms should not be exclusively responsible to their shareholders, because exclusive focus on shareholder value (A) leads to short-term thinking and (B) prevents firms from pursuing some greater social purpose.
The report adopts the first element of this view — from which two testable hypotheses follow. The first is that short-term thinking has increased since the 1970s. The second is that this short-term thinking is causing the decline in capital investment. Given that this is the primary argument of the report, you would think that the report would offer some empirical evidence supporting these claims. However, one apparently doesn’t need empirical support when one can reference the authority of far-left commentators who, judging by other quotes in the report, would fail a course in price theory.
The closest we get to an empirical claim is regarding share buybacks. On this issue, the report shares not only the rhetoric of Bernie Sanders but also his fundamental misunderstandings. It argues, for example, that share buybacks come at the expense of investment or higher wages. Now, it is true that firms that buy back their stock cannot use the same money to pay higher wages or invest in a new project. However, the decision to buy back stock reflects the firms’ view that alternative uses of this money would not provide a sufficient return on investment — and the money does not simply disappear into thin air, but instead is returned to shareholders, who can decide how to reallocate it. What’s more, the argument that buybacks are driven by short-term thinking is simply wrong. If stock buybacks were driven by short-termism, one would expect that the long-term performance of companies who engaged in stock buybacks would suffer. However, the opposite is true. Firms that engage in stock buybacks tend to outperform the market over the long term.
Finally, one might wonder about the appropriate policy prescription for declining investment. Yet the report does not take a stand. Instead, it argues for “a renewed emphasis on the business firm as the primary and necessary allocator of capital in the American economy” and “an institutional arrangement order to this end.” The reader is left to imagine what any of that means in practice.
If you are looking for an explanation of the changing structure of the U.S. economy or the challenges posed by moving to an economy in which intangible capital plays an increasing role relative to tangible capital, this report will provide no answers.