Impatience Kills Capitalism

During the financial crisis, as the U.S. considered nationalizing the banks a socialist friend of mine confidently gloated to all who would listen that capitalism was dead. Greedy corporate swine had gotten their just desserts, and an era of central planning was imminent, he said. Of course, that was before the populist backlash hit, when most Americans expressed their displeasure with the government's overt involvement in the private sector. But it did seem that somehow, capitalism had broken down.

An op-ed in the New York Times today speaks on an aspect of this problem, though not directly related to the financial crisis. Yves Smith and Rob Parenteau write about how corporations' obsession with quarterly earnings to reward shareholders has led capitalism astray. Firms are increasingly neglecting investing for growth as a result. Smith and Parenteau write:

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.

And here's the solution they propose:

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.

This might be a little extreme. The idea of penalizing corporations for taking the conservative route seems kind of crazy. After all, how many more firms would have gone bankrupt during the crisis without a cash cushion on hand during the credit crunch? That rainy day money came in handy when the storm hit.

But the authors are right that corporations generally should be investing more money in research and development instead of rewarding shareholders and executives. Without such investment, the U.S. would be on a stagnant path of low growth. What's causing them to embrace this lame strategy, rather than trying to expand?

One reason might be a lack of consumer demand. Certainly, weak economic prospects might be driving their behavior these days, but that wasn't a valid excuse between 2002 and 2007, a time period that the statistics above include. Instead, the investor culture of impatience is more to blame.

As Smith and Parenteau allude to, these days so much of investing is focused on quarterly earnings and share price that corporations are almost obsessed with such targets. But that has little to do with a fear of risk; it's more because shareholders demand it. Investors care less about the distant future than they do about near future.

This attitude championing instant gratification is at the heart of Americans' desire to get rich quick. Most people would prefer a fast buck than a bigger reward over a longer period of time. Indeed, that's part of what drove the housing bubble. Americans fell in love of the idea of nearly instant cash by flipping a house or refinancing within several months, instead of waiting for the value of their homes to slowly rise over years. Mortgage brokers and banks got their fees upfront and sold off the risk to willing investors who thought the yield on an ultra-safe real estate asset looked great. Of course, the same sentiment can be traced back to the Internet bubble as well.

But capitalism isn't fast. While a few innovative businesses do manage to make a lot of money legitimately very quickly, most don't. For an investment to pan out often takes a lot of work and a long time. That reality doesn't please an investor with the attention span of a gnat. Yet without patience, a capitalist economy will suffer the fate of weak growth and great bubble-driven volatility. Unfortunately, you can't make impatience illegal. Americans need to make a conscious choice to relax, and give investments time to succeed and flourish over a longer time horizon.