One of the key macro frustrations is that US corporate profits as a percentage of GDP is at historical highs, while employment remains stubbornly high.
Instead of burning a hole through corporate pockets, leading to a wave of investment, corporations are hoarding the cash. So, companies are sitting back instead of building and innovating, leading to employment. As they do so, aggregate demand remains depressed, prolonging the weakness of the economy.
The common reasons for the lack of investment we hear include regulatory uncertainty and the lack of demand. Both explanations have something to them. In terms of regulatory uncertainty, there is the Presidential Election coming up along with the current Euro crisis. And existing debt overhang, along with the employment situation, means that consumers have not been spending.
But there is a third reason, as suggested by the Economist, and it boils down to management incentives:
The third explanation for cash hoarding is the most intriguing. Andrew Smithers of Smithers & Co, a consultancy, suggests incentives may be to blame. Managers are motivated by share options and share prices are driven by changes in earnings per share. Spending cash on share buy-backs boosts earnings per share immediately, whereas a capital-investment program may actually reduce earnings in the short term.
Capital expenditure may have a pay-off in the long run but, given the ever-shortening career span of the average chief executive, few may be willing to take a chance that they will be around for the long term. A recent paper from the Federal Reserve Bank of New York suggests that executive incentives may even be driving the business cycle by their effects on investment.
So, it’s perverse that management incentives may be another reason for the current situation, with management incented to play financial games rather than innovate for success. This failure of governance is another reason why so much innovation comes from startups.