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The Real Capitalist’s Dilemma

2015 April 19
by Greg Satell

Last spring, the Clayton Christensen, one of the world’s top management thinkers, suggested that, despite being awash in cash, corporations are “failing to invest in innovations that might foster growth.” He considers this trend so insidious and pervasive that he called it the capitalist’s dilemma in Harvard Business Review.

Others have seized on the current boom in stock buybacks as evidence that supports Christensen’s narrative—intense pressure from activist investors is creating an environment in which short-term profits trump long-term prosperity.  If true, it’s a terrible indictment of our economic system.

Yet buybacks do not necessarily indicate a lack of investment (especially when capital is, as Christensen points out, superabundant).  Only a lack of investment indicates a lack of investment.  When I looked into it, I found that the issue does not lie in the private sector, but the public one.  In effect, it’s not corporations that are the real problem, but the rest of us.

The Current State Of Investment

To illustrate the disconnect, the case of Apple is an instructive, if extreme, example.  Last year, the company spent $56 billion on share repurchases.  That exceeds its operating income of $52.5 billion by more than 7%.  Surely, it seems that Apple is rewarding investors at the expense of its future.

But not so fast.  A closer look reveals that Apple has been expanding investment on R&D at a compound rate of 28%, while also increasing its ratio of R&D to sales.  What’s more, the company still holds more than $170 billion in cash that it has very little idea what to do with.

Of course, Apple is an unusual company and not necessarily indicative of larger trends, but in this case, aggregate data looks similar.  Thomson Reuters reports that companies around the world are sitting on $7 trillion in cash.  Further, data from National Science Foundation (NSF) shows an uptick in US business investment in R&D.

NSF Chart

 

As you can see from the chart above, business investment in R&D has not only been outpacing economic growth in recent years (2012 is the most recent year available), but is also outpacing historical trends.  It’s hard to see how any objective reading of the data would indicate a crisis of business investment in innovation.

The Problem of Growth

Christensen and others also point to the weak economic growth in developed countries since the financial crisis as evidence that firms aren’t innovating.  If corporations are engines of growth, so the thinking goes, then they must also be the source of stagnation.

Yet Albert Wegner of Union Square Ventures explains why that’s not necessarily the case. There are many innovations that diminish economic growth.   For example, in Peter Diamandis’s new book, Bold, he estimates that a smartphone today replaces applications that were worth $900,000 when they were first introduced.

Look further and you’ll find similar trends throughout the economy.  The shift from installed applications to cloud-based software is saving corporations billions, while improving performance.  Advancements in solar, wind and shale technology are slashing energy costs. These innovations lower GDP, but make us better off nonetheless.

Short Term Thinking Or Improving Capital Allocation?

We should also question Christensen’s point that investor preference for quick returns limits managers’ ability to invest in the future.  Here again, the evidence belies his point.  In fact, data from the Federal Reserve Bank shows that private capital investment, an even larger ticket item than R&D, has also been increasing and is at historically high levels of GDP.

And it’s not just short-term investors that like buybacks.  Mark Mulholland, whose Matthew 25 Fund holds investments for an average of five years, argues that share buybacks are healthy.  He says, “a company shouldn’t sit on cash, it should put money to work.  If not in its own business then back to its investors so that it can be deployed elsewhere.”

That’s a crucial point.  Money returned to investors, through buybacks or dividends, doesn’t simply disappear, it gets deployed elsewhere.  So where does it go?  Not to personal consumption, which remains sluggish, but to other kinds of investment.  Weak housing data suggests that the money isn’t being frolicked away on McMansions either.

In fact, it appears that a large chunk of the money corporations return to investors through buybacks is actually going to fund innovative new companies.   The venture capital market has reached levels not seen since the dot com era and has produced an unprecedented number of billion dollar startups.

So it appears that the current surge in share buybacks may be less short-term thinking and more an intelligent allocation of resources.  Faced with a superabundance of capital, firms are both increasing investments and returning the excess to shareholders so that it can be invested elsewhere.

The Real Investment Crisis

Christensen is right about one thing.  We do have a crisis, just not the one he thinks we have. The issue, in fact, lies not with corporations, but in the public sector.  Unlike the private sector, public investment in infrastructure and science is massively underfunded.

So the real problem isn’t that corporations are unwilling to think long term, but the rest of us. It’s easy to point our fingers at overpaid executives and greedy investors for short term thinking, but when it comes to our collective future, we are failing to live up to our basic responsibilities.

The American Society of Civil Engineers gives US infrastructure a grade of D+ and we hardly take notice.  A bill for an infrastructure bank, written in 2007, languishes in Congress due to lack of political support.  Senators gain cheap political points by attacking the NSF and we cheer them on.  We make drastic cuts to funding for an Ebola vaccine and then panic when there’s an outbreak. That’s the real capitalist’s dilemma.

It’s much easier to demand lower taxes than to fix our crumbling roads, bridges and airports. It feels good to laugh at egghead scientists and their goofy research, but much harder to understand the significance of their work.  I shudder to think of what political hay today’s leaders would make of Einstein’s notion of the relativity of time and space.

The truth is that we can only win the future if we invest in it.  It is, in fact, America’s postwar commitment to infrastructure and science that we have to thank for our current prosperity. So if we really care about innovation, we not only need to be forward looking in our private decisions, but our public ones as well.

– Greg

16 Responses leave one →
  1. April 19, 2015

    This is fascinating. I can go with everything said. We know the value of the infrastructure from Hoover Dam to the Interstate Hiway system. We know the value of Federally funded research that led to things like GPS, Fracking, Nuclear energy, medical technology, etc., etc., etc. That all costs money though, tax money. Unfortunately tax avoidance (legal and otherwise) has become a primary corporate strategy. Also, it seems to be a common political and philosophical paradigm these days that government is simply evil and that taxes are robbery. The benefits of government investment are huge. There is no power greater than people working together for the common good. Unfortunately we have a lot of people philosophically pushing that the working for one’s own selfish gain is the greatest good. … What are we going to do about that? It ultimately will lead to the destruction of this country if it is not stopped.

    [Reply]

    Greg Reply:

    And this week, Congress voted to repeal the estate tax, which would cost about $270 billion over a decade. For comparison, the annual National Science Foundation budget is about $7 billion and the National Institutes of Health costs about $30 billion per year.

    Meanwhile, the return from just the Human Genome Project alone has been estimated to be about $1 trillion over the last ten years.

    [Reply]

  2. April 19, 2015

    Interesting read.

    You write “that the current surge in share buybacks may be less short-term thinking and more an intelligent allocation of resources.” I would argue – and I think that’s in line with your argument – that our current form or interpretation of capitalism is at the heart of this problem. For years, there has been a shift of resources from the public to the private. Public spaces (e.g., market squares) become privatized and corporatized (e.g., malls); public fundraising (i.e., taxes) is villainized; public services (childcare; infrastructure building; prisons; policing; military; healthcare) are privatized; and so on.

    Hence, this becomes a matter of level of analysis. While corporations may exercise “intelligent allocation of resources”, the overall allocation of resources (public to private) may not be so intelligent.

    [Reply]

    Greg Reply:

    To be honest, I don’t really see it that way. The fundamental issue is one of appropriability (which I’ll explain in more depth in an upcoming post). Whether the investment is public or private, those who invest should have some reasonable expectation that they will benefit.

    So public and private investment play much different roles. Just as we would not expect the government to build factories and private corporations to pay for roads and bridges, we do not expect private corporations to invest in basic research anywhere near the rate as public institutions and we do not expect governments to fund applied research geared toward developing products for the commercial market.

    So I don’t see the issue as one of transfer of capital, but simple dereliction of duty. The private sector, as a whole, is doing it’s part. The politicians aren’t. What’s worse, it is this same dereliction of duty that got them elected in the first place.

    So the real problem is us.

    [Reply]

    Ingo Reply:

    I understand your argument and agree with the first two paragraphs of your response. I didn’t articulate my argument clearly enough and hadn’t meant to suggest that the public and private sectors have the same incentives/responsibilities.

    I wonder, though, why politicians (and voters – us) aren’t doing their part, as you write. Why does it seem impossible to get elected on an “investment in public infrastructure” (aka ‘raising government revenue’) platform? Why are large segments of the population so opposed to public investments in infrastructure and basic science? Is it the politicians who are at fault? Or is there a larger shift at work?

    You wrote: “we do not expect governments to fund applied research geared toward developing products for the commercial market.” In fact, that’s exactly what is happening. Public investments in basic research are insufficient – as you noted in ‘Why Isn’t What’s Good For Microsoft Good For The Country?’. Instead academic scientists are very much forced to justify their research by demonstrating its applicability; otherwise the funding may just be cut off. Universities are also shifting resources to the commercialization of research as a means to narrow the existing funding gaps.

    You seem to suggest (“the real problem is us”) that we – as citizens and voters – have the power to make different choices. I agree. We can make different choices. But I would also argue that there is a larger discourse at work that has shaped how we see the role of public and private sectors over the past 30 years or so. One consequence has been the shift of resources from the public to the private sphere, which is not proving ‘intelligent’, as is evidenced in the massive underfunding of public investment in infrastructure and science.

    I hope you will reach many people with posts such as this and ‘Why Isn’t What’s Good For Microsoft Good For The Country?’ to help reshape our collective understanding of the role of government and public investment. Because for politicians to change their minds and approaches, the right incentives (i.e., votes) need to be in place. An educated and well informed population will (hopefully) make a difference.

    [Reply]

    Greg Reply:

    Ingo,

    I didn’t mean to put words in your mouth. Sorry if it seemed like I was.

    With regards to Microsoft, I don’t think that’s indicative of a trend as Microsoft has been doing basic research for over 20 years and it amounts to only about 5% of the R&D budget, while basic research makes up about 50% of the total federal R&D budget. This is not a bug, but a feature of how things were set up in the late 40’s and early 50’s. It’s been remarkably successful.

    As to why the political winds have shifted, I think it’s just the Reagan revolution, which in itself was a revolt against the Great Society programs that cast government as the answer to practically everything, coming to its logical end point. The pendulum seems to swing and winds shift.

    That doesn’t mean it makes any sense. In particular with respect to the lack infrastructure investment at a time of historically low interest rates. We’re not saving any money—eventually we’ll have to fix roads and bridges—it just defers the costs to the future, when interest rates will most probably be higher. Another good example was the Obamacare rollout. It was a disaster, but then so are most websites run by large bureaucracies. Integrating internal systems with a consumer website is a big challenge. That’s true if it’s public or private (although probably more so, it seems, at my insurance company:-)

    – Greg

    Mike Reply:

    I read this conversation between Ingo and Greg and I’ll offer a couple comments and questions.
    First I will mention that I agree with Greg that Microsoft is a bad example here. They more than most seem fairly responsible to the society… in ways… sort of.
    Bringing up the Obamacare rollout was a bad example too though.
    Lets start with the Reagan Revolution then…, because that is where the tax cuts started and the shift of public financing to private profit. This raises a couple questions. Is this greed or something more? It’s probably both, but what is that something more? I will offer two possibilities for your consideration.
    1. Natural Law
    2. Racism

    Some people will cite Hobbs and company for their interpretation of Natural Law saying that their property is theirs and no one else’s. This is the currently popular Libertarian take. Sometimes this is an excuse for greed, but sometimes I suspect it is about an older part of Natural Law, the idea that a society should be run by kings. Add your religious connotations to taste, but this idea goes back to the roots of Western Philosophy, notably Plato. So… some people want the power of kings for their own lust for power and wealth, but some because they believe it is the proper order of the world. (Also this is why people like Cheney honestly believe that we must “Give War A Chance”. Well, it has traditionally been the way of the world. It did work really good, though in recent history it hasn’t.)

    … Do not underestimate the power of the truths we hold in the deepest parts of our belief systems, such as what has been called Natural Law.

    Now related to the first point, but differently, might be racism. It does seem that a lot of people do react strongly to President Obama and it clearly has a racial tinge to it. Again, in the deepest part of the mind, where basic truths lie, many people do not feel completely comfortable with a black man as “king”. In the broader sense, they see Liberalism as a force making other races equal. Another violation of natural order, whether they feel it philosophically or religiously. They honestly believe this is a “bad” thing. They do not believe racism is immoral, because we have always had racism and there has even been reason for it. If that has changed, they do not know it.

    Really, you cannot make sense of the shortsightedness completely based on greed. It is not immoral, it is a different moral strategy. You can explain the seemingly self destructive strategy of some of the … really, brilliant and moral people that seem bent on destroying the world just based on greed or even psychopathy. They firmly believe they are morally correct. I work on the thread that the world has changed so much that the old strategy that they are using is no longer valid. They just don’t know it. We have seen the failure of “kings” to maintain a society and so created democracy, but some seem to want to have kings and a feudal society, maybe not consciously, but that is how they act. We have seen the failure of war to forward American interests, but clearly some like Mr. Cotton do not see that. We are seeing the failure of an economic system directed by greed, perhaps because of the change from a system driven by scarcity to a market driven system, but clearly some have not seen that and do not see that greed will kill the golden goose that made the wealth in the first place. All these problems will be amplified by increased automation as it pushes the fundamental changes forward.

    Of course just as you should never underestimate the power of human stupidity, I guess you should never underestimate the power of greed.

    Anyway, does any of this make sense to you folks?

    [Reply]

    Greg Reply:

    I think there’s a lot of truth to that Mike. It’s not exclusively greed. Back in the 80’s, when this all started, many of the programs that were cut were truly inefficient and poorly thought through. Infrastructure investments are famously susceptible to corruption, etc.

    It’s interesting that you bring up Hobbes. One of the issues with the idea of the Social Contract is that it’s often hard to get people to agree on what one is or should be.

    – Greg

    Mike Reply:

    Yah, that’s a problem. How to keep institutions efficient and I do believe that corruption will be one of the biggest problems humanity faces for a long time.
    You are right about the social contract, but I think there is a particular reason it is a problem. As far as I can tell, there largely was agreement on it, in the West, for thousands of years. It was the Natural Law that was the ancient wisdom of the philosophers until the time of the Roman, Ciscero. Then the church took over and they tried to make Natural Law into Divine Law … as they saw it. There was a fair degree of agreement at that point. When science came along with new ideas, religion tried to crush it. Instead science crushed religion and with it Natural Law. So according to this point of view, people don’t agree, because there is no widely accepted body of Natural Law. Of course it was easier when the kings benefited from enforcing it. My next project may to rebuild a foundation for Natural Law, using different premises from those that have been discredited by science. One of the chapters of my last book would be part of it. The importance of balance. Another point that I think would be key to Natural Law is that survival is about more than just the individual, it is also about the society. It may seem obvious, but it is under question right now… and explicitly rejected by Libertarians. Really, I haven’t put much time in that project yet… just been noodling on it. … You have to have a hobby.

    [Reply]

  3. Kenny permalink
    April 20, 2015

    Both the article and the comments are an interesting read. I would caution though to make sure that you hold the calculations in perspective. Let’s just say that all in we provide around 50 billion or so to the NSF and all of the brethern agencies that are mentioned here. That is out of a 3.5 TRILLION dollar annual spend by the US government. If we are failing to invest correctly in our future, it’s all a matter of gutless allocation; not the overwhelming need on the part of some for tax cuts. The money taken in should be more than sufficient to cover the investments sought by this article. The real question is “why do we not allocate the funding in the correct ways”.

    [Reply]

    Greg Reply:

    Actually, it’s a bit more than that. The 2015 budget proposal for federal research is about $135 billion, about half of which is for basic research. However, you’re right that increasing out commitment to where it should be (probably an additional 10-20 billion dollars), would have negligible fiscal impact.

    The budget impact of infrastructure spending would be greater, probably more like $100 billion per year. But then again, we’re not actually saving money. We’re going to have to spend it eventually, and probably when interest rates are significantly higher.

    – Greg

    [Reply]

  4. Eli Cummings permalink
    April 24, 2015

    The problem is way more complicated than is being outlined here. A chart and some opinion regarding American public investment do not do it justice.

    Global GDP growth went from 4% in 2006 to -2 % in 2009. It jumped back to 4% by 2010 but has been declining since with the latest figures at 2.2% for 2013.

    This decline is not a function of a lack of investment. Investment is an indicator of expected growth. Idle capital is indicative of a lack of growth.

    Why declining growth ? No one really knows the answer to this question.

    Global idle capital on corporate balance sheets is about 1 1/2 trillion dollars.

    America as of 2012 ranked 10th in R&D as a percentage of GDP although it still spent way more in terms of actual money. The U.S. government has an investment budget for its agencies at around 150 billion (about 65 billion in non-defense).

    All these figures however don’t really help. It’s like taking the temperature of a patient. One may know if it is above or below normal but that doesn’t tell you a cause.

    We like to think we actually know how economies really work but there is plenty of evidence to suggest this is not the case.

    Correlation is not cause and more often than not we are creating a narrative about something that has already happened with little in the way of a narrative that actually predicts the future.

    I have argued before that people who are concerned about the lack of public investment seem to have not realized that the “public” has been discredited. This was the conceptual shift that was the result of the end of the cold war. We seem to forget that the cold war was not about an arms race but about an ideology and the fact is the “government” as solver of problems ideology lost. This notion has taken hold in people’s minds over the past 3 decades by osmosis. It has been accepted as fact and never been challenged.

    The modern paradigm has been and continues to be “privatization”. All media reports of countries in trouble often highlight government involvement in the economy as a cause of a countries failure. One need only look at the situation in Europe with Greece and Spain to see how too much government has been made to be the problem.

    This is the world everybody wanted and it is what we have. The nation state is no longer as powerful an entity as it has been for 150 years. It operates more like a fire department. It’s there only in case of emergencies. When things are normal, it is international global corporations and global capital markets that call the shots.

    R&D is not public policy, it is return oriented investment in a world in which much of the low hanging fruit has been taken. More than 50% of R&D today occurs in the pharmaceutical world. This may be some cause for concern. The new products on the horizon aren’t objects they are living things. The cell has replaced silicon.

    There are a host of variables out there waiting unexpected in the future. They will surely make their appearance and all narratives about what was going to be the case will have to be revised. Let us not forget that no one is piloting this ship that is our planet, not even us.

    Much of what we read and hear has little relationship to what is actually happening. I tend to think of it like the TSA in airports. It makes people feel better but it is hardly a line of real defense.

    [Reply]

  5. Bill Rose permalink
    April 28, 2015

    The ultimate in short term thinking based on a desire to reward “investors” are politicians who can’t think past the next election. Basically they all want to give payouts to their constituents (their investors) and pay for it with money from the other guy’s constituents. The constituents may differ by party or region but the game is the same. And neither want to spend on long term projects like infrastructure and basic science since the payoff is well beyond the next election. The best way to combat this short-term view of investment (investing in votes rather than what is best for the country) is to go back to the founders’ vision which was all laws must be the same for all people. No progressive tax rates. If you want to raise taxes, it must be across the board. No loop holes or carve-outs for one industry or segment or group over another. No special retirement or healthcare plans for Congress and the administration. If you want to raise taxes, everyone feels the pain equally. Sounds terrible on its face but it creates a more equal constituency. You can’t raise or cut taxes for someone else’s constituents without raising or cutting taxes for yours. That’s not to say we should eliminate medicaid, eliminate food stamps, etc. It means that if you earn money, you pay tax period. Instead of a progressive tax, there should be a phase out on government subsidies that leaves incentive to earn money intact. And there can be no automatic increase in the subsidy based on the tax rate, only on inflation to eliminate the politician’s propensity to move back to a progressive tax rate via a back door. With a reasonable flat tax rate the carve out for capital gains and dividends can be eliminated as well – income is income period. Democrats will still fight to give more to lower income people but they will have to raise everyone’s taxes to do so. Republicans may still attempt to cut the tax rate but it would be an across the board cut meaning less to spend on defense. The incentive to eliminate waste will increase because the alternative will hurt your constituencies just as much as it hurts someone else’s.

    [Reply]

    Greg Reply:

    Do you mean the earned income tax credit? It’s been shown to be successful. It’s hard to make the numbers work with an absolutely flat tax though, unless the tax credits amount to the same thing as a progressive tax.

    The truth is that the main driver of the budget these days is healthcare costs. Poverty measures amount to a small portion of the federal budget and they aren’t growing.

    [Reply]

    Bill Reply:

    Whether its the earned income credit or something similar, the first thing that needs to be done is that for those whose income is inadequate to make ends meet there is help but that help leaves incentive to earn money. It should never be that not working is more profitable than working. There needs to be a sliding scale that always leaves you with more for working than for not working. That is not the case today.

    Also, government programs should be means tested. I have a friend that lives in a $1M dollar home, has 4 cars with only 3 in the family, full cable channel lineup, cell phones for all, a kid going to a private college, and his family’s healthcare is subsidized due to low income. That’s just wrong.

    Flat tax #s don’t add up when over 40% don’t pay a cent but do collect. Welfare must be tied to work. We do owe it to children to make certain they have a roof over their heads, don’t go hungry, and have adequate healthcare, even if their parents are incapable of doing so. But we do not owe anything to able bodied adults who could work but don’t. Yes menial labor sucks, but the best job training program is working at a job. If you can work, you should work, even if its sweeping the streets in your neighborhood. Unemployed? OK. But if within a reasonable amount of time you can’t find a job, you will be assigned one. And if you don’t do it, you will not own a cell phone, have cable TV, etc. Your food stamps will only be allowed to be used to buy food. Your rent will be paid directly to your landlord, not to you so you can’t spend it and then use free legal aid to keep from being evicted for 6 months or more and then move on and do it again.

    If you claim you are disabled, prove it. And then prove it again next year and the year after. I know several people, well educated and healthy people, who got on disability for one reason or another but no longer have anything that would keep them from working. But once on disability there is no incentive to get off of it. Prosecute them if you find they are lying. If you can work, you must work – period. If you can play golf, basketball, tennis, work in your garden, mow your lawn, go grocery shopping, wash your car, etc., you can work. If you can’t then we should help support you.

    If we did the common sense things, attack the waste and fraud, and get able bodied people working, the numbers would support a flat tax. The problem is there is no incentive for government to do common sense things because they can always gain the support of their constituents as long as the tax they raise is paid for by someone else or they can hide it in the form of sales and other non-income taxes. As long as their budgets and raises are predicated on how much they can give out, they have no incentive to eliminate waste and fraud. As long as we condone and even reward bad behavior it will continue.

    When is the last time you heard a proponent of the various entitlement programs say “lets go after the people who are stealing money from those who really need it.” Its always “we need more because there is not enough to for those who need it.” More money breeds more waste and fraud until and unless you make it clear you won’t accept it and go after those who perpetrate or perpetuate it.

    [Reply]

    Greg Reply:

    I’m sorry, but what does any of this have to do with the article? Is it that you think that if your neighbor didn’t watch Game of Thrones, we would invest more on infrastructure and scientific investments?

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