Financialization and its impact on investment Hiep Tran Prof. Thomas Michl Prof. Dean Scrimgeour Econ 490: Honors Seminar Colgate University From the late 1970’s and early 1980’s until the financial crisis of 2007, the U.S. economy witnessed a period of exceptional growth of the financial sector. Financialization, the economic term referring to this phenomenon, has attracted a line of economic research that investigates its impact on economic growth. The first part of this study reviews the literature on the origin and economic impact of financialization. The second part, upon reviewing the literature on investment, attempts to create an econometric model to simulate the effects of financialization on domestic investment in the U.S.A. This model provides evidence that financialization has a negative impact on domestic investment. JEL classifications: E02, E22, G28, D21, G34 1 1. Introduction The development of the global economy in general and of the U.S. in particular in the last few decades has been characterized by the growth in both size and importance of financial transactions. Financial institutions have become more involved in the decision making of firms while non-­‐financial corporations are deriving more of their profits from financial markets through their investment in financial assets and financial subsidiaries. The period starting about 1980 leading to the financial crisis is marked with unprecedented dynamism of financial activities, witnessing the skyrocketing of financial profits. Because of its prominence, many economists refer to this period of financial growth ‘financialization.’ As noted by Stockhammer (2004), there is no formal definition of financialization, since financialization comprises many activities in and of financial markets. The literature up to date has investigated different aspects of the growth of financial activities but none has attempted to give a broad definition. Stockhammer refers to rentiers’ share of non-­‐financial corporate income, defined as interest and dividend come, as a symptom of financialization in his firm analysis. On the other hand, Van Treek (2009) recognizes that increased shareholder value is an important constituent of financialization. Liang(2010) defines global financialization as the increasing power and influences of financial interests and institutions around the world. Krippner(2005) defines financialization as ‘a pattern of accumulation’ in which profits are realized mostly through financial channels rather than through trade and commodity production. Finally, Epstein (2005) puts forth a broad characterization: “financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies.” Applying this characterization to the US economy, I will investigate the implications of financialization since the late 1970’s and early 1980’s until the current period. The starting point of financialization – around 1980, was not spontaneous but was a result of a series of major changes in the financial structure of the US economy. In a comprehensive study of financialization, Orhangazi (2006) suggests that financialization had the root in the financial liberalization and deregulation movement in the two decades preceding 1980. Orhangazi identifies a series of events in the 1960’s and 1970’s that paved the way for financial liberalization and deregulation such as accelerating inflation, the domestic financial problems of the 1960’s and a series of financial innovations. The abnormally high inflation rate in the late 1960’s and the 1970’s damaged the profitability of the financial sector, creating the incentive for the sector to pursue financial innovation and to induce deregulation. On the other hand, The Federal Reserve’s attempt to fight back inflation by tightening monetary policy led to a credit crunch. The monetary policy combined with the fiscal effects of the Vietnam War inflated the nominal interest rates, gearing 2 non-­‐financial corporations toward the short-­‐term money market securities for borrowing, further exacerbating the commercial banks’ problems and at the same time expanding the commercial paper market. Responding to the new challenges, banks devised a series of financial innovations to work around regulations, such as negotiable certificates of deposit (Coleman 1996: 151) as a way to retain market share for commercial banks while working around regulations. Financial innovations were also created on the NFC’s side. Orhangazi describes the entry of non-­‐bank institutions into banking operations, such as financial subsidiaries of Ford Motor Company, as part of the process of increased involvement of NFC’s in financial businesses. Some companies ‘succeeded in breaching not only the wall between commercial banking and investment banking, but the more fundamental wall between finance and commerce, by having affiliated banks, stock brokerages, insurance companies, and real-­‐estate subsidiaries, as well as department stores’. (Kuttner, 171.) A series of financial deregulation and liberalization followed these phenomena. In October 1979, The Federal Reserve announced a change in monetary policy placing more weight on price stability than on output. The Depository Institution Deregulation and Monetary Control Act passed in 1980 allowed banks to merge and allowed credit unions to provide checking accounts. The Act also ordered the phase-­‐out and ultimate elimination of interest rate ceilings. These legal movements favored the rise of finance, ending the long period of financial regulation since the Glass-­‐Steagall Act of 1932. The series of changes in the financial structure of the US economy was almost simultaneous with an essential change in the corporate governance ideology: the shareholder value movement. Lazonick and O’Sullivan explained the history of the shareholder value movement in their paper “Maximizing shareholder value: a new ideology for corporate governance” published in 2000. According to the two authors, in the late 1970’s, major manufacturing firms became harder to manage and generate profit due to excessive expansion and international competition. D’Arista (1994: 94) also realizes that rising energy prices led to a decline in productivity. She notes that corporations were unable to Consequently, there was a need for shareholders to step in and take control of the firms and discipline poorly performing managers. The shareholder value movement, which re-­‐oriented firms’ objectives from the stakeholders to the shareholders, then arose. It is necessary to investigate further this corporate governance issue because of its important implications. The economists in the 1970’s theorized the conflict of interests between shareholders and managers where managers would pursue their own interests at the 3 expense of shareholders’ profits. The misalignment of interests is called the principal-­‐agent problem. The shareholder value movement was supposed to solve this problem. Contemporaneous with the needs to augment shareholders’ roles, the rise of institutional investors such as mutual funds, pension funds and insurance companies – very powerful shareholders -­‐ contributed to the increasing power of the shareholders for controlling firms. A series of deregulation in the late 1970’s and early 1980’s in the financial markets provided more freedom to institutional investors and banks to carry out riskier investments and allowed those institutions to be more active in the financial markets and hence more influential on firms’ strategies. Lazonick and O’Sullivan also pay special attention to the hostile takeover movement in the early 1980’s, in which firms had to save themselves from being taken over by raising their stock prices. It has been argued that the hostile takeover movement was beneficial to the firms and to the economy as a whole since forced managers to push up the firm’s market capitalization and disgorged free cash flow. Lazonick and O’Sullivan argue, however, that the shareholder value movement did not only serve as a strategy for survival in the hostile takeover mania, by pointing out that the stock market crash in 1987 did not disrupt the movement. It is evident then, that shareholder value had become a new, widespread philosophy for corporate governance in US firms. The new corporate governance regime was also supported by firms’ new business strategy, from ‘retain and reinvest’ to ‘downsize and distribute.’ Downsizing refers to the shrinking of firms’ business activities through the means of staff cuts and plant closures. By lowering the level of employment, firms increased the marginal productivity of labor and thereby increased their return to equity. Lazonick and O’Sullivan give much statistical evidence to prove the declined tenure and reduced positions for well-­‐paid, stable blue-­‐collar workers in the 1980’s and early 1990’s. Distribution means distributing revenues in ways that improve the companies’ stock price, particularly through dividend payments, interest payments and stock repurchases. Stock buyback reduces the number of shares owned by the public and hence increases the earnings per share and stock market price, thereby benefiting shareholders. Equity issuance is generally regarded as means to acquire investment funding or to pay off debt, especially when stock prices are inflated. However, as Lazonick and O’ Sullivan recorded, during the 1980’s, net equity issues for US corporations became negative in many years. Interest payments, on the other hand, remove debts from the balance sheets. Finally, dividend payments satisfy shareholders’ demand for returns on equity and keep the stock price high. 4 In explaining the strategic shift in firms’ business, Lazonick and O’ Sullivan refers to the changes in the relationships between top managers and corporate enterprises. Traditionally, until the 1970’s, managers were often attached to the organization, spending a vast amount of time on and dedicated to the development of the firm. This integration was due to the separation between share ownership and managerial control and the salaried compensation of top managers. On the other hand, starting in the 1950’s, stock options became an alternative form of payment for top managers in many US corporations. As the stock market developed, stock options became increasingly important as a component of managers’ compensation. As a result, those managers became more similar to shareholders in terms of expected benefits from the firm; their interests were aligned. As managers became more interested in the stock market value, they started to act more in shareholders’ favor, focusing on boosting share price rather than expanding production. Financial economists in the 1980’s were advocates of the shareholder value movement, arguing that creating shareholder value allows shareholders to freely allocate their financial resources to the most efficient uses. Trained in the classical economic tradition which advocates the efficiency of the market, these economists believed that solving the principal-­‐
agent problem would be beneficial to the firm as well as to the economy as a whole. Lazonick and O’Sullivan offer an alternative view of the principal – agent theory. They argue that the shift from ‘retain and reinvest’ to ‘downsize and distribute’ damaged the incentive to invest in education and skills for US laborers, resulting in US employers falling behind their international competitors on their own playground. Jurgen et al. (2002) also observe the threat of undermining the innovation potential and human resource base of the companies that shift toward a finance orientation and shareholder value. Lazonick and O’Sullivan further argue that the new corporate governance ideology made possible the stock market boom in the 1990’s, but the inflow of cash into the stock market came from individual savings which had been accumulated over the period of ‘retain and reinvest.’ Based on this observation, they raised an important question: what would happen if the stock market turned down, and the US future generation did not have the real savings to back up their financial resources? Their fear became reality with the stock market crash in 2000 and the current financial crisis. An analysis of the European auto industry by Jurgen et al. (2002) reinforces the theory of negative impacts of the shareholder value movement: the case study concludes that companies that rely more heavily on financial indicators and adopt shareholder value policies at a higher degree have the worst performance in terms of labor and capital indicators. Whereas most of the literature on financialization has focused on the structural changes in non-­‐financial corporations, a recent paper by Lapavitsas (2009) analyzes financialization by 5 looking at financial institutions. Firstly, large industrial and commercial firms have become increasingly reliant on open financial markets instead of banks for finance. Secondly, as a result of that, financial institutions have found other ways of generating profits for the last three decades. Specifically, they have turned to individual income as a source of profit by lending to individuals for mortgages and consumption, and adopted investment banking methods, generating income through fees, commissions, and trading on own account. The former phenomenon is called by Lapavitsas as financial expropriation. 2. Effects of financialization on economic development It is clear that shareholders benefit from financialization as a consequence of the shareholder value movement. However, the effect on the economy as a whole is a subject for debate. A line of economic argument contends that financialization is beneficial to an economy. According to Lazonick and O’Sullivan, financial economists believe in favorable effects of financialization. They argue that since managers tend to run firms to their self-­‐interests, the traditional type of corporate control is not efficient. Maximizing shareholder value, on the other hand, those economists argue, will align firms’ economic performance to shareholders’ benefits. The assumption to be made in this argument is that the sort of economic performance that shareholders wish to see in the firm is one that would benefit the firm itself. On the other hand, Crotty (1990) argues that at least some semi-­‐autonomy for both the owner and the manager is necessary to efficiently run the firm. Crotty stresses two facts: that most stocks are now held by institutions, not individuals and that institutions are more often short-­‐term stockholders than not. Under these conditions, the manager has much more complete information on the expected profitability of an investment and hence can make investment decisions that benefit the firm more. Another reason for the owner to make ‘poor’ decisions is that they consider investment in capital risky due to its irreversible nature. To simplify the discrepancy between the owner and the manager of a firm, Stockhammer argues that there is a trade-­‐off between growth and profit: firms can choose to expand market share and growth at the expense of profit and vice versa. Like Stockhammer, Orhangazi investigates the effect of financialization on capital accumulation, taking note of a controversy about the effects of financial payouts. Since the rate of capital accumulation closely matches the rate of retained profits (Dumenil and Levy 2004), and since increased financial payouts in the form of interest and dividend payments drain out retained profits, the rate of capital accumulation should suffer. This hypothesis is also known as the financial constraints hypothesis (Orhangazi, 2008.) On the other hand, if the buybacks are financed by borrowing, corporations may also become more heavily indebted and more reliant on banks. A counterargument is that firms might be able to raise funds from the financial markets to fund investments, which would induce capital accumulation. Orhangazi refutes this 6 counterargument by pointing out that firms transfer part of their earnings to the financial markets before competing with other borrowers to re-­‐acquire these earnings; financial payments come before re-­‐investment and therefore do not enhance future investment. Shorterm-­‐ism is another potential source for harmful effects on economic development. In financial markets, sequential trading is allowed and prices are volatile, making profits or losses very quick. Since short-­‐term financial market value is favored over long-­‐term potential gain, firms that are involved in such markets are induced to shorten their planning horizons, trying to quickly raise their financial market value, abandoning plans that might benefit them in the long run but do not generate immediate profits. Jurgen et al. (2002) quote two reasons behind the criticism for short-­‐termism. Greater stress on financial indicators could lead to changes in investment levels since reduced investment can help the company meet financial targets in the short run. Similarly, downsizing and outsourcing could also be applied since they tend to improve the balance sheet in the short run. Crotty (2005) notes that the tie of firms’ performance to short-­‐term stock price movements induce managers to adopt investment strategies that ‘worsened the overall economic performance of the U.S. economy’. (3) On the same line of literature, Parenteau (2005) notes that ‘As competitive pressures built in the very profitable investment management business, this quickly evolved into a quarterly performance derby’ and that ‘since investment prospect sometimes take a long time to pay off, the incentives for investment managers to ignore or abandon fundamental analysis in favor of more short-­‐term technical analysis-­‐based tools became quite high.’ 3. A brief investigation of investment theories. Investment represents a very significant component of GDP and of economic development as a whole. It has been observed that investment closely follows the patterns of the business cycle, falling in recessions and rising in booms Even though investment makes up only about one-­‐sixth of GDP, in the typical recession half or more of the total decline in spending is reduced investment spending. (Abel et al.) On the other hand, investment determines the long-­‐run productive capacity of the economy, since it creates capital goods, which, alongside with labor, determines production output. Now that the channels through which financialization affects investment decisions have been made clear, it is necessary that we investigate other factors that bear an impact on investment before constructing a model to incorporate the effects from financialization. One of the most prominent theories of investment is the desired capital stock, which hypothesizes that firms attempt to achieve the amount of capital that earn them the largest expected profit. The desired capital stock is where the marginal cost of adding one unit of capital equals the marginal product of capital, MPK. For a firm’s investment decision, the user 7 cost of the additional unit of capital equals the expected marginal product of capital: uc= MPFf. The user cost of capital is calculated as uc=(r+d)pK where r, d and pK are the expected real interest rate, the depreciation rate and the real price of capital goods, respectively. For the short run, the user cost of capital is constant; therefore the graph of user cost of capital is a horizontal line. On the other hand, if we assume the diminishing returns to capital, the MPFf curve shifts downward. Figure 1. Desired capital stock model. We now investigate the factors affecting the uc – MPK f equilibrium of the desired capital stock model. As can be seen on the graph, as the productivity of capital rises, the MPKf curve shifts upward and the equilibrium level of capital stock increases. Effective tax rate is the difference between taxes on capital and investment tax credit. As effective tax rate increases, the user cost of capital increases, the uc cost shifts upward and the desired capital stock is reduced; hence investment decreases. As long-­‐run interest rate increases, user cost of capital is also augmented and user cost of capital increases, leading to a lower level of investment. Since we are interested in the effects of the financial markets on investment decision, the q theory of investment is of special interest. James Tobin (Tobin 1969) argues that the rate of capital investment is related to the ratio of the capital’s market value to its replacement cost. When this ratio, called Tobin’s q, is greater than 1, it is profitable to purchase the capital because its value is less than the cost of acquiring it. When the ratio falls below 1, additional investment in capital becomes unprofitable. In predicting firms’ behaviors, Toblin’s q is defined !
as q = !!! where V is the firm’s stock market value and pKK is the firm’s book value. Other 8 factors being held constant, a rise in stock value of the firm will increase its investment spending. Referring back to the desired capital stock model of investment, as MPKf increases, expected earnings also increase, raising the stock market value of the firm and hence inducing investment. A higher effective tax rate will reduce expected earnings and hence stock market value and investment suffer. A higher long-­‐run interest rate will induce financial investors to replace stocks by bonds in their portfolios and therefore will lower stock market value and investment. Recently, the effect of outward FDI on domestic investment has also been analyzed in a somewhat limited literature. The results are not quite significant. Wolde-­‐Rufael (2008) concludes that outward FDI neither crowds in nor crowds out domestic investment in Korea and Taiwan. Kim (2008) finds that FDI in “FDI in developed countries has no significant relationship with domestic investment”. 4. Theoretical model I build a model to test the effect of financialization on non-­‐farm, non-­‐financial corporations’ investment decision using aggregate data. Based on the discussion of the effects of financialization on investment and investment theories, I propose a model that includes the following variables: investment ratio, financial profit, financial payout ratio, long-­‐run interest rate, effective tax rate and the rate of profit. The investment function is specified as: I/Y = f(Pf, r, T, π/K) Where I is net investment, Y is GDP, Pf is financial payout ratio, r is long-­‐run interest rate, T is tax rate and π/K is the rate of profit. Since firms’ investment decision is based upon the available resources, we take into account GDP growth as the natural motivation for investment. Hence we choose the variable of investment ratio rather than investment by itself; this will also eliminate the possible trending in I and GDP. We can also test the ratio of investment to capital stock for the same purpose. The rate of profit is the ratio of profit to investment, i.e. the returns on investment. It can therefore be the proxy for the marginal product of capital. As discussed above, marginal product of capital should have a positive effect on investment. Blecker (2007) documents a prominent line of literature on investment that focuses on the rate of profit as the main drive for investment. Marglin, S. and Bhaduri, A. (1988) have a framework for investment model in 9 Keynesian theory, regarding profits as a source of saving for the accumulation of capital, and “the lure which attracts investors.” The financial payout ratio is a parameter for the shareholder value movement. Since financial payout reduces firms’ internal funds and is a symptom of the strategic shift from ‘retain and reinvest’ to ‘downsize and distribute’, it should bear a negative impact on investment. No investment models that account for financial payout is found. However, Stockhammer uses in his investment model the interest and dividend income of NFC’s. I will replace this variable by the payout, adding interest payment. This is the variable of interest. In addition, I will also run regressions with financial payout broken up into dividends, interest payment and stock buybacks to analyze the impact of each on investment. Real, long-­‐run interest rate represents the opportunity cost of investment; it should be negatively correlated with investment. Furthermore, Madsen (2003) notes that a high nominal interest rate lowers firms’ accounting profits, thereby damaging the firms’ ability to borrow money to undertake an investment project. Madsen also records a line of literature that argues that stock market investors suffer from the illusion of a high interest rate which is nominal, using it as the discount rate and therefore induce firms to undervalue their projects, leading to a reduction in investment. Stephani Seguino (1999) includes the interest rate in her investment model to test the effect of profit rate. Effective tax rate represents the cost of investment and should be negatively correlated with investment as well. Djankov et al. (2010) find cross-­‐country evidence that ‘effective corporate tax rate haves a large and significant adverse effect on corporate investment.’ Moreover, Vergara(2010) found that corporate tax rate has a negative, statistically significant impact on private investment as a percentage of GDP, using evidence from Chile. 5. Econometric model The equation estimated takes the tentative following form: (I/Y)t=ß0 + ß1 (Pf)t-­‐1 + ß2rt-­‐1 + ß3 Tt-­‐1 + ß4 (π/K)t-­‐1 + u With the following expected signs: ß1 ><= 0, ß2<0, ß3< 0, ß4> 0 When financial payout is broken apart into 3 components, the equation is: (I/Y)t=ß0 + ß1 (div)t-­‐1 + ß2 (intpay)t-­‐1 + ß3 (stockrep)t-­‐1 + ß4rt-­‐1 + ß5 Tt-­‐1 + ß6 (π/K)t-­‐1 + u With the following expected signs: 10 ß1 ><= 0, ß2 ><= 0, ß3 ><= 0, ß4<0, ß5< 0, ß6>0 Stockhammer uses a distributed lag model. I am going to continue building on that framework. He points out that it is important to use lagged values of explanatory variables in the investment equation because of the time lag between the investment decision and capital expenditures and their role in expectation formation. In addition, lagged explanatory variables help avoid problems of simultaneity and reverse causation. Intuitively, the investment decision for the current year has to be made based on the conditions from the previous year, which serve as the proxy for the expectations of the conditions for the current year. I am going to use the 1-­‐year lag for all the variables on the right hand side. On the other hand, several investment models including Djankov et al and Vergara do not lag the tax variable. I will also be investigating this model without lag. Stockhammer includes lagged values of the dependent variable on the right hand side to account for trending. As diagnostic tests in his paper show the possibility of second-­‐order autocorrelation, he includes 2 lags of the dependent variable in the final model. I will be using Newey-­‐West standard errors to correct for serial correlation instead. Orhangazi uses logarithmic forms to account for potential non-­‐linearities in the relationships between the explanatory variables and the rate of investment. Seguino also uses the log forms for all variables, except for interest rate, which might take a negative value. On the other hand, Stockhammer uses level form even in his final model. The choice of whether to express a variable in the level form or logarithm form seems arbitrary in the literature to date. I will use the level form. To detect non-­‐stationarity, I will conduct unit root tests, using the methods of Dickey-­‐
Fuller and Phillips-­‐Peron and include appropriate difference operators. I will also perform a Chow test for structural break in 1980, following Seguino’s framework. 6. Data description: The data for the paper come from 3 main sources. The US National Income and Product Accounts (NIPA) are a set of economic accounts that provide the framework for representing detailed measures of U.S. output and income (NIPA handbook). These data are prepared by the Bureau of Economic Analysis and are one of the three major elements of the U.S. national economic accounts. The NIPAs display the value and composition of national output and the distribution of income generated in its production. 11 The flow of funds accounts, prepared by the Federal Reserve, record the acquisition of nonfinancial and financial assets throughout the US economy, the sources of the funds used to acquire those assets and the values of assets held and of liabilities owed. The Integrated Macroeconomic Accounts for the United States present a sequence of accounts that relate production, income and spending, capital formation, financial transactions, and asset revaluations to changes in net worth between balance sheets for the major sectors of the U.S. economy. They are part of an interagency effort to further harmonize the BEA National Income and Product Accounts (NIPAs) and the Federal Reserve Board Flow of Funds Accounts (FFAs). They are prepared by the BEA. Since The Integrated Macroeconomic Accounts only provides annual data from 1960 to 2009, and since the financial crisis of 2007 created a substantial economic disturbance, I will use annual data from 1960 to 2007 for the analysis. Investment is net private domestic investment, extracted from NIPA Table 5.2.5. GDP is in current dollar and is taken from BEA. Interest rates are effective Federal Funds rates, estimated as weighted average of rates on brokered trades and annualized by the Federal Reserve. 0.12 0.1 0.08 0.06 0.04 0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 0.02 Figure 2. Net investment as a component of GDP The net investment ratio was lower at the end of the period than at the beginning, but the overall trend is not very clear. Tax rates are tax rates on corporate income. In this paper we use two proxies for effective tax rate: the top bracket corporate income tax rate (Ttop) and the bottom bracket corporate income 12 tax rate (Tbot). Both are extracted from the website of the Internal Revenue Service, a bureau of the Department of Treasury responsible for collecting taxes. The rate of profit is calculated as follows: Rate of profit = Net operating surplus /Net reproducible capital Where: Net reproducible capital = net stock of private fixed assets + inventories +currency and deposits. 0.14 0.12 0.1 0.08 0.06 0.04 0.02 0 Figure 3. The rate of profit We can see that the rate of the profit was on a mostly rising trend from 1980 to 2007. Despite the recovery of profitability, investment was not increasing as significantly. The financial payout ratio is calculated as: (Net dividend payment + Net interest payment – Net corporate equities incurred)/ (Net operating surplus + consumption of fixed capital). 13 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 0.1 Figure 4. Financial payout ratio Financial payout was clearly on a rising trend, a clear indicator of financialization and of the ‘downsize and distribute’ strategy documented by Lazonick and O’Sullivan. The three components of financial payout are likewise scaled by (Net operating surplus + consumption of fixed capital). All the data come The Integrated Macroeconomic Accounts, table S. 5. 7. Econometric results Using Phillips-­‐Perron test for unit root, I found that the net investment ratio variable is stationary while net investment is not. Corporate tax rate is trend stationary while other variables are not. The first difference of Pf and its components appears to be stationary. Therefore I first difference the dependent variables as well as the independent variables. In reality, this model makes sense. Firms base their investment decision on the current level of investment and the changing economic environment. The first difference in the amount of investment and other economic factors is logical. Therefore I investigate the lagged first differenced form of the variables. I will try 2 different lag models: simple lag, with all explanatory variables lagged by one year; and finite distributed lag, with Pf lagged by 1, 2 and 3 years. Below is the summary of the regressions: 14 Table1. Regression of investment on financial payout and control variables using simple lags. Constant Pf(t-­‐1) r(t-­‐1) T(t-­‐1) π/K(t-­‐1) Chow Test -­‐1980 Obs Simple lag, Ttop .00027 (.00131) -­‐.04417 (.02718) -­‐.00321 *** (.00059) .00038 (.00065) .65682*** (.22580) p-­‐value=0.0071 47 Simple lag, Tbot -­‐.000034 (.00145) -­‐.04276 (.02667) -­‐.00319*** (.00056) -­‐.00062 (.00069) .64738*** (.21111) 47 Table 2. Regression of investment on financial payout and control variables using finite distributed lag model. Finite Distributed Lag, Ttop Constant .00067 (.0014383) Pf(t-­‐1) -­‐.04083 * (.02384) Pf(t-­‐2) -­‐.03522** (.01735) Pf(t-­‐3) -­‐.02574 (.01902) r(t-­‐1) -­‐.00331*** (.00062) T(t-­‐1) .00036 (.00065) π/K(t-­‐1) .59003 ** (.25604) Obs 45 Finite Distributed Lag, Tbot .00026 (.00153) -­‐.03907 * (.02314) -­‐.03597** (.01689) -­‐.02933 (.01862) -­‐.00329*** (.00058) -­‐.00083 (.00068) .57466** (.23847) 45 15 Table 3. Regression of investment on dividend, interest payment, stock buyback and control variables using simple lags. Constant Div(t-­‐1) Intpay(t-­‐1) Stockrep(t-­‐1) r(t-­‐1) T(t-­‐1) π/K(t-­‐1) Chow Test-­‐1980 Obs Simple lag, Ttop .00034 .00137 -­‐.04107* .02298 -­‐.02795 .07369 -­‐.04640 .03876 -­‐.00323*** .00066 .00041 .00063 .6826*** .21154 P=0.0000 47 16 Simple lag, Tbot -­‐.000032 .00151 -­‐.03879 .02366 -­‐.05321 .07550 -­‐.04367 .03836 -­‐.00315*** .00066 -­‐.00064 .00073 .63640*** .19793 47 Table 4. Regression of investment on dividend, interest payment, stock buyback and control variables using finite distributed lag model. Constant Div(t-­‐1) Div(t-­‐2) Div(t-­‐3) Intpay(t-­‐1) Intpay(t-­‐2) Intpay(t-­‐3) Stockrep(t-­‐1) Stockrep(t-­‐2) Stockrep(t-­‐3) r(t-­‐1) T(t-­‐1) π/K(t-­‐1) Chow Test-­‐1980, div Obs Finite Distributed Lag, Ttop .00228 .00153 -­‐.12960** .05204 -­‐.22258** .10794 -­‐.28074** .15046 .22735** .10443 -­‐.33556*** .09826 -­‐.18468** .08862 -­‐.10473** .04641 -­‐.08110* .04668 .00275 .02642 -­‐.00492*** .00089 .00074 .00058 .82761*** .24394 p-­‐value= 0.0144 45 Finite Distributed Lag, Tbot .00177 .00176 -­‐.12177** .05228 -­‐.21163* .10730 -­‐.26391* .15108 .18175* .10263 -­‐.32874*** .09965 -­‐.17615** .08506 -­‐.10027** .04752 -­‐.07366 .04494 .00064 .02489 -­‐.00476*** .00081 -­‐.00034 .00069 .75391*** .23943 45 *, **, ***: significant at 10%, 5%, 1% significance level, respectively All independent variables have the expected signs in all models, with the exception of tax rate, whose sign depends on which tax bracket we choose to investigate. The fact that this variable appears statistically insignificant in all models shows that tax rate does not have a significant impact on investment decisions. The relatively infrequent variation in tax rate makes it a weak predictor for investment. 17 Even though the one-­‐year lagged financial payout ratio by itself does not have a statistically significant impact in the net investment ratio, including 3 lags reveals that the second lag has a statistically significant effect. The latter result is consistent with Stockhammer (2004), which finds that the ‘rentiers’ share of non-­‐financial businesses’ has a negative impact on investment in the U.S. This confirms the negative impact of the shareholder value movement on the size of domestic businesses, as hypothesized by Lazonick and O’Sullivan. When broken up, financial payout has a more statistical significant impact, especially in the finite distributed lag model. The extra significant is explained by the fact that the 3 components have different degrees of lag for the impact on investment. Dividend and interest payment are most significant in the 2-­‐year lag while stock repurchase has the strongest 1st-­‐lag impact. It is interesting that interest payment has a positive impact in the one-­‐year lag, which perhaps results from firms being more financially credible after paying interests. A lincom test of the three variables shows that the combined effect is statistically significantly negative; therefore the overall impact of the variable is negative. It is also important to note that the coefficients on these variables are much larger than that on interest. The rate of profit is positive and statistically significant in all cases, which confirm the literature by Orhangazi, Stockhammer, Marglin et al. (1988), Blecker (2007) and many others. The coefficient on this variable is extraordinarily large, which further reinforces the power of profit in determining investment. The long-­‐term interest rate has a negative and statistically significant effect on investment, which is consistent with the notion that interest is an opportunity cost for investment, formalized in the theory of the user cost of capital. The Chow Test detected a structural break in 1980, which reinforces the literature on financialization as a phenomenon arising in the late 1970’s and early 1980’s. In addition, the Chow Test also detected a structural change in the coefficients of div, the variable directly representing the impact of the shareholder value movement. In particular, the negative impact of this variable is higher in 1980 and beyond than before. This is evidence that, starting at 1980, shareholders had a stronger influence on firms’ investment decisions. 8. Conclusions Financialization is a significant economic phenomenon lasting from around 1980 until the 2007 financial crisis or beyond. The phenomenon started with the shareholder value movement, as well as a series of financial deregulation in the late 1970’s and the 1980’s which led to the rise of powerful financial institutions. As a result of these causes, firms have diverted more of their resources away from real investment toward financial investment. As a result, their internal fund is reduced. Since the change in corporate governance gave more power to shareholders, 18 firms adopted a new operation strategy, favoring ‘downsize and distribute’ rather than ‘retain and reinvest.’ In addition, firms have reduced their planning horizon under the pressure from shareholders for short-­‐term profits and healthy quarterly reports. All these effects result in a low investment level throughout the period despite the rising rate of profit. A time-­‐series analysis of aggregate macroeconomic and financial data provides evidence for the impact of financialization on domestic investment in the U.S. Using traditional investment variables: the rate of profit, the rate of interest and corporate tax rate, and incorporating financialization variables, the model confirms the negative impact of financialization on domestic investment of non-­‐financial corporations in the U.S. In addition, the investment model verifies some traditional theories of investment, confirming the impact of the rate of profit and the rate of interest, but casts doubt on the impact of corporate tax in the U.S. In the context of post-­‐financial crisis, this paper may suggest a perspective for economic policy. Since the financial deregulation and power financial institutions have a negative impact on investment, it might be time to re-­‐visit financial regulation. In fact, the Dodd–Frank Wall Street Reform and Consumer Protection Act might be the first step toward this direction to build a healthy economic system. 19 Bibliography: Abel, Andrew B.; Bernanke, Ben S.; Croushore, Dean. (2010) Macroeconomics. New Jersey: Prentice Hall Bates, Thomas W., Kahle, Kathleen M., and Stulz, René M.(2009). ‘Why Do U.S. Firms Hold So Much More Cash than They Used To?’ The Journal of Finance; Vol. LXIV, No. 5 October 2009 Blecker, Robert A. (2007) 'The Economic Consequences of Dollar Appreciation for US Manufacturing Investment: A Time-­‐Series Analysis', International Review of Applied Economics, 21:4, 491 -­‐ 517 Crotty, James. (1990) “Owner-­‐manager conflict and financial theories of investment instability: a critical assessment of Keynes, Tobin and Minsky” www.people.umass.edu/crotty/JPKE-­‐
Owner-­‐mgr-­‐confict-­‐1990.pdf August 17, 2010. Crotty, James. (2005) “The neoliberal paradox” Review of Radical Political Economics 2003 35:271 Djankov, S., Ganser, T., McLiesh, C., Ramalho, R. and Shleifer, A. (2010) ‘The Effects of Corporate Taxes on Investment and Entrepreneurship’, American Economics Journal: Macroeconomics 2 (July 2010): 31-­‐64 Duménil, G. and Lévy, D. (2001). ‘Costs and Benefits of Neoliberalism: A Class Analysis’ Review of International Political Economy, 8(4), pg. 578-­‐60. Duménil, Gérard and Lévy, Dominique. (2004) Capital Resurgent: Roots of the Neoliberal Revolution. Cambridge, Mass.: Harvard University Press. Epstein, Gerald A. (2005). Financialization and the World Economy. Massachusetts: Edward Elgar. Jurgens, U., Y. Lung, G. Volpato and V. Frigant (2002), ‘The arrival of shareholder value in the European auto industry: a case study comparison of four car makers’ Competition and Change; 2002, Vol. 6(1), pp. 61-­‐80 Kim, Hyun Jeong ‘The Effect of Foreign Direct Investment on Domestic Investment’ Bank of Korea Economic Papers, December 2008, v. 11, iss. 2, pp. 3-­‐42 Krippner, Greta R. (2005). ‘The financialization of the American Economy’, Socio-­‐Economic Review, 3, 173-­‐208 20 Kuttner, R. (1997). Everything for Sale. New York: Alfred A. Knopf Lapavitsas, Costas. (2009) “Financialisation, or the Search for Profits in the Sphere of Circulation” Research on Money and Finance, London, Britain, Discussion Paper no. 10 Lazonick, Williams. and O’Sullivan, Mary. (2000) “Maximizing shareholder value: a new ideology for corporate governance” Economy and Society, Volume 29, Number 1, February 2000, pg. 13-­‐
35 Madsen, Jakob B. (2003) ‘Inflation and Investment’ Scottish Journal of Political Economy, Vol. 50, No.4, September 2003 Marglin, S. and Bhaduri, A. (1988) ‘Profit Squeeze and Keynesian Theory’ Working Papers, World Institute for Development Economics Research, Vol. 39, 1989 Orhangazi, Özgür. (2008) ‘Financialisation and capital accumulation in the non-­‐financial corporate sector A theoretical and empirical investigation on the US economy: 1973-­‐2003’ Cambridge Journal of Economics; 2008 Seguino, Stephanie. (1999) ‘The investment function revisited: disciplining capital in South Korea’ Journal of Post Keynesian Economics; Winter 1999-­‐2000, Vol. 22, No. 2, pp 313-­‐338 Stockhammer, Engelbert. (2004) “Financialisation and the Slowdown of Accumulation” Cambridge Journal of Economics; Sep 2004; 28,5; Platinum Periodicals, pg. 719-­‐741 Tobin, James. (1969) “A General Equilibrium Approach to Monetary Theory” The Foundations of Monetary Economics. Volume 2, 1999, pp. 137-­‐151 Van Treeck, Till. (2009) ‘The Political Economy Debate on ‘Financialization’ – A Macro Perspective’ Review of Political Economy; December 2009, v.16, iss. 5, pp. 907-­‐44 Vergara, R. (2010). ‘Taxation and Private Investment: Evidence for Chile’ Applied Economics, February 2010, v. 42, iss. 4-­‐6, pp. 717-­‐25 February 2010 Wolde-­‐Rufael, Yemaneb. (2008) ‘Outward FDI and Domestic Investment in Korea and Taiwan’ Empirical Economics Letters, July 2008, v. 7, iss. 7, pp. 741-­‐47 21 22