Corporate Cash, Not Buybacks, are Hurting the American Economy

From my background in the business school and my pursuit of an economics minor, I consider myself a lucky individual who is able to stand at the intersection of the two related fields. I can utilize one school of thought to aid the other, and vice versa, providing me with a unique insight to the connection between financial and economic events. And, as I am finding exceedingly more important, I can understand when the connection breaks down or the facts are presented in such a way to make the two stand at odds.

This is exactly what Nick Hanauer attempts to do is his article Stock Buybacks Are Killing the American Economy. Hanauer attempts to explain how the diversion of corporate profits to share buybacks has been destroying the "real economy" and contributed to the income inequality present in the United States today. While the points that he makes regarding income inequality may be valid, I take contention with his complete disregard of financial theory when explaining how buybacks are destroying the economy. Hanauer explains:

In the past, this money flowed through the broader economy in the form of higher wages or increased investments in plants and equipment. But today, these buybacks drain trillions of dollars of windfall profits out of the real economy and into a paper-asset bubble, inflating share prices while producing nothing of tangible value.

I would like to first take issue with the idea of corporate profits flowing through to higher wages. While it may be true that highly profitable companies can afford to pay its employees more, Hanauer completely ignores the effect of rising stock prices on households' wealth. Outside of real estate investments, the second largest asset individuals hold is their retirement accounts; as a result of increasing share prices, as he himself pointed out was an outcome of share buybacks, these retirement accounts can see appreciation in value. While higher wages may be a positive for the economy, rising household wealth can have the same desired effect.

The other portion of his argument deals with possible increases in investments coming from corporate profits. According to financial and economic theory, investments in these types of projects are only profitable as long as they are the "best" or most "efficient" use of resources (that is to say the opportunity cost is taken into account). Hanauer argues that these investments are the best use of resources but more and more CFOs seem to be disagreeing with him—as evidenced by the increased amounts of buybacks. Hanauer is failing to recognize that there are significant benefits of these buybacks, namely decreased cost of capital, tax benefits, and satisfied shareholders (which is important for the stock market as a whole). For Hanauer's argument to hold, CFOs who themselves are very educated and well versed in the needs of their companies, must be incorrect about capital allocation on an increasingly large scale. If the CFOs are correct, to do anything else would be economically inefficient and actually destroy value.

While share buybacks may not be hurting the American economy, exploring a different area of corporate balance sheets reveal a significant area that could be causing problems: cash. The Wall Street Jounal in conjunction with Deloitte, published an article titled How Record Cash Reserves Influence Corporate Behavior. In the article, they point out that not only large companies, but increasingly small companies, are holding more and more cash:

Between 2008 and 2013, [large companies] nearly doubled their cash reserves from $1.61 trillion to $2.88 trillion, and at the same time, the small cash holding companies kept accumulating at an even pace and increased their reserves from $433 billion to $656 billion.

While these record amounts of corporate cash may have benefited companies during the tough economic times of the recession, but as the economy continues to recover, cash piles are becoming a large inefficient use of resources. With yields across the yield curve near historic lows, the return that cash is currently seeing is paltry. It seems increasingly likely that companies would be able to find profitable investments to take on or, if none exist, they can distribute that cash to shareholders so they themselves can be rewarded for holding the company's stock and be able to find worthwhile investments themselves.