Easy money masks global economy’s precarious health
Too much of economic growth and the accompanying bull market in stocks is the result of financial engineering. Increasingly, companies seek to improve earnings or increase their share price by means that are not necessarily directly linked to their actual business.
Companies have increased the use of lower-cost debt financing, taking advantage of the tax deductibility of interest. In private equity transactions, the level of debt is especially high. Complex securities have been used to arbitrage ratings and tax rules to lower the cost of capital.
Mergers and acquisitions as well as various types of corporate restructurings (such as spin-offs and carve-outs) have been used to create “value.” Given the indifferent results of many such transactions, the major benefits appear to have accrued financially to corporate insiders, bankers, and consultants.
Share buybacks and capital returns, sometimes funded by debt, have been used to support share prices. In January 2008, prior to the global financial crisis, U.S. companies were using almost 40% of their cashflow to repurchase their own shares. Ominously, that position is similar today.
Tax arbitrage, especially by international companies operating in multiple jurisdictions, has increased post tax earnings. The use by many companies of special vehicles in low tax jurisdictions, like Ireland, evidences this trend.
Some companies have used trading to increase earnings. Oil companies can make money from trading or speculating in oil, for example. Accordingly, they can make money irrespective of whether the oil business is good or bad or the price of crude is high or low, profiting from uncertainty and volatility. It is not even necessary to produce, refine, or consume oil to benefit from its price fluctuations.
Even Berkshire Hathaway headed by traditional investor and legendary stock-picker Warren Buffett, enjoys significant gains through financial engineering, including the use of leverage and derivative contracts. Berkshire uses the insurance premiums received as “free float” to finance investments. In the last decade, the company has sold long-dated options on international stock indices, credit default swaps on U.S. corporate credits, and insurance against municipal bonds. The premiums received boost its investment capital.
In both of these cases, the leverage derives from the receipt of cash up-front against a promise to make a contingent payment sometime in the future. The advantage is attenuated by the fact that the risk is back-ended and Berkshire does not have to post collateral to secure the risk. Payment is required only when the contracts are unwound or expire.
Nothing has really changed since the 2008-09 crisis. Low interest rates encourage borrowing. Artificially low capital costs have allowed unsustainable businesses to continue, generating sub-standard returns. Companies seek glib solutions to the complex problem of earning adequate returns by re-engineering their finances, rather than improve their operations.
Governments also are increasingly borrowing and adopting private-sector financial engineering techniques to deal with economic problems. Governments have increased their debt levels, in some cases resorting to forcing purchases of bonds by central banks, domestic banks, and captive institutions such as state pension funds.
Conventional and innovative monetary policies have supported aggregate demand and helped maintain economic activity to prevent prevented even deeper recessions. Policies that have sent both real and nominal interest rates to ultra-low levels have resulted in re-distribution of income and wealth.
According to a 2013 report from the McKinsey Global Institute, between 2007 and 2012, governments in the U.S., Europe and the U.K. collectively benefited by $1.6 trillion, primarily through reduced debt-service costs and increased profits remitted from central banks. Most of this wealth transfer came from households, pension plans, insurers, and foreign investors, mainly through lower interest earnings on savings.
It is time that businesses and governments focus on helping the real economy to solve large problems including debt, lack of growth, industrial stagnation, slowing innovation and productivity, aging demographics, income inequality, resource scarcity, and environmental threats.
Financial engineering masks the true performance and health of companies and nations. But the damage goes much deeper, deluding decision-makers into thinking that things are better than they are, and that solutions to problems can be deferred.