The (over-)cost of capital A report made by Clers (Lille 1) for CGT - - PowerPoint PPT Presentation

The (over-)cost of capital

A report made by Clersé (Lille 1) for CGT (Ires)

Franck Van de Velde (Université Lille 1) Laurent Cordonnier (Université Lille 1) Thomas Dallery (Université du Littoral) Jordan Melmiès (Université Lille 1) Vincent Duwicquet (Université Lille 1)

Framework of the report

• A research program financed by CGT
• Asking for a research project on

« capital cost » while lots of debates were about « labour costs » and competitivity

• Tit for tat?

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Framework of the report (2)

• Report’s antithesis:

– All the problems of the French economy do not stem from a lack of competitivity, coming from too high labor costs.

• Beginning of report’s thesis:

– French meager macroeconomic performances (shared by lots of OECD countries) may have been imputable, for a large part, to the increase in the « financial norm » for the last 30 years.

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A cyclical history of capitalism and finance

• Industrial capitalism in the 19th century…

– Industrial Revolution and the Victorian compromise

• …replaced by Financial capitalism in the 1920s …

– Roaring Twenties and the end of the Victorian compromise.

• …replaced by Fordist capitalism after WW2 …

– The Great Transformation (K. Polanyi) and the Fordist compromise

• …replaced by Financialised capitalism since the 1980s …

– The Great Deformation (O. Favereau) and the end of the Fordist compromise

• … replaced by …?

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The parallel between the 1920s and 1980s: inequality and finance

30 32 34 36 38 40 42 44 46 1913 1916 1919 1922 1925 1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006

Income Share of Top 10% Households, USA (source : Piketty)

2,0% 3,0% 4,0% 5,0% 6,0% 7,0% 8,0% 1929 1932 1935 1938 1941 1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Dividends Share in Households’ Income, USA

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Report’s Thesis

• The increase in the financial norm has provoked an

increase in the over-cost of capital

• The increase in the over-cost of capital has two major

consequences: – A modification in wealth distribution

• « If you want to understand what’s happening to income

distribution in the 21st century economy, you need to stop talking so much about skills, and start talking much more about profits and who owns the capital. Mea culpa: I myself didn’t grasp this until recently. But it’s really crucial » Paul Krugman, 11/12/2012, New-York Times

– A modification in capital accumulation

• The investment projects which do not overcome the financial

norm (15% or 30% of ROE) are not undertaken.

• What is crucial is not the level of profit per se, but the use of

profit (dividend distribution or capital accumulation).

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• 1. What is capital cost?

1.1. Financial norm 1.2. Economic cost 1.3. Financial cost 1.4. Over-cost

1.1. Financial norm

• What we call here the financial norm is the

remuneration considered as « normal » or « exigible » by shareholders (i.e. sufficient to convince them to keep or buy firm’s shares rather than anything else).

• In finance theory, this financial norm is

viewed as the « normal » cost for capital.

• One labels « cost » (for firms) what is the

required remuneration of capital (for shareholders).

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From the financial norm to the (over-)cost of capital

• Here, the « true » capital cost is the cost of producing productive capital.
• To this « real » cost (= economic cost of rebuilding or increasing the stock of

productive capital) is added some « charges » which will compose the over- cost of capital:

– These charges correspond to the « financial » cost which depend on the modalities chosen by firms so as to acquire liquid capital (to finance the acquisitions of productive capital) – Concretely, it refers to incomes taken from firms (interests and dividends), and one part

• f it constitutes a pure rent, with no economic justification (once we have taken into

account entreprenerial risk and the administration cost of finance).

• There is a double change of perspective compared to the capital cost of

finance theory:

– We adopt the viewpoint of firm (or the entire economy), instead of the property one. – We look at the cost supported by the firm (or the entire economy) so as to maintain its productive equipment. – We calculate what the share of unjustified financial incomes represents compared to the economic cost of productive capital. – We have to evolve from an indicator of profitability (flow on stock) to an indicator of margin (flow on flow).

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1.2. The economic cost of capital

Productive capital (Fixed Assets)

Building Infrastructure Machine Equipment Brevet Software

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1.2. The economic cost of capital

Productive capital (Fixed Assets)

Building Infrastructure Machine Equipment Brevet Software Wear and tear,

• bsolescence

(amortisation)

Net investment

Cost of replacement for

• ld equipment and cost
• f adding new

equipment to increase productive capital

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1.3. The financial cost of capital

Productive Capital

Building Infrastructure Machine Equipment Brevet Software

Financial Assets Liquidities Assets Participations

Debt

Bank Loans Bonds Commercial borrowings

Owners’ Equity

(shareholders’ money)

Initial contribution Undistributed Profits Successive equity issues Assets’ revaluations Interest and dividends dividends Interests

Land

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1.4. The over-cost of capital

• The over-cost of capital is the share of (net)

financial cost which does not rely on any economic justification.

Interets and dividends paid ̶ Interets and dividends received Entreprenerial Risk Administration cost of finance Over-cost of capital

• r

Pure financial rent

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• 2. Take the measure of the over-cost

2.1. Compare the over-cost of capital to its true cost 2.2. Evolution of the over-cost since 1949 2.3. Timing: increase in interets then dividends 2.4. Financialisation: a regime change

2.1. The measure

We simply divide the

• ver-cost of

capital by its economic cost

Over-cost of capital

• r

Pure financial rent GCF (Gross investsment)

• r

CCA (Net investsment)

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Method to estimate the financial cost

• f capital
• Dividends: dividends paid minus dividends

received

• Interests: estimation of net real interests paid (to

monitor the effects of inflation)

• No real interest rates available in the data.
• We compute a net nominal debt for

corporations by dividing net nominal interests paid by the long-term nominal interest rate.

• We apply the real interest rate for private bonds

to this net debt so as to build net real interests series.

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Evaluation of entreprenerial risk and administration cost fo finance

• We melt the two in one single measure
• We choose the real interest rate on loans to

firms on the period 2003-2012:

• Period of low rates (mean = 2%)
• Supposed to compensate at least the two

dimensions

• We apply this rate (2%) to the stock of fixed

assets.

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2.1. Calculations for the year 2011

Estimations in Billions €

Value Added Wages and Salaries GCF CCA Cost of capital (1) Over-cost of capital (2)

1004,1 514 202,3 160,1 97,4 59,2

(1) (Net dividends and interests paid) (2) (Net dividends and interests paid) minus (entreprenerial risk and administration cost of finance)

Justified financial cost of capital = (1) – (2) = 38,2 Billions €

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2.2. Evolutions since 1949

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• 20,00%
• 10,00%

0,00% 10,00% 20,00% 30,00% 40,00% 50,00% 60,00% 70,00%

Cost and over-cost of capital

cost of capital / GCF

• ver-cost of capital / GCF

'justified' cost of capital / GCF

2.3. The back-and-forth of interets and dividends

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• 20,00%
• 10,00%

0,00% 10,00% 20,00% 30,00% 40,00% 50,00% 60,00% 70,00%

Structure of the cost of capital

cost of capital / GCF net real interests paid / GCF net dividends paid / GCF

2.4. Comparisons before/after financialisation

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Interest rate used to measure the entreprenerial risk and the administration cost of finance Assets used for the calculation

• f the

« justified » cost of capital Over-cost of capital compared to Gross Fixed Capital Formation 1961-1980 1981-1990 1991-2000 2001-2012

Real interest rate = 2% Fixed Assets Over-cost of capital (1)

• 1

17 31 24 Real interest rate = 2% Fixed Assets Except housing Over-cost of capital (2) 13 30 45 39 Real interest rate = 1% Fixed Assets Over-cost of capital (3) 9 26 41 35 Real interest rate = 1% Fixed Assets Except housing Over-cost of capital (4) 16 33 48 42

Mean for the over-cost of capital 9 27 41 35

A more simple indicator

(Inspired from M. Husson)

0,05 0,1 0,15 0,2 0,25 0,3 0,35 0,4 0,45 0,5 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Share of Operating Surplus which is not invested (France)

(EBE - FBCF)/EBE

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• 3. Micro and Macroeconomic

consequences of the over-cost of capital

3.1. Microeconomic effects on firms’ policies 3.2. Macroeconomic effects on growth path

Micro/macro closing of the increase in the financial norm

• At the micro level, shareholders’

requirements impose the new norm: « Downsize and Distribute ! »

• At the macro level, they put forward a

contractionary regime for investment, growth and employment

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3.1. At the micro level

• Strenghtening of the finance constraint (increase

in shareholders’ demands)

• Increase in the profit margin
• Allowed for by the increase in unemployment
• Slowdown in the accumulation path: selection

effect

« Downsize and Distribute ! »

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3.2. The macrodynamics of financialised capitalism: a change in distribution

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55 60 65 70 75 80

Adjusted wage share in value added

Germany (West Germany jusque 1991) France United Kingdom United States Japan

3.2. The macrodynamics of financialised capitalism: a change in accumulation

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• 2,00%

0,00% 2,00% 4,00% 6,00% 8,00% 10,00%

Rate of capital accumulation

Germany (West Germany jusque 1991) France United Kingdom United States Japan

3.2. The macrodynamics of financialised capitalism

• Atony of consumption out of wages
• Slowdown of investment spending

Setting up auxiliary driving forces for macroeconomic demand

• Consumption out of profits + Wealth effects
• Households’ indebtedness
• Public indebtedness
• Neo-mercantilist strategy supporting trade

surplus.

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• 4. What is the conception of the

firm behind all this?

4.1. Shareholder Value Orientation 4.2. The collective nature of the firm

4.1. Shareholder Value Orientation

• The claim that the firm belongs to

shareholders

• The goal of the firm is thus to serve its

shareholders (see agency theories and the managerial bias)

“There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits.” Milton Friedman (1970)

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Shareholder and short-termism

• The rise of institutional investors
• Assets’ management delegations even for

long-term investors

• Dramatic decline in the commitment of

shareholders in firms

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The rise of institutional investors

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500000 1000000 1500000 2000000 2500000 3000000 3500000 4000000 4500000 5000000 Estonia Slovenia Slovak Republic Iceland Greece Hungary New Zealand Czech Republic Turkey Portugal Poland Austria Luxembourg Chile Mexico Israel Norway Finland Belgium Ireland Spain Sweden Korea Denmark Italy Switzerland Australia Netherlands Canada Germany France Japan United Kingdom ic_2010 pf_2010

The rise of institutional investors: insurance companies & pension funds

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2000000 4000000 6000000 8000000 10000000 12000000 14000000 16000000 18000000 Estonia Slovenia Slovak Republic Iceland Greece Hungary New Zealand Czech Republic Turkey Portugal Poland Austria Luxembourg Chile Mexico Israel Norway Finland Belgium Ireland Spain Sweden Korea Denmark Italy Switzerland Australia Netherlands Canada Germany France Japan United Kingdom United States ic_2010 pf_2010

The rise of institutional investors: the american pension funds

Shareholder short-termism

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4.2. The collective nature of the firm

• The claim that the firm belongs to

shareholders is FALSE: see Robé, 1999.

• Profits are not the income of shareholders,

but profits are the outcome of a collective production, and undistributed profits are, in theory, the income of this collective entity (see Eichner, 1976).

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A classical distinction of national income

• A divide between unearned incomes

(incomes stemming from property) and earned incomes (incomes stemming from activity)

• Inside unearned incomes: a distinction

between interests, rents, dividends.

• Inside earned incomes: a distinction between

wages and undistributed profits

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4.2. Undistributed profits as the income of the firm

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National primary income = 1 + 2 + 3 +4 Property incomes (1) Housing, land Rents Financial Loans Interets Shares Dividends Mixed Incomes (2) Activity incomes (3) Enterprise Undistributed profits Labour Wages State incomes (4) Taxes Production Taxes

The collective nature of profits

• … leads to a collective deliberation on the

affectation of profits.

• Need for corporate governance changes

with workers’ representation.

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Conclusion

• Financialisation and shareholders’ requirements:
• 1/ pressure to increase profit distribution…

0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9

Dividends paid divided by the sum of net

• perating surplus and dividend received

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Conclusion

• Financialisation and shareholders’ requirements:
• 2/ …at the expense of investment

0,5 1 1,5 2 2,5 3 3,5

Net dividends nets divided by net investment

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Conclusion

• Financialisation and shareholders’ requirements:
• 3/ …which threatens growth, employment and

the ability to create profits in the future.

• 0,6
• 0,5
• 0,4
• 0,3
• 0,2
• 0,1

0,1 0,2 2 4 6 8 10 12 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 chômage (EBE - FBCF) / EBE

Unemployment Univested profits

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Conclusion

• Financialisation and shareholders’ requirements:
• 4/ …and the ability to create profits in the

future.

• Larry Fink, CEO of BlackRock (2014) : « Returning

cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons and at the expense of capital investment, it can jeopardize a company’s ability to generate sustainable long-term returns »

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Propositions

• Rebalancing the power among different

stakeholders

• Reorienting profit from dividend distribution to

capital accumulation.

• Monitoring the liquidity of financial markets

and promoting long-term shareholding at the expense of short-term practises.

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