We Need The Very Rich

Two years ago I posted:

The number of new businesses we get seems limited by the number of folks personally wealthy enough to start new businesses. So having more really rich folks benefits everyone via innovation.

Now I learn that very rich folks are crucial not only for business starts, but also for most business investment that takes more than a year or so to payoff! Consider:

As is common in factories, [public firm] Standard [Motor Products] invests only in machinery that will earn back its cost within two years. (The Atlantic, Jan 2012, p.66)

Why look at years-to-payback instead of return on investment? A new NBER paper on private vs. public firms makes the answer clear. Unless project gains can be very clearly proven to analysts, or perhaps so small and numerous to allow averaging over them, public firms are basically incapable of taking a loss on earnings this quarter in order to make gains several years later, no matter how big those gains. CEOs are strongly tempted to instead please analysts by grabbing higher short-term quarterly earnings. So we need the very rich to make long-term investments. The details:

In 2007, private U.S. firms accounted for 54.5% of aggregate non-residential fixed investment, 67.1% of private sector employment, 57.6% of sales, and 20.6% of aggregate pre-tax profits. Nearly all of the 6 million U.S. firms are private (only 0.08% are listed), and many are small, but even among the larger firms, private firms predominate: Among those with 500 or more employees, for example, private firms
accounted for 85.6% in 2007. … 94.1% of the larger private firms in the survey have fewer than ten shareholders (most have fewer than three), and 83.2% are managed by the controlling shareholder. …

On average, private firms invest nearly 10% of total assets a year compared to only 4% among public firms. Second, private firms are 3.5 times more responsive to changes in investment opportunities than are public firms. … A plausibly exogenous tax shock … experiment reveals that private firms respond strongly to changes in investment opportunities whereas public firms barely respond at all. … IPO firms are significantly more sensitive to investment opportunities in the five years before they go public than after. …

For industries in which share prices are unresponsive to earnings news (ERC = 0), we find no significant difference in investment sensitivities between public and private firms. As ERC increases, public firms’ investment sensitivity decreases significantly while that of private firms remains unchanged. … There are significantly fewer stock market listed firms in high-ERC industries. … Investment rates decrease significantly with size among public U.S. firms …

Survey evidence …. find[s] that public-firm managers prefer investment projects with shorter time horizons in the belief that stock market investors fail to properly value longterm projects. … “The majority of managers would avoid initiating a positive NPV project if it meant falling short of the current quarter’s consensus earnings [forecast].”

It seems that the public-private margin is what matters for the effects we observe: We see no differences in investment behavior, among private firms, across different organizational structures (such as sole proprietors, partnerships, or different forms of incorporation) … . Our results are most consistent with the view that public firms’ investment decisions are affected by managerial short-termism.

Interesting that private firms have 67% of employees yet only 20% of profits. Is this mostly because owners take “profits” off the books to avoid taxes, or because owners attend more to growing firm value than to paying current earnings?

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  • david

    Well this is consistent with the idea that the process of investment seems to be naturally regressive, in that the rich find investment inherently cheaper than the poor, cet par.

    Can one simulate it via appointing people to long-term positions of being “rich”, a la sovereign wealth fund management?

  • http://jonathan.graehl.org Jonathan Graehl

    I buy that private firms aren’t so busy optimizing “profits” (may avoid them for tax reasons?), and that many public firms sacrifice long term health for the current quarter (e.g. Sears’ low investment in improving its stores). but you can’t make every investment that computes as NPV-positive or you’ll end up with a bunch of losers (as in multiple hypothesis testing, your threshold has to trade off false positives and negatives). Perhaps some private firms over-invest out of hubris.

    We could ask: assuming a list of investments sorted by projected future returns, (thus NPV given a discount rate), what discount rates and thresholds (below which you reject the investment even if you can obtain the capital for it) do firms seem to be using? It’s quite plausible that public firms are both shorter-horizon and more conservative (bosses don’t want to get fired, or want to boost the value of their stock).

  • Wonks Anonymous

    I’ve been thinking about the (principal-agent?) problems with public corporations recently, in part due to Karl Smith. Rather than “rich people rah, not boo”, I think this should push you to advocate more for corporate governance reform. Tug the rope sideways (can anyone name a corporate governance reform opponent?).

    • Doug S.

      Basically everyone who actually runs a large company?

  • nazgulnarsil

    Incentivizing longer investment time horizons is a key factor in organizational success up to and including at the civilization level. The problem is that the better you do at this the bigger the reward to undermine it. If an organization is able to reliably make 5 year investments pay off this will be very attractive for investment. The resulting flood of cash means a big payday for someone who can subvert the investment payoff and simultaneously take the other side of the bet in the market.

    • http://daedalus2u.blogspot.com/ daedalus2u

      nazgulnarsil that is an easy problem to deal with. You make the tax on capital gains a function of time. Something like 25% + 25%/t where t is time in years. If you hold your investment for 1/3 of a year, there is 100% tax. 1 year is 50%, 2 years is 37.5%, 5 years is 30% and 10 years is 27.5%.

      This would kill speculators that are looking for quick capital gains from speculative bubbles and so lets companies focus on longer term growth and not quarter-to-quarter numbers for analysts.

      • orthonormal

        Those particular numbers are crazy, but I really like this idea in general. It would kill mutual funds, though (which I think would be a very good thing), and thus it would never actually happen (mutual funds hire good lobbyists).

      • Ken

        What’s wrong with speculating to make a quick buck?

  • Phil

    In Canada, larger firms held by a single owner often take all would-be corporate profits as CEO bonuses to avoid double taxation (first corporate taxes, then personal taxes on dividends).

    I bought into an IPO a few years ago where profits the previous year had been zero, for exactly this reason.

    Small companies ($200,000 in profits?) get a lower corporate tax rate that evens things out, but larger ones do not.

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  • Jay

    Your arguments raise the question of whether more investment is always better. If there was more money being invested than there were profitable investment opportunities, I would expect the economy to feature very low interest rates for a protracted period of time and a pattern of investment bubbles as investors stampede from one sector of the economy to the next. Since those symptoms are present in the modern American economy, I suggest that more investment is not needed in America in general.

  • Douglas Knight

    In the 80s, private equity raised a lot of money from banks by issuing junk bonds. They didn’t need rich people to take companies private. They just needed banks that had faith in particular corporate raiders (who did become very rich).

    Interesting that private firms have 67% of employees yet only 20% of profits. Is this mostly because owners take “profits” off the books to avoid taxes, or because owners attend more to growing firm value than to paying current earnings?

    As the article explained and you quoted, private firms are much smaller than public firms and not comparable. The typical private firm is a restaurant with many employees and no profit. Do the numbers still look like this when you restrict to firms with 500 employees?

    Phil, in the US, salary is not deductible beyond $1million. But LLCs can avoid double taxation.

    ungated:
    http://gesd.free.fr/w17394.pdf

  • Marcus

    We need many massive new investments, presumably to help fix the long-term negative effects of old massive new investments? To keep up with the Jones’ militarily? Of course, that’s a generalization. But I think it beats your straw-man investments hands down.

    Whatever the case, it’s always good to see these really clear-cut examples of your long-term support for neo-feudalism.

    • http://entitledtoanopinion.wordpress.com TGGP

      What straw-man investments? Robin didn’t say anything about what specifically should be invested in, or why. The implicit assumption is that investments are useful because they can result in large returns, and new businesses are good (whether because they force existing businesses to stay responsive to customers, or because new businesses innovate more, or because growing new businesses create jobs etc).

  • Mardonius

    Wouldn’t this argument favour development of an aristocracy even more strongly, as such a class would be both rich enough to invest in long term projects and have incentive to extend return on investment past a single human lifespan?

  • http://anamecon.blogspot.com greg

    Yeah, but the rich need the not so rich to be the market for their production. That’s why the increase in income among the rich has not helped the economy. An excessive concentration of wealth will lead to a decrease in investment for that reason.

    A creative and dynamic society would therefore want to counter excess concentration of wealth.

    And the greater inclination for the wealthy to invest long term is still no excuse for an aristocracy, which would likely be generally anti-innovative, and certainly contrary to American ideas of social mobility.

    It should also be mentioned that the decline in American infrastructure has also correlated with the increase in concentration of wealth and influence of the past 30 years or so. Government, even a popularly elected one, when allowed, is also capable of long term investment.

  • ravi

    All through history, rarely has private wealth contributed to innovation. Most “innovation” has come from large governments and kingdoms who have invested in military and city building etc. Look at what private investors are currently funding.. most likely they are into “social media” and “handheld apps” and such “innovations”. Where else is private money going into .. building haunted western looking cities in china and other “emerging” economies perhaps?

    Truly amazing game changing innovations are happening in nanotechnology, nano-medicine and there is almost zero private interest in this. The greatest innovations of this century: semiconductors, computers, networks, biotech and so on have come not from rich speculating barons but from a century long public spending into science, education and military. The current venture cap backed tech industry is riding on top of all the public funding that went into this beginning from world war II.

    so what exactly is private money good for? It is to partake in extremely risky short term ventures. This is an extremely useful service. But is this the only model for encouraging innovation. Consider the cost that in this winner take all tournament setup, we likely have many burnouts. Perhaps there is a better way to use youthful energy for public good.

    • Ryan

      “All through history, rarely has private wealth contributed to innovation.”

      How much of history has actually had “private wealth” and how much of history is dominated by monarchs, political aristocracies, etc? Free markets (and the private wealth and innovation creating mechanisms in them) have been absent for the vast majority of recorded history. In light of that, your point seems VERY specious.

    • http://silasx.blogspot.com Silas Barta

      All through history, rarely has private wealth contributed to innovation. Most “innovation” has come from large governments and kingdoms who have invested in military and city building etc.

      What about the small (“competing”) city-states of Renaissance Italy or Ancient Greece?

    • http://daedalus2u.blogspot.com/ daedalus2u

      There is a Chinese proverb that is relevant.

      “If you are investing for a year, sow rice; if you are investing for a decade, plant trees; if you are investing for a lifetime, educate people”

      Probably the most important investment that the US has made, is in universal public education. The second is probably in supplying sufficient nutritious food to those who cannot afford it. A hungry child cannot learn and ends up with a stunted body, stunted brain and stunted mind incapable of intelligent thought.

      Of course to those who benefit from ignorance, that is a “feature”.

      • Ken

        Probably the most important investment that the US has made, is in universal public education.

        You mean the education system that politicians and political activists use to indoctrinate children into some sort of leftist fantasy involving “social” justice and an active hate for free markets and a capitalist system that ends poverty wherever it is introduced? The education system that fails to properly teach children to read and write and do simple arithmetic (over 30% illiteracy rate here in Baltimore)? The education system that politicians use to feed money into the hands of the greedy teachers union, so it can kick back tax payer money to their political campaigns? That education system?

        The second is probably in supplying sufficient nutritious food to those who cannot afford it.

        There is no one in the US that can’t afford nutritious food. This is simply non-sense spouted by those who want to take money from a large portion of the population, pocket most of that money, then trickle out whatever is left to those for the promise of an election vote.

  • Ilya Shpitser

    Robin, even history aside, it’s unclear why long term investments necessitate ‘the very rich.’ The space of possible societies is very large.

    • Kim Jong Eun

      The key point in our Party work at present and in the future, too, is to thoroughly establish the monolithic leadership system of the Party. We should strengthen and develop the whole Party into an integrated whole of organizational and ideological unity, which is run through with the unanimous will to follow the leader’s intentions unconditionally.

  • Seem

    The very rich are also able to invest in long term rent-seeking strategies. If a firm needs its lobbying to pay off in two years it restricts the options available.

  • kebko

    I’m skeptical of this interpretation. I think other factors could be at play. We are just 10 years removed from an entire economic boom that was centered around overvalued public companies that had never seen a penny of earnings (and many that never did). The idea that public investors are irrationally short-sighted is overdone, for reasons that have to do with signalling & affiliation, which I would not have to explain to you.

    As mentioned, there are industries where earnings have less of an effect than in other industries, so we are dealing with investor expectations. In a tightly held private firm, it would be easy to change the time frame of expected profit realizations. But, in a firm with thousands of owners, even if shareholder valuations are based on a long time frame, the marginal investor may see the firm as a source of consistent cash income, and so it would be reasonable to apply a higher discount to unusual long term investments. Small macro effects on discount rates could naturally have less effect in this environment. In private firms, it would be possible to get a consensus among the owners about changing the time frame of realized earnings.

    Short term earnings affect market prices mainly because surprises must partly be taken as a clue about distant future earnings. But, public firms frequently make large long term investments, and I have owned many firms that everybody understood would have non-linear earnings behavior. I’d like to see a post from you blowing back against this baloney about shareholders unable to handle long term earnings expectations. This idea gives managers an excuse for butt-covering, and a public predisposed against financiers is all too happy to buy it.

  • David C

    Mark Cuban once blogged that a great way to alleviate this problem would be to increase taxes on short-term investments and decrease taxes on long-term investments. There are also numerous places suggesting a transactions tax which would have a similar effect.

  • http://shagbark.livejournal.com Phil Goetz

    You assume that investments are necessarily very expensive. If middle-class wealth had grown at similar levels to upper-class wealth over the past 40 years, members of the middle class today would all be millionaires, and rich enough to make significant investments in their own small businesses.

    • http://daedalus2u.blogspot.com/ daedalus2u

      But that assumes that those controlling government policies want people to have upward mobility. Policies in the US discourage upward mobility more so than in Europe, so as a consequence there is less of it.

      Since the very rich have greatly increased their wealth, while there is less upward mobility in the US, presumably there is a causal relationship there.

      http://moneyland.time.com/2012/01/05/the-loss-of-upward-mobility-in-the-u-s/

      It seems pretty clear, current US policies are stifling upward mobility.

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  • Abelard Lindsey

    Entrepreneurs and the self-employed create wealth. Government bureaucrats consume wealth. Enough said.

    • Doug S.

      That is false.

  • ezra abrams

    Quote
    The number of new businesses we get seems limited by the number of folks personally wealthy enough to start new businesses

    I don’t think so – the number of new businesses is limited by the number of people crazy enough to start a new biz, despite the odds (Kahnemanns thinking fast slow just the latest to poitn out that only a crazy person would, if he knew the odds, start a new restruant)
    There is plenty of capital – huge enormous sums of capital sitting there; what there aren’t enough of are the crazy hardworking dedicated smart people willing to go 4 years without a salary to make something happen

    • http://daedalus2u.blogspot.com/ daedalus2u

      If the extremely wealthy limit everyone else to subsistence wages (as they would do if they could), then the statement will be correct, and will always be correct. However, that is not a reason to divert even more wealth to the extremely wealthy, it is a reason to divert wealth away from the extremely wealthy.

  • Preferred Anonymous

    Mmm.

    I think you’re confusing the need for the very rich with the need for investment.

    Arguing that we need the rich because we need investment simply does not follow. I propose that we take the human element out of the equation, and that we simply have large investment “establishments” whether governmental or corporate in nature. There is no argument that we must, or even should, put a single person behind a large amount of wealth.

    Therefore, we do NOT need the very rich (people). At least in the sense that “need” is bi-directional requirement.

  • http://jcwitmer.blogspot.com Jake Witmer

    “Give me control of a nation’s money, and I care not who writes its laws.” –Mayer N. Rothschild

    I recommend reading “The Creature From Jekyll Island: A Second Look at the Federal Reserve” by G. Edward Griffin. It’s well-researched. I also recommend “You Can Profit From a Monetary Crisis” by Harry Browne, and “The Case Against the Fed” by Rothbard.

    What this conversation is missing is a distinction between stolen wealth, and earned wealth. Alan Greenspan stole his wealth, in spite of originally eloquently defending the opposite principles (I think he was a sociopath, or just totally corrupted).

    The Federal Reserve Bankers and politicians steal their wealth, and devalue the currency. Others, such as Jaan Tallinn, Peter Theil, T. J. Rodgers, John Stossel, Wayne Root, and other wealthy libertarians trade value for value. There’s a world of difference.

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