Wednesday, June 25, 2008

Irrational Market Theory

What was I saying about likely outcomes should the government cut corporate taxes, as the Nippon Keidanren has demanded the government do? That instead of expanding their businesses, increasing the size of the economy, companies would just sit on the cash instead?

40% Of Listed Firms Effectively Debt-Free (behind subscription wall)
Nikkei Online

TOKYO --Publicly traded companies continue to improve their financial health, as seen by 654, or 41%, of them boasting more cash than interest-bearing debt as of March 31, according to a survey by Nikkei Inc.
T'is the top story of this morning's Nihon Keizai Shimbun -- that in an era of negative or near-negative interest rates over 40% of Japan's listed companies are debt-free.

Let me repeat that - at a time when the cost of borrowing money is so cheap that inflation will zero out one's interest payment, leaving one responsible only for paying back the principal of the loan, 4 out of every 10 companies cannot think of a way of taking free money from lenders in order to expand their business in any meaningful sense.

Talk about continuing shell-shock from the collapse of the bubble (18 years ago it happened!) - the paper describes not using leverage as being symptomatic of healthy corporate behavior (zaimu kaizen - "improving financial position" in the Japanese language original report). The article is not complimenting firms for holding down debt to a level where it is balanced out against book value, mind you. It is complimenting debt balanced out versus cash-on-hand!

Please forgive me-- but given this report, the idea that cutting corporate taxes will spur economic growth is simply not credible.

5 comments:

Paul J. Scalise said...

Nomura Research Institute's economist Richard Koo was one of the first to notice this fallacy of composition.* One company wanting to improve its leverage and pay down debt is admirable. *All* companies simultaneously engaging in this activity at the expense of avoiding further capital investment or paying out higher dividends becomes a problem.

In a low interest rate environment, I agree that corporate priorities seem misplaced. However, in the sector I know well (utilities), top management simply reasoned that -- sooner or later -- interest rates will rise again. Taking a long-term view of this capital intensive industry, management concluded that lowering both their already ridiculously high postwar leverage (400% +!) and capital expenditures were more attractive thoughts than rewarding their shareholders.

Is it the right choice? I don't have a crystal ball, but it really depends on whether corporate fears about a return to high interest rates are justified. They might be.

* I reviewed Koo's book here:

http://www.japanreview.net/review_bsr.htm

MTC said...
This comment has been removed by the author.
MTC said...

paul -

I agree with your point about interest rates. Nihoncassandra frequently rails at outsiders who push Japanese companies to cough up cash and load up on debt, not knowing that the company has no wish or capacity to expand(http://nihoncassandra.blogspot.com/2008/04/kinder-gentler-greenmailer.html is a classic. http://nihoncassandra.blogspot.com/2008/05/bad-hair-day-for-aderans-management.html is another.)

Correct me if I am wrong (you know how often that is) but Richard Koo was worried about fallacy of the cleaner balance sheet, with contraction of borrowing feeding a contraction of nominal GDP, all while the profit-and-loss of each company kept looking spiffier and spiffier.

Which is my point, sort of. With so many companies cash rich, it seems unlikely in the extreme that a corporate tax cut will stimulate investment and therefore growth. Indeed, nominal GDP will likely shrink due to both a reduction of government spending and a further paydown of commercial debt. There are also possible knock-off deflationary effects as well, I think.

Looking forward to your return to Tokyo.

- MTC

JAM said...

Gomen, Paul, but you seem to be missing the point (or perhaps I am). It is the reduction of the Corporate Tax that is in question. Given the current environment, will a reduction in the corporate tax spur anything other than windfall profits for the already rich? I thought thought Shisaku was absolutely correct in the "When Pigs Fly" note listing all of the other factors that are far more important than the corporate tax rate.

Given your knowledge of the utilities, could your respond to that? From my (admittedly untrained eye), the bit about interest rates and loading up on debt seems to be a bit of a red herring.

JAM

Paul J. Scalise said...

Hi Jam. There are really two separate issues here. One is politics and the other is economics. I really should have worded my point better, but I'm essentially agreeing with MTC that, if enacted, the tax cut will probably have minimal effect in Japan (but for different reasons).

Why would the LDP promise a tax cut? It's politically popular nowadays for a beleaguered ruling party to promise it will lower your taxes, isn't it? If given the choice between a party which promises higher corporate and consumer taxes or a party which promises lower taxes (and therefore higher disposable income for the consumer or higher net profits for the corporation), who would most voters generally prefer? I remember Walter Mondale's famous televised debate against Ronald Reagan in 1984. On national television, Mondale promised that if elected he would raise everyone's taxes vigorously. Mondale lost the election. Apparently, a few American voters didn't like that prospect.

In any case, it seems that the LDP is taking a page out of the Republican handbook. Promise the voters tax cuts. Will it work?

Well, it depends on whether you believe corporations respond positively to tax cuts. If profits go up, corporations have four choices: (1) raise dividends, (2) raise capital expenditures (3), pay down debt, or (4) sit on the cash for a rainy day. The LDP argues that (2) will happen. MTC argues that (4) will happen. I'm saying that (3) will *likely* happen.

Probably the only thing we all agree on is that (1) isn't going to happen. Sorry shareholders. But it's true.