Monday, October 10, 2011

Are firms acting irrationally by not investing more?

In an amazingly hubristic NY Times opinion piece, Richard Thaler tries to nudge American companies into doing the right thing:

Corporations are hoarding cash at record rates. The Federal Reserve recently reported that nonfinancial companies in the United States were holding more than $2 trillion in cash and other liquid assets — money that is earning next to nothing. A considerable amount of that cash has been accumulated in the last two years — and the totals exclude the substantial sums the companies hold abroad in foreign subsidiaries. Of course, it can be sensible for businesses to have a source of emergency cash, but many appear to be stockpiling so much that it’s hard to imagine what emergency they fear. To cite just one example, Google is holding more than $39 billion in cash...

Yet is such caution rational? As a shareholder, I would worry about a company that says it can’t find investments that can reasonably be expected to earn well above the tiny return of its cash.

Investment does not necessarily have to involve increasing capacity. Are there no plants or equipment that need upgrading? No promising research-and-development opportunities to be explored? Not even any parking lots that need to be repaved and painted?

I also do not buy the idea that companies need all this cash for acquisitions. If they really want to buy another business, they can issue stock to do so.


It's pretty hard to unpack all the errors/hubris in this quote, but let's try.

The biggest error Thaler makes is that he implies that the idea that firms are acting irrationally by delaying investment can be confirmed by the fact that positive NPV projects are not being done.

"Yet is such caution rational? As a shareholder, I would worry about a company that says it can’t find investments that can reasonably be expected to earn well above the tiny return of its cash."

The problem with this "logic" is that it is contradicted by the entire body of modern economic literature on investment. The literature shows that there is an option value to waiting to invest until conditions are favorable.

See for example "The Value of Waiting to Invest" by McDonald & Siegal (QJE 1987 cited over 2000 times according to Google Scholar) or "Waiting to Invest: Investment & Uncertainty", by Ingersoll & Ross (Journal of Business 1992 cited over 350 times according to Google Scholar).

Here's a crucial sentence in the Ingersoll & Ross abstract:

"The ability to delay a project means that almost every project competes with itself postponed"

The second mistake Thaler makes is downright embarrassing. He seems to assume that investment by firms is actually zero!

Are there no plants or equipment that need upgrading? No promising research-and-development opportunities to be explored? Not even any parking lots that need to be repaved and painted?

Umm, what evidence does Thaler show that these routine tasks are not being undertaken? Firms are sitting on a lot of cash, but firms are also currently investing over $1.5 trillion dollars (in 2005 dollars) this year. That should be enough to pave a few parking lots.



Finally, Thaler informs us that: "I also do not buy the idea that companies need all this cash for acquisitions. If they really want to buy another business, they can issue stock to do so."

Amazing! This is true just because he says so? The horrible condition of the stock market, the problems in the IPO market (which is different but clearly related) are apparently irrelevant; just issue stock, you bungling morons!

This is really one of the worst editorials I've ever seen by a respected economist.



5 comments:

JD Cross said...

RE: the shareholder part of Thaler's comment as it intersects with this notion of hubris

I would say that: well, if you're a shareholder and you're worried about this (justifiably or not), then sell your shares.

Pretty simple. Pretty easy to do in the highly liquid market for shares of companies. Requires absolutely no govt. involvement or coercion.

So I guess this means something like: Thaler doesn't believe that the stock market accurate values companies? Yes, hubris indeed.

Steve said...

I particularly enjoy this story in light of the Nobel Prize in Economics announcement this morning.

From the Huff Post, no less:
http://www.huffingtonpost.com/2011/10/10/nobel-prize-economics-sargent-simms_n_1003025.html?ir=World

Sims was asked what he would do with his $750,000 prize money. He said, "First thing I'm gonna do is keep it in cash for a while and think."

Regime uncertainty? Never!

Norman said...

"I also do not buy the idea that companies need all this cash for acquisitions. If they really want to buy another business, they can issue stock to do so."

Wait, is he saying that he can tell firms are being irrational because the IPO market is frictionless and efficient? I... I don't think that's right.

Cindy said...

The Humean Theory of Practical Irrationality. Click www.gofastek.com for more information.

Cindy
www.gofastek.com

Lee Shin said...

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Lee Shin
www.trendone.net