The ingredients for long-term investment are quite simple: all you need is money and favorable legal, accounting, financial and tax conditions. Despite the fact that money is readily available nowadays, the needs for long-term investments are far from being met. How can we change this situation?
ParisTech Review – The aging of some infrastructure on the one hand, constraints of the energy transition, on the other hand, require long-term, even very long-term, investments. Are our societies ready to meet this challenge? What are the tools at our disposal?
Guillaume Sarlat – You’re right, the need for long-term investments is very important. Allow me two preliminary comments before speaking of the tools that our societies can use. First of all, the need for long-term investments is not only about infrastructure and utilities, i.e. the energy companies. It also applies to some long cycle fields of research, such as medical research or future transport (for example, hydrogen cars).
Second point: this need for long-term investment is anything but new. The nuclear energy program or the transport infrastructure were both very long-term investments. Imagine for a moment what kind of world we would live in today if only short-term investments had been made in the past. If you think of it, the development of agriculture and livestock were probably the first long-term investments in the history of mankind…
The ingredients for long-term investment are quite simple: all you need is money with legal, accounting, financial and tax conditions favorable to long-term investment.
Money is readily available today. Thanks to extremely accommodative monetary policies from central banks, especially the European Central Bank (ECB), liquidity is abundant – even overabundant. The relationship between the money supply and gross domestic product (GDP) in the euro area has evolved from about 0.7x at the creation of the euro to 1x today. And quantitative easing (QE i.e. the purchase of public and private debt by central banks in the market) implemented this year by the ECB will further increase this overabundance of liquidity.
However, in terms of legal, accounting, financial and tax framework, the situation is far more complex. Developed countries, especially France, are democratic constitutional States, where the risk for an investment of being expropriated, stolen or destroyed by violence before it becomes profitable is relatively limited. But that’s not all. Rules that apply to investments, especially tax rules, need to be predictable enough to allow investors to take long-term decisions. Unfortunately, investors, both private and public, are still biased in favor of short-term investments.
Clearly, these tools are inadequate or aren’t being used at their full potential. Why is that?
Unfortunately, many OECD countries have chronic problems with their public deficit since over thirty years. The financing of long-term investments implies increasing the existing public debt as self-financing is virtually impossible.
This is where public accounts are problematic because they mix two completely different realities: the debt resulting from current or operational expenditure, i.e. expenditure on goods or services that disappear once consumed; and the debt from investment expenditure. Within the European Union, the Maastricht criteria did nothing to improve the situation: the famous thresholds of 3% and 60% regarding deficit and public debt also apply indiscriminately to deficit and debt resulting from operational or investment expenditure.
And yet, the logic of debt is radically different in one case or the other.
Funding operational expenditure with public debt is similar to what businesses know as working capital (WC), that is to say, the operating liquidity available between the payment of expenses and the collection of revenue. In this case, a Maastricht-type goal, with a deficit/GDP ratio, seems appropriate, just as a WC/revenue ratio in any company.
However, when public debt finances investment expenditures, the logic is different: debt provides the capital necessary to finance a project whose future revenue will repay the investment.
By maintaining this confusion, the rules of public finances and European rules introduce a bias towards short-term and operational expenditure. As these are usually more visible, they are also the first to pay a price, politically. Current rules even lead administrations to transform artificially, and against common sense, long-term investment expenditure in operational expenditure as part of public-private partnerships (PPPs).
Certain countries have more virtuous rules. In Germany, according to Article 115 of the Basic Law, using the debt is only allowed for investment expenditure.
Moreover, some countries have allocated public funds specifically to long-term investment. This is the case of most sovereign wealth funds, such as Europe NBIM, the fund of the Norwegian State, Temasek in Singapore, or funds from the Gulf countries (ADIA, ADIC, Mubadala, Qatar Foundation, etc.). France tried only once to create a SWF with the “Fonds de réserve des retraites” (FRR). But this fund has only a temporary function, namely to help the general pension scheme to face the “demographic bulge” of 2020. And above all, because of the chronic indebtedness of the public administration, the creation of a SWF is ultimately necessarily financed by debt.
What about private investors, companies and financial markets?
Private investors have a structural bias for the short term. Indeed, behavioral economics have shed light on the existence of patterns of bounded rationality, or irrationality, among economic actors, particularly when dealing with longer time horizons. Economic agents, investors and others, show an instinctive preference for the present, because they are unable to project into the future.
While this is a constant in humans, the trend is particularly strong today. For two reasons, which I discussed in my book “En finir avec le libéralisme à la française” (Ending French liberalism), published these days.
First of all, in a context of withdrawal of the State since the mid-80s, public authorities have no economic strategy and no further role in channeling private investment into long-term projects. From this point of view, the debate over “long-term savings” and necessary tax incentives, is particularly misleading: there is no guarantee that these so-called “long-term savings” will be placed in long-term investments.
The second reason has to do with the sharp increase in the money supply, in the euro area as in most developed countries. The more there is liquidity, the less money is expensive, and therefore the more investors are tempted to give in to easy short-term investments, which, as a consequence, become artificially profitable and are structurally often more liquid than long-term investments.
The signs of growing short-termism among investors, companies, banks and financial markets are increasing today.
On markets, the increase in intraday transactions, i.e. the purchase and sale transactions within the same day, now represent 40% of financial flows in France according to the Ministry of Finance. The development of high-frequency trading (THF) is another symptom. This new technique involves placing speculative stock market orders to buy and sell automatically, following algorithms based on asymmetries of information in a very short period of time.
For investors, short-termism translates in the increase of activist shareholders, who purchase company shares to demand a quick return from shareholders. In the United States, this happened with Carl Icahn who successfully forced Motorola’s split in 2011, and is now trying to force Apple to distribute its colossal cash (over 150 billion dollars) to its shareholders – something the company refuses to do for now. Other examples include Bill Ackman and Nelson Peltz.
Among firms, short-termism translates in their strategic decisions, with the proliferation of share buyback operations and the increase of dividends that immediately create value for shareholders, often at the expense of the long term. First of all, in the United States, 95% of the estimated profits of the major listed companies will be used this year on share repurchase and dividends. And even in Europe, traditionally less inclined to returning value directly to shareholders, about 65% of the results of the major listed companies should be used for share buybacks and dividends. As for France, 2013 was an exceptional year with nearly 43 billion euros of the 48 billion profits of CAC40 companies distributed as dividends... Sometimes the distribution rate is even higher than 100% because some companies borrow to fund the dividends paid to their shareholders.
And with banks, finally, retail banking has taken over investment banking, on the long term, by credit activities. Principally because these activities are more profitable than credit activities. The financial crisis seemed to put an end to this phenomenon, especially since the collapse of Lehman Brothers – but not for very long. Instead, the combination of abundant liquidity and very low interest rates favored again market-related businesses at the expense of the profitability of credit activities. Paradoxically, the new and stricter banking prudential standards called “Basel III,” adopted just after the financial crisis, reinforce this trend by disadvantaging banks that retain their stock of credit.
How can do better?
To do better, a whole set of measures need to be taken so that each of these actors, the central bank, the investors, the government, companies and banks face their responsibilities regarding long-term investments.
In terms of monetary policy, I see no other solution than renationalizing – at least partially. As I explained in my book, for the countries of the euro area, this doesn’t necessarily mean leaving the euro, but rather, leaving (at least partially) the ECB as we know it today. This is an absolutely necessity: given the persistent disparities between the economies of the euro area, a more virtuous monetary policy, i.e. more oriented towards long-term investments and less towards speculation and the artificial inflation of asset prices, is virtually impossible as long as this policy is common to all Member States.
For investors, I propose to exempt long-term investments from taxation. More precisely, I suggest that we should exempt from any form of taxation (income tax, wealth tax, social tax, corporate tax, taxation on donations and inheritances) all the products (dividends, coupons, capital gains output) from long-term investments on the national territory, whatever the nature of these investments (real estate, stocks, bonds) and the investment vehicle (individual, partnership) – the long term being defined, for example, as a period of seven or eight years. A measure of this kind would be a simple and clearly readable signal that a country wants to encourage long-term investments in its territory, regardless of the country of origin of the funds.
The State could also issue a perpetual debt, dedicated to financing long-term investments. By perpetual debt, I mean a debt whose capital has no maturity date and only implies the payment of interests. As well as a marketable debt, i.e. a debt that can be exchanged by investors between themselves. This solution has been implemented recently by many companies such as AXA, BNP Paribas, Casino, EDF, Solvay or Volkswagen, to finance their long-term financing needs. This solution would both rebuild a financial leeway for the State and would refocus the latter’s action.
Lastly, I propose to refocus banking activities on financing operations. The Glass-Steagall Act of 1933, in the United States, prevented retail banks from operating business banking activities. Following the crisis, the Vickers Commission in the UK, in the same spirit, recommended to group in a same subsidiary all retail banking activities; this proposal was accepted by the British government and will come into force on January 1rst 2019. In France, unfortunately, the banking jurisdiction only took the decision to group proprietary trading activities, as opposed to client activities, in a dedicated subsidiary. France followed the trend of the new US regulations, instead of adopting the British regulations. This doesn’t allow to isolate the long-term financing activity of banks; moreover, this measure is very difficult to implement in practice, because of the strong connection between trading and client activities.
What are the risks associated with these solutions?
I can’t see any! As long as we give the adequate incentives and nudges, in other words, provided that we structure the choices so that they are virtuous enough.
If we renationalise our monetary policy, we can’t afford having a “weightless” policy like that of the ECB. The national body responsible for the policy must be subject to a democratic control.
If we allow the State to issue perpetual debt to finance long-term investments, this needs to happen under the control of Parliament, and of investors. Moreover, the latter can more easily exercise their responsibilities as creditors with a debt targeted on specific investments, rather than an undifferentiated debt that finances the overall government deficit.
And the separation of the activities of deposit and loans banks from the activities of investment banks must be combined with a more active monetary policy, at a national level, where the allocation of liquidity and capital by banks needs to be followed more precisely, and optionally regulated.
Could you, in conclusion, give us some examples of good practice, or of countries that have had the courage to think outside the box?
I will mention two unexpected examples.
The first, I already mentioned earlier, is the separation between retail banking et investment banking. Ironically enough, on this matter, the leading country today in Europe is the United Kingdom.
Second interesting practice: Blackrock, the first US institutional investor, sent a letter to the leaders of the largest US companies but also to European companies (including twenty French firms), urging them not to misuse dividends and repurchases, if the shareholder return is at the expense of future growth.
As well explained in this letter by the president and the CEO of BlackRock, “too many companies have reduced their investments and even increased their debt in order to increase their dividends and share buybacks (...). The redistribution of cash to shareholders must be an integral part of a balanced management strategy. If done for the wrong reasons and at the expense of investment, it can threaten the company’s ability to generate sustainable returns over the long term.”
The British government, Blackrock: let’s reap good ideas wherever we can find them!