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Where Private Investment Fails

BENNETT HARRISON DECEMBER 19, 2001

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WORK DISCUSSED IN THIS ESSAY

Michael Porter, "Capital Choices: Changing the Way America
Invests in Industry,"
Council on Competitiveness, 1992.
Michael Porter, ed.,"Time Horizons of American Industry" (18
pages from the Council
on Competitiveness and Harvard Business School, Distributed by
HBS June 1992).
Paul DiMaggio and Walter W. Powell, eds. The New
Institutionalism in
Organizational Analysis (University of Chicago Press,
1991).
Mark Granovetter, "Economic Action And Social Structure:
A Theory of Embeddedness," American Journal of Sociology,
91 (1985).
Robert Hayes and William Abernathy, "Managing Our Way to
Economic Decline,"
Harvard Business Review, July-August 1980.
Michael T. Jacobs, Short-Term America: The Causes and
Cures of Our
Business Myopia (Harvard Business School Press, 1991).
Michael Porter, The Competitive Advantage of Nations
(BasicBooks, 1990).
Walter W. Powell, "Neither Market Nor Hieararchy: Network
Forms of Organization,"
in Research in Organizational Behavior, 12, 1990.
Robert B. Reich, The Next American Frontier.(Times
Books, 1983).
Lester C. Thurow, Head to Head (Morrow, 1992).
Oliver E. Williamson, The Economic Institutions of
Capitalism (Free Press,
1985).
To
hear it from the White House, the U.S. experienced a recession
in 1990 after
eight years of extraordinary economic growth, and is still doing
"pretty well"
even now. True, admits President Bush, the current recovery is
less bullish than
he would wish (read: the most sluggish recovery since the 1930s).
But if we just
give it, and him, more time, and perhaps help it (him) along with
a dose of
stimulation via cuts in the capital-gains tax and via
Congressional approval of
his North American Free Trade Agreement with Mexico, everything
will be fine.
Just get government out of the way, and private investment will
save us.

Not likely. Even in absolute dollar terms, growth in real
domestic
non-residential private investment, net of depreciation,
flattened in 1973 (see
chart). Since then, movement in this key indicator of private
sector willingness
to purchase new industrial, commercial, and office plant,
equipment, and
buildings has been entirely cyclical. The strong investment
growth of the 1960s
is now a distant memory.

According to new data from the Bureau of Economic Analysis in the
U.S. Department
of Commerce, in 1965 net capital formation constituted 10.4
percent of net
domestic product (NDP). By 1991, it had fallen to just 3.4
percent. Since the
late 1980s, private investment as a share of NDP has been rising
in Japan, the
U.K., and, more recently, Germany. But in America, it continues
to sink like a
stone.

On news broadcasts, in newspapers, and at congressional hearings,
conventional
economists purveying conventional wisdom repeat one particular
explanation for
the collapse of U.S. private domestic investment: low public and
private savings,
made even lower by the now chronic federal budget deficit. To end
this "crowding
out" problem, the story goes, we need to deflate the economy.
When the deficit
falls, savings rates will rise; long-term interest rates will
fall, and investors
will borrow money again to finance the building of new plant and
equipment. This
is a strictly macroeconomic tale, and in the primacy it awards to
savings
behavior, it is really a warmed-over, pre-Keynesian, pre-1930s
macroeconomics.




In fact, the mainstream assessment of where we have been, and how
far private
investment is capable of taking us, is plain wrong. Now, however,
help in setting
the record straight has come from a most unexpected place: the
Harvard Business
School. Eighteen new research papers known as the "time horizons
project,"
including a synthesis by business strategist Michael Porter, are
reintroducing
a healthy institutional realism into the debate about why
America's private
companies chronically underinvest in projects lacking a
short-term payoff and why
(when they do spend) they tend to invest in projects that, taken
together,
retard long-run economic growth.

Partly a cogent restatement of older institutionalist themes,
partly an effort
to quantify important but hitherto elusive concepts, Porter &
Co.'s time horizons
project has produced the most comprehensive picture so far of why
you can't make
sense of private investment behavior without paying attention to
the
institutional details. Even with its glaring omissions especially
when it comes
to exploring the interdependence between private and public
investment the Porter
report may well be the most thoughtful, systematic analysis of
interrelationships
between capital markets and the big corporations at the core of
American
capitalism since, well, since the work of Porter's Harvard
elders: John Kenneth
Galbraith and Alfred D. Chandler, Jr.

The twenty-five economists, finance experts, business historians,
and industrial
relations specialists who participated in the time horizons
project argue that
Germany and Japan inherited from their own past, and then refined
after World War
II, a coherent set of institutional arrangements that
systematically favor the
long-term growth and survival of their companies over short-term
monetary
earnings. In one of the project's most important papers, Harvard
economist
Lawrence Summers and MIT's James Poterba present the results of
their interviews
with a large sample of Japanese, American, and European CEOs.
They find that U.S.
investors tend to demand much higher minimum acceptable rates of
return for their
capital so-called "hurdle rates" than their foreign competitors
do. In recent
years, investors here have been rejecting projects with expected
inflation-adjusted payoff below 12 percent even though the recent
real cost of
debt has averaged only about 2 percent and the real cost of
equity about 7
percent. Moreover, where a healthy share of the research and
development
portfolios of foreign corporations include explicitly long-term
projects (47
percent for the Japanese companies studied, 61 percent for the
Germans), only one
out of five projects being undertaken by U.S. companies could be
classified as
long-term.

As a result, U.S. corporations are underfunding projects that
could eventually
create lasting employment, profits, and opportunities for
experimenting with new
technologies and new forms of production organization. In their
place, Americans
invest disproportionately in real estate and unrelated
acquisitions which, as
another Harvard economist, F. M. Scherer, has shown, have
generally been poor
performers in the marketplace. Such portfolio investments may
generate short-term
earnings, but they do not add to the net stock of real productive
capital in an
economy. In Porter's words, they merely involve the "trading of
assets from one
owner to another." Moreover, as we now know, the massive
borrowing in the 1980s
to finance all of this essentially unproductive activity drove up
debt-to-equity
ratios to the point where, even in the present cyclical recovery,
investors are
still reluctant to open their wallets one reason why the present
macroeconomic
recovery has been so anemic.

What makes this project, co-sponsored by the "real" Council on
Competitiveness,
so surprising is its conclusion: real capital formation in the
U.S. since the
1960s has been distorted by the rules, procedures, and customs
governing
private-sector allocation of capital rather than by profligate
government
spending or the overregulation of business as the "other" Council
on
Competitiveness the one chaired by Vice President Quayle
alleges.

In the belief that the global competitiveness of U.S.-based
companies can be
enhanced by obliterating bothersome regulations, Quayle's Council
on
Competitiveness ferrets out and dismantles health, safety,
environmental, and
other regulations that increase the "cost of doing business."
That most of the
nations with whom we compete usually have even more stringent
standards than
ours, especially regarding workplace conditions, either goes
unnoticed by the
Quayle council or is deliberately ignored.

Far more compelling is the work of the other Council on
Competitiveness, located
a few blocks from the White House. This council, once a creation
of the Reagan
administration, went private when the White House ignored its
findings. Its work
on the real competitiveness problems of American business is
directed by chief
executive officers and other senior executives from Motorola,
Hewlett-Packard,
and other private firms, labor leaders, presidents of MIT,
Stanford, and other
universities, and directors of the national laboratories. In six
short years it
has produced an impressive number of reports, seminars,
newsletters, and
congressional testimony such as the eighteen papers that
constitute the time
horizons project.

In this new project, Porter's institutional sensibilities lead
him to play down,
without wholly rejecting, the conventional macroeconomic wisdom
about the
responsibility of excessive taxation and extravagant federal
deficits for the
high long-term cost of capital, which supposedly suppresses
long-term investment.
Porter, like the usual suspects, wants to understand why the cost
of capital has
been relatively higher, at least until recently, in the U.S. than
elsewhere in
the industrialized world. But for his answers, he looks to the
institutional
structure of contemporary capital markets, rather than to
macroeconomic
aggregates.

Institutionalism Redux

In the second half of this century, mainstream economics has
given ever shorter
shrift to the role of institutions in explaining the economic
behavior of buyers
and sellers, bosses and workers, investors and managers, public
officials, and
citizens.

In particular, the idea that markets in different countries
especially capital
markets might operate according to qualitatively different rules
and norms, and
present economic actors with different sets of choices and
trade-offs, has been
treated as either uninteresting or unfathomable. After all, we
were told in
Economics 101 that the very process of competition via the free
movement of
"inputs and outputs" across regional and national borders would,
over time, erase
lingering institutional differences that might be of any
consequence to business.
Relative prices and resource endowments two sides of the same
coin, really were
what mattered, not rules, institutions, or norms. That was just
the stuff of
"sociology" or, worse yet, "politics."

No wonder, then, that conventional economic thinking has not had
much luck
explaining why so many U.S. corporations, compared with their
Japanese and German
counterparts, systematically underinvest in ventures that lack a
near-term
payoff, avoid retooling and upgrading "mature" industries, shy
away from risky
research and development, and underinvest in the lifetime
training and education
of employees or in the development of long-term, collaborative
relationships with
suppliers and customers.

On the other hand, over the course of the last fifteen years,
"new
institutionalists" from MIT's Lester Thurow to Harvard's Robert
Reich, Robert
Hayes, and the late William Abernathy have repeatedly sent up
storm warnings
about the "short time horizons" of all too many homegrown
companies and
investment bankers. We have heard a former Republican Treasury
official make
similar arguments in Short-Term America, and a Democratic
counterpart has
been offered in the several reports of Mario Cuomo's Commission
on Industrial
Productivity. This disorder, we have been warned, has been
growing since the
1960s. Only now, as the international competition heats up, are
we realizing the
extent of our systemic disadvantage competing against
corporations based in
countries better equipped than the U.S. to nurture and encourage
such long-run
investments. As Thurow frames the argument in his latest book,
the "new world
order" comes down to a "head-to-head" competition among
qualitatively different
kinds of capitalism. Some of capitalism's national "ensembles" of
institutions
are simply better adapted to the game of global competition than
are others.

ADVERTISEMENT

In fairness, many U.S. companies are still more than holding
their own,
domestically and abroad in chemicals, pharmaceuticals, software,
telecommunications equipment, and for the moment, civilian
aircraft. But,
especially when it comes to the modernization of mature
industries and especially
if the subsidies provided by Pentagon procurement are discounted,
much of the
U.S. economy is falling behind the competition.

The Porter analysis comes at a time of a revival of institutional
sensibility in
American political economy. A history of the rise and decline
into obscurity of
the once-fertile institutionalist stream within American
economics would take us
too far afield of the immediate subject of this article. Suffice
it to say that
the historically and socially empirical economics of Thorstein
Veblen, John
Commons, John Bates Clark, and others who shared Adam Smith's
empirical curiosity
about commerce gave way to the "empiricism" of the mathematical
formalists, for
many of whom ignorance of the details of commercial life has been
a badge of
professionalism.

Something of an institutionalist revival (though not so named)
began in the 1970s
with the work of and reactions to, Berkeley economist Oliver
Williamson.
Beginning with his book, Markets and Hierarchies, and
building on the
earlier (but by this time fugitive) ideas of Ronald Coase,
Williamson sought to
employ the analytical tools of orthodox economic theory to pose a
question that
the mainstream had substantially abandoned since the Depression
era: Why do
market economies inevitably reinvent powerful oligopolies that
engage in
capitalist planning stabilizing market shares, organizing
networks, regulating
technical standards, limiting ruinous price competition? The
answer could not be
merely that offered by Adam Smith a self-interested conspiracy of
businessmen
against the public. For, in some sense, oligopoly seemed
functional to capitalism
itself. A few renegades, including Galbraith, had never ceased
asking this
question, but their work was dismissed by the mainstream as
lacking a consistent
or approved methodological foundation.

In the 1930s, Ronald Coase had tried to use conventional methods
to break inside
the "black box" of the firm to understand the rules and
procedures by which
actors in an organization or polity achieve coordination and
legitimacy. This was
an attempt to integrate the institutionalist idea of governance
with the orthodox
premise that firms must be organized so as to maximize profits in
the short run.
Coase's microeconomics remained largely unnoticed until
resurrected by Williamson
nearly forty years later. Just last year, Coase won the Nobel
Prize in economics
for his seminal ideas. Better late than never.

Williamson borrowed from Coase the concept of "transactions
costs" the idea that
the market price in any transaction may fail to incorporate the
full costs to the
seller or buyer because of the very conditions of exchange. In
particular,
whenever there is uncertainty or the need for long-term
relationships, the
parties to a transaction are unlikely to be able to write
contracts complete
enough to cover all the contingencies or hidden costs.
Furthermore, incomplete
contracts encourage one or the other party to behave
opportunistically,
deliberately withholding information or broadcasting
disinformation to get a
better deal.

In such cases, the transaction is likely to occur under a single
roof, inside a
"hierarchy" (that is, firm). This solution "internalizes" or
reveals to the
decision makers those otherwise hidden costs. Williamson showed
that there are,
even in pure theory, situations in which the inefficiencies of
bureaucratic
organization are offset by the greater predictability of the
outcome. This is
showing quite a lot, at least to academic economists. It says
that under rather
common circumstances it is efficient (maximizing of profits,
minimizing of long
run average costs) for explicit rules, regulations, commands,
organization
charts, and social contracts to replace the invisible hand.

With the first book and then his subsequent amendations,
published a decade later
in The Economic Institutions of Capitalism, Williamson
created a small but
steadfast school within university economics and generated an
enormous outpouring
of explicitly institutionalist criticism, especially from
sociologists and
economic geographers. As a complement to Galbraith's and
Chandler's "logic of
managerial capitalism" the idea that the exploitation of
economies of scale and
scope requires the amassing of considerable political and
economic resources
under the "visible hand" of corporate planners Williamson and his
followers have
revived academic interest in the theory of the business
enterprise.

More recently, Geoffrey Hodgson has written about the "new
institutionalism" from
the perspective of economics, while sociologists Walter Powell,
Paul DiMaggio,
and Alejandro Portes have built on the research agenda of Mark
Granovetter, a
social scientist who resurrected and elaborated Karl Polanyi's
protean idea that
real economies are always "embedded" in a social framework
necessary for their
survival. The task is to figure out how and why individuals and
groups behave in
the context of these conditions.

Within the sub-field of studies of technological innovation,
almost everyone of
consequence, from Richard Nelson to Giovanni Desi, now takes the
centrality of
institutions almost for granted. As exemplified by the work of
Fred Block and
John Gerard Ruggie, international political economy is being
rebuilt around
explicit studies of the nature of the institutional arrangements
governing the
old and the new regimes of global capitalism. Even the "new
trade" theorists,
such as Berkeley's Laura Tyson and MIT's Paul Krugman, are
substantially
institutionalist.

Most of the contributors to the time horizons project would be
surprised to see
themselves characterized as neo-institutionalists. Yet what they
have
collectively produced shows the importance of rules of thumb,
belief systems,
learning behavior, self-fulfilling prophecies, and other nonprice
phenomena in
explaining how and why American capitalists make investment
decisions and why our
particular arrangements harm us in global competition.

The key to understanding why American corporations take an
ultimately
counterproductive short-term approach to investing begins with
the structure and
behavior of what Porter calls "external" capital markets. In
Germany and Japan,
Porter notes, a company's major shareholders tend to be other big
corporations
that have easy access to company information and thus participate
directly or
indirectly in management decisions and monitoring company
progress. Meanwhile,
U.S. insurance companies, mutual funds, and individual investors
alike often know
little or nothing about the messy details of making steel, wiring
silicon chips,
or communicating via satellite. Instead, American investors
employ armies of
professional market analysts and portfolio managers. In the
absence of
substantive inside information (which is illegal as a basis for
trading) everyone
tends to fall back on those indexes that can be most easily and
inexpensively
measured and communicated recent and projected quarterly
earnings. Agents build
their careers by bouncing between investment banks and mutual
funds, competing
for status and income by how well they can predict and how often
they can jump
from one ship to another. There is no lifetime employment in this
system.

Inside the corporations themselves in what Porter calls the
internal capital
markets things aren't much better. American boards of directors
are made up of
executives of other firms, who know too little about the
substantive business
they are being paid to "direct." The firms themselves have become
so complex,
after thirty years of conglomerate mergers, acquisitions,
break-ups, and
segmentation, that even their managers and senior technicians
have difficulty
talking across what often amount to fire walls. In the effort to
communicate
across these barriers, even the "insiders" are driven toward
simple goals such
as maximizing share prices. Once again, we get management by the
numbers.

Moreover, U.S. companies often compensate their managers with
stock options,
which of course only ties their behavior that much more closely
to current share
prices instead of to long-term prospects. Porter is not saying
that incentive pay
is, in principle, the problem, only that the American system ties
incentives to
a short-term rather than a long-term signal.

The predictable result of the existing incentive system is that
the managers'
tenure, like the shareholders', is likely to be short. This
further compounds the
problem caused by inadequate numbers of key employees with
firm-specific
knowledge, which in turn promotes the use of those easy-to-read
indicators such
as stock price and quarterly earnings.

The net result of these mutually reinforcing behaviors, played
out within
strongly entrenched institutions, is that financial capital in
the American
industrial system is indeed, as Reich and Thurow have long
asserted, systemically
"impatient." One set of numbers from the time horizons project
drives the point
home. In 1960, big institutional stockholders in the U.S the
pension and mutual
funds held on to a share on average for seven years. By the
1980s, the average
period had fallen to only about two years.

In Porter and Co.'s encyclopedic accounting of differences in
capital markets,
these particularly caught my attention:

Hostile takeovers are nonexistent in Japan and next to
nonexistent in Germany,
by custom or law or as a result of the extensive
cross-shareholding among
customers, suppliers, and bankers.
The assets of German workers' pension funds are customarily
dedicated to
purchasing only the stock of the company employing those workers
a practice that
may not be "prudent" in the eyes of American regulators but that
undeniably
strengthens the ties between German labor and management. Here we
have the
makings of a "virtuous circle," in which dedicated capital
enhances the firm's
prospects for survival, thereby reducing the need for heavily
regulated
prudence.
The capital budgets of German and Japanese companies treat
expenditures on
training, R&D, development of closer relations with suppliers,
and the initial
losses associated with entering new markets or territories as
investment, on a
par with spending on new plant and equipment; U.S. companies
record only the
latter. In other words, even their accounting practices are
geared toward the
long run.
The Missing Link: Public Investment

It is unfortunate that the time horizons project chose not to
devote any
attention at all to the differences across countries in the
determinants of
public investment especially since Porter acknowledges
that "public sector
investment in education and efficient transportation,
communication, and
information networks is also critical to industrial
competitiveness." Moreover,
he readily admits that "government actions can support or
inhibit" each of the
elements of his own model of the sources of competitiveness: the
inclination of
key customers to press for continual innovation; the availability
of skilled
labor; the local presence of qualified suppliers; and vigorous
but constructive
rivalry between the focal firm and its competitors.

Actually, in the time horizons project and his other recent
writings on strategy,
Porter is inconsistent on the question of the proper role of
government. For
example, because he so highly values the goad of competitive
rivalry, Porter
often warns against public policies designed to promote greater
collaboration
among competitors. That's why he is no great fan of such R&D
consortia as the
U.S. semiconductor collaboration, Sematech, or the European
computer
collaborative, ESPRIT. It is, however, legitimate in Porter's
view perhaps even
critical for customers to collaborate with their suppliers. But
in the brave new
world of just-in-time parts delivery and integrated product
design, where
companies frequently take turns playing customer and supplier,
this advice
becomes somewhat confusing.

Burgess Laird, a staff member of the Center for National Security
Studies at Los
Alamos National Laboratory, observes that while Porter, in his
1990 book, The
Competitive Advantage of Nations, recognizes the importance
of a high-quality
local training infrastructure to Japanese and German
competitiveness, he doesn't
address the fact that such supports are nurtured by regional
government
institutes that provide training, like the Japanese
kohetsushi and the
German Frauenhoffer. Porter's silence in "Capital Choices"
on the
appropriate content of an American-style industrial policy stands
in notable
contrast to the fairly explicitly pro-policy stance embodied in
just about
everything else that the Council on Competitiveness has published
over the last
five years.

Of all the appropriate roles for government in a larger
public-private program
to revive investment, none is more important than what the Swedes
call "active
labor market policy." It is not enough to call for more education
and training,
as another item on a list. Physical and human capital have to be
developed in a
coordinated way. For example, if new technology is embodied in
new plant and
equipment, and if a program to increase the rate of new private
and public
investment is what we most need right now, then any innovative
investment plan
will dislocate some workers certainly as long as the aggregate
rate of economic
growth remains sluggish. Some of that dislocation can be
anticipated by wise
labor market policy. Workers can be offered alternative
employment or steered
toward retraining opportunities before the plant, laboratory, or
store shuts
down. New markets can be sought for the businesses that would
otherwise go under.
And new publicly initiated economic development programs, from
high-speed rail
to the expansion of neighborhood health clinics, can be designed
and timed so as
to ease the transition for those dislocated workers. If there is
a legitimate
role for government in easing working people's pain in the
transition to a North
American Free Trade Agreement, or in the demilitarization of the
economy in the
wake of the Cold War, surely there is a legitimate role for
public policy in
helping workers to bridge the inevitable disruptions that any
investment-led
recovery program worth its salt would inevitably bring about.

Despite
the unwillingness of the time horizons project to investigate
the
contribution of public investment, it is easy to see an
overarching conclusion
emerging from the research. In the international competitiveness
race, we are up
against entirely different socioeconomic systems what
French political
economists would call fundamentally different "modes of
regulation."

The Cold War blinded us into imagining that the global contest
was between
capitalism and communism, as though all capitalist systems were
essentially
similar. Instead, it appears that companies are to a great extent
the products
of, and rely on, the supporting institutions of particular
national systems for
regulating the allocation of capital. Some of these systems
compete more
efficiently than others.

The U.S. may be able to copy some elements of these foreign
institutions. Of
course, Porter wisely warns us that such arrangements come in
complex bundles
and, anyway, the foreigners have their faults too, like their
putative
overcommitment to existing firms at the expense of new startups.
Nonetheless, we
Americans clearly face the need to overhaul our own native laws,
regulations,
institutions, and customs a task rather more daunting and complex
than picking
winners or increasing the savings rate. It is inconceivable that
such an
undertaking can proceed without the close cooperation of the
private and public
sectors, since the relevant rules are deeply rooted in both.
Porter has set a
fine example for his fellow economists by continuing the belated
rediscovery of
comparative institutions.
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