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Andrew Lilico

Andrew Lilico: Why are companies sitting on their cash?

One of the current policy puzzles is why companies are sitting on large cash balances instead of investing them as the government hoped they would.  Indeed, some in the government appear now to hope to apply moral pressure on companies to invest, as if they were letting the side down by not investing.

Let us ponder a few reasons companies might prefer to hold cash.

1. Cash solves problems.  We all know from our personal lives that if emergencies arise, if things don't go as we had hoped, or if there are good surprises, problems are much easier to cope with - indeed, can sometimes be turned into pleasant adventures or new opportunities rather than unhappy episodes - if we have cash available.  The same is true for companies.  Things that might go wrong can be turned into things that go right, disasters can be averted, challenging situations survived without long-term damage, if a company has cash.  When the risk of problems is greater, the benefits of holding more cash increases.

This applies to small problems.  It also applies to big ones.  If the Eurozone were to collapse and/or there were to be widespread banking sector collapses, companies that can purchase with cash may have considerable advantages over, for example, those relying upon normal trade credit (thirty day invoicing etc.).  The collapse of trade credit was important to the collapse of a number of enterprises in late 2008 / early 2009.  Companies will not want to be in that situation themselves in the future.

2. Cash is better than available credit.  Problem-solving cash can sometimes be obtained at relatively little expense through available credit - the business equivalent of "slapping it on the credit card".  But if we fear that banks may withdraw credit availability, or that in order to secure credit we will have to agree to burdensome and invasive inspection (and curtailment) of our activities, or if we lack confidence that the bank itself will be able to provide credit in precisely those circumstances we when have most need of it (because the same economic conditions that would create our cash need would also create a cash shortage for the bank itself), we will rely less upon available credit and more upon brute cash.

Now, if we feared that if a bank were unable to provide credit then it might also be unable to grant us access to our deposits - e.g. because the bank failed - we might be less willing to hold cash.  That is one of the interesting perverse effects of the unlimited guarantee of deposits.  Policymakers believe that by guaranteeing deposits they ensure business continuity, but they fail to note that at the same time they increase the incentives for businesses to hold cash instead of investing.

3. Cash allows the purchase of distressed assets.  If your rivals' businesses collapse, their assets may become available at low prices, if you have cash available to buy them.  More generally, if stock prices might fall dramatically at any time, the value of holding cash available to take advantage of market lows becomes greater.

Closely related to this is the point that cash is a deflation hedge.  In other words, if prices fall dramatically, either across the board or for goods and services you might want to buy, you will benefit from holding cash.

4. There is great uncertainty regarding where it is most productive to invest.  The Nobel laureate economist Robert E Lucas jnr likes to emphasize that although it is common to observe that a recession is a good time for governments to invest because capital and labour are cheap, that is also true of the private sector (indeed, many of the world's largest companies were founded during depressions), yet it often does not invest at that time.  A key reason it does not do so is that, although capital and labour are cheap, there is also great uncertainty as to what it is actually valuable to expend labour and capital upon.  It is all too easy to invest in projects that will be loss-making because economic conditions will change dramatically.  One builds a shop selling outdoor jackets for agricultural workers picking squashes, only to discover that the squashes are all pulled up and the fields turned over to dairy.  One builds a power grid to service a town on the east coast, only to discover that the pattern of trade changes dramatically and half the town moves away to a new growing town on the west coast.  To be sure, the right investment will make a great deal of money - if you had managed to invest in that west coast town you would have done well.  But uncertainty is also very high.

The problem is particularly problematic with investments that are irreversible and not easily scaled (e.g. one can't invest at a small scale and then build up).  In such cases, uncertainty can interact with what is known as the "option to wait".  (For more detail see here, Chapter 9.)  The option to wait, under conditions of uncertainty, can mean that investments become delayed whilst businesses await the resolution of uncertainty, unless rates of return rise rapidly.

Government interventions will tend to exacerbate the above issues.  Government interventions, such as bailouts of companies going bust, prevent rates of return rising rapidly, which in turn will tend to retard investment by meaning hurdle rates of return are not exceeded for investment projects.  Governments promise/threaten grand plans for new investment or grand new regulatory programmes.  Until these are actually delivered they create hotspots of threatened structural change and other uncertainty, deterring investment.  Interventions to prevent banks going bust both increase the short-term security of deposits (making holding cash more secure) and damage the provision of credit (because new banks that would enter if old banks went bust would be able to provide more reliable credit facilities than existing banks propped up by government intervention).  Fiscal injections and other such policies that delay industrial shake-outs that are ultimately inevitable mean that firms hold their cash, awaiting the opportunity to purchase distressed assets.

These are not easy matters to resolve.  If the government were to credibly threaten that inflation would rise rapidly in a few months' time, firms would have strong incentivies to convert their cash into real assets (i.e. to invest) as an inflation hedge.  Governments can also avoid grandiloquent vague promises of growth plans that they have neither the capacity nor the will nor the insight to deliver.  Governments can try to limit other exacerbating interventions such as bailouts or deposit guarantees.

But by and large government cannot do much good in this area, beyond limiting its harm.  It's mainly a matter of getting other things as good as it can (e.g. having credible fiscal consolidation plans), avoiding submitting to the inevitable pressure to tinker (comprehending that almost all tinkering will make things even worse) and, as a textspeak version of Churchill would surely put it, to "KBO".


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