The Economic Cycle That Just Won’t End-by John Rekenthaler
The National Bureau of Economic Research measures the current economic expansion at 111 months and counting. The current period is the second-longest expansion of NBER’s 160-year history, behind only the 1991-2001 boom. That both events are recent is no accident. Of the 34 expansions chronicled by NBER, the past four are each among the six lengthiest.
(The two others occurred during World War II and in the 1960s, making them also relatively modern.)
Some would say this comes from better governance. Others disagree, lamenting the passing of the gold standard, or regularly bemoaning the Federal Reserve’s decisions. I cannot adjudicate such claims. My central-banking knowledge could fit on the back of a large postage stamp, while remaining legible. But I do know that today’s business cycles are longer and calmer, and that regardless of macroeconomic issues, corporate behavior has played a major role in the change.
Corporate executives, as with the rest of us, are products of their times. Their decisions are affected by how other executives behave, what Wall Street advocates, and counsel from the leading business schools. As those influences shift, so do their habits. And those influences have definitely shifted.
A major catalyst was the doctrine of maximizing shareholder value, traditionally credited to Milton Friedman, in 1970. (Friedman, of course, was hardly the first to maintain that a CEO’s duty was to increase the price of his company’s stock, but he did so prominently and forcefully.) Friedman was concerned with a company’s social responsibilities, which, he maintained, should not exist. Its sole duty was to boost the value of its shareholders’ equity investments.
Despite some counterattacks, including from Friedman’s own university, the approach has become mainstream for U.S. businesses. In doing so, it has expanded beyond its original boundaries. Friedman advocated that corporations pursue the highest possible profits, but he did not specify in his shareholder-value doctrine how that would be accomplished. Those items came later, from other parties, who wrapped their recommendations with the name of Friedman.
Chief among these has been the admonition against “empire-building.”
All things being equal, CEOs would prefer to run large companies rather than small ones. They would rather hire employees than fire them; purchase rival firms rather than sell to them; offer more products rather than fewer. Who doesn’t wish to be Alexander the Great? Besides, the pay is generally better. The principle of shareholder value strives to make those all things not equal. By attaching executive compensation to share prices, rather than to imperial characteristics (for example, revenue or employee head count), it rewards executive decisions that raise stock-market prices. And, critically, punishes those who do not.
Sticks and Stones
The key lies in the follow-through. Mere words will not break a CEO’s bones, but sticks and stones certainly will. (Metaphorically speaking, of course.) Professional investors aren’t disinterested parties; they have money to wield. When they follow their criticism by selling the shares of the companies that strike them as having been extravagant, the threat becomes real. That company’s stock price declines, the CEO is chastened, and the example has been set for others.
Thus have corporate managements been trained. The process has been gradual, but persistent, and has gained strength with each new economic cycle. By 2009, the distrust of overspending was applied to all aspects of a company’s business. In this cycle, acquisitions, internal development, and new-share issuance have all been skeptically met. Conversely, firms that cut their payrolls and/or repurchased their stock have been praised.
Slow but Steady
This collective corporate caution has depressed employment growth. Traditionally, companies hired first when the economy burst out of recession, then asked questions later. Managements were horrified at the possibility of losing market share, because they weren’t staffed to service the business. Not anymore. Better to play catch-up than to overstaff.
Slower employment growth means slower wage growth. Workers who know that if they leave a firm it can readily replace them, have little bargaining power. Their demands will be modest, as will be their raises. Slower wage growth permits corporate managements to keep tight control of their cost structures, such that even a moderate increase in orders can lead to sharply rising profits.
This situation, clearly, is more sustainable than with earlier business cycles, which were marked by frenetic hiring, rapidly developing wage pressures, inflationary upticks, spiking interest rates, and a sudden return to economic Earth, as higher interest rates choked off business activity, and sent the boom back to bust. Gradual economic recoveries disappoint labor–but they benefit capital.
I should not overstate the case. The doctrine of shareholder value is far from the only innovation to lengthen the business cycle. That the U.S. economy has evolved from manufacturing to services matters, as has the invention of just-in-time supply chains. Managing customer demand has become easier–or, at least, different–and the tools for doing so have become stronger.
Also important is that American industry has become more concentrated, and therefore less competitive. How much this owes to technological changes, as opposed to government forces, is an open debate. (Those who argue the former point out that Amazon.com‘s AMZN business is easier to protect than, say, that of a commodity steel provider, while those who argue the latter fault the Department of Justice for failing to enforce antitrust statutes.) But there is no quarrel about the fact.
None of this means that the business cycle has been repealed. Eventually, as has recently occurred, full employment is reached, and wage pressures begin in earnest. In addition, companies assume more risk, just when less risk is required. After a long economic expansion, their cautious leaders have been chased out, replaced by the aggressors. That pro-cyclical tendency can be managed, perhaps, but not eliminated.
I do think it likely, however, that after the next economic trough is reached, that the ensuing expansion will once again be lengthy. The current cycle’s behavior is no fluke. It owes to deep underlying forces that took many decades to develop, and which will require many to unwind.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.