Around 1980, the U.S. economy took a dramatic and dangerous turn. From the end of World War II until the late 1970s, wages advanced roughly in parallel with productivity. As workers got more productive, companies got more profitable, and they paid their workers more. The split between the haves and the have-nots was relatively stable. Most people – at least most white, male people – had confidence that the rising tide of our economy would lift all boats.
But in the 1980s the growth in productivity diverged from the growth in wages. Since the Great Recession, worker earnings have flat-lined, while corporate profits have soared. Nearly all the recent productivity gains have gone to the wealthiest 0.1 percent of the population.
The divergence has been attributed to globalization and the growing importance of technological skills. But
recent research by William Lazonick, published in the Harvard Business Review points out a crucial but often-overlooked cause: Corporate share buybacks.
A share buyback is a transaction in which a company buys a large amount of its own shares of stock. This purchase makes the company look more profitable because whatever the company made in profit is now divided into a smaller number of shares of its stock. Profits per share go up. Other things being equal, the price of each share goes up, enriching those who hold them.
Share buybacks have become a huge part of the economy, and a huge drain on corporate cash. Lazonick looked at the prevalence of buybacks in the Standard and Poor's 500 index between 2003 and 2012. Roughly 54 percent of all the money earned by companies in this index was spent to repurchase shares. Another 37 percent of earnings was distributed in dividends. That left only 9 percent of earnings to reinvest in the business! No wonder many American companies are losing their edge to companies in China and elsewhere.
Why have share buybacks become so popular among boards and CEOs? It’s simply a matter of how CEOs are paid. Many CEOs and senior executives derive much their income from grants of stock or options. As a result, share buybacks are the quickest, easiest and safest thing they can do to give themselves a raise. Moreover, since most board members are given stock, share buybacks are the quickest, easiest and safest way for board members to pay themselves more for their service.
While buybacks are lucrative for the CEO and board, they are bad for the company as a whole, its employees and other stakeholders and the economy. The company suffers because there is so little money left over after buybacks to reinvest in the business. The company could have spent that money on research, marketing, staff development and more. Or it could have made strategic acquisitions, buying companies that offer synergies. Lazonick points out that Exxon Mobil Corp. spends $21 billion a year on buybacks but virtually nothing on alternative energy research. It’s hard to argue that this is in the best interest of the company or its stakeholders.
Companies also suffer because share buybacks motivate the CEO to pursue the wrong goals. CEOs should be rewarded for innovation and leadership that creates new value. Not for concentrating the existing value in fewer and fewer hands. A trained monkey could do that.
But there’s more. As companies spend funds for share buybacks, there is less available for other stakeholders. There is less available for employee compensation, benefits and development. There is less available to reinvest in the community and local improvements. There is less available to improve work processes that are environmentally sound but not immediately lucrative – for instance, a cattle business that could use some of its profits to stop the damaging use of antibiotics to make livestock grow faster.
Solving the problem won’t be easy, and the solution starts with executive compensation. Change someone’s compensation structure and their behavior changes. Right now, executives are incented to get the stock price up by any means available. If CEOs were rewarded only for stock price gains in excess of the earnings growth generated by buybacks, the problem would be solved. A prescient board could take this step without any changes in regulations or tax law.
Going further, Lazonick outlines several focused regulatory actions and tax changes that would cut the incentive for buybacks and force companies to be more transparent about their stock purchases. Buybacks have grown by stealth over the past thirty years as key Depression-era rules were relaxed one by one. These rules can be reinstated if we ever get a Securities and Exchange Commission with enough backbone, or a Congress that can legislate.
Corporate stock buybacks are one of the biggest threats to a sustainable economy. It is time to rein them in. That starts with rewarding senior executives only when they create value and not rewarding them simply for moving it around.
David Brodwin is a Co-founder and board member of American Sustainable Business Council. This article appeared in U.S. News & World Report October 3, 2014.