Larry Fink's Muddled Thoughts

Larry Fink, CEO of the world’s largest asset manager, has sent a letter to the CEOs of the 500 largest companies in the U.S. admonishing them for returning too much capital to shareholders.

The New York Times story on this tells us that Mr. Fink believes that such activity is detrimental to investors and the companies themselves. He believes that everyone is thinking too short-term, that we have become a “gambling society.”

Well, Mr. Fink is correct, there does exist a capital allocation problem in the world today. The problem is that Mr. Fink is chastising the wrong groups.

  

Investors and businesses alike have an incentive to maximize their own profits. When interest rates are set at zero, as they are today in the U.S. and below zero in much of the rest of the world, it is quite impossible to get these two groups to focus on the long-term.

  

When central banks peg rates at artificially low levels, two things will happen:

First, savings will fall. At artificially low interest rates, savers have less incentive to put off consumption.

Second, investment rates will naturally decline with the decrease in the savings rate. Also, the natural reaction of businesses to artificially low rates is to reduce investment. Since businesses will invest to the point where marginal cost equals marginal return, with interest rates set at zero, the marginal return on investment will also be zero. There is no incentive to invest. In fact, without savings, they couldn’t invest even if they wanted to.

This is why businesses want to return capital to shareholders. Business and people are reacting rationally to the interest rates forced upon them by central banks. There is no point to saving and investing if returns are set at zero. At an interest rate artificially set at zero, you will get neither savings nor investment.

Mr. Fink does not properly recognize who the culprit is in our live for today, gambling culture. It is the central banks that have created the mess. Everyone is forced to deal with the state planners and their arbitrary and foolish interest rate edicts.

Given that he doesn’t understand the problem, Mr. Fink moves on to proposing the wrong remedy.

Mr. Fink’s solution to our problem is to adjust the tax code. He wants to increase the tax rate on holdings of less than three years to the ordinary income tax rate, whereas today we tax holdings of longer than one year at a lower capital gains rate.

Mr. Fink states this, “would create a profound incentive for more long-term holdings and could be designed to be revenue neutral.”

It would do no such thing. Without a higher, market-based rate of interest, savings levels will be artificially low. Remember, if returns are set at zero, there will also be no income to tax. Taxes are not the driving factor here. If you want more investment, eliminate the Federal Reserve. Let the market determine rates.

The New York Times seems to believe that Mr. Fink’s asset management business has something to gain and little to lose via these suggested changes to tax policy, as they tend to hold investments for some time.

I suspect that Mr. Fink’s real concern is, or at least it should be, that his business is tremendously threatened by the choices that people and businesses are making today. Mr. Fink’s business is managing the savings of people and investing those savings in businesses. If there is no savings, and businesses liquidate, there will not be much for Mr. Fink or his employees to do in the future. Societal capital is being liquidated and Mr. Fink’s business is, therefore, under threat.

No one can rationally allocate capital in this environment. Savings and consumption patterns are being massively distorted by central bank interest rate policies. No one knows the real demand for their products, where they should be sourced from, where they should find the capital to produce them or if they should produce them at all.

Under such conditions, I am certain that corporate CEOs are paying too much to buyback their shares, but they feel forced into this situation because they know that returns on capital that they may invest in plant and equipment are guaranteed to earn zero. They are being as rational as possible given the information that they have been provided by the artificially driven financial markets. Additionally, the real capital, savings, required to increase investment does not exist. Even if executives were to heed Mr. Fink's plea, they couldn't comply.

They think their current cap rate on share buybacks is maybe 3%, and this far exceeds the zero percent that they will earn if they reinvest in their businesses. Share repurchases also push share prices up, and this is not something that too many shareholders, other than Mr. Fink, complain about. Unfortunately, the three percent is also overstated since they will certainly see returns fall in the future as they continue to liquidate their businesses. In the minds of CEOs this is a problem for tomorrow, however.

Central banks have created quite a mess, and tax policy cannot fix it. There can be no rational capital allocation or an increase in the amount of savings and investment as the interest rate required to produce such a result is being massively suppressed by the central banks.

Disclaimer: Nothing on this site should be construed as investment advice. It is all merely the opinion of the author.