Follow The Money

Last week I introduced the phenomenal, yet unnoticed, rise of institutional cash pools – it’s like a mountain erupting in Holland while geographers remain unaware.  But to understand this phenomenon we need to get into the detail of what they are.

I briefly defined them last week as large holdings of “cash” by groups of institutions.  This could be:

  1. The short-term “cash” balances of global corporations
  2. The cash balances of institutional investors such as asset managers and securities lenders
  3. The foreign exchange reserves of central banks

For now, I’m going to focus just on the first of these (shown in yellow on last week’s bar graph), as this is most relevant to the ideas unfolding in the blog.

This is probably the source of the name “institutional cash pool”.  Cash pooling is a service offered by banks to large corporate clients.  These corporations exist in groups of companies, each with their own accounting.  But banks offer the service to treat their separate accounts as if they were one account – the “pool”.  This has two benefits.

First of all, no business, big or small, wants to be sitting on large holdings of cash, they want to put those funds to use making more money for the business.  But at the same time, they don’t want to go overdrawn and incur fees or be left with cash flow problems, so they need to keep a buffer in the bank.  Cash pooling enables a single “buffer” to be used across the whole group of companies – if one account goes overdrawn it is automatically covered by the balances in the other accounts.

Secondly, and more significantly, a larger pool of cash opens up a broader range of investment opportunities (using investment in its everyday, not its economic, meaning).  Such pools will diversify their risk through a range of different financial assets.

And here we get to the nub of the issue.  Deposit insurance only covers accounts up to $250,000.  If a group of companies has in excess of $1bn dollars this insurance is an irrelevantly small amount – if the bank goes bankrupt they lose the vast majority of their deposit.  And hence leaving such funding in the bank is a massive credit risk.  Therefore companies are looking for short-term assets that offer some degree of security.  For example, short-term government bonds or treasury bills would be considered ultra-safe assets – the company is guaranteed to have access to its cash when its funds mature.  As cash pools have grown, there are just not enough safe, short-term assets around, something we will get onto next week.

Another reason for the growth in corporate cash pools is tax avoidance.  Much was made in the news last year of Apple having $750,000bn in offshore “cash”.  Most news outlets reported this as if it was money in the bank.  It wasn’t, it was mainly stored in short-term bonds.  It is a perfect example of a cash pool.  However, even while it held money off shore, Apple was borrowing in the US.  The interest rate on the borrowing would definitely be greater than the yield earnt on its offshore investments, so why didn’t it just use its offshore cash instead of borrowing?

The answer is tax avoidance.  To use the cash, the company had to bring it into the US, where they would be taxed on these profits.  It was cheaper to borrow to meet its funding needs in the US than to pay that tax.  So they just sat on this cash, wondering what to do with it, leaving it in short-term bonds that represented not a good (i.e a productive) investment opportunity, but a safe store of cash.

And we need to clarify this term “cash” in cash pools.  The literal meaning of cash is currency in physical form – that is, notes and coins.  But in accounting it is used to mean bank accounts or any other form of asset that can quickly be turned into physical cash.  Obviously, none of these cash pools are keeping their money as physical cash, but nor are they in bank deposits either for the security reasons mentioned earlier.  This “cash” is all invested in short-term financial assets.

These assets have to be ones that they can be liquidated (i.e. sold for spendable bank deposits) very quickly and with as little risk as possible.  The owners of the pools want to ensure they have quick access to their funds – they are treating these assets as a form of cash. Pozsar has a very interesting discussion of this hierarchy of money in his 2014 paper for the Department of the Treasury.  He points out that traditional measures of the money supply (known as M0, M1, M2 etc) only include physical cash and different types of bank deposits.  But these huge “cash” pools – collectively dwarfing in size most national economies – won’t touch these.  For them, as Pozsar puts it, “money begins where M2 ends“.

But where do they get all this cash from?  The answer is in a very long post 5 weeks ago, in which I went through a set of business accounts in forensic detail – it’s the old adage “follow the money”. In summary, what I showed was:

  1. A firm’s annual profit is calculated by deducting costs from revenue, but those costs do not include investment expenditure (fixed capital and increases in inventory).
  2. That profit is either distributed to shareholders or retained by the business.  By definition, the undistributed profits are business saving.
  3. The undistributed profit becomes income on the firm’s capital account, where investment spending is recorded.  Hence, we can see business saving as a natural source of investment funding.
  4. The last entry in the accounts, at the bottom of the expenditure side of the capital account, is “increase in bank balance”.

That increase in bank balance is, quite simply, the short-term “cash” balances of global corporations that we are exploring this week – no longer bank balances, they are holdings of short-term assets.  Part of the growth of institutional cash pools is the rise in these balances – a four-fold rise in 20 years.  And these balances are rising so dramatically because of the equally dramatic growth in the proportion of GDP income going to profits rather than wages, as shown 2 weeks ago.

Why are global corporations holding onto this “cash” and not re-investing it in their own businesses?  This seems to go far beyond the need for a cash “buffer” explained above?  Well, first of all, the cash buffers of global corporations have to on the scale of the global economy.  The fact that they are looking for short-term assets implies that they do in fact want to keep access to this cash, and not tie it up in long-term investments.  But another factor is tax avoidance, as noted above.  Another factor, much discussed in the literature around declining investment expenditure, is the lack of opportunities for such investment spending.  The modern economy depends less on factories and machines and more on microchips and the knowledge of how to use them (for accounting reasons, research and development is not recorded as investment expenditure) – it may be that these corporations just don’t know what to do with all their cash!

Whatever the reason, multi-national corporations are sitting on ever-growing cash balances of global significance.  The logic of business accounting summarised earlier would be that these balances should be reinvested in these companies.  Is the failure to do so part of the explanation for the decline in investment that is behind the decline in productivity (the central them of the last section of the blog)?

Clearly I think this is part of the explanation, or I wouldn’t have spent so much time on all this.  But free-market economics argues that if a company can amass such vast profits, other firms should step into the market to take advantage of these profit-making opportunities, driving down prices.  And clearly Apple could afford to charge a lot less for its products, and more importantly pay a lot more to the workers in its supply chain.  What is going wrong here?

These are all valid observations, but jumping to conclusions without examining the detail will always lead to flawed conclusions (this explains your opinions, those of everyone you know, every politician, and every journalist, when it comes to the economy – sorry, I didn’t mean to say that out loud).

What we have established this week is that the rise of institutional cash pools has created a massive demand for short-term, safe financial assets.  Next week we will look at the tremendous, distorting impact that this has had on financial markets.

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