America’s giant companies are getting too big, say two professors of finance. After businesses grow beyond a certain size, financial concentration slows investments, which can be a drag on economic growth.
‘Financial concentration’ refers to the dominance of a relatively small number of large firms within an industry or the economy.
Professors Daniel Neuhann and Michael Sockin, from the McCombs School of Business, University of Texas at Austin, wrote about their study and findings in the peer-reviewed Journal of Financial Economics (citation below).
Giant Companies Slow GDP Growth
For the last couple of decades, the US economy has not been running on full throttle, according to several recent studies. This means that businesses have invested a small proportion of their profits into boosting production.
Some economists say that this led to slow growth during most of the past two decades. Over the past twenty years, US gross domestic product (GDP) has grown at an average rate of 2.2% per year, compared to the previous twenty years, when it grew by 3.2% —a full percentage point higher.
Some analysts point to a lack of good investment opportunities as the main culprit. This new study, however, suggests that companies are getting too big. Their sheer size gives them incentives to hoard their profits instead of investing them productively.
Prof. Sockin said:
“If you look at how much of an industry the top 10 firms command, in terms of sales and in terms of assets, industries have become much more concentrated. There are fewer firms, and they’re much larger than they were before.”
In US banking, Prof. Sockin explains, the ‘big four’ hold 53% if total assets. This level of concentration has resulted in a misallocation of capital. As a consequence, businesses fail to direct funds toward their most productive uses, such as investing in research and development or purchasing new equipment.
‘Misallocation of capital’ refers to the inefficient distribution of financial resources, where funds are not directed toward their most productive or beneficial uses.
Prof. Neuhann added:
“When this happens, we become less productive. While we do not consider wages and employment in our paper, it is natural that less productive businesses also pay lower wages and employ fewer workers. This means that overall economic welfare is worse.”
Market Concentration Suppresses Borrowing and Growth
The new study grew partly out of a mystery that economists have been wondering about for years: Why did it take so long for the US economy to recover from the Great Recession of 2007-2009? It wasn’t until 2016 that the unemployment rate returned to its pre-recession levels.
The slow recovery occurred despite the Federal Reserve (Fed) holding interest rates near zero for several years in an attempt to encourage borrowing and investment. However, large corporations did not borrow or invest more.
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Apple Inc.
During that time, giant companies accumulated significant cash reserves. Apple’s financial arm, for example, managed $244 billion, with nearly two-thirds invested in bonds from other companies instead of funding its own operations.
According to the researchers, this was due to concentration. When a large company wants a huge loan, banks tend to increase interest rates. The company, therefore, decides to borrow less than it wants in order to get a lower interest rate.
Prof. Sockin said:
“If a company wants to borrow $100 million, it may be more effective for them to only borrow $85 or $90 million at a more favorable rate. Essentially, they make money by borrowing at the cheaper rate.”
From the company’s perspective, paying off debt saves more on interest than investing additional funds in its operations would earn, Prof. Sockin explained.
However, from the broader economic perspective, if companies don’t borrow sufficiently and lenders hesitate to lend, capital fails to flow to where it’s most needed.
Prof. Neuhann said:
“If Apple doesn’t want to move too much of its money, then Apple will hold too much cash,” Neuhann says. “Meanwhile, another firm has too little capital to take advantage of its opportunities. Overall, both invest too little to have a positive impact on the economy.”
Contrasting Recoveries: Lessons from Economic Shifts
Profs Neuhann and Sockin created a model and fed economic data from 2002 into it to test their theory about size and misallocation.
Their model accurately predicted a range of economic indicators 14 years later, following the recession. Despite borrowing costs being lower, companies were investing less:
- Interest rates in 2016 were 1.1% lower than in 2002.
- Overall, company investments decreased by 0.6%.
Prof. Sockin said:
“It describes the half decade after the Great Recession, when interest rates were low, but the economy was not recovering very fast.”
After the 2020 COVID-19 pandemic recession, the opposite occurred, he noted. The US government provided $2.1 trillion in stimulus, which got the economy back up to speed rapidly.
Prof. Sockin said:
“In the absence of that stimulus, our model would predict that there would have been much less lending, much less borrowing, and we probably would have had a much more anemic recovery.”
When markets become too concentrated or giant companies dominate the marketplace, he explained, they undermine economic growth. When times are hard, the federal government may need to invest where the private sector won’t.
Prof. Sockin said:
“Capital moves very freely when times are good, and it moves very poorly when times are not. But that’s exactly when you want capital moving the most.
“Government intervention is important in bad times to help financial markets function properly, because they’re not going to do it as well on their own. That’s especially true when your economy is driven by a relatively small number of large firms.”
Citation
Neuhann, D., & Sockin, M. (2024). Financial market concentration and misallocation. Journal of Financial Economics, 159, 103875. https://doi.org/10.1016/j.jfineco.2024.103875