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Robert Samuelson

Cautious Capitalists

By Robert J. Samuelson
Wednesday, December 22, 2004; Page A27

President Bush called an "economic summit" last week, but of course the economy will do its own thing without necessarily heeding what Bush wants. To those wondering how it will actually behave in 2005, here are a few instructive facts: Since their recent low in late 2001, after-tax corporate profits have surged by more than 70 percent; but business investment -- in new computers, software, machinery and buildings -- has revived only modestly, increasing about 18 percent.

Capitalism isn't supposed to work this way. Soaring profits usually signal new investment opportunities and provide the cash to exploit them. Indisputably, cash is plentiful. Since 2001 corporate cash flow is up 42 percent and is now running at a record rate of $1.3 trillion annually (cash flow is essentially the sum of undistributed profits and depreciation -- depreciation being a non-cash expense to reflect the obsolescence of existing plants and equipment). But companies aren't aggressively deploying all that money in new products, factories or markets.

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The disconnect reflects a sea change in corporate psychology. Call it the return of "risk aversion" -- a fancy phrase for caution. In the late 1990s, the idea of risk virtually vanished. The business cycle was dead; stocks would always rise; globalization was good; the Internet was empowering; CEOs were heroes. Anybody could do anything. Not to worry. Now risk has revived with a vengeance.

Executives often blame their new caution on the Sarbanes-Oxley Act, the federal law requiring companies to maintain stricter financial controls over their operations. Complying with the law is so time-consuming (it's said) that it's hard to concentrate on new business opportunities. At best this is a self-serving half-truth. The larger truth is that America's corporate elite has been scarred by the tech "bubble"; the recession; the Sept. 11, 2001, attacks, and corporate scandals. Everything has changed. The business cycle endures; stocks fall; globalization is hazardous (i.e. terrorism and high oil prices); the Internet is unnerving; CEOs are felons.

Greater profitability does not, in this climate, automatically become a springboard for action. Companies are not entirely immobilized. But there are higher hurdles, both psychologically and financially, for undertaking new expansions or hiring lots of new workers. "Businesses just love these [profit] margins," says Mark Zandi of Economy.com. "They're not going to sacrifice margins" with risky new investments. In the past year after-tax profits represented 7.7 percent of national income, Zandi reports; that's the highest since 1965.

One way to guard profit margins is to merge with competitors, striving for cost savings and more market power. See, for example, the recent $35 billion merger between phone companies Sprint and Nextel and the $10.3 billion merger of the software firms Oracle and PeopleSoft. Companies can also pay out some of their cash in higher dividends or simply hoard it. They've done both.

In 2004 dividends of companies in the Standard & Poor's 500 index will total $185 billion, up from $161 billion in 2003, says S&P's Howard Silverblatt. And the 2004 figures exclude Microsoft's one-time special dividend of $32 billion. Even more stunning are cash levels (meaning money invested in bank deposits or short-term securities). For S&P's industrial companies, cash now totals about $592 billion, says Silverblatt. At the end of 1999 the comparable figure was $260 billion. Some high-tech firms are especially flush: Dell has $8.3 billion; Intel, $15.8 billion, and Microsoft, $24.7 billion. Companies are stockpiling against future setbacks, opportunities or both.

There are two ways to look at the new "risk aversion." One is that it's healthy. Everyone realizes that the wild spending of the late 1990s was wasteful. Why invest more when many industries still have surplus capacity? (Note: In November the Federal Reserve's capacity utilization index stood at 77.6, well below the 81.1 average from 1972 to 2003.) Companies also want to make better use of existing computers and software before buying more. This, too, makes sense. The economy may benefit from corporate caution. A slow rise in business investment spending sustains the recovery without promoting inflation or speculation.

The other possibility is that it's a potential calamity. It sacrifices future growth for present profits and leaves the recovery too dependent on strong consumer spending. In the past year average home prices have risen 13 percent. Suppose there's a real estate "bubble" that, once popped, depresses consumer confidence and spending. Indeed, if the recovery stumbles for any reason, corporate caution could quickly make matters worse. Companies might react by cutting new hiring and investments. The slowdown would feed on itself.

Of these possibilities, conventional wisdom favors the first. In 2005 the economy is expected to continue a solid if unspectacular advance. In reality we don't know. Psychology is much underrated as an economic driving force, precisely because it's so hard to measure. In the late 1990s the prevailing euphoria became self-fulfilling -- disastrously so. Now corporate caution could become self-fulfilling in the opposite way. That's not a certainty, but it is a risk.

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