Where Private Investment Fails



  • Michael Porter, "Capital Choices: Changing the Way America Invests in Industry," Council on Competitiveness, 1992.


  • Michael Porter, ed.,"Time Horizons of American Industry" (18 pages from the Council on Competitiveness and Harvard Business School, Distributed by HBS June 1992).


  • Paul DiMaggio and Walter W. Powell, eds. The New Institutionalism in Organizational Analysis (University of Chicago Press, 1991).


  • Mark Granovetter, "Economic Action And Social Structure: A Theory of Embeddedness," American Journal of Sociology, 91 (1985).


  • Robert Hayes and William Abernathy, "Managing Our Way to Economic Decline," Harvard Business Review, July-August 1980.


  • Michael T. Jacobs, Short-Term America: The Causes and Cures of Our Business Myopia (Harvard Business School Press, 1991).


  • Michael Porter, The Competitive Advantage of Nations (BasicBooks, 1990).


  • Walter W. Powell, "Neither Market Nor Hieararchy: Network Forms of Organization," in Research in Organizational Behavior, 12, 1990.


  • Robert B. Reich, The Next American Frontier.(Times Books, 1983).
  • Lester C. Thurow, Head to Head (Morrow, 1992).


  • Oliver E. Williamson, The Economic Institutions of Capitalism (Free Press, 1985).


To hear it from the White House, the U.S. experienced a recession in 1990 after eight years of extraordinary economic growth, and is still doing "pretty well" even now. True, admits President Bush, the current recovery is less bullish than he would wish (read: the most sluggish recovery since the 1930s). But if we just give it, and him, more time, and perhaps help it (him) along with a dose of stimulation via cuts in the capital-gains tax and via Congressional approval of his North American Free Trade Agreement with Mexico, everything will be fine. Just get government out of the way, and private investment will save us.

Not likely. Even in absolute dollar terms, growth in real domestic non-residential private investment, net of depreciation, flattened in 1973 (see chart). Since then, movement in this key indicator of private sector willingness to purchase new industrial, commercial, and office plant, equipment, and buildings has been entirely cyclical. The strong investment growth of the 1960s is now a distant memory.

According to new data from the Bureau of Economic Analysis in the U.S. Department of Commerce, in 1965 net capital formation constituted 10.4 percent of net domestic product (NDP). By 1991, it had fallen to just 3.4 percent. Since the late 1980s, private investment as a share of NDP has been rising in Japan, the U.K., and, more recently, Germany. But in America, it continues to sink like a stone.

On news broadcasts, in newspapers, and at congressional hearings, conventional economists purveying conventional wisdom repeat one particular explanation for the collapse of U.S. private domestic investment: low public and private savings, made even lower by the now chronic federal budget deficit. To end this "crowding out" problem, the story goes, we need to deflate the economy. When the deficit falls, savings rates will rise; long-term interest rates will fall, and investors will borrow money again to finance the building of new plant and equipment. This is a strictly macroeconomic tale, and in the primacy it awards to savings behavior, it is really a warmed-over, pre-Keynesian, pre-1930s macroeconomics.

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In fact, the mainstream assessment of where we have been, and how far private investment is capable of taking us, is plain wrong. Now, however, help in setting the record straight has come from a most unexpected place: the Harvard Business School. Eighteen new research papers known as the "time horizons project," including a synthesis by business strategist Michael Porter, are reintroducing a healthy institutional realism into the debate about why America's private companies chronically underinvest in projects lacking a short-term payoff and why (when they do spend) they tend to invest in projects that, taken together, retard long-run economic growth.

Partly a cogent restatement of older institutionalist themes, partly an effort to quantify important but hitherto elusive concepts, Porter & Co.'s time horizons project has produced the most comprehensive picture so far of why you can't make sense of private investment behavior without paying attention to the institutional details. Even with its glaring omissions especially when it comes to exploring the interdependence between private and public investment the Porter report may well be the most thoughtful, systematic analysis of interrelationships between capital markets and the big corporations at the core of American capitalism since, well, since the work of Porter's Harvard elders: John Kenneth Galbraith and Alfred D. Chandler, Jr.

The twenty-five economists, finance experts, business historians, and industrial relations specialists who participated in the time horizons project argue that Germany and Japan inherited from their own past, and then refined after World War II, a coherent set of institutional arrangements that systematically favor the long-term growth and survival of their companies over short-term monetary earnings. In one of the project's most important papers, Harvard economist Lawrence Summers and MIT's James Poterba present the results of their interviews with a large sample of Japanese, American, and European CEOs. They find that U.S. investors tend to demand much higher minimum acceptable rates of return for their capital so-called "hurdle rates" than their foreign competitors do. In recent years, investors here have been rejecting projects with expected inflation-adjusted payoff below 12 percent even though the recent real cost of debt has averaged only about 2 percent and the real cost of equity about 7 percent. Moreover, where a healthy share of the research and development portfolios of foreign corporations include explicitly long-term projects (47 percent for the Japanese companies studied, 61 percent for the Germans), only one out of five projects being undertaken by U.S. companies could be classified as long-term.

As a result, U.S. corporations are underfunding projects that could eventually create lasting employment, profits, and opportunities for experimenting with new technologies and new forms of production organization. In their place, Americans invest disproportionately in real estate and unrelated acquisitions which, as another Harvard economist, F. M. Scherer, has shown, have generally been poor performers in the marketplace. Such portfolio investments may generate short-term earnings, but they do not add to the net stock of real productive capital in an economy. In Porter's words, they merely involve the "trading of assets from one owner to another." Moreover, as we now know, the massive borrowing in the 1980s to finance all of this essentially unproductive activity drove up debt-to-equity ratios to the point where, even in the present cyclical recovery, investors are still reluctant to open their wallets one reason why the present macroeconomic recovery has been so anemic.

What makes this project, co-sponsored by the "real" Council on Competitiveness, so surprising is its conclusion: real capital formation in the U.S. since the 1960s has been distorted by the rules, procedures, and customs governing private-sector allocation of capital rather than by profligate government spending or the overregulation of business as the "other" Council on Competitiveness the one chaired by Vice President Quayle alleges.

In the belief that the global competitiveness of U.S.-based companies can be enhanced by obliterating bothersome regulations, Quayle's Council on Competitiveness ferrets out and dismantles health, safety, environmental, and other regulations that increase the "cost of doing business." That most of the nations with whom we compete usually have even more stringent standards than ours, especially regarding workplace conditions, either goes unnoticed by the Quayle council or is deliberately ignored.

Far more compelling is the work of the other Council on Competitiveness, located a few blocks from the White House. This council, once a creation of the Reagan administration, went private when the White House ignored its findings. Its work on the real competitiveness problems of American business is directed by chief executive officers and other senior executives from Motorola, Hewlett-Packard, and other private firms, labor leaders, presidents of MIT, Stanford, and other universities, and directors of the national laboratories. In six short years it has produced an impressive number of reports, seminars, newsletters, and congressional testimony such as the eighteen papers that constitute the time horizons project.

In this new project, Porter's institutional sensibilities lead him to play down, without wholly rejecting, the conventional macroeconomic wisdom about the responsibility of excessive taxation and extravagant federal deficits for the high long-term cost of capital, which supposedly suppresses long-term investment. Porter, like the usual suspects, wants to understand why the cost of capital has been relatively higher, at least until recently, in the U.S. than elsewhere in the industrialized world. But for his answers, he looks to the institutional structure of contemporary capital markets, rather than to macroeconomic aggregates.



Institutionalism Redux

In the second half of this century, mainstream economics has given ever shorter shrift to the role of institutions in explaining the economic behavior of buyers and sellers, bosses and workers, investors and managers, public officials, and citizens.

In particular, the idea that markets in different countries especially capital markets might operate according to qualitatively different rules and norms, and present economic actors with different sets of choices and trade-offs, has been treated as either uninteresting or unfathomable. After all, we were told in Economics 101 that the very process of competition via the free movement of "inputs and outputs" across regional and national borders would, over time, erase lingering institutional differences that might be of any consequence to business. Relative prices and resource endowments two sides of the same coin, really were what mattered, not rules, institutions, or norms. That was just the stuff of "sociology" or, worse yet, "politics."

No wonder, then, that conventional economic thinking has not had much luck explaining why so many U.S. corporations, compared with their Japanese and German counterparts, systematically underinvest in ventures that lack a near-term payoff, avoid retooling and upgrading "mature" industries, shy away from risky research and development, and underinvest in the lifetime training and education of employees or in the development of long-term, collaborative relationships with suppliers and customers.

On the other hand, over the course of the last fifteen years, "new institutionalists" from MIT's Lester Thurow to Harvard's Robert Reich, Robert Hayes, and the late William Abernathy have repeatedly sent up storm warnings about the "short time horizons" of all too many homegrown companies and investment bankers. We have heard a former Republican Treasury official make similar arguments in Short-Term America, and a Democratic counterpart has been offered in the several reports of Mario Cuomo's Commission on Industrial Productivity. This disorder, we have been warned, has been growing since the 1960s. Only now, as the international competition heats up, are we realizing the extent of our systemic disadvantage competing against corporations based in countries better equipped than the U.S. to nurture and encourage such long-run investments. As Thurow frames the argument in his latest book, the "new world order" comes down to a "head-to-head" competition among qualitatively different kinds of capitalism. Some of capitalism's national "ensembles" of institutions are simply better adapted to the game of global competition than are others.

In fairness, many U.S. companies are still more than holding their own, domestically and abroad in chemicals, pharmaceuticals, software, telecommunications equipment, and for the moment, civilian aircraft. But, especially when it comes to the modernization of mature industries and especially if the subsidies provided by Pentagon procurement are discounted, much of the U.S. economy is falling behind the competition.

The Porter analysis comes at a time of a revival of institutional sensibility in American political economy. A history of the rise and decline into obscurity of the once-fertile institutionalist stream within American economics would take us too far afield of the immediate subject of this article. Suffice it to say that the historically and socially empirical economics of Thorstein Veblen, John Commons, John Bates Clark, and others who shared Adam Smith's empirical curiosity about commerce gave way to the "empiricism" of the mathematical formalists, for many of whom ignorance of the details of commercial life has been a badge of professionalism.

Something of an institutionalist revival (though not so named) began in the 1970s with the work of and reactions to, Berkeley economist Oliver Williamson. Beginning with his book, Markets and Hierarchies, and building on the earlier (but by this time fugitive) ideas of Ronald Coase, Williamson sought to employ the analytical tools of orthodox economic theory to pose a question that the mainstream had substantially abandoned since the Depression era: Why do market economies inevitably reinvent powerful oligopolies that engage in capitalist planning stabilizing market shares, organizing networks, regulating technical standards, limiting ruinous price competition? The answer could not be merely that offered by Adam Smith a self-interested conspiracy of businessmen against the public. For, in some sense, oligopoly seemed functional to capitalism itself. A few renegades, including Galbraith, had never ceased asking this question, but their work was dismissed by the mainstream as lacking a consistent or approved methodological foundation.

In the 1930s, Ronald Coase had tried to use conventional methods to break inside the "black box" of the firm to understand the rules and procedures by which actors in an organization or polity achieve coordination and legitimacy. This was an attempt to integrate the institutionalist idea of governance with the orthodox premise that firms must be organized so as to maximize profits in the short run. Coase's microeconomics remained largely unnoticed until resurrected by Williamson nearly forty years later. Just last year, Coase won the Nobel Prize in economics for his seminal ideas. Better late than never.

Williamson borrowed from Coase the concept of "transactions costs" the idea that the market price in any transaction may fail to incorporate the full costs to the seller or buyer because of the very conditions of exchange. In particular, whenever there is uncertainty or the need for long-term relationships, the parties to a transaction are unlikely to be able to write contracts complete enough to cover all the contingencies or hidden costs. Furthermore, incomplete contracts encourage one or the other party to behave opportunistically, deliberately withholding information or broadcasting disinformation to get a better deal.

In such cases, the transaction is likely to occur under a single roof, inside a "hierarchy" (that is, firm). This solution "internalizes" or reveals to the decision makers those otherwise hidden costs. Williamson showed that there are, even in pure theory, situations in which the inefficiencies of bureaucratic organization are offset by the greater predictability of the outcome. This is showing quite a lot, at least to academic economists. It says that under rather common circumstances it is efficient (maximizing of profits, minimizing of long run average costs) for explicit rules, regulations, commands, organization charts, and social contracts to replace the invisible hand.

With the first book and then his subsequent amendations, published a decade later in The Economic Institutions of Capitalism, Williamson created a small but steadfast school within university economics and generated an enormous outpouring of explicitly institutionalist criticism, especially from sociologists and economic geographers. As a complement to Galbraith's and Chandler's "logic of managerial capitalism" the idea that the exploitation of economies of scale and scope requires the amassing of considerable political and economic resources under the "visible hand" of corporate planners Williamson and his followers have revived academic interest in the theory of the business enterprise.

More recently, Geoffrey Hodgson has written about the "new institutionalism" from the perspective of economics, while sociologists Walter Powell, Paul DiMaggio, and Alejandro Portes have built on the research agenda of Mark Granovetter, a social scientist who resurrected and elaborated Karl Polanyi's protean idea that real economies are always "embedded" in a social framework necessary for their survival. The task is to figure out how and why individuals and groups behave in the context of these conditions.

Within the sub-field of studies of technological innovation, almost everyone of consequence, from Richard Nelson to Giovanni Desi, now takes the centrality of institutions almost for granted. As exemplified by the work of Fred Block and John Gerard Ruggie, international political economy is being rebuilt around explicit studies of the nature of the institutional arrangements governing the old and the new regimes of global capitalism. Even the "new trade" theorists, such as Berkeley's Laura Tyson and MIT's Paul Krugman, are substantially institutionalist.

Most of the contributors to the time horizons project would be surprised to see themselves characterized as neo-institutionalists. Yet what they have collectively produced shows the importance of rules of thumb, belief systems, learning behavior, self-fulfilling prophecies, and other nonprice phenomena in explaining how and why American capitalists make investment decisions and why our particular arrangements harm us in global competition.

The key to understanding why American corporations take an ultimately counterproductive short-term approach to investing begins with the structure and behavior of what Porter calls "external" capital markets. In Germany and Japan, Porter notes, a company's major shareholders tend to be other big corporations that have easy access to company information and thus participate directly or indirectly in management decisions and monitoring company progress. Meanwhile, U.S. insurance companies, mutual funds, and individual investors alike often know little or nothing about the messy details of making steel, wiring silicon chips, or communicating via satellite. Instead, American investors employ armies of professional market analysts and portfolio managers. In the absence of substantive inside information (which is illegal as a basis for trading) everyone tends to fall back on those indexes that can be most easily and inexpensively measured and communicated recent and projected quarterly earnings. Agents build their careers by bouncing between investment banks and mutual funds, competing for status and income by how well they can predict and how often they can jump from one ship to another. There is no lifetime employment in this system.


Inside the corporations themselves in what Porter calls the internal capital markets things aren't much better. American boards of directors are made up of executives of other firms, who know too little about the substantive business they are being paid to "direct." The firms themselves have become so complex, after thirty years of conglomerate mergers, acquisitions, break-ups, and segmentation, that even their managers and senior technicians have difficulty talking across what often amount to fire walls. In the effort to communicate across these barriers, even the "insiders" are driven toward simple goals such as maximizing share prices. Once again, we get management by the numbers.

Moreover, U.S. companies often compensate their managers with stock options, which of course only ties their behavior that much more closely to current share prices instead of to long-term prospects. Porter is not saying that incentive pay is, in principle, the problem, only that the American system ties incentives to a short-term rather than a long-term signal.

The predictable result of the existing incentive system is that the managers' tenure, like the shareholders', is likely to be short. This further compounds the problem caused by inadequate numbers of key employees with firm-specific knowledge, which in turn promotes the use of those easy-to-read indicators such as stock price and quarterly earnings.

The net result of these mutually reinforcing behaviors, played out within strongly entrenched institutions, is that financial capital in the American industrial system is indeed, as Reich and Thurow have long asserted, systemically "impatient." One set of numbers from the time horizons project drives the point home. In 1960, big institutional stockholders in the U.S the pension and mutual funds held on to a share on average for seven years. By the 1980s, the average period had fallen to only about two years.

In Porter and Co.'s encyclopedic accounting of differences in capital markets, these particularly caught my attention:



  • Hostile takeovers are nonexistent in Japan and next to nonexistent in Germany, by custom or law or as a result of the extensive cross-shareholding among customers, suppliers, and bankers.


  • The assets of German workers' pension funds are customarily dedicated to purchasing only the stock of the company employing those workers a practice that may not be "prudent" in the eyes of American regulators but that undeniably strengthens the ties between German labor and management. Here we have the makings of a "virtuous circle," in which dedicated capital enhances the firm's prospects for survival, thereby reducing the need for heavily regulated prudence.


  • The capital budgets of German and Japanese companies treat expenditures on training, R&D, development of closer relations with suppliers, and the initial losses associated with entering new markets or territories as investment, on a par with spending on new plant and equipment; U.S. companies record only the latter. In other words, even their accounting practices are geared toward the long run.




The Missing Link: Public Investment

It is unfortunate that the time horizons project chose not to devote any attention at all to the differences across countries in the determinants of public investment especially since Porter acknowledges that "public sector investment in education and efficient transportation, communication, and information networks is also critical to industrial competitiveness." Moreover, he readily admits that "government actions can support or inhibit" each of the elements of his own model of the sources of competitiveness: the inclination of key customers to press for continual innovation; the availability of skilled labor; the local presence of qualified suppliers; and vigorous but constructive rivalry between the focal firm and its competitors.

Actually, in the time horizons project and his other recent writings on strategy, Porter is inconsistent on the question of the proper role of government. For example, because he so highly values the goad of competitive rivalry, Porter often warns against public policies designed to promote greater collaboration among competitors. That's why he is no great fan of such R&D consortia as the U.S. semiconductor collaboration, Sematech, or the European computer collaborative, ESPRIT. It is, however, legitimate in Porter's view perhaps even critical for customers to collaborate with their suppliers. But in the brave new world of just-in-time parts delivery and integrated product design, where companies frequently take turns playing customer and supplier, this advice becomes somewhat confusing.

Burgess Laird, a staff member of the Center for National Security Studies at Los Alamos National Laboratory, observes that while Porter, in his 1990 book, The Competitive Advantage of Nations, recognizes the importance of a high-quality local training infrastructure to Japanese and German competitiveness, he doesn't address the fact that such supports are nurtured by regional government institutes that provide training, like the Japanese kohetsushi and the German Frauenhoffer. Porter's silence in "Capital Choices" on the appropriate content of an American-style industrial policy stands in notable contrast to the fairly explicitly pro-policy stance embodied in just about everything else that the Council on Competitiveness has published over the last five years.

Of all the appropriate roles for government in a larger public-private program to revive investment, none is more important than what the Swedes call "active labor market policy." It is not enough to call for more education and training, as another item on a list. Physical and human capital have to be developed in a coordinated way. For example, if new technology is embodied in new plant and equipment, and if a program to increase the rate of new private and public investment is what we most need right now, then any innovative investment plan will dislocate some workers certainly as long as the aggregate rate of economic growth remains sluggish. Some of that dislocation can be anticipated by wise labor market policy. Workers can be offered alternative employment or steered toward retraining opportunities before the plant, laboratory, or store shuts down. New markets can be sought for the businesses that would otherwise go under. And new publicly initiated economic development programs, from high-speed rail to the expansion of neighborhood health clinics, can be designed and timed so as to ease the transition for those dislocated workers. If there is a legitimate role for government in easing working people's pain in the transition to a North American Free Trade Agreement, or in the demilitarization of the economy in the wake of the Cold War, surely there is a legitimate role for public policy in helping workers to bridge the inevitable disruptions that any investment-led recovery program worth its salt would inevitably bring about.

Despite the unwillingness of the time horizons project to investigate the contribution of public investment, it is easy to see an overarching conclusion emerging from the research. In the international competitiveness race, we are up against entirely different socioeconomic systems what French political economists would call fundamentally different "modes of regulation."

The Cold War blinded us into imagining that the global contest was between capitalism and communism, as though all capitalist systems were essentially similar. Instead, it appears that companies are to a great extent the products of, and rely on, the supporting institutions of particular national systems for regulating the allocation of capital. Some of these systems compete more efficiently than others.

The U.S. may be able to copy some elements of these foreign institutions. Of course, Porter wisely warns us that such arrangements come in complex bundles and, anyway, the foreigners have their faults too, like their putative overcommitment to existing firms at the expense of new startups. Nonetheless, we Americans clearly face the need to overhaul our own native laws, regulations, institutions, and customs a task rather more daunting and complex than picking winners or increasing the savings rate. It is inconceivable that such an undertaking can proceed without the close cooperation of the private and public sectors, since the relevant rules are deeply rooted in both. Porter has set a fine example for his fellow economists by continuing the belated rediscovery of comparative institutions.

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