Supersized companies are an economic drag

The U.S. economy has been running at less than full throttle for much of the past two decades, several recent studies show. That means corporations invested a smaller percentage of their profits into expanding production.

The result, according to some economists, has been slower growth during most of the past 20 years, when the gross domestic product has grown an average 2.2% a year, compared with 3.2% during the preceding 20 years.

Some analysts have blamed the shortfalls on lack of good investment opportunities. But in new research, two assistant professors of finance at Texas McCombs offer an alternative explanation. Companies are getting too big — and their size gives them incentives to sit on their money rather than put it to work.

“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,” says Michael Sockin, who conducted the research with Daniel Neuhann. “There are fewer firms, and they’re much larger than they were before.”

Sockin points to U.S. banking, where the four largest banks hold 53% of total assets. Such concentration, he says, has led to misallocation of capital. Businesses don’t put money to its most productive uses. For example, they spend less on R&D and equipment.

“When this happens, we become less productive,” Neuhann says. “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.”

Concentration Discourages Borrowing

The research grew partly out of a puzzle that has nagged economists for years: Why was the U.S. economy so slow to recover from the Great Recession of 2007-2009? The unemployment rate didn’t drop back to pre-recession levels until 2016.

That was despite the Federal Reserve Board priming the economic pump. It held interest rates near zero for several years to encourage borrowing and investment. But corporations did not boost either one.

Instead, many of them built up piles of cash. Apple’s financial subsidiary managed $244 billion, with nearly two-thirds of it in bonds of other companies rather than its own operations.

The explanation, the researchers suspected, had to do with concentration. When a large corporation wants to borrow a large amount of money, lenders tend to increase interest rates. To get a lower interest rate, the corporation decides to borrow less than it wants.

“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,” Sockin says. “Essentially, they make money by borrowing at the cheaper rate.”

From the company’s standpoint, he explains, it saves more on interest than it would earn from investing more in its own operations. But from the standpoint of the overall economy, if companies don’t borrow enough, and lenders don’t lend enough, then capital doesn’t go where it’s most needed.

“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.”

A Tale of Two Recoveries

To test their theory about size and misallocation, the researchers built a model and fed in economic data from 2002.

They found their model accurately predicted a wide variety of economic indicators 14 years later in the wake of the recession. Companies were investing less, even though it would cost them less to borrow.

• Interest rates were 1.1% lower in 2016 than during 2002.
• Companies invested 0.6% less overall.

“It describes the half decade after the Great Recession, when interest rates were low, but the economy was not recovering very fast,” Sockin says.

He notes that the opposite happened after the COVID-19 pandemic recession in 2020. The federal government provided $2.1 trillion in stimulus, and the economy quickly got back up to speed.

“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,” Sockin says.

The lesson, he says, is that when markets get too concentrated, they become a drag on economic growth. In hard times, government may need to invest where private companies won’t.

“Capital moves very freely when times are good, and it moves very poorly when times are not,” he says. “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.”

“Financial Market Concentration and Misallocation” is published in Journal of Financial Economics.