Bryan Caplan  

Why Hold Reserves?

Mark Thoma's Response... Moral Failure?...
Suppose you see an individual, a bank, or a corporation sitting on a big pile of money.  What should you conclude?

Theory #1: The actor has nothing good to spend it on.  The individual is satiated, at least relative to existing products.  The bank doesn't expect any more loans to be profitable.  The corporation doesn't think that additional production would be profitable.

Theory #2: The actor wants a buffer.  The individual, bank, or corporation is worried about the world's vicisitudes, and sees the money as an insurance policy.

Note: The two theories make opposite predictions about the effect of exogenous income shocks.  According to Theory #1, winning the lottery or losing a lawsuit won't change actors' behavior (unless the lawsuit is big enough to wipe out the whole money pile).  According to Theory #2, in contrast, winning the lottery or losing a lawsuit matters.  Indeed, it might lead the actor to drastically change his behavior in order to reestablish a buffer or take advantage of bypassed opportunities.

Theory #1 is often popular, but all the evidence I've heard of supports Theory #2.  The most infamous example: In 1936-7, the Federal Reserve acted on Theory #1 by doubling reserve requirements in the face of excess reserves.  Banks' behavior, however, clearly fit Theory #2.  Banks increased their "excess" reserves to restore their buffer.

I'm puzzled, then, by Tyler Cowen's rejection of Alex Tabarrok's view that wage flexibility would have positive effects via the cash flow mechanism.  Alex's point:
Wages are the largest component of costs thus sticky wages keep costs high and profits low... suppose that the problem is that firms can't get capital to expand--perhaps because the banking system is not working well--then what matters for firm expansion is free cash flow.  But sticky wages keep firm costs high, reducing free cash flow and inhibiting expansion.
Tyler responds, "[H]igh cash reserves are one reason why I don't think Alex's nominal wage stickiness story explains current unemployment."

My defense of Alex: The cash flow mechanism doesn't assume cash-poor firms.  It just assumes Theory #2: Firms hold cash because they want a buffer, not because there's nothing good to buy.  And if past experience is any guide, Theory #2 is correct.

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COMMENTS (8 to date)
8 writes:

Theory #3: The actor wants to buy, but assets/goods prices are too high.

Les Cargill writes:

Holding too much cash is to Schumpeter what "hold my beer and watch this" is to Darwin. There's a biiiiiig tech refresh cycle coming due...

Tyler Cowen writes:

At least as the free cash flow hypothesis is tested empirically, this is inconsistent with it. Arguably "free cash," at the theoretical level, is poorly defined (how free is "free"?), but that's hardly a defense of the theory.

Foobarista writes:

3 is actually a variant of (1), in that a company may be holding cash because it can't find any companies to buy at prices it's comfortable with. For an individual, they may be out of the stock market because there's too much uncertainty to reasonably price stocks.

The Unbeliever writes:

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Well, certainly if I won the lottery, I would change my behavior. For one, I would quit the hotel night audit job I have and spend all my time writing scholarly articles on literature and on spontaneous order theory. So I guess it would only moderately change my behavior. :-)

Next best thing would be to get someone to pay me to do said research and write said articles.

W.M. writes:

I may be an armchair economist, but corporate finance is my area. I semi-recently completed graduate studies in business and finance and am currently working in the finance group of a very large publicly traded (non-bank) firm with several billion dollars of cash on-hand. I work in the group that directly addresses the question at hand.

From theory, empirical evidence, and my own experience as a practitioner, I find that the decision is pretty straightforward: a company determines its optimal level of cash reserves as part of its capital structure (debt vs. equity) decision (or capital planning process). Any cash generated above this threshold is available for investment (above and beyond the capital expenditures already planned). A corporation ALWAYS has viable options for use of cash when you consider dividends. In other words, if a company has more cash on hand than it needs or wants, meaning that it is comfortable with its debt/equity situation (i.e., doesn't feel a need to prepay debt) and that it can find no suitable CapEx investments (i.e., no projects with a sufficient return on investment), then it is considered to have "excess cash" which should then be returned to the company's owners in the form of either a dividend or a stock buyback.

Setting the level of desired cash on hand is completely aligned with #2 above, plus the normal operational working capital requirements of the firm. As volatility in earnings has increased, companies need to increase the buffer. At my particular company, Monte Carlo simulations and scenario analysis are used to forecast pro forma financial statements which allow management to select a level of cash that would, with a certain level of probability, keep us out of bankruptcy. We have a laundry list of “NPV positive” capital expenditures (investments) that we would love to make, as well as a need to adjust our capital structure by paying down a significant portion of our debt. In other words, we have a ton of cash, we’re over leveraged, and we have many desirable investment opportunities on hold. Keep in mind that holding cash is very expensive, especially for a leveraged firm and especially when the return on short term, low risk investments is so low (as it currently is). Having said all that, the past several months have generated a substantial positive cash flow for my company, and we expect to start to be able to spend some of it as the balance grows to surpass our target. Most will likely go to repay debt. Also, from a practical point of view, cash balance targets are very often set as a percent of revenue, so even in an improving revenue scenario, it is perfectly reasonable to expect cash balances to increase until management believes that the volatility of those earnings has reduced. It takes time to establish such a trend.

I believe it is also worth noting that there is considerable lag in decisions and actions. There is often a lag of 1 to 2 quarters before management takes action to utilize excess cash, and management may only re-evaluate the optimal capital structure and cash position once or twice a year.

When speaking about returning cash to investors, you have to consider the effect of tax policy. Taxes on capital gains and dividends play a huge role in management’s decision making process. Given that all rates are going up next year, it is pretty reasonable to expect that if any firm were truly sitting on excess cash, they would be working diligently to return it to their investors before the increased tax rates take effect. If the expectation were that rates were going down in the future, then you have a case for companies to hold excess cash for a bit longer.

Based on everything I’ve just said, Theory #1 only explains why firms aren’t spending cash on investments, but only addresses large cash balances if you can make the case that firms expect good investment opportunities to present themselves in the near future. Theory #2 better describes why firms hold cash balances above their working capital requirements.

James C writes:

Just another armchair economist here -- but #1 and #2 arent really different categories IMO.

If you asked me that question straight up, and left it at that, I would say that this person simply has an order of preferences, and for whatever reason, frugality, fear, or "just because", saving money is currently at the top of their preference list.

Taken this way, I dont really see any difference between the two. In #1, I would replace that with "the actor does not currently have a preference greater than saving".

Its different for each person -- hell, someone (an individual) could be saving money because they like like the smell or cash, and they like it more than getting a new TV.

Of course, just from what I know of people... most people save in order to have a buffer for unforeseen circumstances.

However obviously many people save to invest -- Im currently saving as I want to invest in a business idea, but dont have any avenues I like yet.

Other people, who arent as caught up in our consumer culture, have the mentality of spending only when they "need to".


Also, drastic changes can also greatly affect a person's psychology, their beliefs, attitudes, etc.

I.e. prior to a shock, someone could be of the mentality of "No use in keeping money around... use it for something". However, they could be saving because they are like me -- they would LIKE to spend it on an investment but dont have one they like yet, or maybe saving up for a really nice car.

But after the shock, they are like "crap... I need to start saving for emergencies".

So in this case, both theories would apply at different points in time.

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