Hillary Clinton’s Elizabeth Warren Moment

Hillary Rodham Clinton will voice a far-reaching critique of the financial sector in a speech Friday, a major victory for Wall Street's critics.

The stock market, she will say, has become short-sighted, focused on measures of quarterly performance rather than the future viability of American corporations, according to aides. She'll describe worrisome consequences for investors, employees and the economy as a whole.

"Everything’s focused on the next earnings report or the short-term share price. The result is too little attention on the sources of long-term growth: research and development, physical capital, and talent," the former secretary of state said last week, previewing the theme of Friday's speech.

"It's easy to try to cut costs by holding down or decreasing pay and other investments to inflate quarterly stock prices, but I would argue that’s bad for business in the long run."

For decades, some economists and experts on the stock market have been saying that corporations place too much emphasis on generating cash in the short term for shareholders. These critics have warned that firms are passing up opportunities to train their employees, conduct research, or build new factories -- investments that would benefit shareholders and workers alike, but only over the long term.

It's easy to miss how radical this argument is, since many wealthy investorsare making it, too. Yet this reasoning implies that some of Wall Street's basic assumptions are mistaken.

The financial sector operates on the principle that stock prices accurately reflect how much a company is worth, and that if share prices increase, then chief executive officers are doing their job well.

In an ideally functioning stock market, investors would buy up shares in the companies that were making wise investments for the long term, increasing share prices and rewarding more farseeing corporate leaders. They wouldn't have any reason to focus on the short term.Yet critics say that in practice, investors are far from infallible, and they often can't distinguish between temporary factors and a stock's enduring, fundamental value."There is a growing consensus that at least for some firms, this is a problem," said Joan Farre-Mensa, an economist at Harvard Business School and part of a group that has studied decisions about investment in public firms.

He and his colleagues found that privately held firms invested at more than twice the rate of publicly traded companies, suggesting that pressure from Wall Street restrains investment.

The critique is a familiar one. Politicians such as Sen. Elizabeth Warren (D-Mass.) have aired these concerns before. Yet now Clinton is making what she calls "quarterly capitalism" part of the presidential campaign, nailing down the issue as a central plank in her economic platform.

Jared Bernstein, a former chief economist to Vice President Biden, argues that short-termism isn't just a problem for the financial industry. He and others believe that greater corporate investment could improve the economy as a whole and reduce inequalities of income.

Companies that spend money on training their workers improve those workers' wages over the long term. If they buy new equipment, they create opportunities for their suppliers and, in turn, their suppliers' employees. Dividends and share repurchases, by contrast, mainly benefit the wealthy investors who own stock.

"We're arguing about the game being rigged on behalf of the wealthy," said Bernstein, who wrote about Clinton's proposals on his blog.

Among them is a plan to alter the taxation of capital gains in ways that she hopes will encourage investors and corporate managers to take a longer view.

Currently, gains on investments held for less than a year are taxed as ordinary income, and at a lower rate if they're held for a longer period. Clinton would raise the rate on profitable investments held for an intermediate period, according to her aides. If the investment was held less than two years, the gains would be taxed as ordinary income. The rate would gradually decline on investments held for longer periods, and investors would pay today's low rate only on assets they held for at least six years.

Source: Clinton campaign

It's an idea that dates at least to an Aspen Institute committee, which issued a statement on the subject in 2009.

"The short-termers can come in and take a position that harms the company in the long term but produces short term benefits," said Lynn Stout, a law professor at Cornell University and a member of that committee. "If the market were perfectly efficient these short term tricks wouldn’t work, but nobody thinks the market is perfectly efficient any more."Yet she said that changing the capital gains tax would have a limited effect on many of the most influential investors on Wall Street -- the big players that critics blame for the financial sector's focus on the short term.

Consider a hedge fund that takes a large position in a firm and then lobbies its leaders to sell assets and buy back shares, raising the price of the stock. The fund is likely managing the money for major investors such as university endowments and pension funds that are exempt from taxation.

"For most of the big companies, the big shareholders are institutions, who as far as I know are unaffected by this proposal," said Steven Balsam, an accounting professor at Temple University.

The same could be true of mutual funds if their customers are largely small-time investors saving for retirement in a 401(k) account.

Short-termism is a problem, Balsam said, but he added, "We're not in a perfect world, and I don’t know that any of the proposed cures won't make the problem worse."

Harvard's Farre-Mensa worried that by increasing taxes on capital gains in the medium term, Clinton's proposal would discourage investment overall as well as investment for the short-term.

"You might be ending up with a bunch of unintended consequences," he said.

There is some debate among economists about the relationship between capital gains taxation and investment. Bernstein does not believe that capital gains taxation has much effect on what people do with their money, and he doesn't think Clinton's proposal would drive people out of the stock market. Yet for the same reason, he said the plan might not discourage short-term bets, either.

"Certainly she's creating incentives that nudge things in the right direction, but I don't think I'd expect a big change in the investment outlook," Bernstein said. "More needs to be done."

This post has been expanded with details about Clinton's proposed rates on capital gains.