Xavier Gabaix argues that restrained business investment is a natural —
and healthy and problematic — reaction to macroeconomic tail risk. And Brad DeLong responds:
The macroeconomic tail risk that businesses today fear is not a Great Forgetting of technology and organisation or a Great Vacation on the part of the North Atlantic labour force … [These] are the only two “macroeconomic tail risk” shocks I can think of that would make it socially and collectively rational for businesses as a group to refuse to invest in new capacity right now
DeLong’s references make it clear that he persists in viewing our current problems as a liquidity, rather than an solvency crisis. [Say explains that the Bank of England’s tight monetary policy in 1825 triggered a sharp recession by curtailing the supply of credit firms and causing them to hoard cash. Mill explains that it was only after the Bank reversed its policy and loosened the money supply that the economy recovered. And the Kindleberger reference makes the liquidity interpretation entirely clear because a “lender of last resort” only functions because it lends to solvent firms — a condition that Mill also emphasizes. For more on the crisis of 1825 see here.]
In short, Prof DeLong appears to imagine that if we continue to treat the crisis of 2007 as a liquidity rather than a solvency crisis — eventually the solvency crisis will disappear. The theoretic foundations of this view are hard to fathom — especially given that our financial institutions have been relying heavily on “liquidity support” for almost three full years — could there be any stronger evidence that we are facing a solvency crisis, not a “panic”?
[The timeline of the 1825 crisis is as follows: March 1825 Bank of England starts to tighten, December 1825 full blown bank crisis with money center bank failures, met with aggressive lender of last resort action, by June 1826 lender of last resort activities have wound down and by December 1826 monetary measures and bankruptcies have normalized. See Chart 11 here and Chart 1 here.]
In my view business investment is restrained not because of macroeconomic tail risk, but based on elementary macroeconomic analysis: As long as policymakers are determined to prevent the bankruptcy of insolvent firms, necessary economic adjustments will be delayed and valuable assets will be entombed in firms without the balance sheet capacity to borrow the funds necessary to realize the value of those assets. This policy will have the effect of preventing the economy from growing at its natural rate over the next decade and render investment a very dubious prospect indeed.
In short, what’s holding corporate investment back may be uncertainty over future policy and the nature of the institutional structure of the economy. That is, firms may fear that bad economic policy in the form of using liquidity tools to support insolvent firms until they become solvent — in the next decade or two if ever — (similar to the Japanese “solution” of avoiding the restructuring of banks and firms) is going to cost the economy so much that it really doesn’t make sense to invest in a future without economic growth.
Update 7-7-10: Gabaix points out that it is possible that the future policy that firms are worried about may be a failure to bailout in the next crisis. Is this the same point I am making or a different one? Hmm.
And Krugman argues that there’s no need to interject “future government policies” into the discussion at all — a review of data suggests that investment is higher than one would predict in an environment where we simply don’t need that much new construction, etc.
I am happy to acknowledge that I have no way of determining the true source of concerns about the future economic performance, but I hope everyone can agree that too much government intervention, too little government intervention and misdirected government intervention are all on the list of possibilities. For which reason the decision-makers who are actually navigating these shoals have all my sympathy.
2 thoughts on “Does anyone really believe that this is a liquidity crisis?”
Another way of looking at the “entombed assets” is that asset prices are artificially high. That is their acquisition price is too high to generate attractive, risk-adjusted expected returns.
Most economists rely on the “sticky wage” explanation for unemployment, yet they have no similar explanation for underinvestment. If nominal asset prices are “sticky” (due to bail outs), then demand for those assets will be below potential. The solution is to allow the real price of those assets (the obvious one being real estate) to fall. That, however, would require a vast recapitalization of the banking system, combined with a few years of very deep recession. To avoid this outcome, policy makers essentially doom us to a future of chronically low investment-to-gdp rates, without Japan’s escape hatch of external demand. A better alternative is to cushion the blow of banking system recapitalization by spending directly on jobs programs. That opportunity is probably past.
I agree. We can think of an asset in an insolvent firm kept alive by extend and pretend as having three values: the value on the books of the firm/financing institution > market value > value of the asset as it is put into use by the firm.
Since realizing the market value of the asset would bankrupt the firm (and the financial institution), both prefer to cover up their losses and make what use of the asset they can.
Even if the firm found a way to put the asset into its highest value use without selling it, the fact that the firm is paying interest on a loan that should be wiped out in bankruptcy functions as a tax on the economy that flows to financial institutions.