International Finance

How to Cite

Greenspan, A. (2011), Activism. International Finance, 14: 165182. doi: 10.1111/j.1468-2362.2011.01277.x

Author Information

Greenspan Associates LLC 1133 Connecticut Avenue NW Suite 810, Washington, DC 20036 USA

Abstract

The US recovery from the 2008 financial and economic crisis has been disappointingly tepid. What is most notable in sifting through the variables that might conceivably account for the lacklustre rebound in GDP growth and the persistence of high unemployment is the unusually low level of corporate illiquid long-term fixed asset investment. As a share of corporate liquid cash flow, it is at its lowest level since 1940. This contrasts starkly with the robust recovery in the markets for liquid corporate securities. What, then, accounts for this exceptionally elevated level of illiquidity aversion? I break down the broad potential sources, and analyse them with standard regression techniques. I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s. I conclude that the current government activism is hampering what should be a broad-based robust economic recovery, driven in significant part by the positive wealth effect of a buoyant U.S. and global stock market.

I. The Rise of Illiquidity Aversion

The Lehman Brothers bankruptcy of September 2008 appears to have triggered the greatest global financial crisis ever. To be sure, the economic disruption of the Great Depression of the 1930s was far more extreme and disabling, and the failure of thousands of banks curtailed short-term credit availability at the time. But the call-money market, the key overnight source of credit in those days, remained open even as rates soared to 20%. 1

The defining characteristic of the tepid recovery in the United States that followed the post-Lehman freefall is the degree of risk aversion to investment in illiquid fixed capital unmatched, in peacetime, since 1940 (Exhibit 1). Although rising moderately in 2010, US private fixed investment has fallen far short of the level that history suggests should have occurred given the recent dramatic surge in corporate profitability. 2 Combined with a collapse of long-term illiquid investments by households, these shortfalls have frustrated economic recovery.

II. Human Nature Prevails

[ Investment as a share of savings ]

For non-financial corporate businesses (half of gross domestic product), the disengagement from illiquid risk is directly measured as the share of liquid cash flow they choose to allocate to illiquid long-term fixed asset investment (henceforth, the capital-expenditure, or capex, ratio). In the first half of 2010, this share fell to 79%, its lowest peacetime percentage since 1940 4 (Exhibit 1).

Following the Lehman bankruptcy, most of the remainder of non-financial corporation cash flow, not expended on fixed investments, was reflected in a surge in liquid asset accumulation that amounted to more than US$500 billon. 5

The notion of intolerance towards illiquid asset risk, of course, reached beyond the non-financial business community. For householders, the disengagement was reflected in the sharp fall in their purchase of illiquid investments in homes and consumer durables as a ratio to household gross savings, the equivalent of business cash flow. This ratio is at a quarter-century low, reflecting the shift in the investment of cash flows (gross savings) from household illiquid investments to the paying down of mortgages and consumer debt, in addition to the accumulation of significant liquid assets.

American banks exhibited a similar reduced tolerance towards risk on partially illiquid lending. 6 Until early 2011, there was little, if any, evidence that the unprecedented near trillion dollar surge (following the Lehman crash) in depository institutions’ excess reserves had prompted a measurable increase in net commercial bank lending. Indeed, bank loans and leases declined from late 2008 through the end of 2010. The excess reserves (overnight funds) have remained parked, largely immobile, at Federal Reserve banks yielding 25 basis points. This reflects not only the fear-induced shortfall of non-financial business capital investments to be funded, but also bank loan officers’ fears that levels of bank capital are not adequate to absorb potential losses on partially illiquid loans. 7

III. Full Recovery Thwarted

[ Average durability of real private domestic GDP, in years plotted through Q3.2010 Source. Bureau of Economic Analysis.]

The difference between liquid and illiquid assets (with long effective maturities) is the reason non-financial corporations, whose assets are largely illiquid plant and equipment (and in a forced sale would sell at very deep discounts), maintained net worth amounting to 45% of assets at the end of 2006 (just before the onset of the crisis). Commercial banks’ net worth, by contrast, was only 10% of assets.

IV. Policy Disagreements

In these extraordinarily turbulent times, it is not surprising that important disagreements have emerged among policy makers and economists on the issue of economic activism. Almost all agree that activist government was necessary in the immediate aftermath of the Lehman bankruptcy. The US Treasury’s equity support of banks through the Troubled Asset Relief Program, and the Federal Reserve’s support of the commercial paper market and money market mutual funds, for example, were critical in assuaging the freefall. 9 But the utility of government activism, as represented by the 2009 US$814 billion programme of fiscal stimulus, housing and motor vehicle subsidies and innumerable regulatory interventions, continues to be the subject of wide debate.

The problem for policy makers is that there are flaws in both paradigms. For example, a basic premise of competitive markets, especially in finance, is that company management can effectively manage almost any set of complex risks. The recent crisis has cast doubt on this premise. But the presumption that intervention can substitute for market flaws, engendered by the foibles of human nature, is itself highly doubtful. Much intervention turns out to hobble markets rather than enhancing them.

V. Limits to Fiscal Stimulus

The recent pervasive macro-stimulus programs exhibit the practical shortfalls of massive intervention. They assume that the impact on the US economy of a set of tax cuts and spending programmes can be accurately evaluated and calibrated by conventional macro-models. Yet, these models failed to anticipate the crisis, and, given their structure, probably cannot be so evaluated and calibrated. 10

The argument that higher federal spending would raise nominal GDP, and create new saving, is accurate up to a point. But if aversion to illiquidity risk remains high, capital investment and GDP will presumably remain stunted. This raises the broader question of government economic activism as an important economic variable contributing to such heightened risk aversion.

VI. The Boundaries of Activism

I define zero activism or intervention as pure laissez faire, where the government has no economic role other than enforcing property rights and the law of contracts. This paradigm, in its pure form, has never existed. The United States, and much of the developed world, came close in the first half of the 19th century. But, in the United States, slavery and state financed infrastructure, such as the Erie Canal, were departures from the paradigm.

This paradigm eroded during the second half of the 19th century, and was abandoned for a heavily regulated economy in the aftermath of the Great Depression. For the second half of the 20th century, Americans, belatedly dismayed with the restraints of regulation, dismantled most controls on economic activity. Much of the rest of the world followed suit.

Few deny the extraordinary economic growth engendered by competitive markets in the 19th and 20th centuries a tenfold increase in global real per capita GDP (Maddison 2005 ). But the distribution of a competitive market’s rewards, and its periodic crises, led to the emergence, in some countries, of virtually full state (activist) control of economic affairs. The Soviet Union, China (during its cultural revolution) and India (with its embrace of Fabian socialism following independence in 1947) were the most prominent. Yet these models have been abandoned as ineffective creators of material well-being.

The economic policy world is currently split between the advocacy of a state of minimum activism allowing markets largely free reign and the advocacy of a more heavily regulated interventionist model. Both embrace the welfare state and capitalism. 11 They differ only in degree.

VII. The Unthinkable

Henceforth, it will be exceedingly difficult to contain the range of possible activism. Promises of future government restraint will not be believed by markets. This must significantly further raise negative tail risk. This became evident, post-crisis, in the failure of elevated risk spreads on liquid long-term debt to fully fall back to pre-2007 levels.

VIII. Financial Regulation

Among the growing number of variables that future business management must now evaluate are the uncertainties related to future sources of funding of private investment. The major planned restructurings of our financial system must be broadening the range of currently expected outcomes and perceived risk. But while the impact of the restructuring appears significant, its size is too amorphous to measure. It is impossible to judge the full consequences of the many hundreds of mandated rulemakings required of financial regulators in the years ahead by the DoddFrank Act.

Most important will be the reaction of the private non-financial sectors of the US economy to financial reregulation, which is bound to reduce the scope and value of financial intermediation. Finance and insurance in the United States as a share of gross domestic income (value added) rose continuously from 2.4% in 1947 to 8.3% in 2009, a record high. 12 Early estimates of the percentage for 2010 appear little changed from 2009. 13 It will presumably become clear in the coming years whether the ever-higher level of financial services was required to maintain economic growth (no such trend existed pre-war). The answer to this question is of no small consequence for the next decade and beyond.

IX. New Deal Activism

The business cycle had ups and downs in the 1930s, but the level of activity for the decade, on average, was suppresseda status consistent with a persistently high degree of risk aversion to illiquid asset investment.

X. The Metrics of Government Activism