(Originally published here.)
In my previous post, I noted that bad investments create losses that always find a way of showing up somewhere in the economy. Most of the time, the harm caused by these wasteful endeavors is outweighed by the positive impact of worthwhile projects. That’s why the standard of living can rise even when many individual businesses are failing. Sometimes, however, bad investments produce losses greater than the gains that come from successful ones. The question for policymakers is how to distribute these losses. (It’s also important to figure out which distributions produce the best long-term growth outcomes.)
Certain quarters of the commentariat disagreed with this thesis. The most thorough response came from Ryan Avent. He believes we can live in a world where “the only people who suffer from money-losing investments are the money-losing investors.” I wish he were right.
Avent’s conclusion stems from a few crucial misconceptions. First, he seems to think that the total volume of investment spending is basically constant over time. Second, he implicitly assumes that the value of untapped investment opportunities is roughly constant once you adjust for the fact that the private sector sometimes misallocates capital towards unproductive ventures. Finally, he discounts the extent to which his preferred policy remedy (monetary stimulus) creates winners and losers.
In my original post, I noted that excessive investment in the second half of the 1990s “saddled many businesses with unneeded capacity.” This helps explain the subsequent decline in capital expenditures and the U.S. economy’s sluggish performance from 2001 through 2007. Avent disagrees:
“If the problem is that firms were previously making lots of investments that didn’t need to be made, then presumably they were neglecting other investments which did. The potential returns on those unmade investments should look pretty good, particularly given the fall in the cost of capital that came with the end of the boom.”
Avent is saying that there are always equally valuable untapped opportunities for every unprofitable investment. Moreover, according to Avent, those opportunities become increasingly attractive to savvy investors the longer they are ignored by everyone else. His conclusion is that bad decisions by individual businesses and households shouldn’t have significant macroeconomic consequences. In his telling, those who avoided the unprofitable investments will effortlessly swoop in and finance the worthwhile projects that had been previously ignored.
The history of the 1990s and 2000s suggests otherwise. In the 1990s, the world had increasingly unrealistic expectations about the extent to which information technology would transform the U.S. economy. These expectations were based on a germ of truth: The pace of innovation had started accelerating in the mid-1990s after more than two decades of stagnation. The accompanying chart tells the story, using total factor productivity as the measure of technological progress.
Most analysts were slow to catch on to what was happening at first. Later on, they drastically overestimated the extent to which productivity growth would continue to accelerate. By the peak of the bubble, Alan Greenspan, the Fed Chairman, was telling audiences that new technologies would make future recessions less severe and therefore ought to permanently reduce risk premiums.
Even as late as October 2000, the staff economists at the Federal Reserve Board were predicting that the U.S. economy could sustainably grow — in inflation-adjusted terms — at about 5 percent each year in perpetuity. That in turn made savers overeager to finance business spending of all sorts: Private investment spending as a share of gross domestic product climbed by about 2.5 percentage points during the second half of the 1990s. Yet Avent claims that many worthwhile investments were being neglected.
Thus, according to Avent, the early 2000s should have been a great time to take advantage of all the opportunities that people had missed in the 1990s when they were wasting money on overpriced IT products. Yet all we got were houses in the desert. Savers also financed purchases of existing homes at higher and higher prices, as well as the extraction of home equity for the sake of consumption. Almost none of these investments were particularly profitable, especially when compared to the available alternatives. Importantly, the errors of the 2000s were magnified with exceptionally fragile financial structures that left many people and institutions buried in debt.
By contrast, companies weren’t investing much in the U.S. in the 2000s, although they spent a lot of money on foreign investments. Those choices were presumably driven by estimates of relative rates of return, which suggests that the boom of the 1990s created excess capacity. Tellingly, most businesses today aren’t acting as if they had missed a lot of opportunities in the 2000s. In fact, most companies are behaving as if new investments have a rate of return close to or below zero. (A pessimistic outlook for consumer spending is almost certainly part of the picture.) That is why businesses are reacting to record low capital costs by either hoarding cash or returning money to shareholders.
Avent thinks that businesses could be persuaded to invest if only the central bank printed money. This overestimates the central bank’s power. Most of what we call money is actually short-term debt issued by banks (think deposits) or other financial firms (money-market fund shares, repurchase agreements, etc.). Central banks affect the incentives of these firms to create money. As William Dudley, the president of the New York Federal Reserve recently explained in a speech, this is done by bidding up the prices of certain financial assets:
Our view is that asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet. This pushes down risk premia, and prompts private sector investors to move into riskier assets. As a result, financial market conditions ease, supporting wealth and aggregate demand. The fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct — not the goal — of these actions.
Assume, though, for the sake of argument, that Avent is talking about a plan in which the government literally prints money and gives it to people whenever the economy weakens. Even if you think this is the best possible policy response, it clearly creates costs for plenty of innocent bystanders, especially relative to other policies. The likeliest outcome of actual money printing (not to be confused with quantitative easing) is faster inflation.
Inflation might be desirable to the extent that it facilitates the private sector’s aggregate desire to repay its debts. However, it would be irresponsible to deny (as Avent does) that faster inflation would be painful for many people. Needless to say, these people had nothing to do with the bad investment decisions that got them into this mess. Moreover, as Dudley noted in his speech, expectations of faster inflation could produce a range of unanticipated and unpleasant consequences. A significant number of people should rationally prefer the world we have right now to this alternative, even though more people are worse off. It is tempting to conclude from this, as I did in my original post, that the government’s response to the crisis has been partly if not wholly driven by the interests of those who benefit most from the status quo.
I wish that Avent were right that we could live in a world where the only people who pay for bad investment decisions are the people who made those decisions. On balance, however, that seems unlikely. Avent’s preferred solution (printing money) might be the best approach to our current troubles, but it still would cause harm to plenty of innocent bystanders.
(Matthew C. Klein is a contributor to the Ticker. Follow him on Twitter.)