Wednesday, October 20, 2010

When Pump Priming Stops Working


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Why hasn’t our economic recovery been more robust?  The key to an economic recovery is consumer, business, and investor confidence.  All the stimulus and pump priming in the world won’t help if people lack confidence in the future.

Video Script:
The US economy has been recovering from a very deep "Great Recession" and there has been a lot of talk about what economic policies should be pursued to promote the recovery.

The famous English Economist, John Maynard Keynes argued that economies in deep recessions like this one can suffer from 'liquidity traps' where falling confidence leads to contracting credit, leading to lower profits, leading to further declines in confidence in a downward spiral.  Thus, he argued, government needed to borrow aggressively to 'prime the pump' so that it could get pumping again.

Well today we have the spectacle of a government that has borrowed and spent so much money that the private sector pumpers can't even swim down to start pumping.  As the government has borrowed trillions the private sector has retrenched, generating cash flows that they are now sitting on.  So we have the paradox of a pump priming that is doing nothing but dropping dead money on corporate balance sheets.  The more aggressive the spending and regulating, the more frightened businesses seem to get.

I don't think this is what Mr. Keynes had in mind when he invented "Keynesian" economics.  Keynes believed that at its core, investing is about confidence.  We -  you and I - invest in companies because we believe that they will be able to grow and generate profits that cause our investment to grow in value.  If we lose that confidence, we stop investing.  Businesses operate the same way.  All businesses have a range of potential investment opportunities available to them:  expand into new markets, design a new product, put together a new promotional campaign.  They undertake these investments only if they believe that there is a good chance that the cash flow from making them will exceed their cost.

In all investment decisions there is an element of risk that the investor, must take into account:  after all no investment is certain.  With businesses it is the same:  the less risk they perceive around an investment, the more likely they are to make it.  And governments can influence business and investor perceptions of risk both up and down.  The more uncertainty there is about what tax rates, labor costs or regulations will be, the less confidence they will have that their investments will yield the projected returns.

And that's the problem that we face today:  without judging any specific policy, it can be safely said that the level of uncertainty faced by businesses over the key variables that drive their profitability have seldom if ever been under more flux than today.  Virtually every dimension that a business must consider when making a new investment is uncertain:  taxes, labor costs, energy costs, regulations, the value of currencies.

And the practical consequences of this uncertainty?  Businesses are choosing not to make those investments.  But for the companies to deliver the increases in revenues and profits assumed in the prices of securities that they own, the companies need to make these new investments and soon.  In this environment only one thing is certain:  without predictable economic policy, investors are going to be risk averse and many attractive investments will not be made.

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