An Answer To Carl: All Cash and Nowhere to Invest

My longtime friend Carl wrote this:

“If business is making profits then the market should reflect that and invite participation‰Û? But where is one to join in (invest) in order to share in those profits. Banks pay nothing for the use of private cash deposits‰Û? the stock market is no longer trusted‰Û? Where is it? Is there some new ‰ÛÏCapitalism‰Û? we should be looking to discover an understand?”

As usual he takes us to the heart of a very important question: All that cash and nowhere to invest, why?

Because the economy has been utterly trashed by the banks; because it is bereft of good investment opportunities; and because, even though rates are incredibly low, fear prevents people and businesses committing to risky activities.

One at a time.

Businesses are sitting on piles of cash right now. They obviously are not committing to anything long, or even medium, term at the moment. They feel safer with a buffer of cash rather than building new factories, increasing production rapidly, developing new products, or hiring more workers. The reason is clear: their expectations – as expressed in their internal market forecasts – are weak. They do not see sufficient demand out there to justify any large investment outlays. Absent a change in that outlook I doubt that the recovery will gather momentum much above its current anemic level.

But with corporate balance sheets so strong, why hasn’t the stock market taken off?

Because the stock market has a prospective, not retrospective, view. Stock prices reflect what the market thinks will happen, not what has happened. So there is nothing incompatible between modest stock prices and piles of cash sitting on company balance sheets. At least in the short term. Indeed, I would be very surprised if the stock market view of the economy and the aggregated views of business were very far apart. Both seem to be saying the same thing: demand is weak and likely to stay that way for a while.

As for the banks: the rates they offer on deposits are so closely tied to general market rates that it is no shock their rates are historically low. They are focused on rebuilding their capital at the moment so they want to stay liquid and avoid risk. That means attracting and keeping low cost deposits and working down their toxic asset portfolios.

So the problem Carl is facing as he looks for places to invest is common to everyone: the fear of risk is so paramount, and the outlook so uncertain that cash is sitting idle, under deployed, and accumulating. Despite the low interest rates that the Fed hopes act as an incentive to invest – the cost of borrowing is so low, the reasoning goes, that practically any investment project returns a profit.

This is exactly the conundrum that Keynes identified and solved in his “General Theory”. It is a liquidity trap. The economy is awash with cash, but there seems to be nowhere to invest it where the risk and return is proportionate. So everyone hoards the cash. And get progressively more frustrated with the lack of return.

In broad terms this situation can be characterized as the private sector seizing up. If you look at the trend for private sector investment it collapsed back in 2007 and has only marginally recovered. The only thing that prevented a wholesale depression breaking out as a result was the massive increase in government spending that filled the gap left by that collapse.

This upcoming week, on Friday, we will be getting the next revision to the GDP figures for the second quarter. Many analysts are looking for a big downward revision to about 1.4%. That’s awful. But it justifies the weak outlook of business: with demand faltering there is no reason to ramp up investment. But weak investment is a major contributor to that faltering demand. The private sector has fallen into a self fulfilling trap. Under those circumstances the stock market is correct in placing modest values on stocks, and holding cash will exert a greater appeal.

Keynes realized that capitalist economies can get into this bind both easily and frequently. Economic history is full of major swings in capitalist economies. There have been a number of depressions. Most often those depressions were associated with major social unrest. In some instances the result was the emergence of alternative economic ideas and systems- socialism and both fascism and communism took hold or were invented during depressed economic periods. So Keynes set out to ‘save capitalism from itself’. He saw that the great need was to fill the void created by the huge and irrational cycles the private sector is prone to. Which is why he advocated massive government spending programs when such crises occurred – but not when there was no crisis. In effect the only way capitalism can be saved is by adding a large and steady government sector to provide a flow of demand even in down cycles. This is why things like Social Security, Medicare, and Unemployment assistance are so valuable: they act as stabilizers, and ensure a basic level of demand in an economy. In extreme cases, such as the 2007/2008 recession, we also need to add in one time stimulus to top up demand and save the private sector from total implosion.

So we do not need to search for a new capitalism. We simply need to modify our existing system by returning it to the more balanced ways of the immediate post war years, when profits were more shared – wages grew more rapidly – and productivity flowed into general wealth and not simply into the coffers of a limited number of citizens.

Having said all that, I have no doubt that the basic shape of our version of capitalism will indeed change. Perhaps that’s where Carl should look to invest.

The current crisis will abate. As you know I am skeptical of the policies in place at the moment to force us into a better growth path, but let’s assume we get back to normal sometime in the next few years.

That still leaves us with a major problem: the impact of globalization.

The central problem is that capitalism is not geographically constrained, at least not yet. So it will act as usual and seek to maximize profit by moving production to the low cost locations and by substituting cheap capital whenever labor gets expensive. This presents the US with a problem: it has a relatively high cost labor force, so it will be in constant danger of bouts of very high unemployment as its traditional jobs are moved elsewhere. There are two ways to combat this effect: one is to shut the door to trade and suffer the consequent loss in wealth that implies – consumers end up paying much higher prices for goods that are available abroad much more cheaply. Or it is to seek new ways to earn a living. This latter is the better course in the long run, but involves dislocation in the short run. We can build an economy more focused on services – which tend to be less prone to outsourcing. We can develop new industries built around skills and knowledge only available here. And we can alter the way in which our traditional industries do business in order to lower their costs. All three of these courses involve a big investment in education, infrastructure, and technology. More to the point they imply a rethinking of management.

I gave a speech many years ago to the board of the holding company who owned the bank where I worked. One of the features of that presentation was my focus on the American weakness in energy efficiency: the US is the worst of the large industrial economies in converting a BTU of energy into a dollar of wealth. This is a result of its historic energy abundance: it could be wasteful and not worry. Those years have long gone, and yet the US still lags well behind in efficiency. I use this as an example of the way in which our version of capitalism has to change: we need better technology at a basic level, and we need to deploy the fancy technologies more imaginatively.

We need to reinvent our capitalism, or, rather, update for the next century. We are now competing with nations deep in low cost labor. We need to abandon our wasteful ways and shepherd our resources to maximum advantage.

But that’s the opportunity for longer term investment.

Short term, we need to break out of our liquidity trap: more stimulus and more government debt to stoke that demand. Only then will the cash get invested and business start to thrive again.

Sorry Carl, there is no easy answer.