Conservatives Are Right About the Economy; So Are Liberals

The most controversial number in economics today might be $1.8 trillion. That's the amount of excess cash held by S&P 500 companies. Liberals say businesses are sitting on bucks because the government hasn't done enough to create demand. Conservatives say it's because the government has done too much to create uncertainty about the future of taxes and regulation. To make sense of the debate, I spoke with Kevin Hassett, the director of economic policy studies at the American Enterprise Institute. Here's an edited transcript:

(Hassett's take on the economy is admirably even-minded, but skews conservative, especially on his solutions reduce uncertainty for business owners. For a more liberal take, read my interview with Brookings' Gary Burtless.)

S&P 500 companies are hoarding cash at record levels. What does that actually mean?

Corporate cash is used to fund business investments. Investment is a function of the expected future capital. In other words, if I buy a machine, I want to know how much money I can make over the life of the machine. So here's what what we know for sure: cash is piling up because companies expect that future revenues are not enough to justify costs.

Who has the better explanation for why companies are afraid to invest: the liberals who blame weak demand, or the conservatives who blame the Obama administration?

We don't really know. Maybe business people are nervous about the impact of new taxes and regulations. Or maybe they're nervous about a weak market. You couldn't know unless you asked all of them.

The weak demand argument seems intuitive to me: if nobody's buying what I'm selling, I'm not going to buy new machines to make more stuff. Explain the uncertainty argument.

In a traditional neoclassical model, you buy machines the minute the benefits exceeds the costs. Today there's a new school of thought that says uncertainty, in and of itself, makes firms hold off on new purchases. This principle is called irreversibility. In periods of uncertainty, you're nervous about being stuck with a bad buy that you can't easily shed. Even if the raw calculus says "buy today," you still might hold off.

Let's imagine you want to put pink panther insulation in your attic. If the price of oil tanks, it turns out you're not saving very much. You might want to sell the insulation back. But you can't. That's irreversibility. You want to wait until the price of oil gets high enough so that an irreversible investment, like insulation, makes more sense.

If I'm a business owner selling clothes, and I see that demand for my clothes is decent, but precarious, I might hold off on big purchases, because I don't want to be saddled with an irreversible investment if demand dips down again. That's sounds like a combination of low demand and uncertainty.

Right. If you're an irreversibility guy, you say business people are unsure about the economy, or what Democrats might do in a few months, even though right now, the calculus says it's a good time to make an investment.

In other words, all three groups -- the Demand Siders, the Tax-Focused Conservatives, and the Irreversibility Theory Camp -- can all be right at the same time?

If you're a demand guy, you say the reason for all this excess cash is that the marginal benefits of the new machine is low: the market won't buy what you're selling. If you're a tax policy guy, you say companies are afraid of the impact of future tax increases. If you're an uncertainty, or "irreversibility" guy, you're basically with the IMF. You recognize that things are getting better, but you're not sure we're immune to another dip. Those are all legitimate arguments. They can all be true.

So what should lawmakers do right now?

Follow the steps I've laid out. I think you should try to address all three concerns. For the demand guys, let's generate demand. For the tax guys, you want to lower the corporate income tax rate, especially when you consider how uncompetitive it is with other countries. For the uncertainty guys, it's complicated. There is uncertainty about the European economy, but we can't do anything about that. But what about those massive deficits? They need to come down. It would be nice to have a fiscal commission with teeth.

But the fiscal commission can only make plans. It can't actually do anything this year or next year, and I'm guessing most politicians don't want to do anything this year or next year, anyway. Is there any way to cure that uncertainty?

Sure, let's think about Social Security. One reason why Social Security is falling apart in the long run is we're growing the benefits of the first check with wage growth. This is a good way to bankrupt ourselves as we get richer and richer. So why not announce now that we're going to index benefits that first time recipients receive to inflation. That would lock in today's standard of living. That shaves about six trillion dollars off our debt. Take a trillion and use it this year to stimulate demand. That way, businesses see how we're paying for it. It's immediate stimulus that not only adds nothing to the deficit, but also it's part of a package that cuts the deficit. We're coming out ahead, and that's important because it reduces uncertainty about future policy.