Did Government Intervention Slow the Recovery?

Former Fed Chief Alan Greenspan asserts that Washington's stimulus and reform efforts caused firms to hold cash instead of investing it

When Congress passed a massive $787 billion stimulus in early 2009 and legislation to reform health care and the financial industry in 2010, it claimed to have taken action to improve the economy. In 2011, the economy is slowly getting better, but the unemployment rate remains quite high. Did Washington's intervention prevent the situation from getting even worse, or did its actions prevent a speedier recovery? In a new paper (.pdf), former Federal Reserve Chair Alan Greenspan asserts that the government intervention caused firms to hold onto money they would have otherwise invested, which would have stimulated the economy and produced more jobs. Does his argument make sense?

The centerpiece of Greenspan's analysis is his claim that the big dip in illiquid investment was caused by government intervention. He writes:

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. 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. Combined with a collapse of long-term illiquid investments by households, these shortfalls have frustrated economic recovery.

There are two things to consider here: household and business investment.

Any decline in household investment should probably be pushed aside as possibly having been caused by the government's response to the crisis. Most household investment occurs through home buying. Its weakness was pretty obviously a result of this recession in particular. When home prices are unstable or declining, consumers stay away. This phenomenon isn't isolated to real estate: when mulling any major purchase, falling prices can cause a consumer to wait on a purchase. At most, one could argue that the home buyer credit and foreclosure prevention programs prevented housing prices from stabilizing sooner.

But on the corporate side, the lack of investment isn't so easily explained. Greenspan notes that the share of liquid cash flow firms chose to allocate to illiquid long-term fixed asset investment fell to 79% for non-financial corporate businesses in the first half of 2010 -- the lowest peacetime percentage since 1940. He goes on to say that businesses worrying about deficits (which translate into future taxes) and regulatory risk were the major reasons why they weren't willing to spend the cash they had to bet on the future.

Economist Paul Krugman isn't convinced. In fact, in a blog post, he seems almost offended that Greenspan would have the audacity to even pretend he can act as an authority in macroeconomics anymore. Krugman says he led the economy into the worst financial crisis since the Great Depression, so he doesn't get to play the part of the "Man Who Knows" any longer. But Krugman doesn't have time to provide an analysis of the actual arguments Greenspan makes.

Brad DeLong, a UC Berkeley-based economist, does. He doesn't buy Greenspan's logic either. He suggests actually asking firms why they aren't making illiquid investment. Luckily, the National Federation of Independent Businesses does just that. DeLong explains the results:

And, indeed, if you ask people running businesses what is their single most important problem, they say that it is not (as they sometimes say it is) taxes; they say that it is not (as they said it was at the start of 2000) the cost and quality of labor; it is not (as they said it was in 2004) the availability and cost of insurance; it is not (as they briefly said it was at the start of 1993) government requirements. What do they say their biggest problem is? Poor sales.

While taxes and regulation are significant problems, poor sales have been more responsible for holding back the recovery. Consumers just haven't been spending as freely as they would need to in order to justify firms ramping up investment in equipment or additional retail stores. Current personal and existing property, plant, and equipment have been enough to satisfy demand.

But this doesn't necessarily mean that the government's intervention was all positive. Greenspan could have instead argued that the reason why consumer spending was so weak was due to the government intervention. That might have been an equally difficult argument to make, however. Part of the reason why consumers weren't spending was because they were repairing their personal balance sheets by paying down debt and building back up savings. Another reason was unemployment.

The government intervention did not necessarily cause either one of those phenomena to be more pronounced, though it also didn't obviously help get consumers spending either -- with the possible and slight exception of extending unemployment benefits. Unfortunately, the intervention's effect on consumer sentiment would be hard to measure. But it could be argued that a different way to use government funds, like by providing a bigger tax cut, could have helped consumers to repair their balance sheets more quickly and spend again sooner to encourage hiring. Then, those poor sales that prevented firms from illiquid investment would have improved more quickly.