Misallocation of Capital

As we discussed previously, the financial turmoil has prompted a lot of finger pointing. But the real question is why Wall Street, faced with this embarrassment of riches, failed to channel excess global savings into investments that would increase the capacity and productivity of the US economy. Instead of building new factories or improving our crumbling infrastructure, we mostly spent the money on personal consumption or invested it in unsustainable asset bubbles. If on one side of the ledger we have a savings glut, why has there been a dearth of investment in new productive capacity on the other side?

Part of the answer must be that investors judged these investments to be unprofitable. True, they could have been mistaken – plenty of people apparently believed that housing prices could keep going up forever. But perhaps they were on to something.

It has long been an article of faith that the private sector is better able to assess investment decisions than the public sector, and this belief has been invoked to justify curbs on government intervention and regulation of the economy. Indeed, Alan Greenspan, in his latest effort to deflect blame for the current crisis, explicitly states his view that ‘bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do bank regulators.’

But in the wake of the credit meltdown, this blind faith in the ability of private actors to channel investments to the most profitable and productive uses seems misplaced. Wall Street has created a series of asset bubbles by channeling excess savings into areas that will have no long-term benefits to US productivity growth. Engaging in the vendor financing scheme offered by Asian exporters merely gives American consumers access to cheaper goods, but doesn’t increase the productive capacity of the US economy or improve the productivity of our nations’ workers. Likewise, the housing bubble made Americans feel richer via the paper gains they had made on their real estate investments, but these investments merely deflected money away from investments in factories, businesses and infrastructure.

It is true that the severity of the downturn has been exacerbated by fraudulent lending practices like the issuance of ninja loans and the fact that mortgage originators stopped carrying any of the default risk on their books. Packaging up thousands of home mortgages, securitizing them, and selling them off to investors around the world succeeded in spreading risk around, but it did not  eliminate risk altogether.

On another level, the growth of off balance sheet lending, poorly understood derivatives and the huge leverage used by hedge funds and others have rattled the markets perception of counterparty risk – nobody understood where the risk had ended up. Once it became clear that mortgage backed securities had been wildly overvalued and investors were left with hundreds of billions of dollars of these toxic securities on their books, lenders started to pull back, not knowing who they could trust anymore.

These are issues that can and should be addressed through more prudent regulations. Fraudulent lending practices are just that – fraud – and can be prevented through strict oversight. Likewise, the quid pro quo of being given access to the discount window at the Fed (as the prime brokerages now have been) is opening up your books so the Fed can see what’s going on and understand the quality of the assets you’re putting up as collateral. Enacting capital reserve requirements for investment banks and hedge funds to prevent excessive leverage might also be wise at this stage.

But the question remains: why couldn’t excess global savings be invested in profitable, productive new enterprises in the US? To right our trade and current account deficits, the US needs to export more. The falling dollar has made many US goods cheaper abroad, and thus has proved a boon to US export industries. But many of the factories producing goods for export are operating at or near capacity, and will thus require sustained new investment to ramp up production levels.

Likewise, the state of our domestic infrastructure is a disaster. Bridges and levies are literally falling down around us, and state and federal governments can’t seem to come up with the money to maintain and improve our roads, rails, electricity systems, or ports. As the breadth, quality and reliability of domestic infrastructure is becoming an increasingly important component of any nation’s economic competitiveness, this is a worrying predicament, not to mention the tragic loss of life that our infrastructure failures have already caused.

Businesses of all types, from large multinationals to small start ups, increasingly base their investment decisions and placement of offices and factories on assessments of the quality of infrastructure in competing jurisdictions. Moreover, with the rising price of energy, America’s auto-centric transportation system is proving increasingly inefficient and leaving us dependent on foreign sources of oil and gas, further contributing to our trade deficit and sending large amounts of money to potentially hostile authoritarian states.

The point here is that prudent regulations alone will not channel investments into productive uses. What we need now are public policies that will make investing in productive assets in the US more attractive to private investors. Reforming our tax code to eliminate the incentives for companies to transfer production abroad is one step that should be taken. Another could be legislation that would open up infrastructure investments in roads, rails and the like to public-private partnerships. The Private Finance Initiative in the UK is one model that should be looked at, but private investment in toll roads, railroads, water supply and electricity generation are being used in many other countries around the world too. The time has come to stop dismantling the capacity of the federal government in the US to regulate the domestic economy and start promoting investments that will lead to sustained improvements in the capacity, competitiveness and productivity.