The Hole in the Economy

A hush falls over the room. Dr. Alan Greenspan and John Paulson make their entrance, stoically descending the auditorium's steps towards the stage. Dean Henry is close behind and takes to the podium to introduce the highly anticipated interview between two of Stern's most distinctive alumni. All eyes are on them so as not to miss even one glimpse of two individuals defining the nexus of business and policy in the country today. The undergrad sitting next to me nearly falls off his chair from excitement and the entire audience seems to be thinking the exact same thing: this is going to be good.

"Shortsightedness," Greenspan jokes, when Paulson asks what drove him to government service. "I am the quintessential private sector person," Greenspan continues. "I believe in capitalism. I believe in free markets. I like small government. I like as little intrusion as possible. So what happens? I end up in government for 20 years. It wasn't an obvious sequitur, but I wouldn't say it happened by accident. I got a call one day from Martin Anderson, a good friend of mine who was working on the Nixon campaign, and he said you've got to come by and help us handle our economic questions." So Greenspan went and helped, and the rest is history.

Dr. Greenspan continues to take the audience on a vivid tour of his past encounters: President  Ford  apologizing  for  not  taking the economist's advice on a particular issue; Senator Baker calling him on the morning after the Black Monday stock crash of 1987, exclaiming but one word, "Help!"; a four-hour lunch with then President-Elect Clinton in Arkansas; and another first Presidential encounter with George   W.   whose   opening   remark   to Greenspan was that for all the time he'd be in office, he'd never criticize the Fed. Greenspan chuckles, "You can't do any better than that."

Paulson comments on Black Monday too. "I remember that crash well. I was sitting in my office at Bear Stearns," he says. "We were all stuck staring at the screen, as the Dow  dropped  22%.  There  were  rumors that many people took big losses in the market, like George Soros was rumored to have lost $800 million that day. A reporter finally caught up with him to find out if it was true. And George Soros replied – yes it's true, but I'm still up for the year." Laughter breaks out in the audience, as Paulson adds, "And that's when I decided to leave investment banking and go into the hedge fund business."

The conversation then turns from the past to the present, as Paulson asks why the consensus among economists has been that the current recovery is tepid compared to the GDP growth following previous recessions. "I've spent a good deal of time trying to answer that question," Greenspan responds. "I've come up with an analysis that doesn't explain it all, but grasps a very large part of it."

Greenspan argues that the ratio of fixed, illiquid investment to cash flow is extraordinarily low relative to history. "Remember what this ratio represents," Greenspan explains. "It represents the proportion of companies' liquid cash flows that corporate executives are willing to invest in illiquid assets." Greenspan found that Q1 2010 was the lowest point for this ratio since 1940, signifying that non-financial corporate business has not been this reluctant to invest in long-term assets in over 70 years.

Greenspan dives deeper, applying these findings to a certain aspect of the GDP. "A haircut has a one-month life expectancy. A home residence is about 75 years. Factories are on average 38 years," Greenspan says. "If you cut off assets with life expectancies over 20 years, the remaining part of the GDP has been growing at an annual rate that is one percentage point greater than the official published aggregate number over the last three years." He argues that if we had similar levels of investment in assets with life expectancies over 20 years, the unemployment rate would now be below 8%. However, the uncertainties in the economy have been so considerable that investment in those areas has fallen to very low levels. Greenspan concludes, "So you can see the hole in the economy in this particular area."

Why did businesses behave as they did? "Not all of the decisions are conscious choices of corporate executives, but a substantial part of it turns out to be that capital investment is being crowded out – mainly in the construction area - by very large federal deficits," Greenspan explains. In his opinion, a significant part of the problems the economy is facing stem from government activism. "A business man has to estimate not only the average expected rate of return of an investment, but also the distribution of probabilities around that estimate. Clearly, the closer these estimates are to each other, the more likely he'll make that investment and be confident about it. When government intervenes, it scrambles that distribution. For those of you who've had Statistics," – and indeed, Dr. Greenspan, we've had the pleasure – "the kurtosis goes down and spreads out and the so-called negative tail of the distribution rises. This tends to restrict your desire to move liquid cash flow into illiquid investments in longer-life assets."

Looking ahead, Greenspan concludes that the government needs to calm down. "I was wholly in favor of the influx of sovereign credit into the banking industry at the top of the crisis," he says. "TARP was essential, because this was the most extraordinary financial crisis globally ever. To be sure, the Great Depression was worse, but for lots of reasons this was so extraordinary that had we not substituted sovereign for private credit, a vital financial intermediation would've been under very severe pressure."

But now, Greenspan argues, we have to stop doing so many things. "Let the economy heal by itself," he says. "Actually, some of that is happening. The amount of activism has slowed down. There are no more stimuluses, no more cash for clunkers, no more first time housing credits. These were all supposed to spur the economy. In retrospect, I think they may not have. In any event, this is truly a minority view."