The Great Divergence: Private Investment and Government Power in the Present Crisis

Private saving and investment are the heart and soul of the dynamic market process. Together they provide and allocate the resources used to augment the economy’s productive capacity, generate sustained long-run economic growth, and thereby make possible a rising level of living. Economic crises interrupt this process by discouraging investors and causing them to consume their resources or to employ them in relatively safe, low-yielding ways. Absent entrepreneurs willing to take the great risks that characterize investments in great technological and organizational innovations, the growth process fades into economic stagnation or even decline.

The present recession starkly displays this characteristic crisis-related abatement of the economy’s investment process. Indeed, the decline of private investment during recent years has been much greater than most observers realize. Consider the following data, taken or derived from the most recently revised National Economic Accounts prepared by the Commerce Department’s Bureau of Economic Analysis (Tables 1.1.5, 1.1.6, and 5.2.6).

In 2006, gross private domestic investment reached its most recent peak, at $2.33 trillion (in constant 2005 dollars), or 17.4 percent of GDP. After remaining almost at this level in 2007, this measure of investment fell substantially during each of the next two years, reaching $1.59 trillion, or 11.3 percent of GDP, in 2009. This decline is severe enough, but it does not give us all the information we need to gauge the extent of the investment bust.

The greater part of gross investment consists of what the statisticians call the capital consumption allowance, an estimate of the amount of money that must be spent simply to offset wear and tear and obsolescence of the existing capital stock. In a country such as the United States, with an enormous fixed capital stock built up over the centuries, a great amount of funds must be allocated simply to maintain that stock. In recent years, the private capital consumption allowance has ranged from $1.29 trillion in 2005 to $1.46 trillion (in constant 2005 dollars) in 2009. Thus, even in the boom year 2006, about 60 percent of gross private domestic investment was required merely to maintain the economy’s productive capacity, leaving just 40 percent, or $889 billion in net private domestic investment, to augment that capacity.

From that level, net private domestic investment plunged during each of the following three years, taking the greatest dive between 2008 and 2009, when it fell to only $54 billion (in constant 2005 dollars), having declined altogether by 94 percent from its 2006 peak! Last year only 3.5 percent of all private investment spending went toward building up the capital stock. Thus, net private investment did not simply fall during the recession; it virtually disappeared.

Unless this drastic decline is reversed soon, the future will be bleak for the U.S. economy. Without substantial net private investment, brisk economic growth is unthinkable beyond the very short run. Although private investment spending has recovered somewhat since it reached its trough in the third quarter of 2009, gross private domestic investment in the most recent quarter (April to June) of 2010 remained 21 percent below its peak in the first quarter of 2006, and net private domestic investment remained about 64 percent below its previous peak.

While this private-sector disaster was occurring, however, the government sector of the economy was booming. The ratio of all federal government spending – purchases of goods and services plus transfer payments – to GDP increased from 20.6 percent in the fourth (October to December) quarter of 2007 to 25.4 percent in the most recent (April to June) quarter of 2010.

Of this increase, about 73 percent represents an increase in transfer payments. According to the National Economic Accounts (Table 3.2), federal transfer payments for social benefits to persons – old-age pensions, unemployment-insurance benefits, disability-insurance benefits, Medicare benefits, and so forth in great variety — increased from a seasonally adjusted annual rate of $1.28 trillion in the fourth quarter of 2007 to $1.72 trillion in the second quarter of 2010 – a leap of more than one-third in only two and a half years. During the same period, government grants-in-aid to state and local governments rose from a seasonally adjusted annual rate of $382 billion to $525 billion, an increase of more than 37 percent.

Data compiled by the Bureau of Labor Statistics show that the number of private nonfarm employees fell from 114.1 million in 2006 to 108.4 in 2009, and even further this year, reaching 107.9 million in August 2010. At the same time, the number of government employees at all levels increased from 22.0 million in 2006 to 22.5 million in 2009, although a slight reduction has occurred recently, putting the number at 22.4 million in August 2010.

The Federal Reserve System has played a major role during the current recession, acting in unprecedented ways to inject funds into the financial system in general and into selected failing firms in particular, especially AIG, Fannie Mae, and Freddie Mac, which have been effectively taken over by the government, giving rise to a situation in which the government supplies or insures about nine-tenths of all new residential mortgage loans. Before the recession, the Fed’s financial assets consisted overwhelmingly of U.S. Treasury securities. It now holds a variety of securities, including mortgage-backed securities valued on the Fed’s books at approximately $1.1 trillion. In this way, the Fed has become the major direct source of funds for the government-sponsored enterprises that provided an inviting secondary market for the commercial banks and other primary lenders that inflated the housing bubble.

Through the TARP scheme, created late in 2008, the U.S. Treasury acquired ownership stakes in hundreds of commercial banks.

Of course, the government also took over General Motors and Chrysler, bypassing existing bankruptcy laws and ramming into place restructuring arrangements that served the Obama administration’s political goals, especially its support for members (active and retired) of the United Auto Workers.

The foregoing measures constitute only a small fraction of the many significant actions the federal government has taken to augment its size, scope, and power during the current recession. Thus, while the market system’s driving force – private investment – was being brought to its knees, the government’s crisis-driven surge only added an additional discouraging feature to those operating though market channels, such as the reluctance of commercial banks to make new loans and investments and the desire of households to repay debts and increase their holdings of cash balances. A government growing in so many different directions at once, with many additional initiatives — such as higher tax rates, new taxes on energy use, and new restrictions on financial service providers — still awaiting enactment or regulatory specification, creates tremendous uncertainty for anyone contemplating a long-term investment: who knows what the contours of future government exactions, restrictions, and requirements will be, and hence whether a particular investment will prove to be profitable or not?

Therefore, a major consequence of the Great Divergence – the starvation of private investment and the feasting of government – is what I call regime uncertainty. This form of uncertainty is a pervasive incalculable apprehension about the future security of private property rights in capital and the income it yields to investors; indeed, a pervasive apprehension that extends beyond investors to include nearly all private participants in the economy – consumers, workers, and managers, as well as investors — in regard to the future economic order. The Great Divergence in itself is very bad news. Its effects in enhancing regime uncertainty only make it more unfortunate for everyone outside the privileged precincts of government.