Regime Uncertainty Is Dragging Down Investment . . . and the Economy

Regime Uncertainty Is Dragging Down Investment . . . and the Economy
December 13, 2012

Private investment is the most important driver of economic progress. Entrepreneurs need new structures, equipment, and software to produce new products, to produce existing products at lower cost, and to make use of new technology in machinery, plant layouts, and other aspects of the existing capital stock. When the rate of private investment declines, the rate of growth of real income per capita slackens, and if private investment drops quickly and substantially, a recession or depression occurs.

Such recession or depression is likely to persist until private investment makes a fairly full recovery. In U.S. history, such recovery usually has occurred within a year or two after the trough. Only twice in the past century has a fairly prompt and full recovery of private investment failed to occur—during the Great Depression and during the past five years.

In analyzing data on investment, we must distinguish between gross and net investment: The former includes all spending for new structures, equipment, software, and inventory, including the large part aimed at compensating for the wear, tear, and obsolescence of the existing capital stock; the latter includes the gross expenditure in excess of that required simply to maintain the existing stock. Therefore, net investment is the best measure of the private investment expenditure that contributes to economic growth.

Net Investment Below 2007 Peak

Net private domestic fixed investment (a measure that excludes investment in inventories) reached a peak in 2006–2007, declined somewhat in 2008, then plunged in 2009 before reaching a trough in 2010. The pace of its recovery to date implies another three or four years will be required merely to bring it back to where it was in 2007. With adjustments for changes in the price level, the projected recovery period would be slightly longer.

In a 1997 article in the Independent Review ("Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War") I argued a major reason for the incomplete recovery of private investment during the latter half of the 1930s was "regime uncertainty." By this I mean a pervasive lack of confidence among investors in their ability to foresee the extent to which future government actions will alter their private-property rights.

In the original article and in many follow-up articles, I documented that between 1935 and 1940, many investors feared the government might replace the primarily market-oriented economy with fascism, socialism, or some other government-controlled arrangement in which private-property rights would be greatly curtailed, if they survived at all. Given such fears, many investors regarded new investment projects as too risky.

Similar to Depression-Era Fears

During the past several years, I have argued a similar, if somewhat less extreme fear now pervades the business community, which explains the sluggish economic recovery at least in part. Other exponents of this view include such prominent economists as Gary Becker, Allan Meltzer, John Taylor, and Alan Greenspan. (Until recently, Austrian school economists were more receptive than mainstream economists to the idea of regime uncertainty.)

In addition, economists Scott Baker and Nicholas Bloom at Stanford University and Steven J. Davis at the University of Chicago have devised an empirical index of policy uncertainty; it has remained at extraordinarily high levels since September 2008. However, what most other economists—and all of those in the professional mainstream—have noted is not exactly the same as what I call regime uncertainty, but rather a related, somewhat narrower phenomenon.

Over the years, some economists have urged me to forsake the term "regime uncertainty" and to use instead an expression such as policy uncertainty, rule uncertainty, or regime worsening. I have rejected these suggestions because the idea I seek to convey encompasses more than simply policies or rules. Moreover, regime uncertainly does not necessarily signify only apprehension about potential worsening as a central tendency.

Same Laws, Different Enforcers

Regime uncertainty pertains to more than the government's laws, regulations, and administrative decisions. For one thing, as the saying goes, “personnel is policy.” Two administrations may administer or enforce identical statutes and regulations quite differently. A business-hostile administration such as Franklin D. Roosevelt's or Barack Obama's will provoke more apprehension among investors than a business-friendlier administration such as Dwight D. Eisenhower's or Ronald Reagan's, even if the underlying "rules of the game" are identical on paper.

For another thing, seemingly neutral changes in policies or personnel may have major implications for specific types of investment. Even when government changes the rules in a way that seemingly strengthens private-property rights overall, the action's specific form may jeopardize particular types of investment, and apprehension about such a threat may paralyze investors in these areas.

Moreover, it may also give pause to investors in other areas, who fear what the government has done to harm others today, it may do to them tomorrow.

Regime uncertainly is a complex matter. No empirical index can capture it fully, and some indexes may actually misrepresent it. Only the actors on the scene can appraise it, and their appraisals are intrinsically subjective. However, by assessing a variety of direct and indirect evidence, analysts can better appreciate its contours, direction, and impact on private investment decisions.

Robert Higgs (RHiggs2377@aol.com) is senior fellow in political economy for the Independent Institute and editor of The Independent Review. Used with permission of the Mises Daily blog of the Ludwig von Mises Institute.