Friday, December 26, 2008

Sit and Wait: The Option Value of Investment Delay During a Deep Recession

How does a recession end? The cliché story told about World War II is that there was exogenous sharp increase in demand and America’s factories went back to work to supply the needed war supplies.

In that case, the government sent clear signals concerning what it needed and in what quantity. In 2009’s recession, the signals are more murky. You don’t have to be a good game theorist to foresee a complicated signaling game. Each business, ranging from cars to banks, must ask itself; “what is the probability that we will get a government bailout? If we get one, how big will it be? Can we, and should we, take actions today to increase or at least not decrease the likelihood that we receive a government bailout/handout?”. So the "poison pill" defense in business is to hurt your business to make it less desirable as a takeover target, in this case I'm wondering whether a "poison pill" makes a firm more likely to receive a public bailout.

So in my "model", during a recession firms can engage in Keynesian government rent-seeking (seeking a bailout) or engage in productive re-organization. My claim is that many firms now believe that the former activity is more profitable than the second one and in aggregate this will hurt our economy's macro performance.

How would a business plan if it knew that the President was Milton Friedman and that he could credibly commit to bailout no one. In this case, during the 2009 recession the business would say to itself “we will sink or swim based on our own decisions”, such a firm would use the recession to reorganize and focus on future sectors of growth and perhaps even retool to get ready for the next boom.

These stark differences in the firm’s investment behavior crucially depend on the firm’s expectations of “who” is the government that it is playing a strategic game against.

While it is individually rational for each firm and at risk industry to sit still and act like a victim (each has an incentive to appear to be passive victims who do not control their destiny and to convey that innocent people will suffer if they are not protected ---- i.e their blue collar workers) as they await the Obama Team’s largess, in aggregate such actions prolong the recession as more time passes and real reorganization does not occur.

I have tried to read Keynes on several occasions. What I don’t see being discussed in the original text or by Paul Krugman is a clear statement concerning how diverse firms form expectations of the marginal benefits of hiring new workers and how such firms choose the capital stock such that the marginal benefit of hiring new workers (and retaining incumbent workers) remains high. After all, national employment rates will rise if labor demand increases. Implicitly, the Keynesian crew is arguing that a President who can engage in a massive “New Deal” can shift expectations and this will bring about new investment. This represents a massive “average treatment effect” of the form:

Expect Recession to Persist into 2011 = c + b*1(Engage in Big New Deal) + U

where 1() is the indicator function that equals one if a President starts an enormous public works campaign.

The empirical hypothesis is to test whether the coefficient "b" is less than zero.
Do Government stimulus programs shift expectations to raise hope and belief and reign in the crazed "animal spirits" such that prosperity will return?

It seems like behavioral economics (which started in micro-economics) now has merged again with macro-economics to give us a multiple equilibrium model such that the brave government is the only economic actor who can save us from dooming ourselves to chaos and revolution. This sounds a bit heroic to me.

I am arguing that the expectation of a “New Deal” may slow down and retard private investment, not due to crowding out due to higher interest rates, but due to rent seeking as industry seeks to look weak and needy.

In a world where firms recognize that investments in capital are sunk irreversible investments, facing uncertainty such firms always had an incentive to delay such investments. Now they have a second incentive to delay (namely hope for a bailout). In aggregate such choices add up.