The Economic Costs of Government Activism

ROGER ALTMAN: Welcome to the Council and welcome to this morning's breakfast. We're very fortunate to have as our guest Alan Greenspan.

There are few people who need no introduction less than Alan needs no introduction. But I'd like to say it's a privilege for me. Alan and I have been friends for quite a long time. I'm a big admirer of his. And so I'm very -- I'm particularly pleased to be here with you this morning.

I think you all know Alan's extraordinary record of public service, both in the executive branch and, of course, at the Federal Reserve System, and the extraordinary record of intellectual contribution he's made to this country, and other contributions.

Let me remind you, please, of the format this morning. First and foremost, this discussion is on the record. I'd also like to ask all of you, please, to turn off your cell phones and BlackBerrys and iPads and every other imaginable device you may be carrying. And please turn them off, not just on vibrate.

We're going to begin with a discussion, so to speak, between Alan and me. And then we're going to open it up to questions from all of you. And we will -- we will close this meeting promptly at 9:30.

I'm going to base my questions on a very -- I would say very provocative article which Alan has just written and which I think a number of you have seen. It's right here, and the title of the article is "Activism," as in the enormous spate of activism we saw at the federal level following the credit market collapse and the onset of the great recession. And it's a very provocative peace because, in effect -- and you -- feel free to challenge me on this, please, Alan -- but in effect, it's a --

ALAN GREENSPAN: Provocative.

ALTMAN: -- it's a critique of that activism.

So I have a series of questions, and let me start with this one. Alan, the thrust of this is that capital expenditures as a share of corporate cash flow are lower than at any point since 1940. And of course, there's a big cost to that from the point of view of productivity and jobs and income and so forth. And you attribute that weakness to a negative reaction among business or in the business world to the activism, as you call it, which followed the credit market collapse. And what particularly struck me about that observation was that it implies that the, quote, "benefits" of the activism -- the stimulus program, for example -- may have been offset somewhat, entirely, or more than entirely offset by the economic cost of this weakness in investment, so possibly the stimulus program was ineffective. And I'd like to ask if you agree with that characterization and if you'd like to take me on in some form or other in terms of my interpretation.

GREENSPAN: No, I think the interpretation is correct.

What I've endeavored to do is to try to examine what has struck me right from the beginning, the tepid recovery in economic activity that came out of the post-Lehman bankruptcy crash. It shows up most particularly in the structure of the GDP, in the sense that most people look at the GDP as just an adding-up of expenditures, which of course is exactly what it is. But what they rarely if ever do is try to put a life expectancy on each of those elements in the GDP, because when you do that, you see something very interesting in the current period, namely that the -- all of the loss in economic activity, which has engendered this huge rise in unemployment, is attributable to expenditures on assets with life expectancies of greater than 20 years. Now this is basically buildings. It is residential in part, but since the 2008 crash, it's been predominantly nonresidential, and that what we're seeing is that even though there is a modest and actually a reasonable, good recovery in equipment and software, the structures part of capital investment is dead in the water. I mean, it's showing signs of coming back, but it hasn't really, effectively.

Now the reason this is important is, it points out that if you're having, as indeed you do have in these data, a 1 percentage point annual rate of change greater for private domestic GDP excluding those with 20 years of life or more than you do with it.

So in a sense, if you were to convert the GDP excluding these longer -- very longer-term assets into the overall private -- the overall GDP, in fact, and convert that to the unemployment rate, you find that with this extraordinary opening up of a gap since 2007, you account for pretty much all of the rise in unemployment from the 4 1/2 to close to 5 percent up to the 9 to 10 (percent).

And so the issue is what is causing that. And what I've tried to examine is what is sort of obvious immediately: that it is the long distant assets which are being most heavily discounted.

And where I started to look is to go to what essentially is the process by which corporate investment is made. And in my experience -- which, prior to being at the Fed and at the CEA, was pretty much corporate consulting-related, so I was always involved in these capital projects -- and what they do is, they're aware of the fact that they have liquid cash flow and they have to make a decision as to how much of that liquid cash flow they're going to invest in illiquid long-term assets.

This is not taking cash flow and putting it into securities of one form or another, because remember, in a marketable securities market, there is no effective long-term maturity. Everything is three minutes because you can sell it in three minutes. That's not true if you build an aluminum rolling mill. You can't sell it in -- the rates of return are usually quite significant, but they are obtained solely over the life of the asset and not up front.

And what I recall -- and I'm sure it still exists -- is what -- the basic way in which the corporation made its decision of choosing what proportion of the liquid cash flow they would move is that they took a look at, one, their expected life -- I should say expected rate of return on the new asset -- the most likely expected rate of return.

But then they did a simulation of various different forms -- to get a distribution of those rates of return. And if you have to invest over a very long period of time or assets with are irredeemable, making that a very critical choice, you have to have some confidence, in part at least, that you know what the structure will look like. Right now, for example, utility plants are having major problems because they don't know what their carbon costs are going to be, and that is causing them to pull back, to move towards shorter-time type of assets in order to get electric power.

But in general, what this tells me is that if we have had in this crisis a collapse in the ratio of capital investment to cash flow, it's -- you have to remember, they are -- corporations are choosing to make that allocation. And so I look at these data and what's unambiguous is the fact, as you point out in the piece, is I carry these cash flow analyses back into the 1930s, and what is remarkable characteristic about the current period is they look very much like they did back then.

And I don't think it's an accident, but I do recognize that that is not statistical proof. But there's very much similar fear of what government will do, and I go through a little bit of what went on in the '30s -- the National Industrial Recovery Act basically dictated most everything up until it was knocked down by the Supreme Court. That's sort of the extreme form of activism.

Zero-activism has never existed in the sense that I would define it as pure laissez faire, and pure laissez faire has never existed in any society, but it's an issue of relatives. And the reason why you have activism as a problem is that it increases the number of variables that the corporation must deal with. In short, in a statistical sense, it spreads out the variants of the distribution of expected rates of return, and just as importantly -- maybe even more so -- is the evidence also suggests that while both tail risks -- meaning you way underestimate the potential rate of return --

ALTMAN: Or overestimate.

GREENSPAN: -- or you overestimate it -- but the evidence also suggests that it is the tail risk that moves up the most.

ALTMAN: Well, let me press the point a little bit. If, as you just said a moment ago, this gap between the historical relationship of long-lived corporate fixed investment and cash flow that we're now seeing -- if that accounts for the entire rise in unemployment, and if the primary reason for the gap, as the paper says, is business aversion to this activism, then the implication is, if we hadn't had the activism, labor market conditions would actually be better.

GREENSPAN: That's the conclusion, but it has to be proved. In other words, it -- my concern about that is that I don't find listening to what businessmen say is necessarily all that useful. (Laughter.) I've had too much experience. I try to find --

ALTMAN: We won't take that personally, Alan. (Laughter.)

GREENSPAN: OK.

The basic issue is what they do. And this ratio of capital investment or capital appropriations -- which is really technically the more appropriate statistic -- as a share of cash flow is not saying what they believe; it's saying what they are doing. And it's that which is creating this pulling back in the average expectancy of the -- life expectancy of the GDP.

In fact, I -- in one of the charts in the article, I plot the actual average expectancy, and it is drifting down for a number of years as the rate of population growth slows and the need for many more buildings that you need -- obviously for a growing population you have more buildings of all sorts. It's going down very gradually and very -- through about 1992, then flattens out, and then in 2007 falls sharply. The pulling back is obvious. What is unqualified is essentially what the data are showing as to where the hole in the economy is. It's a question of proof that in effect it's the activism which is the major cause. So what I tried to do is to take the actual ratio of capital investment to cash flow -- and this is true, I might add, in small business; it's even true in households; it's true throughout the private sector. You can see the pulling back, which is really quite significant.

If you basically put these data together, what you find is that you're asking the question, why is business doing this, or why are households doing this. What I start doing, and the most surprising part of the paper is the fact that approximately a fifth of the shortfall in capital investment is attributable to so-called crowding out by the federal -- (audio break) -- deficit. It's always been a generally agreed upon proposition that over the long run that large federal deficits crowd out private investment -- which came as a surprise to me is how robust the statistics are in the short run with some lead involved in it.

But the point here is that if you look -- it's not -- it doesn't come as a surprise if you disaggregate the savings and investment and balances of households, business, state and local governments and everything else. Remember that savings investment for the globe as a whole has got to be equal, and the difference between each country is a current account balance. And so that you can set up a series of relationships which -- in which you can see, if you set up the difference between gross savings and investment by sector -- meaning by households, by state and local governments, by federal government, by corporations and others -- what you find is this very sharp rise in cyclically adjusted deficits -- accounts for visually a very significant part of their shortfall that's occurring in capital investment. And then when you go into the econometrics, the numbers are very robust, for those of you who like that sort of thing.

That came as a big surprise to me. I never expected to get that result, and in fact I came upon it by accident. But it -- I tried to do it in other countries -- it works even better in the United Kingdom. It doesn't appear to be working as a general proposition throughout the world, as best I can judge.

Partly the data are not readily available, but partly I also suspect -- and we have too few observations here -- that there is a threshold in which the deficit as a percent of GDP -- you know, 2 (percent), 3 (percent), 4 percent, even -- doesn't show up as any particular impact on private investment.

But there's a nonlinearity that you -- and you can tell -- for those of you who care, I'm using logarithmic equations which pick up part of it, but -- without going into the other details, having disaggregated the stimulus program, it is really awesome how close the issue of the shortfall in capital investment, quarter by quarter, matches the official data on government deficits. I'm using, incidentally, the national income deficits, which are approximately the same. But the reason they are important is they balanced to the rest of the flow of funds, including the current account balance.

So it's -- you come at this in a number of different ways, and what is I would say unequivocal in the result is at a minimum it appears as though the stimulus program, which is a gross statistic, requires at least a minimum offset, which is this crowding out. But there's also additional important issues here. Of the issue of ratio of investment to cash flow, about a quarter seems to be attributed to the normal adjustment of capital investment to changing business cycle conditions. This is abstracting from cyclically adjusted deficits and other aspects. The rest, however, is difficult to judge where it's coming from, other than the sheer uncertainties, because observe what happens if you introduce -- if you take the position, which essentially is what we're doing, that unless the government comes in and keeps pushing, it won't move by itself.

My sense is that what we need to do now is to calm down, just let things move by themselves, and indeed the rate of activism has fallen off quite significantly, and the ratio of capital investment to cash flow has started back up. Now, you can make that statement, and to say it and then demonstrate the cause and effect are two separate issues.

ALTMAN: But you can seen why this is provocative, because, as I said, the implication is that had we not had the stimulus and had we not had, for that reason and certain others, the attendant surge in fiscal deficits, growth -- investment, growth and jobs would have been better. And that's a very important question.

Alan, I want to ask you about lending. The piece also -- the piece makes an analogous point about weakness in lending, and at least my reading of it implies that Dodd-Frank and certain other aspects of the regulatory response to this crisis have suppressed lending in a way that, together with this weakness in investment, has also obviously been harmful to recovery. Is that a fair reading of it?

GREENSPAN: Well, I think it will, but I don't think it has very significantly yet, because remember that Dodd-Frank is not scheduled to actually be implemented by the regulatory agencies until July. The extraordinary amount of regulatory rulings that are required under Dodd-Frank is swamping the regulatory agencies. When I was at the Fed, if we had a ruling maybe once a month, that was a lot because they require adjudication and various other things. There's something like a couple of hundred required under Dodd-Frank.

Now, one of the problems that I have with the Dodd-Frank bill is that there is implicit conceptual structure of how markets work, and I think frankly it strikes me as rather simplistic and doesn't really capture the complexity of what indeed is currently going on in the marketplace.

There has been a major move toward reregulating the financial system and effectively to alter the markets, but what they are finding even now, early on, is that unanticipated consequences are bedeviling the system. I mean, for example, within a day after the bill was signed, Ford Motor tried to issue an asset-backed security but it required by law to have a credit rating agency certify or give an opinion, but they couldn't get any, and the reason they couldn't is there is a provision in the Dodd-Frank bill which specifies that credit rating agencies are liable to what type of credit ratings they give, meaning -- now, it's a legal case; you have to show that it's some form of --

ALTMAN: Negligence.

GREENSPAN: -- negligence. But the mere fact that they are subject -- and so what happened is that they quickly got a reversal with the staff of the SEC, saying we will not bring this issue up to the commission, which effectively made the provision in Dodd-Frank moot.

And we saw a similar thing in the fixing of fees when -- remember there was a wonderful day when both Visa and MasterCard stock prices collapsed. What caused it? It was the implementation of Dodd-Frank allocation of fees between various different -- this is basically the debit card fees. And what struck me about it is that it -- the legislation required a sharp reduction in those going to banks, but the actual preliminary judgment was -- I should say preliminary ruling is even stronger than what the market had expected. And the number of -- the Fed got flooded with all sorts of arguments against it.

I don't know how that's going to come out and how they'll -- I don't know what the final ruling is. I do know that this is the tip of the iceberg and we're going to begin to see it -- meaning that -- a failure to understand these secondary consequences of what these rulings are going to do. And remember that one of the aspects -- to respond to your question -- one of the aspects of the process of determining capital investment is what type of financing is available and what type can I expect, and in refinancing, as the years go on. So it's not a simple one-shot deal. And to the extent that there is uncertainty in the financial structure, it too raises issues which would affect the capital investment to cash flow ratio. By how much I have no way of measuring, but that it does. My experience over the years is that it is not -- it's significant but not critically important to the investment process as much as it is to the financial system.

So I think we still have a number of things out there which are still in play, and we won't see their impact. But what I think is fairly clear at this stage is that, to come to the bottom line, the data do not directly show that the stimulus program net as calculate is negative, meaning I can't demonstrate using the gross stimulus estimate, which both OMB and CBO are measuring, and argue --

ALTMAN: Again, it doesn't prove the stimulus program is negative; it just suggests that.

GREENSPAN: Well, no, it suggests that. But there's another aspect -- this is a two-legged stool. One is that there is no question in my mind that at a minimum you have to take the stimulus impact and debit it for part of at least the crowding out and other aspects. But one of the more -- greater concerns on my part is I think that the gross estimate is faulty.

Let me tell you why. A necessary structure in estimating the impact of, say, a government program of that sort -- remember, this is an 814 billion (dollar) program spread out over a number of years with most of it being, you know, up front.

Well, you have to make a judgment of if you're going to have an increase in transfer payments or tax cuts or something. They all have different so-called impact multipliers on the GDP. I mean, the presumption is that upper-income groups save and they don't spend, so it's lower. The difficulty I have with that is that the impact multipliers are coming off econometric models, as they need to be because there's no other way to do it, which failed to forecast the recession of 2008 and have failed to forecast every recession that I'm aware of. And the reason is the way we build those models.

I don't want to get too technical, but we have standard -- two-stage lease squares fit to a whole series of data, but the technical estimates, the coefficients in the model tend to converge towards the mean of these data. And if you put the mean of all of these data into a model, I defy you, without sort of overriding the model, to create any sort of recession. And I think it's not an accident that the best of these models -- which is the Federal Reserve -- has not ever forecast a recession. It can't. That's not -- that is not the way I would have used it and don't.

But the IMF didn't, and I don't know any that did. And the reason, therefore, is why do we assume that the impact multipliers -- this is now the gross effect -- are any more accurate than the models which they're using which have demonstrated they are faulty? So I have one which I'm sure of, namely that there's got to be at least some debit against any gross stimulus which is the basically crowding-out issue as a minimum. And I then go back and say, well, how do I even know that the gross estimate is correct? And I don't.

So that leaves me in the position where the data that I have directly only applied to the offset to the gross stimulus. I know what the order of magnitude of that is. In and of itself, it doesn't make the gross stimulus turn negative. But I have very serious concerns about what the actual impact multipliers are, especially in this type of thing, and I'm still struggling to find a mathematical means by which I can convert rhetoric into numbers.

ALTMAN: Let me ask you about another aspect of this. In the paper, you say that the one area which government, in effect, left alone, the equity markets, has recovered strongly and that --

GREENSPAN: Until today.

ALTMAN: OK. And that 35 trillion (dollars) or so of wealth that was lost has been -- about three quarters of that until today has been recovered.

GREENSPAN: That's global.

ALTMAN: Global.

GREENSPAN: Thirty-five trillion (dollars), yeah.

ALTMAN: And that's also provocative because it implies that the one part of -- the one engine that's really working, for example, in terms of the attendant wealth effects and everything else, is equity prices, which was not the object of any government response. And so that struck me because, again, the implication is, by leaving it alone, it's managed to recover quickly and have a quite powerful effect on, for example, household balance sheets and propensity to spend in households and so forth.

So I thought you might comment on that a little bit.

GREENSPAN: Well, let's go back to the 35 trillion (dollar) loss. As you know far better than I, you bring down --

ALTMAN: No, I don't. But go ahead. (Chuckles.)

GREENSPAN: You're not going to bring down anything. (Laughter.)

If that market value of equities in, let's say, financial institutions climbs very sharply, it means that that buffer or the liabilities of the institution has come down dramatically and, therefore, the credit quality of the liabilities of necessity worsen. And so if you get a significant collapse in financial equity -- which is the equity in financial institutions -- the collateralization process almost collapses. And we got very close.

One of the reasons I supported TARP was I thought what it did was it injected equity into the banking system just when it needed it, because collateral -- the value of collateral -- which is mainly debt collateral -- but the debt collateral is priced to a large extent on the extent to which the market value of equities in financial institutions are rising or falling.

And you could see the financial collapse in terms of the decline in stock prices even though it's the debt which created the problem, because the quality of debt fell as the stock prices went down.

Then we finally hit bottom in March of 2009, and what we have seen is a dramatic rise, as you point out, not only in the wealth effect -- which very clearly impacts on consumer expenditures -- but just as importantly, in the financial system. And what this has done is, frankly, it has enabled a good deal of TARP to be paid off with capital gains. And you can't actually stipulate that a particular repayment is a capital gain, but if you look at where the equity that is paying it off is coming from, it's largely there.

And so what happens in this case is you get a dramatic rise in stock prices which liquefies the whole system and increases the value of collateral in the system, and therefore, longer-term lending which, indeed, took place quite significantly.

And even though it was never enough to bring capital investment around because, if there's no rate of return on capital investment because you don't see it in the future, I don't care what your financing capabilities are, you're just not going to -- you're not going to invest.

And so what has turned this around is, for other reasons, corporate profits have risen fairly sharply. It's to a very large extent the result of a relatively short period of very significant amount of cost-saving capital investment. This is not -- this is not structures. This is not building. It's software, equipment and the like basically to reduce the unit costs of energy, which it did for quite a while, materials and labor.

So there's a very strong growth in not only labor productivity but also in energy and materials productivity, which has propelled profits very materially and therefore the cash flows that are associated with it.

That, I might add, is beginning to flatten out. All of the profit rise was a result of rising profit margins. There's very little in the early stages of the recovery which came from sales increases.

But what we're seeing now is the profit margins are flattening out, but there's some evidence that the sales increases are picking up. But it's that big surge in profitability which pressed against what economists call equity premiums, which is the rate of return that is required to invest in equity.

And as J.P. Morgan indicated, oh, about six or eight months ago --

ALTMAN: It was very high.

GREENSPAN: It was the highest level in their series for 50 years. Now, it's come back down. In other words, it's come back down, I would say in the last few days it's gone up -- back up. But it's not -- it's not -- the fear is still there, and it is reflected in the equity premium, but the surge of earnings per share is such that that has propelled a very substantial rise in stock prices and in the wealth effect which is across the board.

And this, I might add, is a global phenomenon. It's not just the United States. And as you -- you're quite correct, in my view. I think that, fortunately, we left the stock market alone -- or I should say we left it to function by itself. And it turned around, and it's been an extraordinary rise up through a few weeks ago.

ALTMAN: So let's open this up to questions. Just one or two observations, please, beforehand. Wait for the microphone. Please identify yourself. If you don't mind my saying so, please be sure you ask a question and not give a speech.

Yes, sir. Right in the middle, right there?

QUESTIONER: Thank you. Fred Tipson with the U.N. Development Program.

Mr. Chairman, how does this argument differ from Herbert Hoover's argument in 1929, who got the microeconomics right but seemed to miss the whole macro-psychology of the economy that required government activism to restore confidence?

How can we say that the stock market was left alone when these huge banks and huge auto companies were rescued in a way which gave investors confidence to stay or go back into the stock market? It was dependent on this government activism.

Now, in the '30s, it was the Supreme Court that put a brake on the degree of activism, and you could argue the content and degree of activism. But wasn't that activism essential to maintain the economy in a way that prevented something much worse?

GREENSPAN: Well, let me first say that, as I indicated before, I was in favor of the government activism right after the crisis. And, indeed, I argued in another piece which was published -- I guess I can say the Brookings Institution.

ALTMAN: The small place somewhere around here.

GREENSPAN: Down the street. What I argued there is that the basic surge that has occurred has been very largely localized to what I would argue was the largest financial crisis globally ever. I mean, I'm certainly -- the depression of the '30s was, in an economic sense, much greater, but as far as we had -- we had never seen a shutdown in short-term money markets of the type that we saw subsequent to the Lehman bankruptcy. I mean, the commercial paper market closed down. Even the repo market was shaking, which is extraordinary.

And if the Fed did not move in on the money market and mutual funds, they would have broken the dollar, so to speak, in all the various things that would have occurred as a consequence. So I am arguing -- and as I did in that piece -- that if you have got the type of structure in which the financial system tries to have capital adequate to meet every loan provision, loss provision up to, say, .999 as far as probability is concerned, that theoretically seems adequate.

The trouble is that the .999, there's still, as it happens, .001. And I think that what we've just been through, as I called it hypothetically in a speech I made a long time ago about central banking, is that if you have a fractional reserve system and if you do not cover all of the possibilities and over-cover them, you're always left with the possibility, what about that very small probability, which becomes a hundred percent when it happens.

Now, I can't prove that what we've just been through is a unique or almost a unique phenomenon. That's my presumption, and I grant you that a lot of other things rest on it. I would say, with respect to the activism of the '30s, remember that the initial activism was negative. I mean, the Federal Reserve was tightening up in the '20s. And the whole thing came tumbling down, but then there was a huge amount of activism in the 1930s which, of course, led to the NIRA. But incidentally, it did not alter the continued -- I mean, the Supreme Court ruled the NIRA unconstitutional in 1935, but the evidence is that the cartelization that was coming from that continued on. And I try to -- there are several interesting papers on that issue which I cite in this particular paper.

And it's a very debatable issue. I mean, people think that it's a given that much of what was done during the '30s was essential. I think the evidence is unclear on that.

ALTMAN: Let's have another question. Yes, sir?

QUESTIONER: Mac Gessler (ph), University of Maryland and Peterson Institute.

About two years ago, I had a conversation with a now-famous friend, Carmen Reinhart. And we were talking about whether the stimulus would have a rapid effect, as the administration hoped, or whether it wouldn't. And she said, Don't worry, this recession is going to be with us for some time anyway.

And as I understand it, her reason for saying so was that recovery from financial crisis, banking-crisis-driven recessions is historically much slower than recovery from garden-variety excess-demand recessions.

Now, I'm not, perhaps, describing the economics just right, but the Rogoff-Reinhart book essentially documents very slow recoveries from financially driven recessions. And, therefore, that might be the proper comparative, not recovery from previous recessions that were -- had less fundamental crises driving them.

GREENSPAN: Well, you're raising a question that's very difficult in economics as to what is cause and what is effect and how it functions.

First of all, these are not necessarily mutually exclusive explanations. First of all, if you can basically get to, as I've tried to, the specific decision-making process which is creating the problem, I submit that that is somewhat superior to historic analogies.

Carmen Reinhart has got great credentials. She's an old Federal Reserve employee of great esteem. So I'm scarcely going to argue against her especially since I see her on occasion with her husband. They are both very good economists.

The problem here is a problem of economics. What constitutes proof? Now, by analogy, it is not proof. Most of the types of stuff that we do -- I do, everyone else does, and Carmen does -- is by analogy, an historic analogy. I tried to get a step deeper into looking at the actual decision-making process as it impacts through the distribution of probabilities and the rate of return on facilities. And I submit that that should be a superior view or analysis of what is causing what.

I'm not certain, but I will suspect that, in retrospect, when Rogoff and Reinhart puts their next edition out or something like that, they're going to find that this one is lagging more than any since the '30s. And I think that you have to ask the question, why is that?

That a breakdown in structure occurs in finance, I think, is related to the collateralization issue I was discussing before. It's a question of how deep and prolonged it continues. And all I can say is that I think I've gone a step beyond in trying to ask the question what specific decision-making process creates the subnormal rise in economic activity.

Why has the recovery been so tepid? Now, you can draw analogies and say it's essentially because that, when a financial system runs into problems, it takes a longer time to pick up. I don't deny that. That is not necessarily contradicting what I'm saying. I'm just essentially saying that you need to get beneath the data by analogy in order to come up with a specific analysis.

In other words, I demonstrate, for example, on the crowding-out issue, not by analogy; I mean, I've got a body of data which is highly statistically significant and not basically by analogies to a series of historical episodes which, in most instances, are very valuable and probably essential for getting first judgments.

I'm saying that I don't consider it to be enough because I don't know -- without knowing the individual reasons as to why individual financial crises led to specific delayed economic activity, really has to get down to why did the 1873 crisis differ from, say, 1893? Why did the 1893 last so long? This is way before government activism of the type we're talking about.

I mean, these are questions I don't know the answer to, but I recognize that they are important to answer. And I don't know the answer, but I do know that a sufficient condition to explain the existing state of affairs is captured by the statistic which analyzes what the choice of the capital appropriations committees in business is with respect to what part of their liquid assets they are willing to convert into -- their liquid assets into illiquid long-term investments. That is a very critical decision because you are impairing shareholders' equity.

And this, incidentally, is the reason why the equity-to-asset ratio in non-financial business or non-financial corporations is close to 50 percent. Where, in finance, it's 10. And the important issue that I raise in this paper is that illiquid assets are very different from liquid-asset investment because, as I mentioned parenthetically before, the issue of the maturity -- effective maturity of an investment depends on how long it takes you to get your money back.

A 10-year BAA bond, for example, has got an effective maturity in a market which is liquid. Five minutes is how long it takes you to call your broker and sell it.

What is interesting is that when you get crashes of the type we got in 2008, the liquid markets turn illiquid, or partially so, and the convergence between the rate of return on illiquid fixed long-term investments and these previously liquid BAA yield spreads against treasuries starts to converge.

ALTMAN: Let's have another question. Yes, sir?

QUESTIONER: Arnaud de Borchgrave, CSIS.

Pete Peterson recently described what we've lived through since 2008, beginning with the predatory lending for mortgages. He says it is a reflection of carnivorous and animalistic capitalism. Do you share that viewpoint?

GREENSPAN: What kind of capitalism is that? (Laughter.)

I know Pete. Pete's a very old friend of mine. If you told me he said it in that forum, I don't think he means it exactly the way that the implication of the words are. He is a very pro-capitalist person.

But there are aspects of human nature which have those -- that you could characterize that way. I don't think it's the economic structure that is the problem. I think it's human nature. And I would have never argued, for example, that if you take -- go back and look at Fabian socialism. Fabian socialism, in its early stages, looked far more rational to many people than Adam Smith's model. And the reason, the argument went, was that wouldn't you prefer that the investment distribution of your assets were done by the people most knowledgeable rather than individual market perturbations and the like?

And, you know, indeed, Nehru, when the British essentially moved out of India, imposed a form of Fabian socialism on the grounds that it was the best way to organize as a society. And he did it, as far as I can judge, in the most rational way I can imagine. It didn't work, and it didn't work because human nature prevented it from happening.

And so I would say that the problems that we find in capitalism and in socialism and in communism -- and one of the reasons why Marx was wrong was not that Das Kapital was sort of a book which was inconsistent. It's a very rationally constructed book which presupposes a human nature which doesn't exist. And I would submit that, when we have problems that we see in marketplaces, whether it's greed or various other short-term aspects of the way markets tend to behave, I would say the root is not the structure; it's basically human nature. And I know of no way that we're going to alter that.

ALTMAN: We're going take one last question, a very brief question.

Go ahead, Rick.

QUESTIONER: Mr. Greenspan, I'm having a little trouble with your logic. I heard you say at the beginning that the capital expenditure ratios were the lowest level to cash flow since 1940. And then you talk about crowding out.

When I hear the lowest level of expenditure, I hear that companies have enormous amounts of money that they could spend on capital expenditures if they wanted to. So how are they crowded out? I don't understand that.

Second problem I have is I would be interested to know --

GREENSPAN: Rick, can I just answer that first one first?

The crowding-out issue here is such that you have this very large cash flow occurring, and the question is that they don't want to invest it. What do they do with it? They add it to liquid assets. There was a $500 billion increase in liquid-asset holdings. They've got all of that cash to spend if they felt that they had a rate of return to do it.

QUESTIONER: So how are they crowded out? I don't get it. If they have all that cash, how are they crowded out by the government?

GREENSPAN: Well, the point at issue, it's the savings that the federal government absorbs which -- start off with the proposition. Let's assume that the current account balance is zero, which means that savings investments in the economy are equal. It necessarily means that the amount of investment which can take place must be equal to the amount of savings.

Now, what the data show is that you see is that what happens when the federal deficit rises, which is negative savings, is that it must be offset somewhere in the rest of the system. And what the data show -- and this is basically an analysis of the flows of funds -- is you see a huge increases in -- (inaudible) -- savings and a huge decline in capital investment.

Those are the two major moving parts --

QUESTIONER: Sir, excuse me. But do we still have corporations sitting on $2 trillion of cash? And if so, how are they crowded out? I mean, I hear your numbers, and I hear your charts, but it just doesn't correspond with what I'm seeing and hearing in the economy.

GREENSPAN: Well, no. The basic problem is that when the savings get -- first of all, there is a limited amount of savings in a society. And the question is: Who has most -- who is going to employ those savings in one form or another to invest? The U.S. Treasury will pay whatever interest rate is required in order to basically achieve that part of the savings which are required to finance the deficit.

Now, what that means basically is that interest rates are moved up to a level in which there are certain people in the economy who would like to invest but can't afford the interest --

QUESTIONER: Sir, the interest rates have as low as they've been in decades.

GREENSPAN: No, that is not -- Rick, that is true only of AAA corporates. Microsoft is not being crowded out. IBM is not being crowded out. The ones that are being crowded out are shown to be those which are, say, B-rated corporations.

If you took a look at CCC yields, interest rates are very high. And if you look at where the shortfall in investment is, it is very largely in smaller business and in construction particularly. But it is not the large corporations which are being crowded out.

They would be crowded out if the deficit were twice the size it is. They do not crowd out at this level. So I would say to you, who is crowded out? Well, I can -- I can't put the list of names down, but I could probably go find them if it were necessary. It's those who find that an 8 or 9 percent interest rate, which are required of some junk-bond issuers or smaller business, is too high for them to get a reasonable rate of return.

So the crowding out exists. It's just not -- you can't argue that because Microsoft is not crowded out, that therefore nobody is crowded out. It's a question of the required balance between savings and investment. There's no alternative to that.

ALTMAN: On that note, I do want to be reasonably faithful to our closing time. And I want to thank all of you for coming this morning. (Applause.)

Most particularly, I want to thank Alan, and I would like to remind the members that the next meeting here, on March 17th, is with AFL-CIO President Richard Trumka.

Thanks for coming. Have a good day.

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THIS IS A RUSH TRANSCRIPT.

ROGER ALTMAN: Welcome to the Council and welcome to this morning's breakfast. We're very fortunate to have as our guest Alan Greenspan.

There are few people who need no introduction less than Alan needs no introduction. But I'd like to say it's a privilege for me. Alan and I have been friends for quite a long time. I'm a big admirer of his. And so I'm very -- I'm particularly pleased to be here with you this morning.

I think you all know Alan's extraordinary record of public service, both in the executive branch and, of course, at the Federal Reserve System, and the extraordinary record of intellectual contribution he's made to this country, and other contributions.

Let me remind you, please, of the format this morning. First and foremost, this discussion is on the record. I'd also like to ask all of you, please, to turn off your cell phones and BlackBerrys and iPads and every other imaginable device you may be carrying. And please turn them off, not just on vibrate.

We're going to begin with a discussion, so to speak, between Alan and me. And then we're going to open it up to questions from all of you. And we will -- we will close this meeting promptly at 9:30.

I'm going to base my questions on a very -- I would say very provocative article which Alan has just written and which I think a number of you have seen. It's right here, and the title of the article is "Activism," as in the enormous spate of activism we saw at the federal level following the credit market collapse and the onset of the great recession. And it's a very provocative peace because, in effect -- and you -- feel free to challenge me on this, please, Alan -- but in effect, it's a --

ALAN GREENSPAN: Provocative.

ALTMAN: -- it's a critique of that activism.

So I have a series of questions, and let me start with this one. Alan, the thrust of this is that capital expenditures as a share of corporate cash flow are lower than at any point since 1940. And of course, there's a big cost to that from the point of view of productivity and jobs and income and so forth. And you attribute that weakness to a negative reaction among business or in the business world to the activism, as you call it, which followed the credit market collapse. And what particularly struck me about that observation was that it implies that the, quote, "benefits" of the activism -- the stimulus program, for example -- may have been offset somewhat, entirely, or more than entirely offset by the economic cost of this weakness in investment, so possibly the stimulus program was ineffective. And I'd like to ask if you agree with that characterization and if you'd like to take me on in some form or other in terms of my interpretation.

GREENSPAN: No, I think the interpretation is correct.

What I've endeavored to do is to try to examine what has struck me right from the beginning, the tepid recovery in economic activity that came out of the post-Lehman bankruptcy crash. It shows up most particularly in the structure of the GDP, in the sense that most people look at the GDP as just an adding-up of expenditures, which of course is exactly what it is. But what they rarely if ever do is try to put a life expectancy on each of those elements in the GDP, because when you do that, you see something very interesting in the current period, namely that the -- all of the loss in economic activity, which has engendered this huge rise in unemployment, is attributable to expenditures on assets with life expectancies of greater than 20 years. Now this is basically buildings. It is residential in part, but since the 2008 crash, it's been predominantly nonresidential, and that what we're seeing is that even though there is a modest and actually a reasonable, good recovery in equipment and software, the structures part of capital investment is dead in the water. I mean, it's showing signs of coming back, but it hasn't really, effectively.

Now the reason this is important is, it points out that if you're having, as indeed you do have in these data, a 1 percentage point annual rate of change greater for private domestic GDP excluding those with 20 years of life or more than you do with it.

So in a sense, if you were to convert the GDP excluding these longer -- very longer-term assets into the overall private -- the overall GDP, in fact, and convert that to the unemployment rate, you find that with this extraordinary opening up of a gap since 2007, you account for pretty much all of the rise in unemployment from the 4 1/2 to close to 5 percent up to the 9 to 10 (percent).

And so the issue is what is causing that. And what I've tried to examine is what is sort of obvious immediately: that it is the long distant assets which are being most heavily discounted.

And where I started to look is to go to what essentially is the process by which corporate investment is made. And in my experience -- which, prior to being at the Fed and at the CEA, was pretty much corporate consulting-related, so I was always involved in these capital projects -- and what they do is, they're aware of the fact that they have liquid cash flow and they have to make a decision as to how much of that liquid cash flow they're going to invest in illiquid long-term assets.

This is not taking cash flow and putting it into securities of one form or another, because remember, in a marketable securities market, there is no effective long-term maturity. Everything is three minutes because you can sell it in three minutes. That's not true if you build an aluminum rolling mill. You can't sell it in -- the rates of return are usually quite significant, but they are obtained solely over the life of the asset and not up front.

And what I recall -- and I'm sure it still exists -- is what -- the basic way in which the corporation made its decision of choosing what proportion of the liquid cash flow they would move is that they took a look at, one, their expected life -- I should say expected rate of return on the new asset -- the most likely expected rate of return.

But then they did a simulation of various different forms -- to get a distribution of those rates of return. And if you have to invest over a very long period of time or assets with are irredeemable, making that a very critical choice, you have to have some confidence, in part at least, that you know what the structure will look like. Right now, for example, utility plants are having major problems because they don't know what their carbon costs are going to be, and that is causing them to pull back, to move towards shorter-time type of assets in order to get electric power.

But in general, what this tells me is that if we have had in this crisis a collapse in the ratio of capital investment to cash flow, it's -- you have to remember, they are -- corporations are choosing to make that allocation. And so I look at these data and what's unambiguous is the fact, as you point out in the piece, is I carry these cash flow analyses back into the 1930s, and what is remarkable characteristic about the current period is they look very much like they did back then.

And I don't think it's an accident, but I do recognize that that is not statistical proof. But there's very much similar fear of what government will do, and I go through a little bit of what went on in the '30s -- the National Industrial Recovery Act basically dictated most everything up until it was knocked down by the Supreme Court. That's sort of the extreme form of activism.

Zero-activism has never existed in the sense that I would define it as pure laissez faire, and pure laissez faire has never existed in any society, but it's an issue of relatives. And the reason why you have activism as a problem is that it increases the number of variables that the corporation must deal with. In short, in a statistical sense, it spreads out the variants of the distribution of expected rates of return, and just as importantly -- maybe even more so -- is the evidence also suggests that while both tail risks -- meaning you way underestimate the potential rate of return --

ALTMAN: Or overestimate.

GREENSPAN: -- or you overestimate it -- but the evidence also suggests that it is the tail risk that moves up the most.

ALTMAN: Well, let me press the point a little bit. If, as you just said a moment ago, this gap between the historical relationship of long-lived corporate fixed investment and cash flow that we're now seeing -- if that accounts for the entire rise in unemployment, and if the primary reason for the gap, as the paper says, is business aversion to this activism, then the implication is, if we hadn't had the activism, labor market conditions would actually be better.

GREENSPAN: That's the conclusion, but it has to be proved. In other words, it -- my concern about that is that I don't find listening to what businessmen say is necessarily all that useful. (Laughter.) I've had too much experience. I try to find --

ALTMAN: We won't take that personally, Alan. (Laughter.)

GREENSPAN: OK.

The basic issue is what they do. And this ratio of capital investment or capital appropriations -- which is really technically the more appropriate statistic -- as a share of cash flow is not saying what they believe; it's saying what they are doing. And it's that which is creating this pulling back in the average expectancy of the -- life expectancy of the GDP.

In fact, I -- in one of the charts in the article, I plot the actual average expectancy, and it is drifting down for a number of years as the rate of population growth slows and the need for many more buildings that you need -- obviously for a growing population you have more buildings of all sorts. It's going down very gradually and very -- through about 1992, then flattens out, and then in 2007 falls sharply. The pulling back is obvious. What is unqualified is essentially what the data are showing as to where the hole in the economy is. It's a question of proof that in effect it's the activism which is the major cause. So what I tried to do is to take the actual ratio of capital investment to cash flow -- and this is true, I might add, in small business; it's even true in households; it's true throughout the private sector. You can see the pulling back, which is really quite significant.

If you basically put these data together, what you find is that you're asking the question, why is business doing this, or why are households doing this. What I start doing, and the most surprising part of the paper is the fact that approximately a fifth of the shortfall in capital investment is attributable to so-called crowding out by the federal -- (audio break) -- deficit. It's always been a generally agreed upon proposition that over the long run that large federal deficits crowd out private investment -- which came as a surprise to me is how robust the statistics are in the short run with some lead involved in it.

But the point here is that if you look -- it's not -- it doesn't come as a surprise if you disaggregate the savings and investment and balances of households, business, state and local governments and everything else. Remember that savings investment for the globe as a whole has got to be equal, and the difference between each country is a current account balance. And so that you can set up a series of relationships which -- in which you can see, if you set up the difference between gross savings and investment by sector -- meaning by households, by state and local governments, by federal government, by corporations and others -- what you find is this very sharp rise in cyclically adjusted deficits -- accounts for visually a very significant part of their shortfall that's occurring in capital investment. And then when you go into the econometrics, the numbers are very robust, for those of you who like that sort of thing.

That came as a big surprise to me. I never expected to get that result, and in fact I came upon it by accident. But it -- I tried to do it in other countries -- it works even better in the United Kingdom. It doesn't appear to be working as a general proposition throughout the world, as best I can judge.

Partly the data are not readily available, but partly I also suspect -- and we have too few observations here -- that there is a threshold in which the deficit as a percent of GDP -- you know, 2 (percent), 3 (percent), 4 percent, even -- doesn't show up as any particular impact on private investment.

But there's a nonlinearity that you -- and you can tell -- for those of you who care, I'm using logarithmic equations which pick up part of it, but -- without going into the other details, having disaggregated the stimulus program, it is really awesome how close the issue of the shortfall in capital investment, quarter by quarter, matches the official data on government deficits. I'm using, incidentally, the national income deficits, which are approximately the same. But the reason they are important is they balanced to the rest of the flow of funds, including the current account balance.

So it's -- you come at this in a number of different ways, and what is I would say unequivocal in the result is at a minimum it appears as though the stimulus program, which is a gross statistic, requires at least a minimum offset, which is this crowding out. But there's also additional important issues here. Of the issue of ratio of investment to cash flow, about a quarter seems to be attributed to the normal adjustment of capital investment to changing business cycle conditions. This is abstracting from cyclically adjusted deficits and other aspects. The rest, however, is difficult to judge where it's coming from, other than the sheer uncertainties, because observe what happens if you introduce -- if you take the position, which essentially is what we're doing, that unless the government comes in and keeps pushing, it won't move by itself.

My sense is that what we need to do now is to calm down, just let things move by themselves, and indeed the rate of activism has fallen off quite significantly, and the ratio of capital investment to cash flow has started back up. Now, you can make that statement, and to say it and then demonstrate the cause and effect are two separate issues.

ALTMAN: But you can seen why this is provocative, because, as I said, the implication is that had we not had the stimulus and had we not had, for that reason and certain others, the attendant surge in fiscal deficits, growth -- investment, growth and jobs would have been better. And that's a very important question.

Alan, I want to ask you about lending. The piece also -- the piece makes an analogous point about weakness in lending, and at least my reading of it implies that Dodd-Frank and certain other aspects of the regulatory response to this crisis have suppressed lending in a way that, together with this weakness in investment, has also obviously been harmful to recovery. Is that a fair reading of it?

GREENSPAN: Well, I think it will, but I don't think it has very significantly yet, because remember that Dodd-Frank is not scheduled to actually be implemented by the regulatory agencies until July. The extraordinary amount of regulatory rulings that are required under Dodd-Frank is swamping the regulatory agencies. When I was at the Fed, if we had a ruling maybe once a month, that was a lot because they require adjudication and various other things. There's something like a couple of hundred required under Dodd-Frank.

Now, one of the problems that I have with the Dodd-Frank bill is that there is implicit conceptual structure of how markets work, and I think frankly it strikes me as rather simplistic and doesn't really capture the complexity of what indeed is currently going on in the marketplace.

There has been a major move toward reregulating the financial system and effectively to alter the markets, but what they are finding even now, early on, is that unanticipated consequences are bedeviling the system. I mean, for example, within a day after the bill was signed, Ford Motor tried to issue an asset-backed security but it required by law to have a credit rating agency certify or give an opinion, but they couldn't get any, and the reason they couldn't is there is a provision in the Dodd-Frank bill which specifies that credit rating agencies are liable to what type of credit ratings they give, meaning -- now, it's a legal case; you have to show that it's some form of --

ALTMAN: Negligence.

GREENSPAN: -- negligence. But the mere fact that they are subject -- and so what happened is that they quickly got a reversal with the staff of the SEC, saying we will not bring this issue up to the commission, which effectively made the provision in Dodd-Frank moot.

And we saw a similar thing in the fixing of fees when -- remember there was a wonderful day when both Visa and MasterCard stock prices collapsed. What caused it? It was the implementation of Dodd-Frank allocation of fees between various different -- this is basically the debit card fees. And what struck me about it is that it -- the legislation required a sharp reduction in those going to banks, but the actual preliminary judgment was -- I should say preliminary ruling is even stronger than what the market had expected. And the number of -- the Fed got flooded with all sorts of arguments against it.

I don't know how that's going to come out and how they'll -- I don't know what the final ruling is. I do know that this is the tip of the iceberg and we're going to begin to see it -- meaning that -- a failure to understand these secondary consequences of what these rulings are going to do. And remember that one of the aspects -- to respond to your question -- one of the aspects of the process of determining capital investment is what type of financing is available and what type can I expect, and in refinancing, as the years go on. So it's not a simple one-shot deal. And to the extent that there is uncertainty in the financial structure, it too raises issues which would affect the capital investment to cash flow ratio. By how much I have no way of measuring, but that it does. My experience over the years is that it is not -- it's significant but not critically important to the investment process as much as it is to the financial system.

So I think we still have a number of things out there which are still in play, and we won't see their impact. But what I think is fairly clear at this stage is that, to come to the bottom line, the data do not directly show that the stimulus program net as calculate is negative, meaning I can't demonstrate using the gross stimulus estimate, which both OMB and CBO are measuring, and argue --

ALTMAN: Again, it doesn't prove the stimulus program is negative; it just suggests that.

GREENSPAN: Well, no, it suggests that. But there's another aspect -- this is a two-legged stool. One is that there is no question in my mind that at a minimum you have to take the stimulus impact and debit it for part of at least the crowding out and other aspects. But one of the more -- greater concerns on my part is I think that the gross estimate is faulty.

Let me tell you why. A necessary structure in estimating the impact of, say, a government program of that sort -- remember, this is an 814 billion (dollar) program spread out over a number of years with most of it being, you know, up front.

Well, you have to make a judgment of if you're going to have an increase in transfer payments or tax cuts or something. They all have different so-called impact multipliers on the GDP. I mean, the presumption is that upper-income groups save and they don't spend, so it's lower. The difficulty I have with that is that the impact multipliers are coming off econometric models, as they need to be because there's no other way to do it, which failed to forecast the recession of 2008 and have failed to forecast every recession that I'm aware of. And the reason is the way we build those models.

I don't want to get too technical, but we have standard -- two-stage lease squares fit to a whole series of data, but the technical estimates, the coefficients in the model tend to converge towards the mean of these data. And if you put the mean of all of these data into a model, I defy you, without sort of overriding the model, to create any sort of recession. And I think it's not an accident that the best of these models -- which is the Federal Reserve -- has not ever forecast a recession. It can't. That's not -- that is not the way I would have used it and don't.

But the IMF didn't, and I don't know any that did. And the reason, therefore, is why do we assume that the impact multipliers -- this is now the gross effect -- are any more accurate than the models which they're using which have demonstrated they are faulty? So I have one which I'm sure of, namely that there's got to be at least some debit against any gross stimulus which is the basically crowding-out issue as a minimum. And I then go back and say, well, how do I even know that the gross estimate is correct? And I don't.

So that leaves me in the position where the data that I have directly only applied to the offset to the gross stimulus. I know what the order of magnitude of that is. In and of itself, it doesn't make the gross stimulus turn negative. But I have very serious concerns about what the actual impact multipliers are, especially in this type of thing, and I'm still struggling to find a mathematical means by which I can convert rhetoric into numbers.

ALTMAN: Let me ask you about another aspect of this. In the paper, you say that the one area which government, in effect, left alone, the equity markets, has recovered strongly and that --

GREENSPAN: Until today.

ALTMAN: OK. And that 35 trillion (dollars) or so of wealth that was lost has been -- about three quarters of that until today has been recovered.

GREENSPAN: That's global.

ALTMAN: Global.

GREENSPAN: Thirty-five trillion (dollars), yeah.

ALTMAN: And that's also provocative because it implies that the one part of -- the one engine that's really working, for example, in terms of the attendant wealth effects and everything else, is equity prices, which was not the object of any government response. And so that struck me because, again, the implication is, by leaving it alone, it's managed to recover quickly and have a quite powerful effect on, for example, household balance sheets and propensity to spend in households and so forth.

So I thought you might comment on that a little bit.

GREENSPAN: Well, let's go back to the 35 trillion (dollar) loss. As you know far better than I, you bring down --

ALTMAN: No, I don't. But go ahead. (Chuckles.)

GREENSPAN: You're not going to bring down anything. (Laughter.)

If that market value of equities in, let's say, financial institutions climbs very sharply, it means that that buffer or the liabilities of the institution has come down dramatically and, therefore, the credit quality of the liabilities of necessity worsen. And so if you get a significant collapse in financial equity -- which is the equity in financial institutions -- the collateralization process almost collapses. And we got very close.

One of the reasons I supported TARP was I thought what it did was it injected equity into the banking system just when it needed it, because collateral -- the value of collateral -- which is mainly debt collateral -- but the debt collateral is priced to a large extent on the extent to which the market value of equities in financial institutions are rising or falling.

And you could see the financial collapse in terms of the decline in stock prices even though it's the debt which created the problem, because the quality of debt fell as the stock prices went down.

Then we finally hit bottom in March of 2009, and what we have seen is a dramatic rise, as you point out, not only in the wealth effect -- which very clearly impacts on consumer expenditures -- but just as importantly, in the financial system. And what this has done is, frankly, it has enabled a good deal of TARP to be paid off with capital gains. And you can't actually stipulate that a particular repayment is a capital gain, but if you look at where the equity that is paying it off is coming from, it's largely there.

And so what happens in this case is you get a dramatic rise in stock prices which liquefies the whole system and increases the value of collateral in the system, and therefore, longer-term lending which, indeed, took place quite significantly.

And even though it was never enough to bring capital investment around because, if there's no rate of return on capital investment because you don't see it in the future, I don't care what your financing capabilities are, you're just not going to -- you're not going to invest.

And so what has turned this around is, for other reasons, corporate profits have risen fairly sharply. It's to a very large extent the result of a relatively short period of very significant amount of cost-saving capital investment. This is not -- this is not structures. This is not building. It's software, equipment and the like basically to reduce the unit costs of energy, which it did for quite a while, materials and labor.

So there's a very strong growth in not only labor productivity but also in energy and materials productivity, which has propelled profits very materially and therefore the cash flows that are associated with it.

That, I might add, is beginning to flatten out. All of the profit rise was a result of rising profit margins. There's very little in the early stages of the recovery which came from sales increases.

But what we're seeing now is the profit margins are flattening out, but there's some evidence that the sales increases are picking up. But it's that big surge in profitability which pressed against what economists call equity premiums, which is the rate of return that is required to invest in equity.

And as J.P. Morgan indicated, oh, about six or eight months ago --

ALTMAN: It was very high.

GREENSPAN: It was the highest level in their series for 50 years. Now, it's come back down. In other words, it's come back down, I would say in the last few days it's gone up -- back up. But it's not -- it's not -- the fear is still there, and it is reflected in the equity premium, but the surge of earnings per share is such that that has propelled a very substantial rise in stock prices and in the wealth effect which is across the board.

And this, I might add, is a global phenomenon. It's not just the United States. And as you -- you're quite correct, in my view. I think that, fortunately, we left the stock market alone -- or I should say we left it to function by itself. And it turned around, and it's been an extraordinary rise up through a few weeks ago.

ALTMAN: So let's open this up to questions. Just one or two observations, please, beforehand. Wait for the microphone. Please identify yourself. If you don't mind my saying so, please be sure you ask a question and not give a speech.

Yes, sir. Right in the middle, right there?

QUESTIONER: Thank you. Fred Tipson with the U.N. Development Program.

Mr. Chairman, how does this argument differ from Herbert Hoover's argument in 1929, who got the microeconomics right but seemed to miss the whole macro-psychology of the economy that required government activism to restore confidence?

How can we say that the stock market was left alone when these huge banks and huge auto companies were rescued in a way which gave investors confidence to stay or go back into the stock market? It was dependent on this government activism.

Now, in the '30s, it was the Supreme Court that put a brake on the degree of activism, and you could argue the content and degree of activism. But wasn't that activism essential to maintain the economy in a way that prevented something much worse?

GREENSPAN: Well, let me first say that, as I indicated before, I was in favor of the government activism right after the crisis. And, indeed, I argued in another piece which was published -- I guess I can say the Brookings Institution.

ALTMAN: The small place somewhere around here.

GREENSPAN: Down the street. What I argued there is that the basic surge that has occurred has been very largely localized to what I would argue was the largest financial crisis globally ever. I mean, I'm certainly -- the depression of the '30s was, in an economic sense, much greater, but as far as we had -- we had never seen a shutdown in short-term money markets of the type that we saw subsequent to the Lehman bankruptcy. I mean, the commercial paper market closed down. Even the repo market was shaking, which is extraordinary.

And if the Fed did not move in on the money market and mutual funds, they would have broken the dollar, so to speak, in all the various things that would have occurred as a consequence. So I am arguing -- and as I did in that piece -- that if you have got the type of structure in which the financial system tries to have capital adequate to meet every loan provision, loss provision up to, say, .999 as far as probability is concerned, that theoretically seems adequate.

The trouble is that the .999, there's still, as it happens, .001. And I think that what we've just been through, as I called it hypothetically in a speech I made a long time ago about central banking, is that if you have a fractional reserve system and if you do not cover all of the possibilities and over-cover them, you're always left with the possibility, what about that very small probability, which becomes a hundred percent when it happens.

Now, I can't prove that what we've just been through is a unique or almost a unique phenomenon. That's my presumption, and I grant you that a lot of other things rest on it. I would say, with respect to the activism of the '30s, remember that the initial activism was negative. I mean, the Federal Reserve was tightening up in the '20s. And the whole thing came tumbling down, but then there was a huge amount of activism in the 1930s which, of course, led to the NIRA. But incidentally, it did not alter the continued -- I mean, the Supreme Court ruled the NIRA unconstitutional in 1935, but the evidence is that the cartelization that was coming from that continued on. And I try to -- there are several interesting papers on that issue which I cite in this particular paper.

And it's a very debatable issue. I mean, people think that it's a given that much of what was done during the '30s was essential. I think the evidence is unclear on that.

ALTMAN: Let's have another question. Yes, sir?

QUESTIONER: Mac Gessler (ph), University of Maryland and Peterson Institute.

About two years ago, I had a conversation with a now-famous friend, Carmen Reinhart. And we were talking about whether the stimulus would have a rapid effect, as the administration hoped, or whether it wouldn't. And she said, Don't worry, this recession is going to be with us for some time anyway.

And as I understand it, her reason for saying so was that recovery from financial crisis, banking-crisis-driven recessions is historically much slower than recovery from garden-variety excess-demand recessions.

Now, I'm not, perhaps, describing the economics just right, but the Rogoff-Reinhart book essentially documents very slow recoveries from financially driven recessions. And, therefore, that might be the proper comparative, not recovery from previous recessions that were -- had less fundamental crises driving them.

GREENSPAN: Well, you're raising a question that's very difficult in economics as to what is cause and what is effect and how it functions.

First of all, these are not necessarily mutually exclusive explanations. First of all, if you can basically get to, as I've tried to, the specific decision-making process which is creating the problem, I submit that that is somewhat superior to historic analogies.

Carmen Reinhart has got great credentials. She's an old Federal Reserve employee of great esteem. So I'm scarcely going to argue against her especially since I see her on occasion with her husband. They are both very good economists.

The problem here is a problem of economics. What constitutes proof? Now, by analogy, it is not proof. Most of the types of stuff that we do -- I do, everyone else does, and Carmen does -- is by analogy, an historic analogy. I tried to get a step deeper into looking at the actual decision-making process as it impacts through the distribution of probabilities and the rate of return on facilities. And I submit that that should be a superior view or analysis of what is causing what.

I'm not certain, but I will suspect that, in retrospect, when Rogoff and Reinhart puts their next edition out or something like that, they're going to find that this one is lagging more than any since the '30s. And I think that you have to ask the question, why is that?

That a breakdown in structure occurs in finance, I think, is related to the collateralization issue I was discussing before. It's a question of how deep and prolonged it continues. And all I can say is that I think I've gone a step beyond in trying to ask the question what specific decision-making process creates the subnormal rise in economic activity.

Why has the recovery been so tepid? Now, you can draw analogies and say it's essentially because that, when a financial system runs into problems, it takes a longer time to pick up. I don't deny that. That is not necessarily contradicting what I'm saying. I'm just essentially saying that you need to get beneath the data by analogy in order to come up with a specific analysis.

In other words, I demonstrate, for example, on the crowding-out issue, not by analogy; I mean, I've got a body of data which is highly statistically significant and not basically by analogies to a series of historical episodes which, in most instances, are very valuable and probably essential for getting first judgments.

I'm saying that I don't consider it to be enough because I don't know -- without knowing the individual reasons as to why individual financial crises led to specific delayed economic activity, really has to get down to why did the 1873 crisis differ from, say, 1893? Why did the 1893 last so long? This is way before government activism of the type we're talking about.

I mean, these are questions I don't know the answer to, but I recognize that they are important to answer. And I don't know the answer, but I do know that a sufficient condition to explain the existing state of affairs is captured by the statistic which analyzes what the choice of the capital appropriations committees in business is with respect to what part of their liquid assets they are willing to convert into -- their liquid assets into illiquid long-term investments. That is a very critical decision because you are impairing shareholders' equity.

And this, incidentally, is the reason why the equity-to-asset ratio in non-financial business or non-financial corporations is close to 50 percent. Where, in finance, it's 10. And the important issue that I raise in this paper is that illiquid assets are very different from liquid-asset investment because, as I mentioned parenthetically before, the issue of the maturity -- effective maturity of an investment depends on how long it takes you to get your money back.

A 10-year BAA bond, for example, has got an effective maturity in a market which is liquid. Five minutes is how long it takes you to call your broker and sell it.

What is interesting is that when you get crashes of the type we got in 2008, the liquid markets turn illiquid, or partially so, and the convergence between the rate of return on illiquid fixed long-term investments and these previously liquid BAA yield spreads against treasuries starts to converge.

ALTMAN: Let's have another question. Yes, sir?

QUESTIONER: Arnaud de Borchgrave, CSIS.

Pete Peterson recently described what we've lived through since 2008, beginning with the predatory lending for mortgages. He says it is a reflection of carnivorous and animalistic capitalism. Do you share that viewpoint?

GREENSPAN: What kind of capitalism is that? (Laughter.)

I know Pete. Pete's a very old friend of mine. If you told me he said it in that forum, I don't think he means it exactly the way that the implication of the words are. He is a very pro-capitalist person.

But there are aspects of human nature which have those -- that you could characterize that way. I don't think it's the economic structure that is the problem. I think it's human nature. And I would have never argued, for example, that if you take -- go back and look at Fabian socialism. Fabian socialism, in its early stages, looked far more rational to many people than Adam Smith's model. And the reason, the argument went, was that wouldn't you prefer that the investment distribution of your assets were done by the people most knowledgeable rather than individual market perturbations and the like?

And, you know, indeed, Nehru, when the British essentially moved out of India, imposed a form of Fabian socialism on the grounds that it was the best way to organize as a society. And he did it, as far as I can judge, in the most rational way I can imagine. It didn't work, and it didn't work because human nature prevented it from happening.

And so I would say that the problems that we find in capitalism and in socialism and in communism -- and one of the reasons why Marx was wrong was not that Das Kapital was sort of a book which was inconsistent. It's a very rationally constructed book which presupposes a human nature which doesn't exist. And I would submit that, when we have problems that we see in marketplaces, whether it's greed or various other short-term aspects of the way markets tend to behave, I would say the root is not the structure; it's basically human nature. And I know of no way that we're going to alter that.

ALTMAN: We're going take one last question, a very brief question.

Go ahead, Rick.

QUESTIONER: Mr. Greenspan, I'm having a little trouble with your logic. I heard you say at the beginning that the capital expenditure ratios were the lowest level to cash flow since 1940. And then you talk about crowding out.

When I hear the lowest level of expenditure, I hear that companies have enormous amounts of money that they could spend on capital expenditures if they wanted to. So how are they crowded out? I don't understand that.

Second problem I have is I would be interested to know --

GREENSPAN: Rick, can I just answer that first one first?

The crowding-out issue here is such that you have this very large cash flow occurring, and the question is that they don't want to invest it. What do they do with it? They add it to liquid assets. There was a $500 billion increase in liquid-asset holdings. They've got all of that cash to spend if they felt that they had a rate of return to do it.

QUESTIONER: So how are they crowded out? I don't get it. If they have all that cash, how are they crowded out by the government?

GREENSPAN: Well, the point at issue, it's the savings that the federal government absorbs which -- start off with the proposition. Let's assume that the current account balance is zero, which means that savings investments in the economy are equal. It necessarily means that the amount of investment which can take place must be equal to the amount of savings.

Now, what the data show is that you see is that what happens when the federal deficit rises, which is negative savings, is that it must be offset somewhere in the rest of the system. And what the data show -- and this is basically an analysis of the flows of funds -- is you see a huge increases in -- (inaudible) -- savings and a huge decline in capital investment.

Those are the two major moving parts --

QUESTIONER: Sir, excuse me. But do we still have corporations sitting on $2 trillion of cash? And if so, how are they crowded out? I mean, I hear your numbers, and I hear your charts, but it just doesn't correspond with what I'm seeing and hearing in the economy.

GREENSPAN: Well, no. The basic problem is that when the savings get -- first of all, there is a limited amount of savings in a society. And the question is: Who has most -- who is going to employ those savings in one form or another to invest? The U.S. Treasury will pay whatever interest rate is required in order to basically achieve that part of the savings which are required to finance the deficit.

Now, what that means basically is that interest rates are moved up to a level in which there are certain people in the economy who would like to invest but can't afford the interest --

QUESTIONER: Sir, the interest rates have as low as they've been in decades.

GREENSPAN: No, that is not -- Rick, that is true only of AAA corporates. Microsoft is not being crowded out. IBM is not being crowded out. The ones that are being crowded out are shown to be those which are, say, B-rated corporations.

If you took a look at CCC yields, interest rates are very high. And if you look at where the shortfall in investment is, it is very largely in smaller business and in construction particularly. But it is not the large corporations which are being crowded out.

They would be crowded out if the deficit were twice the size it is. They do not crowd out at this level. So I would say to you, who is crowded out? Well, I can -- I can't put the list of names down, but I could probably go find them if it were necessary. It's those who find that an 8 or 9 percent interest rate, which are required of some junk-bond issuers or smaller business, is too high for them to get a reasonable rate of return.

So the crowding out exists. It's just not -- you can't argue that because Microsoft is not crowded out, that therefore nobody is crowded out. It's a question of the required balance between savings and investment. There's no alternative to that.

ALTMAN: On that note, I do want to be reasonably faithful to our closing time. And I want to thank all of you for coming this morning. (Applause.)

Most particularly, I want to thank Alan, and I would like to remind the members that the next meeting here, on March 17th, is with AFL-CIO President Richard Trumka.

Thanks for coming. Have a good day.

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