The events of the last two months have brought financial liquidity issues into sharp focus. As firms shut down for an indefinite period in response to the Coronavirus, the question on many people lips is “will this firm be able to survive without cash income?”
If they have large amount of cash in the bank, the answer is likely to be yes. Yet most firms don’t have a large amount of cash in the bank. Rather, they have large amounts of productive assets – sometimes physical assets like machinery and equipment, and sometimes intangible assets like good business routines, long standing customers, or patented technologies. These assets will produce them with cash incomes in the future – but only if they can survive until then.
So how can we think about this issue?
The best analysis of this problem has been laid out by two Nobel prize winning economists, Jean Tirole and Bengt Holmström.
In a series of papers begun in the 1990s, they analysed how firms make investment decisions and structure their balance sheets in response to the possibility of liquidity crises that are unrelated to the fundamental performance of their business.
The basic answer is that firms become conservative, and clearly distinguish between fundamental risk and liquidity risk. When contemplating a business proposal, firms evaluate how much money their investment is likely to make in the future – its fundamental risk. They also evaluate how an investment may change their balance sheet and expose them to liquidity risk – the prospect they may go bankrupt during a liquidity crisis unrelated to the investment they are making.
Bankruptcy or closure is a threat if banks change their normal lending practices in response to a crisis, because firms that have spent their cash reserves or undertaken significant borrowing to finance their investments may be unable to pay their bills. As a result, firms overlook a lot of potentially profitable investments, not because they don’t think they will be profitable but because they increase the chance of going bankrupt if something else goes wrong in the economy.
A bloody parable may be in order. Suppose you had an accident in a car. The fundamental risk is that you suffer long term bodily damage – perhaps you lose an arm. The liquidity risk is that you bleed to death before an ambulance comes, even though you would survive and perhaps fully recover if the ambulance arrives in time and stops the bleeding. If you are concerned that an ambulance may not be available in time, you might avoid trips that would have been very enjoyable simply because the risk of dying from an accident that is usually treatable is too high.
We are in the equivalent of one of these situations now. A lot of firms are at risk of bankruptcy not because they don’t have sound business plans and valuable assets but because the usual loans they might expect from banks are not available or may not be available. Perhaps these firms should have secured guaranteed finance (lines of credit) in the event of a crisis – a type of insurance – as many firms have done. But if they haven’t, the economy risks a lot of fundamentally sound firms becoming bankrupt or significantly smaller because a bank is unwilling or unable to provide a temporary loan to help them deal with a temporary shock. If these firm fatalities lead to the loss of a lot of intangible assets, the medium term damage to the economy can be considerable.
Liquidity risk outside of a crisis
I can’t claim any expertise as to what the government, its agent the Reserve Bank of New Zealand, or private banks should be doing during the crisis. As a result, this is an issue that will be litigated elsewhere.
I am more interested in how the Government should respond to the problem of liquidity crises when they are not in a crisis. Obviously it is a good idea to have thought about what to do in advance! But a different implication is to consider how the government evaluates its own investments and its own balance sheets.
Governments are much less susceptible to liquidity crises then most private sector firms, because they can borrow during a crisis as they are indefinitely lived and people are convinced they will exist and repay their loans once the crisis is over. Countries, unlike firms, don’t often disappear – and nor do their tax paying citizens. In fact, the margin between Government borrowing rates and private sector borrowing rates typically increases during a crisis, as Fama and French established over thirty years ago. This is one reason why central banks can act as a lender of last resort when private banking crises occur.
The comparative advantage governments have at managing liquidity means the government should contemplate its own investment strategies differently than the private sector. It faces different fundamental and liquidity risk than private sector firms. This is not a radical idea because very large private sector firms act differently than small private sector firms since they have different liquidity risk profiles as well.
This is one of the reasons that most governments – but not New Zealand – use a discount rate to evaluate their investments that is much lower than the “hurdle” rate used by private sector firms.
Contemplating hurdle rates
This is one of the interesting question facing governments in non-crisis times: what is a reasonable rate of return on government investments?
For years the New Zealand government has argued that it should be the same as the rate of return on private sector investments, and has used this argument to justify one of the highest public discount rates in the OECD.
Yet this is not necessarily the case if the government faces a different combination of liquidity risk and fundamental risk than the private sector. If the public prefers to hold safe government debt rather than risky private sector assets it is perfectly sensible for the government to issue government debt at 2% and invest in projects that return 5 % even if the private sector will not make investments unless the expected return is 10 percent.
To push my analogy to extremes, some people may prefer to travel in a slow government car with guaranteed access to emergency medical services than travel in a fast private sector car with the same risk of an accident but a higher possibility of bleeding to death.
Does the difference between fundamental and liquidity risk matter? Yes, if a very high government discount rate is one of the reasons why New Zealand has underinvested in government-provided infrastructure. Yes, if a very high government discount rate means New Zealand avoids making investments in high yielding long-term projects because the long term return is discounted at too high a rate.
Even if the Government has a comparative advantage at liquidity risk, this does not mean it has a comparative advantage at fundamental risk.
In fact few if any economists believe that governments are better at evaluating fundamental business opportunities than the private sector, because the incentives that politicians and civil servants face are quite different than those sharpening the minds of private investors. This is one of the reasons why western governments usually try to separate government and private sector investments domains, so each can do what each is best at.
Nonetheless, the government should take advantage of its comparative advantage at liquidity management in the sectors in which it can invest, and if this means reducing the government discount rate to a level similar to the more successful OECD economies in the rest of the world, so be it.
Note: this post is based on a paper written for the NZ Treasury in 2016 “Liquidity, the government balance sheet, and the public sector discount rate.” The paper is available on request.
Fama, Eugene F. and Kenneth R. French (1989) “ Business conditions and expected returns on stocks and bonds,” Journal of Financial Economics 25 23-49.
Holmström, Bengt and Jean Tirole (1998) “ Private and Public supply of Liquidity”, Journal of Political Economy 106(1) 1 – 40.
Holmström, Bengt and Jean Tirole (2000) “Liquidity and risk management,” Journal of Money, Credit and Banking 32(3 pt1) 295-319.
Holmström, Bengt and Jean Tirole (2001) “ A liquidity-based asset pricing model,” Journal of Finance 56(5) 1837-1867.
Holmström, Bengt and Jean Tirole (2011) Inside and outside liquidity (Cambridge, Ma: MIT Press).