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Wednesday, January 4, 2012

Regime Uncertainty, Then and Now

In a 1997 article, “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War”, I advanced the idea of regime uncertainty in an attempt to improve our understanding of the Great Depression’s extraordinary duration and of the highly successful postwar transition to a genuinely prosperous market-oriented economy. The idea is more definite than the hoary but vague idea of “business confidence,” though they’re related.

In my conception regime uncertainty pertains above all to a pervasive uncertainty about the property-rights regime—about what private owners can reliably expect the government to do in its actions that affect private owners’ ability to control the use of their property, to reap the income it yields, and to transfer it to others on mutually acceptable terms. Will the government simply take over private property? Will it leave titles in private hands but strip the owners of real control and profitable use of their properties? In any event the security of private property rights rests not only on the letter of the law but also on the character of the government officials who enforce—or threaten—presumptive rights.

Between 1935 and 1940 this matter attained prime importance. So many businessmen and investors lost confidence in their ability to forecast the future property-rights regime that few were willing to venture their money in long-term investments. They constantly sought clarification of the government’s designs, as President Franklin D. Roosevelt raged against “economic royalists” and blamed a “strike of capital” for the economy’s ongoing troubles, including the depression of 1937–38, which undermined the general public’s confidence in the New Deal.

Treasury Secretary Henry Morgenthau tried repeatedly to persuade Roosevelt to make a public statement to reassure investors, but the President steadfastly rejected this entreaty. Morgenthau ultimately became so frustrated that in a 1937 cabinet meeting, he blurted out to his boss: “What business wants to know is: Are we headed toward Socialism or are we going to continue on a capitalist basis?” Strange to say, Jim Farley and even Henry Wallace backed Morgenthau’s insistence that the President spell out what kind of economic system the administration sought to foster.

In his plea Morgenthau encapsulated the wide-ranging uncertainty that Lammont du Pont expressed in the same year, when he said: “Uncertainty rules the tax situation, the labor situation, the monetary situation, and practically every legal condition under which industry must operate. Are taxes to go higher, lower or stay where they are? We don’t know. Is labor to be union or non-union? . . . Are we to have inflation or deflation, more government spending or less? . . . Are new restrictions to be placed on capital, new limits on profits? . . . It is impossible to even guess at the answers.”

I doubt the regime uncertainty that a growing number of commentators and analysts have perceived since 2008 is as great as that of the latter 1930s. However, the government’s frantic actions in the past few years have surely shaken investors’ confidence about future property rights in the United States. The takeovers of Fannie Mae, Freddie Mac, AIG, GM, and Chrysler; the massive interventions in financial markets; the huge bailouts of banks and other financial institutions, mixed with letting Lehman Brothers go down while salvaging Bear Stearns—all these actions and many others suggest that a rational investor might well attach a huge risk premium to any money he ventures even for the intermediate term, not to mention the long term.

Moreover, the upsurge of the federal government’s size, scope, and power since the middle of 2008 has scarcely calmed investors’ minds. New taxes and higher rates of old taxes; potentially large burdens of compliance with new financial and energy regulations; unpredictable new mandatory health care expenses; new, intrinsically arbitrary government oversight of so-called systemic risks associated with any type of business—all these unsettling prospects and others of substantial significance must give pause to anyone considering a long-term investment, because any one of them has the potential to turn a seemingly profitable investment into a big loss.

The Current Picture

In testing my hypothesis about regime uncertainty, I have marshaled three distinct types of evidence: historical documentation of government actions and public reactions; findings of public-opinion surveys, especially surveys of businessmen; and financial-market data.

My most striking financial evidence for the New Deal episode pertains to the yield curve for corporate bonds—that is, to the spreads between the effective yields on high-grade corporate bonds of various maturities. I found that this yield curve suddenly became much steeper between the first quarter of 1934 and the first quarter of 1935 (when the New Deal lurched from its first, or business-tolerant, phase to its second, or business-hostile, phase) and remained very steep until it flattened between the first quarter of 1941 and the first quarter of 1942 (when the New Deal handed the reins to the military and the big businessmen who, along with the President, ran the war-command economy). I interpreted these extreme spreads from 1935 to 1941 as risk premiums on longer-term investments caused by regime uncertainty.

Does the corporate-bond yield curve show the same kind of shift during the past few years that it displayed in the face of the regime uncertainty that prevailed from 1935 to 1941? To find out I examined a number of series of corporate-bond yields by term to maturity.

I found that in 2008, before the onset of the financial panic in September, the corporate-bond yield curve was quite flat—that is, the yields increased only slightly with term to maturity. When the panic hit, yields became extremely volatile, especially for the bonds with two years to maturity (the shortest term in the data), and remained volatile for almost a year. After mid-2009 the volatility diminished. Once the dust had settled, the yield curve for corporate bonds had become substantially steeper.

Thus just as the steeper yield curve of the latter 1930s corresponds precisely with the so-called Second New Deal, when Roosevelt and his leading advisers went on the warpath against investors as a class, the steeper yield curve since mid-2009 corresponds with the bigger government left in the wake of the financial-market volatility and frenetic government action between September 2008 and the middle of 2009 and with the subsequent rash of extraordinary government measures.

Given the current regime uncertainty, investors will probably continue to remain for the most part on the sideline, protecting their wealth in cash hoards and low-risk, low-return, short-term investments and consuming wealth that might otherwise have been invested. Slow economic recovery, at best, will be the result.