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Andrew Coleman explains why good businesses may fail in this crisis and why the Government should have prepared differently

Andrew Coleman explains why good businesses may fail in this crisis and why the Government should have prepared differently

By Andrew Coleman*

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.

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.


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How to respond

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. 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 than 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.

The hurdle rate issue

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.

Liquidity risk and Fundamental risk

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.


Further reference

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).


*Andrew Coleman is a lecturer in the Department of Economics at the University of Otago, where he teaches public finance. He is currently in lockdown while visiting a university in Morocco.

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14 Comments

Translation: We in the private sector know best what should happen and leave us alone, but we want the masses (vit taxes and Govt and future indebtedness) to bail us out when our invisible hand was dipped too far into the pork barrel.

The fact that Treasury is away back at this level is of concern. Gareth Morgan this morning, got closer than most, but still fails the 'business knows best' test.

Interesting times

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"Countries, unlike firms, don’t often disappear"... they get usurped by special money interests though, so where a proud nation once stood, now there stands a collection of people gathered together under the banner of paying interest on loans, and paying taxes, ruled by a class of people more interested in accumulation of power than competence and service.

Case in point, teachers fought tooth and nail to get a wage that allowed them to live in Auckland city - maybe they didn't get it. But the government practically prostrates itself to the banks with taxpayer guaranteed loans to business that the banks only need to put up a percentage of their own skin to issue!

No country this. Coronavirus is the least of our worries when it comes to parasites.

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Yes if you were a nurse or a teacher and if you didn't know your value before this, you will now.

There's no more money for nurses or teachers! Stop protesting!....but in a time of an epidemic (where we need nurses the most) we can quickly create another $40 odd billion of debt to pay everyone's wages! So there is plenty of money, or ability to create money, we just don't value nurses or teachers much.

That, my friend, is the salient take home point.

I have been a teacher. And I know a few nurses. You cannot seriously mention them in the same breath. Nursing is tough, demanding, dirty work with a big emotional toll, unsociable hours, not to mention the dangers, as illustrated at the moment. Teachers get in the main sociable hours, free time at work for admin, and incredibly generous holidays, which most of can only dream about. I left because I didn’t find the work challenging enough intellectually, although I loved teaching my students.

Interesting perspective. My daughter became a nurse so she didn't have to bring her work home with her, after years of observing me, a secondary teacher, putting in many late-night hours and working through my "holidays". I can only conclude that the conditions you speak of were a long time ago.

Hit the nail on the head, 3 months off a year and still complaints. Luckily for you I doubt there are many teachers on here or you would get avalanched with vitriol about how teaching is the hardest most stressful etc etc

But teachets get paid well because they vote Labour. Cosy arrangement.

So essentially you are saying we should always live by emergency rules. I see.

Great article. The key point about the NZ situation is well laid out: the conscious (and unchallenged to date) decision to apply a high hurdle rate to Gubmint investments (which probably includes, as a category, local authority investment decisions), shuts the door to many worthwhile, long-term and fundamentally unexciting investments. I would go further, and note that one solution to this impasse is to bypass it entirely, by devices such as the PGF, which assuredly has zero cost-benefit analysis on any of its 'investments' let alone any real accountability. Worst of both worlds....

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.

What a load of tosh. All very clever, but rubbish really. Why? Because where is the buffer for "unforeseen events"? Even if the private sector will invest at an IRR of 10% (will they, really?) you need to add on a factor for "getting your sums wrong". New mines are typically only funded on an IRR of 30-40% for this very reason and their sums are rigorously double checked independently.

Has this chap ever invested using his own money?

Having said that, my main criticism is that you cannot evaluate a project purely on economic terms. Money is important, but it only measures one dimension of a multi-dimensional problem. Security of supply, or national security, for instance, could override the economic factor. R&D is another; you can know its cost, but cannot know its future value. Another factor is optionality, does this allow highly favourable outcomes or prevent highly unfavourable ones, or is it the other way around?

The suggestion is that governments aren’t good at assessing fundamental risk in projects better suited to private investment. He is the suggesting a lower discount rate for investment in public goods. Perhaps more investment and redundancy in the health system mightn’t be a bad thing to have just now. That would have lowered the liquidity risk being enforced on the private sector right now by an unprepared, under insured government that has just decided to bankrupt a large number of otherwise highly innovative and profitable businesses that are faced with ongoing costs and zero revenue through no fault of there own.

Not typical, always a must.. borrow more.. future tax payers burden (all citizens), then circulated among the view of private buddies that claimed to be the forefront of country's economic prowess, for NZ is easy.. every economic productivity front claims are to be warranted by significant RE backup capital transactions. It shall never change, it's in our recent imported/embedded DNA now. What make us NZ now, RE industries backbone.

The government doesn't borrow to fund it's spending, bonds are sold to drain reserves from the banking system so as to maintain the reserve banks interest rate settings. All government spending is made by creating new currency and it is government spending that creates bank reserves. Spending comes first before taxing and borrowing. Listen here on YouTube to economist Stephanie Kelton explain it. https://www.youtube.com/watch?v=WS9nP-BKa3M

Days to the General Election: 24
See Party Policies here. Party Lists here.