Stephen King: Where will the money come from to fuel a healthy recovery?

The bet by US policy makers is that strength in consumer spending now will boost capital spending later

Had the assembled masses who gloried in the greatness of Greenspan last week taken a look at the performance of their personal share portfolios, they might have been left scratching their heads a little bit. "Sir Alan" is revered wherever he goes, having apparently stamped out some of the wilder excesses of the business cycle. And, to his credit, there have been some – admittedly mixed – signs this year of a recovery in economic activity after an incredibly mild recession last year. This all looks very good. Yet the contradictions are obvious: a recovery in growth against a background of collapsing share prices; consumers spending like there's no tomorrow while companies are engaged in a slash and burn exercise to restore profitability.

Many will argue that the US economy has proved relatively immune to the declines in share prices. The standard argument relates to consumers' wealth. Share prices may have fallen a long way but consumers are still spending. Why? For the simple reason that, for the majority of consumers, the biggest single asset is their house. While the top 10 or 20 per cent of the population in income or wealth terms has been hit very hard indeed by the declines in share prices, the vast majority has benefited from continued gains in house prices. So long as house prices remain buoyant, consumer spending should remain in good shape.

And who to thank for this outcome? Well, it's Alan Greenspan and his merry men on the Federal Open Markets Committee. Mass selling of equities may have robbed from the rich but there's been a windfall gain for the mortgaged poor. The Fed's prompt action to lower interest rates may not have saved the equity market but there's increasing evidence that the FOMC board members have insulated the broader economy from the worst effects of stock market declines.

Or have they? The danger with the argument is simple: it assumes that only households and consumers are likely to be affected by changes in share prices. In reality, the effects are much broader. The majority of consumers may be fine for the time being but the real mayhem has been taking place within the corporate sector. It's becoming increasingly obvious that the declines in share prices are having a bigger effect on corporate – rather than consumer – activity. This conclusion applies not only to the US but to many other countries which, like the US, have seen major declines in both profits and capital spending over the last two years.

The relationship between share price movements and capital spending is never entirely clear but, luckily, the Federal Reserve provides a lot of useful data on how exactly capital spending is funded. In essence, capital spending can be funded either internally – through re-invested profits – or by resort to external funds. These funds include bank loans and, particularly over the last decade or so, equity issuance and corporate bond sales. The bigger the investment boom, the more likely it is that an increasing proportion of investment will be funded through these external sources: after all, heady optimism increasingly leads to decisions based on future hopes – reflected in rising share prices – rather than existing reality – constrained by current levels of profitability.

According to the Federal Reserve's Flow of Fund accounts, the late 1990s saw a massive increase in the so-called "financing gap" – the gap between investment that can be funded through internal profits and the total amount of investment that takes place (see left-hand chart). And, chief among the factors that fuelled the widening of this "financing gap" was a dramatic increase in funds raised via new equity issues. We, the investing public, were so convinced of the merits of the New Economy that we gave away money to any old crazy dotcom start-up. It didn't matter that many of these companies made no money. So long as there was a vague commitment to make profits in the distant future, the great and the gullible alike were happy to park their money in assorted hare-brained schemes. Unfortunately, others then drove off with it, leaving very little behind for savers and future pensioners.

What does all this have to do with the broader economy? The simple answer comes from my right-hand chart. Here, I have shown the level of both consumer spending and investment spending in the US, in both cases re-indexed to 100 at the start of the recession in the first quarter of last year. For consumers, the question might well be "Recession – what recession?" For companies, however, it's a different story.

Since share prices began their terrible journey downwards in 2000, the financing gap has fallen back a long way and, linked to it, there's been a collapse in capital spending. The decline in the financing gap implies either that the investing public is no longer quite so gullible and is not prepared to give money away to risky business propositions, or that companies themselves are no longer prepared to take the risk of raising money in the capital markets given the greater uncertainty about future profitability.

In fact, there's evidence of both effects. The declines in government bond yields that have coincided with the falls in equity values suggest that the investing public is heading for safety and security rather than risk. Meanwhile, companies continue to announce downgrades to their future plans for capital expansion, based on a persistently murky profits outlook.

Given these changes, what are the prospects for capital spending in the next couple of years? The bet made by US policy makers is that strength in consumer spending in the short term will boost capital spending later on. By looking at the financing gap, however, it becomes a little easier to assess how likely a recovery in capital spending really is.

The first concern is obvious. Normally, when the Federal Reserve cuts interest rates, share prices rise quickly. As a result, it should be possible for companies to raise funds increasingly easily from external sources, thereby making it more likely that capital spending will pick up. In our post-bubble world, that process simply hasn't happened.

A second concern is that, in the initial stages of the declines in share prices, companies were able to switch the source of finance from equity issuance towards debt issuance via the corporate bond market. Yet, as investors have become increasingly concerned about corporate balance sheets, this source of finance has also dried up, at least as far as some of the riskier areas of the market are concerned.

A third area of danger is bank lending. The role of bank lending as a support for capital spending fell back significantly during the 1990s. Bank lending could, of course, make a comeback if capital markets remain weak. But it is difficult to imagine banks being prepared to take the same risks today as the capital markets were taking in the second half of the 1990s.

I would say that we're back to a world of investment being financed primarily by internal funds alone. That means profits. And the one thing you hear from companies the world over is that profits are not good and, moreover, are not expected to be good even with consumer spending holding up well in, for example, the US and the UK. For the time being, therefore, it's difficult to see a sustained recovery in capital spending coming through. Moreover, should companies decide to rebuild their internal funds – planning for higher profits – there are only two obvious ways of doing so given the obvious lack of pricing power: either slash capital spending or slash labour costs. Either way, the prospects for a healthy recovery in economic activity do not look good.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com