What the results boil down to is the relative ease with which an investment decision can be reversed. When we talk about this reversibility in terms of the stock market, we refer to it as liquidity. The principle is the same here. As with a company share, we question the likelihood that an investment decision can reach something close to the original purchase price.
The difference between the purchase price and the resale price – otherwise known as a wedge between purchase and liquidation values – is a key measure of investment irreversibility.
Such irreversibility would not normally be a barrier to investment, otherwise the assets in some of the industrial locations, such as textile mills and aerospace plants, would long since have worn out. We should instead focus on the combined effect of this illiquidity in periods of heightened uncertainty.
The real impact of uncertain times
In a moment, we’ll look at two specific such periods, the 1990–1991 First Gulf War, which followed Iraq’s invasion of Kuwait, and the terrorist attacks on New York and Washington in September 2001. But first, a general outline of the interaction between low redeployability of assets and heightened uncertainty.
Costly capital reversibility creates a direct incentive for firms to delay investment at a time of uncertainty because of its possible impact. Irreversibility tend to cause lower resale values, thus selling those assets offers less protection against negative outcomes than if the assets were more easily redeployable.
So, even when expected investment opportunities remain unchanged, an increase in uncertainty regarding the likely pay-off from investments is likely to lead to more firms whose assets are not easily redeployable, delaying investment decisions.
Put another way, because these firms’ assets offer fewer safeguards against possible economic shocks, the irreversible firms are, in effect, buying extra protection by delaying investment decisions.
Focusing specifically on the First Gulf War and the events of September 2001, I found that, perhaps not surprisingly, there was a marked increase in uncertainty regarding the outlook for consumer demand and, consequently, for the profitability needed to make new investments viable.
In both cases, I found a direct relationship between the redeployability of assets and the subsequent levels of capital expenditure. Investment levels went down in both the First Gulf War and September 11 case studies among those firms with the least redeployable assets, relative to those with the most easily reversible assets.
The ability to redeploy assets is also, as mentioned earlier, an influence on the capital structure of businesses. Assets that are relatively easy to redeploy offer protection not only to the company concerned, but also to its creditors. This expresses itself in two ways.
1. The creditors of a business rich in reversible assets will tend to feel happier about waiting to be repaid. Debt maturities for such businesses tend to be longer
2. This protection tends to make creditors more willing to extend generous credit lines than would have been the case with a firm with irreversible assets.
To sum up, heightened uncertainty has a disproportionate effect on the investment plans of firms whose assets can less easily be redeployed to another business, thus could be expected to find a ready market. In general, the more specialised the assets concerned – such as the machinery used in the manufacturing industry – the harder they are to redeploy.
As a reminder, the secondary market for corporate assets is a narrow prism through which to view the huge topic of the effect of uncertainty on business and the economy. But my findings support the argument of policymakers and academics that uncertainty has a negative impact. It can significantly reduce investment in the sectors whose assets are hardest to redeploy, and this effect, in turn, will ultimately reduce the rate of economic growth.