ECONOMIC

A number of factors may have prevented the restoration of business confidenceand hence restrained investment growth. Wage and price controlsare still a recent memory, and fears of a reacceleration of inflation have notbeen completely dispelled. Recollections of the severe 1974-75 recession mayalso restrain business confidence. Because fears of a renewed inflationrecessioncycle may encourage businesses to increase liquidity rather thaninvest in plant and equipment, confidence must be rebuilt before salesgrowth will be translated into higher capital outlays.Laws and regulations to provide necessary protection for the environmentalso create costs and uncertainties. Not only does the spread of regulationsraise production costs, but long-run cost and profit calculations are made lesscertain because of the possibility of future changes in regulations. For instance,if' a change in environmental laws may affect the operations of a newplant, then the risk associated with building this plant is correspondinglyincreased. The impact is more severe on longer-lived investments whichrequire longer commitments with less flexibility once they are made.It is of course very difficult to prove that a decline in business confidenceor an increase in risk premiums is responsible for the failure of investmentto rise as much as might have been expected during the current recovery.This difficulty results partly from our inability to directly measure the uncertaintyor accurately assess the expectational factors and the environmentwithin which long-term investment decisions are made. Most evidence forthe view that business confidence remains poor is qualitative and involvesa degree of casual empiricism. One quantitative indicator of the expectationsaffecting business investment is the market value of a corporation'sstocks and of net interest-bearing debt relative to the replacement cost ofits assets. If, for example, assets are valued in the market significantly abovetheir replacement cost, corporations will be encouraged to invest in newequipment and thereby create capital gains for the owners of their securities.On the other hand, if assets are valued below their replacement cost/corporations which sell new securities to buy new capital goods may becreating capital losses for their security holders. In the latter case we caninfer that the cost of capital has risen relative to the average profitabilityof past investment projects and that new investment will be discouraged.Of course, at the margin the expected rate of return on a significant numberof potential new investments will remain above the cost of capital, eventhough existing assets on average are valued below their replacement cost.Thus even if the market value of a firm fell below the replacement cost ofits assets this would not mean the end of investment incentives. It would beespecially inappropriate to draw such conclusions from estimated aggregatescomposed of heterogeneous corporations.Nevertheless it is probably safe to infer that the almost continuous declinein the ratio of the market value of nonfmancial corporations to the replacementcost of their assets during the last few years (Table 1 and Chart 2) is anindication that investment incentives are much lower currently than in the28