This is an excerpt of the January 2014 Longbrake Letter. To read the letter in its entirety, click here.
There is a general belief that large corporations are awash in cash which could at any time be quickly put to work financing new investment initiatives. However, the inflation-adjusted rate of change in capital spending has been declining steadily and is near zero. Cash is being deployed into nonproductive uses such as share buybacks, dividends, and mergers and acquisitions. These activities fall into the category of financial engineering. They can boost share prices, but they do not contribute to expansion of economic activity.
In a world of repressed interest rates, courtesy of FOMC quantitative easing, the risk-adjusted rate of return on capital is simply inadequate to prompt significant investment activity. This is a demand feature. But, it is reinforced on the supply side by tight underwriting standards that are a legacy of the Great Recession, tighter regulatory capital and liquidity requirements for banks, and closer prudential supervision.
In recent remarks to the American Economic Association, Federal Reserve Chairman, Ben Bernanke, noted that productivity recently has been disappointingly weak for reasons that are “not entirely clear.” He mentioned some possible reasons including the impact of the Great Recession on credit availability, slow growth in sales revenues, mis-measurement, or unspecified long-term trends. Notably, he did not mention the possibility that the FOMC’s own policy of depressing long-term interest rates may be contributing to the investment shortfall and miserable productivity gains.
As I have repeatedly pointed out, the potential rate of real GDP growth depends importantly on the level of productivity. And, higher productivity depends on robust investment spending. However, both private and public investment spending remains extremely weak. In the case of private investment spending the depressed risk-adjusted rate of return on capital incents firms to deploy cash in financial engineering, which returns capital to investors, rather than pursue new capital projects. The shortfall of public investment is simply the result of budget deficit anxiety and significant cutbacks in government spending.
It is interesting that economists do not agree on the repressive effects of quantitative easing on capital investment. In fact, it is argued by many, including FOMC participants, that lower interest rates, particularly on safe assets, should induce greater investment spending. The mystery to them, as Chairman Bernanke notes, is finding a reason why this has not happened. What we do know with certainty is that quantitative easing depresses the long-term discount rate on financial assets and in so doing boosts their nominal value. Stock market investors do very well and paper wealth is created. However, this increase in paper wealth is not translating into greater capital investment.
To be fair, part of the rationale for quantitative easing is intentionally to create financial wealth with the expectation that this will increase consumer spending. Then, as consumer spending increases, sales revenues will improve and firms will be less hesitant about investing cash and borrowing funds to finance capital investment projects. In this way, it is argued, quantitative easing helps accelerate economic recovery.
But, as is so often the case in economics, the supply and demand dynamics are complicated and what appear to be simple logical explanations of what should happen overlook or misunderstand the complexity of these dynamics. But with the passage of time we can assess outcomes and look back and better understand consequences of policy actions.
It may turn out that quantitative easing, which is intended to accelerate economic recovery, has contributed in a meaningful way to a sustained lower potential rate of real GDP growth by discouraging investment necessary to boost productivity. So, although FOMC officials may not understand why the long-run potential rate of growth is declining, as can be seen in the table below, they have acknowledged the reality by steadily reducing the median of the central tendency range of long-term real GDP projections from 2.7 percent in January, 2011 to 2.15 percent at the December, 2013 meeting. The current low value is consistent with my own analysis, but unless investment activity increases, even today’s lower expectation could prove to be too optimistic.
Median of FOMC’s Central Tendency Real GDP Growth Projections Compared to Actual Results – 2011 to 2016
(*GS forecast #Bill’s “Steady Growth” long-run potential = 2.16%; Bill’s “Strong Growth” long-run potential = 2.39% )
Note that Larry Summer’s discussion of secular stagnation (see the December Longbrake Letter) focuses on the long-term consequences of persistent negative real rates of interest. He comes at the issue of a depressed long-term rate of growth by arguing that when the zero bound is binding, monetary policy is unable to lower interest rates enough to achieve positive real rates, which are necessary to induce investment. This is essentially the same logic as summarized above. Summers’ solution is for the government to engage in massive infrastructure investment spending because there is no way that the private sector will engage in significant investment spending as long as the real rate of interest is negative.