Business leaders and entrepeneurs fear another crash
Low real interest rates would normally be expected to stimulate capital investment by lowering the cost of finance for companies – large and small.
Yet real investment remains sluggish in nearly all developed economies.
Some blame austerity measures taken to control fiscal deficits. Others blame the rise in precautionary savings by the private sector resulting from the shock of the financial crisis. Others point the finger at rising inequality of incomes and wealth – rich people spend a lower fraction of any increase in their income than less affluent types. Another school focusses on global imbalances,the diversion of financial flows to so-called safe assets (especially reserve asset flows). Finally, many point to the difficulty central banks have in driving down interest rates far enough into negative territory given that nominal rates cannot fall below zero and inflation remains subdued.
Dangerous times lead to dangerous remedies such as proposals to raise central banks’ inflation targets. In practice, governments are yet again being led to encourage the growth of credit as the only way they can find to stimulate demand.
Nothing could illustrate better how firmly we remain gripped by the money trap
All we have done so far is to patch the patient up – to plaster over the wounds. Like doctors in World War I sending soldiers back to the front line after the field hospital – to suffer, shell-shocked and weary. “Over the top! here we go again!”
Right now, there is a major threat to financial stability coming from the heavy reliance on growth of debt to stimulate demand. The IMF warned in its April Financial Stability report that corporate debt has already risen sharply as companies borrow opportunistically to take advantage of low rates to boost financial ratios. Balance sheet leverage is rising as debt-financed buy-backs of equity boosts shareholder returns while capital investment remains depressed. Net debt to GDP is already very high and equity prices “stretched”, while in many countries loan-loss provisioning by banks is dangerously low.
As in banking, much more radical solutions are required. The major cause of low investment is that the general level of equity prices is so high – “stretched” – that any rational would-be investor expects a crash. Even low borrowing costs will not compensate an investor for the costs of a crash – at some uncertain future date – in equity valuations.
Moreover, repeated boom and bust cycles mean nobody can tell where interest rates – notably longer-term rates – would settle if they were really left to market forces.
Yet markets have not been allowed to determine interest rates for many years.
I can do no better that quote from one of Brendan Brown’s recent newsletters for Mitsubishi UFJ Securities international. (Brendan.Brown@int.sc.mufg.jp) Monday, April 10, 2014
The Bernanke/Yellen interest rate manipulation has now generated a high speculative temperature across many asset markets including high-risk credits and equities. Yet there is widespread scepticism about how all this will end up, which explains in considerable degree why businesses are reluctant to step up their rates of investment. Weak investment is not a fundamental cause of present low real rates as hypothesized by the IMF authors, but a result of the rate manipulation which has been characterized by prolonged periods of rates far below neutral. Small and medium sized businesses are in no rush to take advantage of present high equity markets to step up their capital spending as they realize that by the time they may decide to sell their equity the feared crash might well have occurred. The managers of large enterprises whose pay includes a large element of options would rationally act in similar fashion, deciding to pay out high dividends or buy back equities so as to please their shareholders.
The explanation offered by Brendan Brown for the weakness of investment – fear of an equity crash that will wipe out the expected returns – can be generalised. It is what happens in all prolonged recessions. Uncertainty about future equity values – including the value of unquoted and small companies – naturally makes businesses postpone any new investment beyond essential replacement.
However low central banks push interest rates, businesses will still fear that new investment will be unprofitable becuase of the monetary-policy-induced uncertainty..
Stabilise equity valuations
This puts in a nutshell one of the arguments for a change in the way money is created and controlled. I have proposed the Ikon standard – linking the monetary unit to a diversified equity basket (see the appropriate section of this website or my book). If the monetary value of the equity basket is fixed, the nominal value of the general level of equity prices will be stabilised. The risk of a general crash of equity values is eliminated, although of course there remains the risk that an individual share or investment might disappoint expectations. In economists’ terms, this would stabilise Tobin’s “Q”, the ratio between the market value and the replacement cost of a real asset.
Under the Ikon standard the expected rates of return from an investment cannot be affected by fears of a general crash in values, such as hold back investment at present. When it is realised that rates cannot be manipulated indefinitely far below equilibrium values – and that the attempt to do so distorts the economy without stimulating growth – then alternatives to the present monetary regime will be sought (see following two notes for a further explanation and the Ikon section of the website).
Yet the only solution to stagnation governments and most economists can come up with is once again to expand credit-fuelled asset boom further and hope desperatey that physical controls (masquerading under the fancy name of macro-prudential measures) will keep the lid on inflation.
When such illusions shatter – and I fully realise we are a long way from that point – the rationale for more radical proposals for monetary reform will be fully explored.