The US weekend print edition of the Financial Times carried an interesting Comment by Eric Lonergan, macro fund manager at M&G investments. His piece, “Interest rates are a spent economic force,” suggests that since the consumer and industry have not responded to low and now negative interest rates as expected by central banks, the relationship assumed by bankers and economists between spending and interest rates is kaput. I disagree.
I agree that consumers and private industry have not responded as they have in the past (and increased spending as they should) with low interest rates. But what Mr. Lonergan is missing in his article is the role the environment plays in this relationship. It is not that the relationship between interest rates and spending is broken, it is more likely that there are other factors that were not present in the past that suppress the relationship we thought was pure.
Worryingly though some of the behaviors have been talked about for some time and worse they are quite logical. As such one wonders about the assumptions our economists made all along. For example, lowering interest rates should encourage private industry to increase capital investment. This long-established assumption pre-supposes that firms have capital investments lined up ready to go. This is where the current economic conditions are quite different to what has gone before.
It seems CEO’s do not, as a rule, go looking for new capital acquisitions when interest rates are lowered; or even at rock bottom levels. If you think about it the reality is that CEOs and their boards develop business strategies. These are more likely based 0n the state of the business, their competitors and the clients they serve. Interest rates primarily impact the aspect of the strategy focused on sourcing of funds to pay for that strategy’ funding is not a business strategy per se. Firms have as many effective shovel-ready capital investments than public sector agencies had with their crisis funds.
So why are not a plethora of capital investment strategies today just waiting to be funded? It is believed that there are a range of reasons and a number of them reinforce each other.
- Regulation: many forms, banks are a good example as they are in the business of risk management, are subject to huge increases in red tape; more and unpredictable levels are coming as some rules have been passed without the details drafted: e.g. Dodd-Frank
- Political instability: The very real complexity that derives from unstable, extreme or radical political leadership is rife. The US, UK, Western and southern Eastern Europe, and the Middle East are all subject to huge disruptions
- Quantitive easing: another policy gone array has pumped millions of dollars into, it turns out, into the investor class. As such inequality has worsened and a stock market bubble has formed. Flush with cash, and this is where low interest rates help, CEOs and boards are approving share buy-backs galore. This ‘improves’ earnings per share (EPS) without doing anything material to the business. This negates the need for a more risky long term investment approach to meeting EPS growth targets. M&A is running at all time highs too – and much of this activity has little to do with natural competitive forces and more to do with cheep money. This the effort post M&A ends up being much less productive (i.e. uncreativedestruction).
Firms are thus leveraging logically what has been offered them. Now central banks have egg on their face while business leaders have a wry smile.
The Unintended Consequences of Low Interest Rates
Since capital investments are depressed and have been for some, the long term impact is that productivity will be hampered for years to come. The flat or even declining productivity is a sign. Is quite common in developed economies. The problem is that this is not a quick fix and the harm is being baked into our systems and practices.
Our economy is walking along as in a stupor and we can’t see forward clearly enough. We have to eliminate the over burdening red tape; we need political stability and a simple, private sector friendly and small government minded leadership. We need central banks to sell off their balance sheet assets, reduce QE, and raise interest rates in order for firms to return to making rational investment decisions.
If they do not, the hole will only get bigger and the rope needed to get out of it even longer.