Monetary policy in developed markets like Japan and Europe is failing, and faltering in the U.S., in substantial part because globalization has altered how investment is made and where.
The upshot is that fiscal stimulus is the next magic bullet of choice in the slow-motion older economies, but one which may misfire or miss the mark.
One of the huge puzzles of the long, shallow recovery is why capital investment in the large economies no longer responds with vigor to cuts in interest rates or other newer tactics like asset purchases.
In years past if a central bank like the Federal Reserve cut interest rates, domestic businesses would respond by bringing forward and increasing capital expenditure, investing in new capacity to take advantage of newly cheap borrowing terms. Now, rates are in negative territory or barely above zero in huge swaths of the global economy, yet investment remains low and relatively unresponsive to traditional or extraordinary monetary policy.
Yet, central bankers in developed markets are implying, both in word and deed, that they will stick with and even increase their bets on extraordinary policy.
“We could be stuck in a new longer-run equilibrium characterized by sluggish growth and recurrent reliance on unconventional monetary policy,” Fed Vice Chair Stanley Fischer said last week.
From the Bank of Japan now seeking to control long-term rates while pinning short-term ones to a massive Fed balance sheet which even it implies is a fixture rather than an emergency measure, signs are plentiful that, having seen little benefit from monetary policy, central banks, like the man with the hammer, will continue to treat screws like nails.
The reason this isn’t working is that while central banks can make borrowing in their markets more attractive, they can only do little about the attractions of investing there.
“Developed economies could be in a liquidity trap not only because interest rates are close to zero, but because of the changed nature of where capital expenditures are taking place now in a globalizing world,” Stephen Jen and Fatih Yilmaz of hedge fund Eurizon SLJ Capital write in a note to clients.
It isn’t simply that near the zero lower bound for interest rates, further moves bring diminishing or negative returns. It is also that for those agents who want to invest, the way the global economy is organized now makes it both easier and very likely more productive to put the money to work not in sclerotic aging economies but in emerging markets.
WHY INVEST IN JAPAN? OR EUROPE?
This means that low rates have a lower impact on capital expenditure than once they would have, a point supported by the historically high ratios of corporate cash to investment or profits to investment.
Japan’s experience with Abenomics backs this up. While the theory was that Japan would cheapen the yen and corporations would take the profits and increase production and employment, the reality was different. Why invest in Japan, which is aging, instead of lower-cost locations closer to future demand?
In addition a long-running deindustrialization in developed economies mean there is simply a smaller base of manufacturers to take up the offer of cheap loans. And the services which have grown up to fill the gap are less capital-intensive and more reliant on intangibles like intellectual property.
The U.S. and euro zone have had a similar, though less extreme, experience to Japan’s.
“Since monetary stimulus has reached its limitations, there will logically be a shift toward fiscal stimulus, and that is indeed what we expect to see in the coming quarters, especially in Japan, the UK and the US,” Jen and Yilmaz write.
The risk with this line of thinking is that fiscal stimulus may face some of the same problems as monetary in stimulating growth in a globalized and aging world. A dollar of highway spending in the U.S. of 1970 offered benefit to a much broader industrial base than the same dollar spent today. And in aging economies not only is a dollar borrowed and invested in fiscal stimulus facing the same demographic constraints as one borrowed and spent by industry, it piles a larger debt up which will need to be serviced by a narrower working cohort later.
This is not to say that infrastructure investing isn’t needed, but that all forms of investment in developed economies may garner less bang for a given buck than in the past.
One irony, of course, is that just as central banks struggle under constraints due to globalization, political forces may conspire to roll back its power. From Brexit to Trump and Clinton’s varyingly tough talk on trade deals, we might see a less globalized world.
That would restore some power to monetary policy but only by wrecking economic growth in the process.