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Home Publications Blogs Beat the Press Higher Interest Rates Lead to More Investment

Higher Interest Rates Lead to More Investment

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Friday, 20 June 2014 05:41

That appears to be the central claim of Kevin Warsh and Stanley Druckenmiller in a Wall Street Journal column criticizing the Fed's asset buying program. The central claim appears to be that because asset prices have been rising, companies have been discouraged from undertaking productive investment. While Warsh and Druckenmiller are certainly right that the asset buying program has had limited benefits for the real economy, it doesn't follow that the economy would be stronger without it.

First, they misrepresent the wealth situation when they tell readers:

"The aggregate wealth of U.S. households, including stocks and real-estate holdings, just hit a new high of $81.8 trillion. That's more than $26 trillion in wealth added since 2009."

The sharp rise in wealth since 2009 was due to a sharp plunge in the financial crisis. The notion of a "record" is misleading since the economy is growing we expect wealth to continually hit records. The ratio of wealth to GDP was 4.78 in the first quarter of 2014. By comparison, it was 4.86 for 2006. The Fed's policies have simply brought the ratio of wealth to GDP back to pre-recession levels.

More importantly, Warsh and Druckenmiller seem to turn causality on its head when they say:

"Meanwhile, corporate chieftains rationally choose financial engineering—debt-financed share buybacks, for example—over capital investment in property, plants and equipment."

Low interest rates encourage corporations to invest in stock rather than bonds. If interest rates were higher, then presumably they would do the opposite. Low interest rates (and high stock prices) make it easier to borrow to finance capital investment in property, plants and equipment. It is hard to imagine why they think firms would be investing more, if it cost them more money to make these investments.

 

 

Comments (9)Add Comment
What gets measured, gets done
written by s ken brown, June 20, 2014 6:48
The cost of borrowing is not the only parameter or even the major one, upon which decisions are made. Business is a lot more complicated since Reagan deregulated and Sarbanes Oxely was troweled over the subsequent cracks. I don't fault businessmen for latching onto innovative ways to survive the strange new business reality. Since the crash, while money was apparently cheaper, it was much more hard to get. IMO because lenders experienced the double whammy of lower return and increased risk.
...
written by skeptonomist, June 20, 2014 8:37
The fact is that corporate chieftains are choosing financial engineering over capital investment despite record low interest rates. What this demonstrates is that interest rates are far less important to investment decisions by businessmen than economists assume, especially under recessionary conditions. As Dean has said, the three most important things in business decisions are “demand, demand, and demand”. Lenders understand the importance of demand and general business conditions also and they are certainly not encouraged to lend more when long-term rates are extremely low. Not that it would be a good idea for the Fed to raise its rates - this would have certain consequences that also are generally overlooked by economists.
Warsh
written by Peter K., June 20, 2014 8:52
is the worst. He was a Bush appointment to the Fed.
Keeping It Real
written by widgetmaker, June 20, 2014 12:14
Thanks for telling it like it is, Dr B. It's appalling how so called "serious" economists obviously cherry pick their facts to support their dubious arguments. These guys deserve to be called out for charting the growth in wealth starting from the bottom of the business cycle and not taking into account that the overall economy has grown as well. It makes me think of a financial advisor who points out that your account has made 100%, when in reality it lost 50% the previous year, so it's actually just back to where it started. Why do these guys continuously get a free ride with such shabby analysis? At least not here they don't. Sadly,your common sense analysis is sorely lacking in the rest of the media.
...
written by urban legend, June 20, 2014 3:06
skeptonomist said: "The fact is that corporate chieftains are choosing financial engineering over capital investment despite record low interest rates. What this demonstrates is that interest rates are far less important to investment decisions by businessmen than economists assume, especially under recessionary conditions. As Dean has said, the three most important things in business decisions are 'demand, demand, and demand'."

It bothers me that I never see depression of demand among seniors from low interest rates discussed. It surely happens, since seniors who have been encouraged to shift their assets into stable income-producing vehicles are seeing no income -- and must be careful with their spending to minimize dipping into principal to maintain their standard of living. In real terms, with virtually zero nominal rates on any kind of bank accounts, we are paying the banks in real terms to hold funds that are insured.

If it's low demand that is depressing business investment rather than interest rates, shouldn't the reflex response favoring interest rates near zero bear some re-examination?

I would propose that perhaps there is a "sweet spot" in situations like this, where interest rates are perceived by those living in part on their investments as at least producing enough income to make dipping into principal unnecessary, while while not being high enough to discourage borrowing for business investment. At any rate, I would prefer that even my favorite economists not pretend it is not an issue that even needs to be discounted.
Multiple Demands
written by John Parks, June 20, 2014 9:10
If: "The central claim appears to be that because asset prices have rising, companies have been discouraged from undertaking productive investment" then it is possible that Walsh and Druckenmiller may be overthinking
the problem.

I would suggest that the corporate chieftains are resorting to financial engineering because of their lack of imagination and their personal self-interest.

The corporations have the money, whether it is voluntarily sequestered overseas or here in the States, to make "capital investment in property, plants and equipment" but not only do they not know what to improve or produce they are also averse to taking chances.

The chieftains of the corporate world would not even debate over "stocks vs bonds" if they had a viable product alternative that required no personal risk.

The corporate boards are trapped by the complacency they perpetuate. Why risk investment in anything adventuresome when you are already
guaranteed a healthy income, plus fringes and bonuses guaranteed by your personal "old boys" club!?

Investing in stocks and bonds by the corporate chieftains is simply the safe play.

The only demand that needs to be recognized or fulfilled are the demands required by their perceived personal entitlements.
It'sDemand. dammit
written by Larry Signor, June 20, 2014 9:54
It seems simple to me. Until there is an increase in consumer demand, capital will find more marginally remunerative ways to be deployed. As Dean has said, there are only a limited number of inputs that increase demand.
Even the best are ignorant
written by Dave, June 21, 2014 7:47
Druckenmiller understood a lot going into this crisis, but he doesn't understand how to get out of it. Why would he? It is never happened, and so there's no data.

Let me emphasize: There's no Data!

An understanding of the system dictates that rates need to remain low for the entirety of the foreseeable future. We have a failure of a monetary system to deal with.

No, fiat money is not bad, it is good. Anyone following along will know what I'm talking about.
peak credit
written by john, June 22, 2014 8:35
"The ratio of wealth to GDP was 4.78 in the first quarter of 2014. By comparison, it was 4.86 for 2006." "The Fed's policies have simply brought the ratio of wealth to GDP back to pre-recession levels."

That is to say the Fed has "simply" brought the ratio of wealth to GDP back to the level it was at the height of the biggest housing bubble in the history of the world. I am sure this level is quite sustainable..........at least for the next few months. Dean, I know you hate these guys, but I am not so sure I would use 2006 as some sort of normal baseline.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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