(Originally published here.)
Ben Bernanke, the chairman of the Federal Reserve, recently expressed concern that investors were taking too much risk. To some investors, this was heavy with irony — most of the risk-taking can be attributed to the policies that Bernanke has pursued during his tenure.
Nayarana Kocherlakota, the president of the Federal Reserve Bank of Minneapolis, reinforced this point May 17. He said the Fed’s policies would produce “financial market phenomena” that “pose macroeconomic risks.” He made similar arguments last month in a speech I covered here and here. I’m not going out on a limb when I say that we’ve all endured enough “phenomena” for a while. Wouldn’t it be nice if there were an alternative?
Fortunately, Kocherlakota’s analysis suggests that there is. According to him, central banks have been pushing real interest rates so low because they are reacting to changes in the relative supply of and demand for “safe assets” since 2007. The theory is that heightened prudence and the shrinking volume of genuinely safe assets have suppressed the set of interest rates that produces acceptable rates of unemployment and inflation. Unfortunately, such interest rates also produce recurring cycles of bubbles and crises.
We could get around this by decreasing the demand for and increasing the supply of safe assets. Last month, Kocherlakota seemed to imply that more generous entitlement programs would help reduce the demand for safe assets.
There are alternatives. Investors may be so eager for safety because they are less optimistic about long-term growth. One reason is demographics: aging and population decline translate into slower output increases, assuming a relatively constant rate of innovation. At the same time, several scholars have argued that the pace of technological progress has been slowing and may even stop altogether.
One implication is that companies will be less likely to invest because their expected returns are so low. That helps explain why technology companies have been hoarding cash or returning it to investors, rather than spending on new projects. Companies won’t generate the same volume of investment as in the past unless their funding costs are much lower relative to their expected returns. While the Fed has been working hard to lower funding costs, its efforts haven’t been sufficient to restore full employment.
On May 18, Bernanke tried to talk up the other side of the equation. In a commencement speech at Bard College at Simon’s Rock, in Great Barrington, Massachusetts, the Fed chairman argued that the productivity outlook is better than the techno-pessimists believe. He even suggested that the rate of productivity growth could accelerate as changes in communications technology make it easier for people to collaborate across the globe.
While they may be helpful, speeches by economists won’t do much to affect the earnings expectations of companies on the frontlines of innovation. Even if companies are persuaded by Bernanke to spend aggressively, there is the danger that he is wrong and the pessimists are right. The last thing we need is another binge of wasteful investment after the bubbles of the 1990s and 2000s.
This is why I prefer raising the “equilibrium” interest rate curve through broad-based tax cuts that add to the budget deficit. At one stroke, this would put money in people’s pockets that could be used to repay debts and accumulate savings while also forcing the Treasury to issue more bonds to satiate investors.
Toby Nangle of Threadneedle Investments points out another benefit of this approach. While government bonds and equities both go up over time, they often move in opposite directions. This means that additional sovereign borrowing makes it easier for people managing portfolios to purchase additional equity. Conversely, low yields “have largely extinguished government bonds as an effective portfolio hedge.” In Nangle’s view, this explains why the “equity risk premium” is so elevated. Government deficits could therefore “crowd in” private capital and encourage more business investment. What’s not to like?