On his recent book tour, former Federal Reserve Chairman Ben Bernanke stated that low long-term interest rates are not the Fed’s doing. Low rates result from a shortage of good capital projects. If there were good investment projects, he explained, capital would flow and interest rates would rise. Mr. Bernanke insists that the absence of compelling investment opportunities in the real economy justifies continued, highly accommodative monetary policy.
That may well be true according to economic textbooks. But textbooks presume the normal conduct of policy and that the prices of financial assets like stocks and bonds are broadly consistent with expectations for the real economy. Nothing could be further from the truth in the current recovery.
During the past five years earnings of the S&P 500 have grown about 6.9% annually. As the table nearby shows the current profit picture pales in comparison to prior economic expansions, in which earnings grew significantly faster. Moreover, only about half of the profit improvement in the current period is from business operations; the balance of earnings-per-share gains arose from record levels of share buybacks. So the quality of earnings is as deficient as its quantity. The current economic expansion is also unusual because the stock market and other financial assets have boomed in spite of relatively muted profit gains.
What explains the apparent divergence between earnings and asset prices? The unusual conduct of monetary policy.
Extremely accommodative monetary policy, including the purchase of about $3 trillion in Treasurys and mortgage-backed securities during three rounds of “quantitative easing” (QE), pushed down long-term yields and boosted the value of risk-assets. Higher stock prices were supposed to drive business confidence and higher capital expenditures, which were supposed to result in higher wages and strong consumption. Would it were so.
Business investment in the real economy is weak. While U.S. gross domestic product rose 8.7% from late 2007 through 2014, gross private investment was a mere 4.3% higher. Growth in nonresidential fixed investment remains substantially lower than the last six postrecession expansions. In 2014, S&P 500 companies spent considerably more of their operating cash flow on financially engineered buybacks than real capital expenditures for the first time since 2007. During the precrisis period, by contrast, corporate spending on real assets averaged 10 percentage points higher than on financial assets.
Many believe that today’s lack of capital investment stems from a shortfall of global demand. Output gaps can have a dampening effect on investment. But the demand that drives capital investment is future demand. Efforts by the Fed to fill near-term shortfalls in demand through QE and so-called forward guidance have shown limited and diminishing signs of success. And policy makers refuse to tackle structural, supply-side impediments to investment growth, including fundamental tax reform.
We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose “shareholder friendly” share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.
How has monetary policy created such a divergence between real and financial assets?
First, corporate decision-makers can’t be certain about the consequences of QE’s unwinding on the real economy. The resulting risk-aversion translates into a corporate preference for shorter-term commitments—that is, for financial assets.
Second, financial assets are considerably more liquid than real assets. Trade among financial assets like stocks is far easier than buying and selling real assets like capital equipment. The financial crisis taught an important lesson to investors of all sorts: Illiquidity can be fatal. Financial assets have large liquidity benefits over real assets. In other words, it’s far easier to turn stocks into cash than to liquidate a new factory.
Third, QE reduces volatility in the financial markets, not the real economy. By purchasing long-term securities, the Fed removes significant market volatility from stocks and bonds. Any resulting reduction in macroeconomic volatility—affecting real asset prices—is far more speculative. In fact, much like 2007, actual macroeconomic risk may be highest when market measures of volatility are lowest. Central banks have been quite successful in stoking risk-taking by investors in financial markets, but have found far less success in encouraging risk-taking in the real economy.
Fourth, QE’s efficacy in bolstering asset prices may arise less from the policy’s actual operations than its signaling effect. Mr. Bernanke himself has said that QE “works in practice, just not in theory.” Multiple event studies in the U.S., Europe and Japan show that financial-asset prices move higher when QE programs are announced and implemented, and suffer when QE is thought to be ending. Clearly, market participants believe central bankers use QE, among other reasons, to put a floor under financial asset prices.
For real assets, the benefits of QE are far less obvious—and the results far less impressive. Weak economic data and mixed messages from the Fed in recent months only heighten our concerns about the trajectory of the economy and the sustainability of U.S. financial-asset prices.
Inadequate capital investment means that labor is also underutilized. The impact of low capital investment is apparent in the weak productivity statistics. Productivity—key to raising wages and living standards—rose less than half of 1% annually in 2011-14, the weakest four-year run in productivity outside of a recession since World War II. That is an important contributing factor to the meager improvements in median wages during the recovery and the lowest labor-force participation rates since the late 1970s.
These trends, if not reversed, threaten to harm the U.S. economy’s growth prospects. We recommend a change in course. Increased investment in real assets is essential to make the economic expansion durable.
Mr. Spence, a 2001 Nobel laureate in economics, of New York University, and Mr. Warsh, a former Fed governor, of Stanford, are Hoover Institution fellows and two of the authors of “Growing Global: Lessons for the New Enterprise” (out next month by the Center for Global Enterprise), from which this op-ed was adapted.
