"The key to recovery: Boosting business confidence"
Op-Ed, Washington Post
January 23, 2012
Author: Lawrence Summers, Charles W. Eliot University Professor
As President Obama prepares to give his State of the Union address, and as policymakers and corporate chiefs gather in Davos, there is some diminution in the sense of high alarm that has gripped the global community the past few years. So far in 2012, stock markets are generally up and European sovereigns have experienced less difficulty borrowing than many expected. Economic data have come in ahead of expectations, particularly in the United States. Yet anxiety about the future remains a major driver of economic performance.
The news from financial markets is paradoxical in important ways. On the one hand, interest rates remain low throughout the industrial world. This is partly a result of very low expected inflation, but the inflation-indexed bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the United States, the yield on 10-year indexed bonds has fluctuated around -15 basis points. In other words, on an inflation-adjusted basis, investors are paying the government to store their money for 10 years. In Britain, inflation-linked yields are negative going out 30 years.
Stocks and real estate throughout much of the industrial world appear cheap on a price-to-earnings basis. The combination of low real interest rates and low ratios of asset values to cash flow suggests an abnormally high degree of fear about the future. In recent months there has been a much greater tendency than normal for higher interest rates to be associated with a stronger stock market and vice versa. In today’s economic environment, optimism is associated with a rise in both interest rates and stock prices as the expectation is for more profits and demand for funds.
Historically, it is more typical for interest rates and stock prices to move in opposite directions because of reassessments about future fiscal and monetary policies with expectations of higher rates driving down stock prices. If, for example, an important driver of markets was confidence that foreigners would hold U.S. debt, one would expect interest rates to rise, and the market to fall, as concerns rose and vice versa when concerns declined.
Uncertainty about future growth prospects as a major driver of markets correlates with the abnormally high level of cash sitting on corporate balance sheets, businesses’ reluctance to hire, and the sense that consumers are hesitant about discretionary big-ticket purchases even as borrowing costs and prices of capital goods near record lows.
All of this suggests that the priority for governments in the industrial world must be engendering confidence that recovery will continue and accelerate in the United States and that the downturn in Europe will be limited. How to do this remains an area of debate. At Davos and beyond, many will argue that top priority must be given to increasing business confidence and that government stimulus is useless at best and potentially counterproductive. Others — more economists than business people — will argue that top priority must be given to government stimulus and that issues about business confidence are red herrings.
Keynes saw through this sterile debate 75 years ago, writing to Roosevelt that “the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees” or that “public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money.” The right approach today involves borrowing from both lines of thought.
Government has no higher responsibility than ensuring that economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone significant reduction in joblessness. And without growth and a reduction in unemployment, there is no chance of engineering reductions in government deficit. Meanwhile, the risks of inflation, promoting excessive risk-taking and inefficient spending need to be balanced. But the fact remains that markets are largely concurring with the judgment of individual business managers that increasing demand is the sine qua non of a return to economic health.
Businesses are understandably uncertain about their prospects after the events of recent years. This is no time to add unnecessarily to their worries. Except where the rationale is urgent and compelling, new regulations that burden investment should be avoided. Growing inequality will have to be addressed in the United States and beyond. But there is the risk that policies introduced in the name of fairness that excessively burden job-creating investment could actually exacerbate the challenges facing the middle class. At a moment of substantial doubt about government’s functionality, government could greatly increase confidence by devising clear plans to better align spending and taxing once recovery is established.
By working to directly increase demand and augment business confidence, governments have the best chance of creating economic recovery. That should be the near-term focus of economic debates at Davos and beyond.
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