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The year has started well for financial markets. Equities are generally up. European sovereigns have borrowed with an ease that has surprised many observers. Economic data, particularly in the US, have beaten expectations. So as President Barack Obama prepares to give his State of the Union address, and as policymakers and corporate chiefs come together in Davos, there is less alarm among the global community, though not yet a sense of relief. Indeed, anxiety about the future remains a major driver of economic performance.
The news coming from financial markets is paradoxical. On the one hand interest rates remain very low throughout the industrial world. While this is partially a result of very low expected inflation, the inflation-linked bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the US, the yield on 10-year indexed bonds has fluctuated around minus 15 basis points: 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.
One might expect that with low real interest rates, income-generating assets would sell at unusually high multiples to projected earnings. If anything, the opposite is the case: the S&P 500 is expected to be selling at only about 13 times earnings. In historical perspective, stocks appear cheap relative to earnings. Similar patterns are seen in most forms of real estate.
The combination of low real interest rates and low ratios of asset values to cash flows suggests an abnormally high degree of fear about the future. This idea is supported by the recent strengthening in the association between higher interest rates and a stronger stock market. In our present economic environment this is exactly what one would expect: when people become more optimistic, both interest rates and stock prices rise due to rising expectations of higher profits and of greater demand for funds.
This is in contrast to the usual situation, where interest rates and stock prices often move in opposite directions because of reassessments about future fiscal and monetary policies.
Uncertainty about future growth prospects also correlates with other observations, such as the abnormally large amount of cash sitting on corporate balance sheets, the reluctance of companies to hire, and consumers’ hesitancy about big discretionary purchases of durable goods despite near-record lows in borrowing costs and low capital goods prices.
All of this suggests that for the industrial world as a whole, the priority for governments must be to engender confidence that the recovery will accelerate in the US and that the downturn in Europe will be limited.
How best to do this remains an area of active debate. At Davos and beyond there will be many who argue that we must prioritise increasing business confidence and who say that government stimulus is at best useless and at worst counterproductive. Others will argue that priority must be given to stimulus and that issues of business confidence are red herrings.
Seventy-five years ago, John Maynard Keynes saw through this sterile debate, writing to President Franklin Roosevelt that either “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 “public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money”. The right approach involves borrowing from both contending lines of thought.
Government has no higher responsibility than insuring economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone a significant fall in joblessness. And without either of these there is no chance of reducing debt-to-income ratios.
There are of course risks: inflation, promoting excessive speculation and inefficient spending. But the simple fact is that, in the main, markets agree with business managers – increasing demand is the surest return to economic health.
Businesses are understandably uncertain about their prospects after the events of recent years. This is not the time to add unnecessarily to their worries. New regulations that burden investment should be avoided unless there is an urgent and compelling rationale. Inequality cannot be ignored but there is the risk that policies introduced in the name of fairness could actually exacerbate the challenges facing the middle class by reducing investment. Governments could do much to dispel current disdain for their dysfunction by devising clear plans to better align spending and taxing once recovery is established.
The best chance for economic recovery involves governments working directly to increase demand and to augment business confidence. At Davos and beyond, this should be the focus of economic debates.
The writer is Charles W. Eliot university professor at Harvard and former US Treasury Secretary