Why Bill Gross is wrong to say that rock-bottom interest rates are discouraging investment
By D.D. | LONDON
IT’S ONE of the fundamental lessons of any introductory economics course: lower interest rates, when all else remains equal, leads to higher levels of investment. But today, after several years of near-zero interest rates and only modest increases in investment to show for it, some economists are claiming just the opposite.
On October 26th, an op-ed in the Wall Street Journal by Michael Spence and Kevin Warsh, both of Stanford University, argued that the Federal Reserve’s $3 trillion bond-buying programme, which was designed to push down long-term rates and boost corporate borrowing, has actually caused business investment to fall. The authors write that the Fed’s unconventional policies to expand the money supply, known as quantitative easing (QE), have made short-term financial assets like stocks and bonds more appealing as their capital value increases, thereby diverting capital from more productive longer-term investments in the “real economy”. The result has been low investment growth, weak productivity, and stagnant wages.
At least one prominent investor agrees. Last week, Bill Gross, the co-founder of PIMCO, a big bond fund, and who now oversees some $1.4 billion at Janus Capital, wrote in his November Investment Outlook that low interest rates are short-circuiting financial markets and are causing capitalism to “not work well”. According to Mr Gross, the Fed’s expansionary monetary policy has driven down long-term rates, causing the yield curve—the difference in yields on short- and long-term government debt—to flatten. This has squeezed bank profit margins, which has in turn led to lower business investment and economic growth.
Are low interest rates really to blame for our current economic malaise? Should the Fed, as Mr Gross suggests, intervene in Treasury markets to steepen the yield curve and widen the gap between short- and long-term rates? The answer to both questions is no. First, low interest rates have not hurt investment. Lower prices, as a general rule, tend to encourage higher, not lower, demand. Credit is no exception. Decades of research has shown that when the cost of capital falls, investment rises, as it did when the theory was first articulated by John Maynard Keynes some 80 years ago. As Joseph Gagnon of the Peterson Institute points out, it is weak spending and investment that is keeping interest rates low, not the other way round.
Second, the yield curve is not particularly flat at the moment; and if it were, that would not warrant Fed meddling. The current gap in yields between 30-year bonds and 3-month bills is just under 3 percentage points. While this is below the 4.6% spread that existed in January 2010, it is well above the -0.5% spread seen in March 2007 (see chart). Mr Gross is right that narrower spreads are eating into the returns of some investors. But this does not justify raising borrowing costs for everyone else.
Like Mr Gross, the Fed wants long-term rates to rise. It is simply waiting for this to happen naturally, as a consequence of faster economic growth. For market commentators looking for an easy answer to America’s economic problems, the Fed is a prime target, as it has been for decades. But weak aggregate demand continues to be the principle obstacle to a stronger economic recovery. For this problem, there are no easy answers.
