Features

Central banks are killing business

The experimental monetary policies of central banks are killing off companies’ desire to invest, says Peter Warburton.

811-Opinion-1200

The experimental monetary policies that central banks have deployed in recent years quantitative easing (QE) and negative interest rates are killing off companies' desire to invest, other than in rapid payback items, such as information technology and vehicles. In their enthusiasm to encourage private-sector spending, central banks are distorting capital expenditure (capex) incentives and undermining the motivation for long-term decision-making. They are so fearful of the marauding hordes on horseback that they are sacrificing the furniture to fuel the train.

Central bankers, who have mostly never worked a day in a non-financial private enterprise, don't have a clue about what motivates capital-spending decisions. To echo the sentiments of Eric Lonergan, writing in the Financial Times: "investment decisions have financial consequences over many years and are more influenced by beliefs about future growth and attitudes to risk than by overnight interest rates set by central banks". Ignorance of this process by the central banks is deeply damaging.

There are three strong reasons to believe that, far from promoting greater investment, their policies are doing more to discourage firms from spending.First, corporate cash hoarding is a wholly rational response to an economic environment in which the prospective real returns to business investment are highly uncertain. QE and "lower for longer" interest-rate policies betray a lack of confidence on the part of policymakers towards the economic outlook. Rather than giving the economy an extra push, they introduce yet another layer of doubt and risk.

Second, policies designed to crush the term premium (the spread between the interest rate on longer-term bonds and those on shorter-term ones) have also promoted the idea that the terminal real interest rate has fallen to around 1%, or even to zero.It is impossible to avoid the implication that the long-run pace of real economic growth has been similarly reduced. Hence firms' planned expansions in capacity must be scaled back accordingly in response to expectations for lower growth and weaker demand.

Third and perhaps most damning large-scale asset purchases by central banks have brought down government bond yields and driven investors to search for higher yields elsewhere. When investors reach for yield in equities, they concentrate in safe companies with dependable cash generation. This sends a powerful signal to quoted companies to distribute profits to shareholders, rather than reinvest in physical assets.

As a result, the implied hurdle rate of return the return needed for a company to justify an investment rather than pay the cash out as dividends has been rising even as bond yields have fallen.

Jason Thomas, director of research at the Carlyle Group, a private-equity firm, shows empirically in a recent paper that "by increasing the market value of current income relative to future returns, unconventional policy may lead corporate managers to boost shareholder distributions at the expense of capital accumulation". When the same managers are personally given an incentive by the share-price performance of their companies, the effect is compounded.

The implications of all this are obvious and are borne out by the data. The recent deceleration of US non-residential capital spending is shown in the chart above. The latest statistics from the UK tell a similar story: gross fixed capital formation has slowed from 7.9% in 2014 to just 1% in the second quarter of 2016. In Germany, non-residential construction investment fell by 5.2% and machinery and equipment investment by 2.4% in the latest quarter. In short, central bank policies, with the best will in the world, are poisoning business capex.

Peter Warburton is the founder and chief economist of Economic Perspectives.

Recommended

Forget socialism – shareholder capitalism is delivering
Economy

Forget socialism – shareholder capitalism is delivering

Many Millennials say they would prefer to live in a socialist society. That's understandable. But while socialism promises everyone ownership and powe…
3 Dec 2021
In praise of capitalism, the noble path that leads to profits
Economy

In praise of capitalism, the noble path that leads to profits

Contrary to modern myth, profits are not always a result of greed, but a signal of virtue. Stuart Watkins reports.
3 Dec 2021
It’s official – inflation is no longer transitory
Inflation

It’s official – inflation is no longer transitory

America’s central bank has had a change of heart on inflation, and wants to retire the word “transitory”. John Stepek explains what that means for mar…
1 Dec 2021
What the Omicron variant means for your money
Investment strategy

What the Omicron variant means for your money

The Omicron variant of Covid-19 is panicking the markets. Will we see a new lockdown? What does it mean for the economic recovery, for inflation and f…
30 Nov 2021

Most Popular

Three safe bets on the growing online gambling sector
Share tips

Three safe bets on the growing online gambling sector

Professional investor Aaron Fischer, creator of the Fischer Sports Betting and iGaming ETF, picks three of his favourite online gambling stocks.
29 Nov 2021
Bubbles grow in global property markets as house prices continue to rise
Property

Bubbles grow in global property markets as house prices continue to rise

House prices grew by 6% in the year to mid-2021 in 25 global cities, with the German property market in particular showing signs of overheating.
3 Dec 2021
Making sense of the new minimum pension age rules
Pensions

Making sense of the new minimum pension age rules

The rules surrounding the minimum age at which you can start tapping into your retirement savings have been tweaked, but are still confusing. David Pr…
23 Nov 2021