Stephen King: Crisis of capitalism raises threat of excessive caution
This desire to preserve rather than create wealth is a direct route towards deflation
The Independent
01 July 2002
First Enron. Then WorldCom. Should any of this come as a surprise? For those of you who've read Charles Kindleberger's Manias, Panics and Crashes, the answer should be "no". Kindleberger's book devoted a whole chapter to swindles. He argued that, throughout history, swindles were all too often associated with speculative bubbles.
In one sense, this should not be too worrying. After all, the global economy has gone from strength to strength over the years despite these occasional rather unpleasant setbacks. Crises of capitalism do happen from time to time but, to date, no one has come up with a better alternative to the capitalist system.
Try telling that, however, to the owners of Enron or WorldCom shares. The capitalist system may be the best that's around but, from time to time, it works a lot less well than it should. Of course, we will now enter a feeding frenzy of blame and counter-blame, with directors, shareholders, auditors and regulators all pointing their fingers at each other. Regardless, however, of who is ultimately to blame, perhaps it's worth thinking about some of the key economic consequences of this latest debacle.
The most obvious short-term consequence is a further period of weakness for equities and for corporate bonds. In simple terms, why should people choose to own a company – or lend to a company – that might be guilty of financial jiggery-pokery? This, in turn, has serious consequences for the ability of entrepreneurs to raise funds. If the markets cannot easily separate out the good from the bad and the bad from the downright ugly, there's a good chance that previously decent investment opportunities will simply fall by the wayside.
These observations are already providing a threat to economic recovery. One way to consider this issue is to think about the difference between the cost of capital and the expected future return on capital. On a very simple basis, the cost of capital is a reflection of the level of interest rates or the cost of borrowing, heavily influenced by central bank policy. The expected future return on capital is a lot more difficult to measure but, intuitively, is a measure of the likely profitability of any given investment. As Keynes argued, this expected future return is subject to the "animal spirits" that appear to dominate financial market behaviour.
When profits have been mis-stated or have come in lower than expected and when companies begin to scale back their capital spending, you can be fairly sure that either the expected future return on capital has come down or, alternatively, has become so uncertain that a sensible business decision is impossible to make. Equity markets provide a potentially useful barometer of the expected future return on capital – when they're rising quickly, they may indicate a higher expected future return and when they're falling back, they may be indicating trouble ahead.
This week's table suggests that the recent performance of equities is a cause for concern. I've shown the performance of the S&P500 – purely in index terms – in the six months, 12 months and 18 months after the start of a period of aggressive Federal Reserve monetary easing over the past 30 years. The dismal performance over the past 18 months is completely different from any other occasion since the 1970s. This suggests that, although the cost of capital has fallen in the US – typically a piece of good news for economic recovery – the expected future rate of return has also fallen, thereby reducing the potential power of monetary policy to re-ignite economic growth.
My chart this week is a crude attempt to combine the cost of capital with the expected future return on capital. It's a simple measure of the level of Fed funds (the interest rate that's set by the Federal Reserve) adjusted for inflation. However, unlike the usual approach (where you simply deduct the consumer price inflation rate from the nominal interest rate), I've taken nominal interest rates and deducted the rate of inflation of share prices, which I 'm using as a barometer of expected future returns on capital.
The chart throws up some rather interesting results. In the second half of the 1990s, the nominal level of Fed funds was relatively high. Yet, because equity prices were rising so quickly, this didn't seem to matter very much. If expected future returns were up at 15 or 20 per cent, why would you worry about an interest rate of, say, 6 per cent? On this basis, monetary policy could be described as relatively accommodating, even though interest rates were historically quite high.
Over the last couple of years, exactly the opposite conclusion applies. The Federal Reserve may have slashed interest rates, thereby cutting the cost of capital, but expected future returns have fallen back even faster, if equity market performance is any guide. As a result, the effectiveness of changes in monetary policy may have been seriously reduced compared with the past. Why borrow at current market rates when expected future returns, as revealed through the equity market, are negative?
Central banks do not like these crises of financial confidence. They change the usual relationship between changes in interest rates and their impact on the wider economy. Back in 1998, the Federal Reserve slashed interest rates in the wake of the LTCM crisis in an attempt to restore market confidence. This time around, there's a lot less talk of interest rate cuts to come. However, it's becoming increasingly clear that the Federal Reserve is in no hurry to raise interest rates.
Why bother? Inflation is low and falling. The declines in equity prices suggest a level of financial distress that is limiting the power of the earlier rate cuts. And, in recent months, the consumer has finally started to wobble. From March through to May, consumer spending in the US didn't budge an inch. Admittedly, we haven't seen any significant declines. Nevertheless, the former powerhouse of the US economy now appears to be licking its wounds, a reflection of weaker income growth and persistent losses on the stock market.
In the first half of this year, the markets seemed to think that central banks were engaged in a fight against resurgent inflation. With a cyclical bounce coming through, inflation apparently was an obvious threat. Yet, with final demand failing to sustain recovery in the US, in most of Europe and in Japan, central banks have a far bigger problem on their hands. The persistent declines in equity prices, the falls in bond yields and the signs of corporate misadventure are all signs that excessive caution is becoming an endemic feature of the financial system. As I have argued in this column before, this kind of caution – this desire to preserve rather than create wealth – is a direct route towards deflation.
Central bankers dare not mention the "D" word because it is far too dangerous a scenario to contemplate. But, in the inner recesses of their minds, I reckon that deflation is their worst nightmare. And, as Japan found in the 1990s, excessive equity valuations and subsequent financial misadventure are precisely the vehicles through which deflation may ultimately arrive.
Stephen King is managing director of economics at HSBC.
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