Educating Larry Summers

On October 26, the day after I landed in the US, there was a Op.-Ed in WSJ by Kevin Warsh (former FOMC member) and Michael Spence, a Nobel Laureate. I had not had the time to read it then. Then, I saw a reaction by Larry Summers to that Op.-Ed. I could sense what they would have written. I read it only today. The salient portion of their Op.-Ed. is this:

How has monetary policy created such a divergence between real and financial assets?

First, corporate decision-makers can’t be certain about the consequences of QE’s unwinding on the real economy. The resulting risk-aversion translates into a corporate preference for shorter-term commitments—that is, for financial assets.

Second, financial assets are considerably more liquid than real assets. …. In other words, it’s far easier to turn stocks into cash than to liquidate a new factory.

Third, QE reduces volatility in the financial markets, not the real economy. ….

Fourth, QE’s efficacy in bolstering asset prices may arise less from the policy’s actual operations than its signaling effect. …. Clearly, market participants believe central bankers use QE, among other reasons, to put a floor under financial asset prices.

For real assets, the benefits of QE are far less obvious—and the results far less impressive. ….

I found these points eminently sensible. Mr. Summers did not. My comment on his blog post is reproduced below (with an additional point):

There are many responses to Mr. Summers’ bewilderment.

(1) IS curve slopes downward and, in words, it says that, ‘everything else being equal, lower real rates should lead to higher investment demand’. The crucial caveat is ‘ceteris paribus’, Everything else is not equal, when rates are dropped to zero.

(2) We can see this by breaking down the components of nominal interest rate. IT is Compensation for foregoing present consumption + compensation for erosion of purchasing power (for the sake of convenience, let us call it, ‘inflation’).

When the Left-Hand Side is zero, one of the two components must be zero or even negative if the other is positive. Humans’ need for compensation for forgoing present consumption opportunities can be assumed to stay reasonably constant and above zero. In that case, an interest rate of 0.0% conveys the same message that there would be negative price change (deflation) ahead. Why would anyone invest, when central banks signal deflation?  Indeed, central banks get what they signal!

(3) He has asked the original authors to cite peer reviewed research in support of their arguments. It may not be peer-reviewed but I can cite one Federal Reserve Board Discussion Paper: ‘The insensitivity of investment to interest rates: Evidence from a survey of CFOs’.  When interest rates are dropped, firms do not drop their hurdle rate. Period.

Mr. Summers has to do some simple internet search to find many other papers that make similar points based on empirical evidence. Isn’t that what matters and not what text books taught millions of students? Text books were not wrong because they must have safely included  the caveat, ‘Everything else being equal’….

(4) There was an article in FT on September 7 on how European companies are responding (or, ‘not responding’) to lower interest rates and QE by the ECB. (‘ECB quantitative easing: Failure to spark’, September 7, 2015)

The following two are quotes from that article:

“Richard Dobbs, director at the McKinsey Global Institute, the consultancy’s research arm, says he has “yet to come across a corporation that has adjusted their hurdle rate or WACC to reflect the fact that we’ve had QE.”

“If the cost of capital reflects the low interest rate environment, then so will the cash flows”

“Bernd Scheifele, chief executive of Heidelberg Cement, the cement maker, says: “The problem in a world of zero interest rates is that it’s very difficult to find projects where you can still earn the WACC within a foreseeable future.”

““Expecting companies to invest more when they already have too much capacity is not the answer,” says Mr Dobbs.”

(5) Graeme Wheeler, Governor of the Reserve Bank of New Zealand, had this to say in a speech on the limitations of monetary policy on October 14:

“Monetary policy can influence risk-taking in asset markets, but this does not necessarily translate into risk taking in long term real assets – requiring the investment and entrepreneurial decisions that underpin productivity growth and hence long-run improvements in living standards.” [Link]

(6) Low interest rates sustain excess capacity and hence no fresh investments can take place.

(7) If Summers wants further empirical evidence, it is available from US data. Computers and Peripherals, Information Processing and Intellectual Property Products Investment have recorded the lowest compounded annual growth rate in the last six+ years since the recession ended in June 2009. This is based on BEA data.

(8) Even in the previous cycle, non-residential Investment recorded the lowest CAGR despite the Federal Reserve having pushed rates down to 1.0%, having kept it there for 12 months and then raised rates slowly over the following two years.

The evidence is staring him in the face. It is up to him to see it, for what it really is.

I just (4th August 2016) checked if my comment was there on his blog site. It is not there. I am going to post it there again. I will check tomorrow if it has been ‘approved’.

If you have further 20 minutes, listen to this interview of Stanley Druckenmiller by Andrew Ross-Sorkin. Time well spent. Stan also addresses Larry Summers’ critique of Warsh and Spence. Of course, Warsh and Spence responded to Larry Summers here.


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