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Bernanke's Easy Money Death Spiral

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QE is impeding capital investment by raising cost of capital volatility risk. Here's why the more easy money we get, the longer it will take to build a sustainable recovery.

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MINYANVILLE ORIGINAL It seems that big sucking sound signaling a precipitous drop off in the demand for money that I have been warning about for a few weeks is starting to get some more attention. This past Monday, the Wall Street Journal ran a front page story headlined Investment Falls Off a Cliff: US Companies Cut Spending Plans Amid Fiscal and Economic Uncertainty. According to the article:
Nationwide, business investment in equipment and software -- a measure of economic vitality in the corporate sector -- stalled in the third quarter for the first time since early 2009.

Corporate executives say they are slowing or delaying big projects to protect profits amid easing demand and rising uncertainty. Uncertainty around the US elections and federal budget policies also appear among the factors driving the investment pullback since midyear.

Companies fear that failure to resolve the fiscal cliff will tip the economy back into recession by sapping consumer spending, damaging investor confidence and eating into corporate profits.

The consensus would have you believe that this hunkering down by corporations is solely a function of fears of the current dysfunction in Washington. But upon further investigation, it appears that this decline in capital expenditures is more secular in nature.

Esteemed value investor Jeremy Grantham of privately-held GMO, one of the largest investment firms in the worlds with nearly $100 billion in assets under management, explores this reduction in capital spending in his quarterly letter to investors released this past week. In a sobering dissertation titled On the Road to Zero Growth, Grantham goes through the many drivers of a structural decline in US economic growth capacity. Citing the "Bonus Culture," a term coined by his economic consultant Andrew Smithers, Grantham explains why today's CEOs are averse to capital investment.

Now, in the bonus culture, new capacity is regarded with great suspicion. It tends to lower profitability in the near term and, occasionally these days, exposes the investing company to a raider. It is far safer to hold tight to the money and, when the stock needs a little push, buy some of your own stock back. This is going on today as I write, and on a big scale (approximately $500 billion this year). Do this enough, though, and we will begin to see disappointing top-line revenues and a slower growing general economy, such as we may be seeing right now.

Grantham, it should be noted, has made several significant market predictions including the bubble in Japan's stocks in 1989 and also in US stocks in 2000. In his recent letter to investors, he posts a chart of US Capital Formation as a ratio to GDP that shows a severe decline that began in 2000 with the flowering of Bonus Culture. About the chart he says:
Mostly the data in Exhibit 5 reflects a lower capital spending rate responding to slower growth. The circled area, though, suggests an abnormally depressed level of capital spending, which seems highly likely to be a depressant on future growth: obviously you embed new technologies and new potential productivity more slowly if you have less new equipment. This currently reduced investment level appears to be about 4% below anything that can be explained by the decline in the growth trend. If this decline is proactive, if you will, and not a reflection of earlier declines in the growth rate, then based on longer term correlations it is likely to depress future growth by, conservatively, 0.2% a year.

This decline in capital spending isn't just about fears of the fiscal cliff. This has been going on for over a decade. This got me thinking about what the roles are that interest rates and monetary policies play in this secular change. Last week in How QE Is Impeding Economic Growth, I cited a speech Chairman Bernanke had delivered in the prior week where he extols the benefits of low interest rates (emphasis mine).
At the Federal Reserve, we have sought to support the economic recovery and maintain price stability -- the two goals given to us by the Congress -- by keeping both short-term and longer-term interest rates historically low. Low interest rates reduce the cost to households of buying homes, cars, and other consumer durables while increasing the attractiveness of new capital investments by firms.

Do low interest rates increase the attractiveness of new capital investment?
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No positions in stocks mentioned.
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