What The World Needs Now, It's Getting: Cheap MoneyChristopher Farrell
Welcome to a world of cheap money. In the past three months, 30-year U.S. Treasury bond yields abruptly plunged below 6.75% for the first time ever. And long-term interest rates in Britain, Germany, and Japan fell sharply, too.
This sudden decline in rates, the "money shock" of 1993, could have as dramatic an impact on the world economy as the oil shock of 1973. But unlike the oil shock, which sent the global economy reeling into recession, cheap money may be just the medicine to pull the industrial world out of its slump.
Indeed, cheap money--if it persists--could set off an era of sustained economic growth without triggering a new bout of inflation. Cheap money means that the cost of capital stays low and investments become much more affordable. Higher rates of investment will boost productivity. Better productivity raises economic growth and keeps a lid on inflation. "In the '90s, we could have a low and stable cost of capital, more capital-intensive investment, more business investment, and more productivity gains," says Neil M. Soss, chief economist at First Boston Corp.
The money shock had been building for a long time as inflation rates around the world declined. Long-term interest rates have been falling since the second half of 1990. Yields on 10-year government bonds have dropped by 2.5 percentage points, to 5.9%, in the U.S., by 2.5 percentage points, to 6.5%, in Germany, and by 4 percentage points, to 4%, in Japan.
DEFICIT DRUG. In the U.S., homeowners, businesses, and governments are feverishly refinancing to take advantage of cheap money. The annual interest bill, excluding the federal government and financial institutions, is down to $600 billion from more than $800 billion two years ago, calculates Edward Yardeni, chief economist at C.J. Lawrence Inc. That's a lot of money. And lower rates will keep the federal government's annual interest payments the same in 1993 as last year despite the rising deficit.
But the impact of cheap money goes much further than easing borrowing costs. Low rates will keep the U.S. equity market strong as investors shift more of their assets into stocks to boost their long-term returns. Mutual fund investors poured $87.3 billion into equity mutual funds last year, and another $100 billion could flow into equities in 1993, estimates Gail M. Dudack, market strategist for S.G. Warburg & Co. And pension funds are also flocking to the stock market to improve returns.
Cheap borrowing costs and high stock prices lower Corporate America's cost of capital. Companies can not only afford to invest more in new capital equipment but can wait longer for a payback from their investments. Take the difference between a 10% cost of funds and 7%. That three percentage-point saving means the cost of financing a five-year investment project would be 13% less and a 15-year project a staggering 34% less. "The cost of debt and equity capital has come down considerably, thereby providing for substantial new corporate business investments in plant and equipment and working capital that only very recently provided unacceptable rates of return," says Joel M. Stern, partner in Stern Stewart Inc., a corporate finance consulting firm.
Already, companies are investing more and keeping payrolls lean to boost productivity. U.S. productivity in the last quarter of 1992 rose at an annual rate of 4.8% and at a 2.8% annual rate for all of 1992--the best year since 1972. If long-term productivity growth increases to 2% a year from the 1% it averaged over the past two decades, the economy can grow at a 3% annual rate without igniting inflation instead of the Federal Reserve's estimate of 2%. Says Henry Kaufman, head of his own economic consulting firm and better known on Wall Street as Dr. Doom: "I am much more optimistic about the remainder of this decade than I was about the 1970s and 1980s."
GERMAN CUT? Cheaper rates are also helping to unwind the spectacular borrowing excesses of the last decade in Japan and Europe. Eventually, reducing debt should foster better economic growth everywhere. But much of Europe is waiting for the German central bank to relax its tight monetary policy and bring short-term rates down throughout the Continent. The German monetary officials may cut the discount rate from 8% currently to as low as 4% over the next 18 to 24 months, says the president of one major French bank. In Britain, after nearly three years of recession, the Bank of England cut rates five times in six months, and a mild recovery is under way.
The Bank of Japan has lowered its official discount rate since 1991 from 6.25% to 2.5%, the lowest in memory. Mortgage rates from the government's Housing Loan Corp. have fallen to 4.35%, just shy of a 1987 record low of 4.2%. And in January, 77.1% of new condos put on the market that month were sold, up 10.9 percentage points year-on-year, according to Baring Securities (Japan) Ltd. Housing starts rose by 2.4% in 1992, but jumped by 8.9% in the third quarter and 8% in the fourth quarter. Still, the Japanese economy needs a dose of fiscal stimulus, and one is in the works. It will include some tax cuts and huge public-works spending projects.
Low-cost money in the industrial world will spur investment in the developing nations, too. As interest rates fall and rates of return on stocks decline, capital will seek out higher returns in the emerging market economies of Latin America, China, and Eastern Europe. Indeed, foreign direct investment in the non-oil developing countries tripled from $10.6 billion in 1985 to $33.6 billion in 1991, according to the International Monetary Fund. And in 1992, real plant and equipment investment grew by 13.8% on top of the previous year's 8.7% increase, according to DRI/McGraw-Hill Inc. With all this fresh investment, new export markets will open up for the industrialized nations, and world trade could expand rapidly.
Of course, this rosy global forecast hinges on how long money stays cheap. And some skeptics say that won't be for very long. The culprit: rising inflation. To Albert Wojnilower, senior adviser at First Boston Asset Management, inflation is down because global economic growth is sluggish. In every business cycle, he says, high rates of unemployment and idle industrial capacity ease inflationary pressures. When economic growth picks up in the industrialized nations, the next move in inflation will be up, insists Wojnilower.
Other skeptics argue that Clinton's proposals for steep tax hikes will soon reverse the inflation gains of the past several years. "How long low inflation lasts is a political problem, not an economic problem," says Milton Friedman, Nobel laureate in economics and senior fellow at the Hoover Institution. "The record is clear. Raising taxes is not the way to get a boom. If Clinton gets his plan through, we will have lower growth, higher unemployment, and all the political pressure will be for higher inflation."
In Europe, some economists doubt that Britain and Italy, which have devalued their currencies in recent months, will escape another inflationary spiral. Says Jurgen Pfister, head of economic research at Germany's Commerzbank: "All past experience shows that massive devaluation will be followed by an upswing in inflation." Much of Europe's recent progress against inflation has coming from national governments' tying their financial policies to the tough-minded German central bank in an effort toward monetary union. But that monetary union is once again a distant dream, the European currency system is in disarray, and so a critical anti-inflation discipline has been removed.
HARD LESSONS. Still, the forces keeping inflation down are so powerful that it is hard to make the case that inflation is about to take off soon. "I think we are unwinding the entire inflation psychology of the 1970s and early 1980s," says Steven H. Nagourney, international strategist at Shearson Lehman Brothers Inc. Adds Robert D. Hormats, vice-chairman of Goldman, Sachs International and formerly a trade official in previous Administrations: "Unless something unexpected or irrational happens, low inflation is sustainable."
Start with the world's central bankers. They are all strong anti-inflation hawks these days, convinced that low inflation is necessary for sustained economic growth and determined not to repeat the mistakes of the 1970s. Today, the money supply of the seven major industrialized nations is expanding at less than a 1% annual rate, a pittance. By contrast, the global money supply soared from a 3% annual rate to an 18% pace from 1967 to 1973--and inflation surged even before OPEC jacked up oil prices.
The global capital markets make it difficult for central bankers to deviate from a strong anti-inflation stance. When it looks like the monetary authorities are getting soft on inflation, "the bond markets go crazy" and immediately drive up interest rates, says David Resler, economist at Nomura Securities International Inc. That's a compelling signal to central bankers to tighten the monetary reins and not allow inflation to accelerate further.
International competition is anti-inflationary, too. Companies are locked into brutal battles with overseas rivals for market share and profits. In the U.S. and to a lesser extent in Europe and Japan, the deregulation of telecommunications, airlines, financial services, and other oligopolies has greatly intensified domestic rivalries. Competition keeps down wage hikes and price increases.
Technology also carries a big anti-inflation stick. Prices on high-tech equipment, from computers to digital telephone exchanges, are falling. In the U.S., even as demand has surged for office, computing, and accounting machinery, prices have fallen by 22% since the first quarter of 1991.
Is the new world of cheap money a pipedream? Even if the economics are in place, policymakers could always derail it, as they have so many times before. But for the first time in three decades, it looks like the world has at least an even chance of realizing that dream.