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In this week's Wall Street Journal, Michael Spence and Kevin Warsh say the Federal Reserve's policy of bond buys, or quantitative easing (QE), is responsible for sluggish business investment in recent years.
There is no logical or factual basis for their claim. Indeed, logic and facts point strongly in the opposite direction. It is the reluctance of businesses and consumers to spend in the wake of a historic recession that is forcing the Fed and other central banks around the world to keep interest rates unusually low—not the other way around. Moreover, economies in which central banks were most aggressive in conducting QE early in the recovery (the United Kingdom and the United States) have been growing more strongly than economies that were slow to adopt QE (the euro area and Japan).
At the top of their piece, the authors pull a classic bait and switch, noting "gross private investment" has grown slightly less than GDP since late 2007. Yet the shortfall in private investment derives entirely from housing. No one believes that Fed purchases of mortgage bonds tanked the housing market. The whole premise of the article, that business investment is excessively weak, is simply false. (Hat tip: Brad DeLong.)
But the piece also fails a basic test of common sense. Spence and Warsh posit that "QE has redirected capital from the real domestic economy to financial assets at home and abroad." This statement reveals a fundamental misunderstanding of what financial assets are. They are claims on real assets. It is not possible to redirect capital from financial assets to real assets, since the two always are matched perfectly. Equities and bonds are (financial) claims on the future earnings of (real) businesses.
Spence and Warsh accept that QE raised the prices of equities and bonds. Yet they seem ignorant of the effect this has on incentives to invest. Businesses fund new investments by issuing more equity or bonds. Higher prices of equity and bonds mean that businesses can fund more investment at the same cost, giving a windfall gain to existing owners. There is no way that higher prices of financial assets can reduce investment.
True, some businesses have used rising profits to buy back their own stock. But that is a business prerogative that points to lackluster investment prospects and cannot be laid at the feet of easy Fed policy. Indeed, to the extent that QE has raised stock prices, it discourages businesses from buying back stock because it makes that stock more costly to buy.
Spence and Warsh suggest QE has raised uncertainty about the future because unwinding it may have harmful effects on the real economy. But if unwinding QE can reduce spending, then surely launching QE raised spending. And foregoing QE would have made the recession even deeper and more damaging. The Fed's job is to be sure not to unwind QE before the economy is strong enough. Communicating that strategy is something the Fed could improve.
Make no mistake: There is a deep puzzle as to why businesses have not responded even more strongly than they have to extraordinarily cheap finance at a time of solid profits. Unfortunately, Spence and Warsh shed no light on that puzzle.
