Thursday, August 11, 2005

Returns to capital

In recent posts I noted that returns to labor are going to be suppressed by the effective doubling of the labor pool since the end of the cold war. Economist Brad Setser (see comments) noted that returns to capital (as evidenced by interest rates or market returns) have been poor of late as well. The Economist tries to explain this conundrum, using Investment-Savings (IS) and Liquidity-Money (LM) demand curves. Bernanke (our next Fed Chairman?) has argued that low returns are due to a global glut of savings. The Economist asserts that central banks bear most of the responsibility: low rates have triggered a liquidity glut, which is not the same as a savings glut.

Economist: Bond yields are low largely because central banks have created too much liquidity. Despite rising short-term interest rates in America, monetary policy is still unusually expansionary. Average short-term rates in America, Europe and Japan have remained below nominal GDP growth for the longest period since the 1970s. In addition, America's loose policy has been amplified by the build-up in foreign-exchange reserves and domestic liquidity in countries that have tied their currencies to the dollar, notably China and the rest of Asia. As a result, over the past couple of years, global liquidity has expanded at its fastest pace for three decades. If you flood the world with money, it has to go somewhere, and some of it has gone into bonds, resulting in lower yields. Or, more strictly, bond prices have been bid up until yields are so low that people are happy to hold the increased supply of money. In its latest annual report, the Bank for International Settlements suggests that the fact that the prices of all non-monetary assets (including bonds) have risen could indeed reflect an effort by investors to get rid of excess liquidity.

In fact, the two theories are not mutually exclusive. Too much saving relative to investment may well have gone hand in hand with excess liquidity, ie, both the IS and LM curves have shifted downwards. Central banks' monetary easing was, after all, partly in response to a fall in investment after share prices slumped. However, the current rapid pace of global growth suggests that excess liquidity is the prime cause of low bond yields. The snag is that central banks will eventually have to mop up the overhang of liquidity and bond yields will then rise.

Why isn't excess liquidity generating inflation? The basic IS-LM model assumed that the price level was fixed, and thus its inability to explain high inflation rates in the 1970s and 1980s hastened its fall from grace. If an economy is at full employment, an increase in money leads to higher prices, not lower bond yields. Today, however, the model may be more relevant because the entry into the world economy of cheap labour in China and other emerging economies is helping to hold down inflation. In a world of low inflation, IS-LM rides again.

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