Low Demand For Capital Explains Federal Reserve's Impotence

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One of today's greatest economic mysteries is why the demand for capital is so low. Weak demand for capital is the reason that the Federal Reserve's policies are not stimulating the economy. We economists don't fully understand it, but there's a chance - not a certainty - of a turnaround next year.

Economists believe that demand curves slope downward, meaning at lower prices a greater quantity is demanded. In terms of capital, when interest rates are lower, then the amount of capital borrowed should be greater, all other things being equal. That would be from businesses using capital to expand productive capacity or make their operations more efficient, or from consumers who may be improving their quality of life or buying durable goods that reduce their future operating costs (such as buying a washing machine to avoid spending money at the laundromat).

Today, we see not much additional usage of capital. Corporate issuance of new bonds is flat in recent years according to SIFMA data. And consumer credit (aside from student loans) is growing at about the same rate as consumer incomes.

Corporate Bonds

Companies have the choice of borrowing money or issuing new stock, but The Wall Street Journal reports that stock issuance is very mild.

Interest rates are very low in the U.S., and even lower in all the other advanced economies. Why isn't demand for capital higher?

On the business side, we seem to be living according to John Maynard Keynes's observation that businesses won't borrow if they don't expect to sell more goods. Expectations by business leaders are dour. Keynes was thinking of companies adding capacity, but low interest rates should also stimulate substitution of capital for labor-automation in one form or another. The substitution could also be capital for raw materials, as when new machinery reduces waste of physical materials. Substitution could also reduce land use, as when farmers use better equipment to increase production per acre. Our statistics don't differentiate between the possible motivations for capital spending, but my conversations with business leaders indicate that efficiency is the driving force behind most business expenditures today.

Consumers are not so glum as business leaders, but neither are they so optimistic that they are willing to increase their debt just because interest rates are so low.

If businesses and consumers were more aggressive in taking advantage of cheap capital, then spending would increase, both on business equipment and consumer goods, stimulating the economy. Instead, we are stuck in a period of low growth (low but positive).

What could break the cycle? A bit more economic growth could trigger capacity constraints, stimulating companies to invest more in equipment, which would generate more consumer income and spending. Theoretically, consumers could become more aggressive on their own, but that seems unlikely. A resurgent global economy would boost U.S. exports, stimulating U.S. capital spending. That could be part of the "bit more economic growth" mentioned above.

What could our elected leaders do to help? Not much. Neither the White House nor Congress possesses magical potions to stimulate the economy. Infrastructure investment is a popular notion, but don't expect interminable environmental impact reviews followed by politically-motivated bridges to nowhere to do much good. Some minor improvement could come from regulatory reform and tax simplification. If you think that our political leaders really want that, you imagine power-hungry people voluntarily giving up power. In short, don't look to the government for help.

Our current low-growth environment isn't bad, but it reminds me so much of my 5th grade report card: "Bill doesn't work up to his potential." Nor does the United States economy. But it might sometime in the future.