The "Global Shortage of Hard Assets"

Raghuram Rajan the Graduate School of Business at of the University of Chicago says it's not a global savings glut that's causing such low long-term interest rates, it's a "shortage of hard assets":

Why hard assets are not easy to find, by Raghuram Rajan, Commentary, Financial Times: Signs of extremely benign financing conditions are plentiful, ranging from low long-term interest rates to historically narrow credit spreads on risky assets. Many observers call this a liquidity glut... But in my view, these conditions may primarily be driven by a global shortage of hard assets.

My argument relies on two global ingredients. The first is that, in spite of substantial worldwide income growth, if anything there has been an increase in the desire to save out of it. In emerging markets where income growth is rapid, savings increase. ... Also, emerging market governments, including oil producers, not only have higher revenues but have become more careful about expenditure, given past experiences with deficits.

But perhaps most intriguing is the increase in corporate savings, especially in industrial countries. Profitable corporations ... retain earnings rather than hand them back as dividends to shareholders.

This is where we come to the second ingredient. Nominal corporate investment in hard assets – such as inventories, property, plant and equipment – has been restrained... Instead, more corporate savings have been invested in financial assets. A number of possible explanations exist. ...

Perhaps the key factor ... in holding back investment in hard assets may be economic uncertainty – ranging from corporate takeover threats to the increasing cost-competitiveness of emerging markets. Indeed, it makes less and less sense for corporations in industrial countries to make large domestic investments in the manufacturing sector. But as they look to invest in non-industrial countries, they become subject to the uncertainties of policy there. Not only do they have to worry about whether China is a better place to invest than Vietnam but also whether it will continue to be better 10 years from now. ...

The mismatch between unabated global desired savings and lower realised investment has led to a financing glut, particularly pronounced in debt markets. ... [G]iven that markets are integrated, the glut has spilt over into areas such as property and pushed prices higher. ... Some of these markets are frothy, given the long-term prognosis for the savings-investment balance. ...

What is hard to forecast is how financing conditions will change. As capacity constraints tighten and as the policy environment in emerging markets becomes more clear, more investment will naturally be undertaken, reducing the financing imbalance and pushing up long-term interest rates. If this happens smoothly, the froth in exchange and asset markets will dissipate without much disruption. If long-term rates move more rapidly, for instance because of an inflation scare, the ride could be far more volatile.

Let me see if I can guess what PGL would say. He'll have no problem correcting me if I guess wrong. He would agree that a decline in investment is a key part of the story. He might also note that while low investment demand is usually explained by factors such as the Asian crisis, the collapse of the dot-com bubble, and 9/11, all of which diminished businesses' willingness to undertake risky investments, this adds additional factors associated with "global ingredients" such as competition from emerging markets. With the additional uncertainty these factors add, it "makes less and less sense for corporations in industrial countries to make large domestic investments in the manufacturing sector."

However, if it were just a decline in real investment, we would see low interest rates but also low output (casting this in IS-LM language, think of the IS curve shifting in). However, if there is also a large supply of liquidity, then interest rates would be even lower but output would not necessarily decline, a result consistent with the robust global output we have seen in recent years (think of the IS curve shifting in and the LM curve shifting out). It is also consistent with the low rates of inflation we have seen globally since the low investment demand will offset price pressure from the increased liquidity.