s begun well in markets. Stock markets in 2012 are generally up, and European sovereigns have experienced less difficulty borrowing than many expected. And economic data, particularly in the United States, has come in ahead of expectations. So as President Obama prepares to give his State of the Union address, and as a large group of policymakers and corporate chiefs come together in Davos this week, there is, if not a sense of relief, at least some diminution in the sense of high alarm that has gripped the global community for much of the last few years. Yet anxiety about the future remains a major driver of economic performance.
The news coming from financial markets is in important ways paradoxical. On the one hand, interest rates remain very low throughout the industrial world. While this is partially a result of very low expected inflation, the inflation-indexed bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the United States, for example, the yield on 10-year indexed bonds has fluctuated around -15 basis points. That is to say: On an inflation-adjusted basis, investors are paying the government to store their money for 10 years! In Britain, inflation-linked yields are negative going out 30 years.
One might expect that with low real interest rates, assets would sell at unusually high multiples to projected earnings. If anything, the opposite is the case, with the S&P 500 selling at only about 13 times earnings. Stocks also appear cheap to earnings in historical perspective through much of the industrial world. And similar patterns are observed with respect to most forms of real estate.
The combination of low real interest rates and low ratios of asset values to cash flows suggests as a matter of logic an abnormally high degree of fear about the future. This could reflect expectations that earnings or other cash flows will rise more slowly than anticipated, or simply result from a higher discount associated with future earnings because of abnormally high uncertainty.
This idea that future uncertainties are driving financial markets is supported by the observation that in the recent period there has been a much stronger tendency than normal for higher interest rates to be associated with a stronger stock market and vice versa. This is exactly what one would expect in an economic environment like the present one - on days when people become more optimistic, both interest rates and stock prices rise as the expectation is of more profits and demand for funds.
This is in contrast to the usual situation, in which interest rates and stock prices often move in opposite directions because of reassessments about future fiscal and monetary policies, with expectations of higher rates driving down stock prices. For example, if an important driver of markets was confidence that foreigners would hold U.S. debt, one would expect to frequently see days when interest rates went up and the market went down as concerns rose, and vice versa when concerns declined.
Uncertainty about future growth prospects as a major driver of markets also correlates with other observations, such as the abnormally high level of cash sitting on corporate balance sheets, the reluctance of businesses to hire, and the sense that consumers are hesitant about discretionary big ticket purchases even as borrowing costs and capital goods prices are at near-record lows.
All of this suggests that for the industrial world as a whole, the most important priority for governments must be giving confidence that recovery will continue and accelerate in the United States and that the downturn in Europe will be limited. How best to do this remains an area of active debate. At Davos and beyond there will be many who argue that top priority must be given to increasing business confidence and that government stimulus is useless at best and potentially counterproductive. There will be others - more economists than businesspeople -- who will argue that top priority must be given to government stimulus and that issues about business confidence are red herrings.
Keynes saw through this sterile debate 75 years ago, writing to Roosevelt that either 'the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees' or 'public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money.' The right current approach involves borrowing from both contending lines of thought. Government has no higher responsibility than insuring that economies have an adequate level of demand. Without growing demand, there is no prospect of sustained growth, let alone significant reduction in joblessness. And without growth and reduced unemployment, there is no chance of engineering reductions in government debt-to-income ratios. Of course, risks of inflation, of promoting excessive risk-taking in the future, and of spending that is not ideally efficient need to be balanced. But the simple fact is that markets in the large concur with the judgment of individual business managers that increasing demand is the sine qua non of a return to economic health.
At the same time, businesses are understandably uncertain about their prospects after the events of recent years. This is not the right time to add unnecessarily to their worries. Except where the rationale is both urgent and compelling, new regulations that burden investment should be avoided. Inequality is a growing problem that will have to be addressed in the United States and beyond - it cannot be ignored. But there is the risk that policies introduced in the name of fairness that excessively burden job-creating investment could actually exacerbate the challenges facing the middle class. At a moment of substantial doubt about the functionality of government, government could do much to increase confidence in its functioning by devising a clear plan to better align spending and taxing once recovery is established.
By working both to directly increase demand and augment business confidence, governments have the best chance of creating economic recovery. At Davos and beyond that should be the near-term focus of economic debates.
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