Lawrence Summers is a professor at and past president of Harvard University. He was Treasury secretary in the Clinton administration and economic adviser to President Obama from 2009 through 2010.
As President Obama prepares to give his State of the Union address, and as policymakers and corporate chiefs gather in Davos, there is some diminution in the sense of high alarm that has gripped the global community the past few years. So far in 2012, stock markets are generally up and European sovereigns have experienced less difficulty borrowing than many expected. Economic data have come in ahead of expectations, particularly in the United States. Yet anxiety about the future remains a major driver of economic performance.
The news from financial markets is paradoxical in important ways. On the one hand, interest rates remain low throughout the industrial world. This is partly a result of very low expected inflation, but the inflation-indexed bond market suggests that remarkably low levels of real interest rates will prevail for a long time. In the United States, the yield on 10-year indexed bonds has fluctuated around -15 basis points. In other words, 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.
Stocks and real estate throughout much of the industrial world appear cheap on a price-to-earnings basis. The combination of low real interest rates and low ratios of asset values to cash flow suggests an abnormally high degree of fear about the future. In recent months there has been a much greater tendency than normal for higher interest rates to be associated with a stronger stock market and vice versa. In today’s economic environment, optimism is associated with a rise in both interest rates and stock prices as the expectation is for more profits and demand for funds.
Historically, it is more typical for interest rates and stock prices to move in opposite directions because of reassessments about future fiscal and monetary policies with expectations of higher rates driving down stock prices. If, for example, an important driver of markets was confidence that foreigners would hold U.S. debt, one would expect interest rates to rise, and the market to fall, as concerns rose and vice versa when concerns declined.
Uncertainty about future growth prospects as a major driver of markets correlates with the abnormally high level of cash sitting on corporate balance sheets, businesses’ reluctance to hire, and the sense that consumers are hesitant about discretionary big-ticket purchases even as borrowing costs and prices of capital goods near record lows.
All of this suggests that the priority for governments in the industrial world must be engendering confidence that recovery will continue and accelerate in the United States and that the downturn in Europe will be limited. How to do this remains an area of debate. At Davos and beyond, many will argue that top priority must be given to increasing business confidence and that government stimulus is useless at best and potentially counterproductive. Others — more economists than business people — will argue that top priority must be given to government stimulus and that issues about business confidence are red herrings.
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