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A curious leap in logic

Former Fed Governor Kevin Warsh and billionaire investor Stanely Druckenmiller, in a Wall Street Journal op-ed, blame the Fed's easy money policies for flagging incomes, low growth and depressed business investment in the United States.

But it seems a curious leap in logic that begs for additional evidence and explanation. The argument goes something like this: Since income growth and business investment are low and Fed policy is easy, then Fed policy must be the culprit. "Higher asset prices are not translating into meaningful increases in capital expenditures," the two write.


The Marriner S. Eccles Federal Reserve building in Washington.
Getty Images
The Marriner S. Eccles Federal Reserve building in Washington.
"Long before the Fed eased policy or began quantitative easing, real private fixed investment in the United States was in the dumps."

Warsh and Druckenmiller argue that the Fed's policies of pushing down interest rates and raising asset prices have created balance-sheet wealth but not real economic growth. "Meanwhile, corporate chieftains rationally choose financial engineering—debt-financed share buybacks, for example—over capital investment in property, plants and equipment."

But a look at the connection between stock prices, quantitative easing and investment raises questions about their cause-and-effect argument.

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Long before the Fed eased policy or began quantitative easing, real private fixed investment in the United States was in the dumps, falling at 3-percent annual rate in the two years before the Fed increased its balance sheet by a single dollar. Over those eight quarters, only a single one was positive. In Aug. 2007, more than a year into the decline, the Fed began cutting rates. It is simply impossible to look at the data and see Fed policy causing business investment to scale back.

In the third quarter of 2008, the declines accelerated into double digits. It was only several months later that the central bank lowered its interest rates to zero and began purchasing assets. By the end of 2009, after the Fed has purchased $1.3 trillion in assets, business investment surged 36 percent and would enjoy four quarters of growth. Some of the ups and downs are clearly related to on-again, off-again tax incentives. But it clearly raises questions about the Warsh and Druckenmiller idea that Fed policy caused business investment to decline.

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In 2010, once again, business investment declined and the Fed launched into another round of bond purchases, followed by a recovery, although less robust than the first recovery. And QE3, was launched in September 2012, followed by a rebound in business investment. The pattern is simple: QE has followed by or coincident with declines in investment, not leading.

Finally, Warsh and Druckenmiller must be aware of the long connection between rising stock prices and investment, which has actually been borne out this year. While the Fed has been pumping money into the economy, there have been 134 initial public offerings this year, up 63 percent from the same period a year ago. That follows 2013, which was the strongest full year by a decade. Is not the IPO market the capitalist cradle of job creation and investment?

There is a nearly 90 percent correlation between the S&P 500 and business investment as measured in shipments of non-defense capital goods, excluding aircraft, a monthly proxy for business investment. That is to say, when investment goes up, asset prices go up about 90 percent of the time. And their growth rates are correlated 60 percent of the time. This makes sense. Rising stock prices should make investment more profitable.

These are two exceedingly smart men and it is possible that Warsh and Druckenmiller have a causal agent in mind that they simply fail to detail or believe the case is so self-evident that it needs no explanation. It may be they have data they simply fail to present.

"In an environment of low and uneven business investment, Warsh and Druckenmiller must explain how their implied rise in interest rates ... will help rather than hurt the incomes of ordinary Americans and prompt businesses to invest."

When I asked Warsh about this not too long ago, he suggested that it was fear of what happens when QE runs off that causes business to pull back in the wake of new Fed asset purchases. If that were true, then business investment should fall after QE announcements and purchases, not rise, which is what it's done each time. Fear of higher rates in the future should pull business investment forward, prompting financial officers to lock in low rates now.

None of this is to suggest that we don't have a problem with business investment. Given the sharp double-digit declines during the recession, the rebound has been neither as sustained nor as large as could be expected. Business executives I speak with mostly attribute that to slack demand and capacity. Why build new plant when plants are idle throughout the nation and the world and when demand for new production is uncertain? A clumsy and punitive tax regime is also cited often along with lingering fear of the economy borne of the financial crisis.

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The two talk about a 2-percent growth trap but fail to mention the far more insidious liquidity trap, which comes along with zero growth, falling prices and falling wages. It was an all-effort to avoid the Japanese experience that led the current Fed into its current policy stance. At that effort, they have succeeded, although it has been a long hard slog and the results have been lackluster. But significantly, in neither the jobs nor the growth department, have the results been zero.

It is possible that somehow Fed policy has reduced fixed investment from where it normally would have been. But Warsh and Druckenmiller must offer evidence of a connection, which is contradicted at first glance by the data. They also must answer a more overarching question: in an environment of low and uneven business investment, Warsh and Druckenmiller must explain how their implied rise in interest rates — which increases the hurdle rate for investments — will help rather than hurt the incomes of ordinary Americans and prompt businesses to invest.

Commentary by Steve Liesman, senior economics reporter for CNBC. Follow him on Twitter @steveliesman.

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