Revisiting the monetary policy endgame

Last year, at the beginning of September, we wrote a blog post entitled The Monetary Policy Endgame that laid out one possible future for the path of monetary policy, should economic growth falter, productivity not materialize and populist politics continue to thrive. Some parts of that analysis seem worryingly prescient nine months hence, so we wanted to revisit the analysis from a different vantage point today. Part of the global policy response to the exogenous shock of Covid-19 and the subsequent economic lockdowns has been some combination of new and expanded quantitative easing (QE) programs, interest rates pushed to zero, or even more negative levels, and currency depreciation. These policies should go a long way toward helping us weather the economic storm of Covid-19 and jumpstart the economy once the storm passes, but they do not on their own create a long term trajectory for sustainable growth, which was something already sorely needed in parts of the world before the crisis hit. In this post, we imagine what it might take to reinvigorate such growth and avoid an acceleration toward the negative monetary policy endgame we previously described.

Examining the engine of growth

Coal mines are not often thought of as bastions of technological innovation. Yet, one of the sparks that ignited the Industrial Revolution was a humble invention from just such a mine – the steam engine. Originally intended to solve the problem of flooding by helping miners pump water out of mines, the new technology was quickly applied to transportation, and the construction of new ships and trains eventually led to soaring productivity  in Western Europe in the 18th and 19th centuries.

If the world ever needed another “steam engine moment,” it would be now. A growth spurt on the scale of the Industrial Revolution would be a sure-fire economic lifesaver from the Covid-19 storm. But what is today’s flooded coal mine and where would today’s steam engine equivalent come from? Asked another way, if we happened to be looking back in the year 2030, and the world had just completed a decade of above-trend growth, throwing water on the prophetic fires of today’s economic doomsayers, how might the world have done it?

Before speculating on how above-trend growth might be achieved, we must first understand the component parts that drive economic growth. The Cobb-Douglas production function suggests that real output is a function of labor and capital resources, and a third factor, productivity, which is the ability to extract more output from fixed labor and capital pools. Since the size of the labor resource is largely a function of slow-moving demographic cycles (50 years long or more), the burden of raising output on shorter time horizons falls more heavily on capital and productivity. Capital and productivity themselves are intricately intertwined – only through sufficient investment can productivity-enhancing technologies be invented.

Today, investment is more than just capital expenditures – in our modern economy, total investment includes research and development (R&D) too. To understand the importance of R&D, one need look no further than the epitome of modern-day capex – the energy industry in 2006-2015. Since 1995, energy capex averaged 20% of the S&P 500 total, and from 2006-2015, it never dipped below that 20% mark. From 2008-2014 it averaged 31% of S&P 500 capex, peaking at 33% in 2013. The results of all that investment, the oil price trend over the last six years, needs no further explanation. Nobody can blame the energy industry for not investing, but investment oriented around growing volumes needs to be accompanied by some defense against price declines, especially in a disinflationary world. Perhaps investments must include some form of pricing power preservation, or economic moat. R&D, while not a perfect measure, is a vital component of any comprehensive framework for investing while protecting against industry rivalry (think Porter’s Five Forces) when the global economic pie is not growing as fast as it has historically.

How much investment is enough?

So, both capex and R&D are important, but how much total investment is enough? If the growth rate of total investment is persistently below the growth rate of nominal output, how can an economy maintain the capacity required to function at existing levels of output, much less to grow its output, through increased capacity or productivity? While the world as a whole risks edging towards under-investment post-Covid, recent history shows Europe, in particular, struggling to invest at a rate equal to, or above, its nominal growth rate (see graph). From 2000-2019, U.S. nominal GDP grew at an average of 4.0%, while total investment grew at an average of 4.7%, a 0.7% outspend. In China, this outspend was even greater, at 1.7%. However, in Europe, while nominal GDP grew at 2.9%, investment only grew at 2.8%, leaving a -0.1% under spend. From 2016-2019, this deficit was even more acute, at -3.8% (nominal GDP grew at 3.0% and total investment shrank by 0.8% each year).

Public and private investment correlate strongly with a country’s multi-factor productivity and corporate sales. Given regional investment trends, it should be little surprise that while the S&P 500 and Shanghai Composite have roughly doubled since the turn of the century, the Eurostoxx 50 has declined by about a third. The fact is that in Europe, monetary policy carries an outsized (perhaps insurmountable) burden in driving output, as there is little help coming from Cobb-Douglas’ organic sources of growth when both investment (capital) and demographic (labor) pools are in decline.

Lessons from the past

While QE programs and negative interest rate policies are likely to meet initial success as the world emerges from lockdown, they are no long-term substitute for investment. One of the earliest records of financial repression is to be found in Ancient Rome. In an effort to maintain a quality of life that had become increasingly difficult to finance, as well as an enormous empire whose borders were becoming increasingly difficult to defend, a succession of Caesars began to degrade the quality of the Roman currency, the denarius, by reducing the silver content of coins, so they could then produce more coins to fund deficits. Eventually services would not be rendered (including those of Rome’s mercenary armies), goods would not be traded, and long-term projects would not be financed because the financiers did not know what the real value of their principal repayments would be in the future.

A lesser known fact is that the first prototype of a steam turbine also came from Ancient Rome, 1,500 years before it was (re)invented in the coal mines of England.  Would things have ended differently had the Romans, during a time of relative peace, allocated a strong denarius towards productive investment rather than weakening the currency in order to sustain nominal output?

Today, the world does not have the luxury of peace to deliberate its next policy. Covid-19 is the equivalent of wartime economic conditions. It has rendered financial repression through zero or negative interest rate policies the quickest stop-gap solution, not least because the virus and the policies enacted to combat it pose a threat to our quality of life. We think central banks have been absolutely right to use every tool at their disposal in fighting this devil we know, as it’s not the time to fear any of the devils we don’t. But while these monetary tools exist for policymakers to prevent the economic shocks seen this year from becoming permanent states of affairs, the permanence of such tools may result in the long-term creation of the very shocks they were intended to avoid. That’s because they have the potential to change the capitalist incentive structure.

Innovation/Investment, the engines of growth

As we emerge from the COVID crisis, it is imperative that policymakers recognize the importance of investment in driving long-term output. For now, the current slate of monetary policy will likely prove effective in winning the economic battle with COVID-19 (and as such, is the right prescription), but if central banks want to also win the war against the negative potential monetary policy endgame, the next step would be to start thinking about how to resuscitate private investment in cooperation with federal governments. It’s not the policymakers’ job to invent the steam engine – but they should create an environment so conducive for investment that new inventions start piling up, increasing the odds of some of them being revolutionary. Fields like cloud and quantum computing, and 5G technology, all seem like potential hotbeds for inventions that could spark the next Technological Revolution.

Given its advantage in investment and R&D already, as well as constructive regulatory and legal regimes, the U.S. is an obvious region to see further innovative technologies produced, but China has also been investing at an even greater pace. Europe might seem to be an unusual source of inspiration for the next Industrial (or Technological) Revolution, but perhaps no less unusual than a coal mine was in the 17th century. Europe is already ahead of the world in some notable respects: it is at the forefront of regulation and capital allocation with regards to ESG. Why shouldn’t policymakers incentivize responsible investment the way they do environmental and social awareness?

As the lines between fiscal and monetary policy become blurred, even the European Central Bank (ECB) could explore unconventional ways to incentivize investment, as we also argued in a blog post last year. It is already at the forefront of unconventional monetary policy, even if it is by necessity. After all, necessity is the mother of invention – and there has never been a greater need to invent our way out of the monetary policy endgame, and revitalize global growth, than in the aftermath of the Covid-19 crisis.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is Head of the Global Allocation Investment Team. Russell Brownback, Managing Director, Head of Global Macro positioning for Fixed Income, and Navin Saigal, Director, is a portfolio manager on BlackRock’s Credit Enhanced Strategies Team and he contributed to this post.

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