Institutional Investor - Economist Michael Spence On the New Costly Money Era E-mail
Tuesday, 31 May 2011 14:56

By Julie Segal

For three decades comparatively low-cost capital has given new meaning to the term “free markets” and has been a boon to businesses and banks alike. But now Nobel Prize–winning economist Michael Spence warns that the era of discount money is coming to a jarring conclusion. This is not just because central banks may be nudging up interest rates to damp down inflation, he says. Spence, a professor at NYU’s Stern School of Business, and Richard Dobbs, a director of the Mc­Kinsey Global Institute, argue in a recent paper, “Farewell to Cheap Capital” (available at Insights & Publications at, that shifts in global economic patterns have created the conditions for a protracted period of expensive capital. Spence discusses the shifts and what they mean with Staff Writer Julie Segal.

No more cheap capital?

We’ve lived in a world in which we’ve gotten into the habit of thinking that capital is pretty cheap, and that may not last forever. For a start, the fraction of global GDP going to investment in fixed assets looks like it’s going to reverse course. It has been declining steadily since World War II and the ensuing recovery, when global investment levels reached a very high 26 to 27 percent of global GDP. Since then advanced economies’ investment levels have tended to decline. And although emerging markets went into high-growth mode, the economies of even those that are now big, like China, were once so tiny that their high investment rates didn’t have much effect on the global investment rate. But we appear to be at exactly the moment when this trend turns around. Emerging economies are big enough that their high investment range — 25 to 35 percent of GDP — could cause investment rates globally to go to the 26 percent or so level over the next two decades.

So a change in supply and demand will drive up the price of capital. What does this imply?

For advanced economies, the first order of business must be to get their budgets in shape. If you have a fiscal challenge in front of you, it’s probably better to solve it sooner rather than later. It may come as a bit of a shock when rolling over debt actually starts to cost something. What our study says is that all this may be a little more urgent and that there is less time to get it done.

What about China, by contrast? 

It is in a different situation. China has an excess-savings problem, which it would do well to get rid of, provided it does it in a way that doesn’t muck up growth. The Chinese sort of got it right in the 12th Five-Year Plan; they realize they have to increase household income and, to the extent possible, provide enough social insurance to reduce some precautionary household savings. The Chinese understand this.

What risks do you see?

There’s a real threat of financial protectionism. We’re already seeing a bit of it. Countries that have a current-account deficit or a debt problem may create barriers or incentives to channel savings into domestic investments or even sovereign debt.

Isn’t the end of cheap capital good for investors?

It’s a good thing provided one doesn’t get caught in the transition. From the point of view of the ordinary investor, the returns should be high. It’s possible, however, that with the higher costs of capital embedded in asset prices, you might have lower price-­earnings ratios. You could get caught in that if you place very optimistic bets. But for savers who have accumulated assets, this is probably a fairly attractive world overall. The flip side is that maybe it’s a world with fewer investment opportunities of the sort fueled by growth. But I don’t think the higher cost of capital is going to slow the world down a great deal. It just means everybody has to get ready for higher capital costs, particularly governments with deficits and debt. I would worry, though, for investors about shifts in openness and accessibility to various capital markets, because those risk factors are on the horizon.


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