By Joachim Fels, Global Economic Advisor at PIMCO
Following the economic data flow, financial markets and monetary policy these days feels like watching paint dry – nothing much changes. Also, neither have I anything exciting to report from two recent business trips to Europe and Asia, nor from a week of vacation in-between. Instead, let’s think through the rising importance of intangible capital – e.g. R&D, software, intellectual property and organizational capital – as opposed to physical capital, such as land, buildings, machines and inventories. And no, it’s not as boring as it sounds.
Here’s my thesis upfront : The growing dematerialization of capital accumulation has material consequences for financial markets and for the conduct of monetary policy: It helps to explain why there is a corporate savings glut that contributes to ultra-low interest rates , and why time-honored concepts used by generations of economists such as the output gap and the Phillips curve are becoming increasingly, well, immaterial . Central banking, which has become more of a science that is based on models in which these concepts play a crucial role may therefore increasingly become an art again, or more precisely: the art of steering inflation and inflation expectations without knowing what exactly determines them . Good luck!
Our economy is becoming ever more intangible. A rising share of our consumption is services rather than tangible goods. And to produce these services and goods, firms nowadays typically invest more in intangible capital than in physical capital . New ideas generated by smart people, patents, copyrights, brand, software and cloud space matter more than bricks and mortar, machines and inventories. In short, production processes are dematerializing – more sales are generated with less physical capital.
A growing body of research suggests that the progress of intangible capital has been the most important fundamental driver of the secular uptrend in corporate cash holdings over the past few decades. The reason is that, unlike physical capital, intangible capital cannot easily be pledged as collateral for loans . Therefore, to maintain the financial flexibility to invest in intangible capital – spending more on R&D, buying start-up companies with smart people and products, acquiring or developing brands and patents, investing in artificial intelligence etc .—firms optimally hold larger cash balances. Of course, other factors, such as a U.S. tax system that only taxes corporate profits generated abroad once they are repatriated, also contributes to swelling (foreign) cash holdings. However, the dematerialization of capital investment seems to be the single biggest factors explaining the corporate savings glut.
This corporate savings glut, along with a higher desire by private households to save more in the face of rising longevity and with strong demand for safe assets from emerging economies, is the main reason why the natural or equilibrium rate of interest is very low . A continued rise of intangible capital relative to physical capital will increase the corporate savings glut further, thus contributing to a continuation of the current low interest rate environment. And low returns on low-risk assets will keep pushing investors into higher-yielding more risky assets, a process that has already led to serial bubbles and financial crises over the past several decades.
The consequences for monetary policy of a low natural or neutral interest rate fueled by a savings glut are well known: central banks will have less room to raise rates even in good times and therefore won’t have much ammunition in the form of rate cuts in bad times given interest rates cannot be cut far below zero. Yet, monetary policy makers have found ways to mitigate the problem: quantitative easing, forward guidance and yield curve control have become almost standard tools, and money-financed fiscal programs (“helicopter money”) may become an additional tool of choice in the next crisis.
However, beyond the depressing impact on the neutral rate of interest, the dematerialization of capital, which goes hand in hand with digitalization, poses important additional challenges for the conduct of monetary policy by making concepts such as the output gap and the Phillips curve virtually obsolete . Here’s why.
First, intangible capital is more difficult to measure than tangible capital, implying that the true size of the overall capital stock in the economy is ever more uncertain . Uncertainty about the capital stock translates into uncertainty about potential output and thus the output gap (defined as the gap between actual and potential output). Knowing how much slack there is in an economy – which is an important input into traditional estimates of potential inflation pressures – is therefore becoming ever more difficult.
Enter the Phillips curve – another important concept that central banks like to use to forecast inflation: Declining unemployment should lead to rising wage and price pressures. While this sounds intuitive, dematerialization and digitalization(along with globalization) are likely to have made the link between unemployment and wages less tight . New technologies that result from intangible investment in ideas and R&D reduce the bargaining power of workers who can easily be replaced by new technologies or by a combination of lower-skilled workers and new technologies (think of lower-paid Uber drivers replacing higher-paid taxi drivers with the help of superior technology). Lower bargaining power likely keeps a lid on wage growth for longer have despite declining unemployment.
The monetary policy implication is that in a dematerializing world central banks can no longer rely on traditional gauges of future inflation pressures such as the output gap or the Phillips curve. In fact, empirical work shows that the impact of measures of slack on the economy such as the output gap or the unemployment gap on wages and inflation has diminished, while inflation expectations have become a more dominant factor. However, it remains unclear what factors determine inflation expectations, other than past inflation itself. You can see the problem for central banks: Targeting inflation without knowing what determines it sounds like mission impossible.
There is no easy way out. The radical response would be to give up targeting inflation and target something else, or nothing too specific at all. This is unlikely to happen anytime soon. The more likely outcome, at least for some time, is that central banks will keep pretending that they can measure slack in the economy and that a stable Phillips curve exists, and that they can thus keep the economy on an even keel and achieve their inflation objectives. However, increasing dematerialization implies that the risk of misses on both sides of the inflation objective is rising .