No, low interest rates do not call for more public investment
By Scott Sumner
No matter how hard I try, I can’t stop economists from reasoning from price changes. Now I’m seeing more and more economists claiming that at low interest rates we should do more public investment. In fact, there is no necessary correlation between the level of interest rates and the optimal level of investment, public or private. To see why, consider the past two recessions:
1. In 2007-08 there was a drop in household formation, and also tighter lending standards. These events led to a huge drop in housing construction. Housing construction involves a mix of private investment (houses, shopping centers, etc.) and public investment (new local roads, sewer lines, schools, expressways, etc.) When the housing sector booms, the investment schedule shifts to the right, causing an increase in both interest rates and the optimal amount of investment. But in 2008 the schedule shifted left, causing a fall in both interest rates and the optimal quantity of investment (public and private.) State and local governments issued fewer bonds to support urban expansion, as was appropriate. Now of course there was also bad monetary policy in late 2008, which caused non-housing investment to also plunge.
2. In contrast, the 2001 recession was concentrated in the business investment sector. As business investment plunged due to previous overinvestment in tech, interest rates fell, which led to more investment in real estate (public and private.) Again, those changes were entirely appropriate.
Economists tend to make two mistakes in this area. First, they reason from a price change. They forget that lower interest rates don’t call for more investment. It entirely depends on why interest rates change. Does the supply of saving shift right (more investment) or does the investment schedule shift left (less investment.) The second mistake is to forget that public investment is often motivated by quite similar factors to private investment. The same forces that shift the optimal amount of one type of investment, often shift the optimal amount of the other.