Low interest rates do not call for more investment
By Scott Sumner
A few weeks ago I criticized a Robert Shiller claim that economic theory tells us that low interest rates should lead to more investment. That’s an EC101 level error, reasoning from a price change. Unfortunately, I see this all the time.
Many commenters defend fiscal stimulus by claiming that when interest rates are very low more projects are feasible using NPV criteria. But as the following graph illustrates, that’s just not so:
In this case, the investment schedule shifted to the left, and the equilibrium quantity of investment fell as the interest rate fell. The mistake is assuming that the factor that caused a fall in the market interest rate did not also cause a fall in the NPV of many projects.
A recent Quartz article provides a good example of this fallacy:
Summers has proposed “secular stagnation” (pdf) as the explanation for economic weakness since the 2008 recession: Private investment is falling because firms see slow population growth and innovation as a sign that future returns aren’t likely, creating a self-fulfilling prophecy of slow growth. His answer is more government investment–to jump-start demand, and the economy.
Now of course there might be a case for more public investment. But if so, it would not be because the economy is depressed and interest rates are low. If a depressed economy is caused by slow NGDP growth the answer is clearly a more expansionary monetary policy. For instance, the Fed could cut its interest rate target for 2016. If NGDP is right on target and interest rates are still unusually low, there might be a justification for more public investment, but only if the low rates were caused by a rightward shift in the supply of saving. But the factors in the Quartz article suggest exactly the opposite!
Most public investment is designed to accommodate population growth. This includes roads, sewers, public transport, schools, airports, etc. Much of this should be turned over to the private sector. But if the government insists on doing all this public investment then it needs to make sure that projects meet strict cost/benefit tests. When there’s a population growth slowdown then far fewer projects will meet that criterion.
I’m not saying that the slowdown in population growth is the only factor causing low interest rates. They partly reflect the hangover effects from the recent recession. But circumstantial evidence suggests that slower population growth plays some role. Japan has the slowest rate of population growth, and was the first country hit by the ultra-low real interest rates. Australia has the fastest population growth of the major developed economies, and in recent decades has had real interest rates that were somewhat higher than other developed countries.
When interest rates are low due to slow population growth the correct response may well be more consumption. Does your intuition tell you that this answer is wrong? If so, it may be because almost all governments currently have policies that are massively anti-saving/investment, and pro-consumption. The proper solution is to address the root cause of this investment deficiency—the high taxes on deferred consumption, restrictive urban land use rules, immigration restrictions, etc.