Should governments invest more when rates are low?
By Scott Sumner
Many economists believe the answer is yes. For years, I’ve been trying to convince my fellow economists to first think about the reason for low rates.
Four years ago, I argued that low interest rates did not call for more government investment if the low rates were caused by a leftward shift in the investment schedule:
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 . . .
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 of 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.
Josh Hendrickson directed me to a new paper that makes a slightly different, but related criticism of the standard view. The authors are Julio Garín of Claremont McKenna College, Robert Lester of Colby College, Eric Sims of the University of Notre Dame & NBER, and Jonathan Wolff of Miami University. Here’s the abstract:
Are periods of low interest rates advantageous times for governments to increase expenditure by issuing debt? Because borrowing costs are lower, some economists have argued that the answer is yes. We argue that the logic used in reaching this conclusion may in fact be too simplistic. Whether or not it is a good time to issue debt depends not on whether interest rates are low, but rather on why interest rates are low. We show that if interest rates are low because of an increased preference for saving, then fiscal sustainability requires increasing debt in a period of low interest rates. In contrast, if interest rates are low because of a decline in trend output growth, then it is not sustainable to increase deficit financed spending.
Here the concern is government spending, not just public investment. But the basic idea is similar—the implications of low interest rates entirely depend on why interest rates are low. I hope to see many more research papers on the general theme of “never reason from a price change”. A good place to start is a paper showing that Keynesians and NeoFisherians are both wrong. Low interest rates don’t mean easy money, nor do they imply tight money. Who will write this paper?