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?
READER COMMENTS
Michael Sandifer
Jan 11 2019 at 10:10pm
Isn’t one way of looking at the key insight here that since the expected return on dollars increases in proportion to a tighter future expected path of monetary policy, that this is proportionally reflected in lower interest rates and so, in reality, the opportunity costs of government investment remain constant, given monetary offset?
Dan Culley
Jan 12 2019 at 6:29am
In general it seems people are missing both sides of the equation. All else equal (that is, the project’s rate of return), if the cost of borrowing is lower, more projects will be profitable. But as you note, many of the factors that reduce interest rates may also reduce the project’s rate of return.
That said, if interest rates are low because of a temporary reduction in growth, rather than a permanent change in trend, it does not seem that the project rate of return would change. But in those circumstances, the more persuasive case would seem to be that greater infrastructure intensity is justified when the price is lower. And the price will likely be lower when there are fewer private construction projects competing resources.
Scott Sumner
Jan 12 2019 at 12:46pm
Michael, No, I’m not addressing monetary policy here.
Dan, You said:
“That said, if interest rates are low because of a temporary reduction in growth, rather than a permanent change in trend, it does not seem that the project rate of return would change.”
But in that case why would interest rates fall? Slower growth causes lower interest rates precisely because it reduces the expected rate of return on investments.
Thaomas
Jan 14 2019 at 4:01am
I suppose “slower growth” means in the middle of a recession which is when lots of resources are unemployed (market prices are greater than marginal costs) and borrowing rates are low because the central bank is buying stuff to stimulate the economy.
Thaomas
Jan 12 2019 at 5:11pm
This is a fine calcification but, really, the “invest more when interest rates are low” argument is made only in the context of a inadequate demand recession. It is a ceteris paribus kind of idea. And of course the fact that market prices of some project inputs will exceed there marginal costs will also affect NPV which will also lead to more investment. But the fundamental point is that governments should stick to the NPV rule during recessions rather than adopting “austerity” because of “debt.”
Ghost
Jan 14 2019 at 8:48am
Doesn’t the answer depend in part on the ‘size’ of the government that you’re considering?
The impact of slowing population growth in (say) Denmark on world interest rates is negligible. So with an open capital market, it is extremely likely that lower interest rates will justify more borrowing by Denmark.
The issue isn’t so clear-cut at the US Federal level. But it does seem likely that the downward shift in real yields faced by the US over the last 20 years has a lot to do with developments in the rest of the world, and hence does constitute an ‘exogenous’ price signal to the US.
Bill Wald
Jan 15 2019 at 11:01pm
If a government agency needs something, it can be bought when the interest is high and refinanced when the rate drops.
Comments are closed.