The Inconvenient Truth about Interest Rates and Investment

Actually Post Keynesians are already well aware that the influence of interest rates on determining the level of investment is grossly overrated, but striking confirmation of the Post Keynesian view can be found in fascinating survey evidence in this Federal Reserve Finance and Economics Discussion Series paper:

Sharpe, Steve A. and Gustavo A. Suarez. 2013. “The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs,” Finance and Economics Discussion Series, Federal Reserve Board, Washington, D.C. December 3
http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

In essence, Sharpe and Suarez conducted a survey of 550 corporate executives in nonfinancial industries directly asking them how their investment decisions are affected by a change in interest rates with other factors held constant in September 2012, and 541 responded (Sharpe and Suarez 2013: 3, 7–8).

The executives were asked these questions:

(1) “By how much would your borrowing costs have to decrease to cause you to initiate, accelerate, or increase investment projects in the next year?” and

(2) “By how much would your borrowing costs have to increase to cause you to delay or stop investment projects?” (Sharpe and Suarez 2013: 3).

They could choose from these responses:

(1) not applicable;

(2) 0.5 percentage point;

(3) 1 percentage point;

(4) 2 percentage points;

(5) 3 percentage points and

(6) more than 3 percentage points (Sharpe and Suarez 2013: 3–4).

The findings were as follows:

“The vast majority of CFOs indicate that their investment plans are quite insensitive to potential decreases in their borrowing costs. Only 8% of firms would increase investment if borrowing costs declined 100 basis points, and an additional 8% would respond to a decrease of 100 to 200 basis points. Strikingly, 68% did not expect any decline in interest rates would induce more investment. In addition, we find that firms expect to be somewhat more sensitive to an increase in interest rates. Still, only 16% of firms would reduce investment in response to a 100 basis point increase, and another 15% would respond to an increase of 100 to 200 basis points.” (Sharpe and Suarez 2013: 4).

We can put this in graph form below.

The findings are pretty stark: 68% of CFOs said that they would not expect “any decline in interest rates would induce more investment.” Of the firms in this category many were insensitive to interest rates changes because they finance investment out of retained or current earnings (Sharpe and Suarez 2013: 20).

Curiously, some 139 respondents answered “not applicable” (Sharpe and Suarez 2013: 7–8). Presumably this was because such firms also finance investment through retained or current earnings or do not have easy access to credit anyway (Sharpe and Suarez 2013: 20).

It would appear that many firms that invest via retained or current earnings or just do not have borrowing plans in a coming investment period are relatively unaffected by interest rate hikes – or at least the interest rate hike has to be pretty large to make them cut investment plans (Sharpe and Suarez 2013: 4).

Overall, however, businesses are more sensitive to rate rises than rate reductions.

Furthermore,

“… firms that expected their investment plans to be unresponsive to any conceivable decrease (or increase) in borrowing cost were given the space to provide a reason, and most offered one. The most commonly cited reason for insensitivity was the firm’s ample cash reserves or cash flow. Two other popular reasons were: (i) interest rates are already low (absolutely, or compared to firm’s rate of return); and (ii) the firm’s investment was based largely on product demand or long-term plans rather than on current interest rates. Only about 10% of firms providing a reason for not responding to a decrease cited a lack of profitable opportunities, and only a handful offered high uncertainty as a reason” (Sharpe and Suarez 2013: 5).

The fact that many firms make investment decisions “largely on product demand or long-term plans rather than on current interest rates” should cause no surprise.

Crucially, one year after this survey the respondents were questioned again when longer-term interest rates happened to be 100 basis points higher, and the new answers confirmed that their behaviour had been in line with what they said earlier (Sharpe and Suarez 2013: 5, 23–24).

There is of course one caveat about this survey: interest rates were very low in 2012 and low interest rates may have increased business insensitivity to interest rate changes (Sharpe and Suarez 2013: 20–21). While that is true, it is still quite likely that even this factor has not skewed the survey results so badly that the findings are not generalisable.

In fact, the discovery that most businesses do not regard interest rate changes as a major factor determining investment was already a fundamental finding of the Oxford Economists’ Research Group (OERG) in the 1930s in their survey work: they found that uncertainty was an overriding factor in the investment decision, not interest rates (Lee 1998: 88). Other empirical evidence seems to corroborate this (see Caballero 1999).

A final point can be made about interest rate rises. If interest rates are raised very sharply and severely (as in, say, the “Volcker Shock”), I do not think that anybody disputes that this is most likely to cause recession in a market economy.

But mild to modest rate rises do not necessarily have to depress economic activity. Why? The reason is that many mark-up firms actually include interest payments as part of overhead costs, and many firms will raise their profit mark-up if interest rates are increased (Godley and Lavoie 2007: 265). If demand for a firm’s product is still strong, and a firm then faces an interest rate rise, it can simply raise its prices to recover the cost of higher interest payments.

Further Reading
“Louis-Philippe Rochon on What Should Central Banks Do?,” January 31, 2012.

“Post Keynesian Policy on Interest Rates,” March 12, 2013.

BIBLIOGRAPHY
Caballero, Ricardo J. 1999. “Aggregate Investment,” in John B. Taylor and Michael Woodford (eds.), Handbook of Macroeconomics (vol. 1B). Elsevier, Amsterdam.

Godley, Wynne and Marc Lavoie. 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. Palgrave Macmillan, New York, N.Y.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Sharpe, Steve A. and Gustavo A. Suarez. 2013. “The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs,” Finance and Economics Discussion Series, Federal Reserve Board, Washington, D.C. December 3
http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

Post Keynesian Policy on Interest Rates

I know I have posted this video before (over a year ago), but, in light of recent discussion on the blog comments section on interest rates, I think it deserves to be posted again, since it is a very clear and useful overview of the Post Keynesian policy on interest rates.

First, one should note that this is a summary of what modern Post Keynesianism says about interest rates, not necessarily Keynes himself. Keynes is sometimes charged with having left an ambiguous element in his General Theory, by which he did not sufficiently stress the role of uncertainty and expectations in undermining the coordinating role of interest rates (King 2002: 14). In Chapter 18 of the General Theory, Keynes played down the role of uncertainty (which he had stressed in Chapter 12) and, if he had really maintained the crucial role of uncertainty (as he did later in Keynes [1937]), this would have “ruled out any stable functional relationship between investment and the interest rate” (King 2002: 14). The door was thereby left open for neoclassical synthesis Keynesians to reformulate the General Theory as a general equilibrium model where the interest rate has a pivotal role (King 2002: 14).

But to return to the main point, there are two traditions within modern Post Keynesian economics on the role and effect of interest rates:

(1) the activist Post Keynesians (Basil Moore [1988], Giuseppe Fontana, Thomas Palley), who, instead of an inflation target, advocate activist monetary policy as a useful tool for targeting output, investment or capacity utilization;

(2) the group Rochon calls the “parking it” Post Keynesians, who contend the fiscal policy is the main tool to target output, employment and investment, while monetary policy comes with disturbing side effects on real variables. The relationship between interest rates and output is complex and not linear: the monetary transmission mechanism between interest rates and real economic variables is unreliable and complicated. The interest rate should be parked at a given level and fiscal policy should be employed. There are three further subdivisions within the “parking it” Post Keynesians:

(i) the Smithin rule: the real rate of interest should be very low, close to zero (John Smithin);
(ii) the Kansas city rule: the nominal rate of interest should be zero, possibly negative real rates of interest (Wray, Matthew Forstater, Pavlina Tcherneva).
(iii) the Pasinetti rule/Fair Rate rule: the real rate of interest should be equal to the rate of growth of labour productivity (Pasinetti).

My feeling is that the “parking it” Post Keynesians are essentially right. Notably, some of Basil Moore’s policy ideas have seemed quite controversial to other Post Keynesians, and even to concede too much to neoclassicals (King 2002: 176, 178).

Investment is driven to a great extent by expected profitability and expected growth of sales. Interest rates are overrated as an inducement to investment (Arestis 1992: 104), because expectations complicate matters, and pessimistic expectations can shatter demand for credit and investment, even if interest rates are very low. Even attempts to reduce investment in some predictable or consistent way by means of interest rate rises historically show variable results, ranging from little effect to the inducement of recession (Lavoie 1992: 187). (Of course, nobody denies that very drastic increases such as, for example, during the Volcker shock have severe effects on output and employment.) The evidence shows that credit controls have a much more effective influence on economic activity than interest rate changes (Lavoie 1992: 188–189; King 2002: 179).





UPDATE
Philip Pilkington discusses the role of interest rates here in a great post, with additional comments on Kaldor’s view of interest rates and the possible destabilising influence of monetary policy:

Philip Pilkington, “Monetary Policy and Metaphysics – How Economists Try to Naturalise Terrible Policies and Disappear into their own Theories,” Nakedcapitalism.com, December 5, 2012.

BIBLIOGRAPHY

Arestis, Philip. 1992. The Post-Keynesian Approach to Economics: An Alternative Analysis of Economic Theory and Policy. Edward Elgar Publishing, Aldershot, Hants, England.

Keynes, J. M. 1937. “The General Theory of Employment,” Quarterly Journal of Economics 51: 209–223.

King, J. E. 2002. A History of Post Keynesian Economics since 1936. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Edward Elgar Publishing, Aldershot, UK.

Moore, B. J. 1988. Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge University Press, Cambridge and New York.

Rochon, Louis-Philippe and Matias Vernengo (eds.). 2001. Credit, Interest Rates, and the Open Economy: Essays on Horizontalism. Edward Elgar Pub., Northampton, MA.

Rochon, Louis-Philippe and Sergio Rossi (eds.). 2003. Modern Theories of Money: The Nature and Role of Money in Capitalist Economies. Edward Elgar Pub, Cheltenham.

There was no US Recovery in 1921 under Austrian Trade Cycle Theory!

Austrian economists and their sympathizers are fond of pointing to the US recession of 1920–1921 as proof that recessions can end “quickly” with a recovery and no government intervention.

In fact, their claims are false and misleading, as I have shown here:

“The US Recession of 1920–1921: Some Austrian Myths,” October 23, 2010.

The following points should be made in response to them:

(1) The recession lasted from January 1920 to July 1921, or for a period of 18 months. This was a long recession by the standards of the post-1945 US business cycle, where the average duration of US recessions was just 11 months. The average duration of recessions in peacetime from 1854 to 1919 was 22 months, and the average duration of recessions from 1919 to 1945 was 18 months (Knoop 2010: 13). Therefore the recession of 1920–1921 was not even short by contemporary standards: it was of average length.

(2) The period of 1920–1921 was not a depression (a downturn where real GDP contracted by 10% or more): it was mild to moderate recession, with positive supply shocks. Christina Romer argues that actual decline in real GNP was only about 1% between 1919 and 1920 and 2% between 1920 and 1921 (Romer 1988: 109). So in fact real output moved very little, and the “growth path of output was hardly impeded by the recession” (Romer 1988: 108–112). The positive supply shocks that resulted from the resumption in international trade after WWI actually benefited certain sectors of the economy (Romer 1988: 111).

(3) there was no large collapsing asset bubble in 1920/1921, of the type that burst in 1929, which was funded by excessive private-sector debt;

(4) Because of (3) the economy was not gripped by the death agony of severe debt deflation in 1920-1921;

(5) There was no financial and banking crisis, as in 1929–1933;

(6) The US economy in fact had significant government intervention in 1921: it had a central bank changing interest rates. The Fed lowered rates and had a role in ending this recession: in April and May 1921, Federal Reserve member banks dropped their rates to 6.5% or 6%. In November 1921, there were further falls in discount rates: rates fell to 4.5% in the Boston, Philadelphia, New York, and to 5% or 5.5% in other reserve banks (D’Arista 1994: 62). By June 1922, the discount rate was lowered again to 4%, and the recovery gained momentum.

It is the height of stupidity to claim that a recession that was ended partly by Federal Reserve intervention through interest rate lowering can be ascribed to the “free market,” or is a vindication of Austrian economics. Nor did the recession end “quickly,” either by contemporary or modern (post-1945) standards.

And there is yet another absurd contradiction here.

An Austrian cannot claim that the recession of 1920–1921 ended with a real and proper recovery. Why? The Fed lowered interest rates. Why did this not cause an Austrian trade cycle and unsustainable boom, distorting capital structure? If it did not, they must explain why the Fed’s lowering of interest rates did not make the market rate fall below the natural rate. How did the economy avoid distortions to its capital structure when it had a fractional reserve banking system and Fed inflating the money supply in 1921/22? How could there have been any real “recovery” in 1921?

In other words, by the Austrians’ own economic theory, the “recovery” of 1921 was no recovery at all: just the beginning of another Austrian business cycle!

BIBLIOGRAPHY

D’Arista, J. W. 1994. The Evolution of U.S. Finance, Volume 1: Federal Reserve Monetary Policy: 1915–1935, M. E. Sharpe, Armonk, New York.

Knoop, T. A. 2010. Recessions and Depressions: Understanding Business Cycles (2nd edn), Praeger, Santa Barbara, Calif.

Romer, C. 1988. “World War I and the Postwar Depression: A Reinterpretation based on alternative estimates of GNP,” Journal of Monetary Economics 22.1: 91–115.