Friday, December 19, 2014

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
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.

“… 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.

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


  1. "'The findings are pretty stark: 68% of CFOs said that they would not expect “any decline in interest rates would induce more investment.'

    So 32% of CFOs say that a decline in interest rates would induce more investment. If I were an advocate of interest rate policy this would seem like strong empiric evidence that it should work !

    1. "Strong" empirical evidence? Really?

      That your monetary policy would, for the sake of argument, only affect 32% of businesses.

      That is "strong" evidence that interest rate changes are a highly effective and reliable way to stimulate investment?

      There are none so blind as those who will not see.

    2. Say 8% of businesses respond to a 1% rate cut with a 5% increase in investment.

      That's a 0.5% increase in I.

      Multiply that up along Keynesian lines and that's potentially a pretty hefty boost to AD. And, especially if you subscribe to cost+markup where output is very sensitive to changes in demand , a big boost to income.

  2. I have sympathy for Rob Rawlings's comment.

    Also there is an indirect way interest rates can affect investment. Interest rates have an effect on household borrowing (such as for purchasing houses). Purchasing houses has an effect on demand and output. Investment depends on output/economic activity. Hence interest rates have an effect on investment.

    i.e, even if you start with a model where firms' investment doesn't depend on interest rates as a closure, the model may result in showing that interest rates have an effect on investment

    1. Well, Ramanan, what reasonable person would disagree with what you have said? I do not.

      I am not saying above that interest rate have zero influence on investment, or that they do not have some influence.

      But this is not the point of the post above.

      Most traditional neoclassical economics and Austrian economics sees investment as a highly effective and reliable function of interest rates via the modern form of Wicksellian loanable funds.

      We see from the survey evidence above that you cannot seriously believe this if 68% of CFOs said that they would not expect “any decline in interest rates would induce more investment.”

      This confirms the Post Keynesian view that we need fiscal policy as the main way to affect investment and AD: whereas the affect of interest rates on investment is overrated, unreliable and in times like ours unlikely to be enough to drive an economy to full employment.

  3. LK,

    I agree with you generally. I however think that although it is not as strong as neoclassical economists make it out to be (and who ignore fiscal policy), it is not that weak.

    It is difficult to say this quantitatively and one can only argue about the tone of the language used by any writer. My only point is that it is not as unimportant as heteredox economists make it sound. Of course right now monetary policy can't achieve much.

    But I agree fiscal policy is much more important.

  4. If this study was extended longitudinally then I would expect interest rates to be less effective in times of crisis. This is because firms are never profit maximising in the textbook sense. They offset risk by reducing profits because of uncertainty about the future. The more people worry about the future, the less they are concerned about profit and the more they are worried about survival. The textbook version of profit maximisation assumes economic stability. This is one of several unrealistic assumptions that a pure marginalist approach would require. The important question is what happens in the real world where these assumptions do not apply.