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

Thursday, December 18, 2014

UK Gross Domestic Fixed Capital Formation in the 1873 to 1896 Deflation

The evidence is very strong that British business people were complaining bitterly of a “profit deflation” by the 1880s during the deflation of 1873 to 1896. This was a major cause of depressed and pessimistic business expectations.

But the crucial question arises: did this affect aggregate investment in this period?

We can look at some data on UK gross domestic fixed capital formation in this era.

The following graph shows UK gross domestic fixed capital formation in millions of pounds at current prices from 1850 to 1913, so we can see the long-run trend (with data from Mitchell 1988: 831–833, National Accounts 5, which is based on Feinstein 1972).

The trend of falling and stagnant investment after 1873 to the later 1880s is stark and leaps out of the data. Of course, this data is in current prices, and, given that factor costs must have fallen, is the data here misleading? Do constant, inflation-adjusted prices show a different trend?

Not really.

The next graph shows real UK gross domestic fixed capital formation in millions of pounds at constant 1900 prices from 1850 to 1913, so that, again, we can see the long-run trend (with data from Mitchell 1988: 837–839, National Accounts 6).

Once again we see much the same trend, even if not so pronounced.

UK real gross domestic fixed capital formation began a sharp drop after the post-1873 deflation commenced, and even during the recoveries around 1880–1884 and 1886–1890 it grew only at a markly low rate or even essentially stagnated.

The mid-Victorian boom ended in the early 1870s, and (because of price deflation) real gross domestic fixed capital formation reached an inflation-adjusted value of £132 million in 1876, and then began a downward trend until the late 1880s. It did not attain the 1876 peak again until 1894.

It is interesting to note that an inflationary spurt occurred between about 1888 and 1891 in UK wholesale and consumer prices (see the price data in Mitchell 1988: 728 and 738). This can be seen in the graph below of UK wholesale prices from 1871-1913 from the Board of Trade index (with data from Mitchell 1988: 728).

The brief return to inflation might have contributed to the beginnings of a long-run recovery in business confidence in the late 1880s. However, what recovery in investment that occurred looks weak and it was derailed by the deflationary recession of the 1890s.

At any rate, the really strong recovery in investment happened after 1896 when the deflation ended and an inflationary boom developed until the outbreak of World War I.

All in all, I would say that the evidence supports the view that the great deflation was not a period of a healthy, robust economy in Britain. As we have seen, contemporaries noted the phenomenon of “profit deflation” and loss of business confidence.

Post Keynesians argue that the aggregate level of investment is strongly affected by business expectations and that such expectations are subjective, given the fundamental uncertainty that economic agents face.

These insights can clearly be applied to the 1873–1896 era: price deflation with increasing downwards nominal wage rigidity caused a fall in profits by the 1880s.

Though probably not the only reason, it was nevertheless one major cause of loss of business confidence that in turn caused business people to reduce the aggregate level of investment.

Such a Post Keynesian view of the trend of falling investment in this era is the best explanation in my view. And it does not suggest that deflation is a benign and healthy phenomenon, despite what its advocates think.

Further Reading
“UK Real Per Capita GDP 1830–1913,” December 13, 2014.

“UK Average Money Earnings 1880–1913,” December 14, 2014.

“Armitage-Smith on the Profit Deflation of the 1873–1896 Era,” December 15, 2014.

“Nominal Wage Rigidity in the US and the UK 1865/1880–1913,” December 16, 2014.

“UK Real GDP 1830–1918,” October 8, 2012.

“British Money Wages in the 1873–1896 Deflation,” December 10, 2014.

“Saul’s The Myth of the Great Depression, 1873–1896,” December 8, 2014

“Robert Giffen on the Deflation of 1873–1896,” December 7, 2014.

“Alfred Marshall on Business Confidence,” December 3, 2014.

“Alfred Marshall on Wage Stickiness and Debt Deflation,” November 30, 2014.

“The Profit Deflation of the 1890s,” June 13, 2013.

“Alfred Marshall’s Judgement on the “Depression” of 1873–1896,” June 13, 2013.

“S. B. Saul on the Profit Deflation of the 1873–1896 Period,” June 14, 2013.

“Alfred Marshall on the Deflation of 1873–1896,” October 14, 2014.

“Alfred Marshall’s Interest Rate Theory,” November 3, 2014.

Feinstein, C. H. 1972. National Income, Expenditure and Output of the United Kingdom, 1855-1965. University Press, Cambridge.

Mitchell, Brian R. 1988. British Historical Statistics. Cambridge University Press, Cambridge and New York.