How to Think About Malinvestment
Many in both the U.S. and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy inaction to current economic weakness than to overreacting.They're right to flag the quote and right to criticize it -- but I think we should explain why. In their defense, that's not the point of their articles, but O'Brien does little to rebut the point beyond labeling it "very Austrian view of things."
However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.
Not to be overdone, Yglesias says Summers' preference for fiscal policy over monetary policy is a reflection of "socialism." Summers is "saying that in a low interest rate environment we dare not leave investment decisions up to the private sector, which is going to just blow the money on boondoggles and white elephants—the state needs to step in and plan the economy," Yglesias writes.
I think O'Brien and Yglesias are both right. And I also think that Summers is a smart enough economist to see why he's wrong. However, not everyone does -- in fact, this is one of the most common arguments against monetary accommodation. It deserves a little more destruction than O'Brien and Yglesias give it with the "Austrian" and "socialist" labels.
Let's start with what we know. An investment project requires a large downpayment made with borrowed money with the intention of recouping that money with future revenue. The way that economics thinks about investments is through cash flow -- that is, the net of how much the business would take in and lay out. In the beginning, this is going to be negative, as investments in equipment and construction exceed revenues. As time passes, it'll turn positive.
So here come two concepts you might know already: net present value and the internal rate of return. The net present value of an investment is the sum of all the cash flows, discounted by a cost of capital -- so more future returns receive a lighter weight, because there's an opportunity cost to tying up resources until some future period. The next step is to stop thinking about net present value as a point -- instead, it's a curve, a function, determined by that rate of discount. One more definition: the internal rate of return is the zero of the net present value curve -- in other words, it's the cost of capital at which a project has no net present value.
It's possible that an investment has a positive net present value at a certain interest rate (a low one), but has a negative net present value at another, higher rate. So if all else is equal, Summers is right: If the central bank holds interest rates artificially low, it can in fact induce malinvestment -- the central bank is creating an incentive to invest in projects which have negative net present values at normal interest rates. If the cost of capital was to fall below the internal rate of return, then that may generate a misallocation of resources.
That's a bad thing, and it's not "Austrian" to fear that. Nor is it the irrational response of a private sector to malinvest under those conditions. (I'll concede that the Austrian version, in which the malinvestment theory leads to eventually higher inflation, higher interest rates and a vicious bust, relies on a wildly implausible assumption of basically zero rational expectations -- a collective delusion. But this isn't my concern, though Summers seems to be saying as much.)
But all else isn't equal, and I've been meaning to point out this error for a very, very long time to others. So here's the thing about recessions: They reduce businesses revenue. They do so for the short run, and perhaps the medium run. That, by definition, reduces internal rates of return across prospective investments. If expected future revenues fall and the central bank doesn't adjust the interest rate, in other words, it's misallocating resources, but just in a different way.
This isn't an idle fear. I've sung a lonely chorus for a year or so now arguing that economic commentators have underappreciated the role of expectations. (See here and here and here.) As I document in the last link, investment volatility now explains 77 percent of all volatility in GDP over the last decade, as compared to 47 percent from 1950 to 1960. Our recessions are increasingly about shocks to expectations of future revenues -- they're not about downward shocks to consumption. So many people just don't get this.
This evidence suggests Summers has this backwards. Recessions appear to be about internal rates of return dropping suddenly below the cost of capital, and everyone trying to exit their investment and deleverage at the same time. I also present expectations data in those links. If you think about a roster of investments ranked in order of their internal rates of return, recessions seem to create a sudden jump in how many of those investments would be "underwater."
Here's a simple example. Suppose that you're starting a business. It requires a $10,000 upfront investment in the first year. You'll make no revenue then, either. Then you expect it to bring in $1,000 in positive cash flow for the next 29 years. That's an 8.4 percent internal rate of return.
But, woah, here comes the recession! Now you're expecting the first three years that had positive cash flow to be zero instead. Now the net present value, at the current rate, is -$2,475. Yikes! You'll liquidate the investment rather than take a loss like that. Trouble is, if everyone does this, it's a problem. So the central bank should cut the cost of capital from 8.4 percent to 6.4 percent. (And had it made clear it would have done this in the beginning, none of this would have happened in the first place.)
Further evidence that this is what happens in recessions, and that an NPV-related malinvestment is nothing to worry about, comes from the fact that businesses founded during recessions are more likely to last and be successful. It implies a past discrimination towards higher-NPV ones during recessions, not negative ones. (I don't have the data in front of me on this; I remember seeing it in a Kauffman Foundation report.)
The central bank's solution, of course, is to bring down the cost of capital when net present value falls due to fears of weak future demand. Stabilizing that, so that entrepreneurs can know the sign of the net present value of a prospective business regardless of the point in the business cycle, is really the way you need to think about monetary policy. It's how you kill the business cycle -- by making investment more insensitive, and less of John Hicks' "flighty bird."