Noah Smith — Why Low Rates Failed to Boost Business Investment

This type of research is fraught with difficulties, and causality is very hard to determine, so it’s important not to read too much into this. But one conclusion seems clear -- if we want to increase business investment, policies to promote access to capital seem more promising than policies to reduce interest rates. The latter approach has been tried, and it didn’t work. We might want to give the former a chance. That would mean encouraging venture capital, small-business lending and more effort on the part of banks to seek out promising borrowers -- basically, an effort to get more businesses inside the gated community of capital abundance.

"Causality is very hard to determine."

There are several issues surrounding causality. The first is the identifying the relevant assumptions and avoiding hidden assumptions. This determines the relevance of the endeavor by targeting the relevant causal factors and their relationship. These are the variables in equations.

The second is parameter specification that determines the scope and scale of the endeavor. The parameters are the constants. They can be thought of as positions on dials that controls the output. Moving the dial affects the function and its output without affecting the variables.

In a function, inputs determine outputs in accordance with a rule. Dependent variables are affected by independent variables in accordance with the function as rule.

In the simplest situation, a single independent variable is used along with holding other factors equal, which is called ceteris paribus, abbreviated as cet. par.

Many if not most "narrative economics" is based on a simple model like the one Noah Smith employs in the post, first assuming the interest rate as a policy lever and then switching to credit standards as a factor.

However, a society and its economy are not only complicated, that is, multiple factors (variables) are relevant. But they also complex, that is, conditions change owing to feedback.

Causal systems (functions) are based only in past and present inputs, with no future inputs.

As a result it is difficult to construct a set of equations that specify the condition of the economy overall, that is, from the point of view of macroeconomics. Simple models are rarely sufficient where there is no dominant causal factor, and they are useless when they identify the wrong factor as being dominant.

Noah Smith points out shifting credit standards as a factor. This has been observed previously by Post Keynesian and MMT economists, as well as others that pay attention to institutional factors. Demand for credit is affected by the creditworthiness of potential borrowers and credit standards shift with changing financial and economic conditions.

The problem with interest rate based models is the assumption that the interest rate is a lever that always acts the same way. But shifting credit standards imply that the interest rates operates differently in different financial environments.

Conventional economic models don't take this into consideration and therefore see causality when the system is non-causal in this respect. The result is "pushing on a string."

While the interest rate seems to be completely specified by the nominal value, from which the real value can be computed by subtracting the inflation rate, it is not specified completely with respect to lending owing to shifting credit standards that adjust creditworthiness and therefore determine the potential pool of customers.

Interest rates are low during contractions. This correlation results from the mechanism a central bank employs to increase lagging investment by lowering the cost of borrowing and increasing the interest rate to cool the economy as inflation pressure rises, based on the assumption that the interest rate acts similarly across time as lever influencing leverage.

In some cases the interest rate is sufficient to produce a desired result, but in other cases it is insufficient. Simplifying, the difference is usually between ordinary business cycles in which firms' financial position does not change appreciably and economic conditions suggest that loans will be repaid with improving conditions, and financial cycles in which the financial position of firms is adversely affected.

During contractions, the central bank lowers the target rate, which is the baseline rate, resulting in interest charged by lenders declining. However, owing to economic conditions, lenders also tighten credit standards so that creditworthiness declines. Even though there may be notional demand for loans, many desire loans cannot qualify for them.

Noah Smith proposes this as a causal factor and seems to suggest that it may be a dominant one.

But this doesn't seem to be the case, since many of the largest US firms are in a strong financial position, with high retained earnings. Moreover, when these firms borrow to take advantage of low rates, they use the funds for equity buy-backs rather than new investment, indicating a low rage of return on existing opportunity and a lack of confidence in foreseeable economic expansion.

While agreeing that credit standards are causal factors in lending, Keynesians would dispute that credit standards are a dominant factor. Credit standards tighten for the same reason that liquidity preference rises in "bad times," when "animal spirits" are depressed with good reason —lack of sales.

Keynesians would argue that the dominant causal factor here is lagging effective demand, so that the solution is not trying to force or cajole lenders to loosen credit standards when their business is setting credit standards correctly with respect to conditions. The primary solution indicated is to augment effective demand.

"Money" enters the economy in three ways, from the activity of the private sector, the government sector and the external sector. When the private sector is underperforming, relief must therefore come from 1) increasing private sector lending for investment and consumption or disgorging private sector savings, 2) government spending, or 3) increasing exports.

The chief means for increasing private sector borrowing is lowering the interest rate or (inclusive) loosening credit standards. while there is a mechanism to lower interest rates, there is no mechanism to loosen credit standards, which many would regard as a dangerous solution. Moreover, liquidity preference increases in "bad times," prolonging the contraction. So even looser credit standards might not be effective either and loosening might exacerbate the financial issues the economy is facing.

The conventional thinking is that exports can be increased by lowering the exchange rate relative to other countries. This is a beggar thy neighbor strategy and it cannot be used universally, since the surplus of one country must be offset by other countries. This seems to be a preferred strategy, which is not working either.

That leaves the government sector to increase spending, which a currency sovereign is always in the position to do. The only constraint is the availability of real resources to purchase, which is never an issue during a contraction, when the economy can expand to meet increased demand.

Increased demand draws forth increased supply (production) when the economy is under-producing, that is, when there is an output gap and idle labor.

Put most simply, the world economy is capable of producing much more than is demanded. The reason is not lack of notional demand but lagging effective demand. While there is some leakage to saving owing to increased liquidity preference, the major factor seems to be lack of income, other than at the top tier, and top tier spending is not sufficient to break the cycle.

The Keynesian antidote is for government to use its purchasing power as currency issuer to put idle resources to use, both capital goods and labor, simultaneously increasing output and effective demand in order to spur economic expansion and thereby to create opportunity for private investment.

The current conventional predilection for fiscal austerity based on the disproved assumption that this will increase business confidence and spur investment is misguided.

Noah Smith's solution seems to be based on the assumption that the key fundamental of capitalism is capital formation and this is a result of a combination of technology, innovation and investment, so that capital formation must be stimulated artificially since it is not taking place "naturally."

The question is how to do this as effectively and efficiently as possible.

His solution seems to be "encouragement." To be persnickety, "Where's the model?"

Well, at least his moving off interest rates as the lever.

The Keynesian solution is to decrease demand leakage to saving and increase effective demand using the power of the currency issuer. See monetary economics based on sectoral balances and application of functional finance in policy for the model.

Bloomberg View
Why Low Rates Failed to Boost Business Investment
Noah Smith | Bloomberg View columnist