Tag Archives: investment

The Alice in Wonderland world of low interest rates

When interest rates go close to zero, it is possible that central bankers might just slip down a rabbit hole and discover that what used to be up might now be down.

There is a growing chorus of people arguing against central banks using low (even negative) interest rates to stimulate the economy.  One of the reasons that people point to is that when interest rates are low, cutting them further induces savers to save more.  The logic is that there are two offsetting effects a) a price effect — the lower return on savings makes people more inclined to consume today rather than wait for tomorrow; and b) an income effect where the fall in people’s income from lower interest rates induces them to have to save more today to satisfy their future spending needs.  Economists nearly always assume that the first effect (known as the substitution effect) outweighs the second effect (the income effect). This traditional assumption implies that the supply of savings in an economy is positively correlated with the interest rate.

But when this standard assumption does not hold, and the income effect more than completely offsets the substitution effect. In this case the supply of savings in an economy becomes negatively correlated with the interest rate.  It seems most likely that this could happen when interest rates start to get close to or below zero.  Figure 1 illustrates two savings supply curves, one for each of our two cases.

Figure 1

Fig 1

Whether the traditional assumption about the income effect holds or not when interest rates start to get close to zero is important for policy makers. To see why think about how monetary policy normally works.  Suppose that investment demand is shown as in the figure, and that the equilibrium real rate of interest is r0 (i.e. the rate of interest that equates savings supply with investment demand at A).

Now suppose that the economy looks like slipping into recession. The central bank sees signs of weakening demand for goods and labour. So the central bank intervenes and cuts interest rates below r0.  When it does this, there is an excess demand for investment over savings, which stimulates spending and boosts the demand for goods and labour.  Recession avoided. Good job central bank.

But now suppose that things are different and that investment demand is much lower. Indeed most economists believe that the equilibrium rate of interest has fallen in the last 20 years because of a shortage of good investment opportunities (i.e. a fall in investment demand).  This would shift the investment demand curve in Figure 1 to the left leaving Figure 1 to look like Figure 2 below.

Fig 2

In Figure 2 we see that in the traditional case, the new equilibrium interest rate is lower corresponding to the new equilibrium at point B. If the economy now started showing signs of recession, the policy prescription would be no different  than before — cut rates.

But if the non-traditional assumption held, then things get more complicated. Investment  demand and savings  supply now intersect twice at C1 and C2 and there are now two equilibrium interest rates associated with the two equilibria C1 and C2. But only the one associated with the higher interest rate (C1) is a stable equilibrium.  By this  we mean an equilibrium at which if the economy started to show signs of slipping into  a recession, the central bank could cut interest rates and thereby  create an excess of investment demand over savings supply and help to stimulate the economy to avoid recession. If the equilibrium was at C2 instead and the economy showed signs of recession. A cut in the interest rate in this case would cause savings to rise by more than investment and the recession would get worse, rather than being alleviated. This is the case that some economists are worried about.

The possibility that the savings supply curve might actually be backward bending (i.e. exhibit the non-traditional shape) means that there could  be a constraint on central banks abilities to prevent a recession and prices from falling.  Even if the economy is at an equilibrium like C1, the possibility of the negatively sloped savings supply curve limits the ability of central banks to make deep cuts to the policy rate for fear of driving the rate too low below C2 and creating a deflationary spiral.

Before ending this post, there are two last points to consider. First, it is possible that the slow fall in investment demand and rightward shift in savings supply that the world has witnessed in the last 20 years may continue (especially in countries where populations are starting to age dramatically, like Japan and Europe and even China).  In which case, it might be possible that there is no intersection between investment demand and savings supply (at least not at full employment, which we have been implicitly assuming in this post).  Second, it might be that at really low (say negative) interest rates, investment demand becomes infinitely elastic.  In which case, eventually the central bank could still achieve its goals of maintaining inflation and avoiding if it was willing to go negative enough.   Regardless, the simple analysis here is meant to highlight just one thing, that the economics of monetary policy could soon be much more complicated than one thought.


What the world needs now …

The global growth outlook is glum, driven partly by the uncertainty surrounding the situation in Europe as well as the impending fiscal problems in the United States. It is hard not to get bogged down as Torrens often does in thinking about how much worse things can get. But today Torrens was wondering what, in the simplest of terms, does the global economy need to get it out the funk that it’s in.

In his humble opinion, what the world needs now is … investment, sweet investment (with a little bit of love thrown in, apologies to Dionne Warwick).

TH is not a history of economic thought guy, but it worries him that one of the key factors that helped to turn the global economy around after the Great Depression was world war. He has no data to support his claim, but he suspects that global conflict induced an investment boom in both physical capital, as nations sought to expand manufacturing capacity, and in R&D as they sought advance technology. The war led to expanded manufacturing capacity – especially in the US (probably not in Europe) and scientific advances that resulted in everything from better telecommunications, jet planes, and nuclear technologies to synthetic clothes, along with the productive capacity to make those things.

The trouble is that, at the moment, without going to war (perhaps triggered by a disagreement over a few small islands in the South China Sea or a desire to destroy Iran’s nuclear capacity) there seems no immediate impetus that will trigger large scale investment in capital or technology. Of course there is the lure of profits from inventing the next cure for cancer or a sleek, sexy mobile device, but there doesn’t seem to be anything out there capable of focusing the minds of governments and industrialists alike in the same way that the threat of destruction by some crazed nationalistic dictator does.

But war also incredibly destructive, as the World Wars proved, and should best be avoided. So what would or could create the impetus for a major surge in investment? Could it be building ports and power stations in emerging market economies, or a revamping of the Dwight D. Eisenhower National System of Interstate and Defense Highways in the US TH doesn’t know, and he is somewhat skeptical about building roads to nowhere or airports without planes, but there are great minds out there that might figure something out. Perhaps the threat of global warming? Whatever it is, now is the time.