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Why Cutting The Deficit May Not Boost Investment

Economic Trends


It's an appealing argument. As deficit reduction lowers the government's borrowing needs, interest rates decline and foster a surge in capital spending, which offsets the negative impact of fiscal restraint on the economy. But the trouble with this thesis, contends economist Steven Fazzari of Washington University in St. Louis, is that the impact of lower interest rates on capital investment is highly exaggerated.

Fazzari bases this view on a new study published by the Jerome Levy Economics Institute of Bard College in which he analyzes the behavior of some 5,000 manufacturing companies from 1971 to 1990. His findings indicate that interest rates alone had a very weak effect on business investment.

Far more potent determinants of investment, reports Fazzari, particularly for the 60% of companies in his sample exhibiting average or rapid real growth, were the prospects ef rising demand and the strength of internal cash flow. And this group of companies, he notes, accounted for 75% of capital outlays and posted the biggest rises in research and development spending, employment growth, and stock market valuation.

Fazzari concludes that while deficit reduction may be desirable for other reasons, it is more likely to inhibit business investment by slowing economic growth and hurting cash flow than to stimulate it via lower interest rates. If policymakers want to bolster capital spending, he says, "they would do better to directly enhance aftertax cash flow through such measures as accelerated depreciation, investment tax credits, and lower corporate tax rates."GENE KORETZ

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