Why Low Rates Failed to Boost Business Investment
If you applied for a mortgage in the past few years, you probably noticed that the record-low rates during much of that period were only available to a lucky few. Lending standards tightened a lot after the subprime fiasco.
The torturous process -- supplying the lender with triplicate tax returns, W-2s, character references and so on -- was a form of capital rationing. Rationing is the term for markets where not everyone is allowed to buy. When this happens, prices don’t mean what they seem to. Under capital rationing, the true cost of capital includes not just the interest rate, but the burden of meeting all the criteria to prove you’re a worthy borrower.
I think it’s worth asking whether capital rationing is now widespread in the corporate world as well. If so, that would mean that interest rates are a far less useful indicator of economic conditions than many might think. And it would mean that policies aimed at lowering rates -- lower taxes on capital gains, lower deficits, and the like -- have little hope of spurring investment.
Here are two big important facts about business investment. First, it’s been declining since about 1980:
Second, it’s been getting cheaper and cheaper over the long term. Here is a measure of average interest rates on corporate debt:
Interest rates tend to be highly correlated, so this fall in the price of investment goes along with a general global decline in interest rates.
What does it mean that investment is getting cheaper but there’s less of it being purchased? The most basic explanation is a reduction in demand. If there are simply fewer projects to be invested in, because of falling productivity and/or stagnant population growth, businesses will cut back, reducing both the quantity and the price.
But there are reasons to be suspicious of this simple explanation. A recovery in U.S. productivity growth in the 1990s and early 2000s didn’t reverse the trend of declining investment. Second, a raft of policies designed to increase investment by pushing down the cost of capital -- cuts in the capital gains and dividend tax rates, for example -- failed to move the needle. A recent paper by economist Danny Yagan estimates that the 2003 dividend tax cut had no effect whatsoever on business investment.
So what’s going on? It’s possible that complicated international effects are to blame -- domestic capital might have been getting diverted overseas to such a degree that it swamped the reduction in interest rates, reducing overall availability. There are other explanations. But I think capital rationing deserves a look.
It’s possible that business investment, in the U.S. and in other rich countries, is now mostly rationed rather than priced. A select set of companies -- Apple Inc., or General Electric Co., or whoever -- can borrow to their heart’s content at very low rates. Any business opportunity they see will get funded. But for hordes of smaller companies out there -- including small businesses as well as up-and-coming ventures that could become the giants of tomorrow -- it might be hard to borrow at any price. These unlucky companies could be shut out of the gated community of cheap capital, gazing sorrowfully in. That could lead not just to lower investment, but also to industrial concentration that hurts economic efficiency.
If this were true, we’d expect to see that increases in financing specifically directed at small companies -- e.g., venture capital -- would have big beneficial effects on investment by startups. A 2011 paper by economists Sampsa Samila and Olav Sorenson claims to observe exactly that. Other recent studies tend to find the same. And when other economists looked at data from the Great Recession, they found that small companies that faced financing constraints laid off more workers, meaning they also invested less.
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.
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