## Does Tighter Monetary Policy Increase Investment?

I came across a short piece recently citing a former New York Fed economist entitled *Tighter Fed Policy Will Boost Economy*. I was pretty taken aback by this and I’ve been trying to wrap my mind around it. I couldn’t find he actual report (it may be an internal UBS document or a clients-only sort of thing) and the press release I am going on is pretty brief so I have to guess a little bit as to what Matus has in mind. It’s also worth noting that he is not quoted in the body using the word “tightening” so it’s possible the headline writer is more confused than Matus. But whatever his reasoning, it provides a pretext for an attempt to explain why looking at monetary policy through an interest-rate lens is potentially misleading.

There are two issues here. One is the question: what is tightening? The other is: do low rates cause more or less investment? To answer the first, we have to consider the second and see that it is not really a coherent question.

On the surface, conventional wisdom tells us that low rates lead to more investment. This is the story behind the Keynesian IS-LM model taught in intermediate macro classes. The CB increases the money supply which causes interest rates to fall (shifting the LM curve to the right) and the lower rates increase investment which increases output (moving along the IS curve). In the context of that model, this is what we would call monetary “easing.” Note that whether you look at this as an increase in the money supply or a decrease in interest rates is purely semantic as I try to explain here.

Yet, here is an economist claiming that higher rates will lead to more investment. How is that possible? The short answer is that this is “reasoning from a price change” which is a cardinal sin of economics but which is nearly impossible to avoid if you are thinking about policy in terms of interest rates.

**Interest Rates and Investment**

It makes no sense to try to determine the effect of a change in the price of coffee on the quantity of coffee beans exchanged. But we constantly talk about changes in the interest rate “causing” changes in investment or consumption etc. This is a sort of conundrum created by the central bank saying that they are fixing the interest rate exogenously as a matter of policy. They can do this because they can control the quantity of money and the nominal rate is the price of money (in a sense at least). But even if you take the nominal rate to be exogenous, you still don’t know the cost of investment because the cost of investment is the real rate which is the nominal rate minus the expected rate of inflation.

If you are deciding whether to invest in a new factory, your decision depends on whether or not the (net) present value of the produce of the factory in the future will be more than the cost of building it. The lower the nominal rate, the more these future values will have to be discounted, or to say it another way, the more interest you will have to pay on the loan (or forego on the money) that it takes to build it. But the higher the expected rate of inflation, the higher those future values will be. So if the nominal rate changes, the effect depends on why it changes.

The simplest way to get to the Keynesian result above, is to imagine that expected inflation is fixed and doesn’t change when the CB “lowers the interest rate.” In this case, the real rate will also fall and investments that were not appealing before will become viable. Alternatively, if inflation expectations suddenly increase and the CB does not allow nominal rates to increase* as much*, you also have the real rate decreasing which should also increase investment.

In the latter case, you would see nominal rates rising along with investment. And if you only judged the stance of monetary policy by the nominal interest rate, you might conclude that “tightening” was causing an increase in investment. However, this is not a good way to think about monetary policy because the higher rates would be the result of a more expansionary monetary policy. I can’t think of a possible explanation for thinking that “tighter” monetary policy would cause increased investment unless all that one means by “tighter monetary policy” is higher nominal rates. In which case, as Scott Sumner likes to remind us, Weimar Germany had incredibly tight monetary policy.

The most confusing thing in the article was this statement.

‘The expectation for rising rates may prove helpful,” said Matus. “Low rates not only lower the cost of delaying investment decisions but also encourage other behavior that can be detrimental to business investment.’

In periods of low rates, equity investors usually favor companies that buy back shares and pay dividends, said Matus. That encourages chief executive officers to use cash in those ways, rather than invest in new plants or machinery.

The first part about “lowering the cost of delaying investment decisions” makes no sense to me. Low nominal rates (holding inflation expectations constant) means lower cost of investment. There is a cost and a benefit to investment and we expect businesses to invest when they think the benefit is greater than the cost. Are executives sitting in boardrooms saying “we want to delay some investment but we’re not sure how long to delay it, what are the costs and benefits?” Even if they were, wouldn’t the cost of delaying it be lower with higher nominal rates? You would make more on your “cash” reserves (which I believe is typically not technically cash) in the meantime (or pay less on loans). This seems like pure carelessness to me but seemingly this guy is getting paid to figure this stuff out and I can’t say the same, so maybe I am missing something.

But putting that aside, is it true that investors favor companies that buy back shares and pay dividends when interest rates are low? That doesn’t seem like what we have been observing lately. In fact, we have seen a plethora of “growth” stocks with little to no earnings skyrocket in price relative to broader market averages over the last couple years. It’s true that may larger-cap stocks have increased dividends and buybacks, and some others, like Apple, have been under pressure to do so from activist investors. But is this really a sign that investors are demanding less investment? I don’t think so. Here is an alternative story.

Companies each have access to some set of investment opportunities and some amount of cash/credit, the cost of which is the nominal interest rate. The nominal return on their investment opportunities is given by the real rate of return plus the expected inflation rate. Companies invest until the marginal real rate of return on investment is equal to the real interest rate. When the real rate is lower, it makes more investments look profitable.

Now assume that the low real rates are accompanied by an influx of cash into the economy. But because different companies have access to different investment opportunities, the ones who accumulate this cash may not be the ones with the optimal investment opportunities. For instance, imagine that one company, let’s call it “Tesla,” happens to have the ability to invest a large amount of money and return 2% in real terms, while the real interest rate is 0%. And let’s say that there is another company, call it “Apple,” that is accumulating a lot of cash on its balance sheet but is already investing in all the projects available to it with a positive real rate of return.

Now if you are an investor sitting on a big pile of cash, and just to make things a little cleaner, let’s assume that you have access to a secondary offering of each company at book value, which one do you want to invest in? The answer should be clear, you want the one which will earn a higher return on the money you invest. This means that the companies with the best investment opportunities will attract more capital. Conversely, if you own Apple, and they are sitting on a pile of “cash” which is earning no interest and which they have no productive use for, you will want them to give you that cash *so that you can divert it to a company with better investment opportunities*.

Another way of coming at the same idea is to say that, if both companies are trading at the same premium to book value, people will want to “rotate” into the high-growth companies which will cause them to trade at a higher premium. The companies with a lot of cash, in the face of this rotation away from them, may start throwing off that cash in the form of dividends and buybacks to increase their dividend yields and prop up their stock prices.

The same logic can be applied to mergers and acquisitions. If Apple has a lot of cash and no good investments and Tesla has good investments but not cash, instead of returning cash to shareholders and letting them invest it in Tesla, Apple can just cut out the middle man and buy Tesla itself. But none of this is evidence that low interest rates are causing companies to invest less in aggregate. It is just evidence that cash has to move around to find the best investments. That, after all, is basically the whole point of equity markets.

**Interest Rates and the Stance of Monetary Policy**

Hopefully we can agree that the lower nominal rates, all other things (including inflation) equal, the more incentive to invest there is. Similarly, the higher expected inflation is, all other things (including nominal rates) equal, the more incentive to invest there is.

This is not that difficult to understand, but the problem comes in when you insist on seeing rising interest rates as “tightening” (or for that matter, on seeing “tightening” as rising interest rates). But when you step outside of that mindset, things get a little complicated. This is because, nominal rates and inflation are both components of monetary policy and they are not independent. In order to generate more inflation, the CB has to increase the money supply. And if you see monetary policy as just setting an interest rate, the only way to increase the money supply is by lowering the rate. So you find yourself having to say that they are trying to raise interest rates by lowering interest rates. Is that easing or tightening?

The simplest way around this is to think in terms of the quantity of money instead. Then you can just say that “easing” means expanding the money supply which lowers nominal rates (and increases investment) in the short run but increases inflation and has an ambiguous effect on long-term nominal rates. Of course, if we all did that, then we would dramatically reduce the demand for confused debates about the effect of interest rates on stock prices and investment. And nobody wants that.

## Savings = Investment

I was poking around on Nick Rowe’s blog, and came across this piece on Keynesian economics. If you recall in this post I recently pointed out a peculiar aspect of Keynesian economics:

[H]ow is it that if savings equals investment and savings equals income minus consumption, that when you lower interest rates investment increases but consumption stays the same?

When I was reading Nick’s post, I couldn’t help but think about this and think how ridiculous Keynesian economics would seem to people if they explained what they were really doing in the same way I think about it in my mind. So naturally I figured I should take a stab at this.

As Nick explains, the model begins with two identities (assuming a closed economy and no government for simplicity): Y=C+I and S=Y-C. This gives you S=I as an identity. In other words, given the way we have defined the variables, this must be true. This is different from an equilibrium condition such as quantity supplied = quantity demanded which is true only in an equilibrium. So at this point no economics has been done.

In order to do some economics, you must assume some values of variables and some causal relationships which determine the values of the other variables. The way Keynesians go about this is to assume the following equations from Nick’s post (to simplify even further I will assume that autonomous spending, which is “a” in his model, is equal to 0)

8. Cd = b*Y (where a>0 and 0<b<1)

9. Id = Ibar

Where Cd and Id are desired consumption and investment respectively. Then if you assume that in equilibrium C=Cd and I=Id, you have a model (6 equations and 6 unknowns). But here is what we have done in plain english:

1. We have assumed that investment is equal to a certain value no matter what. This value is not explained in any way in this model and nothing in the model can change it.

2. We have assumed that consumers spend a certain proportion (b) of their income on consumption. This proportion is not explained in any way by the model and nothing in the model can change it.

3. Based on our definition of savings, savings must be the amount of income not consumed, which *by assumption* is (1-b)Y.

4. Since, by definition, savings is always equal to investment, we know that the amount of savings must be equal to the value we *assumed* for investment. (Ibar=(1-b)Y)

5. The only thing we haven’t assumed yet is Y (output) so that must be whatever value makes the proportion we assumed would be saved equal to the value we assumed for investment.

To make this even simpler consider a numerical example. Assume the following:

1. People consume half of their income and save the rest.

2. Investment is $100.

3. Savings equals investment.

Now it follows logically that Income is $200. Why is that? Well it’s simple, since savings equals investment and investment is $100, then savings must be $100. And since people save half of their income and savings is $100, then their income must be 2×100=$200. This does nothing to explain where income actually comes from! Now if, for some reason, people decide to save only 1/4 of their income, then, by assumption, investment doesn’t change so the amount of savings must still be $100. But since people are saving more, their income must be higher in order to generate this arbitrary amount of savings. Therefore, income must increase to $400 to bring the model into equilibrium. This is essentially how Keynesians arrive at the “paradox of thrift,” by assuming that savings will have to be a fixed amount so if people insist on saving a smaller proportion of their income, then income will have to get larger to make that smaller proportion equal to the presumed constant level of savings.

This model works mathematically but it is a terrible way to do economics. Proper economics assumes some scarcity fixed by nature and some purposeful economic agents which choose between different ways of dealing with that scarcity. In other words, the degree of scarcity is constant and the model determines what people do in the face of it. On the other hand, this Keynesian approach takes human behavior for granted and assumes that the degree of scarcity in the system adjusts to make an equilibrium given this behavior. It’s an economic paradigm custom-made for people who think that human nature is the source of all the world’s problems and if only we could get better at social engineering, everything would be great. But this is a mistaken view of reality, and it leads to a mistaken view of economics. Perhaps more troubling, is that the converse is also true. Tread carefully, “practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

*Note: If I were a Keynesian I would probably be fuming at this post and I would point out that the Keynesian cross is only *part* of the Keynesian model, and that it is misleading to present this part as a complete model. For instance, in the larger model, investment is not fixed, it is determined by interest rates. However, it still enters the Keynesian cross part of the model independently of the other variables in that part. It is my belief that the same general criticism is valid with regard to the larger IS/LM model but my goal here was to make the case as simply as possible and it would be much more complicated to analyze that entire model in the same way. So, I will leave it to the interested reader to look into it further, but this should get you started seeing it for what it is.*

## Scarcity in a Macro Model

I made a bit of a breakthrough over the weekend that I eventually want to talk about. First, though, I want to back up and discuss the philosophical foundations of macro theory to provide some context for what I will be discussing.

My main beef with all forms of Keynesian economics is that it assumes there is no such thing as scarcity. Since economics is the study of the production and allocation of scarce goods, I consider this a highly undesirable characteristic of an economic model. I have quoted Keynes on this subject in the past and I won’t rehash that here. Instead I will highlight what I mean with a simple example using the IS/LM model. In this model, if the government increases taxes and increases spending by the same amount, this causes an increase in output. This is because output is assumed to be whatever demand happens to be and investment demand is assumed to be independent of savings. This causes a spending multiplier.

The reason for this is that saving is substituting for scarcity in this model. The only thing holding down output and consumption is people’s stubborn tendency to save part of their income. If everyone would just spend it all, output would be infinite and we would live in a socialist scarcity-free utopia. When the government takes part of your income and spends it, that keeps you from saving some of it and this causes an increase in output.

The obvious question that rarely gets asked is: where does that increased output come from? The model doesn’t really answer this it just assumes that it will appear if it is demanded. Frankly this is complete nonsense. It may be true that increasing government spending increases output but if we get this result from a model with no concept of scarcity we haven’t really explained anything. What’s more, we don’t know if this is desirable or not since we cannot have any concept of efficiency in a model with no scarcity. More is always better and you always get more by increasing government spending or lowering interest rates.

Similarly, this model assumes that if you lower interest rates, this increases investment demand. Since investment demand is assumed to be independent of savings (and therefore independent of consumption), where does this increased investment come from? The answer of course is that it just appears. It must appear because we have assumed that it can’t come from anywhere except an increase in output. For those who believe that some consumption must be foregone in order to invest, this model will seem very unintuitive.

Now to go a bit farther, one might argue that adding aggregate supply introduces scarcity. However, this is not the case because it still does not model any tradeoff between one good and another. Because of this Keynesians believe in the concept of a natural level of output which prevents increases in government spending from having a long-term effect on output but anything that increases the natural level of output can only be considered beneficial. What’s more, there is no reason within the model to interpret a temporary increase in output as undesirable and there is nothing preventing a series of progressive increases in government spending and/or the money supply (decreases in interest rates) from constantly distorting output above its natural level (sound familiar?).

In order to construct a theory with scarcity we must be very careful to focus on real goods or real wealth. Our model must obey the following simple rule. At any given point in time, there is a fixed quantity of real goods in existence. This means that we have to consider carefully what we mean by real goods. This must include all valuable resources in the economy. For instance, it includes gold in a vault but not money in a checking account. It includes a stand of trees that is sitting idle in the wilderness. It includes minerals in the ground that are not yet dug up (although it may be appropriate to exclude these if they are unknown), and perhaps most importantly, it includes a quantity of that one important asset for which every person has an endowment just as rigidly fixed by nature — time.

When we think of wealth in this way, the idea of output takes on a different character. The question is no longer about how much we have but how effectively we are maximizing the value of what we have. The question is not how much will be created. Instead it is into what form will the endowment we have be transformed. To understand this consider the case of labor. A typical view is to look at an increase in employment and a corresponding increase in “output” and say that we got more stuff so we are better off. This is not precisely correct. We did in fact get more stuff but we gave up some other goods to get it. We transformed some amount of labor which could have been used for leisure or some other production, along with some other inputs most likely, into another form. It is quite likely that this resulting form will be of higher value than the inputs, in which case it may be a Pareto improvement but when we lose track of the inputs we lose the ability to even consider this question. The problem with unemployment from our standpoint is not that it causes us to have less but that it represents a situation where we are for some reason unable to transform the wealth we have into its most valuable form.

In this context we can still talk about production and output but if we are to construct our model on markets that are in equilibrium on a micro level, then we will have to make the amount of output at any given time dependent on decisions made at previous points in time. This is because any wealth which is capable of changing form instantly will naturally change to its most valuable form at that point in time. Therefore, we may (and typically will) take these decisions for granted. The important issue for our purposes will be how we arrived at that level of wealth, or to state it another way, how will we make decisions that affect the value of the wealth (output) in the future.

What this boils down to is a distinction between consumption and investment, that is between using the wealth in existence at a given point of time to satisfy consumption at that point in time or to produce wealth at some point in the future. For our purposes, we will assume that if wealth is consumed, it will be consumed in its most valuable form and typically that if it is invested it will be invested in its most valuable form. This latter assumption marks the point of departure from Austrian business cycle theory, although it may at times be worth considering the possibility of “malinvestment.” This would not be a significant change in approach so long as agents *think* that the chosen investment forms are of highest value at the time they are made. Naturally, since there is some amount of time between the decision and the realization of the results, this belief could end up being incorrect, and if this happened in a systematic way it could constitute a valid theory of the business cycle. Once we develop a model of a frictionless economy where markets clear, we can consider the effects of various market imperfections such as sticky prices or price controls.

With this approach in mind, we can consider the question which has been confounding me for some time until now. If the decision between consumption and investment depends on the real interest rate, what happens if the Fed sets the nominal interest rate below the natural rate and manages inflation expectations in such a way that people actually perceive the real interest rate to be lower than the market clearing rate? This question is difficult because this describes a shortage of real investment. In other words, lower interest rates should cause an increase in the quantity of investment demanded but it should also cause an increase in the quantity of consumption demanded (decrease in quantity of savings supplied). If more investment is demanded than supplied, how can this market clear without inflation expectations or interest rates changing? Or in other words, when both consumers and investors are pulling harder on a fixed quantity of wealth, who wins? Stay tuned for the answer.

Update: It’s worth noting that this approach is essentially that embodied in neoclassical growth theory so I don’t mean to make it sound that profound, just to contrast it with the approach taken by Keynesians.