The June quarter 2015 edition of the Reserve Bank of Australia Bulletin has an interesting article – Firms’ Investment Decisions and Interest Rates – which further erodes the mainstream economics claim that business investment is negatively related to interest rates in any continuous way. The implications of the RBA research are many. First, it further helps us understand why monetary policy (adjusting interest rates) is not a very effective way of managing aggregate spending. Second, the research undermines the validity of the mainstream claims that crowding out of private expenditure occurs when government spending rises. The paper finds that investment decisions by firms is not sensitive to interest rate variations within certain ranges. Third, it demonstrates that business investment is driven significantly by subjective sentiment rather than being an exact process driven by quantifiable metrics.
The Bank has commented on the fact that expenditure in Australia does not appear to be particularly responsive to the interest rate changes in recent years.
Interest rates are now at record lows as the RBA attempts (in its own logic) to stimulate growth in the face of subdued private domestic demand, an external deficit and a government intent on imposing fiscal austerity.
The economy has now been operating at well below trend growth rate and unemployment has been rising as private investment growth goes negative as a result of the massive investment in the mining sector ended.
The RBA believed that it could “re-balance” the economy from mining investment to more investment in productive capacity in the non-mining sectors through monetary policy changes (interest rate cuts).
But despite the record low interest rates, non-mining investment growth went negative in the latest national accounts data release and the firms have indicated in recent surveys that they are intending rather large cuts in investment expenditure in 2016.
Please read my blog – Australian National Accounts – the fragility of growth increases and Friday lay day – Australian RBA Governor concludes government policy is failing – for more discussion on this point.
The last blog cited records the frustration of the RBA Governor with the Government. He recently admitted that monetary policy alone will not be sufficient to provide an expenditure stimulus and that there was a need for more fiscal stimulus – larger deficits targetted at public infrastruture investment.
Mainstream economists struggle to understand any of this. For them business investment is inversely related to interest rates and with the downward movements in interest rates in the last two years, it is difficult for them to explain the negative growth in investment.
For Post Keynesians, including Modern Monetary Theory (MMT) proponents there is no difficulty in understanding what is going on. I have said for a long time that monetary policy is a largely ineffective policy tool for stimulating or reducing aggregate spending in the economy.
Please read my blog – Monetary policy is largely ineffective – for more discussion on this point.
Business investment is cost sensitive no doubt. But what the mainstream economists usually ignore is the fact that expectations of earnings are also important as are assymetries across the cycle.
The cyclical asymmetries in investment spending arise because investment in new capital stock usually requires firms to make large irreversible capital outlays.
Capital is not a piece of putty (as it is depicted in the mainstream economics textbooks that the students use in universities) that can be remoulded in whatever configuration that might be appropriate (that is, different types of machines and equipment).
Once the firm has made a large-scale investment in a new technology they will be stuck with it for some period.
In an environment of endemic uncertainty, firms become cautious in times of pessimism and employ broad safety margins when deciding how much investment they will spend.
Accordingly, they form expectations of future profitability by considering the current capacity utilisation rate against their normal usage.
They will only invest when capacity utilisation, exceeds its normal level. So investment varies with capacity utilisation within bounds and therefore productive capacity grows at rate which is bounded from below and above.
The asymmetric investment behaviour thus generates asymmetries in capacity growth because productive capacity only grows when there is a shortage of capacity.
This insight has major implications for the way in which economies recover and the necessity for strong fiscal support when a deep recession is encountered.
So with the Government articulating its intention to savagely cut into expenditure and with incomes falling due to rising unemployment and falling terms of trade, it is little wonder that investment growth is negative at present in Australia.
These dynamics are covered in my 2008 book with Joan Muysken – Full Employment abandoned.
The RBA has therefore come to the party somewhat late if it really believed cuttig rates would reverse the decline in economic growth.
In the RBA paper cited in the introduction, the researchers address the apparent insensitivity of investment spending to interest rates cuts by aiming to undertand the way in which business firms “evaluate investment opportunities”.
They use survey data – that is, actually ask firms to articulate how they male investment decisions.
This is a good sign – get out and try to understand the way the real world operates rather than consider what appears in textbooks (other than the one Randy Wray and myself are writing that is :-)) has much at all to say about reality.
The results are very interesting and telling. Telling, in the sense, that they provide further evidence as to why monetary policy is an ineffective tool for stimulating national expenditure.
And, importantly, the results provide further evidence against the mainstream ‘crowding out’ hypothesis, which claims that government expenditure pushes up interest rates (because it allegedly competes for scarce savings) and the higher interest rates deter private investment in productive infrastructure.
We know the first part of the story is false – there is no competition for scarce savings because rising income (on the back of increased spending) increase savings. Further, bank lending is not reserve constrained which means the banking model that says they are institutions that wait around for savers to deposit funds, which they can then loan out to investors is false.
The RBA paper adds further understanding to why total expenditure (including private investment) is relatively insensitive to interest rate changes – the second part of the ‘crowding out’ hypothesis.
It is very interesting just in that aspect.
The RBA paper describes the “Bank’s business liaison program”, which involves “around 70–80 discussions with contacts on a monthly basis … Liaison meetings are held with firms of all sizes, although most discussions are with mid-sized and large firms where conditions are somewhat more likely to reflect economy-wide trends rather than firm-specific factors.”
The paper says that:
… many contacts have reported that low interest rates do not directly encourage investment. In contrast, economic theory suggests that the rate of interest affects the cost of capital and should influence investment decisions directly, based on standard methods used to evaluate investment opportunities.
Detailed discussions with business liaison contacts reveal why lower interest rates might not have any direct effect on investment, even at the margin. Contacts indicate that required rates of return on capital expenditure, also referred to as ‘hurdle rates’, are often several percentage points above the cost of capital. More importantly, contacts note that the hurdle rate is often held constant through time, rather than being adjusted in line with the cost of capital.
That is the summary. What follows is the more detailed explanation.
Students learn so-called Discounted Cash Flow Analysis (DCF) and payback period analysis as part of their studies in capital theory – learning how investment decisions are made.
The basis of DCF is that there is a time value to money – a dollar now is worth more than a dollar in a year (because it can earn a compound return if invested now). So revenue or costs in future periods cannot be readily compared with revenue and costs now.
So when a firm is evaluating future returns (cash flows) and outlays (costs) it has to bring them back into a comparable monetary unit, which is called the – Present Value – of the income and outlays.
To overcome this temporal issue, we define a present value by ‘discounting’ future cash flows to take into account the ‘time value of money’ and ‘investment risk’.
We thus use some interest rate (discount rate) to bring all future revenue/outlays back to a present day value. You can look up formulas to see how this is done if you are interested.
The net present value (NPV) is just the sum of the revenues (in present value terms) minus the sum of the outlays (also in present value terms). The NPV indicates the value on a long-term project and if the NPV > 0 then the project adds value to the firm.
There is a huge debate about the short-comings of NPVs as a guide to capital expenditure. I will leave it to your curiosity to pursue the literature further should you be interested.
DCF uses a ‘discount rate’ (an interest rate) chosen by the firm to be representative. As we will see the choice of the discount rate is not uncontroversial.
Governments often use very ‘favourable’ (aka studidly unrealistic) discount rates if they want a dubious investment project to meet its business case. I have been involved in court actions (appearing for community groups) where the decision to privatise a community hospital was made on ridiculous discount rates, which made the project appear incredibly profitable for the private operator whereas when a more realistic discount rate was used the project was clearly going to crash. The government went ahead in that case and a few years later the private operator went broke and the government had to ‘buy’ the hospital back. Meanwhile, the private operator walked away with massive public subsidies. It was outrageous. An aside.
In the context of this blog, one such issue is that NPVs do not tell you the profit in percentage terms of investing in a specific project. They merely indicate the value of an investment. They do not provide information about the efficiency or yield of the investment. In this context, the use of the internal rate of return is indicated in the literature.
The – Internal Rate of Return – is often referred to as the “the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR)”.
Imagine you want to know the break-even discount rate where the present value of all outlays equals the present value of all revenue. That discount rate is the IRR. The higher the IRR, the more desirable the project.
The finance literature claims that a firm should undertake all projects where the IRR > cost of capital.
Discounted cash flows are thus adjusted future cash flows (returns or outlays) to bring the monetary sums back into what they are worth in today’s dollars. I won’t go into all the technicalities but the essential point is that DCF provides the analyst with a single present value of the complex future cash flows associated with an investment project (a dollar value) which can then be compared with other alternative uses of the funds.
So two or more investment projects might have very different future patterns of cash flows but can still be compared using the net present value, which is the difference between the present value of the returns less the present value of the outlays over time.
The RBA say that:
In the simplest case, the firm should invest if the NPV is positive for the chosen discount rate; put differently, the project should be approved if the internal rate of return of the project is above this specific discount rate.
For obvious reasons, the RBA calls this discount rate – the hurdle rate. It is the rate beyond which the IRR will invoke a decision to invest.
That seems to be logical.
The next logical point is that:
Theory suggests that the hurdle rate for a typical investment should be set with some reference to the firm’s weighted average cost of capital (WACC), which includes the cost of both debt and equity. For example, the level of the hurdle rate may be greater than the WACC if the potential investment has greater non-diversifiable risk than the overall operations of the firm. The extent of such a gap will also depend on the extent to which managers and shareholders are averse to risk. Changes in interest rates influence the cost of debt and, under reasonable assumptions, the cost of equity, and so should influence the hurdle rate.
The essential point is that for a given risk environment, interest rate cuts that reduce the “firm’s weighted average cost of capital” should also lower the hurdle rate, which means that less profitable investment projects at higher capital costs become attractive and investment rises.
That is the theory.
What is the evidence?
Interestingly, the RBA report that the typical Australian firm does use DCF analysis to assist in their investment decision making. They say this consistent with evidence from the UK and the USA.
But, and this is the point:
Liaison contacts indicate that the hurdle rates used to evaluate business investment opportunities are often several percentage points above the WACC. Hurdle rates of around 15 per cent are quite common.
Around “90 per cent of Australian corporations … used hurdle rates exceeding 10 per cent, and around half … used a hurdle rate exceeding 13 per cent”.
And, even more significantly:
Many liaison contacts also report that hurdle rates are not changed very often and in some instances have not been altered for at least several years.
So firms are using decision making discount rates far in excess of the actual cost of capital and have not updated that discrepancy in the light of the new low interest rate environment.
The RBA reports that “nearly half reported the level of their hurdle rate was changed ‘very rarely'”.
Which means that “changes in interest rates do not flow through to hurdle rates; rather, the margin between the WACC and the hurdle rate changes” – that is, it gets wider.
The RBA reported that firms told them they do not change their decision making rates in line with interest rate changes because they regard the latter as “temporary, and so they are reluctant to react to developments that may soon be unwound”. Other reasons were given.
This all means that calculations of NPV (and IRRs) are insensitive to real world conditions.
Moreover, while firms do use DCF analysis the RBA said that:
It is clear from discussions with managers that the overall investment decision process is often highly subjective, introducing a role for ‘animal spirits’ or ‘gut feeling’ to have an important effect on capital expenditure decisions. This is not surprising, given that future cash flows generated for the quantitative criteria discussed are often difficult to forecast and hence rely on subjective input from project proponents.
Which takes us back to Keynes and Kalecki. Uncertainty and subjective sentiment are very important in the real world and attempts by the mainstream economists to simplify behaviour into asinine mathematical models which provide some semblance of certainty and perfect forward looking knowledge fail.
Further, in the mainstream models when risk is taken into account it is considered to be probabilistic, which defies the reality that the future can never be known in its completeness and so assigning probabilities to all possible future events is impossible.
Given the rigidity of the DCF models that firms around the world appear to use, which makes then insensitive to variations in interest rates, and the highly subjective nature of investment decision making, it is little wonder that firms are currently planning to cut back investment spending in 2016, despite record low interest rates.
The Government is telling the private sector that they are about cutting spending and thus cutting private incomes, which even those with the sparsest knowledge of economics can deduce will push up unemployment.
Households have record levels of indebtedness and consumption spending is moderating even with low interest rates, which are keeping many households solvent given their debt levels.
So, why would anyone invest in more productive capacity in that environment? The existing capital stock is capable of meeting current demand for goods and services and the risks of being burned if further capacity is built are very high indeed.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.