Is It Better to Malinvest During a Recession?
Evan Soltas (HT2 Scott Sumner) writes a more balanced view (compared to Matt Yglesias, who called Summers a communist) on Larry Summers allegedly problematic concern over low interest rates leading to malinvestments. To refresh your memory, here is what Summers said back in 2012, that is now causing a lot of people to flip out since he might be Bernanke’s successor:
Many in both the U.S. and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy inaction to current economic weakness than to overreacting.
However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds. [Bold added.]
Now in reaction to the above Summers quote, Soltas first concedes (unlike Yglesias et al.) that it’s not just those wacky Austrians who think interest rates might have something to do with the sustainability of investment projects:
[Summers’ argument] is one of the most common…against monetary accommodation. It deserves a little more destruction than O’Brien and Yglesias give it with the “Austrian” and “socialist” labels.
Let’s start with what we know. An investment project requires a large downpayment made with borrowed money with the intention of recouping that money with future revenue. The way that economics thinks about investments is through cash flow — that is, the net of how much the business would take in and lay out. In the beginning, this is going to be negative, as investments in equipment and construction exceed revenues. As time passes, it’ll turn positive.
…
It’s possible that an investment has a positive net present value at a certain interest rate (a low one), but has a negative net present value at another, higher rate. So if all else is equal, Summers is right: If the central bank holds interest rates artificially low, it can in fact induce malinvestment — the central bank is creating an incentive to invest in projects which have negative net present values at normal interest rates. If the cost of capital was to fall below the internal rate of return, then that may generate a misallocation of resources.That’s a bad thing, and it’s not “Austrian” to fear that. Nor is it the irrational response of a private sector to malinvest under those conditions.
Right off the bat, I’m already worried. Soltas says “it’s possible” when he should say “it’s mathematically certain.” (If the negative and positive cash flows alternate, then you can get the weird “reswitching” stuff, but even in those cases, strictly speaking Soltas’ “it’s possible” scenario will be true in every single case.) So as I say, I’m already worried that this basic stuff is being treated as almost an interesting thought experiment that Summers has raised.
OK but put that quibble aside. At least Soltas agrees with the Austrians (and Larry Summers) that the central bank shouldn’t be encouraging projects in unusual times that won’t be sustainable once we return to normalcy. Oops, except he’s not. Here’s his explanation:
But all else isn’t equal, and I’ve been meaning to point out this error for a very, very long time to others. So here’s the thing about recessions: They reduce businesses revenue. They do so for the short run, and perhaps the medium run. That, by definition, reduces internal rates of return across prospective investments. If expected future revenues fall and the central bank doesn’t adjust the interest rate, in other words, it’s misallocating resources, but just in a different way.
This isn’t an idle fear. I’ve sung a lonely chorus for a year or so now arguing that economic commentators have underappreciated the role of expectations…
This evidence suggests Summers has this backwards. Recessions appear to be about internal rates of return dropping suddenly below the cost of capital, and everyone trying to exit their investment and deleverage at the same time….If you think about a roster of investments ranked in order of their internal rates of return, recessions seem to create a sudden jump in how many of those investments would be “underwater.”
Here’s a simple example. Suppose that you’re starting a business. It requires a $10,000 upfront investment in the first year. You’ll make no revenue then, either. Then you expect it to bring in $1,000 in positive cash flow for the next 29 years. That’s an 8.4 percent internal rate of return.
But, woah, here comes the recession! Now you’re expecting the first three years that had positive cash flow to be zero instead. Now the net present value, at the current rate, is -$2,475. Yikes! You’ll liquidate the investment rather than take a loss like that. Trouble is, if everyone does this, it’s a problem. So the central bank should cut the cost of capital from 8.4 percent to 6.4 percent. (And had it made clear it would have done this in the beginning, none of this would have happened in the first place.)
First two quibbles: (1) I’m getting internal rates of return closer to 9.23% and 6.71%, which is way different from Soltas (especially the first one). Can anyone else reproduce his numbers?
(2) Once the project is up and running, with the $10,000 being a sunk cost and now the project offers a stream of $1,000 payments starting in 3 years, why would the owner liquidate it? By “liquidate” does Soltas really mean “not start the project”?
Beyond these quibbles, my main point: Soltas’ argument only makes sense if the recession is something that the central bank should solve by cutting interest rates and encouraging people to continue making the same pattern of investments as before the recession hit. (He doesn’t spell it out, but implicitly Soltas must be arguing something like this: If the central bank cuts the interest rate enough, then everybody continues investing, so Aggregate Demand has no reason to fall, and then the investment project returns the $1,000 each year just like it was supposed to. The recession is cured, and the central bank can raise rates back to where they were.)
Yet hang on a second. Suppose for a second that the Austrians were right, and that the reason we have a recession isn’t simply (a la Scott Sumner) that the markets suddenly, and for no good reason whatsoever, just decide to anticipate the slowest NGDP growth since the early 1930s–and then the Fed renders their prediction true (again, for no exogenous reason whatsoever).
In contrast to that Sumnerian explanation (and yes I’m exaggerating to make the distinction), the Austrians explain that a recession occurs when a bunch of entrepreneurs realized they had previously engaged in malinvestment. What for Soltas is “normal times” is actually the unsustainable boom for the Austrians. Soltas wants to prod entrepreneurs to keep investing like it’s 2005, when the Austrians are saying no, there were artificially low interest rates back then.
In case it’s too hard to grasp all of this at a macro level, do it at the individual firm level: Just one entrepreneur thought he could open a franchise restaurant by plunking down $100,000 today, then earning a net income of $10,000 annually for the next 29 years. At this internal rate of return of 9.23%, and with a market interest rate of 8%, he went ahead and started the project.
But the guy was wrong; the people in Auburn AL just weren’t ready for that much sushi. After his experience with this first attempt, the guy now projects that his next target franchise in Birmingham, AL will still require $100,000 today, but then $0 for the next three years, followed by a stream of $1,000 $10,000 net income earnings through the 30th year. With interest rates this high, clearly he won’t do it. So, should the Fed cut interest rates enough to make him open that second restaurant in Birmingham? Of course not.
I realize there are “fallacies of composition” and so forth in macroeconomics, but sometimes microeconomics does extrapolate. If it’s dumb for the Fed to cut interest rates to encourage an entrepreneur to tie up resources in a project that doesn’t offer positive present value, maybe it’s a bad idea for the Fed to do that with millions of entrepreneurs during a recession, when people have legitimate reasons for changing their spending patterns and previous forecasts of demand may have been wildly off.
Hey Murph, get ready for the flood of “Robert P. Murphy should not be the next Fed chairman” posts arising in the blogosphere.
You’re one of those hawks that eats babies, like Summers.
“What for Soltas is “normal times” is actually the unsustainable boom for the Austrians.”
So can all this hubbub simply be broken down as Austrian thinking the natural rate has been higher than what the monetary stimulus proponents think?
You mean after all your antagonism against Austrian theory, after all your posturing, all the “you’re all idiots”, all the “you’ve been demolished”….you actually don’t have even a basic understanding of it?
Now don’t get me wrong, I won’t lose any sleep over this fact, I just think it’s incredibly interesting because there are so many others who think like you. Is there is something at the core of Austrian theory that manifests in statements and arguments that just troubles and upsets you in a deep way?
Maybe it’s the fact that it requires one to self-reflect, which is terrifying for one reason or another. I dunno.
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To answer your question: no. It has little to do with “What Austrians think versus what Monetary proponents think”. It has to do with what actually exists, versus what information is communicated via empirical prices in an monopolist inflationary system.
On a side note, Austrian theory cannot be “broken down” the way you want. Deconstructionism is literally the exact opposite approach that is required to understand Austrian theory. You have to adopt a Constructionist approach. Place the pieces together in a deductive fashion. Build the story.
>You mean after all your antagonism against Austrian theory, after all your posturing, all the “you’re all idiots”, all the “you’ve been demolished”….you actually don’t have even a basic understanding of it?
When did I call anyone an “idiot” or claimed I “demolished” them? I certainly never come to this blog with that attitude towards Austrian economics. (except maybe Ron Paul, but he’s a politician so I’m allowed to do that) My time in this blog has been to get a better understanding, ask questions, and speak up if I disagree with something If I’m wrong about something, being corrected is what I come here for. Calm down, buddy.
Darn, I think I figured it out why your name rang a bell. A while ago I had a very intense series of debates with a person using that monicker, and let me just say his mouth was very dirty.
I think you’re not the only “Desolation Jones”, Desolation Jones.
You are likely not the same person, because your posts on this blog have been very cordial and non-offensive.
Sorry, my bad. My tail is between my legs.
What always fascinates me is that to many the Macro has no bearing on the Micro and vise versa. Yet the Macro is made up of how the Micro operates and of course Macro decisions will have Micro consequences.
For example. I refinanced my house four times in the last two years ( I did it through a company that had no closing costs lol otherwise it would have made less sense ) each time the interest rates dropped. My Mortgage started at a 4.875% interest rate. Then I dropped it to a 4.25% then a 3.875% interest rate, finally I bottomed out ( just missing the lowest rate ( sigh ) ) of 3.3875% ( missing the 3.25% oh well )
The Macro Economic picture caused me to do this. All the while I was shaking my head and wondering how this could possibly be sustained by the market in the long term. Heck we are on track for 2% CPI increase this year alone. I still expect a 3-4% rate of inflation in the coming 2 – 3 years, course I also expect another recession in the next 3 – 5 years so what can that tell you about myself…
In the meantime it freed up a great deal of money that would have gone toward debt service. This money is now sitting, waiting for the next crash in which I will of course purchase other goods and investments. The business cycle is going to be alive and well and pumped up on steroids if what appears to be happening on a macro economic level persists. All this information is driving me to CHANGE the way I behave on a Micro economic level.
Deflation is the natural consequence of asset over valuation. I do not have to buy a tulip bulb for a million dollars… Anyway, great post. Concerned about the direction the world is moving when it comes to economics.
Food for thought:
If the government truly does serve us, why do we not have at least some control over their actions? If my servant does something that displeases me, I can reprimand/fire him, but can we do that with the government? The government officials give their oaths to no one, and are contractually obligated to serve no one. They are but the instrument by which that secret band of robbers and murderers pillage their fellow man for their personal gain.
I’m getting the same IRR’s as you in the two scenarios. I cannot reproduce his $-2475, either. To get that, I have to use an interest rate of 9.17%, which has nothing to do with the IRR’s you calculated, and that’s working with the (-10000), 0, 0, 0, 1000 for 26 years.
Being in corporate finance, I’m struck by the denial of the fact that lower interest rates will lead to lower WACC’s. Lower WACC’s lead to higher NPV by definition. There’s even the “Window-of-Opportunity” theory, that states that execs try to time their investments to coincide with lower interest rates. The go, no-go decision is a function of the discount rate and the cash flows. Interest rates are really just a price. Where else in econ do we say that lower prices don’t lead to more quantity demand? Maybe I’m misunderstanding this, but it stands to reason that lower interest rates will cause companies to invest in projects they otherwise would not have, just as consumers looking for sales will buy when the price falls enough. I guess the disagreement enters when we say “malinvestment”.
By the way, regarding Scott Sumner, here’s something you might like.
http://www.youtube.com/watch?v=ixZuSdcHSZI&feature=youtu.be
In a world where prices and interest rates adjusted automatically to the latest available information then business would always be able to make accurate assessments on the likely return on investments and systematic malinvestment could be avoided.
In such a world ABCT could not occur because interest rates and prices would adjust immediately to any increase in the money supply. So any world where ABCT exists is a world where there is some “stickiness” in the adjustment process for prices and interest rates.
In such a world it may be the case that sticky price and interest rates make some investments appears profitable that in fact are not and some appears unprofitable that may fact be so. The first may appear systematically in the boom and the second in the bust.
If monetary policy can speed up the process of helping prices and interest rates adjust to the underlying economic realities then it might be able to avoid both the boom and the bust and prevent systematic mal-investment or under-investments.
This is factually incorrect, especially when you consider that the information business is using to make it’s decisions is the wrong information. The fact that the information is off (thanks to interventions in the market) is precisely why the ABCT takes place at all; it has nothing to do with access to information itself, but the quality of the information in question.
“it may be the case that sticky price and interest rates make some investments appears profitable that in fact are not and some appears unprofitable that may fact be so”
The problem is not in explaining errors on the part of entrepreneurs, but systematic, economy-wide errors. That doesn’t happen without systematic manipulation of the pricing mechanism.
For analogy, it’s possible that next year, “too few” cars will be made, and the price will rise. But would this cause a shortage due to increased demand? Now imagine a price ceiling on cars. See how the manipulation of the prices creates a mismatch in supply and demand that results in systematic error?
Yes, if the central bank increases the money supply and causes interest rates to be lower than the natural rate then mal-investment can occur.
But these mal-investents only occur because their is a lag between the change in the money supply and the adjustment of the interest rates (and other prices) to the new equilibrium.
It is not only a change in the money supply that can cause disequilibrium though. Changes in money demand or expectations due to non-monetary factors can have the same effect and cause the same kind of “systematic, economy-wide errors.”.
My point is that in this latter case then adjusting the money supply to the changed demand may be a way to avoid these systematic errors.
ABCT appears to embrace pricing frictions when they are needed to back-up ABCT but to deny them when disputing the potential benefits of monetary policy.
The theory, of course, is that different prices will adjust disproportionately — i.e. money is non-neutral. You can think of it as a movement to an unstable equilibrium and then back.
It seems to me that saying “money is non-neutral” is just a shorter way of saying that there are frictions in the adjustment process for prices and interest rates.
Two different things. We can argue that there are frictions in the adjustment process. This isn’t money non-neutrality. When money is said to be neutral what we mean is that it has no effect on the allocation of “real” goods.
“Suppose for a second that the Austrians were right, and that the reason we have a recession isn’t simply (a la Scott Sumner) that the markets suddenly, and for no good reason whatsoever, just decide to anticipate the slowest NGDP growth since the early 1930s–and then the Fed renders their prediction true (again, for no exogenous reason whatsoever).”
I laughed so hard at this.
I can squeeze 8.45% out of the first scenario, but that’s as far as it goes. I’d accept 8.4% as rounded down in a conservative direction.
http://sniffer.lnx-bsp.net/rpm/business_return.pdf
Errr, if a business owner tallys up the present value of their business, only to find it negative, then by definition they have already taken the loss. I think that’s probably where the disconnect occurs here.
Even better than that is taxing the sun (probably at all times)!
http://globaleconomicanalysis.blogspot.co.at/2013/07/spain-levies-consumption-tax-on-sunlight.html
There ya go Bastiat..
Could someone explain to me NGDP targeting? It’s not that I haven’t done my homework, because, trust me, I have (although I haven’t read Sumner’s latest paper yet). Sumner puts a lot of weigh on NGDP expectations. The economy crashed because NGDP expectations crashed (of course, it couldn’t be that both are related to the same cause: a weak economy); we revive the economy by increasing NGDP expectations. But, what is the actual transmission mechanism? I have a hard time believing that Sumner actually believes that all the Fed has to do is increase NGDP expectations. Or, is the idea to target NGDP by just doing whatever monetary policy the Fed can use to increase the supply of money, and stop when NGDP is back on trend?
http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/10/engdp-level-path-targeting-for-the-people-of-the-concrete-steppes-.html
I finally understand. But the current unsatisfactory “equilibrium” is held in place by pre-existing funny money and other interventionist policies. Take those away and a new satisfactory “equilibrium” will appear. There is no need to double down on a failed Weltanschauung.
I’d just like to point this out, for future reference:
Yglesias > “… the state needs to step in and plan the economy. Socialism, in other words.”
Let’s please refer back to this quote the next time a progressive tsk-tsks a libertarian for referring to central planning policies as “socialist”.
Evan is simply not careful with his terminology
His rates are discount rates where you are computing interest rates: 1 – d = (1 + i) ^ -1
Also, the cash flow timing he uses is beginning of period, so the 10000 investment is undiscounted, the 2nd year profit is discounted for only 1 year, etc. I think this actually follows from a careful reading of his example.
ATeamRules, I did the normal way you compute internal rate of return. And it doesn’t matter if you move everything up a year (which I tried, just to be sure). If something has a $0 NPV today, pushing the whole project back a year doesn’t change that, right? What’s the present value to you, of a bond that pays $0 in 50 years?
Sorry, I apparently can’t find the reply button or do a simple proof-read in my zeal. 🙂
Response below – it mostly makes sense.
Right, for an IRR calculation, it doesn’t matter which timing you use. That only matters for the NPV calculation after changing year 2-4 cash flows, the timing matters. I mentioned it because when I first ran the example, I used end of period timing and got a different answer from him.
I think it is odd that Evan calls it an IRR calculation and then reports the result as a discount rate, but that is the reason your numbers are so different from his. It wasn’t poor math on his part and using one versus the other doesn’t matter to the story he is trying to tell.
OK can you please walk through how you get, say, the 8.4% number? I agree it doesn’t change his basic story–that’s why I called it a “quibble”–but I want to know exactly what he did.
Take the 9.23% IRR you got. That is expressed as an interest rate. The discount factor (which is often more convinient than an interest rate for NPV calculations) for 1 year is v = (1 + i) ^ -1 = 1.0923 ^ -1 ~ .91553.
Then d = 1 – v = .08447 is called the discount rate. This is what Evan reported, rounded to 10 basis points. I’m not sure why he would use a discount rate when nearly everyone talks in terms of interest rates.
In your NPV calculations, replace all the of the (1 + i) ^ -t factors with (1 – d) ^ t and you will get Evan’s rates as the ones that get you back to 0 NPV.
I should add two things:
1. I still can’t be bothered to find the reply button
2. Evan does say he using a “rate of discount” in his post, but I’m unsure why he would make that choice. As far as I know, coupon-free bonds are the only place discount rates are commonly used. 1 minus the discount rate gives you the price you would pay for a bond that pays $1 one year from today. That is the only context I can think of where the discount rate notation is the more intuitive.
See here for the definitions.
Austrian business cycle theory seems to depend upon people being either completely stupid or immoral.
They’re stupid if they make stupid plans based on the current interest rate with no thought about what might happen in the future. And they’re immoral if they realize that the current market is completely unsustainable, but they go into it anyway and try to con people out of their money so as to make a quick buck because it’s all going down in flames anyway so who gives a shit.
Given that you guys seem to build your whole philosophy around the supposed wonders of the entrepreneur, it’s strange that the central piece of your ‘theory’ treats him like he’s either an imbecile or a sociopath.
Under a fiat money system, the business cycle is unavoidable.
Once you’ve granted the premise that everyone’s using paper, you’ve also granted the use of an inherently fraudulent system.
Once the interest rate has been set artificially low, you can’t borrow at all without starting some kind of business cycle, even if it’s very small.
And if your competitors can use the artificially low interest rates to expand and take more market share, what are you supposed to do?
Further complicating matters, the central bank might bail out foreign banks in secret. How are you supposed to be able to avoid the business cycle under THAT scenario?
The only way to keep business cycles from happening is to refrain from using paper, opting instead for a commodity money system (and also to keep the government out of the economy).
The business cycle is part of capitalism, not just a product of fiat money. The austrian school just makes up silly excuses for why markets aren’t as perfect as they believe they should be.
There’s nothing inherently fraudulent about paper. It is what it is. You’re only defrauded if the thing you buy pretends to be something it isn’t.
You say interest rates are artificially low, others say they are artificially high.
What are you supposed to do? The excuse of a scoundrel. ABCT claims that entrepreneurs are either stupid or immoral.
The central bank can bail out foreign banks if it wants to. Things like central banks exist. As an entrepreneur you are supposed to be able to adapt to things as they exist, not make up excuses.
Commodity money, whatever. Try exchanging a lump of gold at the shops and see what they say.
There is no ‘government out of the economy’. The government is part of the economy so long as it exists. Again, an entrepreneur is supposed to be able to deal with things as they are, not make up excuses and blame others for their own failings.
Well, central planning, more broadly. Theft (taxation) is a form of artificial purchasing power creation.
If I double the paper money supply and give it to you, you’re going to be able to purchase things you previously weren’t able to. That new money you spend will eventually cause price inflation.
If you borrow artificially created money (the more money a bank has, the lower the interest rate it will be willing to offer), and you’re still paying off the loan as prices start rising, you’re going to have to cut back on consumption to remain profitable.
That’s the business cycle.
Money is something that is bought (with labor, for example).
When someone claims that the paper, itself, is money, that is fraud.
I’m supposed to lose business to someone who DID take the lower interest rate loan?!
And this, every time the central bank decides to increase the money supply?!
Sheesh!
If I don’t know it’s happening, then it’s impossible for me to avoid the malinvestments caused by it.
Scoundrels exist, so stop making up excuses and blaming others … ?
😀
“That’s the business cycle”.
you clearly have a very limited knowledge of economics.
The paper money we use isn’t fraudulent because it isn’t pretending to be something it isn’t. It’s money, you can use it to pay people. I don’t particularly care about your personal little ‘definition’ of ‘money’ and nor does the rest of the world. No one cares.
If interest rates go down and you, as an ‘austrian’ believe that around the corner there’s going to be a bust, then you’d either be an idiot or dishonest to invest in things you think are going to go bust, and then get caught out by the bust. You’d literally have to be an imbecile. “oh look house prices are unsustainably high, there’s bound to be a bust. I know, I’ll invest all my money in houses and not worry about the future. Oh no the housing market has bust and I’ve lost my money – the government is to blame! Idiotic.
If I have the guts to quit my job .