Home > Fiscal Policy, Global Crisis, Growth, sovereign debt > Be Smart, Borrow More!

Be Smart, Borrow More!

Larry Summers has a very interesting piece on yesterday’s Financial Times.

He argues that a few countries (the US, Germany, Japan, the UK; I would also add France) enjoy extremely low borrowing rates, both short and long run. In particular, real rates (nominal rate minus inflation) are negative or zero for maturities up to 5 years, and extremely low for longer ones.  Summers’ conclusions are then straightforward:

  • Focusing on further quantitative easing is not particularly useful;  given the already very low rates, further reductions are unlikely to trigger private spending (it has a name: liquidity trap. And Paul Krugman has been insisting a lot on this, for example here)
  • More importantly, government should borrow now, like crazy, taking advantage of the favorable conditions to reinforce their long term fiscal sustainability. This is what any reasonable CEO would do, and there is no reason why governments should act differently.

Summers makes a point that is almost obvious: Any project that has positive expected return would improve the country’s fiscal position, if financed with debt at negative real rates: This is the time for example to borrow to buy government buildings that are currently leased. Or to accelerate the rate of  replacement of aging capital; or again, to engage in long term infrastructure building/renovation. Makes sense, right? It makes so much sense, that chances are that it will not be done…

I would like to add two considerations. The first is to stress that to get private demand started, it is important that growth perspectives are stronger. Firms today do not invest, not because of borrowing costs, but because even at very low interest rates, expected demand is so low that investment is not profitable. The second is that, for Europe, increased borrowing in Germany, France and the UK would be crucial. Countries enjoying low rates could not only significantly improve their long term prospects, as Summers argues. They could also sustain demand in countries that are consolidating, thus favoring the rebalancing I have repeatedly argued for.

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  1. June 14, 2012 at 6:04 am

    Do you believe governments are good at identifying and then investing in positive NPV projects?

    Second, could you explain your argument that the problem facing firms today is one of low demand?

    My impression was that the problem related more to the supply-side. Greece, for example, ranks lower on the World Bank’s Ease of Doing Business index than Yemen. I thought that impediments to doing business were perhaps then more immediately problematic than the scarcity of demand or investment capital. One conclusion, for me, based on an insights from an article in Foreign Affairs a few months ago, was that the creation of a more business-friendly regulatory and tax regime would do more to address growth problems in Europe than would demand-side policies.

    Third, and unrelateldy, do you have any thoughts on the argument that Greece can both default and remain in the Eurozone? If/when Illinois defaults on its debts, it will probably nevertheless remain on the USD. Any idea why the same logic cannot apply to Greece?

  2. June 14, 2012 at 2:11 pm

    Javaad, you seem to shoot at hte wrong target. I do not think that governments are inherently better (nor worse) than the private sector in identifying worthwhile projects. I just think that if we believe that some public capital is necessary in the economy (and I do), the moment to acquire that capital is when interest rates are low, i.e. now. End of story.

    And yes, I do believe that we are living through an aggregate demand crisis, of the standard textbook Keynesian type. This is why I am opposed to austerity. Supply side problems (that exist) a) are for the long term; b) require more complex solutions than simple liberalization of markets.

    thanks for commenting!

    • June 17, 2012 at 7:19 am

      I guess the reason I asked is that I think Summers is wrong.

      If I understand correctly, the argument that governments should increase borrowing works as follows. Interest rates are basically zero. Any project with an expected return greater than zero is therefore value creating.

      The reasoning above focuses on accounting returns instead of economic returns. It completely ignores risk. From a financing perspective, value creation is measured not against the rate at which someone is able to borrow money, but rather against the riskiness of the investments for which they would like to borrow. So, for example, if I want to borrow to invest in a low risk utility, I will do so at a rate that would be lower than the rate at which I could borrow to invest in a tech start-up. The rate differential would exist even if the two projects had the exact same expected return, and would persist even if the two projects were to be executed by managers with equal competencies for both project areas.

      Value creation is estimated by comparing the returns on a particular investment to the cost of capital for that investment. The cost of capital for an investment is determined as a function of the prevailing risk-free rate, the market risk premium, and the market beta. In other words, the cost of capital is determined using variables that do not include the borrower’s own cost of funds. As such, even if rates are low, I think the argument that borrowing more is a necessarily smart thing to do is still logically incomplete. To establish that borrowing is a smart idea, you need to show that the debt will finance projects that create value in an economic sense rather than just an accounting sense.

      The difference between accounting and economic returns is why reasonable CEOs do not load up on debt every time interest rates dip. It is also why project selection matters. If governments are to become investors, then they need to do so in a way that manages society’s resources in a manner that is at least as responsible as the manner in which private companies would have managed those same resources. To do so, they should estimate the value they aim to create by using the appropriate rate when discounting future cash flows. The appropriate rate is not their own cost of funds. Value is not created by financial engineering. Value is created through smart projects. Paying people to dig ditches and then fill them up again is not a smart, positive NPV project.

      If firms aren’t investing as much as others may like, then I would guess the reason is that there is most likely a shortage of projects out there that, given the regulatory regime here in Europe, qualify as “smart.” That is to say that the supply side argument makes sense to me. You seem to agree, but to believe that demand policy is the more effective instrument for achieving relatively quicker results. If the regulatory framework were to change overnight, I see no reason why firms would not whir back into action to invest in and exploit new profit opportunities. For now, the fact that they aren’t leads me to believe that there is something wrong with the institutional framework in which European firms operate. The list of possible things that are wrong is a long one. So long, in fact, that I suspect that at least some of them are quick fixes. Change those things and you may get a recovery faster than you would if you just increased in government spending.

      So, again, I think Summers is more or less wrong on this one. Either way, I think your first argument in the last paragraph can stand on its own. I don’t know why firms aren’t investing. I am prepared to believe they aren’t investing because they accumulated significant capital during the boom years, and are stuck with excess capacity today. Of course, they have capacity in excess of what they need because they aren’t producing as much as they can, which happens when current demand is less than potential supply. If increases in government spending are supposed to lift demand, then I imagine the government in question would need to direct its spending towards sectors that are currently struggling. In practical terms, I think the research and the risks involved with this kind of spending is not something that makes it amenable to government support. We don’t hire civil servants for this kind of thing, and cannot fault them if/when they get it wrong. For implementation reasons, aggregate demand policy seems to have little upside relative to quick-fix supply policy, and also seems to have considerable downside in terms of distortions and the rest of it. So, I think demand policy will entail more business as usual, and that it won’t produce the results you might expect.

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