Insufficiency of Investment Demand

Raghuram Rajan joins the insufficiency of investment demand club:

Signs of extremely benign financing conditions are plentiful, ranging from low long-term interest rates to historically narrow credit spreads on risky assets. Many observers call this a liquidity glut, thereby implicating central banks and their accommodative policies. But in my view, these conditions may primarily be driven by a global shortage of hard assets. My argument relies on two global ingredients. The first is that, in spite of substantial worldwide income growth, if anything there has been an increase in the desire to save out of it. In emerging markets where income growth is rapid, savings increase. Household consumption in developing countries takes time to catch up with higher incomes – either because households take time to be confident that the increase is permanent or because credit constraints prevent them from borrowing to consume against future incomes.

Mark Thoma wonders what I might say:

He might also note that while low investment demand is usually explained by factors such as the Asian crisis, the collapse of the dot-com bubble, and 9/11, all of which diminished businesses’ willingness to undertake risky investments, this adds additional factors associated with “global ingredients” such as competition from emerging markets. With the additional uncertainty these factors add, it “makes less and less sense for corporations in industrial countries to make large domestic investments in the manufacturing sector.” However, if it were just a decline in real investment, we would see low interest rates but also low output (casting this in IS-LM language, think of the IS curve shifting in). However, if there is also a large supply of liquidity, then interest rates would be even lower but output would not necessarily decline, a result consistent with the robust global output we have seen in recent years (think of the IS curve shifting in and the LM curve shifting out). It is also consistent with the low rates of inflation we have seen globally since the low investment demand will offset price pressure from the increased liquidity.

That about covers it. I will say that back in 2001 that I was very critical of Bush’s fiscal stimulus as I thought the expansionary monetary policy itself would take care of any recessionary tendencies from the inward shift of investment demand. Over time, I began to change my mind as the Federal Reserve lowered short-term interest rates below 1% and the recovery was still anemic. The good news, however, is that the investment slump has started turning itself around and our economy is getting back towards full employment. The bad news is that Bush’s fiscal stimulus has not turned around – which has led the Federal Reserve to raise interest rates. So the crowding-out effect I worried about then is something that we should worry about now. Of course we could pray for a miracle and hope that this White House does decide to do something novel during its term in office – get serious about fiscal responsibility.