A “Slam-Dunk” Case for More Government Spending?

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How should the government respond to low borrowing rates? For Ezra Klein and others, the obvious response is to increase spending:

Because of the recession, construction materials are cheap. So, too, is the labor. And your borrowing costs? They've never been lower. That means a dollar of investment today will go much further than it would have five years ago -- or is likely to go five years from now. So what do you do?

If you're thinking like a CEO, the answer is easy: You invest. You get it done. Happily, that's what the administration is proposing to do. But its plan is too modest. The $50 billion bump in infrastructure spending it has proposed is only for surface transportation. The infrastructure bank envisioned in the proposal is also likely to be limited to transportation. And as for our water systems, our schools, our levees? This is not a time for half-measures. It's a rare opportunity to do what we need to do and to save money doing it.

The implication is that decisions on government spending should mirror what businesses would do in similar situations. The government when thought of as a corporation suddenly faces lower borrowing costs. It should take advantage of this opportunity to spend more on productive improvements in infrastructure. Yet this argument is not so clear-cut.

Governments face numerous constraints in expanding spending, and it’s not clear that lower interest rates are, in and of themselves, a slam-dunk case for rapidly increasing spending. To see why, examine the role of corporations when facing similar situations. Initial financial research on corporate decision-making suggested that corporate investment should be highly responsive to changes in interest rates. By affecting the cost of borrowing, lower interest rates can dramatically change the cost of financing new projects. One might expect, therefore, that lower interest rates would spark large increases in corporate investment. Interestingly, the new economic literature has found this not to be the case.

While lower interest rates increase corporate investment to a degree, they are far from being the sole determinant of investment rates or levels. In part to try and explain this empirical finding, a wave of new research in corporate finance has tried to dig into the actual decision-making process within corporations. There are several reasons to suggest that the link between interest rates and corporate investment may be somewhat weaker than what was originally assumed:

1) Investments are irreversible. As Avinash Dixit and Robert Pendyck have emphasized, the fact that investments cannot be easily reversed has large implications on firm activities. Many large investments commit firms to make expensive decisions in an uncertain environment. Correspondingly, firms may be reluctant to invest even if borrowing costs are low, because they do not want to be tied to a particular investment in the future.

2) The Cost of Waiting. As Raj Chetty (someone whose work has been previously featured at e21 here) points out, lower interest rates have multiple effects. Certainly, they lower the cost of undertaking an investment today. But they also lower the costs of waiting until tomorrow.

That is, a firm facing low interest rates has more options moving forward. It can take advantage of low rates by making a large immediate investment, just as it can also delay that investment until it has more information about an evolving business climate – and it may still be able to take advantage of low borrowing costs. As Chetty estimates, this factor can mean that, at very low interest rates, firms may actually delay investments as interest rates fall further.

3) Hurdle Rates. As Tyler Cowen points out, firms rarely invest purely on the basis of interest rates. Frequently, they impose internal “hurdle rates” that correspond to a pre-specified rate of return that the firm demands before undertaking an investment; say, 20%.

There are many reasons that firms impose such constraints. It may be that managers are over-confident, or that they overpromise the return on projects generally, so the investment evaluation process is more rigorous and tighter restrictions are placed on what investments will actually get funded. Alternately, firms may be worried about the potential for losses, and compensate by requiring or targeting higher rates of return.

4) Agency costs. The corporate managers that set investment policy generally own very little of the firms they manage. As a result, they may pursue investments that are in their interests rather than those of shareholders. (See Jensen, 1986) This problem is several orders of magnitude greater in the public sector given the many layers of bureaucracy between the taxpayer and the infrastructure project. Taxpayers have very little assurance that only the highest value projects would be funded, or that the price of the construction contract would reflect tough negotiations.

Whatever the reason for firms’ behavior, the upshot is that the cost of capital is not the sole constraint holding back investment. Moderate drops in interest rates will certainly raise the net return on a given investment by reducing future interest outlays. But if the project was not close to the hurdle rate to begin with, the firm may be no more likely to invest in the project given a change in interest rates.

In trying to understanding the relationship between interest rates and corporate investment, one can glean some lessons for how the government should think about or evaluate similar situations. Just as corporations do not always find it wise to rapidly increase investment when interest rates are low; so the government should be appropriately cautious as well.

In particular, the government faces the same problems as the private sector when considering investments in infrastructure. Infrastructure investments are large and irreversible. Government projections of the value of infrastructure investments may also be prone to overconfidence, suggesting that imposing a relatively high hurdle rate may be appropriate. Finally, low interest rates lower the cost of delaying projects. (For example, the government will likely also face low interest rates in the near future.)

And when it comes to horrible investments, no amount of interest rate reduction makes the project sensible. Presumably, Ezra would not advocate additional foreign wars now, because lower capital costs make them easier to finance. It is unlikely that there are a vast number of government projects that were unprofitable at 5% interest rates, but have now suddenly become phenomenal ideas.

Even in the field of infrastructure, many spending programs are not slam-dunk propositions. The Big Dig project in Boston, for instance, has wound up costing many billions more than projected, while yielding traffic benefits that were less than advertised. Estimating the costs and benefits of any government program often proves to be a challenge, as does executing them on a reasonable timeframe. Lower capital costs do not ease these constraints.

None of this is to suggest that general investments in infrastructure are inappropriate. Legitimate investments in infrastructure – when evaluated using solid cost-benefit analysis – certainly ought to be financed. But if the government is to think like a corporation, it should consider the same structural problems that real corporations do, along with the cost of capital. Finally, if thinking like a corporation is a plus generally, the government ought to consider privatizing more infrastructure spending (or relying more on private capital, as this e21 Commentary suggests).

Christopher Papagianis is the Managing Director of e21 and was Special Assistant for Domestic Policy to President George W. Bush. Arpit Gupta is a Research Coordinator at Columbia University, where he focuses on consumer finance, real estate, and banking.