by Tyler Cowen
on July 18, 2012 at 4:10 pm
in Economics |
In the IS/LM framework many…are using, doesn’t this mean that we are getting “growth” by firms investing in projects with a negative NPV now made profitable by an even more negative discount rate?
Here is more from Angus.
Wouldn’t it still have to beat, at worst, the hurdle rate of “investing” in a pile of cash?
Yes it would. And that hurdle rate is currently -2% real (interest rate on cash less inflation). And that rate looks to be with us a couple more years.
So the question is a good one, are companies investing in projects with a NPV of -1%, and are we calling that ‘growth’?
But -2% real is still 0% nominal. Financial analyses I’ve performed have all been in the nominal arena, with inflation not counted as a reduction in the IRR. Therefore, a project that loses money, still loses money.
Corporate investments’ discount rates would probably be at a premium to the government bond being referenced, so a negative reference rate may just mean a slightly lower positive discount rate for the company, so the issues you two bring up wouldn’t come into play until the reference rate was much deeper in negative territory.
In my experience, non-financial companies doing capital investment have a discount rate between 30% and 100%. Economists, simply don’t realize how absurdly low financial interest rates really are relative to the rates for capital.
When equilibrium nominal/real interest rates are negative, as is likely the case now, it would imply low expectations for future investment demand, which suggests a poor business environment for some time out. Even if we assume that the real cost of capital for these companies is as negative as the government’s is — Lou brings this point up — I think the NPV values could be depressed by the forecasted weakness in cash flow. The cost of capital is not independent, in other words, of NPV because both are partially determined by broader macroeconomic conditions and expectations of future conditions. If things turned up, then even as businesses’ cost of capital rose, I wouldn’t say that the result is structurally-higher NPV in the funded businesses — it is cyclically-higher NPV. On an empirical basis, there is actually some evidence that businesses founded during recessions tend to have better long-run outcomes (http://www.economist.com/node/21542390). Remember, even if the cost of capital is low, access to capital is heavily restricted during recessions.
Or maybe, like the Japanese, US companies are investing with negative nominal growth rates in anticipation of the future. I find this whole debate confusing since Keynesians are supposed to be against deflation–so why is the Fed not inflating more? A real conundrum as Greenspan would put it. And in other news…Canadians net worth of $320k USD just surpassed the average American’s.
The hurdle rate/discount rate is the firm’s cost of equity. Is the cost of equity lower now than it has been before? Interest rates are, but it does not necessarily follow that cost of equity is.
After all, the narrative in the mainstream media is that “uncertainty” is causing firms to restrain investment. This is just another way of saying that their cost of equity is too high to justify investment.
Also, as a separate point, what firm has a negative cost of equity?
However, certain governments do have negative costs of debt, even on real terms (U.S. and Germany). Wouldn’t that imply that these firms are massively underinvesting? After all, they could borrow $100 (in real dollars), sit on it for a year, and pay back $(100 – X) (also in real dollars), and pocket X. Or they could cut taxes by X.
“However, certain governments do have negative costs of debt, even on real terms (U.S. and Germany). Wouldn’t that imply that these firms are massively underinvesting? After all, they could borrow $100 (in real dollars), sit on it for a year, and pay back $(100 – X) (also in real dollars), and pocket X. Or they could cut taxes by X”
This is exactly the point that Krugman, Summers, DeLong, and others have been making. The US is basically getting free money these days and why not put it to work. I also think that economists are making the analysis of the current situation way too difficult. You can do all the modeling you want and come up with fancy equations but if the demand is not there, there will be no investment. Most of the business surveys I’ve seen mention demand as the number one issue and not uncertainty (whatever that may be defined as).
He said “sit on it”, not spend it.
Is infrastructure improvement ‘spending’ or ‘investing’?
Could spend it too, so long as there is a project that costs $100 but generates at least $(100 – X) in value.
Could also cut taxes.
Either of these options would be preferable to doing nothing.
I think the “real” terms are debatable.
Better to do NGDPLT and not have the ZLB issue.
A negative NPV could be driven by all sorts of factors, so let’s switch to explicitly discussing a project which outright loses money over time. That’s not an investment, it’s consumption. Since it is correct to consume when doing so is the least expensive on a present value basis, there’s no problem with the IS/LM model’s assumptions. Think of say, anonymously sponsoring an artist. There’s no financial benefit to doing so; it’s clearly consumption. But it still makes the most sense to do this when the opportunity cost is (as today) close to zero than when you could instead be making very profitable investments with the same money.
The investments don’t raise the economy’s long term growth rate. But they do move the economy toward full employment–a one time increase in output. “Growth” might be the wrong word but it’s not really a paradox we’re talking about here. The guy’s blog post also asks how you can increase the inflation rate without increasing nominal interest rates one for one. The reason that doesn’t happen is because, by assumption, the central bank is supplying liquidity to “artificially” hold interest rates down, partially undoing the effect of the increased inflation expectations on long term rates. It is the combination of higher inflation expectations and a policy interest rate of zero that is called for in the liquidity trap situation. The higher inflation rate makes the 0% policy rate stimulative, that encourages investments with low or negative return, and moves the economy toward full employment. Tada!
OK so I have a question. I have $5M and am considering two possible investments:
Investment A: High-end movie theatre. Huge IMAX screens, beer and wine served, nice, expensive seats etc. Tickets will cost maybe $25 per person per movie.
Investment B: House Repo Business: On behalf of banks that foreclosed on homes, I will go in and clean the places out, kick out squaters if needed. Auctioners will sell off usable furniture. If a home can be quickly sold or rented we will clean it up, get it on the market and close the deal fast. For homes that can’t we’ll rip out all the valuables like copper pipes, demolish the home and give the bank a clean, empty lot to hold as inventory or sell.
Now I’m going to calculate the NPV on both of these projects. Tell me, will it not make a difference if the city I’m doing this for will have an unemployment rate over the next ten year averaging 3% or 15%?
It definitely encourages negative NPV projects on a real return basis, although not nominal because holding cash would then be better. It’s hard to transfer value into the future. We’ve been lucky to get positive returns in the past, but there’s nothing natural about it. In most of nature storing resources is costly (crops go bad, acorns get lost, you have to spend energy lugging around fat), which is the same thing as saying there’s a negative real return. In that situation slightly negative NPV projects can be great if it lets you reliably store value, and that can be really important for a declining/aging population like Japan.
On nominal rates – If inflation goes up and nominal rates stay at 0, it means that real rates are dropping, encouraging even more negative NPV projects. This is stimulative, so longer term rates should go higher. However, in the short run fed funds will remain at 0, meaning nominal rates don’t increase there.
Economists simply don’t realize how huge the discount rate that non-financial companies actually use for capital expenditures.
In my experience they expect between 30% and 100% for new capital expenditures.
I agree with the sentiment, but 30% to 100% seems high in my experience. Are you saying a typical company would reject a project with a 25% projected IRR?
(Of course, the caveat is what risk profile you’re talking about. If you mean a 30% IRR on a very risky project, then sure you’re right. But if you’re talking about a low-risk project, like those undertaken by utility companies, then clearly 30% – 100% is absurd).
What people don’t realize is that the way out of the liquidity trap is not to lower the interest rate to its current negative equilibrium, but rather to raise that equillibrium rate to a positive level. Keynesians don’t fully acknowledge (notwithstanding Woodford) that investment is driven by rational expectations. This is one of the bones that Scott Sumner regularly picks with Krugman; we actually don’t need that much inflation. Low rates (and low equilibrium rates) are a symptom of tight money, of a policy that has set the wrong expectations. I think one of the barriers to Market Monetarism’s acceptance is how counterintuitive its analysis can be, despite emerging from the most mainstream theory.
Again I think the problem here is the assumption that the NPV of any given project or investment is some type of fixed amount. I don’t see how that can be. The NPV is fixed in real terms if you mean actual goods or services. A set of new machines at an ice cream shop will produce so many cones over their lifetime compared to the old machines. But NPV asks the question of what cash flow that machine will produce and when the interest rate is 0% that’s a very easy calculation, it’s simply the sum of all the cash coming in minus all the cash you have to put out.
That runs right smack into the question that the cash coming in depends entirely on whether or not you’re going to sell any ice cream cones and for how much. Yet this question seems to assume NPV is some type of constant totally disconnected from the larger economy.
If you assume a negative NPV, you are assuming your conclusion, but if you assume this, it means you believe there are many positive NPV projects that are not being funded so why aren’t you investing in them? You may say it is because you don’t know if they are positive NPV but isn’t that what investment is? You may say it is because they are not ready yet, but if they are not ready now will they ever be?
I think the anti-Keynesian perspective is, in fact, that right now there are no non-negative NPV projects out there. We are either in a period of stagnation due to lack of innovation (Tyler), indigestion from too much ‘bad’ investment from during the boom (Austians) or plauged by some fuzzy uncertainity because capitalism just can’t work unless a Republican is in the White House (the vapid right wing punditry industrial complex).
The problem I think is clearly trying to think about maco questions iwth a micro mindset. On the micro level an investment’s NPV is usually an absolute value of some sort. It may be difficult to know ahead of time, but adding a new wing to a hotel will either be profitable or it won’t, a new taco place will either take off or it will falter, people will either flock to the latest Batman movie or it will bomb. On the macro level, though, NPV is clearly not an unchanging amount. The taco place’s failure may become a success if unemployment rapidly drops in the area. The hotel addition may become profitable if the country is able to devalue its currency making it cheap for tourists to come there.
The anti-Keynesian arguments I’ve seen seem to reject that point of view. To them the NPV of the hotel addition is either good or bad. If it’s bad, then profits that result from a currency devaluation do not refute their theory but are simply a ‘distortion’, for which there will eventually be hell to pay. What I’m unclear about, though, is how this school of thought purports to know this and how NPV’s exist as absolute, unchanging numbers rather than variable ones.
They usually put this as there will be profitable opportunities in the future but we have no idea what they may be now and it just takes time for them to be discovered or invented and grow and mature enough to make investment worthwhile. They somehow think these opportunities just occur over time out of the blue but they are the result of much investment, much of which will have negative NPV and which they see as too risky to attempt and future bad investments. Entrepreneurs fail more often than not but they only look at their cost and don’t realize these are necessary to succeed, and if there are no investments worth making it is the result of too few being attempted, not too many.
Cash is better. This is why interest rates get sticky at ZLB — negative rates just don’t make much sense.
I mentioned at Scott’s place that this explains why, counterintuitively, money can be especially tight at lower interest rates — if expectations are deflationary, then real interest rates may actually be higher, and that stickiness tends to drive the gap wider.
An obvious counter to that would be “but inflation isn’t negative; expectations aren’t deflationary.” The answer to that is “you don’t actually know what inflation is, or even really what it means — can such a multivariate concept really be boild down into a single number? Hedonic adjustments are little more than guesswork.” And the number is probably wrong — does anyone really think living standards at a given “real” amount of money haven’t gone up since, say, 1972?
It’s OK for firms to invest at negative real rates. Consider the following:
1. Even at a negative risk-free real rate, most startup investments will have a high enough risk premium to make the investment have a positive IRR in practice.
2. Profit is only one measure of economic well-being created. There are two others – labor producer surplus, and consumer surplus. People who supply labor for the new investment will get producer surplus; many people vastly prefer having a job to not having a job. Consumers who buy the new stuff the investment creates will get consumer surplus.
3. New investment by one firm has positive effects on the profitability of other firms. Standard demand story.
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