Wednesday, December 16, 2009
1. Above is a chart of the growth rate, from four quarters earlier, of real investment in equipment and software. Notice the left scale. Investment spending is very volatile. This is one of the standard stylized facts about the business cycle.
2. Investment has been particularly weak during this economic downturn. Weak residential investment is not a surprise, as the downturn was started by events in the housing market. But as this graph shows, business investment has also been very weak. Indeed, by the metric used in this graph, it is far weaker than in previous deep recessions, such as 1982.
3. Why is business investment so weak? Part of the reason is that the downturn is severe and investment responds to the overall economy. Part of the reason is that the credit crunch makes financing more difficult. Part of the reason is that the policy environment seems adverse to business. I am referring here to a group of policies that include higher minimum wages, the seeming retreat from free trade, proposed mandates to provide employees health insurance, higher prospective energy costs from climate change regulation, and the likelihood of higher future tax rates resulting from the huge fiscal imbalance we are now experiencing. All of these factors have worked in concert to depress business investment.
4. The recent weakness of business investment was one of unstated reasons why, in my recent NY Times column, I suggested that an investment tax credit (ITC) might have been a better form of fiscal stimulus than what we in fact are getting. Given the amount of money being spent on stimulus, the ITC could have been sizable. The measure of investment used in the chart above is about $1 trillion per year. So, to give a very rough example, if Congress had passed a 20 percent ITC in 2009, 10 percent in 2010, it would have cost the Treasury about $300 billion. Essentially, the Treasury would have picked up 20 percent of the cost of all of these investments if done this past year, and half that amount next year.
5. Some readers might wonder if this policy would work in the presence of the zero lower bound on interest rates (aka the "liquidity trap"). The truth is that we don't fully understand the role of the zero lower bound, and most of what we do know is based on stylized theoretical models with scant evidence to back them up. But those models suggest that an ITC would work just fine. The zero-lower-bound whiz kid Gauti Eggertsson in fact endorses the ITC as a plausible policy in that environment.
6. In my most controversial NY Times column, I said that what the economy needed was negative real interest rates, which could be accomplished via inflation. A temporary ITC does something similar. By temporarily reducing the effective price of capital goods, it creates expected inflation in this particular price. Under the numerical example above, the effective price of new capital would immediately fall by 20 percent, and expected inflation would rise by 10 percent. If nominal rates stay at zero, the real interest rate measured in units of new capital goods would become negative 10 percent. That is one way to view the way in which a temporary ITC stimulates investment spending.
7. So much for theory, but would it work? The cash-for-clunkers program is thought by many to have promoted, or at least accelerated, car purchases. An ITC would be similar, but it would apply to business investment rather than personal cars. Instead of targeting a very narrow, politically favored industry, it encourages investment broadly. It should have positive effects on aggregate demand in the short run and positive effects on aggregate supply in the medium and longer run.
8. Recall that an investment tax credit was part of the Kennedy plan to get the economy going again back in the early 1960s. According to historical reports, Kennedy came to this idea of tax cuts with the advice of economist Paul Samuelson, who just passed away. In memory of Professor Samuelson, if the Obama administration wants to switch gears and try a sizable investment tax credit, I propose that we call it the Paul Samuelson Memorial ITC.