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Do lower interest rates increase investment? - Outside View by Asad Dossani

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Do lower interest rates increase investment?
Feb 8, 2011

The most common tool for stimulating an economy during a downturn is lower interest rates. Similarly, to slowdown on overheating economy, especially one with high inflation, higher interest rates are put in place to reduce investment. What is the rationale behind this? The theory goes likes this: Lower interest rates reduce borrowing costs, and this makes it more profitable to borrow money and invest it. Therefore, lowering interest rates in an economy should encourage greater investment, and pull the economy out of recession.

Most of the developed world has extremely low interest rates. The USA, Eurozone, UK, and Japan have interest rates that are at some of their lowest levels in history. This is combined with quantitative easing programs, which are lowering interest rates at longer maturities. The purpose of all of this is to increase investment by lowering borrowing costs. This policy has been in place for some time now, so why hasn’t a big boom occurred? Why are the economies still in the doldrums?

While borrowing costs are certainly an important decision for anyone looking to invest, it is not the most important one of all. In fact, there is another factor which is much more relevant and important. It is something that the government itself has very little control over.

The most important determinant of investment is the willingness to take risk. Investment and economic activity goes up when people are more willing to take risk. Conversely, investment goes down when people are less willing to take risk. Every investment opportunity involves some risk so this is important. The willingness to take risk is highly correlated with the current economic situation. If an economy is in a recession or in a downturn, people expect tough times ahead, and so they are less willing to take risk. When the economy is booming, people expect more good times, and become more willing to take risk.

What has happened in developed economies since the financial crisis is that they have become less willing to take risk. Because people foresee more bad times ahead (especially due to high public and private debt levels), they are not willing to take as much risk. So even though borrowing costs have come down, investment has not gone up in response.

In contrast, emerging economies have seen high capital inflows in the last couple of years. Economic optimism is higher in emerging economies; hence the willingness to take risk is much higher. It is fascinating just how t investors’ willingness to take risk and their level of confidence and optimism have such an important impact on economic prosperity.

While low interest rates do have an affect on investment through lower borrowing costs, it is much less important than investor confidence and willingness to take risk. The challenge for governments is to improve investor confidence in their countries. This is of course easier said than done.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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