Monday, 1 December 2008
I read Paul Krugman's latest NYTimes column (via Economist's View) and it got me wondering. Why does crowding out not happen?
In other words, why does an increase in long-term public debt not result in a reduction in long-term business investment? There's a school of thought which argues that there is money which would otherwise go into productive private investment, but instead is diverted into lending to government (which is likely to lead to less productive spending). Due to less money being available, this pushes up the price of borrowing for businesses and means some otherwise-viable investments will not happen.
Krugman gives part of the answer - that a (successful) stimulus encourages economic growth which in turn makes business investment more, not less, likely.
But there's another reason. This is that business investment is not happening anyway. There is not a large pool of money going into long-term business investment now. Why? Because investors weight short-term returns much more highly than long-term returns, and there are few short-term returns around in a recession.
There are two reasons for this, which I believe are linked.
The first is informational. It is very hard to predict the future in an environment like this. It becomes exponentially harder as you go further out. Even if we are confident of an overall return to growth in a couple of years, it is still very tough to predict the performance of any individual investment opportunity. Think of the weather. We can predict that in April it is going to be warmer than it is now. But nobody can tell me the exact weather in a given place or on a given day even 8 days in advance.
When uncertainty is high, there is a premium on short-term returns because they reduce risk, but also because they are a signalling mechanism. If a project is capable of giving a return quickly, it more quickly proves that it is viable in principle. It's much easier if you can see the money start to flow in three months, to believe that it is going to keep flowing thereafter.
The second reason is behavioural. We all put a high discount on returns in the near term. The most famous experiment which shows this is to offer people $100 now or $120 in a year. They are much more likely to take $100 now, even though 20% is a pretty impressive interest rate. But offer them $100 in three years or $120 in four years, and their preferences reverse. They are more likely to take the $120 in four years, even though it is still a 20% return - and even though they can see that three years from now, they will be in exactly the same position as the first offer puts them in today.
So people have a high discount on returns in the present, even though this is, in economic terms, irrational. It is plausible that there are biological reasons for this - the juices start flowing when you smell that steak, and your body wants to build up its fat stores.
However, I think actually that this is a deep-rooted human instinct originating from precisely the informational problem given above. In most imaginable contexts in which a human could live, information is at a premium. Mostly, the person offering you something now might not be around in a year, or at least you won't know where to find them. This, combined with the short-term nature of our memories and predictive systems, encourages us to act in the moment and forget - or discount - the long term.
Two final notes of interest. First, it seems that people's ability to think long-term and overcome their discount-of-the-now instincts improves as they get older. So even though an older person has less of a future to think of, they spend more time thinking about it. Perhaps reduced supply increases the price of future life, or perhaps they are just smarter.
Second, it would be interesting to know if the limbic (emotional) system in the brain has a specific short-term bias. I suspect that decisions influenced by it are made with a short time horizon, partly because its decision-making mechanisms are only capable of considering the very near future. If anyone has any knowledge on this please post a comment; I have a future post coming on decision-making which will draw on this.