Friday, 2 January 2009

Private investment by central banks

Roger Farmer has taken up my suggestion that central banks should make equity investments. OK, chances are he didn't get it from me - but his proposal is somewhat similar to mine. I explain my suggestion in more detail below.

Farmer's article has provoked much comment on economics blogs – as befits an unorthodox proposal. Although there are understandable objections to it, it is at heart a sound idea.

Most of the responses which argue against the idea use one of two grounds. First, that equity price targeting is not the government’s job. Second, that market indices are not a good way to pick the equities to be purchased (Farmer’s suggestion of the S&P 500 index would privilege those 500 companies at the expense of smaller firms outside the index). For these reasons I would also argue against the proposal in the form that Farmer makes it, but recognise the fundamental reasoning behind it. With a slightly different emphasis, the logic becomes much more compelling.

The reason for central banks to make equity investments is not in order to target an asset price. Asset price targeting is not a well-understood discipline and it seems risky for the Fed to gamble tens of billions of dollars learning about it.

Instead, the reason to do this is because the tools of monetary policy have lost effectiveness – not just because they have reached the zero interest rate boundary, but because of decision-making behaviour in the private sector.

The primary goal of monetary easing is to boost investment and consumption by reducing the cost of money. Ignoring for now the effect on consumption, private investment is meant to increase when interest rates are cut. If money costs 1% instead of 6%, many more investment projects should become viable. However, private actors are behaving as if their investments will not make any positive return at all, and therefore are not worth making.

Clearly this cannot be true across the whole economy; there are always productive investments to be made. However, investors fear that they may require short-term access to capital, which they will not have if it is invested in machinery or intellectual capital that cannot be easily liquidated.

This is a concern which central banks do not have; they can always issue additional currency if needed to meet a short-term call. The credibility of money is not – at least in theory – affected by the holding of illiquid assets, as long as they are likely to provide a return eventually.

Thus central banks should seek ways to directly stimulate productive investment in the economy. This is more likely to be achieved through private equity investments than purchases on the public markets.

A proposal has been made by Lucian Bebchuk and Itay Goldstein to set up state-backed loan funds (to be run by private fund managers). My proposal substitutes for this; it could more quickly and perhaps less controversially be financed by central banks than by taxpayers; and in either case, long-term investment is more naturally financed through equity than through debt.
Measurements of the amount of private investment in the economy are readily available (though on a less timely basis than consumer price indices) so an optimal level of investment could certainly be targeted by central banks.

If this means private companies must accept equity investment instead of loan finance, so be it; this will result in a less leveraged private sector in the short term, though companies can gear up again when the confidence of lenders revives. At this point the central bank may reduce net investment either by selling its equity stakes into the private sector or simply by ceasing to provide new funds or to reinvest its returns.

To make any such scheme more effective, we should also seek ways in which central bank funding can by multiplied – for example by co-investing with private investors, or being offered in conjunction with private lending to reduce gearing and risk.

As Farmer argues, the fundamental productive capacity of the economy is still sound and so there is no reason why equity investments should not make a good return. As long as the central bank only acts to correct clear market failure, these actions should not have a distortive effect on normal private investment.

Update: Nick Rowe of Carleton, who wrote a paper about this in the early 90s, has responded by email with a critique of this proposal - I have posted his comments here.

Update (29/1/2009): The Japanese government has proposed buying equity stakes in small to medium sized companies. Not via the central bank, but the (state-owned) Development Bank of Japan. The plan will be considered by the cabinet next month.

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