Deficits, investment demand and interest rates
Would increases in government borrowing will be counteracted by increased savings in the private sector?
One argument used against deficit spending is the Ricardian equivalence hypothesis: that any increase in government borrowing will be counteracted by increased savings in the private sector.
This has been mainly applied to household behavior, but there is really no less reason to assume that it can't be applied to the behavior of corporations as well, as deficits increase the risk that they will have to pay more in taxes and/or receive less subsidies.
Paul Krugman, who the latest months has been waging a relentless battle for more deficit spending, has been trying to argue against this by claiming that no evidence exist for any "Ricardian equivalence" behavior among corporations. While he acknowledges that business investments are indeed at a record low level, this according to him simply reflects a normal response to a high "output gap".
Since no clear definition of the "output gap" exists (Ask 50 Keynesians and you'll probably get at least 60 definitions), I'll leave that aside and use the proxy of capacity utilization.
It is of course true that low capacity utilization is a factor which will significantly depress business investments, as it makes no sense for a entrepreneur to buy new machinery or build a new factory if you already have it. It is also correct to argue that the current low capacity utilization is a significant factor explaining low investment spending.
However, Krugman overlooks that low investment demand will lower interest rates. That in turn has two implications: First of all, low interest rates will other things being equal increase investment demand, thus to a significant extent canceling out the investment lowering effect of low capacity utilization. Or in other words, like any shift in demand or supply, the effect on the price will reduce the effect on quantity.
And secondly, the fact that investment demand is low is a key (but not the only one) explanation why Treasury bond yields have remained low despite the hugh budget deficit. This implies that the budget deficit nevertheless has had a significant yield increasing effect ceteris paribus. If the deficit had been lower than interest rates would have been even lower, increasing investment demand.
And finally, while the "Ricardian equivalence" effect on investment demand can't be exactly quantified given the many other factors involved (like interest rates and capacity utilization), there are good theoretical reasons to believe in it, and especially given the low interest rates and the fact that capacity utilization is in fact higher than during the 2002 lows, no good reason exist to dismiss its existence.
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