I have recently encountered an analysis made by an investment advisor working in a big bank. I heard a very odd point: if Japan raises its interest rate, it may encourage more investment in this country. I don't know if you have learned some basic macroeconomics. If yes, I guess you will also find this assertion odd as all we have learned from macro is that interest rate will discourage investment, not encourage it.
So, why this investment advisor makes the point above? Obviously he is not someone ignorant of basic macro, or he will not be qualified for his job. We can't just say: he must be wrong. So, let's first assess what he has said.
His point is this. Japan has long adopted a policy of low interest rate, actually nearly zero interest rate. This policy drives out a lot of Japanese money, which would rather invest overseas for a higher return. Now, Japan has prepared to increase its interest rate. This hasn't happened for a long time already. This will attract investors back to Japan as they now can enjoy a higher return, at least not zero return. Therefore, they may invest in Japan and the economy may be stimulated. In fact, this investment advisor has used this point to explain why Japan would allow interest rate to go up when its economy is bad. His point is that raising interest rate may have a positive impact due to the above reason (though other factors may also matter).
Hence, do you think this investment advisor has made a sensible point, if you have some basic macro knowledge? Perhaps you do. Then, how can we reconcile the two perspectives, the advisor's and the macro's?
Perhaps it is simply that the investment advisor has used different terminologies from that are used in our basic macro courses.
If you still remember, in macro, investment refers to capital investment or physical investment. Under this definition, more investments means that extra machines have been used and more factory buildings are built. In macro, for investments, we mainly refers to capital goods like these. Investment is about additional capital goods used.
On the other hand, the investment advisor, I believe, refers "investment" to fund flows, or financial investment, such as money spent on (or "invested" in) buying stocks, bonds, mutual funds, etc. Why do I say this? Why do I think he should refer mainly to "financial investment" instead of "capital investment"? This is because only financial investment will increase with interest rate. Capital investment will not. For example, bond yield is the interest rate on bonds. If it is higher, "investors" want to hold more bonds for its higher return. This is what we have learned from macro. In contrast, when a company needs to buy a machine (makes capital investment), it may need to borrow new money by issuing corporate bonds. But if bond interest rate is higher, the company will hesitate as it needs to pay back more money when the bonds mature.
Thus, the investment advisor's point is sensible? He is just not using terms same as ours?
Well, there is still a problem. If he refers to "financial investment" only, how can he say that a higher interest rate can help stimulate the economy? Capital investment can stimulate the economy. It is a component in GDP. But financial investment is not part of GDP. More financial investment may make the stock market price go higher. But the economy may still be bad. It is common that stock market is hot but the real economy is not.
Well, perhaps he means that when the financial market is hot, the real economy will be eventually stimulated. It seems that many laymen also have this idea in mind: if the financial markets perform well, the real economy will also eventually perform well as people profiting from their financial investment will consume, or even invest, more in the real economy.
This may be a folk wisdom. Is this true? It does not seem to be often true. For US, I guess this is by and large true. But this is not quite true for China, in which its GDP high-growth period is often accompanied with a stagnated stock market. Will this be true for Japan? Is the investment advisor's analysis based on his study in Japanese economy? I guess not. Of course, I don't have evidence. But at least he hasn't indicated there is such a relation in his analysis.
Of course, financial markets are not limited to the stock market. Broadly speaking, real estate market is also included. In fact, real estate market, instead of stock market, may have a closer relation with the real economy. How closely stock and the economy are related may depend on how widely stocks are held by people in the economy. We know stocks may not be widely held in some economies, and this may matter to why the market is not closely related to the real economy. But real estates, especially residential properties, are often widely held by a majority of people. This also explains why the market is closely related to the economy.
Yet, what may be true in many economies may not be true in Japan. It is well known that real estate market in Japan is not good. Can a higher interest rate help it? If you ask this question, I think even the investment advisor above will say no. In fact, most likely he will say the contrary: a higher interest rate simply increases the burden of real estate mortgages and will discourage buyers.
Hence, I don't think the investment advisor above refers to real estates when saying a higher interest rate may help the Japanese economy. I believe he simply thinks casually like most other people: more fund flows to Japanese can make the financial markets, especially stock market, perform better and so will the economy. But as I analyzed above (I have also pointed out the fund-flow mistake elsewhere), I think this is wrong.
Yes, my conclusion is that you can't reconcile the advisor's viewpoint and the macroeconomics viewpoint. And I think the advisor is wrong. He simply takes some casual, and laymen, belief for granted without thinking deeply about the validity of the folk wisdom. I think a higher interest rate actually will harm (capital) investment and so the real economy in Japan. However, the central bank of Japan has to cope with the inflation problem and must take some actions (higher interest rate) to release the problem. It will take the action not because it thinks interest rate can help stimulate the economy. Eventually, other factors may help the economy but it is not interest rate that does this.
In fact, the investment advisor may also make another mistake: confusing the effect of interest rate on investment and saving. In macro, we know in equilibrium investment equals saving. Meanwhile, we know interest rate discourages investment (as investors borrow funds and bear the interest cost). But savers, those who provides funds for investment, will like a higher interest rate (as they earn interest income).
Hence, what a higher interest rate will attract is the savers' funds (financial investors' funds), not capital investors' demand for funds. Yet, in equilibrium, investment equals saving. So, people may easily confuse the effect on one side of the equation with another side of the equation. Yes, a higher interest rate will promote more saving. But will this automatically promote more capital investment? It won't. If the interest rate falls due to more fundings tracing few borrowers, capital investment will increase. But this is not a phenomenon the advisor intends to analyze. He refers to a higher interest rate facilitated by the central bank as a result of the monetary policy. He doesn't refer to a lower interest rate due to more saving.
In fact, from macro, we know when a higher interest rate will be accompanied with more investment: it should be investment to increase first, and then the higher demand for funds bids up interest rate. It is not the other way round, i.e. a higher interest rate causes more investment.
At this point, I hope you are convinced that the macro you have learned are useful. I use only basic macro concepts in all the analysis above. I think I offers a clearer and more likely truer analysis than the advisor.
