Carney on Business Investment: You Read It Here First

Nine days ago, I posted about private non-financial corporations accumulating cash rather than investing in Canada. A week later, the Bank of Canada’s Monetary Policy Report (MPR) noted “the relatively high level of liquidity held by the non-financial corporate sector and weak investment” (page 19).

By my count, the document expresses concern eight separate times about anemic business investment. It acknowledges the point I have been making about capacity utilization, suggesting that business investment “is likely to remain sluggish relative to previous recoveries, owing to high levels of unused industrial capacity” (page 11).

But then the MPR changes tune: “Nevertheless, business investment is expected to increase to levels consistent with previous recoveries, driven by the need to expand capacity and to increase productivity in a more competitive international environment” (page 23). Mark Carney repeated this language in his remarks.

The two statements seem almost contradictory. Don’t the “high levels of unused industrial capacity” obviate “the need to expand capacity”?

The line about productivity and competitiveness is also questionable. Neoclassical economics suggests that business managers always try to maximize profits, with or without international competition. They will make a productivity-enhancing investment if the resultant cost savings are expected to exceed the investment’s cost.

Does the Bank of Canada subscribe to an alternative theory of corporate behaviour? Does it believe that business managers are lazy and try to achieve cost savings only when prompted by international competition? Does it think that productivity is an end unto itself for corporate Canada?

International competition is a double-edged sword. Companies could build capacity here to supply not only Canadian markets, but also foreign markets. Or they could build the capacity abroad to supply both Canadian and foreign markets.

There is no prima facie reason to expect “a more competitive international environment” to increase investment in Canada. In recent years, such competition instead seems to have shifted investment overseas.

The central bank’s mystifying words may simply provide cover for its actions. Two days before the MPR, the Bank of Canada raised interest rates again. This policy encourages cash accumulation and discourages investment in three ways.

First, higher interest rates mean higher returns on cash balances and higher costs on loans to finance investment. Second, higher interest rates diminish the possibility of inflation eroding the value of cash balances and hence the incentive to invest in physical assets as a hedge against inflation. Third, higher interest rates push up the exchange rate, which increases the relative value of Canadian cash holdings but reduces the competitiveness of Canadian production and exports.

The Bank of Canada is serving up anti-investment policy with a side of pro-investment rhetoric.


  • Hi Erin,

    I really enjoy reading your work. It seems that, on the one hand, rising interest rates are an anti-investment policy. But on the other hand, it seems there are dangerous factors at play with regards to low interest rates. I’ve followed your coverage of BoC decisions since around 2007, and it seems that low interest rates has negative consequences which are largely neglected in your posts.

    I would like to hear your thoughts on what low interest rates mean for the working class with regards to household debt (specifically tied up in mortgages). Because housing purchases have gone up as a result of these rates, but any subsequent rise clearly places increased stresses on these new homeowners. Hope this is clear. Thank you!

  • I can’t figure out what macro-model Carney has running around in his head. Given investment and capacity utilization rates (both leading indicators?) increasing interest rates would seem counter productive. Maybe he just does not believe a 1\4 point here and there will have any meaningful effect on investment. If that is the case I really want to know which macro model is running around in his head.

    If it is housing he is worried about and or consumer credit there are much more targeted and effective ways to rein those in. And the house price index suggests that the government should be thinking of increasing the mandatory down payment amount. Of course given the political cycle the last thing Harper wants to do is throw a wet blanket on housing values and accessibility. So a little fictitious wealth creation in the face of what in reality is a lack-lustre economy going forward.

  • Thanks, Matthew. I agree that low interest rates have contributed to excessive real estate prices and mortgage debt.

    However, as Travis notes, that problem can be targeted without subjecting the whole economy to higher interest rates. Specifically, the federal government can regulate mortgage lending directly through the Canada Mortgage and Housing Corporation. Ottawa has taken a small step in the right direction, but I would advocate going further.

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