A growing theoretical literature has focused attention on the impact of risk on investment, and has suggested that the impact may be large. The reason is that most investment expenditures are at least in part irreversible - sunk costs that cannot be recovered if market conditions turn out to be worse than expected. In addition, firms usually have some leeway over the timing of their investments they can delay committing resources until new information arrives. When investments are irreversible and can be delayed, they become very sensitive to uncertainty over future payoffs. For example, in a simple and fundamental model of irreversible investment, McDonald and Siegel (1986) demonstrated that moderate amounts of uncertainty consistent with many large industrial projects could more than double the required rate of return for investments. Hence changing economic conditions that affect the perceived riskiness of future cash flows can have a large impact on investment decisions, larger than, say, a change in interest rates.
This theoretical literature and the insight it provides may help to explain why neoclassical investment theory has so far failed to provide good empirical models of investment behavior, and has led to overly optimistic forecasts of effectiveness of interest rate and tax policies in stimulating investment.' It may also help to explain why the actual investment behavior of firms differs from the received wisdom taught in business schools. Observers of business practice find that the "hurdle rates" that firms require for expected returns on projects are typically three or four times the cost of capital. In other words, firms do not invest until price rises substantially above long-run average cost.
But most important for this paper, the irreversible investment literature suggests that if a goal of macroeconomic policy is to stimulate investment, stability and credibility may be much more important than the particular levels of tax rates or interest rates. Put another way, if uncertainty over the evolution of the economic environment is high, tax and related incentives may have to be very large to have any significant impact on investment.
If this view is correct, it implies that a major cost of political and economic instability may be its depressing effect on investment. This is likely to be particularly important for developing economies. For many LDC's, investment as a fraction of GDP has fallen during the 1980's, despite moderate growth. Yet the success of macroeconomic policy in these countries requires increases in private investment. This has created a sort of Catch-22 that makes the social value of investment higher than its private value. The reason is that if firms do not have confidence that macro policies will succeed and growth trajectories will be maintained, they are afraid to invest, but if they do not invest, macro policies are indeed doomed to fail. This would make it important to understand how investment might depend on risk factors that are at least partly under government control, e.g., price, wage, and exchange rate stability, the threat of price controls or expropriation, and changes in trade regimes.
Our aim in this paper is to explore the empirical relevance of irreversibility and uncertainty for aggregate investment behavior. We will be particularly concerned with the relative experience of developing versus industrialized countries. Although there is considerable anecdotal evidence that firms make investment decisions in a way that is at least roughly consistent with the theory (e.g., the use of hurdle rates that are much larger than the opportunity cost of capital as predicted by the CAPM), there has been little in the way of tests of the theory. In addition, there have been few attempts to determine whether irreversibility and uncertainty matter for investment at the aggregate level.
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