Comparing Cost of Capital Across Countries

Robert N. McCauley is Research Officer and Senior Economist, International Finance Department, and Steven A. Zimmer is Senior Economist, International Capital Markets staff, Federal Reserve Bank of New York.

1 See footnote at end of text.

A relatively high cost of capital burdens U.S. industry and banks alike. The effects of high capital costs on capital formation in the United States are hard to demonstrate, but are believed to be important, especially in research-intensive high technology industries. The inflow of foreign direct investment into the United States in the late 1970s and the 1980s fits with a cost-of-capital interpretation. Cost-of-capital differences assert themselves with particular force in competition in wholesale banking. How foreign banks will respond to the effect Of recession on the cash flows of U. S. corporations is important, because a high cost of capital has shrunk U.S. banks' market share.

IT IS EASY to come away from a reading of the growing body of work comparing capital costs across countries with a question as to the possible consequences. Pairs of analysts perform research on the subject as if the exertion requires a team in harness.(1) The teams seem to arrive at estimates of the cost of capital not just lathered but also winded by the long run of calculations.

Comparing cost of capital across countries elbowed its way onto economists' research agenda from the outside, as it were, from business. Most economists who work on cost of capital are tax experts whose faith in the equalization of all prices of interest across all markets is undisturbed by any attempt at measurements.(2) The convenient consequence of his faith is that tax wedges remain the only matter of interest.

The Semiconductor Industry Association commissioned a study in 1980 of capital costs in Japan and the United States. Concern over the ease with which Japanese firms were making the massive investments required for the next generation of chips motivated the investigation. Later, as the U.S. deficit in international trade widened, so did interest in cost of capital. The flaws of the Semiconductor Industry Association's report and a later pass on the subject by the Commerce Department(3) drew economists to the project. To this day, cost of capital comparisons get more attention at gatherings of the American Electronics Association than at gatherings of the American Economic Association.

WHY CAPITAL COSTS MATTER

Capital costs influence two kinds of investment. First, capital formation depends on capital costs, which may be thought of as setting the required payback period for investment projects. Capital costs also shape direct investment flows.

Capital Formation

Capital costs matter to the level of investment in an economy, and the level of investment per worker matters for the growth of productivity and therefore living standards. On the latter connection the evidence is fairly impressive: the strength of investment spending bids fair to explain cross-country differences in productivity.(4) On the connection between capital costs and investment, most macro-economists will readily admit that capital costs do not add much to a simple accelerator model of investment in explaining investment over time in a given country.(5)

The cost of capital as we measure it bears a striking relation to investment performance of the United States, Japan, Germany, and Britain (Charts 1 and 2).(6) The juxtaposition raises the question of whether it is fair to test the efficacy of cost of capital in the usual fashion. The time series evidence on investment from single countries is unsurprisingly dominated by the business cycle, which may obscure the effect of cost of capital.

The cost of capital advantage enjoyed by Germany and Japan arose from quite different sources. Germany's short-term