Cost of capital for industry and banks

by Robert N. McCauley, Steven A. Zimmer

*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.