An econ 10 question?

Reading through an old copy (September 2007) of the Journal of Economic Literature I found a review by Randall Morck of "The fable of the Keiretsu: Urban Legends of the Japanese Economy" by Yoshiro Miwa and Mark Ramseyer. The review was mixed, Morck celebrated that the authors debunked some of the myths about the Japanese economy and showed that it works largely like everyone else's, but was disappointed that they went too far and pushed some fallacies of their own.



What really caught my attention were the reviewer's comments on the book's economic reasoning. In fact, I'm somewhat confused about what Morck meant. He quotes:

"But the most remarkable aspect of the Fable of the Keiretsu is its economic reasoning. Its explanation of why state-subsidized loan programs "need not (and in Japan most certainly did not) increase investment." (p. 142) is worth quoting verbatim from pp. 142 and 143:"

To see why the programs would not have increased investment, take Figure 6.1 [reproduced as figure 1 below {in the journal review}]. The downward sloping line gives the investment function for a hypothetical firm - I(p), the amount of which depends on the imagined rate of return on investment. At the market interest rate, rm, for example, it will invest I*. With access to cheaper funds, [the firm] will invest more. Hence the obvious intuition: by lending money at sub market rates, the Japanese government coule promote investment in targeted industries.

Unless the government either lends all the funds a firm needs or makes its loans explicitly conditional on a firm making investments it would otherwise find unprofitable (and the Japanese government seldom did either), the intuition is wrong. Suppose the government agreed to lend a firm all amounts it wanted at rate rg (below rm). Then firms would expand its planned investment from I* to I**. Suppose instead, that the government will lend only Lg (below I*) at rg. The firm will happilyborrow the cheap money from the government, but it will merely pocket the savings (given by [rm - rg]*Lg). It will not expand investment and thereby its productivity capacity. Because it will not borrow all the money it needs from the government, to expand it must borrow on the market. For that money, however, it must pay rm. Because it borrows on the margin at rm, it still invests only I*.

"At least here your reviewer finds terms like "exaggerated," "biased," and "misleading" not quite up to the job." Journal of Economic Literature, September 2007 Vol. XLV, Number 3, pp. 764-765.

So, here's where I'm confused: Miwa and Ramseyer's reasoning sounds reasonable. After all, we're continually told to think on the margins in econ classes, but I can see a couple ways that they would be flawed. The first thing I thought was that the market for loanable finds could be moved by the government entering it, therefore the market interest rate ends up somewhere lower than rm but higher than rg, and therefore government intervention would indeed lead to an increase in investment. It wouldn't be as much as rg might imply, but it would definitely increase. Isn't this, after all, what the Fed does? Or, perhaps, rather than treating rm as the marginal interest rate, rg should be. Of course firms would want to borrow cheap money first, but this excerpt doesn't indicate whether the government acted as a normal lender that businesses could go to first, or as a lender of last resort that firms could only go to after other options had been exhausted.

I very much wish Morck had explained why he felt this example of reasoning was so "biased" and against what. Maybe I'm just daft or under read and this is a textbook example they got wrong that everybody reading an econ journal should know? Even in that case, though, at least a sentence would have cleared that up for me, or at least pointed me in a direction to look for clarification.