In my view, if the demand for investment falls, the natural interest rate falls as well. Assuming that the demand for money is less than perfectly interest inelastic, then the quantity of money needs to rise accommodate the increase in the demand to hold money. Nominal expenditure should continue on its previous growth path. The lower natural and market interest rate should dampen the decrease in the demand for capital goods and result in larger than usual increases in the demand for consumer goods. The resulting reallocation of resources may result in structural unemployment and slightly higher prices for a time. Worse, the slower expansion in the capital stock will result in more modest increases in labor productivity, and slower growth in real income. Given the growth path of spending on output, the result could be modest inflation.
If the reason for the decrease in investment demand was empty anti-capitalist rhetoric by politicians, then they should stop. If actual policies are causing the problem, then the economic costs should be weighed against whatever benefits these policies are supposed to generate.
However, some advocates of the free market have argued that an increase in the quantity of money and reduction in market interest rate are inappropriate. For example, Daniel Mitchel is here. Donald Boudreaux is here
In recent weeks, I have discussed the matter in comment threads on Free Banking and Uneasy Money. Comments were made (by the Liquidationist and RobR) suggesting that the "solution" to regime uncertainty was for money wages to fall. (I just found the Liquidationist's blog, here.)
The argument is that firms are accumulating money (and other short and safe financial assets) rather than hiring workers. The demand for labor is lower and the demand for money is higher. The solution is for nominal and real wages to fall enough, and for profits to rise enough, that the higher level of profits compensate firm owners for the higher perceived risk. Given this new distribution of income, firms will again be willing to hire labor, and employment will recover.
One rather obvious problem with the argument is that when the firms spend their accumulated money on hiring workers, wages will rise and profits will decrease, and higher profits no long compensate for the greater risk. However, presumably this sort of process could help explain why employment stops contracting. Lower wages, as well as the higher productivity of labor on the margin as more and more productive workers are let go, combine to make firms willing to bear the greater perceived risk rather than further reduce net revenue per worker by reducing employment further.
The process just doesn't generate recovery. If the nominal quantity of money is held fixed, then lower wages reduce costs, firms reduce prices, and real money balances rise. The conventional analysis is that those holding money balances purchase bonds, and this raises bond prices and reduces bond yields. The market interest rate falls. Real consumption and real investment expand, and as real expenditure rises in total, firms sell more, produce more, and hire more workers.
However, rather than buy bonds with increased real balances, firms might hire workers (and purchase other inputs) and produce output. But this is reducing difference between input and output prices--again reflecting the lower market interest rates.
If saving is perfectly inelastic with respect to the interest rate, then the real interest rate must fall enough so that investment, (including in the working capital firms use to hire workers and purchasing other inputs to produce output,) returns to its initial level. While the distribution of income between bond holders and stockholders might change, with bond holders receiving a lower return and the stockholders receiving higher gross returns and lower risk adjusted returns, real wages would not fall.
But if saving is not perfectly inelastic with respect to the interest rate, then the process results greater consumption. With more consumption and less investment, labor productivity and real wages will grow more slowly, and perhaps might fall.
Taken to the extreme, if saving is perfectly elastic with respect to the interest rate, then any reduction in investment demand, including one caused by "regime uncertainty," has no effect on the natural interest rate, but simply results in less investment and more consumption. Of course, with no decrease in the natural interest rate, there is no increase in money demand and no reduction in spending on output.
Still further, if we assume that the greater "regime uncertainly" applies to wealth accumulated by households, then the supply of saving might fall more than the demand for investment, resulting in a higher natural interest rate along with a shift in the allocation of output away from capital goods and towards consumer goods.
Presumably, firms producing consumer goods would initially be motivated to spend less on labor and other inputs because they insist on a higher interest return. However, the shift in demand from durable capital goods towards consumer goods will result in higher prices. Meanwhile, the firms selling capital goods will see a major contraction in their sales, freeing up "working capital" to use in consumer goods industries.
To sum up, if businessmen respond to "regime uncertainty" by demanding more money rather than purchasing capital goods (or even labor and other inputs for current production,) then this decrease in investment demand results in a lower natural interest rate. Generally, this requires an increase in the quantity of money to maintain nominal expenditure. The allocation of resources shifts from capital goods to consumer goods. If the quantity of money does not rise enough to maintain nominal expenditure, then lower prices and wages will cause real balances to increase and the interest rate to decrease, expanding real consumption and investment expenditure as above. The allocation of resources still shifts to consumer goods from capital goods.
If, on the other hand, businessmen and wealthy households respond to "regime uncertainty" by expanding consumption rather than shifting their asset portfolios to money or other safe assets, then the result is still a shift in the allocation of resources from the production of capital good towards consumer goods. There is no tendency for a decrease in nominal expenditure. There is no need to increase in the quantity of money and perhaps a reason to decrease it. The natural interest rate rises, and real wages will be depressed, or at least grow more slowly.
If "regime uncertainty" leads to an increase in the demand to hold money, then it will tend to depress money expenditures on output. An expansion in the quantity of money and lower market interest rates is exactly the proper response. The result will be the proper change in the allocation of resources. Insisting on "tight money," will simply make a bad situation worse.
While improving "regime certainty" in the sense of creating a better tax and regulatory framework for business would be helpful, it is more important to fix the monetary regime. That involves keeping nominal expenditure growing at a slow steady rate. To the degree greater "regime uncertainty" has been allowed to reduce nominal expenditure, returning it to the trend growth path is desirable and probably necessary for otherwise desirable "supply-side" reforms to be much help.