Although low interest rates have traditionally been viewed as positive for economic growth, this may not be the case anymore. Instead, they may lead to slower growth by increasing market concentration and weakening firms' incentive to boost productivity

Although low interest rates have traditionally been viewed as positive for economic growth, this may not be the case anymore. Instead, they may lead to slower growth by increasing market concentration and weakening firms' incentive to boost productivity

By Ernest Liu, Atif Mian and Amir Sufi

The real (inflation-adjusted) yield on ten-year US treasuries is currently zero, and has been extremely low for most of the past eight years. Outside of the United States, meanwhile, 40% of investment-grade bonds have negative nominal yields. And most recently, the European Central Bank further reduced its deposit rate to -0.5% as part of a new package of economic stimulus measures for the eurozone.

Low interest rates have traditionally been viewed as positive for economic growth. But our recent research suggests that this may not be the case. Instead, extremely low interest rates may lead to slower growth by increasing market concentration. If this argument is correct, it implies that reducing interest rates further will not save the global economy from stagnation.

The traditional view holds that when long-term rates fall, the net present value of future cash flows increases, making it more attractive for firms to invest in productivity-enhancing technologies. Low interest rates therefore have an expansionary effect on the economy through stronger productivity growth.

But if low interest rates also have an opposite strategic effect, they reduce the incentive for firms to invest in boosting productivity. Moreover, as long-term real rates approach zero, this strategic contractionary effect dominates. So, in today’s low-interest-rate environment, a further decline in rates will most probably slow the economy by reducing productivity growth.

This strategic effect works through industry competition. Although lower interest rates encourage all firms in a sector to invest more, the incentive to do so is greater for market leaders than for followers. As a result, industries become more monopolistic over time as long-term rates fall.

Our research indicates that an industry leader and follower interact strategically in the sense that each carefully considers the other’s investment policy when deciding on its own. In particular, because industry leaders respond more strongly to a decline in the interest rate, followers become discouraged and stop investing as leaders get too far ahead. And because leaders then face no serious competitive threat, they too ultimately stop investing and become “lazy monopolists.”

Perhaps the best analogy is with two runners engaged in a perpetual race around a track. The runner who finishes each lap in the lead earns a prize. And it is the present discounted value of these potential prizes that encourages the runners to improve their position.

Now, suppose that sometime during the race, the interest rate used to discount future prizes falls. Both runners would then want to run faster because future prizes are worth more today. This is the traditional economic effect. But the incentive to run faster is greater for the runner in the lead, because she is closer to the prizes and hence more likely to get them.

The lead runner therefore increases her pace by more than the follower, who becomes discouraged because she is now less likely to catch up. If the discouragement effect is large enough, then the follower simply gives up. Once that happens, the leader also slows down, as she no longer faces a competitive threat. And our research suggests that this strategic discouragement effect will dominate as the interest rate used to discount the value of the prizes approaches zero.

In a real-world economy, the strategic effect is likely to be even stronger, because industry leaders and followers do not face the same interest rate in practice. Followers typically pay a spread over the interest rate paid by market leaders – and this spread tends to persist as interest rates fall. A cost-of-funding advantage like this for industry leaders would further strengthen the strategic contractionary impact of low interest rates.

This contractionary effect helps to explain a number of important global economic patterns. First, the decline in interest rates that began in the early 1980s has been associated with growing market concentration, rising corporate profits, weaker business dynamism, and declining productivity growth. All are consistent with our model. Moreover, the timing of the aggregate trends also matches the model: the data show an increase in market concentration and profitability from the 1980s through 2000, followed by a slowdown in productivity growth starting in 2005.

Second, the model makes some unique empirical predictions that we test against the data. For example, a stock portfolio that is long on industry leaders and short on industry followers generates positive returns when interest rates fall. More important, this effect becomes even stronger when the rate is low to begin with. This, too, is consistent with what the model predicts.

The contractionary effect of ultra-low interest rates has important implications for the global economy. Our analysis suggests that with interest rates already extremely low, a further decline will have a negative economic impact via increased market concentration and lower productivity growth. So, far from saving the global economy, lower interest rates may cause it more pain.


Ernest Liu is a professor at the Bendheim Center for Finance at Princeton University. Atif Mian is a professor at Princeton University and Director of the Julis-Rabinowitz Center for Public Policy and Finance at the Woodrow Wilson School. Amir Sufi is Professor of Economics and Public Policy at the University of Chicago Booth School of Business.  Copyright: Project Syndicate, 2019, published here with permission.

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"a further decline will have a negative economic impact via increased market concentration and lower productivity growth." = Lower Wages!
"So, far from saving the global economy, lower interest rates may cause it more pain."

2007: Median wage = 1.675 x minimum wage
2010: Median wage = 1.56 x minimum wage
2014 Median wage = 1.54 x minimum wage
2019: Median wage = 1.44 x minimum wage

Mic drop!

That's because minimum wages are pumped up by law.

Don't let the facts get in the way of a good mic drop!

Yes, of course. Central banks are insane to keep pushing harder on the same policies that haven't worked for over a decade, with effects they don't even understand. They need to be abolished.

10
up

At last, some sanity. Falling interest rates favour the large bureaucracies, corporate and state. They can borrow at, say 1%, while mortgages are at say, 3.5% and small businesses pay 8% to 12%. More crucially, the large bureaucracies can borrow as much as they want, while the hurdle for everyone else goes up dramatically.

Small businesses can only borrow against their house, if they can borrow at all. The bank goes from lending freely up to 60% of the house value to only lending 40% max. How do you survive that when sales and margins are going down?

Ernest Liu saying what the rational amongst us have believed for a while.

Adrian Orr is Mr Wrongly Wrongson. When he says monetary policy is still effective at these levels, he's wrong. When he says that near-zero interest rates will cause people to spend, he's wrong. The data bears this out. The only way you believe these absolutely nonsensical economic policies work is if you're a PhD in Keynesian economics, which just seems to boil down to: more debt, more spending, less capital investment, less long term thinking. All that results in poor or no growth in the long run.

Unintended consequences...whodathunk?

I suspect our INFLATION AND INCOME TAX ADJUSTED yield for bank deposits is ZERO right now or maybe even negative

And in the consumer sector yesterdays Westpac MM Consumer confidence survey , for those that missed yesterdays wrap up:

Spend it or save it?
Each quarter we ask households what they would do with an unexpected cash windfall. This quarter, we saw two very big changes:
– First, the number of households who said they would spend it has plummeted, dropping to its lowest level in 20 years.
– At the same time, the proportion of households who said they would use a cash windfall to repay debt has rocketed higher, back to levels we last saw in 2009.
Those results were echoed across all income and age groups.

Looks like last months 0.5% OCR cut has backfired..

Thousands of people around the country have purchased overpriced houses by leveraging the next 10 or more years of their income.
Lately, the risk of them not having a stable job with the economic s**t storm approaching is increasing. So central banks do them the favour of reducing their interest load and hope they buy a car or go on a holiday with those "savings".
Sounds like a great plan to me!

The whole NZ economy would be a whole lot more healthy if $5 billion were not leaving NZ each year as bank profits for the 4 big Aussie banks.

Then you and the other 87% of NZ need to stop complaining and start banking with an NZ alternative. Actually, on second thoughts, it's a lot easier just to whinge.

Naturally I do. But for the rest of our fellow citizens, I cannot understand why they are so willing to give their money to the Australian economy.

Because they offer better interest rates. I always give kiwibank the last chance to best the Oz banks' offers, they invariably cannot.

When debts are at levels that eat most of disposable income and profits as interest payments, nothing much can go into consumer spending. Lowering interest rates any further has diminishing effects on stimulating an economy.
At the same time, with global debts st levels that cannot be repaid, rising rates is a sure way to immediate disaster.
In a financial system where money creation is in private hands, debt forgiveness, entirely possible in a public banking system, is unheard of, most likely, it can be ruled out.
Negative yields on government bonds in the developed countries, a fundamental reflection of their stalled development and imbalanced income distribution, are actually a way to improve wealth distribution, through levying taxes on the savings of the rich.
Negative rates, although unheard of throughout history achieve debt forgiveness a bit slower but they do the same thing eventually by bringing the volume of savings on the asset side of the balance sheet down to the volume of debt that can be repaid.