Commentary: These ultra-low interest rates are hurting the economy

Commentary: These ultra-low interest rates are hurting the economy

In today’s low-interest-rate environment, a further decline in rates will most probably slow the economy by reducing productivity growth, say Ernest Liu, Atif Mian, and Amir Sufi.

A trader looks on as a screen displays the U.S. Federal Reserve interest rates announcement on the
A trader looks on as a screen displays the U.S. Federal Reserve interest rates announcement on the floor of the New York Stock Exchange in New York, U.S., July 31, 2019. (Photo: REUTERS/Brendan McDermid)

CHICAGO, Illinois: The real yield on ten-year US treasuries is currently zero, and has been extremely low for most of the past eight years, after adjustment for inflation.

Outside of the United States, meanwhile, 40 per cent of investment-grade bonds have negative nominal yields.

And most recently, the European Central Bank further reduced its deposit rate to -0.5 per cent as part of a new package of economic stimulus measures for the eurozone.

REDUCING INCENTIVES TO BOOST PRODUCTIVITY

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.

This means reducing interest rates further will not save the global economy from stagnation.

READ: Commentary: Many sectors are already in a recession

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.

FILE PHOTO: A woman walks past an electronic board showing the stock market indices of various coun
A woman walks past an electronic board showing the stock market indices of various countries outside a brokerage in Tokyo, Japan on Oct 11, 2018. (File photo: REUTERS/Kim Kyung-Hoon)

So, in today’s low-interest-rate environment, a further decline in rates will most probably slow the economy by reducing productivity growth.

FUELING MONOPOLIES

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.

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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".

REMOVING THE INCENTIVE TO WORK

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.

A trader works on the trading floor at the New York Stock Exchange (NYSE) at the opening of the mar
A trader works on the trading floor at the New York Stock Exchange at the opening of the market in New York City, US on Aug 26, 2019. (Photo: REUTERS/Andrew Kelly)

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.

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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 trader works on the trading floor at the New York Stock Exchange (NYSE) at the opening of the mar
A trader works on the trading floor at the New York Stock Exchange at the opening of the market in New York City, US, Aug 26, 2019. (Photo: REUTERS/Andrew Kelly)

A cost-of-funding advantage like this for industry leaders would further strengthen the strategic contractionary impact of low interest rates.

A FEW WAYS LOW INTEREST RATES HURT THE GLOBAL ECONOMY

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.

The contractionary effect of ultra-low interest rates has important implications for the global economy.

FILE PHOTO: A woman points to an electronic board showing stock prices as she poses in front of the
A woman points to an electronic board showing stock prices as she poses in front of the board after the New Year opening ceremony at the Tokyo Stock Exchange (TSE), held to wish for the success of Japan's stock market, in Tokyo, Japan, January 4, 2019. (File photo: REUTERS/Kim Kyung-Hoon)
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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.

Source: Project Syndicate/sl

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