By Ernest Liu, Atif Mian and Amir Sufi
JEWEL SAMAD/AFP/Getty Images
CHICAGO ( Project Syndicate ) — The real (inflation-adjusted) yield on 10-year U.S. Treasuries /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y -0.12% 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 negative 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.
Low interest rates can reduce the incentive for firms to invest in boosting productivity.
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 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.
Leaders have lower funding costs
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.