As the Fed lowered rates for the second time this year in response to uncertainties in the economic outlook, economists Ernest Liu and Atif Mian (at Princeton), and Amir Sufi (at Chicago Booth) challenge this approach arguing that prolonged long-term low-interest rates may be responsible for sluggish investment, productivity, and growth. Read their recent commentary at Project Syndicate.
Since the Great Recession of 2008, interest rates have reached historic minimums around the globe, in some cases even dipping below zero. Switzerland, Sweden, Germany, France, the Netherlands, and Japan have, for example, recently issued securities with negative yields. The continuous fall in interest rates since the 1980s has generated a large body of literature in macroeconomics.
Scholars have focused on the causes and effects of the fall of interest rates, as well as on the policy implications of approaching and surpassing the Zero Lower Bound -ZLB-. Traditionally, lower interest rates have been understood as an incentive for agents to increase investment that would ultimately lead to increases in productivity and economic growth. Larry Summers (1, 2) and Paul Krugman, among others, have written about the secular stagnation and the liquidity traps, respectively, that are behind this phenomenon. They question whether monetary policy has enough traction to incentivize growth under the sustained low-interest environment.
In a recent paper, Liu, Mian, & Sufi present a novel argument that a prolonged period of low-interest rates deepen market concentration, reduce incentives to invest, and thus slow productivity growth. Low-interest rates not only don’t have the teeth to incentivize investment but actively hamper it.
Their research draws on findings from the field of Industrial Organization (IO) economics, which has focused on corporate consolidation and the overall increase in market concentration since the 1980s. Industrial Organization economists have both studied and shaped this phenomenon, heavily influencing a shift in antitrust policy and the regulatory landscape since the late 1970s, as Popp Berman argues in a forthcoming book to be published by Princeton University Press.
Liu et al (2019) bring together these two strands of research to show that a prolonged low-interest rate environment can further the market power and concentration of already dominant firms in an industry. While the traditional effect of low-interest rates typically incentivizes investment, Liu, Mian, & Sufi show that the incentive is greater for market leaders and that the disparity of the effect between the firms grows as the productivity gap between the leader and the follower is larger.
As the interest rate approaches zero, dominant firms invest more and raise productivity more than followers, leading towards market concentration. As industries become concentrated and monopolistic, all while interest rates remain low, investment and productivity growth by leaders and followers stagnates, against the traditional wisdom of macroeconomic literature.
The logic of their model is straightforward. Firms invest to obtain higher payoffs in the future. However, the ability to reap the benefits of the investment –in the form of increased future profits— depends on their relative productivity vis-à-vis their competitors. A larger productivity gap gives the leading firm a larger share of the industry profits. Under the reasonable assumption that increasing a firm’s productivity does not happen overnight (i.e. change is slow and incremental), the investment effect created by low interest rates is stronger for leading firms, who are better positioned to obtain higher returns on their investment, thus increasing the productivity gap between leaders and followers in a given market.
As low interest rates persist over time, the gap continues to grow and increases the monopolistic structure of the market. As the productivity gap increases, the market reaches a point where both leader and follower firms cease to invest due to the grip of the leader over the market and the lack of any credible threat of being overthrown by a follower.
To test their model, Liu et al use stock market data that goes back to 1980 on the excess returns for industry leaders versus followers. This allows them to study the relationship between interest rates and industry concentration. Specifically, their empirical tests confirm the two main predictions of the model.
On the one hand, the data shows that leaders’ stock asymmetrically benefits from a reduction in interest rates in comparison to followers and that the asymmetry is larger when interest rates are low, to begin with. On the other hand, the data confirms that lower interest rates are associated with a higher profit share, higher markups, and higher concentration across the different industries.
Moreover, using the US Census’ Business Dynamics Statistics database, they show that lower interest rates are associated with lower rates of entry and exit of firms in a given market. In other words, lower interest rates are associated with more stable markets, with lower levels of business dynamism. They suggest that under a low-interest rate environment it is less likely that a follower will overtake a leader in an industry.
Liu et al highlight that their findings are consistent with those of other studies. Berlingeri and Crisucuolo (2017) have found evidence consistent with the model, using firm-level productivity data from OECD countries. In that study, the productivity gap between leaders and followers has been increasing steadily from 2000 to 2014 as long-term interest rates have fallen. A similar result is in Andrews et al. (2016), who show a widening gap in labor productivity of frontier versus laggard firms in both manufacturing and services for OECD firms.
This new literature raises significant questions about the relationship between monetary policy, market competition, and productivity growth. While traditional monetary policy approaches suggest that low-interest rates foster growth and investment, this new evidence suggests that it may have the opposite effect in the long-term.