New paper finds falling interest rates make industries less competitive, lower productivity growth
Feb 4, 2019 10:23 am ET
Imagine you’re the owner of a small restaurant and you’re thinking of expanding. If interest rates are high, you might think twice. When rates fall, you might be more willing to borrow to grow your business.
But the big chain restaurant down the street also borrows at similarly low rates to fund a much larger expansion that could steal your customers and perhaps put you out of business.
Over the past two decades or so that phenomenon has been playing out across industries, making the overall economy less dynamic, according to new research by economists Ernest Liu and Atif Mian of Princeton University, and Amir Sufi of the University of Chicago’s Booth School of Business.
When interest rates fall, they find, the big players in an industry can take advantage to a far greater extent than their smaller counterparts. That allows them to grow faster and become more productive, but it also makes it harder for everybody else to keep up.
Over time, the smaller players get discouraged and stop investing in new products or technologies. And the leaders become so big that they’re no longer vulnerable to competition. They also pull back from investing. With market power increasingly concentrated in a few big firms, fewer entrepreneurs will decide to open new businesses.
The result is a slowdown in productivity growth, measured as the output per worker per hour, and sluggish overall economic growth.
“[Interest] rates will first start to go down, then you’ll get a rise in concentration and then you’ll get a slowdown in productivity growth,” said Mr. Sufi.
The research offers some answers to questions that have vexed economists for the past few years. It helps explain why productivity growth has averaged just 1.3% per year over the past decade, well below historical levels. And it can be one reason why the economy has been sluggish since the Great Recession even though the unemployment rate has fallen to its lowest level in almost 50 years. It could also explain why the birth rate of new establishments has fallen to 10.3% in 2016 from 15.4% in 1987. The birth rate is the share of establishments less than one year old as a share of all establishments.
Under the framework outlined by the researchers, it can take decades for lower rates to make an economy less dynamic. In fact, they find that growth quickens in the early years before slowing down.
That’s because when interest rates first start falling, smaller firms will borrow aggressively and invest to try to catch up to their bigger rivals, speeding up productivity growth.
That’s what happened in the 1990’s. A decline in interest rates, as measured by the 10-year Treasury yield, led big and small firms to invest. Productivity growth averaged 2.2% a year in the 1990’s and 2.8% in the 2000’s.
But around 2003, productivity growth started to slow even though interest rates kept falling. That’s roughly when the smaller players gave up catching up with the leaders, Mr. Sufi said.
“We think the late 90’s, early 2000’s is when you crossed that threshold,” he said.
The paper doesn’t explain why interest rates have been steadily falling. Other economists, such as Harvard University’s Lawrence Summers, have suggested that the aging population could be holding down overall demand in the economy and keeping rates low.
Federal Reserve officials and others expect rates to remain low for the foreseeable future, which means the phenomenon described in the paper could be with us for some time.