“You must unlearn what you have learnt.” – Master Yoda, Star Wars
In a Nutshell: Lower for longer rates anchored even more emphatically by the Fed’s flexible average inflation targeting (FAIT) policy regime, could perversely suppress productivity growth for many years to come. Granted that conventional monetary stimulus is premised on lower interest rates boosting demand (both consumption and investment). But exceptionally low rates turn demand-boost mechanics on its head; as adverse selection, asymmetric access and allocative inefficiencies conspire to erode returns, stifle competition and amplify distortions as well as misaligned incentives.
The unintended consequence to exacerbate inequality from financial repression, in turn feeds back as a drag on future productivity. Upshot being, received wisdom about low rates boosting growth is at odds with decline in productivity that is clearly a risk. And so Master Yoda’s counsel demands a re-assessment; and possibly recourse employing a mix of monetary policy-fine-tuning and fiscal intervention may be necessary to ensure that productivity is not unnecessarily squandered.
Circularity of Productivity and (Real) Interest rates
Conventional economic logic is that productivity determines long-term real interest rates. Specifically, that (neutral/equilibrium) interest rates are determined by return on capital, which is in turn driven by productivity. And it is on this logic that monetary stimulus rests. That is to say, cutting interest rates stimulates higher investments chasing capital returns rendered more lucrative by comparatively lower rates.
But equally, it is important to recognise a circularity of this relationship whereby, exceptionally low interest rates drives down the required rates of returns, which in turn leads to a profusion of projects/firms with much lower rates of productivity, which can clear the lower bar for minimum required return. In other words, persistently low real interest rates can lead to lower productivity in aggregate.
Point being, the steep drop in real rates across US and Europe, insofar that it diffuses more widely on a global basis, may be the recipe for further suppression of productivity growth in coming years. Especially if lower for longer rates amplified under the Fed’s flexible average inflation targeting (FAIT) regime conspires with a flood of QE money, to inadvertently result in the profusion of otherwise unviable, low-productivity investments/projects.
Inevitably, this leads to the perverse outcome of well-intentioned, ultra-low rates/easy policy meant to stimulate growth resulting in a period of suppressed productivity in aggregate; and consequently, lacklustre growth, if not stagnation.
This problem of unintended suppression of productivity from adverse selection of investments/firms due to the distortions created by ultra-low rates is further compounded by significant asymmetry of access to cheap financing; specifically favouring large firms which also tend to be dominant industry players.
A recent study suggests that ultra-low interest rates increase market concentration of dominant firms to the detriment of smaller competitors. And the resultant monopolistic tendencies ultimately drive down incentives for productivity boosting investments. Instead, the incentive may be for dominant firms to exploit access to cheap financing to engage in anti-competitive practices; which distract from, if not diminish, efforts to boost productivity.
Finally, ultra-low interest rates inadvertently amplify misallocation. The surge in asset and financial markets resulting from this artificially suppressed levels of interest rates alongside a deluge of money raises the opportunity cost of investing in productive capital; as capital is attracted to non-productive financial/real estate investment assets. And this refers not only to financial capital, but potentially even human capital as the allure of becoming day traders and/or pursue aspirations associated with rent-seeking behaviour.
Worst of all, the euphemism of “allocative inefficiencies” fails to do justice to the reality of financial repression that re-allocates wealth and capital in manner that tends to exacerbate already stark inequalities in society. And this has very real and damaging ramifications for productivity insofar that gaping inequalities tend to depress the quality labour (in terms of access to and dispersion of, education/training). Arguably, this is a critical factor in lifting total factor productivity (from the interaction of labour and capital) to lift growth potential.