Tuesday, February 26, 2019

"The Anticompetitive Effects of Low Interest Rates"

From ProMarket:

A new study argues that declining interest rates are in fact the cause of the recent decline in competition.
Corporate profits in the United States have been steadily increasing since the early 1980s. Academic researchers and nobel laureates, the Council of Economic Advisers, media outlets like The New York Times, The Economist and The New Republic, and elected officials have recently written about the negative consequences of rising profits and declining competition. Despite the obvious importance of the rise in corporate profits, we know very little about its underlying causes. 

In a recent study with Seth Benzell, I presented aggregate measures of profits for the US corporate sector over the past 70 years. The data clearly show low profits in periods of high interest rates (e.g. early 1980s) and high profits in periods of low interest rates (e.g. late 1940s and today). Some have suggested that mechanical errors in the calculation of profits are responsible for this striking fact. However, this pattern of high profits in periods of low interest rates appears in measures of corporate profits that are calculated from different data sources using vastly different techniques. Motivated by these aggregate facts, two recent papers argue for an economic relationship in which an increase in market power causes an equilibrium decline in the interest rate.

A new study by Ernest Liu, Atif Mian, and Amir Sufi presents a theoretical model and empirical evidence arguing that the declining interest rate is in fact the cause of the recent decline in competition. The richness of the model allows the authors to simultaneously explain many important features of the macro-economy over the past 30 years.

I will try to lay out the main features of the model and empirical results. The paper is very rich and offers nice results that go beyond what I describe. I have tried to limit myself to the essential points and I strongly recommend reading the paper. At the end, I will discuss two underlying mechanisms in the model that I would like better understand and that perhaps could be explored in future work.
 Low Interest Rates and Monopolized Industries
The model (with minor alterations for illustrative purposes) features firms that compete with one another to gain market share and profits. The only way for a firm to gain market share is to produce a better product at a lower cost than its competitor. So long as no particular firm in the industry has a decisive edge, all firms will invest heavily in the design of better products and better methods of production. So long as markets remain competitive, these gains in the form of better products and lower costs are passed on to consumers. The prospect of gaining an edge over competitors and monopolizing the industry at some point in the future incentivizes investment today and grows the economy.

While the promise of future monopolization spurs economic growth and gains to consumers, monopolized industries provide no such benefit. Once a single firm manages to gain a sufficiently large competitive edge, other firms understand that they stand very little chance of clawing back significant market share and essentially give up. After competitors drop out, the leading firm no longer has any incentive to produce better products or offer consumers lower prices. The only concern of a leader in a monopolized industry is to maintain its market position.

At a lower interest rate, future cash flows are more valuable and as a result, the benefit of future monopolization increases. The increased value of future monopolization has three effects. First, it causes firms to compete more intensely in competitive industries. Second, it re-introduces competition into industries where trailing firms had given up hope of overtaking the current leader. The internal calculations of trailing firms now make them view the same investment as more attractive. Lastly, it gives market leaders an even greater incentive to ward off competition. Losing market share becomes far more costly at low interest rates and competitors have a greater incentive to stay active. If industry leaders are comfortable with being three steps ahead of their competitors when interest rates are high, they will try to remain four steps ahead when interest rates decline.

While the first two incentives induced by lower interest rates (increasing competition in competitive industries and re-introducing competition in some monopolized industries) are pro-competitive, the third effect (industry leaders having a greater incentive to ward off competition) is anticompetitive. Which of these effects do we expect should dominate?

Perhaps the key insight of the paper is that we should expect the anticompetitive effects of lower interest rates to dominate the pro-competitive effects. The intuition is as follows. At any point in time, some industries will be competitive and others monopolized. The amount of time that a given industry remains dominated by a single firm determines the (steady state) fraction of industries that are monopolized. When interest rates are very high, dominant firms are unwilling to invest heavily today to prevent the loss of future market share. This unwillingness results in monopolized industries that revert back to competitive industries quickly. As interest rates decline, dominant firms invest more and more to prevent future loss of market share. These actions on the part of dominant firms result in monopolized industries that stay monopolized for longer....