Peter Franklin

Peter Franklin is Associate Editor of UnHerd. He was previously a policy advisor and speechwriter on environmental and social issues.

March 28, 2019

Brexit began 27 years ago.

On the 16 September 1992, the Chancellor of the Exchequer, Norman Lamont, put up interest rates from 10% to 12%. The aim was to stop currency dealers from selling the Pound and forcing the UK out of the EU Exchange Rate mechanism (or ERM a precursor to the single currency). It didn’t work. Markets continued to ‘short’ the Pound – and so Lamont announced that he would raise interest rates to 15%. (Let me assure younger readers that I haven’t missed out a decimal point – rates really were that high back then).

But while borrowers looked on in absolute dread, the wheeler-dealers were unmoved. The Pound was forced out of the ERM and fell sharply in value, just as the short sellers had intended. Interest rates fell back down, the economy picked up, but the credibility of John Major’s government never recovered – and nor, among a large part of electorate, did trust in the EU.

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So much flowed from that fateful day – ‘Black Wednesday’; 13 years of New Labour; the rise of British Euroscepticism; and a lingering horror of high interest rates.

That last one might just prove the most significant. Along with other economic crises, it laid the groundwork for the so-called ‘great moderation’ – an era in which monetary policy was delegated to central bankers who used their control to squeeze inflation out of the economy. A long-term decline in interest rates was thus enabled. It all came to grief in the 2008 financial crisis, of course; but the after-effect was that interest rates fell even lower – in many cases right down to zero or thereabouts.

Still, what’s bad for savers is good for the economy, right? If it’s cheap to borrow then that means more spending and more investment at a time when there’s not enough of either (especially the latter).

But what if low interest rates are the reason why investment and, therefore, productivity and wage growth are all so anaemic?

Evidence that this is the case is presented in a working paper by the economists Ernest Liu, Atif Mian and Amir Sufi. They suggest that the standard economic models have overlooked an entire dimension of economic reality:

“Traditionally, a lower interest rate is viewed as expansionary for the production side of the economy…

“However, these models do not take strategic competition and market structure into account. Is it reasonable to assume that a significant reduction in the long-term interest rate would have no impact on the competitiveness of an industry?”

Liu and his colleagues propose an alternative model based on the assumption that low interest rates are more advantageous to the leading companies in each sector of the economy than for their competitors. We’ll come back as to why that might be case, but assuming it is, what are the implications?

The argument is that the market leaders respond to the advantageous environment by investing more than their rivals, thus extending their lead – so much so, in fact, that their competitors see there’s no point in trying to catch-up and therefore invest even less. That’s the first blow to investment and productivity. The second blow is that the market leaders notice that their position is unassailable and therefore also ease up on investment. Obviously, that’s bad news for the economy – investment dries up, productivity growth decelerates and markets become less competitive.

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So, why would low interest rates give the market leaders a strategic advantage in the first place? The authors make the point that when money is cheap, investment can be patient – i.e. it doesn’t need to unlock some game-changing innovation; all that’s required is the slow but certain extension of the company’s market dominance.

Strategies include buying out the competition; acquiring the rights to potentially disruptive technology; mopping up untapped markets; establishing effective control over an industry’s supply chains; or splashing out on lobbyists to rewrite regulation to the company’s advantage. These things won’t make the company better than the competition, just bigger – indeed big enough to establish an effective monopoly.

Because the leading company in any sector is by definition the one already closest to sewing up the market, it is also the one most likely to benefit from, and therefore attract, the cheap money. Its lesser rivals, meanwhile, retreat into niches, put themselves up for sale or go bust.

The rewards of dominance include the favour of the stock market. In a low interest rate environment, investors are desperate for half-way decent returns – and so an unchallenged industry leader, with reliable earnings, provides the ideal cash cow. Share values therefore go up; and if the company uses its capital to buy back its shares, their value goes up even faster.

If you ever wondered why stock markets boom and the corporate elite gets rich despite the general slow down in growth and productivity improvements, there’s your explanation.

This isn’t just a theory, by the way. Liu and colleagues find plenty of real world evidence:

“The empirical analysis tests this hypothesis using CRSP-Compustat merged data from 1962 onward. A ‘leader portfolio’ is constructed that goes long industry leaders and shorts industry followers, and the analysis examines the portfolio’s performance in response to changes in the ten year Treasury rate. The model’s prediction is confirmed in the data. The leader portfolio exhibits higher returns in response to a decline in interest rates, and this response becomes stronger at a lower initial level of interest rates.”

The authors aren’t saying that this effect explains the whole of the great growth slowdown (or ‘secular stagnation’ as economists call it), but it does help explain why we see productivity problems and market concentration across such a wide range of sectors and economies. Interest rates are at historically low levels across the western world and beyond – helping big companies to eat the competition just about everywhere.

How could those in charge of monetary policy not have noticed this disastrous side effect? I suspect the answer lies with the standard economic models I mentioned at the beginning of this article, on which basis monetary policy is based. All models simplify, but if they over-simplify what they bring is blindness not clarity.

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