(Bloomberg Opinion) -- The U.S. Federal Reserve faces myriad challenges in deciding where to set interest rates. In addition to its mandate to balance unemployment and inflation, it must consider financial stability, Congress’s spending decisions and, lately, maybe even whether it is enabling President Donald Trump to engage in a damaging trade war.
Add another concern to the list: If the central bank lowers rates to head off a recession, it might actually undermine the productivity needed to raise living standards in the longer term.
Interest rates are already close to zero in much of the developed world. This all but guarantees that they will go to zero – or lower – in the next recession. And if the most recent U.S. peak of about 2.4% is judged to have been enough to touch off a slowdown, the country could be headed for a Japan-style regime of permanent zero or near-zero interest rates. Europe is already there.
The Fed has both fiscal and macroeconomic incentives to hold rates down. For one, lower borrowing costs minimize the Treasury’s debt-service burden at a time when the national debt is high and rising. Also, low population growth and low productivity growth -- both of which are now a reality all over the developed world -- tend to lower the natural rate of interest. That means that the Fed can keep rates lower without risking inflation, and also that raising interest rates even a moderate amount above zero could cause unemployment.
Now, though, the Fed must contend with a new question: Could long periods of low rates actually undermine growth, by hurting productivity? Macroeconomics typically takes productivity as a given, and focuses on shorter-term issues like inflation and unemployment. But in a long tweet thread ahead of the Fed’s annual policy symposium at Jackson Hole, economist and veteran policy adviser Larry Summers laid out some possible reasons that a regime of permanently low rates could end up doing long-term damage.
One is what Summers calls the “zombification” of companies:
According to textbook corporate finance, low rates don’t encourage wasteful investment. In that idealized picture, businesses assess new projects based on the difference between their cost of capital and the return they can realize. If interest rates go to zero, more projects become profitable and investment goes up. This is rational and efficient, because the businesses are earning a positive return on their capital.
The real world might not function so rationally. Investors and managers are only human, and behavioral finance researchers have identified plenty of biases that can distort lending and capital budgeting decisions. For example, managers who are able to borrow money easily to sustain their companies might become lazy, choosing to live a “quiet life” instead of using recessions as opportunities to restructure their businesses.
Alternatively, by increasing the number of businesses that can be profitably financed, low rates might convince investors that they can’t fail. That overconfidence might cause them to throw money at companies that have little or no chance of ever becoming profitable.
Financial institutions can also make mistakes. As Summers notes, low rates can make banks more vulnerable to failure by compressing the spreads they earn. Such distressed lenders might be reluctant to acknowledge bad loans, preferring instead to keep unproductive borrowers afloat with still more loans -- a process sometimes known as “evergreening.” This has been blamed for the proliferation of zombie companies in both Japan and Europe.
Finally, there’s the possibility that even if low rates don’t create zombies, they could create monopolies. Various economists have theorized that excessively easy credit conditions, by keeping inefficient incumbent companies alive, might make it harder for innovative new companies to break into markets.
So there’s no shortage of reasons why permanently low interest rates could lead to slower productivity growth. Ironically, that lower growth could further increase the incentives for central bankers to keep rates low, while suppressing any possible inflation that resulted. That sort of stagnation would be a bit different than the variety Summers has posited, but could be even harder to escape from.
This doesn’t necessarily mean the Fed should keep rates above zero. Even if low rates engender zombies or monopolies, higher rates could trigger a disastrous recession that might be even worse. But the possibility that low rates are now affecting productivity will make central bankers’ decisions even harder than they already were.
To contact the editor responsible for this story: Mark Whitehouse at mwhitehouse1@bloomberg.net
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Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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