Thread by @AtifRMian

1/ If you are feeling bored, let's talk about the very low interest rate and why it may not be good for the global economy.

I am talking about long-term rate (r), e.g. 10 year treasury, which is not directly determined by the central bank.

2/ r has been marching down since the 80's, and essentially stuck around zero in real terms since the Great Recession.

I will not go into the reasons for why r has gone down to zero (a super-interesting question). Instead I'll focus on the *consequences* of very low r.

3/ r is one of the strongest economic forces around. A low r increases the present value of future cash flows, making it more attractive to invest today. This is why a low r is thought to be expansionary - call this the "traditional effect".

4/ However, there is a second force that has been overlooked so far IMHO. This "strategic effect" works in the opposite direction, and can make a very low interest rate environment *contractionary* by increasing market concentration.

I'll explain the "strategic effect" next.

5/ Consider two firms competing in an industry. The firm that is more productive, call it leader, grabs a larger share of industry profits. The other firm, call it follower, tries to innovate to catch up. Competition between the two firms thus generates incentives for growth.

6/ Now imagine r falls. The "traditional effect" says both firms would want to invest/innovate more, and that is true. However, there is a second effect driven by the fact that the increase incentive for the leader is *stronger* than that of the follower.

7/ The fact that leader increases investment more than the follower as r falls discourages the follower since it is already behind. The stronger leader investment makes it less likely that follower will ever catch up. This discouragement effect is the negative "strategic effect".

8/ It turns out that at r close to zero, the strategic effect *must* dominate the traditional effect. The result? As r goes to zero, follower falls further behind the leader, i.e. market concentration rises, and ultimately growth falls.

9/ Do we have empirical proof that this force is operative in the real world? I think so. The fall in r has been followed by rising market concentration, e.g. industry profit share and market share going to top 5% of firms rose as r fell.

10/ Similarly, market dynamism, i.e. entry of new firms and exit of old, decreased as r went down. Finally productivity growth also slowed post-2005 as r got closer to 0. These patterns are global and not specific to a single country, again suggesting a common cause like low r.

11/ Is there stronger, additional, evidence that the "strategic effect" is real? Yes, there is. A specific prediction of the strategic effect is that as r falls, industry leaders gain more in value than industry followers, AND this effect becomes *stronger* for lower r.

12/ U.S. stock market data from 1960 onwards confirms this unique prediction. Moreover, there is direct evidence that productivity gap between industry leaders and followers has increased as r fell over the last couple of decades.

13/ If you have been kind enough to follow the thread up to this point, you may be interested to read the full formal treatment of this idea in this joint work with Ernest Liu and @profsufi Comments are very welcome
papers.ssrn.com/sol3/papers.cf…

14/ Some remarks for the more wonkish crowd
(i) The paper explains the so-called "secular stagnation" without resorting to Keynesian forces like ZLB / price rigidity that are hard to rationalize in the long-run
(ii) Model doesn't rely on any financial frictions, its an MM world

15/ (iii) What can be done to get out of this situation of very low r, high market concentration and low productivity growth? Something to think about.