Concerns about low interest rates

There has been some discussion about whether we are entering an era of permanent stagnation/low growth or whether the natural interest rate will remain low for an extended period.

Many have voiced concerns about low IR environments, but I don’t often hear discussions of skew:

when rates are low, future payments are discounted less, meaning that well-understood cash-flows are more valuable than more speculative cash-flows vis-a-vis the higher rate period.

As a simple example, if you had a choice between purchasing a firm that pays out $1 per period if alive, but has a 10% chance of dying every period, OR purchasing a consol that pays out $1 per period guaranteed, then even assuming quadratic utility, if the risk free rate were 5%, the risky firm would be worth 0.3 consols, but if the discount rate were 1%, the risky firm would only be worth 0.08 consols. Similarly, at a 5% discount, a firm that has a 15% chance of dying each period is worth 0.71 times the firm with the 10% death rate. But at a 1% discount, the riskier firm is worth only 65% of the less risky firm.

In other words, in a low rate environment, we must peer farther out in the future, and value stable cash-flows more relative to the uncertain cash-flow. As a result, investments that offer more stable returns (such as land) are given more preferential lending terms to investments whose distant returns are more speculative.


In this relative financing sense, the higher the interest rate, the smaller the gap between the risky and riskless investment (in the limit of an infinite discount rate, our firm would be priced at 0.9 of a consol, as we only care about the first period in which the firm has a 90% chance of paying out a dollar).

This is one argument for why demand-stabilization — effectively increasing certainty about future incomes, can be less distortionary and more supportive of risky investment than lowering rates, which skews the relative value of investments towards safety.

Even within the sphere of productive capital, firms like Coca-Cola will have better borrowing terms than firms like Intel. Of course this is always true to some degree, but the relative advantage increases as the interest rate falls. Safety becomes more important in a low IR environment.

Moreover, financing structure plays a role. In such an environment firms will tend to agglomerate and engage in all sorts of odd business practices — starting resorts, stockpiling metals, etc, as the larger the firm and the more diverse business practices, the greater the borrowing advantage vis-a-vis smaller, more focused firms. Political backing — being too big to fail — also becomes much more important as the interest rate falls. Any aspect of the firm that can increase the likelihood of survival 50 years from now becomes more important than total earnings in the next few periods.

The worst borrower would be the individual who is borrowing against their own labor income. The *relatively* higher rates that they pay for purchase of durables vis-a-vis the rates offered to landholders or well-established/diversified firms is effectively a tax on consumption and a subsidy to investment; or possibly more appropriately, is a tax on personal consumption and a subsidy to the consumption of the conglomerate.

Concerns about low interest rates

3 thoughts on “Concerns about low interest rates

  1. Hey, you’re blogging again! Hooray. And great post. This is a question I have been thinking about a lot, too.

    I am going to suggest a friendly amendment in terms of presentation. The interest rate is a market price. If an asset as an expected yield y (measured in dollars or some other numeraire) per period forever, then to say the interest rate for that asset is i means that people are just willing to hold the asset at a price of y/i. So it seems somewhat confusing to say that “in a low rate environment, we must peer farther out in the future.” Putting it that way implies the wrong direction of causality. It would be better to say, “a very low interest rate means that we are comfortable peering further into the future.”

    So it seems to me the point you are making here — and it is a very important point! — is not that super-low interest rates cause people to do strange things, but that we only get super-low interest rates if people are doing strange things. In other words, this is an explanation for why interest rates WON’T get lower, not for why they shouldn’t. Or more precisely, it’s an argument for why the term structure does not move as a unit with the policy rate, but rather, spreads are wider when the short, risk-free rate is low than when it is high.

    The other point I would disagree with you somewhat is that there is something pathological about efforts to reduce the uncertainty of the distant future by vertical integration, etc. On the contrary, I think it’s very desirable to increase the weight we put on far-future outcomes. To take the most obvious example, dealing with climate change requires us to act as though we were in a very low-interest environment.

  2. Put another way, there are many actions for which the long-term social benefit is more predictable than the long-term private benefit. (If only because people die, firms go bankrupt, but society continues.) Again, dealing with climate change is an obvious example, but investment in any long-lived capital good has the same quality. Structures are a big part of the capital stock, and they last practically forever — personally, I don’t think I’ve ever lived in a building that was less than 60 years old. When the market interest rate is low, more of those long-term social benefits are internalized by private actors.

    1. Hi J.W.,

      Regarding whether risky rates will be low, yes, I am making the point that it is a trade-off, in the sense that in response to a decrease in the risk-free rate, risky rates will fall a little, and the risk premium will increase a little.

      In regards to whether it is pathological or beneficial to reduce certainty, well, it depends on who is reducing the uncertainty and with what means? We want investors to reduce uncertainty by diversifying, but we don’t necessarily want firms to try to do the same thing, because they tend to be inefficient at doing many different things, which has an overall cost in terms of productivity. Ideally we would like the capital markets to charge firms based on the collective risk rather than forcing the individual firm to attempt to reduce its own idiosyncratic risk.

      This is just like insurance. We don’t want insurance companies discriminating too much about who they cover — we want them to put people in large buckets, because the only social gain from discrimination is to reduce moral hazard. But there is a profit incentive for insurance firms to discriminate. That profit incentive increases dramatically as interest rates fall, because the value of the firm with the 1% hazard rate diverges from the firm with the 2% hazard rate (or the individual with a probability of needing catastrophic medical care). And although it may beneficial for the individual to take steps to reduce their risk of needing catastrophic insurance, it is not necessarily beneficial for the firm to try to reduce its own idiosyncratic risk. In fact, there can be substantial aggregate social benefit from an increase in idiosyncratic risk of all firms while keeping aggregate social risk constant, as the main such idiosyncratic risk faced by a firm is that it will lose business to another firm — e.g. competition. We want a lot of competition. We want firms to be subject to as much idiosyncratic risk as possible (that keeps aggregate risk unchanged). And we want firms to be charged an interest rate that is only dependent on the aggregate risk. Lowering the rate of interest increases the profit motive that undermines this goal.

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