The Federal Reserve gave interest rates a haircut again this week. Overall, this was undoubtedly the right call: The economy needed the boost, and there's ample evidence the central bank increased its rate target too high and too fast in recent years. But no policy tool is perfect, and lower interest rates do come with downsides.
One well known problem is lower interest rates leave the Fed ill-prepared to fight the next recession. The less room it has to cut, the less juice it can give the economy. But there's another, more subtle problem with low interest rates: they encourage bigness.
In some key ways, lower interest rates make life easier on big, established companies, while helping to kill off smaller firms and businesses that are just starting out. This leads to markets and industries across the country being dominated by a smaller number of massive players. That means more monopoly and monopsony power; less competition, less innovation, and less investment; depressed wages for workers and more payouts for the wealthy; and a less vibrant and democratic society in general.
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First off, lower interest rates make it harder for smaller and community banks to thrive. The basic business model of banking is that you make your money on the "spread" — the difference between the interest the bank pays to depositors and firms and other banks, and the interest it charges to borrowers. As overall interest rates in the economy fall lower, the spread naturally shrinks as well. And big banks, being big, have the resources and buffer to survive low-profit environments longer — they just outlast their smaller competitors, or just as often gobble them up.
Since 1980, U.S. interest rates have been on one long and almost-continuous slide, and are now barely above zero — the Fed's current target range is 1.5 to 1.75 percent. Meanwhile, from 1994 to 2014, banks with less than $10 billion in assets went from controlling 40 percent of all assets in the banking industry to just 18 percent. The five largest banks went from controlling less than 20 percent of all banking assets to controlling 46 percent. The total number of banks in the country was over 35,000 in 1994, and less than 15,000 in 2014.
Interest rates aren't the only culprit. In particular, a 1994 law removed a lot of the barriers to banks opening branches in multiple states, and opened the door to more bank mergers. But the two forces also reinforce one another: As law changes make mergers easier, lower interest rates make failing smaller banks easier prey. (Conservatives also try to argue that more costly and complex regulations drove smaller banks into the ditch, but their evidence is sketchy, to put it kindly.) Overall, a 2014 Fed study concluded that three-fourths of the decline in smaller banks since 1990 was due to the consequences of falling interest rates.
The other critical point here is the financial system really is the "shadow government" for much of the rest of the economy. By directing credit and investment, banks and financial firms decide which companies and business practices and industries and entrepreneurial efforts get support and which don't. They decide which economic experiments to pursue and which to forego. They pick the winners and the losers. Banks are the central planners that dare not speak their names. The fewer banks there are, the bigger and more centralized the planners for the entire economy become.
But lower interest rates affect the rest of the non-financial economy in a more direct way as well.
The traditional assumption in economics is that lower interest rates encourage investment and growth across all companies, regardless of their relative sizes or the structure of the overall market. But economists Ernest Liu, Atif Mian, and Amir Sufi released a paper recently suggesting it's not so simple. If interest rates are cut to stimulate the economy, and then return to their previous level — if low interest rates are a temporary interlude, in other words — then the traditionally assumed effect holds. But if low interest rates are persistent over time, the advantages accrue to the market players that are already bigger. Cheap credit allows them to just keep investing and investing to gobble up even more market advantage, until they pull so far ahead that they swamp the rest of the competition.
In a presentation to the Federal Reserve, Mian took this argument further, pointing out that low interest rates are not handed out equally by the financial system. Sure, interest rates have fallen for everyone across the economy since 1980. But they've fallen faster for the dominant 5 percent of players in various industries (Figure 8 here), so the gap is getting bigger and bigger. Basically, the financial system considers the companies that are already the biggest players in their respective sectors to be the surest bets, so it favors them with the lowest interest rates, further increasing the gap.
In short, interest rates that just keep falling for a long time leave the economy more and more dominated by a small number of giant firms. They do this by both consolidating the financial industry — the economy's "shadow" government — but also by consolidating all the other industries that finance directs.
Does this mean the Fed should start hiking interest rates again? No. The economy couldn't take it, and we'd get another recession right away. That wouldn't solve anything.
Mian also pointed out in his presentation that rising inequality is a huge factor here: As incomes stagnate for most Americans, and more of our total national income and wealth gets hoovered up by the top 1 percent, the economy turns to debt to generate enough consumption to keep functioning. At this point, there's so much debt sloshing around out there that central banks can't hike interest rates without setting off a crisis.
What we need is to use the other tools available to us to create a more egalitarian economy again, where everyday people get a big enough chunk of wealth and income to consume and keep the economy humming without relying on borrowing. That means unions and labor law reforms and minimum wage hikes and public investment and government hiring to tighten up labor markets and generate sustained full employment. With the economy back on sound footing again, then the Fed can safely raise interest rates.
Left to its own devices, the Fed's desperate efforts to drive interest rates ever lower haven't been enough to stop the economy from rotting. And they've produced some nasty side effects, to boot.
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