Artificially Low Interest Rates Harm Economies in the Long-Term

by: David Trainer

Main­tain­ing arti­fi­cially low inter­est rates or exces­sive money sup­ply does per­ma­nent dam­age to economies in the medium- and long-term because it delays cre­ative destruc­tion, the process of replac­ing low-return invest­ments with higher-return invest­ments.

To help illus­trate this point, I present the “Invest­ment Oppor­tu­nity Sched­ule” in Exhibit 1 (click to enlarge), which plots the num­ber of invest­ment oppor­tu­ni­ties against the level of poten­tial return for each oppor­tu­nity. The most impor­tant take­away from Exhibit 1 is that low­er­ing the cost of cap­i­tal increases the num­ber of prof­itable invest­ment oppor­tu­ni­ties at the low-return end of the spec­trum. Nat­u­rally, investors grav­i­tate to the eas­i­est ways to make money and will allo­cate cap­i­tal to low-return endeav­ors as long as those low-return endeav­ors are prof­itable. The longer inter­est rates are low and money is cheap, the more cap­i­tal gets allo­cated toward the lower return activ­i­ties.

Simul­ta­ne­ously, as low-return activ­i­ties attract exces­sive lev­els of unde­served cap­i­tal, high-return activ­i­ties are starved for cap­i­tal. There­fore, arti­fi­cially low inter­est rates sub­si­dize invest­ment in low-return oppor­tu­ni­ties at the expense of invest­ment in high-return opportunities.

Exhibit 1: Lim­ited High Return Oppor­tu­ni­ties – Unlim­ited Low Return Activities

Source: Novo Cap­i­tal Man­age­ment, LLC as adapted from The Quest For Value by Ben­nett Stewart.

This exhibit also illus­trates some key facts about cap­i­tal allocation:

  1. There is a finite num­ber of prof­itable business/investment oppor­tu­ni­ties, which means there is a finite sup­ply of cap­i­tal as well. If not, then finan­cial cap­i­tal and wealth would be infinite.
  2. The higher the poten­tial return on an invest­ment oppor­tu­nity, the more com­pet­i­tive the busi­ness and the more dif­fi­cult it is to main­tain a high return on investment
  3. There is an infi­nite num­ber of low-return and money-wasting opportunities.

As long as the inter­est rates are kept arti­fi­cially low, profit from lower-return busi­nesses is pos­si­ble even if it is not sus­tain­able. Hence, the short-term ben­e­fits of arti­fi­cially lower rates are that they keep more busi­nesses oper­a­tional and slow the decline of exist­ing jobs and con­sumer spend­ing – which is what helps keep politi­cians in office and reg­u­la­tors employed.

How­ever, since there is a finite amount of finan­cial cap­i­tal, the oppor­tu­nity cost of sub­si­diz­ing invest­ment in low-return oppor­tu­ni­ties is lost oppor­tu­nity to invest in high-return oppor­tu­ni­ties. I believe that the longer this pat­tern per­sists, the more dam­ag­ing and the larger the per­ma­nent loss of cap­i­tal, the longer the delay in cre­ative destruc­tion and the lower the long-term growth poten­tial of an economy.

I believe the Invest­ment Oppor­tu­nity Sched­ule also applies to the cap­i­tal mar­kets. In the con­text of the equity cap­i­tal mar­kets, spec­u­la­tive investors are those that flock to the easy and plen­ti­ful low-return oppor­tu­ni­ties that emerge in low-interest rate envi­ron­ments. Their invest­ment returns rely much more on other spec­u­la­tors fol­low­ing them than on the value cre­ated by the under­ly­ing busi­nesses they choose to own. Value investors make their money by find­ing stocks at the oppo­site end of the spec­trum: the few high-return oppor­tu­ni­ties.

In the same way that arti­fi­cially low inter­est rates lower the long-term growth poten­tial of economies, spec­u­la­tive invest­ing low­ers the long-term growth poten­tial of cap­i­tal mar­kets because it dri­ves allo­ca­tion of cap­i­tal to lower-returning invest­ments. In fact, taken to its log­i­cal con­clu­sion, arti­fi­cially low rates and spec­u­la­tive invest­ing can even­tu­ally, if left in place for too long, ruin economies and mar­kets entirely. In addi­tion, spec­u­la­tors, like low-return investors, can be put out of busi­ness quite quickly when rates rise or money gets tighter.

Disclosure: No positions