Monday, 27 March 2017


Interest rates, profits and competition

July 9, 2015

Over at the Wall Street Journal, Greg Ip sees a lack of competition in corporate America. He notes that:

Competition forces companies to invest in new products and new capacity to hold on to customers and capture new ones. Less-intense competition may thus explain some of the puzzles that hang over the U.S. economy.

Profits are at or near all-time highs, both as a share of economic output or relative to assets. And the cost to borrow has seldom been lower. In a perfectly competitive world, firms ought to exploit those cheap borrowing costs to add profitable new capacity and products, until all the added competition pushes profits down.

It all seems rather straightforward, but Ip has mistakenly reasoned from a price change.

A (1) lack of borrowing in the face of low interest rates and (2) high profits as a share of economic output or relative to assets do not indicate that corporate America is less competitive. Interest rates are low because the demand to borrow has fallen. Profits are high on the margin because there is less investment. Technological growth just isn’t what it used to be and businesses are borrowing and investing less as a result.

Anyone with an Econ 101 course under their belt should be able to wrap their head around the low interest rates. As total factor productivity declines, businesses reduce their demand for loanable funds. Interest rates fall and the quantity of funds borrowed to purchase new plant, tools, and equipment falls as well.

The rise in marginal profits might seem counterintuitive, but, again, it is consistent with basic economic principles. When you reduce investment, you forego taking on the least profitable projects available. The ones that remain are necessarily more profitable. And your portfolio of projects is smaller. As a result, we see profits as a share of economic output or relative to assets rise when investment declines.

Assessing the extent of competition is always a challenge. As Hayek made clear, competition is “by its nature a dynamic process”. Unfortunately, the task is made even more difficult when one fails to account for genuine changes in the real economy. We might not like low technological growth and low economic growth, but the existence of historically low growth rates does not imply there is something we can do to make things better. And it certainly doesn’t imply there is a lack of competition in corporate America today.

One Comment

  1. WaltFrench July 9, 2015 3:45 PM

    “Interest rates are low because the demand to borrow has fallen.”

    The writer apparently is not of the “supply side” school*. There is the little matter of our Central Bank, which has been trying desperately to jumpstart economic activity so that there WILL BE stronger demand for borrowing.

    * Yes, a joke. But what only talking about demand is a joke.