For small businesses, low interest rates are typically a good thing, making it cheap to borrow money and put it to work. The result is—or should be, at least—higher productivity.

But after a decade of ultralow interest rates, productivity growth in the US and many other developed countries is relatively low. Princeton postdoctoral research associate Ernest Liu, Princeton’s Atif Mian, and Chicago Booth’s Amir Sufi have a theory to explain this conundrum—and may also explain why low rates can hurt competition and hold back economic growth.

Big gets bigger, and underdogs quit trying

To understand their argument, imagine a small pipe-making company and its larger competitor. Conventional economic expectations hold that interest-rate declines lead to higher business spending. When rates are falling, both the small and large companies might borrow to upgrade equipment, invest in new technology, and improve their production lines. If big enough, they might buy out competitors.

The researchers’ model finds these expectations hold true in some cases, namely when the companies involved have roughly the same market share, or at least are on somewhat equal footing in terms of competition and productivity.

The issue is that while interest rates initially spark company spending, they then induce a productivity gap between dominant and smaller companies that ultimately discourages both groups from spending. As interest rates fall, dominant companies gain advantages. These companies typically invest the most—and gain the most too. When the big pipe-making company invests, it produces a better, cheaper product and becomes a larger competitive threat. It gets more productive and gains an ever larger share of industry profits.

By the time interest rates reach near zero, the productivity gap between the large and small companies is particularly large. At this point, industries enter what the researchers call a monopolistic region, where smaller companies’ productivity is too far behind to make investment prudent. Small companies become too discouraged to invest because “these investments pay off only if you actually have a chance of getting to market leadership,” the researchers write. Eventually, if the pipe-making market is no longer truly competitive, the dominant company will stop investing, too, because it sees no more threat from smaller competitors. It needs only to maintain its market position, not to innovate and improve to the same extent as before.

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The researchers tested their findings by building a mock stock portfolio long on industry leaders and short on smaller followers. Looking at the performance in response to changes in the 10-year Treasury rate going back to 1962, the researchers find that the portfolio clocked higher returns when interest rates were declining, and the returns were largest at the lowest interest rates. “As in the model, the fall in long term rates has been associated with a rise in industry concentration, higher markups and corporate profit share, and a decline in business dynamism,” they write, defining dynamism as the likelihood of a follower company overtaking a leader.

In short, as interest rates fell, rich companies got richer, and the smaller companies got stuck, or worse.

A global problem with a common history

Though central banks cut rates in the wake of the 2008–09 financial crisis, Liu, Mian, and Sufi note that productivity growth started sliding in 2005, before the Great Recession. Their model ties together a number of global trends, offering an explanation for why the decline in interest rates has been accompanied by falling competition, a decline in business openings and closings, and slower productivity growth. It also offers possible insights into the widening productivity gap within industries, in which fewer dominant companies now control more market share than they did before the recession.

Productivity growth has stagnated or declined throughout the advanced world. Giant companies have accrued massive wealth as their competitors fall behind. Two recent studies using Organisation for Economic Co-operation and Development data demonstrate that productivity gaps within industries have been rising, while there have been fewer exits by weak companies and fewer new entrants.

Liu, Mian, and Sufi don’t doubt that consumer issues were the impetus for the past decade of falling interest rates, but they suggest the persistent economic slowdown can be explained without relying on popular reasons for the consumer reaction. Rather, if companies have adjusted their spending in response to consolidation in the way that the researchers describe, higher concentration and less-competitive markets are why today’s economic recovery doesn’t look exactly like many hoped it would.

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