We are told that when interest rates are too low, they are encouraging entrepreneurs to take risk. So we have low interest rate policy LIRP, Zero interest rate policy, ZIRP and negative interest rate policy NIRP.
However, these policies impacts the business models differently. At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. At the other extreme, there are weak business models, those that are viable only in low return scenario. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks.
How low interest rate leads to mal-investment
A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. Ideally, even in lower interest rate scenario, those projects with best risk-return trade-off should get financed.
However, in reality, lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. Typically, such irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers.
First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Intelligent investors will find that this contradicts with the "diversification as risk management" strategy. But being with herd has a stronger lure and is treated as risk mitigation (though wrongly).
Further, at lower interest rates, debt starts being used as an instrument to amplify equity returns. With unchanged return on capital employed, you can have higher return on equity when return on debt reduces. Return on debt is function of interest rates and lower share it claims from the total returns made by the firms.
Thus the second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy.
In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios.
This is particularly true when there is some demand in the system.
What happens when there is no demand?
When there is no demand in the economy, low interest rates / ZIRP / NIRP etc are said to stimulate this demand. This, to my simplistic mind, sounds like offering desserts to the already overfed diner (AOD) with the hope to eliminate world hunger. Let me explain.
We hope this AOD, when offered with a free desserts will take them and pass them along to the hungry. In this method we depend on the magnanimity of intentions of our already overfed diner. Then we presume he shall act on his instincts and find worthy hungry who can transmit the benefits to others. It is quite possible our Glutton may pass the desserts to his friends or family and each can be a little more fatter. Are we, then to wait for all the gluttons to be severly beefed up or porked up before the trickle down starts to the hungry?
It sound like bull-shit method to me. Particularly I cannot understand why you are preventing the hungry from feeding themselves - either by employing them or letting entrepreneurs do it by financing them with reasonably priced debt/credit. These entrepreneurs are left to finance their ventures with credit cards, overdrafts and other very high cost financings at considerable peril. Now since these financing schemes are not on the business side, they are paid out of the post-tax income generated by the firm (but they should have been tax deductable at firm stage itself). This is doubly onerous for the entrepreneurs.
Treat Interest rate like friction
A better model is to think of interest rate like engineers think of friction. Some is good, too much is bad, too little is bad too. In fact friction analogy should be best suited for determining neutral rate of interest.
Economist too think of interest rate as friction. To the economist - road mileage of the car represents growth, fuel represents capital availability or liquidity. The economists' metaphor of friction is flawed. They need to get their metaphor right.
Engineers will tell you - you need to maximize friction at the tyres and eliminate it from the engines. At the clutch and brakes too you need friction. So you need interest rates high at some places and low at some others. So Economists better figure out where you want low interest rates and where you want high interest rates. Note the question is where not when.
The hazards of the LIRP, ZIRP and NIRP far outweigh the benefits. These policies do not pass the smell test. We need a better understanding of interest rate as a tool for improving economic growth.