Prosperity in a Low Interest Environment

Knolle, Julia (2020): Prosperity in a Low Interest Environment. Published in:

Abstract

Persistently low interest rates in several advanced economies during the past decade have puzzled economists. Explanations on what caused them and what could or even should be done in light of such rates abound. One of the most prominent narratives is the so-called “secular stagnation hypothesis”. According to this theory, low interest rates indicate a lack of profitable investment opportunities. If left unchecked, this leads to high unemployment and stunted growth for the economies in question. This has caused several economists to call for government interventions in order to close the presumed gap between investment and saving. However, these gloomy predictions are in stark contrast to the actual economic development observed over the past decade, which featured record-lows in unemployment, continuing growth, and more or less steady capital investment levels.

The ongoing debate focuses mainly on interest rates on debt instruments. The cost of equity is often overlooked, even though it is a significant source of financing for firms. This thesis addresses this shortcoming by taking into account both cost components. Instead of approximating the marginal productivity of capital using interest on government bonds, a new measure based on the Weighted Average Cost of Capital (WACC) is employed. The WACC – a widely used instrument from the field of finance – takes both equity and debt into account and constitutes a hurdle rate for firms’ investment decisions. Using proprietary data from Bloomberg, an analysis covering all OECD countries ranging from 2000-2017 is undertaken, including over 25,000 firms. The results are striking: while the cost of debt has declined over the course of the timeline, the cost of equity has remained stable or even increased, keeping the overall WACC constant. This stresses the importance of distinguishing between different sources of financing to get a comprehensive picture. The approach introduced here is thus able to shed new light on different aspects of the current low interest environment.

• Item Type: MPRA Paper
• Language: English
• Keywords: Low Interest Environment, Marginal Productivity of Capital, Investment, Weighted Average Cost of Capital, WACC, Secular Stagnation, Equity Premium Puzzle
• Subjects: D - Microeconomics > D2 - Production and Organizations > D24 - Production ; Cost ; Capital ; Capital, Total Factor, and Multifactor Productivity ; Capacity; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E60 - General; H - Public Economics > H6 - National Budget, Deficit, and Debt

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