Companies have a bigger incentive to collude with low interest rates

On top of impotent monetary policy and the risk of new bubbles forming, there is another downside to low interest rates: more collusion, a situation in which companies (implicitly) agree to charge higher prices. With lower interest rates future gains become relatively more important to companies (and anyone else) when compared with the present. This leads companies to pay more attention to the strategies of their competitors and the effects of these strategies. In turn, that means that cartels become more stable, and hence lower interest rates lead to more collusion.

When the interest rate is high, present income becomes relatively more important than future income. With an interest rate of 10% per year, an income of $100 a year from now, is equal to $91 today. With an interest rate of 1% per year, an income of $100 a year from now, is equal to $99 today. Evidently, future income becomes more valuable with a lower interest rate.

Companies that are competing consider how their competitors will respond to their (potential) actions. Starting a price war may be lucrative in the short run, as the company that moves first gains more customers (temporarily), as these consumers look for the best bargain. The competition will soon follow, so this lucrative moment is only short-lived. Once the price war ensues, profits will drop. In a low interest environment the anticipation of these lower future profits weighs heavier in the decision making, as these future profits become more important as argued before. So, with lower interest rates companies have a weaker incentive to compete fiercely.

Lower incentives for companies to compete, lead at the very least to more tacit collusion: companies collude “without explicitly saying so.” Moreover, in a cartel (explicit collusion) the retaliation by the competition for breaking the cartel hurts more when interest rates are low, following the same logic as before. A cartel is more stable, and detrimental to social welfare, when the companies in the cartel are a more credible threat to any company that contemplates leaving the cartel. The negative impact on the deviating company of retaliation (the cartel joins the price war) is higher when interest rates are low. This means that companies that consider to deviate, will do so less often when interest rates are low. And therefore low interest rates contribute to more collusion, offering another reason for boosting interest rates.

This article was inspired by a Coursera lecture by Tobias Kretschmer on Competitive Strategy.