Interest Rates: How Superstar Firms Depress R‑Star

SUMMARY

  • Technology and globalization have disproportionately benefited the most innovative and productive firms, leading to rising concentration as a small number of “superstar firms” (think of so-called FAANG) increasingly dominate their respective industries.
  • Superstar firms make higher profits, save more than they invest, and pay out a smaller share of their value-added to labor. The rising importance of superstar firms therefore helps to explain key macro phenomena such as the global ex-ante excess of saving over investment, rising income and wealth inequality, and low wage inflation despite falling unemployment (the “flat Phillips curve”), all of which have contributed to the current environment of low natural (r-star) and actual interest rates, which in turn supports high equity valuations for the superstars.
  • What could reverse the ascent of superstar firms and thus the decline in r-star? (1) protectionist policies that accelerate deglobalization; (2) antitrust policies that curb superstar firms’ quasi-monopoly profits; and (3) a surge in labor’s bargaining power that leads to significantly higher wage growth for the bulk of the workforce. None of these seems particularly likely anytime soon. So superstar firms and super-low natural interest rates are likely here to stay.

Over the past quarter century, large and ever-larger companies have significantly increased their share of total intra-industry sales across a majority of industries. These superstar firms – including Facebook, Amazon, Apple, Netflix and Alphabet’s Google (known collectively as FAANG) – increasingly dominate their respective industries in terms of revenues, profits and stock market capitalization. The winner these days may not take all, but most.

What explains this “winner takes most” trend? The two most plausible explanations are technological change and globalization. The latter has increased the size of the market in which large companies can exploit their competitive advantages, thus reaping economies of scale. Technological advances also support concentration. Search engines and price aggregators allow consumers to find the most competitive suppliers more easily, channeling sales to the industry leaders at the expense of laggards.

Moreover, a recent National Bureau of Economic Research (NBER) working paper finds that rising concentration is more prevalent in dynamic industries exhibiting rapid technological advances, as measured by total factor productivity and patent intensity (see D. Autor, D. Dorn, L. Katz, C. Patterson and J. Van Reenen, The Fall of the Labor Share and the Rise of Superstar Firms, May 2017). Many superstar companies also benefit from network effects that are especially strong in social media and software platforms, where the value of the services increases with the number of users. Size begets size, which in turn begets size.

The long-term decline in interest rates

The secular rise of superstar firms helps to explain several important macro trends, which in turn have all contributed to a secular decline in natural interest rates (r-star) and actual interest rates.

First, superstar firms earn larger profits relative to their revenues, and they save (retain) most of these profits rather than distribute them to shareholders via dividends or share buybacks. Typically, superstar firms’ saving exceeds investment, implying that they are net lenders to the rest of the economy. As a consequence, many have accumulated large cash piles that are invested in financial assets such as government or corporate bonds. An important reason for larger cash holdings appears to be that most of their investment in intangible capital – human capital, research and development, and intellectual property such as patents and trademarks – cannot easily be financed by bank credit.

Led by superstar firms, the corporate savings glut has contributed to low natural and actual interest rates. In fact, a recent research paper by the Federal Reserve Bank of Minneapolis documents how the global corporate sector transitioned from being a net borrower to a net lender to the global economy over the past several decades (P. Chen, L. Karabarbounis and B. Neiman, The Global Rise of Corporate Saving, March 2017).