The hidden cost of cheap credit

Is a low interest rate always a good thing? If you’re a homeowner with a mortgage, your answer is going to be a resounding yes. What if we think on a more macro level, and consider how those low interest rates are going to affect the allocation of capital? In this case, the answer is a bit more nuanced. The situation played out in the real world over the last few decades, as Southern European countries joined the Eurozone and gained access to cheap credit. Policymakers initially suggested that this stimulated investment and boosted growth. However, if banks cannot distinguish between productive and unproductive borrowers, this logic may not hold, as we saw in Southern Europe when low-efficiency firms obtained funding, sometimes at the expense of more productive ones and hampering long-term growth.

To better understand this relationship, Anastasios Dosis, professor of economics at ESSEC Business School, explored the link between low interest rates, capital misallocation and welfare in a recent article published in The Journal of International Economics. Hefound that low interest rates over a prolonged period can in fact allow weak firms to survive at the expense of stronger ones that could otherwise have boosted the economy. In other words, while there may be a boost in investment, overall economic welfare slumps.

To explore the relationship, Dr. Dosis used a theoretical model of a small, open economy, including entrepreneurs (or firms), ranging from bad to good. The “good” entrepreneurs were defined as those more likely to produce positive returns. These entrepreneurs had a fixed amount of wealth to deposit, and could spend this wealth on their technology or apply for a loan to capitalize on the risk-free interest rates. Banks lent at competitive rates, but were at an informational disadvantage as they were unable to fully detect if the entrepreneurs were good or bad. This meant that the decision to give a loan depended greatly on the quality of the average borrower.

His model found that these low interest rates meant that low-productivity firms, who would not have otherwise qualified for a loan, could get a cash infusion, even if their product technology was risky. This led to a chain reaction, with banks raising lending rates over time to compensate for these risky investments, meaning high-productivity firms had to limit borrowing and investing. Looking at it another way, this meant that the risk-free interest rate and entrepreneurial wealth affect lending equilibrium. For any level of wealth, there’s a key interest rate threshold: below it, all good firms and some bad firms borrow. The number of bad firms borrowing and the amount each firm borrows depend on this rate. At very low rates, all firms borrow. As rates rise, fewer bad firms seek loans, because the opportunity cost is greater and their projects become less valuable. Once the rate passes a certain point, only good firms borrow, meaning the pool of borrowers improves in quality. In this way, it acts as a screening device for banks.

Key takeaways

Low interest rates allow riskier firms to overinvest, since their investment is subsidized by the higher-productivity firms who underinvest.
Risk-free interest rates can act as a tool for differentiating productive firms from unproductive firms - a finding that was overlooked in past research.
A rising rate can make lending more efficient, and can boost long-term economic welfare.
In a case where banks have asymmetric information, this type of easy-to-access loan is not always positive for welfare, since it allows lower-productivity firms to survive with the cheap credit. Dr. Dosis notes that there is a “welfare-reversal interest rate” - and that below this rate, the credit has a cost, since it leads to the allocation of capital to unproductive firms.

Dr. Dosis underlines that a key message from this research is that not all investment has a beneficial impact. Increased access to borrowing can undermine economic growth in the long run - so pinpointing an interest rate that remains low enough to encourage firms to invest, yet high enough to filter out the less productive firms, is essential in preventing capital misallocation. Policymakers and central banks should ensure that their long-term goal is not just to stimulate more lending, but also to make sure loans go to the most productive borrowers - otherwise, cheap credit becomes very expensive indeed.

Further reading

Dosis, A. (2025). Low interest rates, capital misallocation and welfare. Journal of International Economics, 104096.