Dr. Keynes Was Right

It's the Distribution, Stupid
DECEMBER 29, 2011 11:06AM

The Point of No Return

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A comment on Can I Peak Your Interest, said, "there's also a basic supply and demand element to interest rates." (this guy).  For better or for worse, this is a common misconception, due to treating cash as a commodity.  It isn't.  As Adam Smith, the real one, asserted, it exists only to simplify barter.  Yes, currency arbitrage has been around at least since Jesus tossed out the money changers.  That still doesn't mean that, in a functional economy, cash is anything more than WD-40.  That's really all it is.

Where it gets a little more complicated, is in capital.  Currency is fiduciary capital, whose only reason to exist is to buy physical capital, which economists have long referred to as plant and equipment/machinery.  Until recently, anyway, when the quants on Wall Street invented new and bizarre ways to separate "investors" from their currency.

What determines supply and demand?  In consumer goods and services, economists have long hung their argument on "utility":  an iPhone or Hostess SnoBall or a visit to a massage parlor each bequeath to me some level of this "utility".  It is the utility that justifies the payment.  And this utility is in my head.  The utility of the three legs of the survival stool; food, clothing and shelter, is easier to calculate.  But most of what we consume these days is outside the realm of basic survival.  For a bit longer, at least.  In any case, the supply and demand idea applies here:  the perceived utility sets the level of demand.

With physical capital, it's pure arithmetic.  If a new plant or machine yields a 10% improvement in production, that's what I'll pay to have that plant or machine.  A lower interest rate won't entice my to buy more of that plant or that machine, if there isn't a market for the widgets I'm making.  A higher interest rate will compel me to say no.  The interest rate is set by the physics and engineering of the plants and machines available to capitalists.  In an ideal world, of course, and the one devised by the Wall Street Banksters is pretty far from that.  But all they can do is distort the process, mostly to their advantage.  The fact remains:  the real rate of return on new plant and machines determines the interest rate.  Since we've moved on to a Post Industrial Society (haven't we?), matters get a bit more complicated.  If money is lent for purposes other than conversion to physical capital, what's the proper interest rate?

Ah, there's where the Banksters messed up.  By convoluting the connection between cash and real investment (which broadens the definition to assets beyond simple plants and machines to include any amortizable purchase; I said it was a bit more complicated), they've been able to obscure the process.  

By now most understand that Greenspan is Patient Zero of The Great Recession, when he caved interest rates under BushII.  If ours were still an industrial economy, very low interest rates *would* have led to a surge of physical investment, since useful, but lower return, plants and machines become profitable.  Rather than buying productive plants and machines, all that Greenspan cash ended up in housing CDOs.  Why?  Because it was viewed as being easier.  Easier for two reasons:  1) there wasn't all that pesky stuff to keep track of and 2) the Banksters didn't have to go find capital intensive businesses to soak up the cash.  Recall, much of the free cash was coming out of Asia, and profitable physical investments had already been transferred to Asia.  Even the Chinese were looking elsewhere to stash (at a profit) all that cash.  

Thus was born the subprime loan.  And a short respite for the middle class from the debilitating effects of declining median income.  The respite also happened to capitalists:  while the Right Wingnuts among them rail against consumer debt, without it, all those cushy executive jobs would go the way of the dodo, along with the companies.  As Eccles says, an industrial economy requires a way to absorb increasing productivity.  If it doesn't get distributed as wage increases, other methods will be found.  They were.

The problem from a capital allocation, macro-economic, point of view is that housing isn't capital investment.  Housing is just serial consumption of that "utility" thingee.  The home owner doesn't generate an economic return on his use of the house; he just lives there with Wifey and 2.2 mini-thugs.  For what it's worth, China is finding itself in a housing frenzy, too.  Again, not enough clever engineers figuring out better plants and machines.  And if they did, there'd be still lower wages for workers to buy the widgets.  Can't get away from the distributional collateral damage.  Mortgages are supported by (median) income, and nothing else.  They're not real investment.

So, back to the initial comment.  A supply and demand answer to interest rates in capital is less true than for consumer goods just because the value of the use of capital (not the cash itself) is, with sufficient effort, exactly calculable.  This is not true for most consumer goods, which are valued by intrinsic "utility".  Thus, the interest rate is determined by the inventiveness of engineers to devise more efficient machines.  

Absent, of course, Dr. Evil.

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if economics were subject to calculation, why aren't we living in a socialist state?
I didn't say that all of economics was calculable, only physical investment decisions. But...

Because: for the 28 years from Reagan to BushII, the Right Wingnuts controlled at least 3 of the 4 branches of government for 22. What we have is the Eden of Fascism.

What we have is fascism; the difference between it and socialism: fascist governments tilt the economic playing field to benefit corporations, while socialist governments tilt it to benefit regular citizens, i.e. the 99%. Check Wikipedia.

The calculations take place all the time in corporations. It is well known in the trade that gross profit margins run in the 40% range. Gross profit is revenue minus direct cost of production; the latter includes labor costs. The fact that all those .1%-er tax cuts and interest rate drops didn't yield new physical investment is the indictment of "capitalism". It doesn't serve the economy or the society.

It's worth noting that "Wealth of Nations" and other works cited by the Right Wingnuts, discuss a world which doesn't exist now, and largely didn't exist then. The real world is monopoly, not free markets. The 18th century image of the Right Wingnuts is Rose Colored. The reality was that the White Folk plundered an Eden of resources (after killing off the pesky natives) not available in hated Europe. I heard a clip of one of the Right Wingnuts (Perry or Mitty, not sure) claiming that we aren't Europe. Guess again. We're just as crowded and resource scarce. That's what matters.
Just noticed this now Robert. I'm rushing off but will give it a fuller read tomorrow.
Robert, there's a rough correlation between interest rates and economic growth but I'm not sure how well the above analysis holds up when a larger proportion of the economy is service based or comprised of things like software development where there's relatively little plants and machinery.

And while money isn't a commodity in quite the same way that a physical good is, there is still a certain level of supply and a certain level of demand. So why wouldn't normal market clearing principles act to have some effect on the rate of interest?
Define the market. That's the difficulty. The "value" of a currency is arbitrary, even one "backed" by specie. Value exists in the real world goods and services produced in the economy. As I've written extensively, economies which choose to de-industrialize end up failing; the currency is no longer "backed" by stuff anyone wants.

As I mentioned before, the 19th century US economy was, largely, one of specie currency, as was marked by continued deflation. We had a growing population, a virgin (to white folks, anyway) continent, and a growing economy. But, by and large, a fixed amount of specie. Price level fell over the century.

That's what, GE for instance, did: stop making stuff and go for financial services. One of the largest TARP welfare queens. Has gotten religion and gone back to making stuff.

The problem with purely fiduciary "investment" is that there is no connection to real world productivity. This disconnect is quite while the Great Recession was preceded by sub-primes, housing is un-productive "investment". The Smartest Guys in the Room decided that more money could be made by putting money into houses rather than machines. They were wrong.

As to currency-as-commodity, it's been tried over the centuries. Ultimately, whatever's defined as cash can be traded like real goods (and services), but it's eventually pointless. Value lies in real goods and services, not gold or coins and papah bills (as my German money and banking professor said).

The supply side view of investing, savers, doesn't work any more than supply side silliness works any where else. As TARP and the 0% Fed window have demonstrated, cash doesn't get converted into plant and machinery unless there's real productivity (which can be converted to greater sales to consumers) to be bought. You can't push a string.

My assertion is simple: no matter what the fiduciary markets think they can do, the rate of interest, ultimately, is set by real world productivity. One of the hallmarks (and economists have known this for decades) of a service economy is that capital has little impact, since so little is needed to conduct business. Understanding that leads to a clue why the Great Recession won't go away: even with near 0% interest, there's just no demand for the cash for real investment.

The Banksters created the subprime, high return, mortgage to satisfy the demand for a low responsibility (not having to find real physical investment opportunities) use of the cash. Inflation paranoia on the part of those who engage in mere financial "investing" is driven by the simple realization that there's "no there, there" backing up these "investments". Thus, the demand that the currency never inflate; deflation is even better. But these actors have no connection to real world productivity.

As to savers responding to higher interest rates by saving more, hasn't happened. The Chinese are heavy savers because the economy and culture don't support consumption, due mostly to really nasty distribution. In other words, Chinese families haven't sent us remnimbi because they want dollars. The cash has come our way because the Chinese government has extorted it from the citizens. Chinese government, and capitalists, need the American consumer more than we need China. Most of the stuff that comes from China is out of the realm of sustaining; mostly toys, literally and figuratively.

Typing this all into the teeny comment window may yield gibberish, since a train of thought longer than a nanosecond doesn't fit.