The Point of No Return

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.