The ‘Natural Interest Rate’ Is Always Positive and Cannot Be Negative

The ‘Natural Interest Rate’ Is Always Positive and Cannot Be Negative:

Key Excerpt: “Some economists have been arguing that the “equilibrium real interest rate” (that is the “natural interest rate” or the “originary interest rate”) has become negative, as a “secular stagnation” has allegedly caused a “savings glut…”

The notion of a negative interest rate is against nature. The concept of interest rate is based on the human action of choice and preference, as the actor moves in space and time. For example, we choose things based on the preference of things that will provide us some sort of “pleasure”. If a person chooses item (x) before item (z), this means that in that moment in time, item (x) is preferred over item (z).  This process happens in space and in time. Time has passed forward, as the actor moves from item (x) to item (z). The definition of the natural rate of interest is the price ratio of goods at two different points in time. Based on this definition, and the notion of time, and space, the natural rate of interest can not be negative. Also, we can not go backwards in time based on our actions. This notion makes the concept of negative interest rates fallacious.

More Thoughts on Interest Rate

The Interest Rate: The mystery. The intrigue. Most individuals concern themselves about this when they are purchasing a home loan, acquiring credit cards, or purchasing a new vehicle. However, this notion is much broader than obtaining more debt. It is much broader, yes, much deeper than imagined, as is not well understood, even by philosophers, economists and finance scholars. The natural rate of interest, or ordinary interest, is inherent in every thing we do as actors in a “free market” economy.

What is the Natural Rate of Interest?

Classical Economic Model

There are two divergent models of analyzing the notion of natural rate of interest. The first model is derived from the Classical Economic school of thought.  This model is based on the popular Economic frame work of supply and demand. Simply put: The interplay of the supply and demand of money, produces a particular interest rate.(Ceteris paribus)  For example, if demand is held constant, and the central bank increases the monetary base, the interest rate would fall. Conversely, if the Central bank decided to reduce the money supply, with demand remaining constant, the interest rate would rise (Ceteris paribus) If this is analyzed from the demand side, if demand rises for the currency, and the currency bases remains the same, the interest rate rises.(Ceteris paribus). If the demand for the currency falls, and the currency base remains the same, the interest rate will fall.(Ceteris paribus) This Classical model of analyzing the interest rate views things at a macroeconomic level.

Marginalist Economic Model

This model was specifically pushed forward by Marginalist Economist, Eugen Bohm Bawerk. As per Bohm-Bawerk et al, the notion of the natural rate of interest speaks to the time preference of consumption from the individual actor in the marketplace. To Wit: The time preference of from the individual’s consumption between today’s goods, as compared to future goods. Notice that this definition has little to do with the bank’s rate of interest, although the bank’s rate is a singular actor’s rate of time preference, as that actor would be the bank. This ratio, nets the prices between the two respective time periods. Of course, this activity is not a static, so the interest rate is constantly shifting, modulating and changing, as the actor’s preferences change.

Interplay of Interest Rates to Meet Equilibrium

Going back to the Financial Intermediaries, e.g Banks, Credit Unions, Financial Institutions, Insurance companies, and etc.) need to manage cash and their monetary equivalents, these institutions’ role in the market economy is vital. They are responsible for allocating scarce resources, to wit, providing cash capital to entrepreneurs. Many people mistakenly assume the bank’s interest rate is the same as the natural rate of interest, as this is demonstratively false.

Let us suppose that the bank’s interest rate is 5%, and the natural rate of interest, in the marketplace, was 8%. The bank would loan out, or invest, or place money in capital goods that would yield a 8% return. This process would continue until the bank’s interest rate matched the return on those capital goods. Why does this happen? As the bank continues to invest or loan out money into those capital goods, the demand for those monies and goods rise. As the money demand rises, due to the need to invest in capital goods, the bank’s price on money, the interest rate, rises. Once the bank’s interest rate, and the return on investment in capital goods equals the same rate, it makes no sense for the bank to move money into those capital goods.

What happens if the natural rate is below the bank’s interest rate? If the bank interest rate is 5%, and the natural interest rate is 3%, the bank will not seek to loan or invest into capital goods at that lower rate. What may occur is the following: Banks may continue to hold the cash, at 5%, until the demand for long term capital projects rise above 5%. In this case, as in the prior case, the opportunity cost of the bank’s money must be considered.

Banks are seeking to profit from the arbitrage: In the former case, the Bank seeks to make a profit from the spread of 8%, the natural rate, and the 5%, the bank rate. As for in the latter case, the bank seeks to take a more conservative position and hold onto its cash. In both cases, on the long run, all actions will seek to meet equilibrium.

Based on these two examples, the bank’s interest rate will not equal the natural rate of interest. This is true since there would be no profit seeking opportunities. The bank’s funds would sit idle, no cash capital would move other sorts of capital markets. This sort of analysis demonstrates that these two interest rates are not the same.

An Example of the Use of Interest Rates in the “Real World”

With a business that is capital intensive, management of this capital equipment is vital for the success. When a business owner is seeking more cash capital to acquire a piece of capital equipment, he should be factoring how this equipment can benefit his operation, on the margin. He will look at how the marginal cost impacts the marginal benefit. If the firm has extra cash, or investment capital, it will seek to obtain a return on investment on that capital. So, if the owner of the firm is purchasing a piece of manufacturing equipment, and will yield a return on investment higher than the natural rate of interest, and the current “bank interest rate”, the business owner will invest in that manufacturing equipment. The owner, like all humans, is engaged in a profit seeking enterprise. And, it is that profit that is his return on investment.

Conclusion

As with all things, in the capital markets, actors are constantly pushing towards equilibrium. All actors are seeking a state of peace, or in economic terms, equilibrium. The constant ebb and flow of the play between the natural rate of interest, and the interest rate placed by financial intermediaries demonstrates this. The natural rate of interest simply is an expression of human action, as the individual’s preferences span throughout the space/time continuum. 

Chinese Currency Manipulation and Price Controls

Introduction

The curious claim made against the Chinese about “Currency Manipulation” is gaining momentum. Many believe that the United States are “losers” in trade relations with China.  Somehow these modern day mercantilists believe that this impacts the trade deficit with China. In reality, the United States benefits from China’s “currency manipulation”, at the expense of the Chinese citizens. To have a deeper understanding why this is true, “currency” must be analyzed as a good, and the Chinese government, in effect, is placing price controls on its currency. When analyzed under this light, the outcome is pretty clear: the Tax Payer class in China pays the economic cost of this action.

Economic Theoretical Considerations of Price Controls

In economics, there are two types of price controls. The first type is where the Government places a price maximum on a particular good or service. When this happens, the price maximum is above the equilibrium price. Based on the law of demand, the stock of the goods will increase, thus creating a surplus of that particular good. An example of this is the “ghost” cities in China. There are many buildings that are empty because the prices of those buildings are above the equilibrium price. The second type of price control is where the Government places a price minimum on a particular good. In the event of having the Government implements a price control that is below the equilibrium price, a shortage occurs. An example of this situation is the long gas lines that occurred during the 1970s when the Government implemented price controls.

Currency Manipulation is a form of Price Control

To move forward in this analysis, one must look the currency as a “good”. Looking back at the claim that China is manipulating its currency, let us look at the ways that this falls under the two forms of price controls, as mentioned previously. When the Central Bank decides to increase the money supply, based on the Central Bank’s estimates, and not what the market demands, it is placing a price maximum on the currency. This creates a surplus of currency in circulation. On the other hand, if the Central Bank decides to remove currency out of the circulation, but not based on what the market demands, it is creating a price minimum on the currency.

The Case with China 

The Chinese currency, relative to the US dollar, in this exchange, is a victim of price controls. There is an exchange ratio between the US Dollar and the Chinese Yuan. That ratio is “fixed”(sort of). When the Chinese central bank increases the Yuan supply, it creates a surplus of Yuan in circulation. Since there is an increase of Yuan in circulation, this devalues the Yuan, in terms of the US Dollar. Since the US Dollar is not commonly used by the vast majority of the Chinese citizens, and those citizens use Yuan to purchase goods and services, the Chinese citizens pay the price for the increase in the money supply. This is inflation. The Chinese citizens will see the prices, as expressed in Yuan, increase. This also usurps their savings, and it impacts citizens that are on fixed incomes. The goods they normally purchase take more Yuan to purchase, yet the dollar becomes stronger, relative to the Yuan.

Who Benefits from Chinese Currency Manipulation? 

It is obvious that the Chinese citizens are not benefiting from currency price fixing. The savers lose out, and the folks on fixed income also lose too. But, the folks who can hold US Dollars are “winners” in this scenario. Why is this true? Since the Yuan is being held to a price maximum, and a surplus is created, this drives down the value of the currency. Yet, assuming the US Dollar stays constant, this raises the value of the Dollar, relative to the Yuan.  The holders of the US Dollar, who live in China, they all benefit greater than the other residents who use Yuan.

Conclusion

This dynamic is simply an expression of Gresham’s Law. The higher valued currency, drives out the lower valued currency, albeit in a “black market”.  In this case, the US Dollar and Gold are held by a minority of individuals, political class and the tax consumer class–and the Chinese Tax Payer is using the devalued Yuan to use to purchase goods and services. This entire scheme is all set up by the Chinese central bank and Chinese government.

The Luxury Tax: A Folly of The Consumption Tax

Introduction

Many politicians and lay persons believe the urban myth that Economics is a quantitative science, and that static analysis works with the interaction of human beings.  Politicians believe this when creating tax policy to generate revenues for the Government. These politicians sell the citizens that “taxing the rich” will increase revenue, or the implementation of a consumption/sales tax can simply be passed on to the consumer. All of these points are remarkably false.  All the costs of a consumption tax go back to the business owner, as it impacts the original factors of production: Labor, land and capital.   A glorious example of how this is proven to be true can be found in the famous Luxury Tax of 1990.

The Promise of the Luxury Tax of 1990

This tax was one part of a larger bill named: “The Revenue Reconciliation Act of 1990”.  This bill was created to generate over $140 Billion over a five year period. (Woof, 1991). For this analysis, we will simply focus on the maritime industry and the impact the firms in this market segment due to the implementation of this law. Specific to the maritime industry, any boat sales exceeding $100,000, there was a consumption (excise) tax levied.  The assumption was that consumers of yachts would absorb the increase price, as the other assumption was that the tax would be simply be passed on to consumers, and the Government would receive their projected revenues. However, this was not the case.

The Economic Impact of the Luxury Tax of 1990

The results of the implementation were not surprising for those who understand economics. First of all, the division of labor was impacted.  George Will remarks on the job losses due to this bill: “According to a study done for the Joint Economic Committee, the tax destroyed 330 jobs in jewelry manufacturing, 1,470 in the aircraft industry and 7,600 in the boating industry.” (Will, 1999)  In the State of Florida, the luxury tax impacted the layoff of approximately 13,000 workers. (Pin, 2011) This shows how the consumption tax impacts the division of labor, as it is one of the original factors of production.  Next, the businesses took a huge hit due to this tax. The Wall Street Journal notes here the following: “Yacht retailers reported a 77% drop in sales..” (Wall Street Journal, 2003)  Since sales drops, this reduces the amount of capital that business owners can purchase, borrow and pay back. The end result with this example:  Capital is impacted. What about land? How is this impacted? One can deduce that if sales are impacted, revenues are not able to keep up with the expenses.  Many of the boat manufacturers shut down their plants, and/or filed for bankruptcy protection from their creditors. (Salpukas, 1992) This would impact the land, since the boating manufacturing plants were closed down.

Economics is about Subjective Value

Many think Economics is about stats, graphs, charts and the like. While these items play a vital role in the historical analysis of human behavior, it does not tell the entire story.  Our individual preferences, as humans, are highly subjective. This sort of subjectivity cannot be accurately quantified, nor is the analysis static.  This is the fundamental reason why these sorts of Central Planning projects always fail.  It assumes that humans do not seek alternative choices when the costs to obtain a good change or rise.  Rising prices act as a harbinger for consumers, so they can alter their ordinal goods/services preference ranking. If someone prefers eggs over toast, yet the price of eggs rises exponentially, this does not mean the consumer will continue to purchase eggs. The consumer’s resources are scarce as well, even if they are “rich”. They have other items they prefer, and may choose to plow resources into those items when the price of eggs, using our example, rises too high. This is the notion of elasticity of demand.  Each individual actor has a different preference ranking, and that ranking changes constantly. It is impossible for any human to “plan” out or predict what those rankings will be for millions of individuals.

Other Economic implications from the Luxury Tax of 1990

The Luxury tax bill of 1990 was passed into law in the hopes to generate more tax revenue for the U.S. Government. However, the tax revenues fell short.  After the first year of its roll out, the tax revenues, due to this tax, was about a few tenth of a million dollars. (Pin, 2011) This is not shocking since many of the firms went bankrupt, shut its operations down, or lost revenues.  Ironically, since there were layoffs due to this tax law, the number of unemployment claims rose during this time period.  The explicit cost to the U.S. Government thanks to the job losses from this law was approximately $24.2 million in unemployment benefits. (Will, 1999)  This shows a double whammy for the U.S. Government: There was a short fall in tax revenues, and the Government had increased cost thanks to paying out unemployment insurance to displaced or unemployed workers.
It should also be noted that during this time period, the United States was suffering from a recession. This also impacted the luxury item industry. However, the “solution” would not be raising taxes on these items during this time period. The proper “solution” would be lowering the taxes to encourage growth and economy expansion.  Raising taxes during this time period simply strengthens the argument on how taxes impact business owners.

Conclusion

The economic impacts of the luxury tax of 1990 are quite clear. This version of a consumption tax demonstrates the ill effects of a consumption tax.  Politicians will sell the citizens on the notion of a consumption tax is “better than” an income tax. Just recall the Luxury Tax of 1990 any time the notion of a consumption tax is raised.  The results will be similar, yet it will spread through the entire economy quicker, since it will impact all good/services sold.   It also will not be passed forward to the consumer, but the economic cost will be pushed backwards to the business owner. Regardless if it is a sales tax on specific items, or all items, the tax will impact those original factors of production: Land, Labor and Capital.

Works Cited

Pin, L. (2011, March 10). U.S. Luxury Tax-A Total Failure. Watching America.
Salpukas, A. (1992, Febuary 7). Falling Tax Would Lift All Yachts. New York Times.
Wall Street Journal. (2003, January 3). Good Riddance to The Luxury Tax. Wall Street Journal.
Will, G. (1999, October 28). Tax Break for the Yachting Class. Washington Post.
Woof, S. M. (1991). A Corporate Perspective on the Revenue Reconcilliation Act of 1990. Journal of Corporate Accounting and Finance.

The Economic Issue of Scarcity

The Central theme of the study of Economics is how humans manage scarce resources, as those resources have alternative uses. Why are those resources scarce?

Law of Marginal Utility

The individual preference ranking, or utility ranking, is central to economic action. Humans make choices and act on those choices in a spatial and temporal fashion. If an economic actor chooses activity A prior to activity B, it is clear that that actor prefers activity A over activity B, in that particular moment…in time. Likewise, if B is the next preferred activity, it is preferred over C and D. These activities are ranked from top preference, in an ordinal fashion, to the lower preference of activity. This process happens naturally, as the human mind processes this information. As time progresses, the preference, or ordinal ranking of preferences will change. This is not a static process, as it is highly dynamic in action.

For example: I may have a list of “to do” items, at the beginning of the day. However, I may have external events that alter my preference listing, or “to do” list. I may experience heavy traffic that causes me to run late for my first appointment. This will alter my priority of things on my “to do” list, as sitting in traffic ranks higher on my “to do” list.

Space and Time

Since we only have 24 hours in one day, things must be done in a priority fashion, as mentioned in the previous paragraph. However, time is a factor in scarcity. In fact: Time is the notion that creates scarcity. It is not resources. Another fact: so is space. Space is the other cause of scarcity.  This is also true since we can only occupy one space at one time.

Time is a notion of our intuition. It is not something that is external to us, rather it is internal to us. This also goes for the notion of space. Space is a concept, along with time, that is vital to how the human mind processes things through the senses. Since humans are not demigods, and we do not possess the trait of omniscience or omnipotence, time and space becomes the restricting factors. It is our minds that create the scarcity.  This does not mean that somehow we can expand our thinking to rid ourselves of scarcity, as this impossible due to the law of negation. This law impacts us spatially and temporally.

Example: Can a person be at the barbershop, but not at the barbershop at the same time? Of course not. Thus, the person must be at one place at one time. Since this concept is true universally, we must now deal with the law of marginal utility. One preference over the next, acting in time and space. This is how it works no exception.  Staying consistent with the barbershop example, either we can go to the barbershop, or we can go to the movies. If the barbershop is chosen, it’s clear, based on that decision at that time, the activity of going to the barbershop is preferred over the activity of going to the movies.

Conclusion

Time and Space are the causes of economic scarcity. As objects appear to us, these objects, or concepts, appear to us in our minds as things in space and we act upon them temporally. Since space and time are concepts of our intuition, we are limited on those things we can act upon during one moment in time and in space.

What is the Significance of Elasticity of Demand?

Elasticity of demand is a concept that is tied into the subjective value of the individual actors, to wit, buyers of the good or service. It is a concept that can be used to analyze how to target a particular group of potential buyers for a product or service. It is a way to attempt, for business owners,  to measure how consumers will respond to the price of a good or service. This concept is the foundation of many uses in business, specifically, revenue optimization.

Price Discrimination with Elasticity of Demand

Airlines may implement “price discrimination” by segmenting the price of their services, as this is a means to optimize revenue. This notion is based on the principle of elasticity of demand. Some customers are willing to pay more for a seat, e.g. First class passengers, for the exact same flight. Whereas other passengers are less willing to pay for a first class seat, but are willing to pay for a coach seat. Airlines then will attempt to optimize their marginal benefit by allocating a certain number of seats for 1st class, followed by the rest of the seats for coach passengers on one flight. Hotels utilize a similar strategy to fill up hotel rooms. They will price the rooms higher for business clients, who typically stay Monday through Friday. The hotel will lower the price on the weekends to drive up demand for the non-business clients. Using this pricing strategy, hotels can maximize their revenues to cover the costs to run the hotel.  In both cases, prices still can be further segmented in both of those respective groups.

Consider another example of Price Discrimination: Cell Phones. When the latest version of a cell phone is marketed to the public, the news will show clients standing in long lines for hours, as they are willing just to obtain this latest cell phone. Cell phone producers know this, as this segment pays a higher price for that cell phone. Buyers who are more responsive to price increases, will simply wait until the price of the cell phone falls, then attempt to obtain the latest model. The cell phone manufacturer optimizes its profits for the economic costs to produce and bring that phone to market.

The significance of the elasticity of demand is that individuals value things differently. An increase in price, or costs from the business owner, simply can not be passed onto customers on an absolute scale. If the price is raised too high, then many customers will simply look for alternatives for that good or service. When this happens, the business owner will see a decline in revenue. Yet, if the business owner locates the proper price point, he/she can optimize their revenues and make a profit, relative to their costs to run the operation.

Products that are 100% Inelastic, do they exist?

No good, service or product is 100% Inelastic.  Mainstream economists will teach that Insulin, for example, is absolutely inelastic. This is not true. Yes, it is relatively more inelastic as compared to other goods. But, when dealing with humans, each of us value things differently….as value is subjective. In short, if the price of insulin was too high, humans would seek other means to deal with their diabetes issues. Those options maybe so extreme to the point that they stretch out how frequently they utilize insulin. Or, they may resort to stealing the insulin, or other extreme measures. The point is that there is no way to absolutely predict what all humans’ actions would be based on raising the price to the point of beyond anyone’s reach. And, the business owner, in turn, would eventually lose money…even with insulin if the price was raised egregiously high.

A thought exercise: If Insulin was absolutely inelastic, then drug companies could charge whatever price needed to make an egregious amount of profit.  However, they do not, since they need consumers to continue to purchase the insulin on a regular basis. It makes no sense to charge too much, as consumers would reduce their purchase of insulin, and the drug companies would take a loss on the profits of that drug. Remember: Drug companies inject large amounts of capital to manufacture drugs, and these companies want to earn a profit to provide a return on capital for that large capital investment.

To assume no elasticity, or a good that is 100% inelastic, would assume no scarcity, as this is a false concept. The next blog article will discuss the notion of scarcity, and the origins of this concept. Scarcity is the foundation of the Science of Economics.

The Process of Capital Formation

Capital formation is a process that is vital to help facilitate economic growth. With an upward trend in economic growth, new jobs can be created, technology, innovation, and etc. With regards to the concept of Capital, it comprises many items, viz: Money, equipment, Real Estate, machinery, etc etc. With regards to this article, the focus of Capital Formation will be simply cash and its equivalents.

How is Capital Formed?

It all starts with human action. Humans seek to improve their circumstances via voluntary exchange. Voluntary exchange takes place, as the actors in the marketplace continue to produce and trade. In this process, humans will seek to place some “capital” aside. They may place it in a mattress, coffee can, a hole in the backyard, a pillow, or with a financial intermediary. Some examples of a financial intermediary are as follows: A bank, credit union, investment brokerage, and insurance company. Once the actors begin the process of production, some of the “savings” goes into the bank. This is the start of the process on how capital is formed.

The Role of the Financial Intermediary

As actors in the market begin to produce and engage in Voluntary exchange, the money is stored in a financial intermediary. Financial intermediaries, in turn, seek to “grow” their capital base. This base comes from the depositors. The financial intermediary seeks to market loans to others in the market place. These loans, limited to the scope of our analysis, are used to help business owners acquire capital equipment, fund labor, purchase real estate, and other economic inputs. 
The Natural Rate of Interest
The concept of the natural rate of interest is derived from the Law Of Marginal Utility. In short, it is the ratio between present goods and future goods.  With that ratio, and other factors(risk, etc), the financial intermediary charges interest for borrowers.  Another point to add: it is indicative of the temporal preference of things on the individual’s utility ranking. Each of our actions precede the next action. Those actions we select first are preferred over the latter actions. If those actions involve some voluntary exchange, with prices used in the exchange, the interest rate can be calculated…somewhat. In our analysis, the actor simply defers his capital for present consumption and places it into a financial intermediary. For those who use the bank to store capital, the bank provides an interest rate on those monies.  This rate of interest acts as a signal to the actors in the marketplace, as it is tantamount to a price. The rate of interest will fluctuate as the actors are constantly moving towards an over all equilibrium. In an un hampered market, all the actors in this scenario, seek to balance present needs vs future needs. 

Conclusion

With the process of capital formation, it begins with productivity. The actors involved in the labor market place aside some of their earnings, as they prefer to use that portion for future consumption. In turn, financial intermediaries loan out monies from this capital base to business owners, individuals and the like to help them acquire assets. 

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