Negative Interest Rates: A Delusional Concept Beyond Space and Time

At the time of this writing, the notion of Negative Interest Rates are being pushed forward by central banks throughout the world. Bankers are developing new and improve ways to help stimulate the economy, and the employment of negative interest rates is the latest tool in the banker’s tool kit. Why the use of negative interest rates? How does it actually help the economy?(If it actually does) With this article, it will explore some things that make this concept of negative interest rates against reality. Keep in mind, an entire treatise can be written just on the notion of interest rates.

What Is the Interest Rate?

The non economist(and some mainstream economist) think the concept of the interest rate is exclusively related to the money and finance. There is some truth to this claim. Yes, interest rates are used in the world of finance, for example, loans to obtain a home, cars, or other fixed assets. Most will see the interest rate in these transactions as the “cost” of purchasing the underlying asset.

However, the origins of the interest rate does not begin in the world of Finance. It starts in the world of Economics. One of the forerunners of the development of the concept of the interest rate was Eugen Bohm Bawherk. His critique of Karl Marx’s work(Exploitation theory) lead to an expansion of the interest rate, and subsequent thinkers such as Knut Wicksell continued the development of this notion.

The fundamentals of the interest rate is straight forward: It is all directly related to human action. All behavior is purposeful. Since humans are unable to be in multiple locations in space and time, this means certain actions are done before others. This explicitly means there is a preference in ranking of preferred actions. For example, if three items are preferred, the first item, the second, and the third must be done in order temporally. The utility ranking(as this is called) simply is a preference ranking of the activities the actor chooses to engage. Of course, this example is given for simplicity, as this process is much more dynamic and there are many more options. Nonetheless, the ranking still exists, and due to the constraints of space and time, some items are done now(in the present) others in the later(in the Future).

The interest rate is derived from the economic actors choosing goods in the present versus the future. The prices of those goods–ones purchased in the present versus the ones in the future. That net ratio is the actual “interest rate”. The other consideration: This “interest rate” is unique to each individual. It is subjective to the individual’s preferences, as each person’s utility ranking varies.

Since each person’s utility ranking varies, and the interest rate is unique to each individual, how is it possible for the Central Bank to calculate the overall interest rate? It can not.

The Folly of the Negative Interest Rate

The interest rate, as it is based on present and future transactions, makes the outcome a positive integer. This is the first thing that makes the negative interest rate fallacious. Moreover, in consideration of how man moves through space and time, time travel going backwards in time is not possible. Having a negative interest rate implies the economic actor is moving backwards in time, and currently is choosing things in the past over things in the future. This is nonsensical. Back to the first point, if we take two prices of the same good, a current price versus a future price, how would that yield a negative number? One of those prices, in our ratio, would need to be a negative. Do Vendors sell goods with negative prices?

Vendors with Negative Prices

If vendors(firms) sell goods(currently or in the future) sell goods for a negative price, this would yield a negative interest rate. This also is absurd. The vendor is seeking to sell his goods at the highest price possible, and the consumer is seeking to purchase those goods at the lowest price possible. The optimal point of this scenario is the equilibrium price; this price is not a negative integer. Also, the business owner needs to earn a profit on the sale of his goods. The profit serves several purposes: (1) It allows the owner to cover his expenses to repurchase more goods to sell, (2) The net profit(revenue less expenses) acts as a return on his investment; this is adjusted against the interest rate. Having a negative interest would imply no prices, or no positive integers acting as prices, and the consumers would be receiving the goods plus extra cash(acting as a credit). This also works against the incentives of human action.

Negative Prices

Prices serve as signal callers in the marketplace. They allow both buyers and sellers to realize if there are changes occurring. For example, if prices rise sharply, this could indicate a scarcity issue with that certain good. Perhaps something along the supply change is impaired, causing a delay in the distribution or manufacturing of that good. Note: sharply rising prices will not detail why the food’s price has risen. Based upon that sharply rising price, the consumer can choose to re prioritize his utility preferences and elect to choose a viable substitute, at a lower price, or opt out of buying the good. With this activity, the increased prices discriminate against those who are willing to pay the increases price versus the group of persons who seek to pay for those goods a lower cost.

How would a negative price come into play? If goods became scarce, the owner would not lower the price to the point he give the goods away for free AND provide additional monies to the consumer. The business owner would not stay in business very long. Eventually, consumers would run out of those goods.

Conclusion

As bankers adopt negative interest rates, it simply is a move from the sublime and into the land of folly. Consumers pay for goods with positive integer prices, and firms accept their cash with positive integer prices. This directly correlates into a positive interest rate. Moving interest rates to zero or in the negative simply has a negative impact on the economy, and it should be rejected as a means of monetary policy.

Taxation: Do Costs determine Prices?

Introduction 

In the advent of intense competition, due to rise of  innovation and technology, domestic consumers are benefiting from higher standard of living, at lower costs. Due to this exponential expansion of growth, contemporary economists are analyzing in great detail utilizing a menagerie of statistical models to provide civic leaders the most precise information—these leaders feel compelled to make an informed decision while making public policy.

While these publicly elected officials engage in that decision making process, the subject of taxes always seems to rear its ugly head. For some, they see taxes as a necessary function to fund the operations of government. While others may quibble regarding the role of Government in today’s society; the notion of excess taxation always strikes as a rapier into the hearts and minds of the general public, nonetheless, it still something of worthwhile analysis.

Who Pays The Tax?

While the political experts engage in verbal combat over the notion of taxation, two questions always rise during these debates is about this notion: Who pays the tax? Is the tax passed down to the consumer?

Before these questions are analyzed, let us recall the supply and demand model. With this supply and demand model, there comprises two intersecting curves. The first curve, rising from left to right, is the supply curve. This represents the supply of a certain “good” provided to the market. The demand curve, sloping downward left to right, represents the consumers desire for that particular good. Both curves are analyzed graphically as follows: The horizontal axis(x-Axis) shows the quantity of the good, and the vertical axis(y-axis) shows the price of the good. As the two curves intersect, they reveal the Equilibrium point. This is the market price for that good, assuming all things are  constant(ceteris paribus).

Back to our two questions: Who Pays the Tax? Is the tax passed down to the consumer? Before we answer these questions, more analysis must be completed, so patience is required. With regards to taxation, it must be conceded that the notion of taxation is a trade off. A trade off: In a republic, in order to have various Government “positive liberties”, namely, public goods, to be provided to its citizens, taxation is required to underwrite this political model. Since it is a trade off, that means there is an economic cost related to having Government provide these “positive liberties”. We shall keep our analysis of the costs restricted to taxation, as the costs are many. Oh, and speaking of cost, in an economic sense, taxation is a cost.

Are The Taxes Paid By The Consumers?

Economic costs play a role in the bringing of goods to the marketplace. Each firm must gather up all the factors of production in order to bring their goods to consumers to purchase. Those individual firms must pay some sort of tax on those goods. Now is the time we must address the first question: Is the tax passed down to the consumer?

Here is the answer: Yes and no…it all depends. Yes: If the good’s costs are increased due to taxation, and the consumer sees the good as inelastic, meaning they are less concerned with the price of the good relative speaking, the consumer will simply buy that product. When this happens, the consumer simply absorbs “some” of the costs of the good. No: If the price of the good pushes the price elasticity to the point, for the consumer, where the good goes from “inelastic” to “elastic”, the firm selling the good begins to lose gross revenue. This is due to the fact that consumers have found alternative uses for that product, due the price increase. Based upon these answers, it all depends…depends on the price elasticity of the consumer purchasing the good. In both cases, the consumer pays the cost; this is due to the fact that owners of firms are also consumers. So, firms and consumers pay the tax.

In the latter case, once revenues decline, firms are unable to purchase more of the inputs for that good, subsequently increasing the scarcity factor, which leads to a higher economic cost of that good. This cost is absorbed by firm, due to the fact it has declining revenues and increasing input costs for the good; the consumer also is impact, as the good’s economic cost increases due to scarcity.

Supply and Demand Model

Now it is time for the supply and demand model to be revisited. As previously stated: The equilibrium point is the market price. Stated differently, this is the optimal price firms can sell the good. If they sell the good at a higher price, based upon elasticity of the good, they will sell fewer  units. This is an instance where the economic cost of the good is paid for by the firm.

Since the equilibrium price is the optimal price, as previously stated, the cost is passed to the consumer; the final price is not determined by cost. If the good’s price was determined by the cost, the firm could simply raise the price to meet the costs of the good, but the business runs the risk of having declined sales. The equilibrium price demonstrates the power the consumer has with the sale of the good.

Conclusion

The discussion of taxes is never a pleasant one. It always lends itself to cantankerous banter, and distribution of mis information…bordering on prevarication. When individuals state that the cost of taxation, of a good, can be simply passed onto the consumer, this is a misspeak of the facts.

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.