The Problems With Interest Equilibrium
One of the most influential and dominant ideas in macroeconomics, is the idea of interest equilibrium, that any issuer of a financial asset, must offer a comparable risk adjusted return.
There are a lot of technical challenges to get to this conclusion.
Many models assume homogenous capital for the sake of simplicity. I think this is recognized as a simplifying assumption, but at the same time it influences how people think about and discuss capital and growth.
The problem of investment involves two basic challenges:
Forecasting future consumption, both the price and quantity for goods and services
Provisioning that consumption for the lowest possible cost.
Not only is it possible to overproduce capital, it is extremely easy to do so, and moreover, the more wealthy you are, the more likely you are to do this.
One of the appeals of capital investment, is that it is perceived as a more durable, longer term store of value and wealth. So if your material needs are satisfied for the next year or two, you will likely focus on upgrading machines, equipment, and building durable capital that has long term value.
But the challenge is that the more you do this, the more likely you are to overinvest, and bring down returns. If you build two machines, but you only needed one, and the second sits idle, then you have waste.
This problem is exacerbated by rapid technological change, which means that machines and equipment become outdated more rapidly, and have higher costs to upgrade, maintain, and train staff on how to use.
Furthermore, a lot of what we do in modern economies, seems unnecessarily abstract and indirect. A tool can make you more productive, but that only pays off if the time to make the tool, is less than the time you save by using it. A lot of jobs seem to try to justify their existence in a market that may not need them. There is a huge premium for being seen as the next great thing.
Interest in particular, is modelled as exponential growth, but companies can saturate markets, they can have waves of popularity and decline, and even their consumer base can age out.
All these things, make it very hard to consistently maintain a return above zero. It is easy to buy or build a machine that becomes obsolete before it has paid itself off. If you are wealthy, it is easy to spend more on cars then you actually need for example. The activity of playing with your cars becomes the thing you are consuming, not the original utility of it to get from A to B.
But another important thing, positive returns to capital and investment are not required to grow wealth, either individually or collectively. So long as you have hours in the day, you can keep creating more value, even if returns are negative.
The problem of exponential gains is a race against the clock. You have to get the most efficient use out of tools, equipment, technologies, before those are replaced by newer and better alternatives.
But aside from all this, what we call capital income, and what we call labor income, is also subjective. The return you get on your investments, you could attribute to the time that you spend researching them.
Importantly, modern portfolio theory describes an efficiency frontier for investments, that optimize the tradeoff between risk and return. But I think there is another variable that we don't talk about enough: actively managed investments or passive investments. If you have to use your knowledge and influence to make sure the enterprise is being operated properly, that is labor that is unaccounted for.
Owners spend their own time to make sure that the things they own provide maximum returns.
If we want to compare alternative investments in an objective manner, we need to subtract the value of all the time that owners contribute to help the investment do well, from the return it offers.
And how much of returns could be a result of companies relying on public institutions which are supported through taxes. If the tax base doesn't align with who benefits from public institutions, then returns will be artificially inflated, as costs are dumped on the public, but profits remain privatized.
To expect to completely passively earn interest in perpetuity, seems a crazy proposition to me. It sounds like nobility or feudalism, if people can just live off of interest completely passively.
These problems are not necessarily a bad thing. They can be good and desired. If you are so wealthy that you can afford to buy more cars than you need, and tinker with them for entertainment, then there's nothing wrong with that.
If everyone is so materially satisfied, that new investments are likely to lose money, then there's nothing wrong with that. We can afford to not be efficient.
Moreover, I think that when you have inflation specifically, that that is a period of rapid economic reorganization. The economy needs to have these cycles so that it can grow.
I think if we get too aggressive about raising rates, you aren't giving these cycles a chance to play out. You are trying to pre-empt the inflation, when it may be a process that needs to run its course, and it only makes sense to raise rates modestly after it has had a chance to correct a currency's value.
I think trying to compete on rate of return using short term thinking is very counterproductive and even destructive. It increases the cost of interest on the national debt. It increases wealth inequality. It doesn't allow the market processes of price correction to play out naturally. And a high nominal rate with high inflation feels like walking on a treadmill-- working really hard just to stay in the same spot.
I think this paradigm has been counterproductive and destructive for far too long. Public policy should not try to counteract or control the market determination of valuing currency. Markets price assets, including currency, in order to make corrections. If we try to counteract this process to quickly or aggressively, then these corrections become more expensive and longer.
I am not arguing for complete lassez faire or passiveness. Only that we need a balance for different kinds of interventions, supports, and restrictions. Instead of monetary restriction, sometimes we should let inflation happen so that it becomes a political issue that politicians can address by adjusting spending or tax policies.
If we always try to stop inflation before it's a political issue, then we are enabling the precise kind of political irresponsibility people are always complaining about. In this sense, accommodative monetary policy may be fixing inflation too fast, so we never address political issues. I don't think central banks can fix political and fiscal problems. And trying to cure inflation when it happens is just protecting politicians from consequences.