There is no need to complicate our model unnecessarily at this point, but it is important to understand the complete role interest rates play in our simple model. The interest rate not only affects the level of savings and investment, but also the levels of production and consumption over time. Interest rates, whether 2% or 5% or 15%, influence our decisions because they change the relative values of present vs. future consumption. A high interest rate encourages us to save, thus deferring consumption and reducing borrowing. Conversely, a low interest rate encourages us to consume now and borrow, since the pay-off received for deferring consumption is low. Because we value present consumption over future consumption (this is rational, not only do we value instant gratification, but life is unpredictable), the interest rate that tips the balance in our decision between present or future consumption is often called the time value of money. (The interest rate will also reflect the risk premium to the lender in case the borrower cannot repay, and the inflation premium[15] if the lender anticipates future price inflation, which would reduce the value of the money he was repaid.)
The interest received by individual savers for lending money is the interest paid by borrowers for the use of their savings. If rates are high, there are fewer borrowers and more savers, and the rate must fall if savers want to attract more borrowers. If they are low, there are more borrowers and fewer savers, and the rate must rise. For borrowers and investors, the level of interest rates influences the cost of capital and how profitable their investments have to be to justify the risk of borrowing and lending. If it costs me 10% interest to borrow funds, my investment has to return more than 10% or I will lose money. Consumption that is deferred into savings that are then profitably invested in new production leads to an increase in the stock of wealth. We call this increase economic growth.
Economists have documented some natural patterns in the ebbs and flows of consumption, savings, investment, and production. One is the "lifecycle hypothesis" that shows greater consumption and lower savings at the beginning and at the end of life, among the young and the old. Saving and producing is maximized during the middle phase of our lives. So, the consumption pattern of the entire population will be influenced by the demographic distribution of that population. In the U.S., this has been most noticeable with the economic boom associated with the postwar baby boom generation in its most productive middle-aged years. As baby-boomers enter their retirement years, their consumption levels will increase.
Another natural pattern is associated with the evolution of technology. Consider, for example, the impacts of the industrial revolution, the development of such technologies as the railroads, steel production, electricity, the automobile, telegraph and telephone, airplane transportation and, more recently, the development of the microchip, the personal computer, and the Internet. During periods of technological advancement, consumption is deferred as investment is poured into new productive opportunities. This is facilitated by rising interest rates, increased saving, increased productivity and economic growth. Technology also changes the mix of capital and labor in the production process as it increases labor productivity. Think of how the personal computer has eliminated the need for the office typing pool.
These two cyclical patterns of demographics—or population growth—and technological progress are the true determinants of economic growth. A rising population supplies more workers to produce, while technological innovation causes more investment, combining capital with labor and increasing the productivity of both. The result is greater national wealth. It would appear that the political goal of economic policy should be to promote a larger working population and foster technological innovation. If it were only that simple.
Not surprisingly, government policies seek to accelerate these two natural cyclical patterns with the goal of stimulating economic growth. The road to wealth, however, is not guaranteed only by a higher birth rate or larger population. Otherwise, China and India would be the world’s richest nations. Demographic trends respond to much larger sociological and economic factors and cannot be easily manipulated in the short-term through government policy.[16] The more important policy goal is to put the population to productive work, and this is where technological progress comes in. Technological innovation thrives in an environment of freedom and confidence-inspired risk-taking. The government can do much to insure these conditions through attention to property rights, the rule of law, civil rights, a judicial system, and functioning capital markets. These are the institutional structures that serve to ensure the sustainability of economic growth through time.
However, because politics demands more immediate results, we are often given short-term fixes that yield very mixed outcomes. Many of us are aware that the Federal Reserve Bank manipulates interest rates in order to promote certain policy objectives, such as full employment and increased economic growth. This manipulation is not always an unqualified great idea. For instance, if the interest rate is subsidized too low, people can consume more by borrowing cheaply, rather than dipping into their own savings. In other words, they can max out the credit card. Artificially low interest rates result in increased savings, investment, and consumption all at the same time! Our basic economic decision is no longer consumption now OR later, but consumption now AND later. If this sounds too good to be true, that's because it is. Unproductive ideas get funded along with productive ones while the bill for increased borrowing always comes due. This should sound familiar. It is the root cause of the enormous credit bubble that has been building for the past three decades, leading to the financial meltdown in 2008.
1.5 Capital vs. Labor: Friends or Foes?
Capital and labor are defined as factors of production. We labor, or work, in order to produce something and we use capital to leverage our labor. Capital is any resource that is put to productive use (this will be explained more thoroughly in the section on Capital and Financial Markets in Chapter Two). The farmer may work with a hoe all day long but can still only till a small field. But with a tractor, or fleet of tractors and farmhands, he may be able to cultivate many acres of crops. The physical capital of the tractors is financed by financial capital, while the expertise of farming becomes a store of human capital. We combine these factors as inputs into the production process. Then we pay out the costs of employing the various inputs with shares received from the sale of the output.
To demonstrate, let us consider the simple business of baking and selling a pie. First we need capital, either our own savings or perhaps a loan from the bank, to pay for the ingredients and other costs upfront. We need milk, flour, butter, sugar, fruit, chocolate or vanilla flavoring, etc. and we pay for these ingredients according to the prices they command in the marketplace. Then we either use our own labor or pay a pastry chef. We also need an oven, preferably in a kitchen with a supply of water. After we bake the pie we can sell the pieces and use the proceeds to pay back the bank or investor who financed the cash payments to buy the inputs. Hopefully, at the end of the day there is some pie left over, which we can either eat ourselves or sell for a profit.
Notice here that the sale of the pie is ultimately what will cover the payments for the chef and the ingredients, which were paid out before the pie was ever sold. If the pie had been spoiled, the loss would have been borne by the baking entrepreneur, who would still have to pay back the bank or default on the loan. Thus, there is financial risk here borne by both the bank and the entrepreneur. This introduces the important concept of risk and return: Investment risk is an additional factor of production that must be compensated with an expected positive return. The banker receives an interest premium on the loan to compensate him for the risk of default, and the successful baking entrepreneur earns a residual profit to reward her for the overall risk of the business venture. The greater the potential risk of loss, the greater the expected return for success. Note that certain inputs took little or no risk – the sellers of the flour or butter or sugar or even the chef – thus, their share of the
product is minimal. They make their money on volume as all pies made require a certain amount of inputs that add up to a significant market for the sale of these inputs.
There are two important elements of this process to note. First, that the prices of inputs are set by the supply and demand for these inputs. If there were only one cup of sugar but many pounds of flour available to five bakers who all wanted to make and sell pies, then the price of sugar would be much higher relative to the price of flour. The same applies to the supply and demand for chefs, or labor, as well as the supply and demand for capital. If required labor is scarce, it can command a higher share of output through a higher wage. If capital is scarce, it can command a higher share of profits relative to the payouts to other factors of production. The risk of loss assumed by the capital investor will also factor into the cost of capital. Thus, the higher the credit risk of the baker, the higher the interest rate the bank will charge on the loan.
The second important point concerns the flip side of input prices—indicating how the final product of the wealth-creating process is distributed. We can calculate how much of the total income created by the baking enterprise is received by the sellers of ingredients, the chef, the bank, and the baking entrepreneur. When firms are highly profitable and growing, the entrepreneur/owner will receive a larger share of the pie. These profits can grow or shrink depending on outside competition from additional bakers. Of course, if the business fails the hired chef has received her last paycheck and the business will be buying no more ingredients. The initial payments to these costs become part of the loss incurred by the baking entrepreneur, and possibly the bank.
This simple analogy illustrates how the capitalist production process determines the relationship between capital and labor. The chef cannot command a higher wage unless there is a shortage of chefs or a new technology is introduced that increases her productivity. Otherwise, the chef’s raise will result in higher prices for pies, less labor employed, or will force the baker into closing the business because of inadequate profits. The crucial difference between the chef and the entrepreneurial bakery owner is who assumes the burden of risk for the success or failure of the enterprise. Whoever assumes the bulk of the risk, will receive the requisite compensating share of the reward.
Another way to look at this is to think of the production process as an equation. On one side we have the value of the final product less all the costs of production. On the other side we have the residual profits. So, revenues minus costs equal profits:
REVENUES – COSTS = PROFITS
Any kid with a lemonade stand can figure this out. We take the money received from the sale of the lemonade and subtract the cost of the lemons and the labor and we are left with profit or loss. In this equation, prepaid labor is on the cost side of the equation and owner-entrepreneurs are on the profit side. Businesses succeed by raising profits and lowering costs, so the success of the capitalist economy is enhanced by lower labor costs yielding higher profits to risk-taking investment.
This might suggest that labor is in a weak or losing bargaining position relative to capital, i.e. the more labor loses, the more capital gains (Marxist conflict is rooted in this idea). But this is not necessarily true over time. As profits rise, more entrepreneurs enter the business to capture those profits. They will employ additional labor, increasing demand relative to supply and driving up the price (wages/salaries) of labor.
More importantly, what our baking example does show is that risk of loss is a factor of capitalist production that must be paid for. Whoever successfully assumes the risk will gain a share of the reward. This should give us a clue as to the role of Wall Street and its securities markets in our economy. Capital markets help us manage risk in more efficient ways by distributing it far and wide. If a venture is successful, this assumption of risk commands a positive return. This is how a high-flying hedge fund manager can make almost $4 billion in one year – by making large risky gambles with borrowed capital that ultimately pay off. There is nothing depraved or scandalous about this. (Of course, none of these gambles should ever be bailed out by taxpayers when they fail – the game of "heads we win, tails you lose" is arguably an unfair and immoral one.)
1.6 Risk, Return and Uncertainty
In Section 1 above we briefly discussed consumption and acquisitiveness as the fundamental building block, or behavioral assumption, of economic analysis. Some have disparaged this human impulse as greed and avarice, and certainly it can be described so in the extreme. But the impulse is instinctual for a very good reason. We need resources to survive, so, by nature, it is imperative to acquire these resources by hook or by crook. This is no more of a moral choice than that of a lion eating a gazelle. More important is the logic that drives our desire to acquire is the even stronger in our fear of losing what we have. We refer to this possibility as risk.
The concept of risk is fundamental to understanding how our political economy and society work. In a world of constant change, risk is ubiquitous. (The alternative—a world that never changed—would mean we were frozen in time with no risk and no reward.) Because change is unpredictable, or uncertain, we are never sure how it might affect us or whether it will threaten our well-being. There is the dual possibility that change will be either good for us or will be bad for us. As a consequence, our natural survival instincts have made us very sensitive to the threat of uncertainty and loss. For this reason, many people innately fear change, and their fears are not merely the flip side of acquisitiveness, they are far more acute. With experimental studies, behavioral scientists have shown that test subjects are twice as sensitive to a possible loss than they are to a possible gain. We call this behavior loss aversion. (See note.[17])
Loss aversion is a critical concept that governs our psychological behavior. Imagine two patrons enter a Las Vegas casino. The first gambler has $10 to bet and the second has $100, so the second is 10 times richer than the first. They both wager at the blackjack table and the first wins $10 while the second loses $80. Now they both have $20, but imagine how they feel. The first patron, having doubled his money, leaves feeling flush and hails a cab in a moment of extravagance. The second, normally a free spender, feels impoverished and hoards his $20, choosing to walk. These two gamblers now have the same endowment and economic theory would expect them to behave the same. But their histories and their psychological experiences differ and so, accordingly, does their economic behavior. This has been amply demonstrated through behavioral studies.[18]
The concept of uncertainty is related to risk, but is not the same thing. Uncertainty is the unpredictability, or variability, of any particular outcome; risk is the probability of actual material loss. The movement of stock prices is very uncertain from day to day, but if we don’t own shares these gyrations present little risk of loss to us (unless our employer goes bankrupt).
The state of the world is uncertain and our most primal behavioral responses are reactions to uncertainty and the risk of potential loss. This is why I argue that risk and uncertainty are the keys to understanding economic choices and outcomes and that risk is the glue that holds our economic models together.
No matter how much we seek to avoid losses, we cannot avoid the ever-present risks we face due to events outside our control. Often the best we can do is to shift various risks around, seeking to manage them in ways that enhance our survival. Our ancestors moved into caves to protect themselves from the elements and wild beasts. They built walled cities and defensive weaponry to protect themselves from invaders. In modern times we take self-defense classes, adopt workplace and environmental standards, and establish Social Security and Medicare for the same reasons. All through our lives we seek to manage risks and avoid losses, hoping to live to enjoy another day. But even if we could, we would never completely eliminate economic risks because without risk there is no reward in life. We are motivated to seek gains subject to an acceptable level of risk and if risks and returns are too low, we will seek out bigger risk-taking
gambles to manage in search of larger gains.
Managing risks, not avoiding them, is how we gain the rewards that life offers. Because risk is a negative good (in economic parlance, a good is something we will pay to obtain), we will pay someone to take it off our hands. This is why we pay premiums to insurance companies to compensate us if we suffer a loss. We pay them to absorb the risk of loss. If the loss never occurs the insurer pockets the premium and reinvests it. The insurer can assume these risks because it diversifies the risks it is assuming across a large risk pool of clients. Turning this logic on its head, when we assume risks ourselves and are successful in managing them, we can receive the payoff.
There is actually a direct relationship between risk and return: the higher the risk, the higher the expected return; and vice versa, the lower the risk, the lower the return. This relationship between risk and return is called the "return-to-risk ratio" or the "risk-adjusted rate of return" (RAR). In theory, the RAR is the same for all investments and in practice all RARs will revert to that mean. This is just another way of saying that if an investment's RAR is higher than an alternative investment, investors will prefer the higher and bid up the price of the investment until the higher RAR reverts to the average RAR.[19] Think about this: If you pay more for an investment while the expected return stays the same, the RAR ratio must fall.
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