Thursday, March 05, 2009

Interest Rate Manipulation: Insights From Joseph Schumpter

About a week ago, I finished reading Progress and Poverty, and started up a biography called Prohpet of Innovation: Joseph Schumpeter and Creative Destruction, by Thomas K. McGraw. It's a very enjoyable read. Schumpeter himself, as told by McGraw, is turning out to be a very interesting character. Even better, some of the description of his intellectual influence upon the field of economics is cluing me in to some of the logic behind interest rate manipulation in the interest of economic progress. I've barely begun to read (I'm only on the sixth chapter or so), but it has inspired me to tackle this issue from another angle. I don't know, yet, if it is Schumpeter's angle, but it may be a good one, nonetheless.

Schumpeter, apparently, was the first to effectively make the point that the proper pricing for a product is not necessarily based upon the average cost per unit, but rather upon the marginal cost. The idea is that if one charges the marginal cost, the low price will result in increased demand, meaning that, in the long run, one who charges the marginal cost will make a better profit.

Say you're a kid with a lemonade stand. You plan to make fifty glasses of lemonade. It will cost you $40 (totally arbitrary number out of a hat) to produce those fifty glasses. Average cost is $20/50 glasses, or $0.40. Fifty cents is a nice round number, and gives you a small profit over the average cost.

However, you could make one more glass of lemonade for, say, ten cents. This is because, once you've bought your equipment (your table, sign, lemon squeezer, pitchers, etc?), you don't have to buy it again (economy of scale). According to Schumpeter, you'd do better to base your price off that ten cent marginal cost, than the fourty cent average cost. You take a loss in the short run, but in the long run, people come running for the cheap lemonade, and you end up selling hundreds or thousands of glasses at a larger total profit than you would have sold the fifty around average cost.

However, the businessman who prices in this manner must be able, somehow, to cover the losses on those initial units. He has to start off in the hole... and this requires financing. The lower the interest rate he's offered, the more likely he is to to enact such a plan. A plan of this sort is very good: the entrepreneur makes a profit, and lots of people get a desired product much cheaper than they used to. Resources are being used more efficiently. Everybody wins.

If lower interest rates induce entrepreneurs to innovate, lower interest rates are automatically better, right? John McCain was correct to wish the interest rate would go to zero, right? Not really. Associating low interest rates with innovation, then deciding that it causes the innovation by itself, is, I think, an example of post hoc ergo proctor hoc. It's a bit like the modern economics equivalent of a cargo cult: planes with gifts land on airstrips, therefore we can cause such planes to land on our island by building an airstrip.

Returning to our hypothetical lemonade stand kid, imagine if he established his stand in the middle of winder. Imagine if he established it in the depths of an industrial recession, amid people poor enough they'd rather drink fetid water than pay ten cents a glass. Imagine if he established it in the middle of a sparsely populated desert (sure, folks are thirsty, but there aren't many customers out there). Imagine if he spent hundreds, thousands, millions of dollars on equipment that would bring his marginal costs down to one cent per glass at a certain level of production... and not enough people showed up even to cover his fixed costs. With a zero percent interest rate, he could try... but he could not succeed unless economic conditions were such that people were "ready" for this particular innovation.

This is particularly true for new products that customers don't know enough about to know whether they want one or not.

It isn't enough for the entrepreneur to establish a new productive process; his potential customers must be in a position to buy. A whole host of factors go into this: their current perceived financial security, their attitude regarding novel products, the marginal utility of the new product as compared to their existing stock of wealth, the number of competing new products, and so on. While lemonade stand kid could easily figure this out through simple observation, for larger scale production the information necessary to appraise the likelyhood of customer acceptance is much more difficult to come by.

However, there is one piece of information that reflects conditions better than any other, and it is very easy to find: the interest rate. The interest rate is the price of borrowing money: the intersection between the supply and demand curve for loanable funds. When these curves are not interfered with by government action, they accurately transmit the necessary information to the entrepreneur.

The supply curve indicates, most basically, the aggregate savings rate of all the individuals in a given society, and how available those funds are for loan. (If they're not available for loan, this savings rate expresses itself in lower factor prices, which can work nearly as well, I think.) It indicates a willingness on the part of people to contribute to production without immediately consuming the results, which is necessary for the establishment of new capital. It also indicates how financially secure people might feel, and how much people might be willing to spend on new products (the wealth effect).

The demand curve, on the other hand, telegraphs just how much competition there is for the available loanable funds, and therefore the available resources they represent. If there's a load of new construction, innovation, consumption, and such already happening, there isn't much left in the way of resources to divert to yet more new production. Divert more, and you end up diverting it from basic necessities. It's a bit like a new colony full of people who spend the summer digging for gold, and enter the winter with little to no food stores. What it is actually, is what we call the business cycle: a burst of activity and optimism, followed by sudden disaster.

These two numbers set a barrier of sorts to innovation, which is higher or lower depending upon the conditions. A higher rate might indicate either a society not receptive to trying out new things; or a society that is quite ready, but also with a great deal of competition as to who is going to do the innovation. Either way, the high barrier dissuedes new entrepreneurs from entering the fray, diverting their abilities to safer efforts. A low rate definitely indicates a consumer base that is ready for new products and factors of production available for use in the production of such, and possibly a dearth of entrepreneurs... assuming the supply curve isn't being manipulated by dishonest banking practices, nor the demand curve by excessive borrowing by the government.

In other words, low interest rates don't cause progress. They merely indicate that conditions are ripe for progress, and invite the would-be entrepreneur to try his hand. Artificially low interest rates, the result of an inflationary monetary policy, trick the would-be entrepreneur into innovating at a time when the economy is not yet ready for it. The naturally high rates that result from such conditions would encourage consumers to cut their consumption, thus preparing the ground for future innovation.

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