Consequences of interest

Hoardable money leads to interest and a number of other economic issues.

Marginal efficiency of capital

The marginal efficiency of capital is the expected return that will be generated by investing in the creation of the next piece of new capital. In other words, with a given quantity of existing capital, how much money can an entrepreneur expect to make by investing in the creation of a new piece of capital, whether that means buying a new piece of equipment, building a new factory, increasing inventory, etc.

The interest rate on money plays a large role in determining the minimum accepted marginal efficiency of capital. If the base interest rate is 3% an investor would not be incentivised to invest in anything that doesn’t yield above a 3% return. The investor is able to get a risk free rate of 3% without investing their money into a risky venture. Interest therefore imposes an artificial limit on the amount of investment and employment that happens, as it sets a standard in which the marginal efficiency of capital must reach if new capital is to be produced. It is due to this minimum threshold of efficiency that interest can be seen as one of the root causes of poverty, unemployment and recurring economic crises.

It should also be pointed out that the marginal efficiency of capital is not an objectively measurable quantity, because it is a prediction about the future. It is an estimate of how much future revenue will be generated as a result of an investment in new capital today. So by its nature it is uncertain.

In a barter based economy, where goods and services are exchanged for other goods and services, this ability to extract interest and expect a minimum return on investment does not exist. Both parties in the exchange benefit from completing the exchange as soon as possible due to the decaying nature of their goods and services.

The limiting factor to the creation of new capital has nothing to do with the natural levels of supply and demand for tangible assets but is rather a consequence of the hoardability of money. An obvious conclusion is that if money didn’t have this advantage over tangible wealth and therefore didn’t enable holders of money to exact interest, the capital formation process would continue beyond the current artificial limit set by money.

Impact of artificial limits on capital formation

The more capital there is, the more labour you need to employ it. An artificial scarcity of capital causes there to be less demand for labour than there would be if the capital creation process continued beyond the point at which the rate of interest causes it to stop. Therefore artificially scarce capital means artificially low wages.

Then consider the prices of goods & services. More capital means more competition among producers and therefore higher quality and lower priced goods & services. So just as the artificial scarcity of capital leads to artificially low wages, it also leads to artificially high prices of goods & services.

Workers get the short end of the stick both as producers and consumers. The impact of interest on the production of capital means they earn less in wages, and they pay more for the goods & services than would be the case if the capital formation process continued beyond the limit set by the rate of interest.

The situation for the owners of capital is the mirror image of that of workers. The fact that employers pay less for labour and receive higher prices for their goods & services means they make higher profits.

Imagine how different the world would be if the owners of trillions of dollars which are currently being unproductively hoarded in cash, checking accounts or short-term, risk-free lending, were no longer offered those artificial safe havens in which to store wealth and had to instead choose between seeing their wealth lose value with the passage of time or investing it in productive capital. Imagine how much more capital there would be. Imagine how much more demand for labour there would be. Imagine how much higher wages would be. Imagine how much cheaper goods & services would be.

Impact of inflation and deflation on hoardable money

Under inflationary conditions, money performs the medium of exchange function much more effectively, which means that it performs the store of value function less effectively. Just as how money is a great way to hold wealth when prices are falling, since its purchasing power increases, the opposite is the case when prices rise. Money loses purchasing power when prices rise, therefore holders of money are incentivised to convert their money into other forms in order to preserve their wealth. And often, just like with deflation, inflation can be a self-reinforcing process. Prices rise, causing people with stores of money to want to get rid of their money — that is convert it into other forms by buying other assets, which causes prices to rise even more.

So the hoardability of money, which makes demand discretionary, causes money to zig when society needs it to zag and to zag when society needs it to zig. Our form of money incentivises the exact opposite behaviour from what society needs holders of money to do in order to maintain economic stability. Thus “animal spirits” drive economic sentiment to swing from one extreme to the other causing what we erroneously refer to as “the business cycle”. We should describe it more accurately as “the money cycle”.