Paul Solman in an article (link is below) about interest rates and inflation identifies three factors that affect interest rates: waiting, repayment risk, and inflation. Then a reader in the comment section to Paul's article adds the availability of money.
O.K., so there are four factors that contribute to the variance in interest rates, but aren't we overlooking the obvious. How about the willingness of the lender to loan us the money. I know from my experience in banking that lenders evaluate hundreds of factors before making a loan: the credit history of the borrower, the collateral the loan will be secured against, the market conditions affecting the likelihood of the borrower making a profit on his loan, competition from the bank across the street, the contents of the banks loan portfolio, the business case of the borrower, the general business environment, the geographic area where the funds will be employed, etc. Granted some of these issues the bank evaluates are "repayment risk factors," but many are simply business preferences. At the end of the day the personal relationship between the borrower and lender may affect the interest rate more than "repayment risk."
In N Theory I argue it is these factors that largely determine interest rates as manifest from the two major players in the loan transaction, the borrower and the lender. It is their characteristics and their negotiation that establishes the interest rate and the economic environment in which they live. The interest rate to borrow a million dollars for a snowmobile dealership in Miami will be quite different than borrowing for the same use in Edmonton, Ontario.
The simplistic explanation of Paul Solman misses the biggest point about interest rates. He fails to consider that interest rates are set by market conditions. Of course, duration, repayment risk and inflation enter into the equation, but there are many more factors. The two most important issues are who determines the repayment risk, and at what cost will the borrower walk away from the deal. Paul ignores that interest rates are a product cost and that there are two sides involved in setting the interest rate.
First and foremost interest rates are a market negotiation (N Theory). A lender will not get her interest rate unless a borrower can make the rate fit into his business plan. Paul may grant me a few points, but I suspect his argument would be that he was referring to the interest rate set by the Federal Reserve. If his three factors are all that weighs into a interest rate, why the huge historical difference between interest rates in the past 50 years between Japan and the United States? I suspect the interest rate difference is more determined by the Japanese borrower than financial factors alone.
Sunday, April 15, 2012
Friday, April 13, 2012
Should Countries Borrow?
We all know too well that countries borrow, but should they? To answer this question requires knowing why different sectors borrow. It is not solely to have more money to spend. In the case of government it is to provide services that their citizenry want. In this regard, the government sector differs from the business sector in one significant way. The business sector borrows to make a profit. The government sector does not make a profit. The motivation in the government sector is to meet a request from their citizenry. Governments react like harried parent in a Toy 'r Us at Christmas time. Governments do not evaluate whether they can afford the gift, they just make the purchase and look for a lender to support their extravagance.
The profit factor is key in answering the question of whether governments should borrow. A profit provides the monetary resources to repay a loan. Since a government does make a profit they should not borrow. A government will not have the resources to repay the loan.
I can hear you stammering, but, but .... The fact of the matter is Governments are different from businesses. Borrowing is the vehicle that drives business. Business borrows, because it is just another way to increase their profits and acquire more wealth. Borrowing is central to business activity and one of the primary ways wealth is created in a society. It is not something that should be used by the government sector.
I can hear you arguing that government borrowing is older than business. Originally, government borrowing was for waging wars and capturing territory. This activity (tribute or tax revenue) is the equivalent of profit in the business sector. When a government undertook this risky activity borrowing made sense, because the hope was funds would be generated to repay the lenders. But in the modern world governments rarely seek additional territory to replenish their Treasuries.
Most borrowing by the government sector is for providing things for their citizenry: clean water, roads, good schools, social services, health care, etc. None of these activities when managed by unrestrained government bureaucracies provide a revenue stream sufficient to repay the cost of borrowing. Consequently, they should not be undertaken by the government sector.
You are starting to see the light. Yes, all these activities can be managed by the business sector. Business management is efficient and controlled by market factors that ensure a profit and an ability to repay the loans.
Why do governments undertake to provide all these services? It is simply to ensure their citizens provide tribute or taxes.
The profit factor is key in answering the question of whether governments should borrow. A profit provides the monetary resources to repay a loan. Since a government does make a profit they should not borrow. A government will not have the resources to repay the loan.
I can hear you stammering, but, but .... The fact of the matter is Governments are different from businesses. Borrowing is the vehicle that drives business. Business borrows, because it is just another way to increase their profits and acquire more wealth. Borrowing is central to business activity and one of the primary ways wealth is created in a society. It is not something that should be used by the government sector.
I can hear you arguing that government borrowing is older than business. Originally, government borrowing was for waging wars and capturing territory. This activity (tribute or tax revenue) is the equivalent of profit in the business sector. When a government undertook this risky activity borrowing made sense, because the hope was funds would be generated to repay the lenders. But in the modern world governments rarely seek additional territory to replenish their Treasuries.
Most borrowing by the government sector is for providing things for their citizenry: clean water, roads, good schools, social services, health care, etc. None of these activities when managed by unrestrained government bureaucracies provide a revenue stream sufficient to repay the cost of borrowing. Consequently, they should not be undertaken by the government sector.
You are starting to see the light. Yes, all these activities can be managed by the business sector. Business management is efficient and controlled by market factors that ensure a profit and an ability to repay the loans.
Why do governments undertake to provide all these services? It is simply to ensure their citizens provide tribute or taxes.
Tuesday, April 3, 2012
N Theory versus Supply and Demand Theory II
The approach to solving economic problems differs greatly between N Theory and Supply and Demand Theory. N Theory identifies the components of an effective economic system and then looks at the economic system a country is using and identifies the flaws. Imagine instead of an economy the N Theory technique was used to identify the problems in a golf swing. First, N Theory would establish the features of a good golf swing: keeping your left arm straight, raising the club over your head, keeping your eyes on the ball, keeping your head motionless, and releasing your cracked wrist at impact. After a list is created the N Theory process evaluates each item on the list for proper functioning and then evaluates how each step coordinates with the other steps. This analytical approach reveals cracks in the whole process and focuses on strengthening the areas needing improvement.
Supply and Demand Theory is a mathematical model where prices and quantities of goods are compared. From this process of comparison certain trends are derived from past results. These past results are used to predict future results or the results of alternative inputs. The major difference between N Theory and Supply and Demand Theory is how human choice is involved. Supply and Demand Theory asserts price setting results from concrete factors: the number of goods for sale or the changes in the money supply. N Theory states prices are determined by human decision making on both sides: Buyer and Seller decisions. Supply and Demand Theory comes up with an absolute result that applies to all sales. N Theory states all price setting is potentially unique and one of a kind.
In N Theory the roles played by people: Buyers and Sellers is most important. In Supply and Demand Theory the quantity of products for sale and the quantity of money in the hands of Buyers are the most important factors. N Theory does not ignore these quantity factors, but diminishes their importance. N Theory sees quantity factors as part of a long list of factors that affect and influence decision makers: Buyers and Sellers. Supply and Demand Theory by focusing on things (products and money) fails to explain financial events caused by rational or irrational human action. Supply and Demand Theory cannot predict panics. N Theory is based on the human factor that precipitates financial panic.
Jean Claude Trichet in a speech at Harvard indicated that economic models based on Supply and Demand failed to predict or suggest a way out of the Global Financial Crisis of 2008. The strategies employed by central banks throughout the world did little to restrain or reverse the economic slide caused by poor political leadership. Throughout the world political leadership followed the tenets of Supply and Demand Theory and as stated by Keynes: "control of interest rates is the best way to encourage market growth." The central banks immediately instituted policies to lower interest rates, but nothing happened. Why? The decision makers were not convinced. Business people did not invest and expand, but reduced staff and horded investment cash. Consumers did not rush out to buy capital goods because interest rates were low, but delayed making purchases and put money into savings accounts.
The Global Financial Crisis is a vivid example that the things policies of conventional economics does not work. The only effective policy is one based on the actions and expectations of people. That is exactly what N Theory purports to do, but more than that, it also suggests a regular economic check-up to ensure the components of commercial enterprise are working properly.
Supply and Demand Theory is a mathematical model where prices and quantities of goods are compared. From this process of comparison certain trends are derived from past results. These past results are used to predict future results or the results of alternative inputs. The major difference between N Theory and Supply and Demand Theory is how human choice is involved. Supply and Demand Theory asserts price setting results from concrete factors: the number of goods for sale or the changes in the money supply. N Theory states prices are determined by human decision making on both sides: Buyer and Seller decisions. Supply and Demand Theory comes up with an absolute result that applies to all sales. N Theory states all price setting is potentially unique and one of a kind.
In N Theory the roles played by people: Buyers and Sellers is most important. In Supply and Demand Theory the quantity of products for sale and the quantity of money in the hands of Buyers are the most important factors. N Theory does not ignore these quantity factors, but diminishes their importance. N Theory sees quantity factors as part of a long list of factors that affect and influence decision makers: Buyers and Sellers. Supply and Demand Theory by focusing on things (products and money) fails to explain financial events caused by rational or irrational human action. Supply and Demand Theory cannot predict panics. N Theory is based on the human factor that precipitates financial panic.
Jean Claude Trichet in a speech at Harvard indicated that economic models based on Supply and Demand failed to predict or suggest a way out of the Global Financial Crisis of 2008. The strategies employed by central banks throughout the world did little to restrain or reverse the economic slide caused by poor political leadership. Throughout the world political leadership followed the tenets of Supply and Demand Theory and as stated by Keynes: "control of interest rates is the best way to encourage market growth." The central banks immediately instituted policies to lower interest rates, but nothing happened. Why? The decision makers were not convinced. Business people did not invest and expand, but reduced staff and horded investment cash. Consumers did not rush out to buy capital goods because interest rates were low, but delayed making purchases and put money into savings accounts.
The Global Financial Crisis is a vivid example that the things policies of conventional economics does not work. The only effective policy is one based on the actions and expectations of people. That is exactly what N Theory purports to do, but more than that, it also suggests a regular economic check-up to ensure the components of commercial enterprise are working properly.
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