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Posted May 21, 2021

Sean Ring

By Sean Ring

How Artificially Low Rates Alter Your Behavior By Changing Your Incentives

Happy Friday!

Let me give some big shout-outs to Hunter, Naushad, and one other very kind reader whose name I didnt get. Your kind words made my day! Im getting access to the mailbag soonest, at which point I will reply!

Weve had a helluva week. May your liver get a workout later today. Mine surely will!

But first, your morning coffee and a more didactic Rude today.

Quick Warm-Up

Everything I write in todays essay you already know subconsciously. Some of you may have studied economics and consciously understand it. But the reason why I love economics - especially the microeconomics of the Austrian School - is that, to me, its inherently inborn knowledge pulled into the front of ones mind.

Its almost as if youve always known it but were never aware of it. The enormous benefit of becoming aware of it is that you can wield it to your advantage.

Im going to walk you through, step-by-step, my ideas of whats going on today. I didnt originate any of this. Its knowledge brighter people than I have discovered, but Ive been lucky enough to come into contact with and piece together.

Time Preference

I want it all,

I want it all,

I want it all,

and I want it now.

-Queen

Allegedly, Queen guitarist and astrophysicist (really) Brian May wrote this song. His wife, Anita Dobson, an English television actress, inspired him by constantly saying, "I want it all, and I want it now."

Thats a believable explanation for any married man.

What is time preference, and why is it so important? Lets start with the axiom that everyone wants more satisfaction rather than less. And we want that satisfaction earlier rather than later. Thats the practical way to think about time preference. Well get more definitive in a bit.

We know big goals take more time to accomplish. If were willing to invest more time to achieve these goals, were demonstrating a low time preference. Someone who wants their flatscreen TV and new car RIGHT NOW reveals a high time preference.

(Sometimes, the terminology gets confusing. Just remember, lower time preference means longer. Lower, longer. Lower, longer. Now, youve got it.)

Why does time preference matter? It matters because people who save and invest, rather than consume, build civilization. To forgo your immediate desires to build resources for increased future consumption is how we move forward as a civilization. Prudence. Long-term planning. Ah, the days of yesteryear.

We can thank our lately besmirched forefathers for setting up all this for us. If they didnt save and invest, putting off consumption until later, wed still be hunting every day for food. (The enviroMENTALists overtly desire this with gardening rather than hunting.)

Essentially, our civilization is not the privileges our forefathers bequeathed us so much as the consumption they forewent. Frederic Bastiat distinguished between the seen and unseen. I encourage you to do the same.

And that leads us to our next step: marginal utility.

Marginal Utility

Understanding this concept changed my life. It changed the way I view objects, people, and goals.

Utility in economics means pleasure or satisfaction, not usefulness. Marginal means additional. When economics professors teach this, they go for cardinal numbers (number of units at a price level). And if youre Apple, you can indeed gauge demand for, say, iPhones. But ordinary people have neither the resources nor the know-how to do that.

So for us, thinking of utility in an ordinal way makes much more sense.

That is, we just list out our preferences in order from most desirable to least desirable.

For instance, our list at this moment may look like this:

    1. Eat a good breakfast.
    2. Talk to the boss about a promotion.
    3. Pick up kids at 3 pm from school.
    4. Move into a McMansion.

You may look at this list and say, Geez, surely the promotion is more important than picking up the kids! Or Why is having a good breakfast even on this list?

Good questions, both. But this is my list, not yours. And thats the beauty of economics. Understand that every one of us has different ways of thinking about our priorities.

Why does my list look like this?

Perhaps I forgot to pick up my son last time, and he thinks I dont love him as much as I used to. Or I need a good breakfast because my health isnt that great. My promotion matters, for sure, and I need that first before I move into my McMansion.

Crucially, this list may change in the next 5 seconds. Things come up all the time.

Of course, my time preference matters. I have to pick up my kids at 3 pm. Thats when they get out of school. I have no choice there.

But Ive been working for years on my promotion, so I think the time to talk about it is today. But Ive got leeway if my desire to talk about my promotion may not be high on my bosss marginal utility list.

Ok, say I ate a good breakfast. Yum! My list now looks like this:

    1. Talk to the boss about a promotion.
    2. Pick up kids at 3 pm from school.
    3. Move into a McMansion.

Now, I just talked to my boss about my promotion. Its not happening. Ugh. Heres my new list:

    1. Pout and surf the net all day at work because Im pissed off.
    2. Pick up kids at 3 pm from school.
    3. Look for a new job.
    4. Tell my wife the McMansion is on hold.
    5. Check my wifes phone to make sure she doesnt have a Tinder account.

See? The list radically changed.

The Powers That Be (TPTB) know this. They mess with it all day, every day. There are two primary ways for them to do this: monetary policy and fiscal policy.

Monetary policy has been king for quite a while, so lets show how artificially lowering interest rates distorts incentives.

How Artificially Low Rates Leads to Malinvestments

Its 2008. The stock markets follow real estate and credit markets down the toilet. The Fed (duh! duh! daaaa!) shows up in a red cape to save the day. It lowers interest rates to zero. Were thrilled they stepped in to rescue the economy.

The markets rally. We feel better.

But what really happened there?

What The Fed did was mess up everyones incentives. By lowering interest rates, they reduced the discount on all future cash flows in the economy.

Take a look at these tables. They are the same project. The only difference is the rate at which we discount the future cash flows is lower in the left table.

discounted future cash flows

Ill walk you through it.

When it comes to project finance or financial modeling, we use the NPV method. NPV stands for net present value. Essentially, we estimate all the cash flows of a project and its interest rate. Then we discount all the cash flows by that rate back to the present.

If the NPV is positive, we accept the project. If its negative, we reject it.

So lets look at our project with two different discount rates.

First, we have an initial investment, or outflow, of $50,000. The next five years cash flows are all positive: $10,000, $10,500, $11,025, $11,576.25, and $12,155.66, respectively. The DF column represents the discount factor applied to each cash flow. That formula is 1/(1+r)^t. So for Year 1, at a 2% discount rate, the discount factor is 1/(1+0.02)^1, or 0.98039. The present value of that future cash flow (PVCF) is $10,000 x 0.98039 = $9,803.92.

We apply that formula to each cash flow.

If the project has a 2% interest rate or cost of capital, the net present value (NPV) is a positive $1,989.18. As its positive, we would take on the project. That is, wed spend the $50,000 and start the work.

But notice the NPV when rates are at 5%.

Wed reject this project outright, even though it has the same cash flows. In fact, wed reject this project for any rate above 3.315%, the projects internal rate of return (IRR). That means rates must be pretty darn low to make this project attractive to investors.

Heres the project at various discount rates:

net present value chart

Now imagine this happening for millions of projects around the world. Thats the power central banks wield. Were not exaggerating when we say they alter incentives worldwide.

Projects that are marginally profitable at lower interest rates would be woefully unprofitable at historically normal rates like 5%.

At a more retail level, think how much more likely one is to buy that flatscreen TV on credit at zero interest rates, rather than, say, 5%. Because you cant earn any money at all on your savings account anymore. This has huge repercussions for society.

It may be the main reason why women are Instagram addicts and sometimes promote themselves to OnlyFans. Its why many men have given up on ever owning a home or getting married. It also explains the rampant gambling in the stock market via RobinHood and in the cryptocurrency markets.

Why not, right? Its just too hard to do things the old-fashioned way.

Economists blame womens literacy rates for the decrease in birth rates. What if we suppose its not reading, but mathematics skills, that lower birth rates. After all, if a woman knows her and her husband she cant support a kid, why would they have one? Everything is more expensive when rates are on the floor.

To sum it up, central banks incentivize companies to create malinvestments by artificially lowering rates. This makes projects look more profitable than they actually are once rates get back to normal.

Congratulations, youve just quantified time preference!

To Wrap It Up

Central banks bring investments forward in time that may not have happened at all. And perhaps should not have happened at all.

And now you know why weve been messed about since 2008. We wont get out of this mess until The Fed takes its foot off the yield curve and lets the market find its clearing rate.

But if you understand time preference, marginal utility, and how central banks manipulate our preferences with rates, then youre better prepared than most to face the upcoming reckoning.

For now, I wish you a wonderful weekend with wine, whisky, and song!

All the best,

Sean

P.S. Jeff Tucker wrote the best article on marginal utility Ive ever read. And thanks to Jeffs article on shaving, I have a babyface at age 46. For more on time preference, Hans-Hermann Hoppes first essay in his excellent book, Democracy: The God That Failed, is an excellent start. Enjoy the reading!

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