Savings and Investment-Twin Cities

To understand inflation, one must understand how society uses money and resources.

Edward Lotman

For an economy to use resources effectively, it needs tools for people to save money for the future, with low risks and low transaction costs, and it expects some real growth over time. By “real”, we mean “above inflation.”

It is also necessary to provide tools for those who need to borrow money, whether it is for personal emergencies or for profitable businesses, and it must also borrow in a way that has low transaction costs and manages the risk of default by the lender. Lenders need to know that, over time, they will receive actual loan returns that are higher than inflation.

In addition, since the emergence of identifiable evidence, economic history has shown that, in general, societies that limit current consumption so that surpluses can be used to expand future production capacity have developed faster and more prosperous than societies that use all production to meet immediate needs. . Remember the fable of the ant and the grasshopper?

The ant economy has achieved higher output and living standards than the grasshopper economy. Just like in a one-off psychological experiment, a society that can avoid the temptation of a single marshmallow can allow their next generation to produce more over time. Savings promote better use of available resources, higher output over time, and better ability to meet people’s needs and desires.

To meet the savings and investment needs of households and businesses, and to incentivize the entire society to save and invest in kind for the future, two types of things are needed:

The first is a well-functioning institution that connects depositors and borrowers with low transaction costs, and determines and manages risks.

Secondly, there must be an incentive to let us collectively let go of the marshmallows and delay our current satisfaction, so that our children can live a better life in the future. In addition, under long-term prudence, there must be incentives to promote borrowing.

In a market economy like ours, prices signify the motivation of human decision-making-and therefore the impact of today’s inflation cycle.

Low prices — blueberries as a coupon special offer or six-month interest-free car financing — tell us “These items are now abundant. Buy them instead of other things.” Low interest rates tell us to buy a bigger house. They told the company to build a new distribution center or buy a new locomotive or spend $10 million to develop breakthrough software or new medical equipment.

The price is high, chicken has risen by 80 cents a pound, but the ground beef is the same as a month ago, telling people to forget the legs and thighs and make meatloaf instead. The high interest rate tells people to let Honda run for another year, while farmers push the new pig barn somewhere in the future.

Modern industrialized economies like the United States do not lack institutions-intermediaries between depositors and borrowers. Our product range is very wide, from traditional commercial banks to hedge funds, to venture capital, to cryptocurrencies. If anything, we have too many types of financial intermediaries, many of which are risks we don’t really understand.

Where we are failing now lies in appropriate incentives. As taught by economics professors, interest rates are “just a price,” but the difference from all other prices is that the money supply that affects these interest rates can be changed by the central bank within a second.

These central banks and their tools to control the flow of money have developed over time to promote savings, borrowing, and investment, and to reduce the risk of disruptive financial panics that regularly occur in unregulated markets. As the “lender of last resort,” they can prevent bank failures that could disrupt people’s savings and stop business activities. In addition, under normal circumstances, they make the flow of funds smoother and safer.

Now think about what happened today. For the past 20 years, the Federal Reserve has focused on its “prevent collapse” function. In doing so, it ignores its implicit function of ensuring currency prices—the interest rates earned or paid on savings or borrowing—to establish long-term health incentives. These must essentially include positive “real” or inflation-adjusted interest rates.

On average, savings investors must get some real returns from savings and investment. Otherwise, they will hardly do enough for the benefit of society as a whole. The borrower must pay the regular price when borrowing money. If they can pay back less money after inflation than they borrowed, then they will seek more money for indiscreet consumption or unwise corporate spending on facilities, machinery, or technology. All of these have cultivated the grasshopper mentality.

The negative effects will compound. If saving year after year is punished, and borrowing is rewarded, and interest rates are low, then more people will go to more cruise ships or buy more $60,000 pickup trucks. More steel will be used to build cruise ships, not good ones. There are countless examples of improper resource allocation.

In the long run, real interest rates are positive on average, even if they are tortuous with changes in inflation and monetary policy. Since the Fed corrected the excessively loose currencies of the 1960s and 1970s, they were at a high level in the 1980s. Inflation has remained high for some time, so according to current standards, interest rates before inflation are sky-high. The 10% 30-year mortgage in 1986 was a real deal. Imagine today.

Inflation, at least in the categories we measure for consumers, has been low for two decades. Therefore, the nominal interest rate before inflation may also be very low. Borrowing money is very cheap. But financial companies that accept savings are eager to find “profits” somewhere, so they won’t lose accounts because of competitors who claim to have better returns. This creates risks.

Years ago, Ben Bernanke, the chairman of the Federal Reserve at the time, identified the global “savings surplus” as the problem, not the wrong monetary policy. possible. But some of the obvious savings are funds created by the Bank of China and other Asian central banks. For the grasshoppers on Wall Street, the cruel fact remains that a series of interest rates must return to long-term trend levels. Since the party does not seem to be strong enough and lacks the courage to take the punch bowl, it will only delay overflow when the leg of the table is finally kicked out of the environment.

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