Domino Valdano

So, our hunt for the origins of profit has led us to the question of where interest rates come from... and one answer to that question is that they are simply dictated by the Federal Reserve. But it's not quite that simple because even if they are adjusted in the short term to boost the economy or to ward off inflation, maybe in the long run they try to set them to some kind of objectively determined rate that depends on economic growth. And maybe if they didn't set them approximately right, the whole economy would break down? We're getting into territory where I don't have enough knowledge to say much and I suspect asking different economists would give you very different answers depending on what school of thought they subscribe to. Nevertheless, I will continue along my train of thought, making the best guesses I can.

Interest rates are closely connected to the amount of money in circulation. And by money I don't mean the M1 supply (physical money) but all of the money in the economy, most of which is created by commercial banks through fractional reserve banking and the practice of lending out money that then gets deposited in another bank and then lent out again, multiplying the base currency by the "money multiplier" that's determined by the reserve requirement. The bigger the money supply is, the lower the "price" to borrow money is, ie the lower the interest rates. The smaller the money supply is, the higher the interest rates. This is how the Fed controls interest rates. Yes, they directly set the rates that they charge commercial banks for loans through the discount window, but the main way they achieve a targeted interest rate is by buying or selling government securities on the open market, pumping new money directly into the economy or extracting it out. So if you were to make some kind of objective assessment about what the interest rates "should" be it would have to depend on how big the money supply is, but that's what's controlled directly by the Fed.

Now let's return to the concept of "normal profit" for a moment. We've already seen that abnormal profits are unearned and simply due to someone being in a pre-existing position of privelege compared to someone else. But can normal profits be justified? They are typically justified by today's neoclassical economists by the concept of "opportunity cost". But if you think about it, this is somewhat of a circular justification. Let's assume company A returns a normal profit to their investors, that is 0 economic profit. If you ask what value it was that the investor added to the final goods the company produced and sold to its customers, the answer is supposedly "the investor could have used the money to invest in company B which also would have yielded a normal profit--the value added was that the investor gave up the right to invest in company B". But then if you ask what the value added was from an investor who did invest in company B, the answer is that the investor could have invested in company A which returns a similar profit. It all seems like a circular justification aside from the size of the money supply, which is set by government policy. If the money supply is large then interest rates are low and the bar for a "normal profit" correspondingly gets set lower, therefore more money is invested and more business ventures happen. If the money supply is small then the interest rates are high and the bar for a normal profit gets higher, so less business ventures happen and more people are laid off. Hence there is a constant struggle between wealthy investors who want profits to be as high as possible and therefore interest rates as high as possible, and employees who don't want to get laid off who want interest rates to be as low as possible which makes for more business ventures and less unemployment but thinner profit margins. Whoever can lobby the government more easily for their side of the story ends up winning out, and the interest rates get set somewhere in between.

I think the only other part of this whole thing I had intended to mention originally which I haven't yet is the idea of "economies of scale". I wrote an entry in April 2010 about the origins of profit and said that I thought "it takes money to make money" is a central principle behind it. You can see that with interest rates as well--if you have money, you get paid more on a regular basis for having it, even if it is just sitting in the bank.

I likened the principle of "it takes money to make money" to a group of bullies ganging up to have more leverage against smaller cliques on the playground. But defenders of capitalism would call the same thing "economies of scale". Sometimes it is cheaper to produce something when you are producing a whole lot of them than if you are just producing one. And this sounds reasonable, until you realize the connection between this and the idea of "barriers to entry" and the deviations from the perfectly competitive market we mentioned earlier. The more economies-of-scale come into play, the bigger the barrier to entry for other firms and hence the higher the profit margin. If anybody can produce each item at the same cost then the market is highly competitive. But the more it takes a huge amount of capital to get started, the closer the market becomes to a monopoly and the further it gets from the capitalist's ideal of free competition. So an economy of scale makes the capital the investors can raise more valuable, but only because it pushes the market further from free and more towards monopoly. So it's not clear that this is in the end any different from what I described initially, where pooling money together allows you to make more money in the same way that a group of people are stronger than an individual and therefore can more easily team up on smaller groups or individuals, having more bargaining power to get their way.

Bottom line is, our system of fractional reserve banking makes profits possible and economic growth possible, but maybe the Koran has it right in terms of fairness, and neither profits nor interest are really fair in any sense other than "might makes right". Which after all, is the basis for evolution. Is it really a surprise that capitalism, based on social Darwinism, has to rely on a similar justification? The fundamental paradox of capitalism seems to be that, if the market were free then there would be no economic profits, and yet the only thing that can convince people to start businesses and drive growth is economic profits. So capitalism necessarily involves coercion, and there is no such thing as a truly free or fair market where value is exchanged for value.