Credit, Interest, Inflation

Aug 2014

(Follow up Essay to How The Economy Works)

 

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”

– Sam Ewing

 

“Congress has not raised the minimum wage since 1997. The minimum wage is now at its lowest level in 50 years adjusted for inflation and will continue to be each year until it’s increased.”

– Russ Carnahan

 

After publishing the last essay I got an email. What happens if a company can’t find money from investors? Or if they want more money than the investor has? Well, they’ll have to borrow it. And when you borrow something sooner or later you’ll have to return it.

3 important concepts that were omitted are credit, interest and inflation. They heavily influence where money is allocated and are all central to a functioning economy. The reason is because they are supplementary to the core concept not the core itself. Like how a receipt is the documentation of a purchase and includes any tips and taxes but not the purchase itself. Something can cost X, but other factors can distort the value of X. These are those other factors.

An interesting question is what does a government do when it wants money. Because a government can’t really raise money from investors conventionally. Instead it might use a proxy by selling bonds instead. But for the most part, it has to borrow money. And borrow from other countries.

Credit and debt are basically the same thing. Being able to borrow money is having credit. After you’ve borrowed it, you have debt. Debt can be transferred from one to another. There are many situations when a company would prefer to borrow money over selling shares. Like if they wanted to retain control or are doing really well and think they could repay it quickly.

So they would borrow money, invest it into something that will return the money and then repay the loan. Sometimes companies will borrow money to buy other companies to grow faster or to open new branches to expand. Then when the loan is repaid, they own another company and are bigger. This has been the tried and true method for most of history for growing a company. The benefits are you don’t have to deal with the bullshit of outside people. But then you have to pay interest on whatever you borrowed.

Borrowing money, or raising debt as it is frequently called can be a dangerous thing. Especially without a means of repaying it. Because with interest, it constantly increases. It compounds. A bad decision can end in a situation where you accidentally are in debt forever. It becomes a spiral. You can’t pay off interest, let alone the debt itself.

 

Interest is like a small fee you get charged for borrowing money. It’s usually a percentage of whatever was borrowed. It’s supposed to be an incentive for a person to repay their debt quicker. Otherwise you could borrow money and never repay it. Interest makes it so that if you did that, the debt will increase.

The more risk involved typically the higher the interest rate. It’s why credit cards have a really high interest rate while home loans have a comparatively low interest rates. These are usually set by the institution lending the money.

Another form of interest is when you save money in a bank and get paid small amounts of money for doing so. If you’ve ever had lots of savings, the balance will increase with interest. It’s like a bonus and encouragement for having large amounts of savings. This is compound interest. The savings are constantly increasing. As Einstein once said, “The most powerful force in the universe is compound interest.”

The reason people get this is because it is a fee banks pay people for allowing the bank to use their savings to invest and lend to other people. You allow a bank to do this when you store money with one. Of the interest the people who’ve borrowed pay, a portion of that goes to people with a lot of savings. Because through a means of complex financial engineering, the borrower really borrowed from the saver, with the bank acting as intermediary.

A low interest rate makes it easier to get money. Capital is more available because money can be borrowed and repaid slower and over a longer period of time. So more people will borrow money to finance their companies or expansion. Big companies will sometimes borrow money to buy other companies or invest in new products. It’s why frequently a government will try to fix a slow economy by reducing the interest rate.

By the opposite, a high interest rate reduces the amount of borrowing and investment. Because they’d have to spend more when repaying a loan. So companies invest less and will start saving more. Typically during times of high interest, savings increase because people become reluctant to spend. While during times of low interest, debt increases because people are borrowing more.

Money is a fairly efficient system and typically is always allocated to the highest returning asset. So an asset to be a good investment doesn’t just have to have a good return, but also a better return than any other form of asset. Because of this, what makes a good investment change when interest rates change. When rates are high, people save more because they get a better return from a bank. When rates are low, they spend and invest more.

When people borrow more, they typically are spending or investing it. By spending this money it stimulates the economy and businesses grow faster because there is more money available. Businesses thrive and hire more people creating lots of jobs. But what happens when money is easy to get is people start to speculate. They invest in things they can’t afford or have no hope of paying back. When this starts to happen interest rates need to be increased to slow down speculation. A healthy economy doesn’t need low interest rates, they are a tool used by governments to kickstart the economy.

It’s what people are referring to when they say money is cheap or expensive. They are talking about the relative cost associated with borrowing it. And this is influenced by interest rates. To get a great return when there is a high interest rate, you’d have to be making better investments. This is because the way people benchmark investing returns is against 2 metrics.

The first is how much it would increase if they just kept the money in a bank which is usually the interest rate. The other is how much the general stock market is going up. So if the interest rate is 4% and the general stock market is going up 8%. Then to be making a good investment, you’d have to make more than 4% or 8% respectively. This is the heuristic most money managers use when allocating money. Can this asset return more than 8%? if it can, it’s a great investment.

4% or 8% appreciation is what would happen if money was just kept still in a bank or the stock market. It’s why children are taught to save from a young age. Because once they have a large amount of savings, the compounding returns takes over. If you had a million dollars in a bank account, you would make close to $60k per year just from the interest. It’s what people mean when they say the rich will always get richer. Just by having money, even if you do nothing with it, you will get richer.

For startups, it means that when interest rates are low, it’s easier to raise money because more is available because it is cheaper to get. Investors are flush with cash. And when they are high, it is difficult to raise money because less is available because it is expensive to get. Investors have no cash. When high, it also means there are less acquisitions and they are further and far between so it is more difficult to get acquired. It’s because companies aren’t using their money to buy other companies, they are saving it.

This filters down and less startups end up started because less end up financed because less end up acquired. It also means less companies will shift their business from their current providers so it’s harder to get new customers. This becomes a domino which effects the whole system. Outlook becomes less promising and bleaker as a result. The companies that thrive during periods of high interest rates are ones that figure out a cheaper way of doing something. Because it’s a time when companies are trying to reduce their cost structure and expenses.

It also means when the interest rate is low acquirers will tend to pay higher prices to buy startups because money is easier to get. It’s how bubbles are created. Money becomes cheap while the number of great opportunities remains relatively fixed and so more people send a greater number of dollars chasing fewer opportunities. The opposite is true when interest rates are high.

As a general rule: When money is cheap, there is a surge of activity with more players. When it is expensive, there is a drop in activity with fewer. Low interest rates cause bubbles. High interest rates cause depressions. Peaks and troughs.

 

Inflation is the process by which money becomes less and less valuable over time. It’s also referred to as purchasing power meaning the amount you can buy with it. The purchasing power of money goes down over time. So you need more and more money to buy the same things. It’s why when my dad was in school it cost 35 cents to buy a can of coke but today it is nearly $3 dollars. As more money enters an economy, people start to increase their prices accordingly. That is inflation at work.

If the amount of money people earn doesn’t increase to keep up with inflation, they will find quickly they’ll be able to buy less with it. It’s why median incomes have to increase or else they’re in trouble and is why if a a minimum wage doesn’t increase, eventually you won’t be able to survive on it, defeating the purpose of a minimum wage. Inflation theoretically runs forever. The price of money will always increase because there is always more money being created. When a country has high inflation, it means that too much money is being created.

This is what happened in a lot of countries that just printed money to pay off debts. Suddenly everyone increased their prices to keep up and no one could buy anything. A potato would cost millions of dollars. It’s important for there to be balance in all of these as changes, in small ways, affect the lives of nearly everyone.

How people make these decisions is largely confidence in the future. People don’t spend, invest or borrow when they’re not confident about the future. In fact, it’s all about confidence. If someone is confident in a company, even if it’s doing badly, money will still go into it. That’s how you get situations like the tech bubble. The companies all sucked but just by everyone being confident, they would continue to pour money in and the stock prices would go up. Until one day they lost confidence and then it didn’t anymore.

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