Who Knows The Right Interest Rate

On January 6, we wrote the Surest Way to Overthrow Capitalism. We said:

“In a future article, we will expand on why these two statements are true principles: (1) there is no way a central planner could set the right rate, even if he knew and (2) only a free market can know the right rate.”

Today’s article is part I that promised article.

Let’s consider how to know the right rate, first. It should not be controversial to say that if the government sets a price cap, say on a loaf of bread, that this harms bakers. So the bakers will seek every possible way out of it. First, they may try shrinking the loaf. But, gotcha! The government regulator anticipated that, and there is a heap of rules dictating the minimum size of a loaf, weight, length, width, depth, density, etc. Next, the bakery industry changes the name. They don’t sell loaves of bread any more, they call them bread cakes. And so on.

There is always a little arms race going on, wherever there are government controls. One recent example is Uber. This company actually illustrates two different workarounds. One, is labor law. Labor law sets not only a minimum price for labor, but also adds many other restrictions that make companies less flexible, and therefore less able to deliver what customers want. So Uber drivers are not employees. Oh no, they are independent contractors.

Two, is taxi regulation. Uber is not a taxi. It is a ride-sharing service. Under regulation, definitions determine the difference between life and death. So everyone is forced to play a game of hair-splitting.

But what does not happen: consumers can buy as much bread as they want, below production cost. Something has to give. And if nothing else can give, then bakeries are ruined and you arrive at Venezuela. The average adult there lost 11kg (24 lbs) in 2017.

What does not happen is: bakeries pay workers $15 to produce $12 worth of bread.

Why not? What is it about production cost that makes bakers unable to go below it, even if they were willing? What is it that makes employers unable to pay workers more than the revenues generated from the work? And make no mistake about this point. Our socialist friends may try to turn it into a character attack (especially on the minimum wage), alleging evil motives for the baker, who is greedy and exploiting workers.

Of course it has nothing to do with motives. Reality does not permit you to consume more than you produce. If you spend $1.01 to produce a loaf of bread that you sell for $1.00, then you lose a penny on every loaf. This is true, regardless of whether a price-fixing law caps bread at $1.00, or whether a minimum wage low hikes your cost to $1.01.

You only have so many pennies. And eventually, you will run out.

Production consumes resources. It consumes the obvious resources that everyone can see. For example, baking a loaf of bread consumes flour, water, labor, etc.

It also consumes the not-so-obvious resources that most people do not see. Such as wear and tear of the mixing equipment and ovens, depreciation of the building, etc. It consumes capital.

To illustrate this, let’s look at Able Bakery. Able publishes financial statements showing only the first category, the flour, labor, and other ingredients. But they do not address capital at all, the ovens and mixers, the building, etc.

Able’s financial statements do not paint an accurate picture of the business.

Suppose Able reports a small profit. It does not count the (potentially large) costs of wearing out equipment and the building. So, the true picture of the bakery business may actually be that it loses money. We don’t know for sure (but we suspect from the small profit and potentially large cost that is excluded).

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