Misconceptions about money-lending often take the form of laws attempting to help borrowers by giving them more leeway in repaying loans. But anything that makes it difficult to collect a debt when it is due makes it less likely that loans will be made in the first place, or will be made at the lower interest rates that would prevail in the absence of such debtor-protection policies by governments. #56 в контекст | | |
In some societies, people are not expected to charge interest on loans to relatives or fellow members of the local community, nor to be insistent on prompt payment according to the letter of the loan agreement. These kinds of preconditions discourage loans from being made in the first place, and sometimes they discourage individuals from letting it be known that they have enough money to be able to lend. In societies where such social pressures are particularly strong, incentives for acquiring wealth are reduced. This is not only a loss to the individual who might otherwise have made wealth by going all out, it is a loss to the whole society when people who are capable of producing things that many others are willing to pay for may not choose to go all out in doing so. #57 в контекст | | |
| | |
Interest, as the price paid for investment funds, plays the same allocational role as other prices in bringing supply and demand into balance. When interest rates are low, it is more profitable to borrow money to invest in building houses or modernizing a factory or launching other economic ventures. On the other hand, low interest rates reduce the incentives to save. Higher interest rates lead more people to save more money but lead fewer investors to borrow that money when borrowing is more expensive. As with supply and demand for products in general, imbalances between supply and demand for money lead to rises or falls in the price—in this case, the interest rate. As The Economist magazine put it: #59 в контекст | | |
Most of the time, mismatches between the desired levels of saving and investment are brought into line fairly easily through the interest-rate mechanism. If people’s desire to save exceeds their desire to invest, interest rates will fall so that the incentive to save goes down and the willingness to invest goes up.{440} #60 в контекст | | |
In an unchanging world, these mismatches between savings and investment would end, and investors would invest the same amount that savers were saving, with the result that interest rates would be stable because they would have no reason to change. But, in the real world as it is, interest rate fluctuations, like price fluctuations in general, constantly redirect resources in different directions as technology, demand and other factors change. Because interest rates are symptoms of an underlying reality, and of the constraints inherent in that reality, laws or government policies that change interest rates have repercussions far beyond the purpose for which the interest rate is changed, with reverberations throughout the economy. #61 в контекст | | |
For example, when the U.S. Federal Reserve System in the early twenty-first century lowered interest rates, in order to try to sustain production and employment, in the face of signs that the growth of national output and employment might be slowing down, the repercussions included an increase in the prices of houses. Lower interest rates meant lower mortgage payments and therefore enabled more people to be able to afford to buy houses. This in turn led fewer people to rent apartments, so that apartment rents fell because of a reduced demand. Artificially low interest rates also provided fewer incentives for people to save. #62 в контекст | | |
These were just some of many changes that spread throughout the economy, brought about by the Federal Reserve’s changes in interest rates. More generally, this showed how intricately all parts of a market economy are tied together, so that changes in one part of the system are transmitted automatically to innumerable other parts of the system. #63 в контекст | | |
Not everything that is called interest is in fact interest, however. When loans are made, for example, what is charged as interest includes not only the rate of return necessary to compensate for the time delay in receiving the money back, but also an additional amount to compensate for the risk that the loan will not be repaid, or repaid on time, or repaid in full. What is called interest also includes the costs of processing the loan. With small loans, especially, these process costs can become a significant part of what is charged because process costs do not vary as much as the amount of the loan varies. That is, lending a thousand dollars does not require ten times as much paperwork as lending a hundred dollars. #64 в контекст | | |
In other words, process costs on small loans can be a larger share of what is loosely called interest. Many of the criticisms of small financial institutions that operate in low-income neighborhoods grow out of misconstruing various charges that are called interest but are not, in the strict sense in which economists use the term for payments received for time delay in receiving repayment and the risk that the repayment will not be made in full or on time, or perhaps at all. #65 в контекст | | |
Short-term loans to low-income people are often called “payday loans,” since they are to be repaid on the borrower’s next payday or when a Social Security check or welfare check arrives, which may be only a matter of weeks, or even days, away. Such loans, according to the Wall Street Journal, are “usually between $300 and $400.”{441} Obviously, such loans are more likely to be made to people whose incomes and assets are so low that they need a modest sum of money immediately for some exigency and simply do not have it. #66 в контекст | | |
The media and politicians make much of the fact that the annual rate of interest (as they loosely use the term “interest”) on these loans is astronomical. The New York Times, for example referred to “an annualized interest rate of 312 percent”{442} on some such loans. But payday loans are not made for a year, so the annual rate of interest is irrelevant, except for creating a sensation in the media or in politics. As one owner of a payday loan business pointed out, discussing annual interest rates on payday loans is like saying salmon costs more than $15,000 a ton or a hotel room rents for more than $36,000 a year, {443}since most people never buy a ton of salmon or rent a hotel room for a year. #67 в контекст | | |
Whatever the costs of processing payday loans, those costs as well as the cost of risk must be recovered from the interest charged—and the shorter the period of time involved, the higher the annual interest rate must be to cover those fixed costs. For a two-week loan, payday lenders typically charge $15 in interest for every $100 lent. When laws restrict the annual interest rate to 36 percent, this means that the interest charged for a two-week loan would be less than $1.50—an amount unlikely to cover even the cost of processing the loan, much less the risk involved. When Oregon passed a law capping the annual interest rate at 36 percent, three-quarters of the hundreds of payday lenders in the state closed down.{444} Similar laws in other states have also shut down many payday lenders.{445} #68 в контекст | | |
So-called “consumer advocates” may celebrate such laws but the low-income borrower who cannot get the $100 urgently needed may have to pay more than $15 in late fees on a credit card bill or pay in other consequences—such as having a car repossessed or having the electricity cut off—that the borrower obviously considered more detrimental than paying $15, or the transaction would not have been made in the first place. #69 в контекст | | |
The lower the interest rate ceiling, the more reliable the borrowers would have to be, in order to make it pay to lend to them. At a sufficiently low interest rate ceiling, it would pay to lend only to millionaires and, at a still lower interest rate ceiling, it would pay to lend only to billionaires. Since different ethnic groups have different incomes and different average credit scores, interest rate ceilings virtually guarantee that there will be disparities in the proportions of these groups who are approved for mortgage loans, credit cards and other forms of lending. #70 в контекст | | |
In the United States, for example, Asian Americans have higher average credit scores than Hispanic Americans or black Americans—or white Americans, {446}for that matter. Yet people who favor interest rate ceilings are often shocked to discover that some racial or ethnic groups are turned down for mortgage loans more often than others, and attribute this to racial discrimination by the lenders. But, since most American lenders are apt to be white, and they turn down whites at a much higher rate than they turn down Asian Americans, racial discrimination seems an unlikely explanation. #71 в контекст | | |
Where there are lenders who specialize in large, short-term loans to high-income people with expensive possessions to use as collateral, these “collateral lenders” (essentially pawn shops for the affluent or rich) charge interest rates that can exceed 200 percent on an annual basis. These interest rates are high for the same reasons that payday loans to low-income people are high. But, because the high-income loans are secured by collateral that can be sold if the loan is not repaid, the high interest rates are not as high as with loans to low-income people without collateral. Moreover, because a collateral lender like Pawngo makes loans averaging between $10,000 to $15,000,{447} the fixed process costs are a much smaller percentage of the loans, and so add correspondingly less to the interest rate charged. #72 в контекст | | |
| | |
Most market transactions involve buying things that exist, based on whatever value they have to the buyer and whatever price is charged by the seller. Some transactions, however, involve buying things that do not yet exist or whose value has yet to be determined—or both. For example, the price of stock in the Internet company Amazon.com rose for years before the company made its first dollar of profits. People were obviously speculating that the company would eventually make profits or that others would keep bidding up the price of its stock, so that the initial stockholder could sell the stock for a profit, whether or not Amazon.com itself ever made a profit. Amazon.com was founded in 1994. After years of operating at a loss, it finally made its first profit in 2001. #74 в контекст | | |
Exploring for oil is another costly speculation, since millions of dollars may be spent before discovering whether there is in fact any oil at all where the exploration is taking place, much less whether there is enough oil to repay the money spent. #75 в контекст | | |
Many other things are bought in hopes of future earnings which may or may not materialize—scripts for movies that may never be made, pictures painted by artists who may or may not become famous some day, and foreign currencies that may go up in value over time, but which could just as easily go down. Speculation as an economic activity may be engaged in by people in all walks of life but there are also professional speculators for whom this is their whole career. #76 в контекст | | |
One of the professional speculator’s main roles is in relieving other people from having to speculate as part of their regular economic activity, such as farming for example, where both the weather during the growing season and the prices at harvest time are unpredictable. Put differently, risk is inherent in all aspects of human life. Speculation is one way of having some people specialize in bearing these risks, for a price. For such transactions to take place, the cost of the risk being transferred from whoever initially bears that risk must be greater than what is charged by whoever agrees to take on the risk. At the same time, the cost to whoever takes on that risk must be less than the price charged. #77 в контекст | | |
In other words, the risk must be reduced by this transfer, in order for the transfer to make sense to both parties. The reason for the speculator’s lower cost may be more sophisticated methods of assessing risk, a larger amount of capital available to ride out short-run losses, or because the number and variety of the speculator’s risks lowers his over-all risk. No speculator can expect to avoid losses on particular speculations but, so long as the gains exceed the losses over time, speculation can be a viable business. #78 в контекст | | |
The other party to the transaction must also benefit from the net reduction of risk. When an American wheat farmer in Idaho or Nebraska is getting ready to plant his crop, he has no way of knowing what the price of wheat will be when the crop is harvested. That depends on innumerable other wheat farmers, not only in the United States but as far away as Russia or Argentina. #79 в контекст | | |
If the wheat crop fails in Russia or Argentina, the world price of wheat will shoot up, because of supply and demand, causing American wheat farmers to get very high prices for their crop. But if there are bumper crops of wheat in Russia and Argentina, there may be more wheat on the world market than anybody can use, with the excess having to go into expensive storage facilities. That will cause the world price of wheat to plummet, so that the American farmer may have little to show for all his work, and may be lucky to avoid taking a loss on the year. Meanwhile, he and his family will have to live on their savings or borrow from whatever sources will lend to them. #80 в контекст | | |
In order to avoid having to speculate like this, the farmer may in effect pay a professional speculator to carry the risk, while the farmer sticks to farming. The speculator signs contracts to buy or sell at prices fixed in advance for goods to be delivered at some future date. This shifts the risk of the activity from the person engaging in it—such as the wheat farmer, in this case—to someone who is, in effect, betting that he can guess the future prices better than the other person and has the financial resources to ride out the inevitable wrong bets, in order to make a net profit over all because of the bets that turn out better. #81 в контекст | | |
Speculation is often misunderstood as being the same as gambling, when in fact it is the opposite of gambling. What gambling involves, whether in games of chance or in actions like playing Russian roulette, is creating a risk that would otherwise not exist, in order either to profit or to exhibit one’s skill or lack of fear. What economic speculation involves is coping with an inherent risk in such a way as to minimize it and to leave it to be borne by whoever is best equipped to bear it. #82 в контекст | | |
When a commodity speculator offers to buy wheat that has not yet been planted, that makes it easier for a farmer to plant wheat, without having to wonder what the market price will be like later, at harvest time. A futures contract guarantees the seller a specified price in advance, regardless of what the market price may turn out to be at the time of delivery. This separates farming from economic speculation, allowing each to be done by different people, who specialize in different economic activities. The speculator uses his knowledge of the market, and of economic and statistical analysis, to try to arrive at a better guess than the farmer may be able to make, and thus is able to offer a price that the farmer will consider an attractive alternative to waiting to sell at whatever price happens to prevail in the market at harvest time. #83 в контекст | | |
Although speculators seldom make a profit on every transaction, they must come out ahead in the long run, in order to stay in business. Their profit depends on paying the farmer a price that is lower on average than the price which actually emerges at harvest time. The farmer also knows this, of course. In effect, the farmer is paying the speculator for carrying the risk, just as one pays an insurance company. As with other goods and services, the question may be raised as to whether the service rendered is worth the price charged. At the individual level, each farmer can decide for himself whether the deal is worth it. Each speculator must of course bid against other speculators, as each farmer must compete with other farmers, whether in making futures contracts or in selling at harvest time. #84 в контекст | | |
From the standpoint of the economy as a whole, competition determines what the price will be and therefore what the speculator’s profit will be. If that profit exceeds what it takes to entice investors to risk their money in this volatile field, more investments will flow into this segment of the market until competition drives profits down to a level that just compensates the expenses, efforts, and risks. #85 в контекст | | |
Competition is visibly frantic among speculators who shout out their offers and bids in commodity exchanges. Prices fluctuate from moment to moment and a five-minute delay in making a deal can mean the difference between profits and losses. Even a modest-sized firm engaging in commodity speculation can gain or lose hundreds of thousands of dollars in a single day, and huge corporations can gain or lose millions in a few hours. #86 в контекст | | |
Commodity markets are not just for big businesses or even for farmers in technologically advanced countries. A New York Times dispatch from India reported: #87 в контекст | | |
At least once a day in this village of 2,500 people, Ravi Sham Choudhry turns on the computer in his front room and logs in to the Web site of the Chicago Board of Trade. #88 в контекст | | |
He has the dirt of a farmer under his fingernails and pecks slowly at the keys. But he knows what he wants: the prices for soybean commodity futures.{448} #89 в контекст | | |
This was not an isolated case. As of 2003, there were 3,000 organizations in India putting as many as 1.8 million Indian farmers in touch with the world’s commodity markets. The farmer just mentioned served as an agent for fellow farmers in surrounding villages. As one sign of how fast such Internet commodity information is spreading, Mr. Choudhry earned $300 the previous year from this activity that is incidental to his farming, but now earned that much in one month.{449} That is a very significant sum in a poor country like India. #90 в контекст | | |
Agricultural commodities are not the only ones in which commodity traders speculate. One of the most dramatic examples of what can happen with commodity speculation involved the rise and fall of silver prices in 1980. Silver was selling at $6.00 an ounce in early 1979 but skyrocketed to a high of $50.05 an ounce by early 1980. However, this price began a decline that reached $21.62 on March 26th. Then, in just one day, that price was cut by more than half to $10.80. In the process, the billionaire Hunt brothers, who were speculating heavily in silver, lost more than a billion dollars within a few weeks.{450} Speculation is one of the financially riskiest activities for the individual speculator, though it reduces risks for the economy as a whole. #91 в контекст | | |
Speculation may be engaged in by people who are not normally thought of as speculators. As far back as the 1870s, a food-processing company headed by Henry Heinz signed contracts to buy cucumbers from farmers at pre-arranged prices, regardless of what the market prices might be when the cucumbers were harvested. Then as now, those farmers who did not sign futures contracts with anyone were necessarily engaging in speculation about prices at harvest time, whether or not they thought of themselves as speculators. Incidentally, the deal proved to be disastrous for Heinz when there was a bumper crop of cucumbers, well beyond what he expected or could afford to buy, forcing him into bankruptcy.{451} It took him years to recover financially and start over, eventually founding the H.J. Heinz company that continues to exist today. #92 в контекст | | |
Because risk is the whole reason for speculation in the first place, being wrong is a common experience, though being wrong too often means facing financial extinction. Predictions, even by very knowledgeable people, can be wrong by vast amounts. The distinguished British magazine The Economist predicted in March 1999 that the price of a barrel of oil was heading down, {452}when in fact it headed up—and by December oil was selling for five times the price suggested by The Economist. In the United States, predictions about inflation by the Federal Reserve System have more than once turned out to be wrong, and the Congressional Budget Office has likewise predicted that a new tax law would bring in more tax revenue, when in fact tax revenues fell instead of rising, and in other cases the CBO predicted falling revenues from a new tax law, when in fact revenues rose. #93 в контекст | | |
Futures contracts are made for delivery of gold, oil, soybeans, foreign currencies and many other things at some price fixed in advance for delivery on a future date. Commodity speculation is only one kind of speculation. People also speculate in real estate, corporate stocks, or other things. #94 в контекст | | |
The full cost of risk is not only the amount of money involved, it is also the worry that hangs over the individual while waiting to see what happens. A farmer may expect to get $1,000 a ton for his crop but also knows that it could turn out to be $500 a ton or $1,500. If a speculator offers to guarantee to buy his crop at $900 a ton, that price may look good if it spares the farmer months of sleepless nights wondering how he is going to support his family if the harvest price leaves him too little to cover his costs of growing the crop. #95 в контекст | | |
Not only may the speculator be better equipped financially to deal with being wrong, he may be better equipped psychologically, since the kind of people who worry a lot do not usually go into commodity speculation. A commodity speculator I knew had one year when his business was operating at a loss going into December, but things changed so much in December that he still ended up with a profit for the year—to his surprise, as much as anyone else’s. This is not an occupation for the faint of heart. #96 в контекст | | |
Economic speculation is another way of allocating scarce resources—in this case, knowledge. Neither the speculator nor the farmer knows what the prices will be when the crop is harvested. But the speculator happens to have more knowledge of markets and of economic and statistical analysis than the farmer, just as the farmer has more knowledge of how to grow the crop. My commodity speculator friend admitted that he had never actually seen a soybean and had no idea what they looked like, even though he had probably bought and sold millions of dollars’ worth of soybeans over the years. He simply transferred ownership of his soybeans on paper to soybean buyers at harvest time, without ever taking physical possession of them from the farmer. He was not really in the soybean business, he was in the risk management business. #97 в контекст | | |
| | |
Inherent risks must be dealt with by the economy not only through economic speculation but also by maintaining inventories. Put differently, inventory is a substitute for knowledge. No food would ever be thrown out after a meal, if the cook knew beforehand exactly how much each person would eat and could therefore cook just that amount. Since inventory costs money, a business enterprise must try to limit how much inventory it has on hand, while at the same time not risking running out of their product and thereby missing sales. #99 в контекст | | |
Japanese automakers are famous for carrying so little inventory that parts for their automobiles arrive at the factory several times a day, to be put on the cars as they move down the assembly line. This reduces the costs of carrying a large inventory of parts and thereby reduces the cost of producing a car. However, an earthquake in Japan in 2007 put one of its piston-ring suppliers out of commission. As the Wall Street Journal reported: #100 в контекст | | |
For want of a piston ring costing $1.50, nearly 70% of Japan’s auto production has been temporarily paralyzed this week.{453} #101 в контекст | | |
Having either too large or too small an inventory means losing money. Clearly, those businesses which come closest to the optimal size of inventory will have their profit prospects enhanced. More important, the total resources of the economy will be allocated more efficiently, not only because each enterprise has an incentive to be efficient, but also because those firms which turn out to be right more often are more likely to survive and continue making such decisions, while those who repeatedly carry far too large an inventory, or far too small, are likely to disappear from the market through bankruptcy. #102 в контекст | | |
Too large an inventory means excess costs of doing business, compared to the costs of their competitors, who are therefore in a position to sell at lower prices and take away customers. Too small an inventory means running out of what the customers want, not only missing out on immediate sales but also risking having those customers look elsewhere for more dependable suppliers in the future. As noted in Chapter 6, in an economy where deliveries of goods and parts were always uncertain, such as that of the Soviet Union, huge inventories were the norm. #103 в контекст | | |
Some of the same economic principles involving risk apply to activities far removed from the marketplace. A soldier going into battle does not take just the number of bullets he will fire or just the amount of first aid supplies he will need if wounded in a particular way, because neither he nor anyone else has the kind of foresight required to do that. The soldier carries an inventory of both ammunition and medical supplies to cover various contingencies. At the same time, he cannot go into battle loaded down with huge amounts of everything that he might possibly need in every conceivable circumstance. That would slow him down and reduce his maneuverability, making him an easier target for the enemy. In other words, beyond some point, attempts to increase his safety can make his situation more dangerous. #104 в контекст | | |
Inventory is related to knowledge and risk in another way. In normal times, each business tends to keep a certain ratio of inventory to its sales. However, when times are more uncertain, such as during a recession or depression, sales may be made from existing inventories without producing replacements. During the third quarter of 2003, for example, as the United States was recovering from a recession, its sales, exports, and profits were all rising, but BusinessWeek magazine reported that manufacturers, wholesalers, and retailers were “selling goods off their shelves” and “the ratio of inventories to sales hit a record low.”{454} #105 в контекст | | |
