Small or conservative investors are typically told that government debt is the safest and most conservative type of investment they can have. Of course, given the current level of political stability in the world, that might not be saying much.
That’s why the ongoing saga of the Federal Reserve and what to do about interest rates — although a completely illusory situation created by the fallacy of Keynesian economics — has small investors and those of a conservative bent all bent out of shape trying to second guess what the Federal Reserve is going to do . . . at a time when the Federal Reserve has no idea what it is going to do . . .
Of course, the rational thing to do would be to adopt the Economic Democracy Act and (among other things) let the market set interest rates, the discount rate, and other things that go into the true cost of capital. The discount rate, by the way, is NOT an interest rate, even though even people who know better call it that. Consider it more of a quasi-interest rate, and then only to be able to make financial projections, not a rate of return.
Thinking of the discount rate as an interest rate is sort of the financial analog of a legal fiction. A legal fiction is something that everyone knows isn’t real, but it’s treated as real for the sake of convenience and expedience. For example, a corporation isn’t really a person. Strictly speaking, only human beings can be persons — unless you’re religious and include God, gods, angels, demons, afrits, and all those nifty things. Asking a true financial professional if a discount rate is a type of interest rate should get you an answer that begins, “No, but —”
But back to the subject at hand. Evidently because they think the Federal Reserve is going to raise interest rates again, small investors are buying low-interest government debt at an incredible rate.
Come again? Isn’t that a mug’s game? To buy a low yield investment when the same amount of money in the near future might get you the exact same thing with a much higher yield?
If you think that, you’re out of date and thinking in archaic, non-Keynesian terms. In ancient times, i.e., a hundred years ago, people thought in terms of Say’s Law of Markets. That is, if you wanted to consume something, you first had to produce something. Either you produced something that you wanted to consume yourself, or something to trade to someone else for what someone else produced that you want to consume. As usually (inaccurately) summarized, Say’s Law boils down to “Production equals income, therefore, supply generates its own demand, and demand generates its own supply.”
We won’t go into all the reasons people like Keynes and Marx rejected Say’s Law. What eventually happened is that financial thinking shifted away from focusing on production, distribution, and consumption, to manipulating the money and credit system to achieve desired results, i.e., make money. Money became a thing valuable in and of itself, and not as a way of measuring and conveying things that have intrinsic value, viz., marketable goods and services. The cart jumped out in front of the horse and has stayed there ever since.
|John Maynard Keynes|
Investors stopped looking at the earnings of the investment itself, i.e., the interest rate on debt or the dividend rate on equity — in other words, true investment — and began buying and selling assets in the hope that the value of the asset itself would change. In this way they could make a profit buying and selling the asset itself instead of using the asset to generate income, that is, produce a marketable good or service — speculation.
This was a fundamental change in how view people viewed economics. No longer was the primary focus to be on production, distribution, and consumption. Rather, the focus was on gambling, betting on whether the asset itself, regardless of whether it produces anything, will change in value. Income no longer came from producing something, but from manipulating the value of something somebody else produced. Production, as Keynes always insisted, didn’t matter.
This explains why Keynes focused exclusively on manipulating the symbols and units of value. He just assumed production would appear. It was a given. In the real world, of course, nothing exists if it isn’t produced, but Keynes thought in magical terms, what Richard Feynman called “Cargo Cult Science,” i.e., manipulate the symbols and reality will conform to symbols rather than the other way around.
So, why are investors flocking to government bonds when the Federal Reserve is considering raising interest rates again? As interest rates rise, debt with a lower interest rate falls in value. For example, a $1,000.00 bond with a 5% annual interest rate yields $50 per year. Essentially, the bondholder paid $1,000 for an income of $50 per year. Suddenly the interest rate rises to 10%. A $1,000.00 now buys an income of $100.00. That means if the holder of the 5% bond wants to sell it, he or she won’t find any buyers at $1,000.00. The buyer will have to lower the price to $500.00 to make it the same value as whatever else is available.
Thus, when the interest rate is 10%, a $1,000.00 bond with an interest rate of 5% will have a market value of $500, a 10% bond will have a market value of $1,000, a 20% bond (for example only, a 20% is probably purely speculative anyway) will have a market value of $2,000, and so on.
So why would investors be buying bonds when they expect interest rates to rise? Shouldn’t they be selling so they can buy an income cheaper? Not if they expect the higher interest rates to 1) cause an economic downturn and a crash in interest rates, or 2) reduce debt issuances from the government making a presumably safe investment worth more even with a lower interest rate. Either one is hardly a good investment strategy, however good it is for gambling.#30#