Interest rates, discount rates, and trade-offs¶
Consider a hypothetical business which is somewhat profitable. Say it makes $1M each year. Consider a hypothetical business opportunity. In this case, assume the business knows for certain:
How much investment it would take (and it’s less than $1M).
How much money would it increase the profits per year.
Should the business invest in the business opportunity?
There are two cases to consider. One in which the million dollars in profit have not been allocated. In that case, one alternative to investment is to keep the money in some liquid form and earn interest on it. The other one is in which the profit has been allocated. The business could take out a loan, and pay interest on it each year.
The two interest rates are not the same. The bank is probably loaning some other business’s money, and needs to make profit. The “spread” between the two rates is limited: banks are competitive, so there are always banks happy to give more interest on a deposit or charge less interest on a loan.
If the investment opportunity makes less than the deposit interest on the investment, the business would be better off not taking it, even if it had the cash. If the investment opportunity makes more money than the loan interest on the investment, the business would be better off taking it, even if it has to borrrow the cash.
In other words, a rational business would look at the interest rates before deciding which investment opportunities to invest in, even in a state of perfect information. A state of perfect information does not exist, but the same calculation shows that regardless of what the business’s state of knowledge is, there are some investment opportunities that would only be taken if the interest rate is in a specific range.
Marketing and brand image¶
One business “opportunity” that often comes up is marketing. Much of marketing is building “brand awareness”. This is the kind of marketing that tends to pay off slowly over time.
Businesses care about their image to the extent that the image helps sell the products. An investment in “image” or “brand” that makes sense during low-interest times might not make sense during high-interest times.
If you are not ready for this pattern, this might look like a trend among several businesses who did things “the right way” or “the respectful way” suddenly turning around and “maximizing short term profits”. They are increasing short term profits at the cost of long term profits. This is because the price signal from the economy is that the cost of money is high and they should not spend that money on their brand image.
Pricing signals and regulation¶
Businesses that do not respond to this pricing signal are similar to businesses that do not respond to any other pricing signal. A metal chair factory that ignores the price of iron will quickly go out of business, outcompeted by more savvy metal chair factories.
Does this mean that during a high interest period, businesses will behave in more sneaky, underhanded, and aggressive ways? Yes!
This means that during high interest periods, society has to depend on more explicit regulation of business practices. This includes both the private sector, in the form of watchdog non-profits and individuals coordinating information, and the public sector, drafting and enforcing laws and rules.
Business sectors that could be trusted to self regulate during low interest periods can no longer be trusted to do that. This was never supposed to be their jobs! Regularing the market for the benefit of society is the main job of the government.
Market regulation is always the job of the government regardless of the interest rates. Times of high interest rates lead to a false sense of security, where it seems like there is enough regulation. This bias should be understood and then dismissed.
Regulations are easier to pass during a period of high interest rates, because businesses will not be incentivized to lobby against it. This is not the time for the government to rest on its laurels. It is the time for enshririning then-current business practices into laws and regulations that society can benefit from.