Maintaining artificially low interest rates or excessive money supply does permanent damage to economies in the medium- and long-term because it delays creative destruction, the process of replacing low-return investments with higher-return investments.
To help illustrate this point, I present the “Investment Opportunity Schedule” in Exhibit 1 (click to enlarge), which plots the number of investment opportunities against the level of potential return for each opportunity. The most important takeaway from Exhibit 1 is that lowering the cost of capital increases the number of profitable investment opportunities at the low-return end of the spectrum. Naturally, investors gravitate to the easiest ways to make money and will allocate capital to low-return endeavors as long as those low-return endeavors are profitable. The longer interest rates are low and money is cheap, the more capital gets allocated toward the lower return activities.
Simultaneously, as low-return activities attract excessive levels of undeserved capital, high-return activities are starved for capital. Therefore, artificially low interest rates subsidize investment in low-return opportunities at the expense of investment in high-return opportunities.
Exhibit 1: Limited High Return Opportunities – Unlimited Low Return Activities
This exhibit also illustrates some key facts about capital allocation:
- There is a finite number of profitable business/investment opportunities, which means there is a finite supply of capital as well. If not, then financial capital and wealth would be infinite.
- The higher the potential return on an investment opportunity, the more competitive the business and the more difficult it is to maintain a high return on investment
- There is an infinite number of low-return and money-wasting opportunities.
As long as the interest rates are kept artificially low, profit from lower-return businesses is possible even if it is not sustainable. Hence, the short-term benefits of artificially lower rates are that they keep more businesses operational and slow the decline of existing jobs and consumer spending – which is what helps keep politicians in office and regulators employed.
However, since there is a finite amount of financial capital, the opportunity cost of subsidizing investment in low-return opportunities is lost opportunity to invest in high-return opportunities. I believe that the longer this pattern persists, the more damaging and the larger the permanent loss of capital, the longer the delay in creative destruction and the lower the long-term growth potential of an economy.
I believe the Investment Opportunity Schedule also applies to the capital markets. In the context of the equity capital markets, speculative investors are those that flock to the easy and plentiful low-return opportunities that emerge in low-interest rate environments. Their investment returns rely much more on other speculators following them than on the value created by the underlying businesses they choose to own. Value investors make their money by finding stocks at the opposite end of the spectrum: the few high-return opportunities.
In the same way that artificially low interest rates lower the long-term growth potential of economies, speculative investing lowers the long-term growth potential of capital markets because it drives allocation of capital to lower-returning investments. In fact, taken to its logical conclusion, artificially low rates and speculative investing can eventually, if left in place for too long, ruin economies and markets entirely. In addition, speculators, like low-return investors, can be put out of business quite quickly when rates rise or money gets tighter.
Disclosure: No positions