The science of finance/Inequalities in front of finance
"If you give a fish to a poor man, he will eat one day; but if you teach him to fish, he will eat every day. "
And we can add: if a fisherman does not have a boat, you can make him pay every day the boat that you lend him.
The private property based financial system is unfair because it favors owners over less fortunate workers. It allows the richest to earn a lot of money without working and thus aggravates social inequalities (Stiglitz 2012, Piketty 2013). It can sometimes partially correct some economic inequalities by offering the less fortunate the means to undertake, but even so it remains deeply unequal.
The problem of the property of the means of production
When workers do not own their means of production (equipment, buildings, vehicles, machines, tools ...), they must yield the profits to the owners of the company, the shareholders. When the amounts involved are not too large, it is a problem that can in principle be solved by finance. If workers can borrow at a low interest rate, they can become owners of their means of production. If they have good projects and if they do not have the financial means to achieve them, the job of bankers and financial intermediaries is to solve their problem. If all good projects could always be properly funded, the less fortunate could undertake as much as the rich (Shiller 2012). Of course this condition is not often realized. Human beings are not all equal in the face of borrowing, and the interest rates offered to them, when they are, are often too high to encourage business ventures.
The solution to the problem of ownership of the means of production can not be that workers always own their means of working. Some companies require very expensive equipment for a relatively small number of workers. All of them should be very wealthy to own their company, so all low-income workers should be prohibited from participating. This would surely not be considered a solution to the problem.
Shareholding allows in principle to democratize the freedom of entrepreneurship. Anyone can try to sell shares on a business plan and finance it as long as he or she finds investors. Startups are usually funded this way. Crowdfunding exploits the same principle. This allows an entrepreneur with no personal fortune to finance her projects without going into debt. This does not solve the problem of the separation between labor and ownership of the means of production, since the shares are shares in the ownership of a company, but the designer, responsible for a project, can ask to be partially paid in shares. In this way, she can retain part of the property of her business without having advanced funds at the outset.
Why are there interest rates?
When the investment is risk-free, collecting interest means collecting income without working and without worrying, it is like having a goose that lays the golden eggs, and the richer we are the bigger the eggs.
When the debts result from taxes or fines, the rate of interest is fixed by the power which imposes this obligation. Other debts generally result from loans. In theory, and except in the case of a forced loan, loan agreements are freely concluded. Both parties are volunteers. There is an interest rate because some people want to lend their money with interest and others want to borrow it. Borrowers often agree to pay high rates, far in excess of the rates at which they could safely place money if they had any. A loan agreement therefore always has a negative net present value for them. It seems that they engage in a project at a loss and that they are wrong to borrow. However, we often have excellent reasons to apply for a loan. We must distinguish investment loans, consumer loans and loans to repay previous debts.
- An investment loan finances a project to make a profit. If the rate of profit is higher than the interest rate of the loan, the borrower will be able to cash the difference between the profit and the paid interest. Even if the rate of profit is slightly lower than the borrowing rate, it may be interesting to borrow part of the cash advances if it enables us to realize projects with a profit rate higher than the risk-free rate, and if we can not do them without borrowing. As soon as the agents have profitable projects, they have an interest in borrowing to realize them.
- A home loan can always be considered an investment loan, even if you buy the property to live in it and not to rent it. In this case the housing service provided can be considered as profit, as if one had paid a rent to oneself.
- A consumer loan finances the purchase of a consumer good. Many reasons, not just unconsciousness or lack of foresight, may make a present purchase better than a delayed purchase due to lack of available money.
- When you can not repay your debts, getting a new loan can be a big help, because the costs of insolvency are generally quite high. But if we do not have prospects of future income sufficient to repay, we are of course only sinking into debt.
It would be wrong to believe that the existence of interest rates is exclusively linked to indebtedness. Loan interest is just one form of ownership income, and as soon as there is income from ownership, we can calculate an interest rate. A rent is with respect to a housing identical, from an accounting point of view, to an interest with respect to a loan. The rent rate (the annual rent discounted at the end of the year, divided by the price of housing) is the interest rate of the real estate property. The same calculation can be made for any rental of durable goods, provided that the charges are correctly counted. The profits of a project are the income from the ownership of the committed funds. The rate of profit is the interest rate of the business property.
These three forms of property income, interest on loans, rent on rented property and business profits compete. The supply of loans with interest depends on the other forms of property income, because one can choose between lending money, or buying real estate to rent, or buying shares to receive profits. The demand for interest-bearing loans also depends on the other forms of property income, because one can borrow to buy real estate, and because profit expectations encourage businesses to borrow. The existence of other forms of property income means that interest rates on loans can not be arbitrarily reduced to zero. If, for example, a central bank agreed to lend to everyone at zero rate (technically it could do it, because it can create the money lent) it could seriously disrupt the economy, because everyone would be encouraged to borrow to invest in real estate or in companies, and because companies would be encouraged to invest too much. Interest rates work as a brake on the desire for debt. If this brake were removed, an economy founded on private property would be exposed to a high risk of high inflation and other imbalances.
There are interest rates simply because there is an interest in being an owner. Even if everyone owned their home and their equipment goods and no one was in debt, we could still calculate interest rates - but it would be more difficult. The existence of interest rates is not even unique to human economies. Animals have a supply of energy that is vital to their daily activities. At the beginning of the period, this reserve is like a cash advance. At the end of the period, after the animal has researched its food and performed all its other activities, all the energy consumptions can be counted as expenses, and all the food eaten as recipes. If there is a surplus, it can be counted as a profit, because the animal has increased its reserves. We can therefore calculate a rate of profit, which is the interest rate on reserve property. That the animal is owner of its means of production (its body, including the reserves) does not prevent that there is a rate of interest.
As soon as we have a project, we can evaluate its profit or loss. If the project requires cash advances, a rate of profit can be calculated. As soon as there are profitable projects that require cash advances, then there are interest rates.
If an equipment good is required by a project, it must be counted as a cash advance. If it is still there the end of the project, we count it among the final revenues, otherwise it was consumed by the project. Whether or not workers own their means of production does not change the fact that profit rates can be calculated for projects that make use of these means.
Real estate income exists even when the property is not rented. A house helps because we are better in it at night than on the street. The housing service, whether paid or not, is an income from the property. Even if everyone owned their homes, virtual rents could be assessed, because homeowners can choose between different ways to find lodgings and various ways to invest their funds in a variety of other profitable projects. The profit rates of the other projects are thus representative of the value that the owners give to the services provided by their housing.
If interest rates measure the interest of projects, so the interest in living, why do we say that they must be very low, in order to promote economic development? The interest rates of the loans are not representative of the interest of all our projects, they play the role of a limit between the projects that can be realized and the others. If the rate of profit of a project is higher than the interest rate at which one can borrow, it is better to borrow, otherwise one is dissuaded from it. The higher the interest rates, the more difficult it is to complete projects, even if they are profitable. The lower the interest rates, the more it becomes possible to realize many projects.
All investments are always risky, because there is always the risk of an economic catastrophe so serious that it would affect all investments, even those usually considered risk free. Even the debts of the US federal state are risky if we take into account the risk of inflation (there is no counterparty risk because the Federal Reserve always has the possibility of creating dollars to repay. As debts are denominated in dollars, it is certain that they can be so repaid). But as long as the economies are a little prosperous or not too badly hit by a recession, it is usually quite easy to find low risk investments because many states or large corporations can be considered very reliable borrowers and because some real estate investments are low risk.
The existence of some property income can be considered a serious injustice, because it is a way of making money without working and because it aggravates social inequalities. It is possible to design an economic system that removes some income from property (interest on loans, shareholder profits, and homeowners who rent real estate) while retaining other economic freedoms, i.e. other property rights, freedom to undertake, work, sell, buy and consume all goods and services produced. A very powerful state could finance the entire economy and all the real estate available for rent. But one may fear that such a public power is a remedy worse than evil, because it is likely to be a dictatorship. In the sequel such a possibility is ignored. We think about an economy such as ours, where property income is respected. The resulting aggravation of inequalities can sometimes be partially compensated and corrected other than by completely renouncing capitalism.
Inequality in front of risks
Agents are not equal in front of the risk of loss. A poor agent who goes into debt for a risky project and then suffers heavy losses will probably pay dearly for the rest of his life. When we can not pay our debts, we add additional costs (fines, court fees and lawyers, loss of reputation ...) to the initial costs that can not already be paid. These costs of insolvency are very dissuasive, even if we are no longer going to jail because of unpaid debts. As a result, poor people are discouraged from going into debt to engage in risky projects. If on the other hand we have a substantial fortune, we are more solid to bear any losses. If the project is ultimately losing, we lose a part of our fortune, but in general we keep a large part, even after paying all our debts.
The projects that earn the most on average are most often the most risky projects. Those with fortune and a bold mind are in the best position to take advantage of these opportunities. The less fortunate are much less well placed, and they are generally encouraged to abstain, if only to avoid the risk of being drowned in debt.