Thursday, August 21, 2008

The Hidden Costs of Corporate Protectionism

If you criticize ExxonMobil for generating $40 billion per year, then Austrians would respond to you and cite that its profit margin is only 9%. However, the 9% is higher than it should be. The profit margin should be less than 2%.

Many Austrian School economists do not actually understand the Austrian theory of the Business Cycle. They think that it is just a miscalculation error, but it is actually much deeper than that. Speculation during the cycle is purposefully increased. An example is the Chinese correction on February 27, 2007. It started out with rumors lowering the central bank interest rate and the speculators crashed.

Negative real interest rates do not have to be negative

In a purely free market, the profit margin of every capitalist equals the total equity times the market interest rate. For example, if a factory is valued at $10 million and the market interest rate is 5%, then each year the capitalist would earn $500,000.

However, due to the lower interest rates that can be borrowed at the Federal Reserve System, capitalists would invest more. For example, if the Federal funds rate is lowered to 2%, the capitalist would borrow $10 million to invest in a factory. He would then earn $500,000, as usual per year. However, because the Federal funds rate is only 2%, he has to only return $200,000 to the Federal Reserve System. Thus, he would earn $300,000 ($500,000 of factory profits minus $200,000 interest), by borrowing at lower interest rates. It is accurate to interpret that the interest rates are negative, because he had earned $300,000 out of nothing.

Thus, due to the lower Federal funds rate than the natural market rate, it would rise to negative real interest rates and overinvestment, even if inflation has never happened. This encourages malinvestment and speculation. Expansion of businesses would occur, and the expansion would stop until the real interest rates are not negative anymore when the net income divided by the equity of factory capital approaches the Federal funds rate.

If inflation has occurred, then it would get more speculation. The raising income inequaity is due to speculation.

The catallactics of inflation

Investment would increase in long-term capital goods such as factories, since only long-term capital would profit the capitalist. Short-term profit margin from sales would not increase since they do not profit the capitalist.

The prices of long-term goods increase more than short-term goods. If speculators predict that the money supply would double over the next year, then they would bid up the price of the long-term goods in order to sell it next year, to profit from negative real interest rates. However, because of the increased demand for long-term goods from speculators, the prices of long-term goods raise immediately, before any increases in money supply. This would bring down the profit from the negative interest rates. This demonstrates that prediction or speculation, besides money supply, would have a great impact in prices.

If the long-term goods require labor to build, then the wages of building long-term goods would temporary increase, and eventually decrease to equilibrium as more individuals switch to these jobs.

Short-term goods, conversely, are not affected by prediction or speculation. Short-term goods like wheat and corn would not last very long. Thus, the prices of short-term goods are dependent on the money supply, without any prediction or speculatory influences. The prices of short-term goods would double only if the money supply is actually doubled.

As long as the speculators profit from the market interest rate, plus the risk, the prices of long-term goods can raise arbitrarily. Speculators may bid up the prices of long-term goods multiple times if they predict that inflation would multiply over the next year. Thus, inflation hurts the non-capitalists, and may even benefit the capitalists because they can sell their capital and use the money to consume cheap short-term goods.

There are three kinds of individuals. The entrepreneur innovates for profit. The capitalist gets profit from interest payments. The speculator predicts the intertemporal patterns to profit. The entrepreneurs are the productive class. Capitalists, the owners of capital, profit from interest rates. Speculators may lobby politicians that would increase or decrease inflation. Resources are wasted to the speculators. The speculators do not do any contributions to society, but still profit. This redistributes the wealth from the productive individuals to the speculators.

The real profits

Many Austrian economists confuse profit margin with return on equity. The profit margin is the percentage of net income occurring from sales revenue. The return on equity is the net income divided by the total equity. The profit margin should be much less than the market interest rate, and the return on equity should equal the market interest rate.

If the Federal funds rate is lower than the market interest rate, the market interest rate would equal the Federal funds rate. If the market interest rates are higher, then borrowers would borrow from the Federal Reserve System. This decrease demand from the market interest loaners, which would cause the market interest rates to equal the Federal funds rate.

Total equity is the total capital invested. Assuming that there are no liabilities, then in a purely unhampered free market, the return on investment (ROI) should be the net income divided by total equity.

If you see Google finance, the return on equity for ExxonMobil is 35%, which is much higher than 2%. The return on equity for monopolized firms such as Microsoft is 50%, which is much higher for 2%.

So ExxonMobil's return on equity is much higher than the market interest rate.

But what if there are liabilities? The return on investment is the net income plus the total liabilities times the market interest rate, then divided by the total equity.

ROI = (Net_income + Total_liability * Market_interest_rate) / Total_equity

This equation is derived from this equation:

Total_equity * ROI - Total_liability * Market_interest_rate = Net_income

If you add everything after the ROI and divide Total_equity, then you should get the first equation.

But since there are artificially below market interest rates such as the Federal funds rate, the market interest rate is the Federal funds rate. The Federal funds rate is currently at 2%.

For example, if you take the ExxonMobil statistics. The net income is 40,610.00, total liability is 120,320.00 and total equity is 121,762.00.

If you calculate, then you would get (40,610.00 + 120,320.00 * 0.02) / 121,762.00 = 35.3%. You then found out that the ROI of ExxonMobil is 35.3%, which is much higher than 2%.

If the total liability is not much greater than the total equity, then return on equity is fairly a good measure for ROI, since the 2% Federal funds rate is insignificant to make any difference.

Defending the criticizers

If you heard arguments defending

ExxonMobil, you shouldn't trust them. First, ExxonMobil practices tax loopholes that understate their net income. Second, the profit margin shouldn't be confused with the return on investment. Third, the return on investment is much higher than it should be.

Why does ExxonMobil has such a high ROI? The only answer is regulatory capture.

In a purely free market, the interest rate would be much lower because of the lack of banking regulations. Everyone can loan their capital at interest, which increases the supply of capital that decreases demand and interest rate. If the natural interest is 1% in a purely free market, then the capitalist of the $10 million valued factory would only earn $100,000 per year. The money monopoly should be vanished.

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