Too Many Investments — The Trade-off between Chaos and Order
Investments are considered worthwhile, and central banks legitimize their inflation targets by stimulating investments. Looking at the interplay of risk-taking and the desire for security offers a clear perspective on why there can be too many investments and what that entails.
Our current financial system is based on fiat money grounded in central banking. It doesn’t matter if one looks at the Dollar, the Euro, or the Yen. Fiat currencies are being inflated over time, and it goes so far that there is considered to be an optimal inflation rate of roughly two percent. The official reasoning behind this premeditated inflation target is the stipulation of investment. If money loses value over time, you incentivize people to employ their savings in some interest-generating endeavor. That means that more money will be put towards investing, making it possible to acquire more capital and, by extension, increase economic output and wealth.
Generally speaking, we live in an industrious age. While there has always been a certain spirit of enterprise among different people since the Industrial Revolution, the mindset changed towards an ever higher valuation of efficiency, progress, and economic growth.
The resulting rising living levels worldwide strongly indicate the beneficial aspect of the changed zeitgeist. A will to acquire capital and rationalize production facilities is not uncommon, and investment in more competent production capabilities is broadly accepted as something universally desirable.
As with everything in economics, there is a trade-off. Understanding this trade-off is necessary to adjust the investment rate appropriately and help people live more fulfilled and prosperous lives. Understanding this trade-off also helps to comprehend why the aforementioned argument for a two percent inflation target is a complete myth.
Why is investing worthwhile?
An essential aspect of a positive civilizing process is increased living standards over time. To improve these standards, more goods need to be produced. This is where the idea of capital comes into play:
Capital is a good that produces goods.
If somebody manages to acquire capital, more goods can be produced, and the standard of living can be raised. Equally, this effect can be scaled to a whole society. The more capital society acquires, the more its living standards are raised. Capital creation is a prerequisite for wealth creation.
The endeavor of capital creation requires an investment. Let’s say you are, as is your neighbor, the proud owner of a fishing rod. You can use it to fish whenever you please. On a daily basis, you can get a couple of fish with your fishing rod; for your neighbor, it is roughly the same.
But what if you had a boat? You wouldn’t be restricted anymore to fishing on the shore solely. There waits plenty and bigger fish for you in the middle of the pond. So you think to yourself: Maybe I should build a boat! While this might be a good idea in principle, building a boat takes resources and time.
Let’s assume you cannot stop fishing entirely because it is your only way of getting something to eat for you or your family. You could, for example, try to fish less and simply eat less for some time so that you can start building your boat in the meantime. Or you work longer to acquire more and more fish to have some saved, which would allow you some free days to build a boat.
Let’s say you finally managed to build your boat. You can now go out fishing daily in the middle of the pond. Your investment of time and resources starts paying off. You can now acquire more fish than before at the same time. You, and the society you are a part of, benefit from the availability of more fish.
Long story short: Investing is excellent because it is the crucial prerequisite for capital creation. Capital is a good that produces goods. A society that manages to acquire more and more capital over time will be able to increase the economic output of goods in general, which means it will improve its living standards.
What is the trade-off when investing?
While investing in the sense that it is the prerequisite for the creation of capital, and capital is a good that produces goods and that itself is the prerequisite for a raising of living standards and wealth, there is a trade-off happening when investing. Let’s stay at our example with the fisherman and the investment into building a boat.
What could be a trade-off the entrepreneurial fisherman takes that the conservative fisherman doesn’t?
The conservative fisherman continues fishing at the coast. One can anticipate how well it works and how fruitful of an endeavor this statistically tends to be. This differs for the fisherman willing to invest time and resources into the boat. Many uncertainties must be checked first until it can be evaluated if the additional work was worth it. There may not be more fish in the middle of the pond, or the fish are not of the quality anticipated. Maybe the fisherman doesn’t know how to build a boat, or he does and still makes some mistakes in the design, so the boat sinks soon after it is finished. With the boat sinking, so goes all the additional work put into its crafting down the drain.
Ultimately, the question of whether to build the boat comes down to the willingness to take a risk.
The fisherman who continues fishing conservatively at the coast knows he can be sure of a certain return on his work.
The fisherman who starts crafting the boat is willing to try to acquire capital in the form of a boat but can never be sure of the return he is getting. It may be a losing business for him.
The trade-off when investing comes down to an exchange of security and risk. Investing is risky; further, it changes something safe, like money, into something uncertain, like a try to acquire additional capital.
While for society, the process of further civilizing is closely interrelated to acquiring additional capital, acquiring capital is always contaminated with an uncertainty of success. As investments have advantages and disadvantages, one can quickly understand that there must be a sweet spot where the benefits of risk-taking and the advantages of risk avoidance are optimum.
Why can there be too many investments, and what does it entail?
The core trade-off with investing is between risk-taking and risk avoidance. The prerequisite for investing is saving; acquiring resources makes it possible to transform them into capital. The investment amount should then be a function of the savings in society. The more savings exist, the more investments can be made.
At the same time, the more savings are accumulated, the more safe people feel, as they can always fall back on their savings and don’t have to fear material impoverishment if something goes wrong. There is an essential insight into this relationship:
Before investing, there must be a saving phase, and savings are the prerequisite for investing.
The higher the accumulated savings in a society, the higher the willingness to part with certain amounts of those savings for the risky business of capital acquisition. The preference to hold one’s savings compared to the willingness to take risks in investing is calculated on a free capital market. On a free capital market, potential investors gather on one side of the aisle to offer savings for investment. On the other side of the aisle are entrepreneurs willing to take risks but need money.
So, in conclusion, on the free capital market, you have people who offer something safe, the savings, to someone who is offering risk, the investment. The market then calculates the proper interest rate for investments and regulates the amount of investments that will be made. High-interest rates on the free capital market signal the preference of people to continue saving and satisfy their need for safety. Only a few investments will be made in such an economic environment, strongly selecting the enterprises that promise the most return.
Equally, when interest rates are low on the free capital market, people generally signal their willingness to take more risks as they feel that their desire for safety is satisfied well enough. In such an economic environment, more investments will be made as the return on investment can be smaller due to the lower interest rate for capital.
One can easily imagine a hierarchy of potential investments at any given time. This hierarchy will have the investments with the lowest risk and the highest potential return at the top and the ones with the highest risk and the lowest potential return at the bottom. Starting from the top, the interest rate dictates how many investments will be attempted to acquire new capital.
The more such enterprises are attempted, the more will fail in consequence, potentially destabilizing the whole society as savings are destroyed, and people start to lose more resources than they gain eventually. This is why you don’t want to have too many investments. The uncertainty and chaos will be too much for people in such a society, and a downward spiral of living standards and feelings of comfort and safety will follow.
Are we investing too much or too little?
Ok, and here goes the 1 million dollar question. What about ourselves, and by ourselves, I mean all modern economies worldwide? Are we investing too much or too little?
With a free capital market, that question would not arise. The interest rate would set the price for money for investment, and the interest rate would be a function of the savings a society accumulated. Unfortunately, since modern economies are organized through a central bank, there are no free capital markets as central banks set a minimum interest rate for capital.
For our question, it is relatively simple to understand the influence of a central bank. As it sets a minimum interest rate, this rate is either too low, leading to more investments than should be made, or too high, leading to fewer investments than actually should be made.
Further, central banks will almost exclusively set the interest rate too low. One can easily understand this when looking at the trend of inflation and deflation. As modern economies tend to inflate their currencies over time, they create a situation in which a saver is punished for saving, as his savings will be worth less and less over time. To stop this from happening, a saver will have the incentive to invest his money to get a return in the form of interest paid to him for his invested money. He wins if the interest rate he receives is higher than the inflation rate. If the interest he receives cancels out the inflation, he is saving in real terms, and if the interest rate received is lower than the inflation, he loses money, but less, than if he hadn’t invested.
In an environment where inflation reigns supreme, as is the case in all modern economies, most of the time, there will be more investments than there should be.
People don’t satisfy their need for safety, and endeavors will be undertaken that promise disproportionate risk in consideration of their potential benefit. In reality, that means that people spend their money and time on things that are not worthwhile. People feel unsafe and unsure about the future, as their savings don’t support an unworried lifestyle.
As investing and capital accumulation are the engines of a civilizing force, too many investments lead to the opposite. A society with too many investments will suffocate under the permanent risk-taking it employs. Chaos will reign in the people’s hearts, and unnecessary resources will be burnt away.
All in all: Too many investments don’t lead to a higher living standard and don’t progress civilization’s force. They produce an opposite outcome of permanent confusion., uncertainty, unnecessary risk involvement, and waste of resources.
All in all: The progress of the civilizing force will first slow down, then stop, only to turn around to produce degeneration and promote a de-civilizing power towards a fragmented tribal society as nothing else can satisfy the unsatisfied need for safety anymore.
Sources/Further Reading
[1] Farrington, Allen (2020): Wittgenstein’s Money
[2] Farrington, Allen (2021): The Capital Strip Mine
[3] Farrington, Allen (2021): Bitcoin is Venice
[4] Hayek, F. A. (1945): The Use of Knowledge in Society
[5] North, Gary (2021): Dancing on the Grave of Keynesianism
[6] Rothbard, Murray (1976): The Austrian Theory of Money
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