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I wanted to open a discussion to evaluate Soddy’s thought experiment used to show that capitalists are incentivised to repay interest-bearing debt by raising prices.
Full article: https://capitalaspower.com/2021/09/frederick-soddys-debt-dynamics/
In the thought experiment Soddy asks us to imagine that.
1. Alice is a would-be cattle farmer. She inherited some land and wants to use it to farm cattle. The problem is she has no money.
2. Alice goes to the bank and gets a $100,000 loan. With this money, Alice buys 100 cows.
3. Alice’s bank requires no regular payments. Instead, after t years, the bank demands full repayment (with interest).
4. If the bank calls in her loan after 10 years, she owes $163,000. That’s the equivalent of 163 cows
5. After 10 years, the bank calls in her loan at $163,000. If cow prices don’t change, Alice needs to sell 163 cows to pay her debt.
6. Alice could either: breed more cows so that she has 163 cows to sell or she could raise the price of cows.
7. So repaying interest-bearing debt doesn’t necessarily require economic growth. It can also be financed with inflation.
This is supposedly analogous to mechanisms in the wider economy because “The economy must grow” or “Prices must grow”
My issue with this argument is that we have to pretend, in Soddy’s thought experiement, that cows have no ability to generate cash flows. We are told to imagine that no cow can produce beef worth more than $1630 nor produce more than $1630 worth of milk in its lifetime. So it seems Soddy has created a false economy in which assets are bought purely for their speculative value. This is therefore not a helpful thought experiment because I would imagine that the vast majority of investments are made into assets that generate cash flows which are worth more than the cost of the asset and the interest used to buy it. In the real world, Alice would have used a DCF model to ensure that the NPV of her purchasing 100 cows was positive, taking into account the projected future cash flows, the cost of the loan and interest payments.
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I think of things a bit more simply.
Price = Cost + Profit
Profit = Price – Cost
Profit Margin = (Price – Cost)/Price
Interest expense increases Cost.
To maintain the same Profit Margin with increased Cost requires increasing the Price.
For example, achieving a Profit Margin of 50% requires setting the Price equal to twice the Cost.
So, if the self-funded (debt-free) Cost is $10 and the desired Profit Margin is 50%, the Price is $20.00.
If the debt-based cost is $11 (adding $1.00 in interest expense), to achieve the same 50% Profit Margin requires increasing the Price to $22.
While there’s nothing physically stopping the seller from maintaining the same Price of $20 and accepting a reduced Profit of $11 and a lowly Profit Margin of 45% (or merely increasing the Price by $1 to maintain $10 in Profit while accepting a reduced 47.6% Profit Margin), the capitalist ethos requires increasing the Price to maintain the Profit Margin. Profit margins are indicative of the rate of return of the capital asset (aka the discount rate) and much more important to investors than the absolute amount of profit.
Now, assume the increased Cost is not due to interest but to increased labor costs . . . exact same analysis.
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My issue with this argument is that we have to pretend, in Soddy’s thought experiment, that cows have no ability to generate cash flows.
Like many natural scientists, Soddy thought mostly about commodities, not investments and the property rights that come with them. Obviously, if you have property rights that ‘generate’ an exponentially growing income stream, then paying off interest is not a problem. But I agree that Soddy’s arguments have limited use.
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