Chapter 02 · Why does the system fail?

When Interest Rates Tell the Truth

7 min

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This chapter builds on the ones before it. You can read it now, but it will not count towards your progress until the earlier chapters are done.

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Prosperity doesn't come from what you spend. It comes from what you choose not to consume right now. Sounds backwards? And yet it's the real engine of the economy! It runs on a single signal: the interest rate. Let's see how it tells the truth, before we learn to make it lie.

In the previous chapter, we saw that the of our currency has been sacrificed. The problem? The hidden cost of that sacrifice is massive.

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To really understand it, let's ask ourselves a fundamental question: "How is wealth actually created?".

Time Preference and Interest Rate

As humans, we'd rather consume now than later. But to build a more comfortable future, we have to postpone part of our consumption: this tension between favoring the present or the future is what we call Time Preference⁠(opens in a new tab).

High time preference: the present wins. Donald and his nephews consume all their resources right away. They live decently, but their situation won't improve tomorrow.

Low time preference: the future wins. Donald and his nephews set resources aside. That surplus (savings) is what lets them take on ambitious projects, like extending their house, for a more comfortable future.

Sacrificing the present for the future isn't natural. That sacrifice needs a reward in return. Postponing your consumption until tomorrow or until ten years from now carries very different levels of risk and waiting. In economics, this reward is called the interest rate: it's the price of time.

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So savings aren't a pile you stack up just for the view! They fuel investment - that is, projects (sometimes long ones) that make society more efficient and free up our time.

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These investments take the form of roundabout production, fitting into a capital structure.
Hold on, don't run away - behind these intimidating words hide very concrete ideas!

Capital structure - what's that?

Capital isn't just a pile of banknotes.

It's a whole sequence of intermediate steps that lead to producing a final good for the consumer. It's a process that takes time and mobilizes a lot of resources.

Let's take the sandwich example (click on the small boxes to trace back the production chain):

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SandwichOur final consumer good

As you can see, producing a simple sandwich requires hundreds of steps. It doesn't happen in five minutes.

These steps are roundabout production⁠(opens in a new tab): you first build the tools that will then make you far more efficient. All these tools and steps together form a complex structure - capital.

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If Capital is a time-consuming structure of steps (like our sandwich), how do we know whether we can afford to launch a new project? That's where the interest rate comes in.

In a world without monetary manipulation, this rate acts as a natural compass. Here's how it works.

The honest compass

Citizens save: they don't spend everything right away (low time preference). Money is plentiful, so the price of borrowing it (the interest rate) drops on its own.
That low rate sends a message to anyone looking to build: "Society has set aside enough resources - go launch your long, complex projects." And it's telling the truth: the savings are really there.
The payoff: we build machines, factories, tools that make society more productive. Prices fall because we produce more with less effort. Everyone's purchasing power climbs. That's what real prosperity looks like.

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In an honest world, the rate tells the truth. It reflects the real savings available. One unsettling question remains: what happens when the compass is rigged?