The Winds of Economic Change: Capital, Inflation, Interest Rates and the AI Revolution

I was talking to a friend the other day, a cup of masala chai in hand, discussing where to invest in these tumultuous times. It got me thinking — what are the bigger and overarching trends at play here, especially when it comes to inflation and interest rates — the two buzz words we’ve been hearing about, for the past year (other than Artificial Intelligence of course). This post is all about possibilities based on what I have read in the interwebs and NOT bolstered with numbers that I have independently verified.

We’ll touch upon the correlation between interest rates and capital availability, the potential influence of key societal trends, and the potential future under the shadow of burgeoning artificial intelligence. So buckle up as we traverse through the vast economic landscape, sifting through the complex realities to spot emerging patterns that could shape our world

Capital, Interest and Inflation

To start off, we need to understand the interplay between interest rates and capital availability. These rates are greatly influenced by many factors, predominantly the monetary policies set forth by central banks worldwide. The main goals of these policies are typically price stability (i.e., controlling inflation) and promoting economic growth. Essentially, these policies determine the money supply in the system or the availability of capital. An inverse relationship exists between capital and interest rates — when more capital is accessible for use, interest rates tend to be lower, and the opposite is also true. The growth of our modern world heavily relies on capital; hence, lower interest rates often encourage growth by facilitating capital for consumption, investment, and the like, thereby stimulating the demand side of the economy. However, if the supply side can’t keep pace with this growth (despite investments), inflation could rise, depreciating the value of the available capital

So a world with a lot of money sloshing around will by inference have a lower interest rate and higher inflation and the one that’s capital poor will have a higher interest rate and generally moderate inflation; And inflation of course is caused due to a mismatch between supply and demand of goods and services

Given this understanding, the following trends are worth understanding —

1. The Retirement of Baby Boomers

The baby boomer generation, hailed as the largest and wealthiest in the Western world, has been steadily transitioning into retirement over the past few years. When they were actively earning and saving for retirement, instruments like the 401K and various global pension funds were their primary tools of wealth accumulation. This enormous reservoir of wealth fueled some of the most significant booms in recent history, from the dotcom surge to the mobile internet and numerous capital-intensive growth spurts (Shale, Cloud, etc) over the past few decades. However, as this generation shifts from riskier investments to the safety of T-bills in their retirement years, the overall pool of risk-tolerant capital is shrinking. This transition could result in an uptick in interest rates for entities beyond blue-chip companies, directly impacting the capital available for innovation-driving industries. It’s another signpost pointing toward a future of higher effective interest rates.

2. The Debt Bomb: A Perspective from Thomas Piketty

Thomas Piketty’s renowned theory posits that nations can remain economically healthy as long as their nominal growth exceeds their nominal interest rates (and in turn interest payments). This idea is being tested at a global scale now. Over the last year, despite stubbornly high inflation, we’ve seen some economic growth, which has kept the nominal growth above the interest rate. This situation has allowed countries to expand their economies at a pace faster than their debt. However, as we step into 2023, predictions indicate that countries, including the United States, may face stagnant or even negative growth in the upcoming quarters. If inflation persists around the current 4–5% mark, we could witness a first in a long while, where interest rates surpass nominal growth, leading to ballooning debt. Provided we break this cycle within a few quarters, the situation should stabilize. Otherwise, an uncontrolled rise in debt might ensue. If the government continues to drain cash from the system,by taking on more debt, it would necessitate higher effective interest rates for the rest of us. This forms yet another trend hinting at elevated effective interest rates over a 5–10 year timeframe.

3. The End of Long Term Debt Cycle: Borrowing from Ray Dalio

Ray Dalio’s famous argument states that we’re currently standing at the precipice of a long-term debt cycle, urging countries and corporations to begin the process of deleveraging from their high-risk positions before things get any worse. Personally, I perceive this more as an extension of the impending ‘debt bomb’ Thomas Piketty warns about.

Deleveraging can be facilitated if countries choose to erode their debt through inflation, by maintaining artificially low interest rates. While seemingly straightforward, this tactic could have massive collateral damage on individuals’ savings and can potentially catalyze a capital exodus from any country opting for this route. Imagine if the United States decided to go down this path — the ramifications would be felt globally. The surplus capital, in pursuit of profit, could result in the creation of numerous ‘White Elephants’ around the world, akin to the Belt and Road Initiative. Such unproductive investments would constrain global growth for an extended period, as an increasing number of countries could fall into a debilitating debt trap

So to conclude — this can go either ways — high interest rates or run away inflation but challenging times ahead nonetheless.

4. Deflationary Effects of Artificial Intelligence

With the advent of Artificial General Intelligence (AGI), we stand on the cusp of a major shift in economic dynamics. As AGI becomes more of a reality in the next 5–10 years, the cost of intelligence — and consequently, the cost of energy — is predicted to fall drastically. This can trigger a deflationary ripple effect throughout the global economy.

Consider this example: with the aid of AGI, it would be feasible to obtain an iPhone-quality device from a manufacturer other than Apple, without paying a multiple of the Bill of Materials (BoM) cost. This scenario could extend to virtually all industries, leading to a significant reduction in the cost of producing goods. Consequently, our purchasing power could increase annually in line with AI advancements.

Further, if AGI could develop a strain of grain resistant to pests and climate change, the cost of food and other agricultural commodities could plummet. As the prices of manufactured goods, services, and food drop, this would inevitably exert downward pressure on prices, leading to a deflationary climate.

In such a scenario, where we require less capital to sustain our lives, capital would depreciate. Consequently, interest rates in the long term would likely decrease as a result of the AI revolution.

Conclusion

Now, looking at all these trends we can see that there are powerful overlapping forces in play that have opposing effects on inflation and capital availability and for now, if the AI revolution and adoption is interrupted or blocked, then the world would see higher inflation and moderate interest rates and when the AI revolution comes here, it would result in a more egalitarian and equitable society (since the crazy opportunities around leveraging capital to build wealth wouldn't exist anymore).

Regardless, it’s reasonable to anticipate significant social upheaval in the coming years or even decades, leading to a clear stratification between the haves and have nots. The wealthy may find ways to protect their assets by turning to alternative investments in a hyper-inflationary world or investing in safe treasury bills in a deflationary world. Conversely, those with less wealth may see their savings erode in a hyper-inflationary environment (due to lack of access to alternative investments) and face challenges climbing the socio-economic ladder in an AGI-dominated, deflationary economy.

This leaves us with two potential strategies: accumulate as much wealth as possible while opportunities persist, or align ourselves with industries and careers likely to remain vital in the future — such as healthcare, manufacturing, and hospitality — where the current technology sets limitations on automation

In spite of all the morbidity surrounding the trends, there’s still immense hope that we, as a society, will come out of this stronger and completely changed. We just have to hold together stronger and be there for each other!