We’ve already taken a look at the ways in which modern Keynesian economics and its nephew modern portfolio theory insulate finance from economics by failing to use the interest rate as a bridge between the two disciplines. But what makes matters even worse is that even if they learned the error of their ways and changed their models and recognized the centrality of the interest rate as a bridge between the world of economics and the world of finance, that would still not protect them from the fact that every major economy in the world is currently manipulating its interest rates for political purposes.
In other words, the fact that interest rates tell us the truth about ourselves is intolerable to the political class. They don’t want us to be told the truth. They want low interest rates to foster the illusion that inflation is low in order to create the perception that capital is abundant, and to enable their governments to borrow more than they should by subsidizing the interest rates through money creation; the latter necessary to muffle the alarm bells of rising default risk.
But if the interest rate is the basis on which all investments, or for that matter, all spending decisions are made, and the interest rates are being distorted by central banks, then that means that all valuation is plunged into chaos. That is exactly what is happening right now. Nobody knows how to value anything.
And the only way to fully remedy that would be for the central banks to return to honest money. Since there is very little chance of that in the short-term, then the only way for investors to remedy the situation is to determine what the interest rate would be if it were not intentionally being distorted. In other word we have to extract the lie from the interest rate in order to get it back to telling the truth. There is simply no other way to properly value any investment than to start by correcting this distortion.
One of the biggest problems in valuation is inflation. This may seem strange to you, since generally financial chatter ignores the inflation factor in valuation. The few who address it, misunderstand it, holding that monetary inflation is good for growth and therefore good for stocks. Even the few commentators who address inflation concerns properly focus almost exclusively on commodity valuation, especially gold.