The Road to Hell Is Paved with Good Intentions
How Regulation Rewrites the Interest Rate
Introduction
There is an old saying, attributed to different people across different eras, but true regardless of its origin: the road to hell is paved with good intentions.
In the early 1950s, only 5% of working Americans needed a government license to practice their profession. Doctors, lawyers, engineers. Logical. Understandable. If someone is going to operate on you or design the bridge you drive across, it is reasonable to require proof of at least minimal competence.
Today, without fanfare, without debate, without anyone making the decision out loud, that share has reached 25%. One in four working Americans needs a permit to do their job. Florists. Dance instructors. Hair braiders. Interior designers. And the expansion is irreversible, almost by definition: once a profession is licensed, it almost never returns to the free market.
Every single one of these decisions was made with good intentions. To protect the consumer. To ensure quality. To prevent abuse.
Nobody sat down and said: "Let us reduce the efficiency of capital and push interest rates to zero." And yet, that is precisely the end result. Not directly. Not immediately. But inevitably, once you understand the mechanism.
I. What Is the Efficiency of Capital and Why Does It Matter
John Maynard Keynes, in The General Theory of Employment, Interest and Money (1936), introduced the concept of the marginal efficiency of capital (MEC). The definition is simple in form but profound in substance: MEC is the expected rate of return on the last unit of investment, compared to its cost of acquisition.
Put plainly: if you build a factory for $1 million and it generates $100,000 per year, the efficiency of capital is 10%. If the next factory, in a more saturated market, generates only $70,000 from the same investment, the efficiency is 7%. Keynes observed that as investment in a given economy increases, this rate inevitably declines, because the best opportunities are exhausted first.
This is where Knut Wicksell enters the picture. The Swedish economist of the late 19th century, whose contribution remains underappreciated to this day, distinguished between two types of interest rate: the monetary rate, which banks announce, and the natural rate, determined by the real productivity of capital in the economy. When these two align, the economy is in equilibrium. When the monetary rate is too low relative to the natural rate, capital flows toward poor-return projects and asset bubbles inflate. When it is too high, investment stops.
The key insight that unites Keynes and Wicksell: the natural interest rate is not set by the central bank. It is set by the efficiency of capital in the real economy. The central bank merely follows something generated far from its boardrooms.
II. Why Emerging Markets Have Higher Efficiency
The standard explanation for the difference in returns between emerging and developed markets is well known: less competition, underdeveloped markets, unfilled niches. If you open a cement factory in a country with no cement industry, the profit margin will be far higher than if you do the same in Germany.
This is true, and it is the real basis for capital flowing from developed to emerging markets in search of higher returns. When capital can move freely, it follows efficiency like a compass.
But here something appears that standard textbooks rarely address: the difference in efficiency between developed and emerging markets is not driven solely by the stage of development. A significant role is also played by something that is entirely a political choice: the regulatory environment.
III. The Third Factor: Regulation as an Invisible Tax
Let us return to our $1 million factory.
In a low-regulatory environment it generates 10% per year. In a high-regulatory environment, the exact same factory, with the exact same output, must hire a compliance manager, produce quarterly environmental reports, pay licensing fees, pass inspections, adapt its production process to regulatory requirements, and participate in procurement procedures for certifications. The costs are real. The return is no longer 10%. It is perhaps 6%.
Regulation is a tax on the efficiency of capital. Not in form, but in function.
And here lies the central mechanism that almost nobody writes about systematically.
The Degradation Chain
Over-regulation requires a bureaucratic apparatus to enforce it. More inspectors, more agencies, more compliance officers. This is a cost paid by taxpayers. Those taxpayers are the entrepreneurs and workers whose net return has already been reduced by the regulation itself. A double blow: the direct regulatory burden, and the tax-financed cost of enforcing it.
The result: the net efficiency of capital in the economy falls. Wicksell's natural interest rate follows downward. The central bank, attempting to "discover" the market interest rate, finds an artificially suppressed signal and follows it.
Add to this the price mechanism described by Friedrich Hayek: the interest rate is not merely the price of money, it is an information signal. It tells capital: there is productivity here, go there. When the signal is distorted downward by regulatory burden, capital stops flowing to where it is most productive. It flows to where the regulatory environment is most tolerable. This is an allocative distortion at the very core of the economy.
The Central Bank Has No Choice
Here it is important to clarify something that is often missed in public debate. Central banks do not keep interest rates low because of political pressure, ideology, or because they are printing money irresponsibly. They do it because they have no alternative.
The mechanism is mathematically straightforward. If the efficiency of capital in the economy is 4% and the interest rate is 6%, no rational entrepreneur will take out a loan to start a business. The business generates 4%, the loan costs 6%. The result is a guaranteed loss before the doors even open. Investment stops. The economy contracts.
And here it is worth being precise about who we are talking about. Not technology companies, whose operating margins reach 30 or 40% and can absorb virtually any interest rate. We are talking about bread producers, honey processors, transport companies, construction firms, small manufacturers. The businesses that make ordinary life possible, and whose margins rarely exceed 5 to 8%. For them, the difference between a 3% interest rate and a 7% interest rate is not a question of profitability. It is a question of existence.
The central bank does not choose low rates. It follows the reality of suppressed efficiency. The interest rate must sit below the level of MEC for there to be any incentive to invest and grow. When regulations and taxes have compressed that efficiency to 5%, an interest rate of 5 or 6% is not restrictive policy. It is a death sentence for economic activity.
The central bank's choice is illusory. The real choice was made much earlier, in the legislative chambers where the regulations and tax laws were written.
IV. Low Interest Rates and Their Own Toxicity
Low interest rates, produced by suppressed capital efficiency, are not a neutral phenomenon. They carry their own dynamic, one that closes the vicious cycle.
When the cost of capital is artificially low, companies survive that would not survive in a normal environment. The academic literature calls them "zombie companies": firms whose revenues cover operating costs but not debt service at normalized interest rates. The Japanese economy after 1990 is the classic illustration. Europe after 2012 offers its own variant.
Zombie companies are not merely underperforming participants. They are active destroyers of efficiency. They retain labor that would otherwise flow to more productive employers. They compete on artificially low prices, funded not by real efficiency but by cheap money, and compress the margins of healthy competitors. They lock capital in low-productivity use.
The end result: the average efficiency of capital in the economy falls further. Even lower interest rates are needed for any growth at all. And new regulations are needed to "stabilize" the system. The cycle closes.
V. Governments as Cause and Cure
Here lies perhaps the most provocative aspect of the thesis.
When central banks measure r* (the neutral interest rate), they treat it as an embedded characteristic of the economy, a natural constant. But r* is not a natural constant. It is a political outcome. The regulatory environment, the tax system, the size of the public sector: these are all political choices, not natural givens.
Governments, through accumulated regulation and rising tax burdens, suppress the efficiency of capital. Then they observe low growth and conclude that the economy "requires" low interest rates. Then they blame central banks for "easy money" and the asset bubbles that follow. Then they introduce new regulations to contain the risks from those bubbles.
They are cause, diagnostician, and therapist simultaneously. And in none of these roles do they acknowledge their own contribution to the problem.
Problems cannot be solved at the level at which they were created. In the case of regulation, interest rates, and capital efficiency, the problem is structural. The solution requires acknowledging the chain, not managing each of its links in isolation.
Conclusion
The connection between regulatory burden and interest rates is not hidden by conspiracy. It is hidden because it requires connecting threads from Keynes and Wicksell's economic theory, from Hayek's price theory, from public finance, and from political economy, into a single coherent framework.
When 5% of workers needed a license, the efficiency of capital reflected real productive conditions. When 25% need a license, when opening a business requires dozens of permits, when compliance is an industry in its own right, the efficiency of capital reflects something else entirely: the political and administrative cost of doing business.
The road to hell is paved with good intentions. Every regulation was introduced for a reason. None has been repealed. And the sum of good intentions is a system in which capital is increasingly inefficient, interest rates are structurally low, zombie companies survive, and growth is a chronic problem.
Not a natural phenomenon. A political outcome.
Liquidity Desk publishes monthly analysis of global liquidity, sector rotation, and macro market conditions.
