(I'm not 100% happy with this post. Too much emphasis on interest rates, for one thing. I sat on it for a few days, but have decided to post it anyway. Because I like my question better than I like my answer. So let's see your answers.)
Decades ago I read Graham and Dodd. I thought it was a great book. But one thing bugged me more and more as I read it. They talked a lot about Price/Earnings ratios. And about how some firms had P/E ratios that were overvalued compared to other firms. And about how some times might have P/E ratios that were overvalued compared to other times. But they said nothing at all about what determined P/E ratios on average, across firms and across times. They just assumed there was some 'normal' P/E ratio, but said nothing about what determined it. The book was partial equilibrium analysis. It lacked a macrofoundation. Ultimately, it lacked a theory of interest rates, because a P/E ratio is like (though not exactly like) the reciprocal of a rate of interest.
Given what Graham and Dodd were trying to do in that book (help Warren Buffett get rich by choosing the right stocks) it was perhaps unreasonable for a young macroeconomist to expect anything more. But I do expect more. How can you do finance without a theory of interest rates? And I don't just mean interest rate differentials.
Here's a very simple (and totally inadequate) theory of the rate of interest: it is set by the Bank of Canada. Add or subtract adjustments for risk, duration, liquidity, and earnings growth, and you get the equilibrium earnings yield on stocks. Take the reciprocal, and you get the P/E ratio. Done.
Why is that theory totally inadequate? Because the Bank of Canada does not set interest rates in a vacuum. It sets the rate of interest it thinks it needs to set to keep inflation at the 2% target. And that interest rate in turn depends on things like the demand for goods, and the Phillips Curve, and on the inflation target. And the demand for goods in turn depends on things like desired saving and investment, both in Canada and around the world. And those in turn depend on time-preference, and expectations of future income, and on the marginal rates of transformation of present goods into future goods, and whether there will be a demand for those future goods or a recession.
And the Bank of Canada is only able to set interest rates at all because its liabilities are used as money. And the liabilities of commercial banks that are also used as money are valued at par with Bank of Canada liabilities because those commercial banks peg their exchange rates with Bank of Canada liabilities. And Bank of Canada liabilities are used as the medium of account, as well as a medium of exchange, so if there is an excess supply of Bank of Canada liabilities the value of those liabilities will fall, which means the prices of other goods will rise. And if people expect prices to rise you need to distinguish between real and nominal interest rates, and ask how monetary policy affects both.
And those monetary liabilities are used as media of exchange, and that what makes media of exchange special is that they have no markets of their own, but are traded in all other markets, and so talking about "the money market" is nonsense, because all markets are money markets. The bond market is a money market; the stock market is a money market; the labour market is a money market; the supermarket is a money market. The foreign exchange market is a monies market.
And if the Bank of Canada tightens monetary policy, does that mean lower or higher interest rates? Well, it depends, on things like the slope of the IS curve, and how it affects people's expectations of future inflation and future real growth.
And are Ponzi schemes really unsustainable, and destined to burst like the bubbles they are? Well, not necessarily; if the rate of interest on Mr Ponzi's liabilities is less than the growth rate of the economy, it might be sustainable. Look in your pocket, and you will see an example of just such a financial asset. It's paper currency. There may be more.
If the first principle of finance is the "time value of money", aka the rate of interest, how can you even begin to understand finance without having a solid money/macrofoundation?
It is even possible for the "time value of money" to be negative, as Silvio Gesell showed.
Can you do finance while knowing nothing about any of that stuff? Well, I expect you can. But is it a good idea?