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Confusions About Interest Rates Part 2

Interest-Rates / Economic Theory Sep 10, 2015 - 03:24 PM GMT

By: Frank_Hollenbeck

Interest-Rates

Following the 2001 dot-com crisis, interest rates were lowered to 1% and then slowly raised to 5% over a 4-year period. This timid policy still created a massive bubble in housing that finally bust in 2008. Instead of learning from the past, we doubled down on this same failed policy. Interest rates were then lowered to 0% and have been held there with little political will to raise them one iota.

We are now on the eve of another major financial crisis, yet economists (except Austrians) still don’t really understand the role played by interest rates in a capitalist economy. To avoid repeating economic mistakes of the past, we must understand the faulty logic that led us to these errors.


The role of interest rates is by far the most important and misunderstand concept in macroeconomics. Most PhD programs should (but don’t) have a course entirely devoted to the history, significance, and economic consequences of manipulating interest rates. Instead, interest rates are primarily taught as just one, amongst many, of the necessary tools in a central bank’s policy tool kit.

However, the economy is not a car and interest rates are not the gas petal. Interest rates are the economy’s most important prices since they align output with society’s time preference of consumption across time. Manipulating interest rates can only create a distortion between what is, and what should be produced in different time periods. A depression is inevitable to realign the time dimension of output with demand.

According to the Keynesians and monetarists, the interest rate is a pure monetary phenomenon. Real factors do not play any role in the determination of interest rates. However, changes in interest rates can cause a change in real factors.  For some reason, these economists fail to see the inconsistencies in this view. If a change in interest rates can causes changes in real factors, the original level of interest rates must therefore have determined or have been determined by real factors.

Mises in 1912 had this to say about our current enlightened economic thought:

“It regards interest as a compensation of the temporary relinquishing of money in the broader sense –a view, indeed, of unsurpassable naiveté. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest holds an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy.”

This exclusively monetary view of interest rates is based on Keynes theory of liquidity preferences.  The interest rate is determined by the intersection of the supply and demand to hold cash (hoard). Yet, neither the supply nor demand to hold cash (hoard) is dependent on the interest rate (see explanation here).  Therefore, together they cannot determine the rate of interest.

Keynes had a visceral hatred for what he called the “rentier”, a person who survives by sitting back and receiving interest. To attack the rentier, he also had to attack the notion of any economic justification for positive interest.  His liquidity preference theory had little to do with sound economic analysis but more to do with developing a theory to justify a political conviction: the “Euthanasia of the rentier”.

In reality, the natural rate of interest rate determines where the demand and supply for loanable funds intersect. It is not the other way around, as many economists still believe and continue to teach by drawing the demand and supply curves first instead of last. It is the interest rate that comes first and then the  demand and supply curves are drawn to intersect at this rate.

There is a natural tendency to prefer current consumption over future consumption. The natural interest rate is the economic manifestation of time preferences.  It is the ratio of the value assigned to current consumption relative to the value assigned to future consumption. It is not a price but can be viewed conceptually as the price of time preferences.

Mises proved this characteristic of the natural interest rate with a counterfactual. If there was no time preference, then output would be valued the same if it was produces today, in ten years or in a thousand years. An asset that produced a perpetual stream of output, such as land, would have an infinite value. Since land regularly trade at less than infinity, a time preference of output must exist where earlier output is value more than output produced later.  The actual level of  interest rates (the yield curve)  are obtained by adding to the natural rate of interest  a premium or discount for changes in prices (to compensate for a change in the measuring stick or money) and a premium for the risk  of nonpayment or of uncertainty (entrepreneurial profit for bearing risk).  

Although Keynes rejected the classical concept of time preferences he constantly referred to a “time discount” in The General Theory.  This is just one of Keynes’ many inconsistencies.

A capitalist always has many choices for the use of his assets. He must decide which is the most profitable amongst different uses. He looks at the present value of the different income streams and chooses the one with the highest net present value. For example, if the asset is an acre of land, he could mine it, farm it or put it up to forestry.  If the interest rate is 5%, the income stream may determine mining as the alternative with the highest net present value. An optional choice may instead be farming at 4.5%, or forestry at 4%. The natural interest rate (part of the %5) as the price of time preference is the most important price in a capitalist economy. It helps aligns output with society’s demand across time. As economist Irving Fisher wrote, “Thus a change in the rate of interest results in a change in the choice of income streams. A high rate of interest will encourage investment in the quickly returning income, whereas a low rate of interest will encourage investment in incomes which yield distant return”

Now suppose the natural rate is 3% when the interest rate is 5%. Through this price, society is sending a signal that it values mining more than either of the two other alternatives. In other words, the best way to meet current and future demand is to use the acre of land for mining. Now suppose that the central bank through the printing press lowers the interest rate temporarily to 4%. The acre will be put up to forestry. Yet, the printing of money did not change time preferences or the economic manifestation of time preferences, the natural rate of interest. Time preferences are mostly immutable [1] and are determined by human nature.  It did not change what society really wanted to be produced. What the printing did do is introduce a wedge between what society wants to be produced and what is produced.  Printing money creates misallocation of resources and the longer the printing the greater the misallocation.  Once one realizes that recessions are never a problem of demand, (see explanation here ) but of supply being misaligned with demand, one sees the idiocy of following a monetary policy that increases this misalignment.

Many economists say “this time is different, we know better now”, but it’s always rinse and repeat. History repeats itself, and money printing ultimately leads to hyperinflation, social unrest, and war. We never seem to learn!

Notes

1) In Human Actions, Mises explains how inflationary or deflations episodes can alter the the natural rate of interest by altering the distribution of incomes and wealth of different segments of the population. Furthermore, he notes that there are probably multiple natural rates since “nothing would justify the assumption that this discounting of satisfaction in remoter periods progresses continuousIy and evenly”.

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.

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© 2015 Copyright Frank Hollenbeck - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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