Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
UK Covd-19 FREE Lateral Flow Self Testing Kits How Use for the First Time at Home - 10th Apr 21
NVIDIA Stock ARMED and Dangeorus! - 10th Apr 21
The History of Bitcoin Hard Forks - 10th Apr 21
Gold Mining Stocks: A House Built on Shaky Ground - 9th Apr 21
Stock Market On the Verge of a Pullback - 9th Apr 21
What Is Bitcoin Unlimited? - 9th Apr 21
Most Money Managers Gamble With Your Money - 9th Apr 21
Top 5 Evolving Trends For Mobile Casinos - 9th Apr 21
Top 5 AI Tech Stocks Investing 2021 Analysis - 8th Apr 21
Dow Stock Market Trend Forecast 2021 - Crash or Continuing Bull Run? - 8th Apr 21
Don’t Be Fooled by the Stock Market Rally - 8th Apr 21
Gold and Latin: Twin Pillars of Western Rejuvenation - 8th Apr 21
Stronger US Dollar Reacts To Global Market Concerns – Which ETFs Will Benefit? Part II - 8th Apr 21
You're invited: Spot the Next BIG Move in Oil, Gas, Energy ETFs - 8th Apr 21
Ladies and Gentlemen, Mr US Dollar is Back - 8th Apr 21
Stock Market New S&P 500 Highs or Metals Rising? - 8th Apr 21
Microsoft AI Azure Cloud Computing Driving Tech Giant Profits - 7th Apr 21
Amazon Tech Stock PRIMEDAY SALE- 7th Apr 21
The US has Metals Problem - Lithium, Graphite, Copper, Nickel Supplies - 7th Apr 21
Yes, the Fed Will Cover Biden’s $4 Trillion Deficit - 7th Apr 21
S&P 500 Fireworks and Gold Going Stronger - 7th Apr 21
Stock Market Perceived Vs. Actual Risks: The Key To Success - 7th Apr 21
Investing in Google Deep Mind AI 2021 (Alphabet) - 6th Apr 21
Which ETFs Will Benefit As A Stronger US Dollar Reacts To Global Market Concerns - 6th Apr 21
Staying Out of the Red: Financial Tips for Kent Homeowners - 6th Apr 21
Stock Market Pushing Higher - 6th Apr 21
Inflation Fears Rise on Biden’s $3.9 TRILLION in Deficit Spending - 6th Apr 21
Editing and Rendering Videos Whilst Background Crypto Mining Bitcoins with NiceHash, Davinci Resolve - 5th Apr 21
Why the Financial Gurus Are WRONG About Gold - 5th Apr 21
Will Biden’s Infrastructure Plan Rebuild Gold? - 5th Apr 21
Stocks All Time Highs and Gold Double Bottom - 5th Apr 21
All Tech Stocks Revolve Around This Disruptor - 5th Apr 21
Silver $100 Price Ahead - 4th Apr 21
Is Astra Zeneca Vaccine Safe? Risk of Blood Clots and What Side Effects During 8 Days After Jab - 4th Apr 21
Are Premium Bonds A Good Investment in 2021 vs Savings, AI Stocks and Housing Alternatives - 4th Apr 21
Penny Stocks Hit $2 Trillion - The Real Story Behind This "Road to Riches" Scheme - 4th Apr 21
Should Stock Markets Fear Inflation or Deflation? - 4th Apr 21
Dow Stock Market Trend Forecast 2021 - 3rd Apr 21
Gold Price Just Can’t Seem to Breakout - 3rd Apr 21
Stocks, Gold and the Troubling Yields - 3rd Apr 21
What can you buy with cryptocurrencies?- 3rd Apr 21
What a Long and Not so Strange Trip it’s Been for the Gold Mining Stocks - 2nd Apr 21
WD My Book DUO 28tb Unboxing - What Drives Inside the Enclosure, Reds or Blues Review - 2nd Apr 21
Markets, Mayhem and Elliott Waves - 2nd Apr 21
Gold And US Dollar Hegemony - 2nd Apr 21
What Biden’s Big Infrastructure Push Means for Silver Price - 2nd Apr 21
Stock Market Support Near $14,358 On Transportation Index Suggests Rally Will Continue - 2nd Apr 21
Crypto Mine Bitcoin With Your Gaming PC - How Much Profit after 3 Weeks with NiceHash, RTX 3080 GPU - 2nd Apr 21
UK Lockdowns Ending As Europe Continues to Die, Sweet Child O' Mine 2021 Post Pandemic Hope - 2nd Apr 21
A Climbing USDX Means Gold Investors Should Care - 1st Apr 21
How To Spot Market Boom and Bust Cycles - 1st Apr 21
What Could Slay the Stock & Gold Bulls - 1st Apr 21
Precious Metals Mining Stocks Setting Up For A Breakout Rally – Wait For Confirmation - 1st Apr 21
Fed: “We’re Not Going to Take This Punchbowl Away” - 1st Apr 21
Mining Bitcoin On My Desktop PC For 3 Weeks - How Much Crypto Profit Using RTX 3080 on NiceHash - 31st Mar 21
INFLATION - Wage Slaves vs Gold Owners - 31st Mar 21
Why It‘s Reasonable to Be Bullish Stocks and Gold - 31st Mar 21
How To Be Eligible For An E-Transfer Payday Loan? - 31st Mar 21
eXcentral Review – Trade CFDs with a Customer-Centric Broker - 31st Mar 21

Market Oracle FREE Newsletter

FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

Confusions About Interest Rates Part 2

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

By: Frank_Hollenbeck


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!


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.

You can subscribe to future articles by Frank Hollenbeck via this RSS feed..

© 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.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules