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Confusion About Interest Rates Part 1

Interest-Rates / Economic Theory Sep 10, 2015 - 03:22 PM GMT

By: Frank_Hollenbeck

Interest-Rates

Since 2008, central banks have rushed to lower interest rates to spur growth. This has induced mal-investments in almost all asset classes. For example, with oil prices below $50 a barrel and trending lower, the shale oil industry is in serious trouble as is the banking industry that lent it over $1 trillion.

Of course, economists and faulty economic theory are 100% responsible for what is to come. The professional economist today is like the doctor of the past whose prescription to bleed the patient was considered state-of-the-art medicine; the cure, of course, being much worse than the disease. 


This century has witnessed two devastating financial crises, with a third shortly on the horizon. When writing about this era, historians will conclude that these booms and busts could have been avoided had politicians not been swayed by economic misconceptions about the true role of interest rates in a capitalist economy. 

The history of interest rates (yield curve) is a fascinating one. It all started with Aristotle who strongly condemned charging interest as contrary to nature since money is a medium of exchange and is not, in itself, productive or adding to wealth. Money is sterile and bears no fruit, and therefore cannot lawfully command interest. This view of interest rates was held by most theologians even up to the modern era. 

Although usury (charging any interest and not the modern definition of abusive interest) had a negative connotation, it was not strictly forbidden until the first church council in 325. This ban on usury was, at first, mostly limited to church dealings.

Many theologians of the time considered usury to be theft, a crime worse than adultery or murder since the sin of usury could continue, through inheritance, from one generation to the next. In 1139, the church finally extended the prohibition to all men.

The Parisian theologian William of Auxerre (died 1231) added a new twist to the anti-usury campaign by claiming that the interest rate was the price of time, and that since time is free, no one should charge for something that has no cost. Another anti-usury advocate was the theologian Thomas Aquinas (1225-1274) who considered money to have a fixed face value. The charging of interest on something that is fixed is a violation of the nature of money and is therefore sinful and should be outlawed.  

Aquinas and other theologians clearly did not understand the nature of money. We don’t work for the face value of money but for the goods and services that this face value can buy – also called its purchasing power. However, the consumption value of this purchasing power varies across time. In other words, even if a dollar could buy an apple today and an apple tomorrow, it does not mean we would assign, today, the same consumption value, or time preference, to the consumption of an apple in the future, or equivalently the money used to buy them. The consumption of apples or money in different time periods can be seen as different products. It was the Frenchman Turgot (1727-1784) and  the Austrian economist Eugen von Bohm Bawerk (1851-1914) among others,  that realized that current consumption is preferred to future consumption so that the natural rate of interest reflects the premium the market imposes to equalize the consumption exchange value of goods in difference time periods. The natural interest rate can be viewed as  the exchange ratio between current and future consumption.

The equilibrium interest rate in a functioning market economy is related to the supply and demand for loanable funds. The supply arises from the time preference of consumption, while the demand comes from businesses who invest in plants and equipment based on the marginal efficiency of capital. This may give the impression that the equilibrium interest rate is therefore determined by a combination of time preferences and production considerations. This however, is only an illusion. The value of this capital is also determined by time preferences since it is the value of productivity over time discounted by interest rates reflective of time preferences. The marginal efficiency of capital is therefore obtained from the value of capital which in turn is determined by time preferences. It is the interest rate that determines the positions of the demand and supply curves.

Gabriel Beil (1420 to 1425 –1495) and Conrad Summerhart (1465-1511) weakened the prohibition against usury by claiming that interest was the payment for the opportunity cost of money. A merchant should be compensated for giving up the use of his money, just like the farmer should be compensated for the sacrifice of the use of his land. Also, the borrower has the opportunity to make more profits from the loan than the interest he has to pay the lender. Why should such mutually beneficial transactions be forbidden?

Summerhart went further by making the case that present money was a different good from future money- that the value of the right to use money today was different from the value of money paid tomorrow.  Murray Rothbard once remarked that “Summenhart came close to understanding the primordial fact of time-preference, the preference of present over future money.”1

Summerhart also pointed out that lending is not without risks and that the interest rate paid is to compensate for the risk of the borrower going bankrupt. Hence the risk premium concept justifying interest on a loan. The franciscan Juan de Medina (1490-1546) was the first writer in history to clearly advance the view that charging interest on a loan is legitimate if it is in compensation for risk of non-payment.

Cardinal Thomas Carjetan (1468-1534) made business loans legal, and by the Jesuit congregation of 1581, restrictions on charging interest had been, for all practical purposes, eliminated.

Islamic banking or “Sharia compliant finance” also condemns usury (Riba). Loans for consumption should be charity while business loans should not have fixity of the interest payment. The return on the money borrowed is always unknown initially because the future is uncertain.  If, for example, the interest rate is 5% and the return on the money borrowed is 2%, part of the fixed interest payment, 3%, made to the lender is viewed, under sharia banking, as unearned. If the return instead is 10%, the borrower is viewed as unjustifiably gaining 5% in income. According to Islamic banking there should be a sharing of risks in any loan transaction.  This divergence between the fixed rate and the return on the money lent is also blamed for creating income inequalities. Of course, this totally ignores default risk, and differences in risk preferences. The voluntary choice to fix the interest payment reflects a difference in risk preferences which mutually benefits both the lender and borrower. Furthermore, consumption loans can simply reflect differences in time preferences of consumption.

If the natural interest rate reflects time preferences, then it also reflects society’s consumption choices (demand) across time. These consumption choices then determine the optimal, in a market economy, inter-temporal production choices to best meet this demand. Interference with this crucial alignment will cause a divergence between what society wants to be produced across time relative to what is actually produced. Recessions or depressions are never a problem of demand (see explanation here), but of a misalignment of supply with demand.

Unlike what is taught in almost all undergraduate or even graduate economic programs, the best monetary policy is no monetary policy.

Notes

1. Murray Rothbard, “Economic Thought Before Adam Smith: An Austrian Perspective on the History of Economic Thought, Volume I”

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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