Incredible Confusions, Part 2

Of Interest and the Dangerous Habit of Suppressing It

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usury woodcutThe idea that the charging of interest is unethical and should be banned has a long tradition in the history of human civilization. It seems to have played a role at some point in all the major religions, certainly in Christianity, Judaism and Islam, and it is today promoted most strongly by advocates of Islamic banking.

As an economist I cannot (and should not) comment on matters of religion. Religion and economics deal with completely different aspects of human existence. Religion is about ‘ultimate ends’ and ‘personal values’. Economics does not deal with ends but with means. Economics does not tell anybody what his or her values should be. Contrary to what is frequently claimed – usually by those who do not understand economics – economics does not tell you that you should strive for more material goods and more services at your disposal.

But it so happens that we live in a world in which most people have personal aims or goals that involve having at least a certain material wealth, and in which most people prefer the possession of more material goods to less material goods; and the science of economics – for economics is a science, and in fact an objective, wertfreie (value-free) science – can then explain why people have a better chance of achieving these (material) aims if they use such social institutions as the division of labor, private property, trade, money, and many others. Additionally, the science of economics can show how these social institutions work, demonstrate the laws and regularities inherent in them, and can develop rules for their most appropriate use. Economics is purely about the means of social cooperation for the attainment of material goals. It never concerns itself with ultimate ends.

If most of the population became Buddhist monks tomorrow and would lose any interest in accumulating material wealth, would happily withdraw into monasteries and dedicate themselves to mediation, none of the principles and laws of economics would have suddenly become less true or invalid. The law of comparative advantage as articulated by David Ricardo would be as true on that day as on any other. The laws of economics would still apply just as the laws of gravity would. Of course, the interest in economic studies would probably diminish rapidly but that is all. Or, not quite all: Society would also be rapidly impoverished in material terms – even to the point of mass starvation –, and this the economist can ascertain with certainty, although nothing can be said about any compensating gains in spiritual wealth, of course.

If you believe that your God demands that if you lend money you should not charge interest, than there is nothing that I, as an economist, can say to you – other than, maybe, give me a call whenever you have some extra cash. The point at which I can – and should – comment is when you were to claim in addition that the observance of this rule would lead to a more stable and better functioning economy, that the non-charging of interest would not diminish society’s wealth but even increase it, or that the resulting economic structure would at least conform better to some generally accepted notion of fairness. Here we have reached a point where debate has become possible, not because I, as an economist, have intruded onto the religious ground of values and ultimate ends but because the advocate of religion has intruded onto the economists’ ground of the study of the laws for wealth creation.

I am not saying that all advocates of the non-charging of interest for religious reasons also claim that this would fix the economy. I assume that in the case of most religious rules the goal is spiritual not material, meaning the objective is to make the follower a better person, not better off. But in the wake of the financial crisis interest in fundamental aspects of our economy has increased, and within the ensuing debate it has certainly been argued by some that non-interest models of finance and banking could address fundamental problems of our present system, or even provide a functioning alternative to present arrangements. I have also encountered skepticism to the charging of interest, or, as it is often put, ‘interest on money’, by apparently non-religious commentators to my website.

Usury and the Mainstream

To many readers this debate may at first appear as a bit of a sideshow. It does not appear to be one of the main areas of debate between economists, policy makers and financial market participants right now, at least outside Islamic finance. However, I fear that the representatives of today’s economic and political mainstream have much more in common with those who want to reintroduce usury laws than might at first appear. The vast majority may not ask for the banning of interest per se. However, it is today certainly the view of the vast majority that interest can and should be depressed to low levels in order to squeeze more growth out of the economy. It is today generally believed that, as long as inflation is not a major problem, policy makers may manipulate interest rates to lower levels with impunity. In fact, almost our entire financial infrastructure is designed for the utmost flexibility in the production of money under the guidance of the central bank, and this is done almost for the sole purpose of being able to ‘guide’ interest rates to the benefit of economic growth, which almost always means guiding them downwards. That is why the inelastic monetary base that once formed the foundation of finance and banking and that consisted of gold or silver, was replaced with the fully elastic base of limitless fiat money as the new bank reserves; and why in every economic downturn it is now the unquestioned obligation of monetary authorities to lower interest rates and to keep them low.

The advocates of the banning of interest (a minority in the present debate) argue that no interest makes for a better economy; the advocates of the periodic but frequently long-lasting artificial depressing of interest rates (an overwhelming majority in the present debate) argue that low interest makes for a better economy.

Both are wrong.

The answer from the economist should be this: Interest rates are market prices and they express, like all market prices do, the subjective valuations and preferences of market participants. In order for economic processes to be guided ultimately by the valuations and preferences of the public, prices need to remain completely uninhibited in their formation and in whatever impact they may exert on the employment of resources, including labor.

The financial crisis is not the result of the habit of charging interest but the inevitable consequence of the systematic distortion of interest rates– usually to the downside – through our fiat money arrangements and our monetary policy of making credit artificially ‘cheap’ in the mistaken belief that this aids economic performance.

Time Preference

Interest is not confined to a monetary economy and not exclusive to the lending of money. Even in a society that does not know and use money, we could observe the phenomenon of interest. At its most basic level, interest is the difference between the present price of a good that is available today and the present price of a good of the same kind that is only available later. An apple today is worth more than an apple next week or next month. The ratio between these two prices is interest and it is an expression of time preference.

Time preference is not a psychological phenomenon in the sense that some people may have it and others do not. If you want something – and ‘wanting something’ is in fact the precondition for considering this something to be a ‘good’ – then you will value you it higher at a nearer date than at a date further in the future. As George Reisman put it so well: “All else being equal, to want something means to want it sooner rather than later.”

Let us assume you claimed to have no time preference in respect to a specific good. That would mean that you were indifferent as to whether you could obtain that good today or tomorrow; and tomorrow you would be indifferent as to whether you could have it that day or the next. Logically, this means you would be indifferent as to whether you obtained it at all, which means you wouldn’t really want it and it was therefore not a ‘good’ to you. (Quod erat demonstrandum.)

This would also mean you would never feel the urge to act to obtain it. Economics deals with action and action requires ‘wanting’ and ‘wanting’ logically entails time preference and time preference is the core element of interest.

There is nothing mysterious, suspicious, sinister or wicked about the phenomenon of interest.

If you lend a consumption good or a small amount of money to a close friend or a close relative, you may not ask to be compensated for not having this good at your disposal for some time, or for departing with some of your purchasing power for a while, but in the more extended network of human cooperation among otherwise unconnected individuals that makes for the modern society you would probably expect most people to ask for some compensation when lending to others, and for their counterparts to grant them some compensation, and none of this would appear irrational, unjust or forced.

The height of time preference is subjective and will be different from person to person, and different for the same person at different moments in time. Time preference and therefore interest is always an expression of personal, subjective valuation.

Market Interest Rates

The interest rates we observe daily in markets contain, of course, certain other elements in addition to time preference, although time preference remains the core ingredient. These other elements are usually a risk premium for the risk that the borrower cannot repay (credit risk) and a premium that money will have lost some of its purchasing power by the time the loan gets repaid (inflation risk). Thus, when lending to entities with non-negligible risk of default (most private entities) and in a currency that has a tendency to inflate (most paper monies), market interest rates will be higher than would be justified by time preference alone.

Under certain circumstances, these ‘premiums’ may actually turn into ‘discounts’. If the period for which the loan is agreed is expected to be a period of general deflation, than the nominal loan rate could actually be lower than justified by time preference, as the expected rise in the purchasing power of money during the life of the loan already constitutes a form of compensation. Under a strict gold standard the monetary unit could reasonably be expected to gradually gain in purchasing power over time (secular deflation, which means money has an inherent real rate of return), and loans to borrowers with relatively low default risk would be extended at very low nominal rates of interest.

Negative Interest Rates

Certain interest rates are presently very low, zero or even negative. To the extent that they are policy rates we have no trouble explaining them. They are not market rates and not even ‘prices’ in the strict economic definition. They are administrative decrees, determined by central bank bureaucrats, and not the outcome of the voluntary interaction of market participants. For what it is worth, I expect some of these rates to be lowered again, probably from near-zero into negative territory. But this is entirely a political phenomenon.

However, certain government securities, usually in the so-called safe-haven markets and usually those with shorter maturities, have also been trading at zero interest rates or even at negative interest rates (yields) lately. Very low administrative rates (policy rates) may have helped here but on their own they cannot cause this phenomenon. How can we explain it?

Deflation could be one explanation but I do not think it is the main driver, as other indicators of inflation expectations often still point to ongoing declines in money’s purchasing power. I think that in these instances the ‘credit risk premium’ has actually been turned into a ‘credit risk discount’.

Government bonds, in particular those with shorter maturities, are often held not for their return but their liquidity and safety. In these instances, they do not compete directly with equities or corporate bonds or real estate but with money. In the present environment there is, I believe, a strong demand for money holdings. Holding cash or cash equivalents allows investors to remain on the sidelines, to keep their firepower dry and wait how things pan out. But for many institutional investors holding large sums of money inevitably means holding sizable bank deposits and thus incurring considerable counter-party risk in respect to the fragile banking sector. Government bonds are expected to be (almost) as liquid as money proper or deposits, and to have lower counter-party risk than bank deposits. The demand for them is so considerable that investors even accept a negative yield, which means they are willing to pay a fee rather than collect a return for the privilege of ‘parking’ funds with the state.

A personal comment here: I think that these investors are sitting on a powder keg as I expect inflation to rise and concerns over sovereign solvency to intensify. But I have no problem understanding why certain market rates can become negative under certain conditions. It has to be stressed, however, that none of this means that the public’s time preference has disappeared or has even become negative. Time preference is always positive.

‘Interest on Money’

Money – or at any rate, money proper – does not earn interest or any other income. Money is a medium of exchange. It has no direct use-value, only exchange value. Gold used to be money and gold does not pay interest (other than its inherent real rate of return in the case of deflation). Today, otherwise worthless pieces of paper are used as money and these paper tickets do not pay interest, either.

Already, the Romans knew that pecunia pecuniam parere non potest, money doesn’t beget money. You have to invest money to make a return, that is, you have to spend it.

If you pay money into a bank, ownership of that money passes on to the banker. You no longer own money proper but you now own a claim against the banker for the payment of money proper. You own a monetary derivative. For obvious reasons, the public today considers these derivatives as good as money proper (at least most of the time) but they are certainly not the same thing. If you hold money proper (cash) you hold a form of money that is not somebody else’s liability. Also, your bank deposit does not constitute a contract for safekeeping, as in that case you would have to pay the banker a fee rather than the banker paying you interest.

There is no such thing as interest income from holding money.

The Manipulation of Interest Rates

There can be no doubt that a lot of the blame for the deterioration in the quality of economic debate can safely be put at the feet of Keynesianism’s half century of intellectual domination. Today, many people still seem to perceive the main economic problem to be one of a lack of overall activity, so the government should boost that aggregate by adding its own activity (through deficit spending) or by providing an extra dose of caffeine for the private sector in the form of low interest rates. Any activity seems to be better than too little activity, although nobody can explain how activity came to be so insufficient all of a sudden.

The key challenge for any economy, however, is not the aggregate level of activity but the coordination of the activities of diverse and usually unconnected individuals with different ideas, values, plans and objectives. Nobody participates in the economy for the sake of a higher GDP but only for the fulfillment of personal plans. A well-functioning economy is not one that delivers a certain aggregate of activity but that allows its individual participants to achieve their own individual objectives in the best possible way. (Remember the Buddhist monks.) For that we need uninhibited markets with unobstructed price-formation.

One of the important challenges of coordination for any economy is this one: To what extent should society’s available pool of resources be employed for the satisfaction of immediate consumption needs, and to what extent can resources be used to meet consumption needs in the more distant future, that is, to what extent can they become capital goods in the meantime? Evidently, this should be determined by the public’s time preference, and this is communicated to all actors in the economy via interest rates.

If the public has a high time preference it means it values present goods particular highly relative to future goods; it has a strong urge for present consumption; it has a low tendency to save; and market interest rates will tend to be relatively high. Every one of these sentences is simply a different way of describing the same phenomenon: the public has a high time preference.

Low savings availability on capital markets and high interest rates mean that entrepreneurs can only realize investment projects with the highest prospective returns. This changes naturally if the public lowers its time preference, increases savings, which lowers interest rates and encourages extra investment. Real resources are being shifted from present consumption to investment and allow for future consumption.

Saving and investing are the key inter-temporal decisions in an economy, and they are being coordinated by interest rates. Low interest rates are not necessarily good or bad. What matters is that they correctly reflect the preferences of the public.

The temptation to artificially lower interest rates is understandable. Investment increases the capital stock, and raising the amount of capital per worker is one of only two means we know of, of how to increase overall prosperity (the other being the division of labor). But a proper capital stock requires real resources, and those can only be made available through acts of real saving from real income. Printing more money and lowering interest rates on loan markets artificially creates the illusion of savings and it must lead to the dis-coordination between real saving and real investment, and thus to economic imbalances. Those are the true cause of financial crises and economic recessions.

Interest is an essential component of human action and the charging of interest rates an integral component of human cooperation on markets. Abolishing interest rates or depressing them through policy intervention will never make markets work better, will never make financial markets more stable, and will never make society more prosperous.

In the meantime, the debasement of paper money continues.

Source: Paper Money Collapse

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About Detlev S Schlichter