14 May 2014

How Economists Treat Interest

Austrian School, Capital & Interest 8 Comments

I got an email from a colleague (reprinted with permission):

Dear Bob:

Please settle a bet between me and [another colleague]. One of us maintains that without borrowing and lending, no interest rate could arise. The other of us takes the view that there is always time preference, and this guarantees an interest rate, even in the absence of borrowing and lending (for example, this option has not yet been discovered). Even in this case, one of us maintains, there will be a gap between what workers are paid for goods that are immediately sold, and what workers of equal productivity are paid for goods that don’t come onto the market for a year.

Before I jump in, I want to note that this writer is committed to objectivity; notice that he didn’t say, “I think X, but so-and-so thinks Y, who’s right?” Because then he would have biased me in favor of either the guy I like more, or the guy who is scarier.

But, I will in turn be crafty, and not simply choose which position I endorse. Rather, I will make a series of what I hope are true statements about the way economists should approach these issues, then I will let my colleagues determine who wins the bet.

(1) Economists often make a distinction between an actual market price in a transaction, versus a “hypothetical price” that we imagine must be the case in order to complete our model. For example, suppose we have a group of potential workers and potential employers, and that we know their preferences for leisure/wages and output/money. Every day we can compute what the market-clearing wage is. Now suppose that on a religious holiday, the market-clearing wage is $82/hour, at which price the total quantity supplied and demanded of labor is 0 hours. (Nobody wants to work on this very holy day, and the wage needs to be $82/hour in order to make no employer want to hire even a single hour of labor.) So it’s fine to academically say, “The wage is $82/hour even though no wages are paid,” but on the other hand, in the real world we would have no way of actually knowing that. We couldn’t actually observe what the wage was, so if someone said, “Nope, I don’t see any wages being paid today, so they don’t exist,” then that would be a perfectly defensible statement too.

(2) It is possible for people to earn what everybody would describe as “interest on their invested financial capital” even in situations without explicit lending at a contractual interest rate. For example, suppose it’s December 1 and people would pay $110 for a mature Christmas tree right now, but would only pay $100 for an airtight claim entitling them to delivery of a mature Christmas tree in a year. Furthermore, everyone expects (correctly) that this structure of market prices will be the same, a year from now. In equilibrium, this means that a capitalist could spend $100 today buying a Christmas-tree-that-needs-another-year-to-grow and then hold it for a year. (I’m neglecting any other expenses, including the opportunity cost of the land on which the tree grows.) After a year passes, he sells the mature tree for $110. In general this type of discounting will be applied to factors of production (including labor), and that’s how capitalists earn interest even when they don’t formally lend out a sum of money at a contractual interest rate. Indeed, this is what Bohm-Bawerk referred to as “originary interest” which he (and subsequent Austrians) thought of as more general than the specific offshoot of contractual loans. If you want to see more on this, read up on Bohm-Bawwerk’s masterful demolition of the socialist exploitation theory of interest.

(3) Ah but let me come back full circle: Austrians tend to argue that without money prices various things are metaphorical at best. For example we can vaguely talk about economic calculation in a barter world, but you really need explicit money prices for true accounting to take place. So that’s why I argue in my dissertation for a monetary (as opposed to a “real”) approach to interest theory, where ultimately the market rate of interest is “set” in the explicit, contractual loan market and then the implicit discounts (which also include risk) are adjusted in other intertemporal markets.

8 Responses to “How Economists Treat Interest”

  1. skylien says:

    So what you are actually saying with “interest is a monetary phenomenon but no “real” phenomenon” is not that interest only exists because of money (of course interest exists even without money, also in a barter world) but only with money you can actually pin a market rate of interest down. Without money no accounting. There would only be individual expressions of interest in every exchange that is not spot. But no way to compare them with each other because there is no single denominator.
    I mean your second example can be done without money as well. E.g. a man would barter 2 pigs for a Christmas tree this year, but only 1 pig for an airtight claim entitling him to delivery of a mature Christmas tree next year.

    That is not the same as what Keynes means when he says interest is a purely monetary phenomenon, right? Because Keynes merely traces interest back to “liquidity preference” expressed by the preference to hold money.

    Can you clarify that?

    • guest says:

      … but only with money you can actually pin a market rate of interest down. Without money no accounting. There would only be individual expressions of interest in every exchange that is not spot.

      Having a money just means more people are more likely to be able to be traded with. So, even with money, prices and interest rates are always subjective the individual.

      So there’s no such thing as a collective “market rate”. There is only the configuration of individual rates that result from individuals’ time preferences affecting other individuals’ time preferences. It’s always about the individual.

      All individuals have time preferences, so yes there are always interest rates.

      • Bob Murphy says:

        So there’s no such thing as a collective “market rate”.

        Is there a market price for crude oil, or do we each have our subjective oil price?

        • guest says:

          We each have our subjective oil price. This is expressed (to ourselves, anyway) when we want to buy gas but another preference ranks higher and therefore we refrain from doing so.

          When we don’t buy, the seller is the highest bidder.

          Your video, “Hurricane Sandy and Gas Lines” relies on the fact of individual subjective pricing.

  2. Adrian Fiorito says:

    Professor Murphy,

    This maybe a little off topic. It’s the age old ‘ice in the summer vs ice in the winter’ example.

    Why do we compare ice in the summer vs ice in the winter. Shouldn’t we be comparing ice in the summer vs ice in the following summer. Shouldn’t the commodities being appraised intertemporally be of the same use value to the individual? Money clearly being the best commodity that meets this criteria.
    And if that’s the case then isn’t time preference sufficient to determine the interest rate and its being positive?

  3. Major-Freedom says:

    Nice explanations. Very helpful even to those who think about this sort of thing a lot.

    I like to think that lending/borrowing at interest is but one effect of time preference; other effects are profits, discount rates to price future cash flows from utilizing capital goods, and finite time horizon thinking (which might even be a cause of time preference, not sure).

    Even if nobody lent/borrowed money, profits could still be earned with fixed money supply and fixed aggregate spending over time.

    OT: I like to play detective, so I am going to suspect that the guy who emailed you is the guy who talked about time preference.

  4. Tel says:

    Now suppose that on a religious holiday, the market-clearing wage is $82/hour, at which price the total quantity supplied and demanded of labor is 0 hours

    Are you deliberately trying to make LK’s blood boil by using “market clearing” to describe a plain state of rest where no transactions take place?

  5. Tel says:

    For example we can vaguely talk about economic calculation in a barter world, but you really need explicit money prices for true accounting to take place.

    Stock accounting is still perfectly valid accounting. For a long time stocks (both grain and livestock) formed the basis of all transactions, and all accounting. Half the clay tablets from Sumer (5000 BC) were stock accounts and tax evaluations. There’s at least some evidence that the origin of money started with stock tokens.

    I might also point out that even Robinson Crusoe benefits from making some effort to keep track of how much available food he has, and he also needs to balance immediate consumption against building infrastructure, stockpiles, etc. With some sort of accounting you can’t do economic calculation.

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