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Interest

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Interest is the ratio in the mutual valuation of present goods against future goods.[1]

History[edit]

On Mesopotamian clay tablets are recorded repayments of commodities that had been loaned. The lending system of ancient Babylon was evidently quite sophisticated. Debts were transferable, hence should be paid to the bearer rather than a named creditor. Clay receipts or drafts were issued to those who deposited grain or other commodities at royal palaces or temples. Borrowers were expected to pay interest (a concept which was probably derived from the natural increase of a herd of livestock), at rates that were often as high as 20 percent. Mathematical exercises from the reign of Hammurabi (1792-1750 BC) suggest that something like compound interest could be charged on long-term loans.

In the Middle Ages, lending money at interest was a sin for Christians. Usurers, people who lent money at interest, had been excommunicated by the Third Lateran Council in 1179. Even arguing that usury was not a sin had been condemned as heresy by the Council of Vienna in 1311-12. Christian usurers had to make restitution to the Church before they could be buried on hallowed ground. They were especially detested by the Franciscan and Dominican orders, founded in 1206 and 1216.

In medieval Venice, Jews had been providing commercial credit. They did their business in front of the building once known as the Banco Rosso, sitting behind their tables - their tavule - and on their benches, their banci. Jews, too, were not supposed to lend at interest. But there was a convenient get-out clause in the Old Testament book of Deuteronomy: 'Unto a stranger thou mayest lend upon usury; but unto thy brother thou shalt not lend upon usury.' In other words, a Jew might legitimately lend to a Christian, though not to another Jew. Jews had been expelled from Spain in 1492. They sought refuge in the Ottoman Empire and from its ports they then established trading relationships with Venice. At first the city's government was reluctant to accept them, but it soon became apparent that they might prove a useful source of money and financial services, since they could be taxed as well as borrowed from.[2]

Composition of interest[edit]

There are several theories regarding the composition of interest and from which sources interest is induced from. This surplus proceeds earned by investment in capital goods is sometimes referred to as originary, net, or natural interest.[3][4]

Productivity Theory of Interest[edit]

The productivity theory explains the interest or net return received by the investor of the capital stock by the productivity of the physical goods in question. E.g., using a $50 dolly might increase an individual's profits by $10 per year over the course of the dolly's maintainable lifespan of 20 years. This return of $200 is due to the physical productivity of the dolly, and that more inventory can be moved than without one.[5] Bohm-Bawerk distinguishes between two different types of productivity theories. One which infer from the physical productivity of capital that the phenomenon of surplus value is self-evidently and necessarily bound up with it. The other suppose surplus value immediately from the productive power. This latter being referred to commonly as 'the naive productivity theory'.[6]

Most economists critique such theories because they claim that they conflate the productivity of the capital with its value. In the example of the dolly, the fact that the dolly is physically productive does not immediately explain why the $50 value of the dolly is lower than the $200 accrued from it.[7][8]

Schumpeter's Theory of Interest[edit]

Schumpeter argued that in a circular-flow equilbrium, that the interest rate and thus originary interest was in fact zero. If output were decomposed into land, rent, and labor, and nothing to interest. This is because in long-run equilibriums, prices would be imputed back to their originary sources. E.g., the fact that a single grain of rice could later produce 10 grains of rice would be included as part of the present price of rice. Such a theory thus comes at direct odds with other theories such as the productivity theory of interest.[9] Indeed, Schumpeter insisted that in the long run, the interest rate would be zero; and that the positive rate of interest that we actually observe is actually due to disequilibrating elements.[10]

A common objection by critics of this theory is that it does not explain how is the capital stock maintained without interest (as Bastiat explained in his Parable of the Plane).[11] And that it does not explain the incentive given to save. The answer given by Schumpeter and others with similar theories, like Frank Knight or Proudhon, is to state that capital maintains itself permanently in the ERE. However, this is explained due to how Schumpeterians defined the value of the capital stock, since the value of capital is maintained by definition in the ERE. Critics, however, point that this theory leaves similar questions remaining.[12][13]

Pure Time Preference Theory[edit]

According to Pure Time Preference Theory (PTPT) originary interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remoter periods of the future. It manifests itself in the discount of future goods against present goods. It is a ratio of prices, not a price in itself. There prevails a tendency toward the equalization of this ratio for all commodities. In the imaginary construction of the evenly rotating economy, the rate of originary interest is the same for all commodities. [1]

The granting of credit is necessarily always an entrepreneurial speculation which can result in failure and the loss of a part or of the total amount lent. Every interest stipulated and paid in loans includes not only originary interest but also entrepreneurial profit.[14]

The purchasing power of money can change and so affect credit contract. A price premium can be introduced to amend this problem. It can be negative when it reflects an anticipated rise in the purchasing power of money, i.e., a drop in prices, and positive when it reflects an anticipated drop in the purchasing power of money, i.e., a rise in prices, as is frequently the case when inflation is anticipated.

However, in a changing economy, there is no uniform rate of originary interest; there only prevails a tendency toward the establishment of such uniformity. Before the final state of originary interest is attained, new changes in the data emerge which divert anew the movement of interest rates toward a new final state. Where everything is unceasingly in flux, no neutral rate of interest can be established.

In the world of reality all prices are fluctuating and acting men are forced to take full account of these changes. Entrepreneurs embark upon business ventures and capitalists change their investments only because they anticipate such changes and want to profit from them. The market economy is essentially characterized as a social system in which there prevails an incessant urge toward improvement. The most provident and enterprising individuals are driven to earn profit by readjusting again and again the arrangement of production activities so as to fill in the best possible way the needs of the consumers, both those needs of which the consumers themselves are already aware and those latent needs of the satisfaction of which they have not yet thought themselves. These speculative ventures of the promoters revolutionize afresh each day the structure of prices and thereby also the height of the gross market rate of interest. [15]

Zero interest[edit]

Originary interest is a category of human action (although some economists like Bohm-Bawerk and Fetter considered this to be an empirical fact as opposed to an apodictic one[16]). It is operative in any valuation of external things and can never disappear. If one day people started to believe like at the close of the first millennium of the Christian era, that the ultimate end of all earthly things was impending, men would stop providing for future secular wants. The factors of production would in their eyes become useless and worthless. The discount of future goods as against present goods would not vanish. It would, on the contrary, increase beyond all measure.

On the other hand, the fading away of originary interest would mean that people do not care at all for want-satisfaction in nearer periods of the future. It would mean that they prefer to an apple available today, tomorrow, in one year or in ten years, two apples available in a thousand or ten thousand years. We cannot even think of a world in which originary interest would not exist as an inexorable element in every kind of action. Whether there is or is not division of labor and social cooperation and whether society is organized on the basis of private or of public control of the means of production, originary interest is always present. In a socialist commonwealth its role would not differ from that in the market economy.

As long as the world is not transformed into a land of Cockaigne, men are faced with scarcity and must act and economize; they are forced to choose between satisfaction in nearer and in remoter periods of the future because neither for the former nor for the latter can full contentment be attained.

There are always goods the procurement of which we must forego because the way that leads to their production is too long and would prevent us from satisfying more urgent needs. The fact that we do not provide more amply for the future is the outcome of a weighing of satisfaction in nearer periods of the future against satisfaction in remoter periods of the future. The ratio which is the outcome of this valuation is originary interest.[1]

Interest is not a price[edit]

Originary interest is not a price determined on the market by the interplay of the demand for and the supply of capital goods. Its height does not depend on the extent of this demand and supply. It is rather the rate of originary interest that determines both the demand for and the supply of capital and capital goods. It determines how much of the available supply of goods is to be devoted to consumption in the immediate future and how much to provision for remoter periods of the future.

People do not save and accumulate capital because there is interest. Interest is neither the impetus to saving nor the reward or the compensation granted for abstaining from immediate consumption. It is the ratio in the mutual valuation of present goods as against future goods.

The loan market does not determine the rate of interest. It adjusts the rate of interest on loans to the rate of originary interest as manifested in the discount of future goods.

Originary interest is not "the price paid for the services of capital." The higher productivity of more time-consuming, roundabout methods of production, which is referred to by Böhm-Bawerk and by some later economists in the explanation of interest, does not explain the phenomenon. It is, on the contrary, the phenomenon of originary interest that explains why less time-consuming methods of production are resorted to in spite of the fact that more time-consuming methods would render a higher output per unit of input.[1]

Interest and Land[edit]

The phenomenon of originary interest also explains why pieces of usable land can be sold and bought at finite prices. If the future services which a piece of land can render were to be valued in the same way in which its present services are valued, no finite price would be high enough to impel its owner to sell it. Land could neither be bought nor sold against definite amounts of money, nor bartered against goods which can render only a finite number of services. Pieces of land would be bartered only against other pieces of land. A superstructure that can yield during a period of ten years an annual revenue of one hundred dollars would be priced (apart from the soil on which it is built) at the beginning of this period at one thousand dollars, at the beginning of the second year at nine hundred dollars, and so on.[1]

Pattern Coordination and the Liquidity Theory of Interest[edit]

The liquidity theory of interest argues that interest has its origins as the variable preference for liquidity. This means whereas PTPT says that interest is a priori positive due to the preference for present goods over future ones, liquidity theory argues that negative interest rates are possible due to individuals prefering to hold liquid assets such as money as a means of reducing risk.[17]

Some Austrians such as Robert Murphy argue that the PTPT assumes stationary and non-dynamic economy. Saying that a positive interest rate is simply the price for present money over future money. He argues that labeling this as 'time preference' is confusing and unnecessary, and that a theory of interest shouldn't divorce itself from money entirely. Likewise a similar 'pure size preference theory' could be constructed. Where a consumer preferring bigger goods to smallers ones can be proven since, ceteris parabus, if a consumer did not prefer a good to half of it, then he wouldn't prefer it to a quarter, and so on. And pure size preference explains the correlation between prices of T.V., planes, computers, etc., and counterexamples are comparisons of different goods (in much the same way that PTPT would talk about 'ice cream in summer').[18][19]

While the liquidity theory of interest has its origins with Keynes, some Austrian economists like Lucas Engelhardt claim that PTPT implies the liquidity theory of interest. They argue that if money is a present good, and if interest is a price of present goods over future goods, then there should be no contradiction between the two theories.[20]

The Means-Ends Theory of Interest[edit]

Hulsmann argues against the PTPT, claiming that it and its corresponding ERE model used to explain it are self-contradictory. He still maintains a theory of positive interest, however, by instead using a teleologically based theory. He argues that originary interest stems from a value relationship between means and ends, claiming that means of action are less valuable than the ends desired or served. And, thus there is a value spread between means and ends, and that this is what is originary interest. Such a theory thereby derives many similar consequences as PTPT.[21][22]

More recent authors have claimed that both Hulsmann's theory and the liquidity theorists above confuse the related terms in the debate around PTPT.[23]

See Also[edit]

References[edit]

  1. 1.0 1.1 1.2 1.3 1.4 Ludwig von Mises. "XIX. INTEREST: Originary Interest", Human Action, online version, referenced 2010-05-11.
  2. Niall Ferguson. The Ascent of Money, Chapter 1, p. 31, 35-37. Published 2008, ISBN 9780141035482. Referenced 2012-06-08.
  3. Bohm-Bawerk (1890). Capital and Interest (pp.7). London: Macmillon & Co..
  4. Murphy, Robert. 'Unanticipated Intertemporal Change In Theories Of Interest' (pp.4). Ph.D. New York University, 2003.
  5. Murphy, Robert. 'Unanticipated Intertemporal Change In Theories Of Interest' (pp.2). Ph.D. New York University, 2003.
  6. Bohm-Bawerk (1890). Capital and Interest (pp.118). London: Macmillon & Co..
  7. Murphy, Robert. 'Unanticipated Intertemporal Change In Theories Of Interest' (pp.2). Ph.D. New York University, 2003.
  8. Bohm-Bawerk (1890). Capital and Interest (pp.140). London: Macmillon & Co..
  9. Herbener, Jeffrey. The Pure Time-Preference Theory of Interest. p.108
  10. Herbener, Jeffrey. The Pure Time-Preference Theory of Interest. p.163
  11. Bastiat, Frederic (1874). Essays on Political Economy by the Late M. Frederic Bastiat. New York: G. P. Putnam’s Sons, and London: Provost
  12. Murray Rothbard (2009). Man, Economy, and State (Chapter 6, Section 11, p.450). Auburn: Ludwig von Mises Institute.
  13. Hülsmann, Jörg Guido. Further Considerations in the Theory of Interest. Retrieved from https://www.youtube.com/watch?v=yUbh5KNbXpk
  14. Ludwig von Mises. "XIX. INTEREST: Originary Interest in the Changing Economy", Human Action, online version, referenced 2010-05-11.
  15. Ludwig von Mises. "3. The Price Premium as a Component of the Gross Market Rate of Interest", Human Action, online version, referenced 2010-05-11.
  16. Herbener, Jeffrey. The Pure Time-Preference Theory of Interest. p.22
  17. Hutt, W.H.. The Yield from Money Held. [1].
  18. Murphy, Robert. Unanticipated Intertemporal Change in Theories of Interest. Dissertation. New York University, May 2003. [2]
  19. Murphy, Robert. Pattern Coordination and the Theory of Interest. F. A. Hayek Memorial Lecture at the 2010 Austrian Scholars Conference. Held at the Mises Institute, Auburn, Alabama, March 11-13, 2010.
  20. Engelhardt, Lucas. An Attempt at Reconciliation of Time Preference Theory of Interest and Liquidity Preference Theory of Interest. Austrian Economics Research Conference. Recorded 23 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama. [3]
  21. Hülsmann, Jörg Guido. A Theory of Interest. QJAE Volume 5, No. 4 (Winter 2002).[4]
  22. Hülsmann, Jörg Guido. Further Considerations in the Theory of Interest. Ludwig von Mises Institute's 2010 Mises University conference, held at the Mises Institute in Auburn, Alabama; July 25-31, 2010.[5]
  23. Herbener, Jeffrey. The Pure Time Preference Theory of Interest. pp. 55--56. [6]

Bibliography[edit]

  • 1986, Ingo Pellengahr, "Austrians Versus Austrians II, Functionalist Versus Essentialist Theories of Interest", In: Malte Faber, dir., Studies in Austrian Capital Theory, Investment and Time. Berlin: Springer-Verlag
  • 1996, Ingo Pellengahr, The Austrian Subjectivist Theory of Interest: An Investigation into the History of Thought, Frankfurt/M., Berlin, Bern, New York, Paris, Wien


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