11. Interest

Interest is a rather controversial topic. While there are many critics hardly anyone makes the effort of understanding what interest is. Interestingly enough, interest is not purely a monetary phenomenon but goes beyond and is more fundamental to human action.

11. Interest
Monetary graph
List of contents
Pecunia pecuniam non parit

Pecunia pecuniam non parit

Aristotle already criticized that money would not give birth to money. Like many others after him, the great Greek philosopher concluded: An increase of money through the means of applying money itself can only indicate a state of injustice. The criticism against interest is thus ancient and has always been a constant companion of mankind. In addition to philosophers, the interest rate had also fallen out of favor with spiritual authorities early on. They, too, sensed some sort of injustice and the unjustified exploitation of states of emergency. Interestingly, criticisms against interest rates have persisted to this present day. In addition to the argument of injustice and interest bondage, the main criticism today is that interest demands eternal economic growth that is needed in order to continuously service interest and compound interest.

Criticizing the Critics

Criticizing the Critics

Nothing is more valuable than constructive criticism. However, historical and contemporary criticism of interest rates is united by one thing above all: a moralizing tone. However, moralizing criticism often has the following shortcomings: those who do not understand the issue at hand reach for the moral cudgel. From moral high ground, the unpleasant and undesirable is chastised. This is humanly comprehensible, but knowledge and understanding of the matter fall by the wayside. A first important insight concerning the understanding of the phenomenon of interest is that money itself does not give birth to money. Only what of it is "bound up" into a productive capital structure increases prosperity and earns interest. It was the Dominican theologian Antoninus of Florence who recognized that true capital, that is, money, is in goods; Pecunia in mercatoribus verum capitale. Therefore, money productively used in commercial transactions is true capital.

What is Interest?

What is Interest?

Interest is commonly associated with financial transactions. A look at the real world, however, suggests that "interest" also occurs independently of money and economic exchange. This is striking: There are valuation differences that are related to the factor of time. Thus the interest embodies, in the long run, the exchange in time, and time can be exchanged even with oneself. As such, time is a fact of life. Every human being is inevitably subordinated to it, which is why an evaluation of time by man has to take place constantly. Even if one believes not to evaluate time consciously, also the apparent non-evaluation of time is a subconscious evaluation.

Time Preference

Time Preference

Valuations are ultimately an expression of preferences and a valuation of time is thus an expression of individual time preference. Thus, those who prefer time have a high time preference. The focus is on the temporally close. The decisive factor is when you get something (better sooner than later) and not how much you get of it. Those who have a low time preference, on the other hand, signal a greater willingness to postpone immediate benefits in the hope of having more at their disposal in the future. The time preferences that differ from person to person therefore decide on existing savings. The important thing is that savings are not made because there is interest accruing on them. The interest is not the cause of saving, but the value ratio, which emerges in saving and determines the extent of saving. Savings are thus an expression of individual time preferences and interest is in turn an expression of valuation differences over time.

Uncertainty

Uncertainty

But why do we humans value time differently? One answer lies in the fact that the present is closer to us than the future. Thus the present seems to impose itself on us through our senses, while we have to consciously decide for the future. Those who do without today hope to get more in the future. However, the "more" is not certain, since the future and thus the time until the future is realized is uncertain. The present is always more certain than the future. Not only do we know not what the future will look like, but we know that it is impossible to know it at all. Therefore we humans value present goods higher than future goods. Thus the human time preference rate is positive. So in the end interest rates represent the difference in value between present and future goods. Or formulated differently: The interest rate is the share of present goods expressed in future goods.

Interest as an Economic Phenomenon

Interest as an Economic Phenomenon

Preferences and thus also time preferences of acting individuals are ultimately translated into economic structures. One speaks of market interest rates, and these arise through the interaction of market actors in capital or financial markets. The respective market interest rates reflect the current price on the markets for those goods that are currently available and that people are willing to forego for the promise of future goods. A market interest rate results from the following concrete components: -Original interest rate -Risk premium -Purchase premium -Terms of Trade Premium

Business Cycle

Business Cycle

Market interest rates are a dynamic phenomenon. If people's time preference or their assessment of the other components changes, this leads to adjustments in the economic structure. The price of money is subject to continuous change, since entrepreneurs, savers, and consumers are caught up by uncertainty and made errors are uncovered by these very market actors. An up and down of the economy is thus inevitable. But what about crises that affect the entire economy? Keynesian theory in particular considers them to be a natural phenomenon and attributes them to the irrationality of market players. So-called "animal spirits" lead to cyclical fluctuations and involuntary unemployment.

Artificial Lowering of Interest Rates

Artificial Lowering of Interest Rates

Similar to the critique of interest rates, Keynesian explanation of the business cycle appears too moralizing and simplifying. One has to ask the question: Do economic crises perhaps have systemic causes? One explanation focuses on interest rate distortions. For example, the open market operations that have always been common practice have an influence on market interest rates. In the majority of cases, central banks buy securities, thereby increasing the base money supply and thus lowering interest rates. Open market operations set distorting signals since bonds and interest rates correlate inversely: Investors speculate that they can sell bonds at higher prices to central banks in order to arbitrage between short- and long-term bonds, a practice commonly called front-running. As a result, interest rates have been in free fall over a long time period.

Effects on the Real Economy

Effects on the Real Economy

Artificially low-interest rates have an impact on market participants in the real economy. They signal to companies and producers that consumers are prepared to wait longer for more and better goods and services to be made available. But the time preference of customers does not necessarily have to be lower. The level of consumption is not declining - rather the opposite is the case because the lowered interest rate makes saving less worthwhile. Time preference rate and interest rate gape apart. Artificial interest rate cuts distort the interest rate signal, resulting in malinvestment and misallocation of capital - the greater the interest rate distortion, the greater the misallocation. Capital is consumed or even destroyed, but as long as interest rates do not rise and new liquidity is constantly being generated, the excess misallocations remain, to a great extent, undetected.

Glut of Capital and Interest Rate Manipulations

Glut of Capital and Interest Rate Manipulations

Nevertheless, interest rate interventions by central banks are a fact. Nevertheless, the argument that ever-lower interest rates are driven by the market and thus correspond to the natural course of human history holds good. A glut of savings, a low time preference or ever greater confidence in market participants and the economy are parameters that can influence interest rate cuts. That these factors are effective today cannot be excluded. However, falling interest rates are not just an expression of changing preferences, greater thrift or greater trust. Today, ever lower interest rates are also the result of continuous interest rate interventions, which cause central banks to manipulate interest rates even further downwards with every incipient market correction.

Distorted Blood Circulation

Distorted Blood Circulation

If interest rates are manipulated centrally, they can no longer fulfill their coordinating function of production in time and instead take on a misleading role. This leads to misallocation of capital and ultimately to an increasingly bypassing of the preferences of consumers and economic actors. Market interest rates are for an economic area what the blood circulation is for a human being: essential. Just as a distortion of the blood circulation of a human being leads to symptoms of illness, an economy suffers when market interest rates are distorted. Constantly falling interest rates only intensify these distortions even more. With every drop in interest rates, new marginal projects become "profitable". Economic competition is artificially stimulated, while productive and growth forces within the economy weaken.

Zero to Negative Interest Rate

Zero to Negative Interest Rate

Once a central bank has tasted the sweet poison of interest rate intervention, there is hardly any way back. Apart from a few entertaining attempts to increase interest rates, interest rates have now fallen to zero or even below zero. The phenomenon of negative interest rates, which have even become reality, reinforce the consumption of capital or make it appear as unvarnished destruction of capital. The world of zero interest rates is ultimately a world that stands on its head. It is a world in which the arrow of time runs upside down, i.e. backward. In the negative interest rate, the present is more valuable than the future, so the now seems more desirable than the tomorrow. This can by no means be a sustainable world. So while central banks have apparently fallen into the zero interest rate trap, economic and market players find themselves in an ever faster spinning hamster wheel. In addition to distorting effects on the economy and economic culture, manipulated interest rates also have largely misunderstood but devastating consequences for society and politics.

From risk-free Interest to Interest-free Risk

From risk-free Interest to Interest-free Risk

And finally, the negative interest rate makes work and the activity of the entrepreneur as well as that of the investor more and more difficult and burdensome. The important instrument for discounting expected future investment returns is completely taken ad absurdum. If the interest rate is negative, the cash values go into infinity, reasonable discounting becomes impossible. Entrepreneurs and investors are in the dark when it comes to intertemporal planning. They make mistakes that they would otherwise be less likely to make. Assets and goods of all kinds are wrongly priced and will inevitably be priced correctly again by the market at intervals. This implies shock-like volatility. Those who suffer are not only the entrepreneurs though, but society as a whole.