Positive Liberty

It did seem strange to me that, in a book on money and credit, I did not find the first real discussion of interest until near the end of the volume. As I noted in an earlier post of this series, interest was one of the ancient conundrums of money: How was it, Aristotle asked, that sterile lumps of metal should multiply like living things? (And shouldn’t we do something to stop them?)

Not one of the philosopher’s finer moments, I might say.

Near the start of chapter 19 of The Theory of Money and Credit, Mises writes,

Until now we have considered variations in the exchange ratio between money and consumption goods only and left out of account the exchange ratio between money and production goods. This procedure would seem to be justifiable, for the determination of the value of consumption goods is the primary process and that of the value of production goods is derived from it. Capital goods or production goods derive their value from the value of their prospective products; nevertheless, their value never reaches the full value of these prospective products, but as a rule remains somewhat below it. The margin by which the value of capital goods falls short of that of their expected products constitutes interest; its origin lies in the natural difference of value between present goods and future goods.

To which there is an interesting footnote…

The fact that I have followed the terminology and method of attack of Böhm-Bawerk’s theory of interest throughout this chapter does not imply that I am an adherent of that theory or am able to regard it as a satisfactory solution of the problem. But the present work does not afford scope for the exposition of my own views on the problem of interest; that must be reserved for a special study, which I hope will appear in the not too distant future. In such circumstances I have had no alternative but to develop my argument on the basis of Böhm-Bawerk’s theory. Böhm-Bawerk’s great achievement is the foundation of the work of all those who until now have dealt with the problem of interest since his time, and may well be the foundation of the work of those who will do so in the future. He was the first to clear the way that leads to understanding of the problem; he was the first to make it possible systematically to relate the problem of interest to that of the value of money.

Böhm-Bawerk’s theory, as I understand it, is that time preference dictates that interest will exist, and that variances in time preference explain variances in interest rates that individuals are willing to pay or offer: Consumers and entrepreneurs alike would generally rather have money now than later, but at some point they will more readily accept less-money-now rather than more-money-later. Lenders would of course prefer to receive more money for the time that their capital spends in being lent. These two tendencies, negotiated against one another according to the laws of supply and demand, together establish a rate of interest. In Human Action, Mises gives a striking thought experiment to demonstrate this proposition:

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 to be 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.

Because, after all, a piece of land has an infinite potential to satisfy those wants that land can satisfy — an infinite potential, albeit spread evenly across all of future time. If we do not discount its future satisfaction, then the value of a piece of land is infinite when compared to all other economic goods.

The time preference theory of interest seems like a good start to my mind, with two caveats: First, I don’t yet know how Böhm-Bawerk elaborated upon this explanation; all I have to go on are Mises’ critiques in The Theory of Money and Credit and Human Action, neither of which cites Böhm-Bawerk at any length. Second, I don’t know if Mises ever wrote the more complete treatment of interest that he promised. (I would certainly like to read it if he did, though I suspect I may have to get into later Austrians to read more, particularly Israel Kirzner.)

With that said, there are two things I see missing in the above observations on interest: First, I would think that there should be some account of the role of perceived risk in the setting of interest rates, and second, some notion of the opportunity cost of holding money over time.

Because the future is inherently risky, future goods are inherently less likely to be provided than present goods. A war, a natural disaster, a bankruptcy, or even just the death of the consumer may at any point make it impossible to enjoy future goods, and therefore the price of future goods, as opposed to present goods, will necessarily be less. This may seem more of an explanation of time preference than of interest, yet it is quite common in the lending market to discriminate based on the degree of perceived risk in a given loan.

Consider again Mises’ thought experiment about land in an economy where future goods were never discounted. To sever fully the market for land from all other markets, we would have to presuppose that all land was indestructible and that it could never lose its value to soil exhaustion, desertification, or any other environmental change. There could be no risk of the land sinking into the sea, nor of nuclear warfare rendering it uninhabitable, nor of the state seizing it through eminent domain (oddly, this would be an even greater calamity than in our own world, as in this world no amount of money can ever be sufficient to compensate for the undiscounted future value of a piece of land). Risk therefore seems necessary to any general theory of either time preference or interest.

As to the second addendum, there is a very real cost to holding money idly over time; during this time, it could easily be used to purchase something useful and durable — land, perhaps — that could later be turned back into money, either at a profit or at least with a net gain in satisfaction. In holding the money idle, you are giving up this benefit, which potentially someone else might take advantage of. This individual — a borrower — may approach you then, and offer you payments with interest in an effort to buy from you the difference in satisfaction.

Interest would therefore also seem to be a reflection of opportunity cost in some sense, though it is not clear to me how this relates to risk or to time preference, each of which seems like a viable and possibly independent explanation for some aspects of interest. (Personally, I’d always thought it was primarily a matter of opportunity cost, but the more I think about it lately, the more it seems complicated to me.)

So what role do these processes play in Austrian economics, if any? Or are they too psychological (or too technical?) for this school of thought, and thus too far removed from economics proper?

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