Mises And Interest Rates

[Jimbean]

I am currently studying Ludwig Von Mises, and I was reading his book, “The Theory of Money and Credit.” Something I do not understand about the so-called demand for money and the rate of interest is how the interest rate changes when the supply of money is constant. I would also appreciate it if someone explained how interest rates affect saving and investing.

I’m coming from a mainstream perspective and I am having trouble with classical economics. If someone can give me a clear explanation, that would be great. Thanks in advance.

[jrs]

It has been decades since I studied economics. So take my answers with a grain of salt.

Something I do not understand about the so-called demand for money and the rate of interest is how the interest rate changes when the supply of money is constant.

An interest rate is the result of an agreement between a lender and a borrower. It is affected by several factors, including: the expected rate of inflation or deflation (change in the purchasing power of money); the expected risk that the borrower will default in whole or in part; the expected risk that the lender will encounter a need for the money before it is paid back; the duration of the loan; the way the payments are structured over time; and especially the time preferences of the borrower and the lender.

When considering the economy as a whole, most of the variations in these factors will average out. However, the inflationary expectations can and often do change under our current system. Even if the quantity of money were fixed, changes in the rate of economic growth would change the rate of deflation of prices.

And the time preferences of people could change due to: natural disasters which create an immediate need for resources just to survive (hence higher interest rates); or, in good conditions, a saturation of investment opportunities (hence lower rates); or a cultural change which affects people's feelings about the relative value of the future compared to the present.

I would also appreciate it if someone explained how interest rates affect saving and investing.

If the rate of interest increases, then people will be more inclined to lend money to get that interest. So savings will increase. On the other hand, people who were considering borrowing money to build a business (or for any other reason) will be discouraged. So investment will decrease.

Conversely, if the rate of interest decreases, then savings will decrease and investment will increase.

[softwareNerd]

I'm not an expert, but since you've only received one reply, I'll present my layman's reading of Mises' interest rate theory:

Real "Originary" Interest vs. Nominal Interest: As jrs pointed out, the rate that one actually pays "contains" multiple components: an amount for inflation, for borrower risk, perhaps for currency risk...and... a kernel of "real" interest. This idea is not unique to the Austrian theory.

Determinant of Originary Interest Rate: The differences among the schools come in their explanation of how the original interest comes about -- what determines it. For instance, some theories say that the rate is determined by the demand and supply of "loanable funds". Mises says that the originary rate of interest is a reflection of time-preference. By this theory, the rate of interest does not cause people to save; instead, the causation works the other way round. According to this theory, the originary rate of interest is simply the ratio of the value of future and current goods (qua their "futureness" or "currentness").

So, a 2% originary rate of interest means that consumption this year is valued (approx.) 2% more than consumption next year. If people are not that keen on current consumption, and want to save, then the interest rate might be only 1%, because they place less value on the currency of consumption.

I know I cannot do justice to the original. The complete text of "Human Action" is available online. Check out chapter XIX - "Interest".

[Aureus]

If the rate of interest increases, then people will be more inclined to lend money to get that interest. So savings will increase. On the other hand, people who were considering borrowing money to build a business (or for any other reason) will be discouraged. So investment will decrease. Conversely, if the rate of interest decreases, then savings will decrease and investment will increase.

If the aggregate time preference (the interest rate) is increasing, then the aggregate proportion of consumption to saving is also increasing. A rising rate of interest doesn't mean that people are becoming more inclined to save: it means that people are becoming more inclined to consume and less inclined to save. It must also be remembered that savings earn interest, i.e., savings not only fund investment, savings are also a form of investment. Therefore, if the aggregate time preference (the interest rate) is decreasing, then the aggregate proportion of consumption to both saving and investment is also decreasing.

Another important point to note it that we have been speaking about a free market economy. America does not have a free market economy, much less a free market in money. Economic central planners and powerful political forces manipulate free market interest rates to achieve nationalist-collectivist ends, i.e., "the greatest good for the greatest nation."

[jrs]

I would also appreciate it if someone explained how interest rates affect saving and investing.

If the rate of interest increases, then people will be more inclined to lend money to get that interest. So savings will increase.

A rising rate of interest doesn't mean that people are becoming more inclined to save: it means that people are becoming more inclined to consume and less inclined to save.

By asking how interest rates AFFECT savings, Jimbean is asking about causation from interest rates to savings. While also true, your statement reverses the direction of causation -- you are answering about causation from savings to interest rates. This is a different question. There is a negative feed-back loop here.

Interest is a price -- the price of using the principal for a period of time. As with other prices, it changes to bring supply (lending) and demand (borrowing) into balance. But the supply and demand also depend on other factors.

... savings are also a form of investment.

I assumed that Jimbean was using the words as follows:

Saving is a private entity lending money or buying equity, i.e. parting with money for a period of time in order to get interest or dividends.

Investment is a private entity borrowing money or selling shares for the purpose of building its business: buying raw materials; paying workers; renting a plant; buying or renting tools; paying shipping costs; etc.. The hope is that it will make enough from selling its products and services to repay the borrowed money with interest and have a profit left over.

With these definitions, saving is not a form of investment.

Nor are they necessarily equal in amount, contrary to what some people say. Money could be borrowed for consumption which is not investment. And the government can either borrow or lend money and so unbalance the equation further.

[softwareNerd]

Interest is a price -- the price of using the principal for a period of time. As with other prices, it changes to bring supply (lending) and demand (borrowing) into balance. But the supply and demand also depend on other factors.

This is not Mises's view. I do not know enough to defend one view or the other, but Mises was very specific that interest was not the result of an interplay of demand and supply. He was also specific that interest is not just the payment to capital.

Originary interest is not a price determined on the market by the interplay of the demand for and the supply of capital or 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.

Since the original question was specific about Mises's theory, rather than about what the correct theory ought to be, I wanted to clarify what Mises said.

[Aureus]

By asking how interest rates AFFECT savings, Jimbean is asking about causation from interest rates to savings. While also true, your statement reverses the direction of causation -- you are answering about causation from savings to interest rates. This is a different question. There is a negative feed-back loop here.

In an unhampered market, interest rates do not affect time preference (the consumption-saving proportion), they measure it. Changes in the interest rate are not the cause but the effect of changes in time preference. Confusion arises when economic central planners intervene to alter the free market rate of interest in order to "stimulate" economic behavior that serves nationalist-collectivist-statist ends.

Perhaps we would do better to consider how our government's artificially low interest rates have affected savings.

Here is a graphic example:

There is simply no other choice than this: either to abstain from interference in the free play of the market, or to delegate the entire management of production and distribution to the government. Either capitalism or socialism: there exists no middle way.

~ Ludwig von Mises

[softwareNerd]

Aureus, By what basis do you conclude that U.S. interest rates are too low -- i.e. lower than they would be if the government was not interfering?

[donnywithana]

Another thing that's important to note is that money supply alone doesn't determine interest rates in an unregulated economy.

Try this. Draw some first quadrant axis and label the X axis "Q" for Quantity, and the Y axis "i" for Nominal Interest Rate.

Draw a diagonal line going from the bottom left to the top right and label this "M" for Money Supply. As (i) increases, banks will be more likely to offer riskier loans, because the return will be higher for them. Therefore, the supply of money will increase as interest rates rise.

Draw a diagonal line going from the top left to the bottom right. Label this one "D" for Demand. As (i) increases, consumers will demand less money from banks, because their return will be lower. Therefore the demand for money will decrease as interest rates rise.

The point where the demand for money equals the supply of money is the point of equilibrium.

Now your question is how the interest rate changes with the supply of money held constant. In an unregulated economy, the interest rate is determined by the equilibrium point of this graph. If we hold (M) constant and shift (D) then we can change the interest rate. How does this happen?

Well, for one example let's look at Price Level (or "P" for short). If (P) rises, and (i) stays the same, then "r," the Real Interest Rate, is going to drop. This is because it will cost less, in terms of real value, to take out a loan at the same interest rate. Therefore, if (P) rises, then the entire (D) curve is going to shift right, because at every given (i), people will demand more money. The inverse is also true.

When (D) shifts right, and (M) stays the same, the point of equilibrium moves to a higher (i) and (Q). This means that if people demand more money, then more money will be put into the economy, but the price of that money is going to rise in the form of interest rates. There are many other things that can affect the relationship between (D) and (M), but I think you can probably see the basics at this point. Hope that helps!

[softwareNerd]

Once again, that is the theory of interest rate as a price. It could be the price of "money" or the price of "loanable funds". However, that is not von Mises view.

[Aureus]

Aureus, By what basis do you conclude that U.S. interest rates are too low -- i.e. lower than they would be if the government was not interfering?

In order to "stimulate" consumer spending, government forces interest rates to artificially low levels by means of inflating the supply of money and credit. The fact that it took only $0.41 in 1980 to purchase a dollar's worth of goods in 2005 is a big indication that interest rates have been kept too low. The dollar has lost approximately 60% of its purchasing power over the last 25 years, and 5% of its value in just the last year alone. No wonder people aren't saving as they once did.

[softwareNerd]

Aureus, When you speak of interest rates, I gather you are speaking of the nominal rates, right?

Just to be clear are you saying that inflation causes low interest nominal rates, or that low nominal interest rates cause inflation?

If the former, do countries with the most inflation also have the lowest interest rates?

[Aureus]

Just to be clear are you saying that inflation causes low interest nominal rates, or that low nominal interest rates cause inflation? If the former, do countries with the most inflation also have the lowest interest rates?

Monetary inflation causes the rate of savings to fall and the prices of goods and services to rise. However, a fall in the savings rate or a rise in commodity prices will not necessarily cause government to engage in legalized counterfeiting.

In answer to your question, the country with the lowest aggregate time-preference (consumption/investment ratio) is the country with the lowest natural rate of interest. An interventionist country with a higher time-preference could artificially lower its interest rate by means of engaging in the immoral and deceptive practice of monetary inflation, but once higher prices make their appearance due to more fiat money chasing fewer goods and services, interest rates begin to climb because the purchase of present goods becomes increasingly more attractive than the purchase of future goods in terms of fiat money. The choice of government then becomes one between laissez faire or further interventionism in the form of more monetary inflation, or perhaps even price controls.

"Laissez faire, laissez passer does not mean: let the evils last. On the contrary, it means: do not interfere with the operation of the market because such interference must necessarily restrict output and make people poorer."

~ Ludwig von Mises

[softwareNerd]

Thanks for the clarification.

... but once higher prices make their appearance due to more fiat money chasing fewer goods and services, interest rates begin to climb because the purchase of present goods becomes increasingly more attractive than the purchase of future goods in terms of fiat money...

I have an additional question. The US has been inflating for decades. So, wouldn't one expect US interest rates to have risen above their natural rate rather than still be below that rate? Or, are you saying that interest rates are lower currently (than say the 70's) because people are misjudging the height of future prices?

[Aureus]

Since the corrupt and misguided rejection of the gold standard by governments and their central banks, the U.S. Government can inflate its currency far beyond levels that would destroy the monetary unit of other countries because of the sheer size and privileged position enjoyed by the U.S. dollar as the world's primary reserve currency.

An interesting article appeared yesterday by Texas Congressman Ron Paul on the subject of rising gold prices.

[donnywithana]

A big cause of inflation is the nature of government spending as well. The government doesn't tend to operate on a for-profit basis, and therefore is simply throwing its money away with no hope of return. The plus side is that the government very sneakily tends to use deflationary operations to raise the value of the dollar right before large expenditure so that they don't actually end up paying as much as they should, but it still doesn't make it right that I should be forced to give my money to someone else for nothing I've hired them to do for me.