Theories of Interest: Understanding Capitalist Savings and Monetary Policy

ENTREPRENEURIAL ECONOMICSTime and Interest Prof. Dr. Stefan Kooths UE, Campus BerlinSummer term 2019 www.kooths.de/bits-ti

Outline • Introduction and overview • Theories of interest in retrospect • Böhm-Bawerk’s three causes • Pure Time-Preference Theory (Agio theory) • Capitalist savings, interest, and production structures • Market interest rates and monetary policy

Reading • Herbener, J. M. [Ed.] (2011): The Pure Time-Preference Theory of Interest. Ludwig von Mises Institute: Auburn/Alabama. • Kirzner, I. M. (2010): Essays on Capital and Interest – An Austrian Perspective. Liberty Fund: Indianapolis. • Essays on Capital and Interest (1966), Edward Elgar: Cheltenham et al. • Rothbard, M. N. (2009): Man, Economy, and State with Power and Market. 2nd Edition (Scholar’s Edition), Ludwig von Mises Institute: Auburn/Alabama. • Skousen, M. (2015): The Structure of Production. New revised edition, New York University Press.

Eugen v. Böhm-Bawerk • Capital and Interest - A Critical History of Economical Theory (1890, Vol. I) • German version (1884) • The Positive Theory of Capital (1891, Vol. II) • German version (1888) • Recent Literature on Interest (1903, Vol. III) • German version (1900) Eugen v. Böhm-Bawerk (1851-1914)

DEBATE • What is interest?

What to explain • The phenomenon of an income flowing constantly from all • kinds of capital, without personal exertion of the owner (Böhm-Bawerk I, p. 1)

BUT: Beware of mixing ERE with reality • Year 0: Capital of 1 cent, saved for eternity (including all incomes) • Year 2019 • Interest rate of 1 percent  5.3 million Euro • Interest rate of 2 percent  2,310,717.1 billion Euro • Interest rate of 3 percent  8.28622E+14 billion Euro • There is nothing automatic in generating interest, human action matters

What interest IS NOT • Interest is not the price of money.

Conventional/business view

Praxeological (pre-)view • Interest as an economic phenomenon(nature of interest) • Interest reflects a price relation: Discount of future goods as against present goods(price of time)

Pure (originary) interest vs. market interest rates • Market interest rates • Pure interest • Risk premium • Inflation premium

Real vs. nominal interest rates r Real interest rate  Inflation rate i Nominal interest rate

Term structure of interest rates (yield curve) • Term = time to maturity(contract length)

Interconnection between long-term interest rates and expected short-term rates time t0 t1 t2 t3 t4

: Discounting and present value (r = 5 %) cash flows 100 100 100 100 time t0 t1 t2 t3 t4

Formula for present value of an annuity

Present value of a perpetuity (= eternal rent)

Present value = price of assets • Inverse relationship between interest rate and asset prices(assets = stream of future payments) • r  AP  • r   AP  The longer the lifespan of the asset, the stronger is the impact of r on AP

Early opposition against interest • Ancient philosophers (Aristotle, Plato) • Condemned usury  Interpreted as general disapproval of interest • Aristotle's argument, that money does not breed: On this account it is inadmissible and unfair to take anything over and above the lent sum for the use of the same, since this is not so much taken from money, which brings forth no fruit, as from the industry of another. • Similar statements can be found in great number in ancient sources • Roman empire • Less stricture, interest as a commonly accepted part of the business world • Regulations (Codex Iustinianus, AD 528) • The intellectual opposition however persisted

Middle ages • The Aristotelian position adopted by the Church (prohibition of interest) • Up until the 14th century • Absolute power of the Church • Hardly any defenders of interest • Widespread opposition against interest on loans, but not against interest on capital and land • Strongest enemy against the canonist position: Business reality • Reformers • Criticizing misinterpretation of the Bible by the Church • Luther or Zwingli plead for tolerance in the case of usury • Calvin justified the taking of interest

Calvin, Molinaeus, Smith • What should be outlawed is not interest in general but only those forms of usury that violate the laws of brotherly love • Molinaeus (1546) • Shows that in each loan some “interesse" of the creditor comes into existence, either as injury caused or as use foregone • Experience demonstrates that capital sums do bear fruit • A credit contract must be analyzed in a greater context than just the initial and final transaction As something can everywhere be made by the use of money,something ought everywhere to be paid for the use of it. (Adam Smith)

Enlightenment/Classics • Interest on loans as a special case of interest on capital • There is loan interest because there is originary interest. • This is “The driving back of an advanced post on the main army” (BB1, p.59) • No search for explanation of originary interest • Unawareness of the phenomenon of originary interest • Importance of capitalists yet too small to trigger a discussion • Systematic approach to economics still in its infancy • Locke, Law, Hume, James Steuart, Justi, Sonnenfels (and others) • Loan interest is bound to emerge from the possibility of making a profit … • … but none of them asks where that profit comes from

Turgot’s fructification theory • First scientific approach to explain interest • Essence of physiocratic reasoning:Land provides the owner with a constant stream of goods • Land can be exchanged against money and other goods • Any form of capital is equivalent to some piece of land • No capitalist would lend money without interest since he could always buy land that yields a positive return • The borrower, in turn, can pay interest since he is invested in land • Without interest on capital all forms of industry would be abandoned for agriculture • Circular reasoning: Finite price of land implies discounting (i.e., interest)

Adam Smith • No distinctive theory of interest • There must be a profit from capital, because otherwise the capitalist would have no interest in spending his capital in the productive employment of laborers • Schumpeter argues that he might have considered the interest problem as solved • Conflicting versions of profit theory • Customers pay an excess amount over the cost of production  Profit and interest as value added • Workers are not paid the full amount of the value that they contribute to production Room for profit and interest (exploitation?) • Neutral/ambiguous position on the phenomenon of interest …… but germs of later theories

Böhm-Bawerk’s classification of theories (BB1, pp. 78 f.) • Colorless theories • Productivity theories • Naïve theories • Motivated theories • Abstinence theories • Labor theories • Exploitation theories • Eclectic theories

Böhm-Bawerk’s classification of theories (BB1, pp. 78 f.) • Colorless theories Basically draw on Smith and Turgot without much elaboration or further thought • Productivity theories Capital as a production factor that produces a surplus • Naïve theories • Motivated theories • Abstinence theories Interest as a compensation for abstaining from consumption (= premium for waiting) • Labor theories Interest as a compensation for the (managerial) work of the capitalist • Exploitation theories Interest corresponds to no surplus whatever but constitutes a curtailment of the just wages of workers • Eclectic theories Combination of some of the other theories

The meaning of productivity (BB1, p. 112 ff.) • Weak sense: Capital is used in production processes • Stronger sense: The use of capital allows to increase production • Physical/volume productivity: Capital allows to produce more goods or goods of higher quality • Value productivity: Capital allows to produce goods of greater value • Goods produced with capital are valued higher than those produced without capital • Goods produced with capital have higher value than the capital that helps to bring them into existence (capital produces more value than it has in itself) • Meaning 2.b.ii dominates (interest as a surplus phenomenon)

Common ground of productivity theories Key question:Why is the gross return to capital of higher valuethan the portions of capital consumed in its attainment? Common answer:Capital-using production increases productivity (lower output without capital) • BUT: Though production turns out valuable goods, it is not production that gives them value (condition ≠ explanation!)

Naïve vs. motivated productivity theories • Naïve (direct) theories • Value creation via capital is considered as self-evident • Mere empirical observation that the employment of capital is followed by surplus value • Some authors confuse gross and net output of capital-using production • Motivated (indirect) theories • Attempt to explain why the goods produced via the use of capital must be of superior value • Use theories: Interest as surplus of value that emerges from the use of capital (as distinct from the substance) of capital

J. B. Say • First version • Goods arise through the interplay of land, labor, and capital • Each of those factor of wealth provides a service, e.g. natural power or work, for which there is compensation in the market • By analogy, interest is the compensation for the productive service of capital • Naïve productivity theory • Second version • Prices for goods must be so high that an entrepreneur is able to give compensation to the providers of capital • Thus, there will be interest • Nucleus of a use theory

What’s the problem with productivity theories so far? • Challenge by the logic of arbitrage • Why should not the value of capital rise till it becomes equal to the value of its products? • Why should not competition of capitals increase till the claim of capital is reduced to its simple replacement? Interest is the difference between the minuend (product) and the subtrahend (capital consumed), and, as the value of capital is bound up with the value of its products, productive power can only affect the one as it affects the other, leaving the difference between them unchanged, and the question of interest untouched. (Böhm-Bawerk) • The growing recognition of the identity between value of product and value of means of production was bound to suggest that something had been overlooked among the sacrifices of production  use theories

Use theories • Spin-off of productivity theories • Value of output is in some way determined by the cost of production • The problem of the productivity theories was to explain why, in general, the prices of the factors of production (here: capital) were not bid up to the point of equality of revenue and costs • Introduction of an independent cost element besides rent, wages, and costs of capital goods  Use of capital • This allows to still explain prices via cost of production • And it allows to incorporate interest into the system • BUT: Central thesis (i.e., the substance of capital does not contain the value of its use) cannot be substantiated (there is no such separable use value)

Conclusion by Böhm-Bawerk (Vol. I, p. xlv)

Böhm-Bawerk‘s mission • Integrating the theory of interest into the subjective theory of value(interest as a subjective value phenomenon)

The legacy of Carl Menger • Subjective theory of value  Discarding all cost theories • Marginalism and diminishing marginal value  Cost as foregone opportunities • Order of goods  Production as a time-consuming process [T]he value of goods of higher order is dependent upon the expected value of the lower order they serve to produce. […] The value of the goods of higher order by means of which we shall have command of goods of lower order at some future time is by no means measured by the current value of similar goods of lower order, but rather by the prospective value of the goods of lower order in whose production they serve. (Menger, Principles of Economics, p. 150)

Interest as intertemporal exchange • Definition of capital: Capital being produced from labor, land, and time • Factors of production as future goods (= future consumption goods) • Present goods are, as a rule, worth more than future goods of like kind and number • (1) Systematic difference between the wants and want provision of present goods • (2) Psychological underestimation of future needs • (3) Roundabout production increases future provision of consumer goods • The exchange value of present (more mature) goods is higher than that of future (less mature) goods, which guarantees an income to their owners (the capitalists)

Clarifying • Present price of future goods(today‘s price of factors of production) • ≠ • Price of present goods in the future(future price of consumer goods)

Goods and value: Present and future today future time t0 t1 t2 … tn Value of present goods(consumer goods) Value of present goods(consumer goods) Value of present future goods(factors of production)=Present value of future consumer goods Discounting (agio on present goods) Interest emerges as goods mature(ripening of future goods into present goods)

Böhm-Bawerk‘s line of exposition • Book 1: The Nature and Conception of Capital • Book 2: Capital as Instrument of Production • Book 3: Value • Book 4: Price • Book 5: Present and Future • Book 6: The Source of Interest • Book 7: The Rate of Interest

BB: Economiclife in thepassing of time

BB: 1st cause

BB: 2nd cause

BB: 3rd cause

The interplay of the three causes

The interplay of the three causes • Interest-rate determination is a market process in which the third cause is related to a willingness to pay, while the first two causes are related to a willingness to sell • Which of these thresholds (“sanctions") becomes binding depends on the specific circumstances, but the greatest among them is always the relevant one • Moreover, the fact that all these thresholds are by themselves greater than zero explains that observed interest rates are generally positive

Causes for the existence of interest • The underestimate of the future compared with the present goods thus comes from many sides and classes: • From the young who expect to be better off in the future • From the rich and improvident who wish to enjoy the present • From the industrious who wish to add to their wealth • Most likely the majority of mankind

Theories of Interest: Understanding Capitalist Savings and Monetary Policy