To a modern economist, commentator, or even to a common man, interest rates in an economy are determined by the credit granting institution, such as a commercial bank or a money-lender. Interests are costs, part of production, and explicitly stated in loan contracts. According to this conventional understanding, interest is a price to be paid to obtain the services of capital.
In an economic sense, interest is just like rent, wages and payments for other factors of production; such as for machinery, raw materials. Entrepreneurial profit appears only as a residue after taking into account total costs.
Financialisation of credit markets has expanded the attributes and mechanisms of credit-contracts. Interest can be fixed or variable and repayable at regular intervals or as a bullet payment. There are 'zero-interest' credit contracts too. A further sophistication is default-contracts which bear entrepreneurial risks; that is, the costs of underlying credit risks are borne by new investors in default-contracts.
In order to resolve creditor-debtor conflicts, legal framework around financial markets including specific laws and courts have been developed. This framework enforces contracts, recovers assets from wilful defaulters pay and apportion genuine entrepreneurial losses. These enable the ongoing functioning and integrity of loan markets.
Yet, the financialization or sophistication of capital markets are not a necessary condition for understanding the origin of interest rates. Financialisation simply optimizes carrying costs, improves capital mobility and shares risks among participants. Financial markets are therefore not the place to be looking for the fundamental origin of interest rates. They don't explain the cause and meaning of interest rates in an economy.
A more basic, economic explanation of interest is necessary. We can only achieve this by removing the veneer of visible, tangible credit contracts, the sophistication of financial marketplace, and the legal terminologies of contract making and frameworks for contract enforcement.
With this look-through purpose, we will examine the fundamental causes of interest rates in an economy.
Consumers exhibit a greater degree of preference for goods in the immediate future, over the same goods when offered in a more remote time in the future. Time is a limited, scarce factor in all spheres of human life. Due to this limiting factor, we prefer goods in the present or an immediate future, over that of a time period farther into the future when intervening uncertainties are perceived to be higher.
This is called the time-preference of the individual. Time preference is greater when an individual prefers goods today, over tomorrow. Between individuals, time preference varies in degree. A child has a high degree of time preference - his wants are immediate, with little cognition of varying future lengths of time. A middle-aged individual exhibits lesser degree of time preference since he understands the need for want satisfaction even years later. A much older person, again, much like a child, exhibits a high degree of time preference. He knows his life is short, so there is no purpose of deferring want-satisfaction into a distance future.
The predominant force in a society is generally, towards 'greater' than 'smaller' degree of time preference. That is, collectively, the preference is for an immediate future, as against a remoter time period farther into the future.
This high time-preference implies that in order to satisfy the more valuable wants of the immediate future, production methods are arranged in such a manner, that more capital goods are made available for production of goods in the immediate future, than the production of more complex, roundabout capital goods that enable production of goods in the distant future.
This may appear confusing at first, but is simpler through an analogy. More bread making machines (say ovens) are made available for making breads in the immediate future, than producing machines that make those ovens. The oven-making machines are referred to as complex and roundabout capital goods.
Roundaboutness, was a term coined by Bohm-Bawerk. One of the benefits of roundaboutness is higher productivity of capital, enabling more output per unit of goods. Using this understanding, one could extend reasoning, by saying that the lower unit cost of those future goods, should tip the satisfaction of wants in favor of more remote future periods, than immediate time interval. However, this is not true. The production process to enable a final lower cost of unit, are fraught with challenges, that aren't apparent at the start.
Suffice to understand now that, the lack of complementary factors of production, renders the roundaboutness argument futile. An entrepreneur who embarks on such calculations, would soon realize that the cost of producing missing complementary factors of production is too high, rendering his whole plan unprofitable. In our bread making example, the factor of production necessary to make oven-making machines, haven't fully formed in an economy; and an entrepreneur will be forced to dedicate time and cost to first make those missing complementary factors first. This is a futile exercise, and an entrepreneur who is foresees this would abandon such a plan.
This brings us back to the previous conclusion that, immediate future goods are more valuable than remoter, future goods.
Collectively, we provide inadequately for the satisfaction of wants in the remoter future periods. This is because, individuals weigh the satisfaction of nearer periods of the future more heavily against satisfaction derived in remoter future periods. When expressed as a ratio, we arrive at something called as an originary interest (some texts call this a neutral rate of interest). Originary or the neutral interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to the want-satisfaction in remoter periods of the future.
Originary interest is the ratio found in the commodities market place. It is not a price. It is also not homogeneous across commodities. It is this interest, that deters more time-consuming methods of production, despite its merit of higher productivity; and instead favors channelizing capital goods to produce goods for immediate want-satisfaction.
Therefore, interest is not a price determined by the interplay of demand-supply of capital goods. It is not a price paid for the services of capital goods or capital. Rather, it is the rate of interest that determine the demand and supply of capital. It allocates capital between capital goods that enable production of goods for nearer want-satisfaction and capital goods that enable remoter want-satisfaction.
Capital markets or loanable funds market don't determine interest rates. It mirrors the originary interest ratio in the commodity market place. It adjusts its magnitude in proportion to this ratio. Allocation of capital goods, described above between immediate and future wants, are not based on interest rates on offer in the loanable funds market. The interest rates on offer in capital markets, ceteris paribus, don't decide capital allocation. (We will see in a future post, the conditions when and how loanable funds market distort capital allocation).
To restate, interest rates in an economy are first determined in commodity markets. It is the discount rate attached to the future goods as against present goods. The lower the discount rate attached, that is higher the willingness to wait for future want-satisfaction, the lower is the rate of interest. It doesn't matter whether low rates stimulate production or if a high rate depresses activity. Those are the wrong questions to ask. A high interest rate means, entrepreneurial activities would be best served in production processes that are shorter in time length; that which satisfy near distant wants. And, on the other hand, a low interest means entrepreneurial activities may be directed at using complex, roundabout methods of production - which also enables unit cost reduction - for satisfaction of wants in the far distant future.
High time-preference leads to high demand on the resources in the economy. Therefore, resources are 'expensive'. Lengthening of the production process is unattractive; with intermediary capital goods whose prices look unattractive when compared to the final product prices, entrepreneurial prospects are dim. Essentially, it begins with less freeing up of resources due to society's high time preference.
Low time-preference leads to low demand on the resources in the economy. Therefore, resources are available 'cheap'. Lengthening of the production process is made more attractive; with intermediary capital goods priced at attractive valuations compared with final product prices, entrepreneurial prospects appear brighter. Essentially, the precondition is is the freeing up of resources due to low time-preference.
Therefore, the consumption urgency of a society determines its level of interest rates. These rates are transmitted into capital markets by entrepreneur interaction, bargaining and negotiation with loan providers. The entrepreneur reveals his plans, estimation of the 'hidden' margin available (between price of future goods and costs of production) and the loan provider corroborates this with his understanding of originary interest in the commodity market (ratio of postponement of wants in time distances). This negotiation results in an interest rate which appear as an actual cash cost to the entrepreneur. This interest rate is conventionally understood as interest. But as we now realise, this is only a derivative.
Aside, institutional customs express loan interest rates on an annual, uniform basis, or with compounding at agreed intervals. Despite these sophistications, the real interest is the outcome of valuation of wants in the near future against remoter future periods.
The activities of the entrepreneur tend to close the originary interest gap between commodity sectors. The originary interest is not a static, but a moving target. The activities of other entrepreneurs too influence this ratio. As market gets flooded with new goods, consumer preferences change, and different commodity markets exhibit different levels of originary interest. The entrepreneur must be aware of these changing ratios, and adjust his plans accordingly.
A few words on mal-investment
Malinvestment arises when entrepreneurial activities are mis-directed when loan markets induce entrepreneurs with cheap credit. The entrepreneur, instead of focusing on interest ratio in the commodity market, allows himself to be misled by bank interest rate levels. He undertakes long gestation (roundabout) projects that might increase output, yet, for which consumer time preference is still high; that is, a greater weight exists for near want-satisfaction. We will cover malinvestment processes in another post.
The purpose of this post is to highlight that the real interest rate is the one generated by consumer valuations of near time want-satisfaction versus distant want-satisfaction. This is expressed in his daily transactions in the commodity market. The correct perception of these ratios is the 'job' of the entrepreneur. The transmission of this ratio to the credit or loan markets happens when the entrepreneur meets the banker. The magnitude of the loan interest rate is a function of the originary ratio, as communicated by the entrepreneur, and as agreed by the banker. The banker's interest rate, in turn contains an entrepreneurial element, which is the compensation for the risks taken by the banker. Therefore while directionally, bank interest rate and originary interest rates concur, in terms of constituents they are different. While originary interest is a pure form of interest, bank interest rate contains banker's share of entrepreneurial profits.
Beyond these definition problems, our focus is on identifying the origin, causes and processes behind interest rates. It is clear now where the pure form of interest in an economy can be found.