|Montreal, March 6, 2004 / No 139|
by Chris Leithner
Eugen von Böhm-Bawerk (1851-1914), on three occasions the finance minister of the Austro-Hungarian Empire, was at the turn of the twentieth century one of the world's best-known economists. His major work, Capital and Interest (vol. 1, 1884; vol. 2, 1889; 3-volume compendium, 1909-14), influenced early neo-classical conceptions of economic growth; and Karl Marx and the Close of His System (1898) ranks with
A stalwart classical liberal and robust defender of private savings, entrepreneurship, limited government and laissez-faire capitalism at a time when popular antipathy towards frugality and commerce – and demands for state intervention and expenditure – began to appear, Böhm-Bawerk's methods and insights have either been belittled or forgotten by today's politicians, bureaucrats, academics, businessmen, investors, employees, consumers and taxpayers. Members of today's mainstream, whether they call themselves "liberal" or "conservative," are firmly and often unknowingly wedded to the ideas of John Meynard Keynes; Keynesians, in turn, applaud expenditure by individuals, businesses and governments, disparage savings in any form and by anybody and thereby take blissfully for granted the process of capital accumulation (see also GNP and Consumer Confidence in Australia: A Dissenting Argument).
Not only did Böhm-Bawerk demonstrate that savings neither harm individual businesses nor attenuate the general pace of economic activity: he also showed that growth and prosperity occur only if savings are accumulated and profitably invested. Productive savings and entrepreneurship by businesses and individuals is a necessary condition of capital formation; and the expansion of productive capital underpinned by clear property rights is a sufficient condition of a higher material standard of living (see also Letter 41 and A Tale of Two Islands). Influenced by Böhm-Bawerk and the insights of his successors, contemporary Austrian School economists promote what today's mainstream deride as archaic and even subversive: first, voluntary savings and the successful investment of those savings in free markets underpinned by property rights is the key to long-term prosperity; and second, governments' attacks upon capital (in the form of interventionism, inflation and deficits) and consumption whether by individuals or governments that has not been financed by savings, temporary appearances to the contrary, retard and corrode prosperity.
But how much to spend today and save and invest for tomorrow? According to Böhm-Bawerk and elaborated by his successors, interest harmonises the quantities saved and invested. The "pure" or "natural" rate of interest depends upon individuals' time preference – that is to say, their willingness to exchange a given amount of present goods and services (those which can be consumed today) for a specified greater amount of future goods (intermediate or unfinished goods which will become present goods at some point in the future). The greater (less) the willingness to trade present for future goods, or to outlay a given amount of money today in order to receive a specified greater amount at a particular point in the future – the greater, in short, the preparedness to wait – the lower (higher) the natural rate of interest (see also Hans-Hermann Hoppe, Democracy, The God That Failed: The Economics and Politics of Monarchy, Democracy and Natural Order, Transaction Books, 2002).
The Austrian School conception of interest is hardly monolithic. Most notably, Ludwig von Mises (Human Action, Fox & Wilkes, 1949, 1996) and Frank Fetter (Capital, Interest and Rent, Sheed, Andrews & McMeel, 1977) thought that Böhm-Bawerk's rendering was unsatisfactory in various respects (see also Murray Rothbard, Man, Economy and State: A Treatise on Economic Principles, Ludwig von Mises Institute, 1962, 1993, and Israel Kirzner, Essays on Capital and Interest, Edward Elgar, 1996). Yet these Austrian approaches, at whose heart lies the notion of time preference, are far more similar to one another than they are to the mainstream. All, it is reasonable to summarise, emphasise that the discount on future goods vis-à-vis present goods (or, equivalently, the premium that present goods command over future goods), which is the pure or natural rate of interest, is at best indirectly observable. Observable or "market" rates of interest comprise three things: the pure rate, an entrepreneurial or "risk" component (which is akin to the "risk premium" in the mainstream literature) and any expected change in the currency's purchasing power ("inflation premium") over the relevant period.
Yet Another Reason to Criticise Keynes
In an unfettered market (and particularly in the absence of a central bank), interest responds to the laws of supply and demand. In a free market, in other words, interest co-ordinates the actions of borrowers and lenders. Anchored by the natural rate and varying from case to case and time to time according to risk and inflation premiums, the financial resources committed to investment projects will accurately reflect individuals' willingness to forego consumption today in order (they hope) to consume more in the future. This market-directed process of saving and investment underwrites healthy economic growth; further, minor and gradual movements in the natural rate of interest generate small adjustments to the rate of growth and thus protect the structure of production against larger, more abrupt and extended corrections (i.e., recessions).
John Meynard Keynes and the contemporary mainstream reject the very possibility that interest might co-ordinate the activities of borrowers and lenders and equilibrate the desire for jam today versus more jam in the future. In The General Theory of Employment, Interest, and Money (1936) he stated that "classical economists" (a phrase he used to denigrate Alfred Marshall, A.C. Pigou and sometimes David Ricardo) "are fallaciously supposing that there is a nexus which unites decisions to abstain from current consumption with decisions to provide for future consumption." This rejection has fundamental implications. As Roger Garrison ("Ditch the Keynesians: Why Policy-Infected Rates Must Go", Barron's, 2 September 2002) puts it, "Keynes's verdict of 'no nexus' left interest rates up for grabs. And if they weren't doing [any useful job], maybe they could be used for macro-management."
In Keynes's world, the optimism ("animal spirits") of consumers and businessmen inspires them – preferably with credit not backed by savings – to spend and invest. (Keynesians, it is worth mentioning, notoriously confuse and conflate the distinct concepts of investment and consumption). It is this bullishness, Keynesians say, which creates jobs, bolsters spending and generates economic growth. Sunny dispositions thus beget the prosperity which reinforces the optimism. (Yes, upon careful reading much of Keynes's reasoning, such as it is, reveals itself as circular and reliant upon self-fulfilling prophesies).
To Keynes, interest reflects people's "liquidity-preference" (i.e., the extent of their desire to hold cash). The greater this desire, the greater the inducement – the rate of interest – required in order to persuade them to exchange cash for less liquid assets. Three things underlie the liquidity preference. The first is the "transactions motive." This is the cash required to finance everyday personal and business transactions. The second is the "precautionary motive," i.e., the desire for a cash hoard stuffed under the mattress as a hedge against the uncertainty of the future. And the third is the speculative motive, i.e., the desire to profit "from knowing better than the market what the market will bring forth." Keynes denounced high interest rates and blamed them upon "excessive liquidity preference" and an "insufficient propensity to consume." In his view, the reduction of interest rates is a good thing because it induces greater spending (which is an even better thing). To borrow the vernacular of today's financial commentators, to reduce interest rates is to "make cash trash."
Interest rate "stimulus" is an important spanner in the Keynesian policy toolkit because the spending spurred by optimism and animal spirits may be insufficient to satisfy politicians' electoral promises and bureaucrats' appetite for bigger empires. If not, then lower rates (which render credit cheaper, reduce the liquidity preference and thereby induce more borrowing and spending), engineered by the central bank's expansion of the base and supply of money, may be required. Conversely, if the coup de whiskey of easy money produces too much optimism – the contemporary term is "irrational exuberance" – for economists' and politicians' liking, then higher rates engineered by a slower rate of monetary expansion may be the order of the day. In Keynes's world, then, individuals and the natural rate of interest, the risk premium, etc., that they negotiate are denied, obscured and bastardised by central and commercial banks.
Hence today's conventional, man-in-the-street conception of interest: it is the cost of a loan to the borrower (or its proceeds to the lender), decreed by the central bank and accepted by borrowers and lenders alike. To many homeowners these days, the cost of a loan is the monthly mortgage payment on the house that is financed by the loan. In an analogous vein, U.S. Treasury Secretary John Snow told The Washington Post (21 October 2003) "interest rates are the price of capital." Alien to Mr Snow, homeowners and the contemporary mainstream is the notion that lack of capital is dearth of time and that interest expresses time preference.
Austrians versus Keynesians Redux
The conception of interest in Keynes's world presents a problem. If interest rates are instruments of policy that are strongly influenced if not decreed by extra-market entities such as central banks, and if their purpose is to yoke investors' expectations to politicians' preferences, then rates cannot perform the harmonising, market-based and growth-governing function that Austrian and other early neo-classical economists attribute to them. Roger Garrison's insight deserves emphasis: to believe as Keynes did and his successors do that interest rates cannot or should not do their "traditional" job is effectively to license interventionist institutions (such as central banks) and an interventionist policy régime (such as "accommodative" monetary policy) whose raison d'être is to ensure that interest rates damn well don't do their traditional job.
This problem has another facet: central bankers and interventionist monetary policies have occasionally (i.e., during the late 1920s-to-early 1940s and late 1960s-to-mid-1970s) misjudged and backfired spectacularly. Central banks have also regularly – most recently, during the late 1980s, early 1990s and mid-1990s-to-early 2000s – misjudged less disastrously. And it is not at all clear that the most recent misjudgment will in retrospect be categorised on the "less disastrous" end of the spectrum. Disastrous or not, during each of these unfortunate episodes businessmen, entrepreneurs, savers and investors were implicitly encouraged – not least by central bankers – to undertake actions which in retrospect were much riskier than they realised. This belated realisation cost many people very dearly for extended periods of time.
But no matter: central bankers are sorry and promise that they will not do it again. On 8 November 2002, for example, at the conference celebrating Milton Friedman's 90th birthday, Benjamin Bernanke, a member of the Federal Reserve's Board of Governors, stated "let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton: regarding the Great Depression, you're right; we did it. We're very sorry. But thanks to you, we won't do it again." Even the mainstream now acknowledges that the interventionism of the U.S. Federal Reserve transformed a severe recession into the Great Depression (see in particular Alan Meltzer, A History of the Federal Reserve, Vol. 1: 1913-1951, University of Chicago Press, 2003). Alas, the lesson learnt from this débâcle is to intervene even more aggressively next time (see in particular Alan Ahearne et al., Preventing Deflation: Lessons from Japan's Experience in the 1990s, Federal Reserve International Discussion Paper No. 729, June 2002).
Hence the nub of the problem that the mainstream conception of interest has bequeathed to today's investors: economic policy-makers do not allow interest rates to do their traditional job of harmonising and equilibrating the behaviour of borrowers and lenders. Further, the interventionist policies unleashed by Keynesian assumptions occasionally induce many people to commit egregious mistakes. But despite their laudatory press, only irregularly (and in no small measure by happy accident) do the results of economic policy-makers' interventions correspond to their intentions; and when they make mistakes, which as humans they necessarily and regularly do, their exalted and protected status shields them from the harsher fate that befalls small businessmen and investors who miscalculate.
Given this spotty track record and assuming for the sake of argument that Böhm-Bawerk correctly defined interest and identified the role it plays, it follows that much of what is uncritically accepted by today's investors in order to value securities and undertake investment is wrong. The conventional wisdom bequeaths to us institutions and policy-makers who often generate incorrect (in retrospect, typically too low) bank interest rates – and therefore incorrect (again in retrospect, typically too high) asset prices. But over more extended periods of time these prices regress towards historical means (see "Regression to the Mean and Value Investing"). Accordingly, to follow Keynes – consciously or otherwise – is occasionally and unwittingly to participate, like an exuberant lemming in a mad herd, in mania and egregious error. To follow Eugen von Böhm-Bawerk and his successors, on the other hand, is to arm oneself with sceptical and critical armour and thereby reduce one's propensity to partake in herd-like behaviour.
A More Sensible Interpretation of Quoted Rates
Two conclusions for investors emerge from this look at interest from an Austrian School point of view. First, the relevant question to ask about an observed rate relates not so much to its level but to its integrity. Easy money can encourage many delusions and mask many distortions. Borrowers, lenders and investors would therefore do well to ask themselves: given pervasive government intervention, do today's interest rates convey accurate information about borrowers and lenders? Acting on them, and using historical standards as rough baselines, would they make reasonable choices? Or would they undertake "malinvestments" which must be liquidated when the bullishness and sunshine end?
Second, what is needed for a sound expansion of production is more savings, productive capital goods and interest rates that reflect time preference – and thus (to use Roger's Garrison's words) rates that "tell the truth about time." What is not needed is ever more credit unbacked by savings, and historically-low (and likely bastardised) rates of interest. Yet more and more, it seems that Australians, Americans, Britons and Canadians, like participants in methadone trials, regard the "fix" of low rates as an entitlement owed to them by government. They are living on borrowed money – and therefore, as Böhm-Bawerk showed, on borrowed time. "Investment" (which is often actually consumption) prompted by subsidised rates of interest can continue only as long as central and commercial banks create credit at subsidised rates. It is this margin between the subsidised (sub-natural) and the natural rate which misleads entrepreneurs and gives their investments the false appearance of profitability. It also misleads consumers and gives their spending sprees the false appearance of sustentation.
The final word – and a bold prophesy – belongs to Garrison. In "Ditch the Keynesians: Why Policy-Infected Rates Must Go" he concluded "current interest rates are too policy-infected to have much significance at all except as a basis for guessing about future interest-rate policy. Keynes, we now should all see, did his job very badly. The Federal Reserve will eventually have to abandon interest-rate targeting if the market economy is to have a chance to right itself. (The Volcker Fed turned rates loose in 1979 under very different but equally untenable circumstances.) Interest rates can do their job, but they need some on-the-job training. Ongoing debate in Washington and on Wall Street suggests that in the foreseeable future, they're not likely to get any."
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