Eugen von Böhm-Bawerk expressed concern that the interest rate might not get rid of its “moral shade”—its moralischer Schatten. Thorsten Polleit chronicles the attempts to drive it to zero under totalitarian regimes, but also in Western democracies, where central bankers attempt to make it vanish. Holding the bank rate below the natural rate requires a continuous expansion of bank credit and thereby money supply. FULL ARTICLE
Source link: http://blog.mises.org/3805/the-demise-of-the-interest-rate/
The Demise of the Interest Rate
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Excellent and interesting analysis! Insufficient attention is paid to the theory that high long bond prices reflect pessimism in other investments. If that is a dominating factor in the current low-interest flat yield curve, it bodes ill for future bond prices, as government flood markets with bonds to raise cash to pay for ever-expanding welfare programs and cover deficits from deceasing tax revenues derived from a diminishing economy.
I have two questions regarding an otherwise very good article. The author states:
“The market yield is an equilibrium price, signalling where peoples’ savings and investment intentions are brought in line with each other. Whereas the former reflects consumers’ time preference, the latter is driven by investor expectation regarding the marginal return of investment.”
My reading of this passage is that it contradicts the Mises/Fetter/Rothbard pure time preference theory regarding the determination of the (originary) rate of interest. In fact, I believe Bohm-Bawerk himself demolished the productivity theory as an explanation for originary interest in his “Capital and Interest”.
In addition, the author also refers to an inflation component as being added to interest rates to account for expected changes in the price level. Rothbard, however, argues that this explanation is fallacious, since if market participants actually believed that prices were going to increase in the future, they would bid up prices in the present in anticipation of the increase.
Am I off base here?
Hi Dennis: I think you have something regarding time preference and the interest rate being strictly under the consumer’s control (all investors are also consumers too).
However, Rothbard seems to argue that there can be an inflation expectation element to the interest rate:
“But after this period, the public and the market begin to catch on to what is happening. They begin to realize that inflation is chronic because of the systemic expansion of the money supply. When they realize this fact of life, they will also realize that inflation wipes out the creditor for the benefit of the debtor. Thus, if someone grants a loan at five percent for one year, and there is seven percent inflation for that year, the creditor loses, not gains. He loses two percent, since he gets paid back in dollars that are now worth seven percent less in purchasing power. Correspondingly, the debtor gains by inflation. As creditors begin to catch on, they place an inflation premium on the interest rate, and debtors will be willing to pay it. Hence, in the long-run anything which fuels the expectations of inflation will raise inflation premiums on interest rates; and anything which dampens those expectations will lower those premiums…”
Paul,
Thank you for your comment. From what work of Rothbard’s is the quote from? My comment, assuming I conveyed it correctly, is from Rothbard’s MES, chapter 11, section 5.G. Here is a quote from that section:
“The purchasing-power component, then, is not the reflection, as has been thought, of expectations of changes in purchasing power. It is the reflection of the change itself; indeed, if the change were completely anticipated, the purchasing power would change immediately, and there would be no room for a purchasÂing-power component in the rate of interest. As it is, partial anÂticipations speed up the adjustment of the PPM to the changed conditions.”
I must admit that these concepts are at times confusing and hard to fully understand.
Take care.
Paul,
Sorry for any confusion, but in the third sentence of my posting I meant to say: “My comment, assuming I conveyed Rothbard’s argument correctly, reflects Rothbard’s MES, chapter 11, section 5.G.
Dennis
Hi Dennis: I pulled that quote from p16 of “Making Economic Sense”. I looked at your quote and i admit i had to ponder it a bit. But i think he means this: There is a purchasing power component to the interest rate, and it is a reflection of the change in purchasing power itself (rather than the anticipation of this change).
Paul,
Thanks for your reply. It is more or less what I was thinking regarding Rothbard’s discussion in MES — the rate of interest does not reflect expected changes in the purchasing power of the monetary unit, but rather actual changes.
The author makes a crucial mistake. He assumes that nominal yields can be broken down into real yields, plus expected inflation, plus risk premium, which he summarizes as
(1+i_nom) = (i+i_real)(1+pi^e)(1+phi)
by definition, where phi is defined as the risk premium. Pi is undefined, but from his discussion it is clear that it must be equal to the logarithm of expected inflation. Then he states that the market agents’ expected inflation is given by
(1+i_nom)/(1+i_real) = (1+pi^e)(1+phi)
This is, however, incorrect. The above includes both expected inflation _and_ risk premium. Therefore Mr Karlsson’s argument only holds if risk premiums have remained constant over the years. A rather arbitrary assumption for which there is no proof.
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