July 5, 2004 9:45 PM
by David J. Heinrich
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These notes are from the lecture Further Considerations in the Theory of Interest, given at the Mises University. Any errors are mine, feel free to point them out so that I can correct them. This lecture was given by Prof. Hülsmann.
Profit vs. Interest
- Classical view -- just profit
- Modern (Austrian) view:
- Interest -- survives even in the ERE (evenly rotating economy).
- Profit -- pure product of disequilibrium.
- The following is a situation of disequilibrium:
- Company A: $100 ==> $120 : $30 interest, -$10 loss.
- Company B: $90 ==> $130 : $30 interest, $10 gain.
- In such a situation, there is a tendency towards equilibrium via arbitrage -- the reallocation of factors of production until all return is the same:
- Company A: $95 ==> $125
- Company B: $95 ==> $125
- However, you can't really say that the first situation is disequilibrium, because you have to consider psychic revenue, which could be higher in A than B.
- Interest is the spread that subsists in general equilibrium, $20 in the second case.
- Now, we can define profit and loss.
- The ERE allows us to see the difference between profit and interest.
History
- Frank Knight:
- Risk, Uncertainty, and Profit.
- Profit can only exist in a world in which we have error.
- Mises wrote a lengthy article clearly explaining and improving upon Knight.
Interest
- What we've called interest so far is total interest
- Components of total interest:
- Pure interest.
- Price premium -- compensation for predicted inflation.
- Entrepreneurial component -- compensation for risk and uncertainty.
- Risk: class probability, characterizeable risk.
- Uncertainty: case probability, something we don't know.
Non-Austrian Interest Theories
- Marxist theory of interest -- exploitation of the employee by the employer.
- Interest theory of production -- productivity theory of interest:
- time 1: 100t ==> time 2: 250t
- 5oz ==> 125oz since
- This is wrong, because it assumes that prices are constant -- price are not stable.
- The idea is that productivity of a thing determines the interest: must assume that there is something in the thing itself that
determines its value innately, which is non-sense since value is subjectively determined.
- Schumpeter said profit, or interest, can only exist in disequilibrium, and arbitrage eliminates it in equilibrium -- so there is really no interest. This is wrong.
Böehm-Bawerk's Theory of Interst
- Present goods are always more valuable than some future goods temporally displaced.
- Time-preference for the present.
- Why time-preference? Future needs under-estimated.
- Explanation of interest as a difference that is dependant on value-difference in time.
- Problems: Hard to test and contradicts intuition:
- In all product-possibilities, we never have a product that is homogenous with the factors of production. This is problematic
because Bawerk's theory mandates that they be the same good temporally displaced.
- This theory contradicts, in fact, the liberty of choice that we have, because we can always make bargains inconsistant with the
theory.
Mises' Theory of Interest
- Time-preference is something that does exist.
- Mises: by the very fact that I do certain things, I demonstrate that I prefer doing it now rather than later, that it's more important to do it now than later.
- All actions have this feature.
- So far, this doesn't explain interest, just that we prefer now not later.
- Mises' and Bawerk's point of view is that interest is entirely determined by the price consumers pay and the costs of the factors of production.
Modern Austrian Theory of Interest (Hülsmann)
- If you cannot obtain interest, you go out of business.
- Interest comes from the fact that entrepreneurs from outside seek a spread between output and factors of production.
- Interest payments subside in the market only in those businesses where the interest rate cannot be arbitrated away, because people enjoy doing the activity (e.g., opera).
- For a more detailed explanation, see A Theory of Interest. Hülsmann, Jörg Guido. QJAE, vol 5, num 4.
