The Paradox of Interest Revisited

Courtesy of Antal E. Fekete @ ProfessorFekete.com

The classical formulation of the paradox of interest is due to Böhm-Bawerk and Schumpeter. Its modern formulation is due to Hausman and Kirzner. I quote Kirzner:

Much – perhaps all – will turn out to depend on the way in which the interest problem is formulated. For present purposes we adopt a modern formulation of the problem, but wish to emphasize that this formulation is very similar in spirit and character to classic formulations… The modern formulation we cite is that of Hausman. Hausman points out that an “individual’s capital . . . enables that individual to earn interest. If the capital is invested in a machine, the sum of the rentals the machine earns over its lifetime is greater than the machine’s cost. Why?” Common observation, that is, tells us that possession of a given stock or capital funds can, by judicious investment (say, in a machine) yield a continuous flow of income (annual rentals net of depreciation) without impairing the ability of the capital funds to serve indefinitely as a source of income. The problem is, how this can occur. Why is not the price of the machine (paid by the capitalist at the time he invests in the machine) bid up (by the competition of others eagerly seeking to capture the net surplus of rentals over cost) – to the point where no such surplus remains? We are seeking, then, an explanation for an observed phenomenon which is, in the absence of a theory of interest, unable to be accounted for. Absent a theory of interest, no interest income ought to be forthcoming, except as a transient phenomenon; competition ought to squeeze it out of existence.

In this note I propose to solve the paradox by suggesting that the exchange of wealth and income should be made the cornerstone of the theory of interest, replacing the exchange of a present and a future good.

To say that the capitalist “invests” his wealth is too simplistic. Investing is bound to confuse the issue. Moreover, possession of wealth does not automatically guarantee access to income. There is an implicit exchange of wealth and income interposed between the capitalist and entrepreneur that needs to be made explicit. Here is what happens.

The capitalist exchanges wealth for income. Income is yielded by the entrepreneur, who converts wealth into capital goods (such as a machine or a fruit tree) and hires a manager to tend them (including the task of setting depreciation quotas in anticipation of having to replace the capital goods at the end of their useful life without further charges to the capitalist). The entrepreneur sets up three accounts for the distribution of the yield after depreciation, namely, one for each of:

(1) a fixed interest income payable to the capitalist,
(2) wages payable to the manager,
(3) the remainder, or entrepreneurial profit, payable to himself. Continue reading

Analysis of the Yield Curve

Courtesy of Sandeep Jaitly @ FeketeResearch.com:

One of the greatest conflicts that prevented the establishment of a credible theory of interest was that between the time preference & productivity schools. Fekete, looking back to Menger, synthesised the two schools to produce the only coherent & complete theory of interest.

Looking back to Menger’s observation of the existence of a bid/offer spread as opposed to a monolithic price, Fekete combined the productivity and time preference schools via marginal analysis with marginal time preference and marginal productivity of capital. Ludwig von Mises admitted only time preference – and not marginal time preference at that – as the basis for the formation of interest. This was an oversight and not in keeping with the Menger’s established form of marginal analysis.

Space – via marginal productivity of capital – and time – via marginal time preference – were united in Fekete’s theory of interest. Marginal time preference is expressed via the marginal bond holder. The marginal bondholder is the first to refuse to exchange gold coins for bonds in view of the (bid) rate of interest falling below their time preference. The time preference of the marginal bondholder is defined as marginal time preference. In a similar fashion, marginal productivity of capital is expressed via the marginal entrepreneur. The marginal entrepreneur is the first to refuse to exchange bonds for capital goods in view of the offered rate of interest being above their (potential) productivity.

Marginal analysis coupled with Menger’s original observations, can be extended further to determine the theoretical shape of the yield curve under an unadulterated gold standard: discussion of which occupies the faculty of The New Austrian School & Fekete Research. Would it be flat? Would it have an upward bias? Continue reading

Where Mises Went Wrong

Courtesy of Antal E Fekete @ Soundhaven.com:

Ludwig von Mises erred when he dismissed what is known as the Fullarton Effect. In 1844 John Fullarton of the Banking School described how low interest rates were resisted by savers in selling their gold bonds and hoarding gold instead. Mises ridiculed the idea, calling gold hoards a deus ex machina in Human Action (3 rd revised edition, p 440). My theory of interest corrects this mistake in giving due recognition to the Fullarton Effect. I can well understand the frustrations of Robert Blumen, Sean Corrigan, and other detractors of mine reluctant to read the voluminous outpourings of this “inflationist monetary crank”. Rather than finding a weak point in my argument they call me names, stonewall Adam Smith, conjure up the bogyman of John Law, set up straw men only to knock them down again, and quarrel bitterly with my ad hoc examples while ignoring my comprehensive theory of interest. For the benefit of discriminating students of Carl Menger and Eugene Böhm-Bawerk I restate this novel theory in a concise form.

The rate of interest is a market phenomenon. It is defined as the rate at which the coupons of the gold bond amortize its price as quoted in the secondary bond market. The mathematician has shown us formulas expressing the rate of interest in terms of the price of the gold bond. They confirm that the two are inversely related: the higher the bond price, the lower is the rate of interest and vice versa. As a consequence, the lower bid price of the gold bond corresponds to the ceiling and the higher asked price to the floor of the range to which the rate of interest is confined. The question is what economic factors determine these constraints and how.

Continue reading