What is interest? And why does it matter?

We begin with the definition from Wikipedia:

Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets.

That definition leads to the interpretation that interest is the cost of borrowing money.  Wikipedia continues:

Economically, the interest rate is the cost of capital and is subject to the laws of supply and demand of the money supply.

This is the Keynsian economics definition that the Federal Reserve uses, because it attempts to influence the borrowing of capital by setting the interest rate through the Fed Funds rate, and through its programs of Quantitative Easing by purchasing US Treasury securities, to lower the yield on bonds.  By having low interest rates, the market will borrow and use the capital to expand economic output, creating growth and reducing unemployment.

But this strategy is not working.

Let’s re-examine the definition of interest.

Ludwig von Mises explains interest in chapter 19 of Human Action.  This is the Austrian School of economic thought’s explanation.  He starts at the beginning, by explaining why interest exists:

Time preference is a category inherent in every human action.  Time preference manifests itself in the phenomenon of originary interest, i.e., the discount of future goods as against present goods.

He goes on to explain what interest is not:

Interest is not merely interest on capital.  Interest is not the specific income derived from the utilization of capital goods.

This flies in the face of classical economics. He uses the term “originary interest” to indicate the rate in market transactions:

Originary interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remoter periods of the future.  It manifests itself in the market economy in the discount of future goods as against present goods.  It is a ratio of commodity prices, not a price in itself…Originary interest is not ‘the price paid for the services of capital.’

On January 25, 2012, the Federal Open Market Committe (FOMC) issued a press release explaining it’s policy:

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy.  In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Bernanke and Co. have centrally planned the interest rate for the free market, and decided that it should be essentially zero.  But how can this work, when interest is the ratio of future goods vs. present goods?  This would imply that there is no difference in the value of capital today and in the future.

Mises wrote about the implications of zero interest:

the fading away of originary interest would mean that people do not care at all for want-satisfaction in nearer periods of the future. It would mean that they prefer to an apple available today, tomorrow, in one year or in ten years, two apples available in a thousand or ten thousand years. We cannot even think of a world in which originary interest would not exist as an inexorable element in every kind of action.

This leaves us with a dilema.  Who is correct?  And why does the Federal Reserve purchase the debt of the US Treasury?

Yesterday, the New York Times reported that the Senate voted to increase the debt limit for the US Govenment by $1.2 trillion.  “Increasing the debt limit permits the Treasury Department to pay the bills we have already incurred,” Senator Max Baucus, Democrat of Montana, said.

As the debt limit increases, the Fed becomes the lender of last resort.  And by buying the debt, the interest rate is kept artifically low.

What happens when the debt ceiling is raised?  More money is created to pay for the debt.  This devalues the dollar.

At the Barron’s 2011 roundtable, Marc Faber said:

Negative real rates amount to expropriation and destroy one function of money: to be a store of value and a unit of account. If you measure the stock market not in dollars but gold, it is down 80% since 1999. I no longer regard the U.S. dollar as a valid unit of account. People shouldn’t value their wealth in dollars because one day, in dollars, everyone will be a billionaire.

At the Barron’s 2012 rountable, he said:

It is not that the gold price will go up. It is that the value of paper money will go down

The numbers don’t lie.  This is from Zerohedge.  This charts the US debt limit on the right axis, and the Gold price on the left axis since 1994.

This chart is from the Federal Reserve itself, over the same time period:

Gold is the enemy of the Federal Reserve and Keynsianism.

Charles Rist wrote:

In reality, those theoreticians dislike monetary stability, because they dislike the fact that by means of money the individual may escape the arbitrariness of the government. Stable money is one of the last arms at the disposal of the individual to direct his own affairs, whether it be an enterprise or a household. It is certain that nothing so facilitates the seizure of all activities by the government as its liberty of action in monetary matters. If the partisans of [unbacked] paper money really desire monetary stability, they would not oppose so vehemently the reintroduction of the only system that has ever insured it, which is the system of the gold standard.

I did not believe in the following: Keynesianism, Federal Reserve monetary policy, and federal regulation.



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