The classical theory of rate of interest
Most of us and all of us who went for Econ 101 know this theory. Higher interest rates spur people to save higher part of their income and at the same time those same rates cause investment, which is funded with the savings of people (savings must come first, investment follows... also incorrect but that matter is somewhat out of the reach of this post), to decrease as rates becomes higher. In "equilibrium" the savings and investment schedules meet and that is where the rate of interest and amount of savings and investment is decided.
The well-known supply-demand diagram of how interest rates are decided according to the amount of savings and investment in the economy.
This is the static theory of rate of interest: rates get higher and people will save more, no questions asked. This is of course nonsense, otherwise how would one explain situations like this one?
A question in a survey I asked people to participate in. Higher rates don't seem that interesting if you cannot access your money. Obviously, the number of responds might not be significant enough, but you get the point: higher rates don't necessarily mean that people jump automatically on that bandwagon as the static theory of rate of interest implies.
The classical dynamic version is that people ask for the rate of interest because they are willing to wait for that price (rate of interest) for their chance to spend their money. The longer you wait the higher rates you will get. Interest rates are the price of time according to this theory. This seems like the most accepted view of most economists and it’s an old one. It is essentially built on the idea that interest rates are decided on where the marginal disutility of waiting to consume (save) is equal to the marginal productivity of capital (I’m not going to get into how flawed the terms “marginal disutility of savings” and “marginal productivity of capital” are).
Hayek (Austrian) held that interest rates reflected the collective (market) preference of individuals to consume now rather than later. If people wanted to consume now, interest rates would have to be high in order to get them to save part of their income until they could use it and the accrued interests for consumption later.
Mises (Austrian) was of the same opinion: “Interest is the difference in the valuation of present goods and future goods; it is the discount in the valuation of future goods as against that of present goods” and “The greater the fund of means of subsistence in a community, the lower the rate of interest.”
Hicks (neo-Keynesian, the one who thought he grasped Keynes’s General Theory in the IS-LM model but apologised for his faults later): “There are other instruments of economic policy which can attain the same objective as a rise in interest rates; and some of these may well be less destructive instruments. But we should not forget that in these days of scarcity time is short; and the rate of interest is the price of time.” (1947, ‘World Recovery After War – A Theoretical Analysis’ my emphasis).
Marshall (neoclassical): “Interest, being the price paid for the use of capital in any market, tends towards an equilibrium level such that the aggregate demand for capital in that market, at that rate of interest, is equal to the aggregate stock forthcoming at that rate”.
So the rate of interest is the price of waiting according to the classical/neoclassical/Austrian theory. A rather convenient corollary of this – note especially the latter quote from Mises – seems to be that the only thing needed to decrease the rate of interest in the economy is to get the public to save more: if the public increases its savings, the supply of investment-funds increases and, given the same investment schedule, the rate of interest lowers and investment increases exactly by the same amount of increased savings.
This view of the origin of rate of interest has never been proven to apply in practice. And it is of course very very flawed once one takes a step back and thinks about it.
“This is a nonsense theory”
Keynes declined the classical theory out of the simple observation that it was inconsistent with the assumptions it rested on:
The independent variables of the classical theory of the rate of interest are the demand curve for capital and the influence of the rate of interest on the amount saved out of a given income; and when (e.g.) the demand curve for capital shifts, the new rate of interest, according to this theory, is given by the point of intersection between the new demand curve for capital and the curve relating the rate of interest to the amounts which will be saved out of the given income. The classical theory of the rate of interest seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down. (from the General Theory, Chapter 14, my underlining)
So Keynes had to come up with another theory since he realised the classical theory was useless for the simple fact that one cannot both eat the cake and keep it.
Keynes’s Liquidity Preference Theory of Rate of Interest
Keynes’s LPT was based on the sober observation that savings could be kept in many different forms. It wasn’t the amount of savings that decided the rate of interest, as in the classical/neoclassical/Austrian theory, but the form which the savings were kept in. 1,000 euros kept in cash are just as much of savings as 1,000 euros kept in corporate bonds. If people were willing to shift from one form to the other, interest rates would change. How people saved mattered, not the amount they saved.
A simple way to show the subtle difference is hopefully the following. A man has 1,000 euros in after-tax income. He spends 900 of them in living expenses (consumption) and the rest is savings.
Now the question he must ask himself is the following: “will I possibly need the 100 euros I’ve saved this month in case something happens in the near future that calls for unexpected expenditures that I cannot meet with my regular after-tax income? If so, I need to keep the savings in a form which I can easily access to meet the unexpected expenditures. If not, I can keep the savings in a form that could possibly take me days or years to access.”
If the man thinks he needs the cash in near future, he will keep it in liquid form, such as cash, which yields no rate of interst, or a demand-deposit bank account which he can withdraw the money from any time he wants. But at the same time, the demand-deposit account has very low rate of interest.
If the man thinks he doesn’t need the cash, he’s OK with keeping it in illiquid form that takes him days to get into the type of wealth he can spend on consumption, i.e. cash. One such form is time-deposit bank account which he cannot withdraw the money from until sometime later. This is beneficial for him as the time-deposit account has very high rate of interest in comparison to the demand-deposit account.
Notice the very subtle difference: no matter how he decides to keep his savings (20 euros in the demand-deposit bank account and 80 in the time-deposit account or 50 in each...) he will always save the same amount! The rate of interest does not influence the amount he saves but only how he saves it – how much goes into the immediately accessible but low interest rate demand-deposit bank account in comparison to the ill-accessible but high interest rate time-deposit account.
So the rate of interest is not the price of waiting to consume (to save) but the price of our willingness to depart with the ability to use our money in case something unexpected happens. Interest rates are, as Skidelsky called it, the price we are willing to accept for losing our “instant command over sums of money.”
A wonderful corollary to this fact is that the Central Bank can, and should, influence not only the short term rate of interest downwards but the long-term rates as well. It does this by securing full liquidity in the market for public-debt instruments of all maturities. Doing so, the public can be as liquid as it wants and the rate of interest will decrease.
The Future Nominal Monetary Target?
It is here where the “Death of the Inflation Target” plays its part. The inflation target was built on the classical, and wrong, theory of the origin of the rate of interest. More importantly, the majority of central bank theorists have not accepted what market makers have been knowledgeable about for a very long time: money is endogenously created at the same time as credit is but not exogenously (the textbook helicopter model): money does not come first and then credit but credit-demand first and then credit-creation and money-creation at the same time. And it is the Endogeneity of money that creates the asset boom-and-bust cycle.
Blatantly, as the Austrians realised (although they used the wrong theory of interest to reach that conclusion) and Keynes as well, if the rate of interest is lower than the marginal efficiency of capital, a bank credit-driven investment boom and bubble will commence. But at the same time, the rate of interest must be kept low in order to fuel investment demand and thereby labour demand. High interest rates kill off productive investment that would have otherwise lowered the unemployment and increased production in the economy. Low enough interest rates – as low or lower than the marginal efficiency of capital – would almost definitely secure full employment in the economy, permanently.
The problem that arises from a situation where interest rates are lower than the marginal efficiency of capital is the threat of a credit boom with all the accompanying money creation and demand that will hit supply-constraints resulting in the inevitable: high inflation.
But the remedy against this is to keep the endogenous nature of money on a short leash. Money in a modern economy is created by the banking system sidelong the creation of credit and debt. If the credit creation capabilities of the banking system are kept under control, not with high rates of interest – for dear money does not automatically mean that money will not be easy – but with direct control of how much credit it can give, the credit boom problem is solved. If those limitations are put into place, there is no chance that credit-driven investment bubble can form with the resulting inflation unless the funds come from abroad.
But foreign inflow of funds into an economy means that the nominal exchange rate of the currency will strengthen. Stronger exchange rate means lower exports and shift from domestically manufactured goods to imports, resulting in a decrease in employment. Full employment in an economy where the Endogeneity of money is kept on a short leash does not go along with too strong exchange rate. At the same time, too low exchange rate means imports-inflation.
Somewhere, there is a wonderful but ever-changing balance in the exchange rate which is weak enough to secure full employment but not so weak that it causes overinvestment, credit-fuelled expansion of money supply and imports-inflation.
The future monetary target should be to keep interest rates low at all times with full liquidity provision of the central bank, fulfilling the public’s demand for liquidity – i.e. full access to their wealth – at all times. At the same time, in order to stop bank-credit fuelled investment booms-and-busts from forming, the credit creation capabilities of the banking system should be limited in such a way that the limitations are directly influencing the banking system to reach full employment and low inflation at the same time through balancing the exchange rate.
Nota bene: this exchange rate would be a free-market solution restrained only by the rules the central bank puts into place regarding credit creation. At the same time, the central bank influences the rate of interest downwards in order to reach the rather socially and economically well acceptable target of full employment through private investment projects.