Leithner Letter No. 51
26 March, 2004

Perhaps more fallacies have been committed in discussions concerning the interest rate than in the treatment of any other aspect of economics. It took a long while for the crucial importance of time preference in the determination of the pure rate of interest to be realised in economics; it took even longer for economists to realise that time preference is the only determining factor. Reluctance to accept a monistic causal interpretation has plagued economics to this day.

Murray Rothbard
Man, Economy and State, 1962

There are several things that we can stipulate with some degree of certainty: namely, that those who argue that we are already in a recession. are reasonably certain to be wrong.

Alan Greenspan
Federal Open Market Committee, 21 August 1990
(According to the National Bureau of Economic Research,
America entered a two-year recession in July 1990)

In a false prosperity, good economic ideas are marginalised. That’s why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. In time, Austrian Economics could be again seen as the mainstream theory. It should be.

James Grant
The Austrian Economics Newsletter, 1996

What If Böhm-Bawerk Was Right?

Eugen von Böhm-Bawerk (1851-1914), on three occasions the finance minister of the Austro-Hungarian Empire, was at the turn of the twentieth century one of the world’s best-known economists. His major work, Capital and Interest (vol. 1, 1884; vol. 2, 1889; 3-volume compendium, 1909-14), influenced early neo-classical conceptions of economic growth; and Karl Marx and the Close of His System (1898) ranks with Ludwig von Mises’ Economic Planning in the Socialist Commonwealth (1920) and Socialism (1922) as one of the most devastating from-first-principles refutations of the claims of state planning and interventionism.

A stalwart classical liberal and robust defender of private savings, entrepreneurship, limited government and laissez-faire capitalism at a time when popular antipathy towards frugality and commerce – and demands for state intervention and expenditure – began to appear, Böhm-Bawerk’s methods and insights have either been belittled or forgotten by today’s politicians, bureaucrats, academics, businessmen, investors, employees, consumers and taxpayers. Members of today’s mainstream, whether they call themselves “liberal” or “conservative,” are firmly and often unknowingly wedded to the ideas of John Meynard Keynes; Keynesians, in turn, applaud expenditure by individuals, businesses and governments, disparage savings in any form and by anybody and thereby take blissfully for granted the process of capital accumulation.

Not only did Böhm-Bawerk demonstrate that savings neither harm individual businesses nor attenuate the general pace of economic activity: he also showed that growth and prosperity occur only if savings are accumulated and profitably invested. Productive savings and entrepreneurship by businesses and individuals is a necessary condition of capital formation; and the expansion of productive capital underpinned by clear property rights is a sufficient condition of a higher material standard of living. Influenced by Böhm-Bawerk and the insights of his successors, contemporary Austrian School economists promote what today’s mainstream deride as archaic and even subversive: first, voluntary savings and the successful investment of those savings in free markets underpinned by property rights is the key to long-term prosperity; and second, governments’ attacks upon capital (in the form of interventionism, inflation and deficits) and consumption whether by individuals or governments that has not been financed by savings, temporary appearances to the contrary, retard and corrode prosperity.

But how much to spend today and save and invest for tomorrow? According to Böhm-Bawerk and elaborated by his successors, interest harmonises the quantities saved and invested. The “pure” or “natural” rate of interest depends upon individuals’ time preference – that is to say, their willingness to exchange a given amount of present goods and services (those which can be consumed today) for a specified greater amount of future goods (intermediate or unfinished goods which will become present goods at some point in the future). The greater (less) the willingness to trade present for future goods, or to outlay a given amount of money today in order to receive a specified greater amount at a particular point in the future– the greater, in short, the preparedness to wait – the lower (higher) the natural rate of interest (see also Hans-Hermann Hoppe, Democracy, The God That Failed: The Economics and Politics of Monarchy, Democracy and Natural Order, Transaction Books, 2002, ISBN: 0765800888).

The Austrian School conception of interest is hardly monolithic. Most notably, Ludwig von Mises (Human Action, Fox & Wilkes, 1949, 1996, ISBN: 0930073185) and Frank Fetter (Capital, Interest and Rent, Sheed, Andrews & McMeel, 1977, ISBN: 0836206843) thought that Böhm-Bawerk’s rendering was unsatisfactory in various respects (see also Murray Rothbard, Man, Economy and State: A Treatise on Economic Principles, Ludwig von Mises Institute, 1962, 1993, ISBN: 840212232 and Israel Kirzner, Essays on Capital and Interest, Edward Elgar, 1996, ISBN: 1858984076). Yet these Austrian approaches, at whose heart lies the notion of time preference, are far more similar to one another than they are to the mainstream. All, it is reasonable to summarise, emphasise that the discount on future goods vis-à-vis present goods (or, equivalently, the premium that present goods command over future goods), which is the pure or natural rate of interest, is at best indirectly observable. Observable or “market” rates of interest comprise three things: the pure rate, an entrepreneurial or “risk” component (which is akin to the “risk premium” in the mainstream literature) and any expected change in the currency’s purchasing power (“inflation premium”) over the relevant period.

Yet Another Reason to Criticise Keynes

In an unfettered market (and particularly in the absence of a central bank), interest responds to the laws of supply and demand. In a free market, in other words, interest co-ordinates the actions of borrowers and lenders. Anchored by the natural rate and varying from case to case and time to time according to risk and inflation premiums, the financial resources committed to investment projects will accurately reflect individuals’ willingness to forego consumption today in order (they hope) to consume more in the future. This market-directed process of saving and investment underwrites healthy economic growth; further, minor and gradual movements in the natural rate of interest generate small adjustments to the rate of growth and thus protect the structure of production against larger, more abrupt and extended corrections (i.e., recessions).

John Meynard Keynes and the contemporary mainstream reject the very possibility that interest might co-ordinate the activities of borrowers and lenders and equilibrate the desire for jam today versus more jam in the future. In The General Theory of Employment, Interest, and Money (1936) he stated that “classical economists” (a phrase he used to denigrate Alfred Marshall, A.C. Pigou and sometimes David Ricardo) “are fallaciously supposing that there is a nexus which unites decisions to abstain from current consumption with decisions to provide for future consumption.” This rejection has fundamental implications. As Roger Garrison (Ditch the Keynesians: Why Policy-Infected Rates Must Go, Barron’s, 2 September 2002) puts it, “Keynes’s verdict of ‘no nexus’ left interest rates up for grabs. And if they weren’t doing [any useful job], maybe they could be used for macro-management.”

In Keynes’s world, the optimism (“animal spirits”) of consumers and businessmen inspires them – preferably with credit not backed by savings – to spend and invest. (Keynesians, it is worth mentioning, notoriously confuse and conflate the distinct concepts of investment and consumption). It is this bullishness, Keynesians say, which creates jobs, bolsters spending and generates economic growth. Sunny dispositions thus beget the prosperity which reinforces the optimism. (Yes, upon careful reading much of Keynes’s reasoning, such as it is, reveals itself as circular and reliant upon self-fulfilling prophesies.)

To Keynes, interest reflects people’s “liquidity-preference” (i.e., the extent of their desire to hold cash). The greater this desire, the greater the inducement– the rate of interest– required in order to persuade them to exchange cash for less liquid assets. Three things underlie the liquidity preference. The first is the “transactions motive.” This is the cash required to finance everyday personal and business transactions. The second is the “precautionary motive,” i.e., the desire for a cash hoard stuffed under the mattress as a hedge against the uncertainty of the future. And the third is the speculative motive, i.e., the desire to profit “from knowing better than the market what the market will bring forth.” Keynes denounced high interest rates and blamed them upon “excessive liquidity preference” and an “insufficient propensity to consume.” In his view, the reduction of interest rates is a good thing because it induces greater spending (which is an even better thing). To borrow the vernacular of today’s financial commentators, to reduce interest rates is to “make cash trash.”

Interest rate “stimulus” is an important spanner in the Keynesian policy toolkit because the spending spurred by optimism and animal spirits may be insufficient to satisfy politicians’ electoral promises and bureaucrats’ appetite for bigger empires. If not, then lower rates (which render credit cheaper, reduce the liquidity preference and thereby induce more borrowing and spending), engineered by the central bank’s expansion of the base and supply of money, may be required. Conversely, if the coup de whiskey of easy money produces too much optimism – the contemporary term is “irrational exuberance” – for economists’ and politicians’ liking, then higher rates engineered by a slower rate of monetary expansion may be the order of the day. In Keynes’s world, then, individuals and the natural rate of interest, the risk premium, etc., that they negotiate are denied, obscured and bastardised by central and commercial banks.

Hence today’s conventional, man-in-the-street conception of interest: it is the cost of a loan to the borrower (or its proceeds to the lender), decreed by the central bank and accepted by borrowers and lenders alike. To many homeowners these days, the cost of a loan is the monthly mortgage payment on the house that is financed by the loan. In an analogous vein, U.S. Treasury Secretary John Snow told The Washington Post (21 October 2003) “interest rates are the price of capital.” Alien to Mr Snow, homeowners and the contemporary mainstream is the notion that lack of capital is dearth of time and that interest expresses time preference.

Austrians versus Keynesians Redux

The conception of interest in Keynes’s world presents a problem. If interest rates are instruments of policy that are strongly influenced if not decreed by extra-market entities such as central banks, and if their purpose is to yoke investors’ expectations to politicians’ preferences, then rates cannot perform the harmonising, market-based and growth-governing function that Austrian and other early neo-classical economists attribute to them. Roger Garrison’s insight deserves emphasis: to believe as Keynes did and his successors do that interest rates cannot or should not do their “traditional” job is effectively to license interventionist institutions (such as central banks) and an interventionist policy régime (such as “accommodative” monetary policy) whose raison d’être is to ensure that interest rates damn well don’t do their traditional job.

This problem has another facet: central bankers and interventionist monetary policies have occasionally (i.e., during the late 1920s-to-early 1940s and late 1960s-to-mid-1970s) misjudged and backfired spectacularly. Central banks have also regularly– most recently, during the late 1980s, early 1990s and mid-1990s-to-early 2000s– misjudged less disastrously. And it is not at all clear that the most recent misjudgment will in retrospect be categorised on the “less disastrous” end of the spectrum. Disastrous or not, during each of these unfortunate episodes businessmen, entrepreneurs, savers and investors were implicitly encouraged– not least by central bankers – to undertake actions which in retrospect were much riskier than they realised. This belated realisation cost many people very dearly for extended periods of time.

But no matter: central bankers are sorry and promise that they will not do it again. On 8 November 2002, for example, at the conference celebrating Milton Friedman’s 90th birthday, Benjamin Bernanke, a member of the Federal Reserve’s Board of Governors, stated “let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton: regarding the Great Depression, you’re right; we did it. We’re very sorry. But thanks to you, we won’t do it again.” Even the mainstream now acknowledges that the interventionism of the U.S. Federal Reserve transformed a severe recession into the Great Depression (see in particular Alan Meltzer, A History of the Federal Reserve, Vol. 1: 1913-1951, University of Chicago Press, 2003, ISBN: 0226519996). Alas, the lesson learnt from this débâcle is to intervene even more aggressively next time (see in particular Alan Ahearne et al., Preventing Deflation: Lessons from Japan’s Experience in the 1990s, Federal Reserve International Discussion Paper No. 729, June 2002).

Hence the nub of the problem that the mainstream conception of interest has bequeathed to today’s investors: economic policy-makers do not allow interest rates to do their traditional job of harmonising and equilibrating the behaviour of borrowers and lenders. Further, the interventionist policies unleashed by Keynesian assumptions occasionally induce many people to commit egregious mistakes. But despite their laudatory press, only irregularly (and in no small measure by happy accident) do the results of economic policy-makers’ interventions correspond to their intentions; and when they make mistakes, which as humans they necessarily and regularly do, their exalted and protected status shields them from the harsher fate that befalls small businessmen and investors who miscalculate.

Given this spotty track record and assuming for the sake of argument that Böhm-Bawerk correctly defined interest and identified the role it plays, it follows that much of what is uncritically accepted by today’s investors in order to value securities and undertake investment is wrong. The conventional wisdom bequeaths to us institutions and policy-makers who often generate incorrect (in retrospect, typically too low) bank interest rates – and therefore incorrect (again in retrospect, typically too high) asset prices. But over more extended periods of time these prices regress towards historical means. Accordingly, to follow Keynes – consciously or otherwise – is occasionally and unwittingly to participate, like an exuberant lemming in a mad herd, in mania and egregious error.

As an example, consider the article “Yield Curves Can Predict the Future” (The Australian Financial Review, 11 February 2004). It notes, accurately, that “this year economists and strategists [have] spent a lot of time pontificating about the next move in interest rates.” It also notes, far less accurately, that “another indicator investors can use to predict the future direction of interest rates is the yield curve” (for a contrary view, see What’s With the Yield Curve? by Frank Shostak). A yield curve is a chart that plots “market” interest rates on its vertical axis and bonds’ (or loans’) time-to-maturity on its horizontal axis. The curve typically slopes upwards because longer-term rates are generally higher than shorter-term rates; longer-term rates, in turn, are typically higher because market participants recognise that central banks’ inherent function is to manufacture inflation and thereby create an inflation premium in credit markets.

According to a source cited in the article, the yield curve is important because interest rates are the primary driver of investment markets. From this reasonable point a debatable one is inferred: “the yield curve tells us exactly what borrowers and lenders think about the future direction of short-term interest rates.” Far more accurate is the view expressed by Christopher Mayer in What the Fed Can’t Control: ”let’s [just] say that interpreting the yield curve is a murky, debatable business with many opinions as to why things are the way they are at any point in time.” The article also states “simply, the slope of the curve provides a snapshot of the market’s view on [Reserve Bank of Australia] policy, inflation and even fiscal policy. A relatively flat curve, as we have in Australia now, shows investors believe the outlook for monetary policy and inflation to be relatively benign. [And] in times of strong growth and as the potential for inflationary bubbles grows, the curve will respond becoming more positive [i.e., upward-sloping] as expectations of a tighter monetary policy are built in.”

Paul Kasriel makes a much more general and fundamental point, namely “the tendency for yield curves to be upward sloping since the inception of [central banks], whereas, prior to this event, they were, more often than not, downward sloping” (see also James Grant, The Trouble With Prosperity: A Contrarian’s Tale of Boom, Bust and Speculation, Random House, 1996, ISBN: 0812929918). Kasriel continues: “the median ratio of high-grade corporate bond yields to commercial paper interest rates [in the U.S.] was 0.87 in the years 1857 through 1913. Thus, prior to the inception of the Fed, there was a tendency for bond yields to be below money market yields. With the creation of the Federal Reserve System in 1914 through 2002, the median of this ratio jumped by 52% to 1.32. That is, since the Fed came into existence, it has been more common for bond yields to be above money market yields. Of course, this change in relationships between bond yields and money market interest rates is not surprising given the change in the behaviour of [price] inflation. If inflation is the rule rather than the exception, then higher future interest rates would be more likely than not. Hence, a positively sloped yield curve would be the norm.”

Investors who consciously or otherwise embrace Keynes’ conception of interest and ignore the Austrians’ – like the author of The AFR article of 11 February – thus obsess about governments’ and central banks’ present actions and those they might undertake during the next 3-6 months. They also fret about distractions and irrelevancies such as consumer and business confidence, generally adopt “bullish” outlooks, fixate upon observable rates corrupted by central banks and ignore the natural rate of interest. As a result, they proceed blissfully unaware that observed rates that are significantly lower than the natural rate – which, Kasriel arguably shows, they typically have been since the establishment of central banks– imply that risk and inflation premiums are less than zero. This implicit (and manifestly absurd) assumption enthuses speculators-who-think-they-are-investors and pushes the prices of assets well above those that unfettered markets would generate. Hence investors who embrace Keynes’ conception and ignore Böhm-Bawerk’s necessarily (and probably unwittingly) write themselves tickets for infrequent but possibly severe trouble.

Some Sober Consequences for Value Investors

To follow Eugen von Böhm-Bawerk and his successors, on the other hand, is to arm oneself with sceptical and critical armour and thereby reduce one’s propensity to partake in herd-like behaviour. If Austrian School economists are correct about interest and the role that it plays in the economy, then investors would do well to abandon certain tenets of the conventional wisdom.

Reassessing the Role of Central Banks

Most importantly, investors should be flabbergasted that today’s central banks and bankers are acclaimed and even revered. Rather, investors should regard these institutions with a mixture of scepticism and fear. James Grant, a Forbes columnist and editor of Grant’s Interest Rate Observer, regards the Federal Reserve as a bizarre “cross between America’s unlamented Interstate Commerce Commission and the Wizard of Oz.” Communism, socialism and central planning have been refuted by Austrians since Böhm-Bawerk’s day, and by some others since the collapse of the Berlin Wall and Soviet totalitarianism. In the wake of these collapses, the onus is upon the proponents of intervention to justify why the price of mutton or petrol or newspapers or visits to the doctor or insurance premiums should be fixed by governmental fiat. And monopoly control properly puts a bad taste in the mouth. But virtually everybody – including prominent policy makers and market participants who have spent considerable periods in élite academic institutions – still believes fervently in the central planning and price-fixing practiced by this one institution manipulating one observable interest rate.

A related point, one that James Grant has put well, is that investors should realise that central banks do not dictate rates. Rather, they set a single rate, namely that at which they are prepared to lend to commercial banks. Other rates, such as the short-term ones at which commercial banks lend to one another, are indeed strongly influenced by the central bank; but the further to the right one proceeds along the yield curve (e.g., to the rates at which commercial banks lend to individuals and businesses), the more indirect and feeble the central bank’s influence becomes.

Thirdly, and also a theme of Grant’s (who adapted it from Friedrich von Hayek), the cardinal sin of central banks – ably assisted by an army of commentators, brokers, financial planners and the like – is not that in the past they have unwittingly encouraged investors and businesspeople to make grievous mistakes. The point is not that central banks regularly enact measures that help to generate what in retrospect are clearly incorrect rates: it is that no one individual or organisation, no matter how intelligent and diligent, can possibly supplant the myriad actions of countless borrowers and lenders. If this smug assumption (namely that a small number of disinterested “élite” minds knows better than a large number of buyers and sellers with skin in the game) is the fatal conceit of socialism, then it is also the Achilles heel of central banking. In short, at any given point in time nobody knows what the yield curve should or will look like; and it is the greatest canard and danger of present monetary arrangements that its captains presume that they do know.

But perhaps (as Grant contends) people need to believe that somebody is in charge. The realisation by members of the public that the pull of a given policy lever does not and cannot cause a mechanistically predictable response would neither surprise nor disturb – indeed, would comfort – an Austrian School economist. But neither would it hearten the average superannuant or buyer of stocks, managed funds and residential real estate. Perhaps people are reassured that the central bank is there; and perhaps they need to believe that it knows what the “right” rate is. As Letter 50 observed, most and perhaps virtually all Australians think that politicians’ lofty rhetoric and veiled coercion can deliver more and better goods and services than individuals’ voluntary efforts. They think these thoughts with respect to the long and growing list of private and toll goods whose production and consumption politicians arrange and regulate. But to do so is to give much more weight to hope than to reason and experience. Less charitably, a four year old who believes that Santa Claus exists is charming; but an adult who believes that a central banking Santa Claus can give him exactly what he wants, now and in the future, is probably mistaken.

Time to Go?

Central banks, it needs to be stated bluntly, are anachronisms of an era when the pretensions of central planners were taken seriously. Yet uniquely among the institutions established during that era, and inexplicably, they survive with their prestige not just intact but enhanced. Stephen Roach of Morgan Stanley agrees that their reputation is undeserved. In “Central Banks Discredited” (17 February 2003), he writes that “they are yesterday’s heroes [and] have overstayed their welcome. And now, with their arsenals dangerously depleted, they are woefully ill-equipped to cope with [today’s] ever-daunting complexities. I fear modern-day central banking is on the brink of systemic failure.”

On three occasions in 2003 (18 August, 25 August and 1 September), Gene Epstein, the “Economics Beat” columnist of Barron’s, advocated the abolition of the U.S. Federal Reserve. So did Ronald Reagan (Reagan: A Life in Letters, The Free Press, 2003, ISBN: 074321966X), and on 17 July 2003 Congressman Ron Paul introduced HR2755 “to abolish the Board of Governors of the Federal Reserve System and the Federal reserve banks, to repeal the Federal Reserve Act, and for other purposes.” Perhaps it is time that Australians did the same to the RBA. Its abolition would not only remove the major source of asset “bubbles,” the absence of “accommodative” (i.e., inflationary) monetary policy that accommodates profligate fiscal policy would also force the Commonwealth and state governments to shrink massively – i.e., to a size small enough to fit inside the Constitution.

A More Cautious Way to Weigh Risk and Reward One of James Grant’s most intriguing insights is that just as there is a structure of production there is also a structure of speculation. It is given to us by the yield curve, which can be– and usually is– corrupted by interventionist monetary policies. In the era of central banking, remember, and diametrically unlike the era of the classical gold standard (roughly 1814-1914), yield curves are typically upward-sloping. This, it is important to realise and emphasise, provides a speculator’s paradise: in a “carry trade” that occurs 24 hours per day and seven days per week, speculators can borrow at low short-term rates and use the proceeds to “invest” at higher longer-term rates.

The distortion of the structure of speculation that typically results from the central bank’s “stimulus” is usually most marked at the front or “short” end of the yield curve. This distortion provokes needless additional uncertainty and occasionally threatens instability because the entire structure becomes vulnerable to a sudden change in the cost of borrowing. Hedge funds and owners of whopping mortgages (who typically have more in common than either thinks) are you listening? Under these conditions, which in retrospect occur disturbingly often, the calculation of risk and reward becomes distorted and people are lulled into taking risks they do not realise they are taking.

A More Sensible Interpretation of Quoted Rates

Two conclusions for investors emerge from this look at interest from an Austrian School point of view. First, the relevant question to ask about an observed rate relates not so much to its level but to its integrity. Easy money can encourage many delusions and mask many distortions. Borrowers, lenders and investors would therefore do well to ask themselves: given pervasive government intervention, do today’s interest rates convey accurate information about borrowers and lenders? Acting on them, and using historical standards as rough baselines, would they make reasonable choices? Or would they undertake “malinvestments” which must be liquidated when the bullishness and sunshine end?

Second, what is needed for a sound expansion of production is more savings, productive capital goods and interest rates that reflect time preference – and thus (to use Roger’s Garrison’s words) rates that “tell the truth about time.” What is not needed is ever more credit unbacked by savings, and historically-low (and likely bastardised) rates of interest. Yet more and more, it seems that Australians, Americans, Britons and Canadians, like participants in methadone trials, regard the “fix” of low rates as an entitlement owed to them by government. They are living on borrowed money – and therefore, as Böhm-Bawerk showed, on borrowed time. “Investment” (which is often actually consumption) prompted by subsidised rates of interest can continue only as long as central and commercial banks create credit at subsidised rates. It is this margin between the subsidised (sub-natural) and the natural rate which misleads entrepreneurs and gives their investments the false appearance of profitability. It also misleads consumers and gives their spending sprees the false appearance of sustentation.

The final word – and a bold prophesy – belongs to Garrison. In Ditch the Keynesians: Why Policy Infected Rates Must Go he concluded “current interest rates are too policy-infected to have much significance at all except as a basis for guessing about future interest-rate policy. Keynes, we now should all see, did his job very badly. The Federal Reserve will eventually have to abandon interest-rate targeting if the market economy is to have a chance to right itself. (The Volcker Fed turned rates loose in 1979 under very different but equally untenable circumstances.) Interest rates can do their job, but they need some on-the-job training. Ongoing debate in Washington and on Wall Street suggests that in the foreseeable future, they’re not likely to get any.”

Chris Leithner


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