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What Is Interest?

Posted by
December 22, 2011
in Blog

Consumers and entrepreneurs often speak of “the cost of money” when referring to interest rates. Modern lenders also refer to the interest they charge as “loan pricing.” Viewed this way, interest is viewed as if it were any other good. The cheaper a good the more affordable it is. And so the lower the interest rate, the more affordable. By dictating key interest rates, modern central bankers are believed to be alchemists, lowering interest rates to magically transform scarcity into prosperity.

As the world struggles to deleverage, with the market constantly forced to clear malinvestments of a continuous string of asset bubbles and crashes, central bankers continue their faith in the ancient tradition. All the economy needs is more monetary elixir. If the patient hasn’t yet responded, it must mean larger doses are needed: Interest rates must be too high.

The mainstream view has devolved to the belief that zero is too high. In the spring of 2009, Harvard economist, and former adviser to President George W. Bush, N. Gregory Mankiw seriously wrote in the New York Times, “It May Be Time for the Fed to Go Negative.” But who would lend money to only receive less in return?

Mankiw approvingly cites German economist Silvio Gesell’s argument for a tax on holding money, an idea John Maynard Keynes himself approved of. Crazier still is Mankiw’s idea that one of his graduate students floated, of turning interest-rate policy into an absurd game of chance.

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw — it’s a benefit.[1]

Mankiw recognizes that the idea of negative interest rates is nonsense to most people. But he writes, “Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace.”

However there is nothing new about the idea of the state juicing up an economy with low interest rates. John Law’s monetary theory for an ailing France in the early 1700s was built on a foundation of low interest rates. The Scottish economist and policy maker believed interest rates were derived from…

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image from mises.org