Interest Rates in One Lesson

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The financial
press returns to the theme of interest rates again and again.
This concern is not limited to the modern financial press. The
investment world has always been concerned over the direction
of interest rates. The problem is, there is so much confusion
about the origin of interest rates that the analyses presented
in the press are often conflicting. Their readers rarely can sit
down and explain to a novice what they have just read and why
it is important.

The concern
over interest rates is not wasted by the press. Interest rates
are as important for the man in the street as they are for policy-makers
at the highest level of government. But when confusion reigns,
as it does today, people are apt to make the wrong decisions regarding
their investments, which in turn affect their life’s plans. Obviously,
it will make a great deal of difference when you retire whether
your bank pays you 7% or 1% on your deposit.


The fundamental
fact of the interest rate is that it is a discount of the future.
Let’s say that you win a contest. First prize is a fully restored
dream car of your youth. In my day, this was a red 1957 Ford Thunderbird,
although a 1955 or 1956 would do nicely as a substitute. Someone
might even prefer a 1958 Chevrolet Impala, with 1955—57 Bel
Airs as substitutes. Ten years later, it would have been a red
Ford Mustang. Whatever it is, you just won it.

You are now
given a choice. You can take delivery immediately, or you can
wait a year for delivery. The outfit won’t drive the car or in
any way wear it out, but maybe they want to do research on its
suspension system. Assuming that you are not about to be sent
to Siberia for a year of research on tundra, which delivery date
would you prefer? Do you want your prize now or later?

The answer
is obvious: you want delivery today. You don’t want to wait. Why
not? Well, for one thing, you might be dead in a year. For another,
you want to re-live your youth before Alzheimer’s arrives. Most
important, your responsibility is in the present, not the future.
Maybe you want to sell the car and use the money for something
else. Whatever it is that you plan to do with the car, you are
responsible for that decision now. It is better to own the asset
now than later. You don’t know what is coming later.

But you are
probably willing to forego the delivery if the contest organizer
offers you compensation. Maybe you are promised 1,000 gallons
of gasoline along with the car if you will wait a year. Maybe
they promise to run your photo, your name, and a photo of the
car every month in your industry’s trade magazine. Maybe you could
use the publicity. The point is, if they offer you something of
value, either immediately or over the next year, you might decide
to accept a later delivery date.

To persuade
you to delay delivery, they have to offer something extra to you.
Why? Because you apply a discount for delay. Someone wants to
use the car — your car — during the interim. At some price, you are
willing to forfeit the use of your car. They must pay you more
than the discount that you apply to forfeited use.

This same
analysis applies to every asset that can provide you or anyone
else with benefits over time. Usually, people discuss interest
in relation to money. Interest is said to be the price of money.
This concept is incorrect if it is said to apply only to money.
Interest is a discount applied to every stream of benefits, or
as economists say, stream of income.

people apply different rates of discount to streams of income.
Some people are intensely present-oriented. They want action now.
They don’t want to wait. This is common among children. It is
common in the inner city. A borrower would have to offer a high
rate of interest to get such a person to give up the use of his
money or any other asset. Think of what you would have to pay
an alcoholic on skid row to give up his bottle of Thunderbird — the
T-bird of the underclass.

Other people
are comparatively future-oriented. They are willing to surrender
the use of money or other assets for a third of the discount rate
that an inner city resident would. The more of these people in
a society, the lower the rate of interest in that society: lots
of thrifty people who are ready to lend at low rates. Competition
among these people to find borrowers will lower the interest rate.

The central
fact of interest is this: we discount the future. Item A is worth
more to us today than it is a year from now. We have a year to
enjoy it. We therefore have to be offered compensation to persuade
us to forfeit the use of it. This is also true of item B.


The next
factor is the reliability of the borrower. Let’s return to that
1957 Thunderbird. You want to take it out for a spin today. You’ve
been dreaming about doing this ever since you were 15. You’ve
waited long enough.

Now the outfit
says it wants you to postpone that spin, or any spin, for a year.
It promises to let you have the car plus 1,000 gallons of gasoline
in a year. That sounds good, but are you sure that the outfit
will still be in business in a year? Are you confident that this
story about researching the suspension system is legitimate? It
sounds fishy. What are they really going to do with the car? Are
they going to spend a year joy riding, and then roll back the

You have
already discounted the value of the car. Now you must make an
assessment of the reliability of the person making the promise
to deliver your car and 1,000 gallons of gasoline in a year. There
is risk here. How reliable are these people?

You think
it over. You are taking a risk. You are being asked to trust someone.
You do not have perfect foreknowledge. A promise to pay is not
the same thing as paying. It’s one thing to discount the future
value of the car. It’s another to assess the likelihood of delivery.

So, you tell
the company that you want 1,200 gallons of gasoline in a year.
Maybe the outfit agrees or maybe it delivers the car to you today.
The point is, you want to be compensated for the risk you must
bear in accepting a promise to make delivery vs. actual delivery.

In every
loan there is a risk premium. This is in addition to the discount
that both the lender and the borrower apply to the future. The
discount is applied to the value of the expected stream of benefits.
"How much do I want to drive that car this year?" The
risk premium is applied to the person making the promise. "How
much does he want to drive that car, and how good is he at rolling
back an odometer?"


You and the
contest organizer would be wise to take into consideration the
value of money. He says he will give you a credit for 1,200 gallons
of gas when he delivers the car. If you think the dollar is going
to depreciate by 5%, that’s a good deal for you. But if he thinks
the same thing, he has to factor this expense into the price he
will have to pay to get the use of the car to study its suspension
system, either in the garage or on the highway at 90 miles an

I am not
talking about the rise or fall of the price of gasoline alone.
The gasoline futures market allows people to lock in the future
price of gasoline, either as buyers or as sellers. I am talking
about changes in the value of the dollar.

If you think
the value if the dollar will rise, you are predicting price deflation.
You would then rather receive a fixed quantity of money for gasoline
instead of actual gasoline. The contest organizer would prefer
the reverse, assuming that he agrees with you about the rising
value of the dollar. He would rather give you a credit card for
gasoline. On the other hand, if you both expect price inflation — a
lower dollar — then you want the gasoline, and he prefers to promise
you money to buy as much (or as little) gasoline as the fixed
sum of money will buy when you want to buy it.

So, there
is a discount for time that both you and the contest organizer
apply to the future. There is a risk premium that you, as the
lender, apply to the organizer and his promise to deliver the
car. Finally, there is an inflation or deflation premium that
both you and the organizer apply to the value of money, assuming
that any aspect of the payment is tied to money. In a high division
of labor economy, some part of the payment will be tied to money.


It is time
to cease discussing 1957 T-birds and start discussing 2004 T-bills.
Reality intrudes.

When discussing
free market interest rates, economists prefer to begin with T-bills.
This is because a U.S. government T-bill is considered as close
to risk-free as any investment on Earth. The U.S. government is
probably not going to default. Also, a 90-day T-bill is unlikely
to depreciate or appreciate as a result of changes in the rate
of price inflation. The time period until maturity is too short,
and Federal Reserve monetary policy is too stable. So, when we
discuss the rate of interest, we are discussing the discount.

Or are we?
Financial commentators watch T-bill rates, not as indicators of
a society’s discount on the future, but as indicators of FED policy.
The FED drove down the T-bill rate from over 6% in late 2000 to
a little over 1% in mid-2003. That
enormous fall surely did not reflect a change in world opinion
regarding the appropriate discount for the future. It reflected
a change in monetary policy.

To sort out
the confusion, we need advice from parrot #1. "Supply and
demand. Supply and demand." Parrot #2 is still calling out,
"High bid wins," but he is less important at this juncture.

The interest
rate allocates capital. That is to say, it allocates expenditures
between present consumption and future consumption. People with
high discount rates allocate most of their money to present consumption.
Call this the pawn shop rate. People with lower discount rates
allocate a larger percentage to future consumption. Call this
the T-bill rate.

The members
of the Federal Open
Market Committee
(FOMC) of the Federal Reserve System decide
how many T-bills to buy or sell. These members have a very low
discount rate — not for themselves, of course, but for money
they create to buy T-bills. They are like counterfeiters. A counterfeiter
has a much higher rate of discount for goods that he loans out
compared to any counterfeit money that he loans out. An FOMC member
is not lending his own money. He is also not lending depositors’
money. He is lending counterfeit money. The difference between
counterfeit money and FED money has more to do with trademark
analysis than economic analysis.

Murray Rothbard once described a cartoon of a bunch of counterfeiters
at their printing press. One of them says, "The local economy
is about to get a shot in the arm." Again, the issue here
is trademark infringement, not economic analysis.

The FED drove
down interest rates in 2001 through 2002 because it bought T-bills
with abandon. It bought T-bills with newly created money. "Supply
and demand. Supply and demand." The supply of money went
up, so the price of money went down. That is, the interest rate
on T-bills went down. O, happy day for the Treasury Department.
What the U.S. government had been paying to lenders in early 2001
fell by a factor of at least 5 by mid-2003. O, happy day for all
other borrowers. O, woeful day for retirees with most of their
money in the bank.

discount rate did not change. The risk premium on T-bills and
other short-term loans did not change. Even the price inflation
premium did not change, although it is changing now: upward. What
changed was the supply of money being funneled by the FED into
the market for T-bills. "Up, up, and away!" as radio’s
Superman used to say. "To infinity and beyond!" as Buzz
Lightyear says.


Like that
counterfeiter in the cartoon, the policy-makers at the FED wanted
to give the American economy a shot in the arm. The FED has few
ways to do this. Buying T-bills is the main one. But, this time,
the shot in the arm did not produce much economic euphoria. The
economy barely recovered until late 2003. The housing market continued
to boom during the recession of 2001 and the aftermath. The public
kept buying consumer goods and running up credit card debt. But
the economy barely recovered, and profits remain a disaster zone.

The shot
in the arm did not accomplish much, despite a 1% federal funds
rate — the rate at which commercial banks lend money overnight to
each other. The economy today is growing, and price inflation
has returned. But this has been the weakest recovery on record.

The Dow Jones
recovered, but seems to have stalled in the mid-10,000 range.
It is now falling back. It never regained its 2000 high. The NASDAQ
has also stalled, and is well under 5040: March 10, 2000. The
stock market has sent a signal to investors for four years: the
days of wine and roses are over. The boom of 1982 to 2000 is over.
The dreams of compound annual growth rates above 10% are still
alive, but the American stock market has not met these dream world
expectations for four years. Now it is heading down again.

Fiat money
has created comparable price inflation, but it has not sustained
the boom except in housing. The shot in the arm has lured millions
of Americans to pile up layers of debt. When the price of anything
falls, more will be demanded. The price of loans has fallen. The
result is the expansion of debt.

When will
the boom in financial assets reappear? Even the optimists have
no clear answer.

The boom
in housing is being sustained by fiat money, which in turn has
driven down interest rates. This fiat money came from the FED
in 2001 and 2002. Today, it comes from Japan and China, whose
central banks have been buying T-bills with the dollars they bought
in the international currency markets with newly created yen and

The problem
is, our personal discount rates have not fallen, even though T-bill
rates have fallen. People may lend money at low rates because
they expect an economic crisis, and therefore they remain content
with low rates because of what they perceive is much higher risk
of non-guaranteed investments, such as stocks. That is, people
accept low rates of interest because of their fears regarding
other investment avenues. But when they lose this fear of other
investment avenues, their underlying discount rate will reappear
in the credit markets.

The boom,
if it continues, will push interest rates up.


The world’s
investors did not move from a personal 6% discount for time (late
2000) to 1% (2003—2004) just because the FOMC’s members decided
1% is better. What changed was the quantity of money being allocated
to T-bill purchases. The officially licensed counterfeiters gave
the T-bill market a shot in the arm. They still are doing this.

The day that
these counterfeiters decide to stop supplying the euphoria-inducing
substance that allows the Treasury Department to mainline at below-market
prices, interest rates will rise as surely as a drug addict has
withdrawal symptoms.

I think this
is why the stock market has stalled. Investors look into the glassy
eyes of the U.S. government and conclude: "Even counterfeiters
want a more reliable borrower than this spaced-out wastrel."
They think the counterfeiters will find other borrowers. When
that happens, the FOMC will have to replace the Asian pushers.
If the FOMC refuses, then there will be withdrawal symptoms on
a scale not seen in decades.

19, 2004

North [send him mail]
is the author of Mises
on Money
. Visit
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