OP-ED: What is an interest rate?

Editor Note: This is the second part of a three-part op-ed regarding money. You can check out the first installment here. When we were figuring out what constitutes something as money, we saw how the value the baker held for maple syrup diminished when his supply of that good increased and that the value someone holds for something is subjective and unique to that individual. The hunter will, likely, always hold more value in venison than the baker no matter how much venison the hunter has, as the baker is a vegetarian and holds no value in venison. Hence, even with diminishing marginal value, a person could still hold more value in a unit of money even if they have more money than the next person. Today I will explore what interest is and what affects the interest rate.

What is an interest rate?

An interest rate is the “premium” one gets on “loans” of money.  Not only banks and credit card companies loan individuals money.  When individuals hold money in certain types of accounts in banks or purchase bonds they are essentially loaning their money. There are more factors that have an effect on the rate of interest than I can hash out in an opinion column but the ones I will touch on will help to explain why there is an interest rate and were originally presented by Eugen von Böhm-Bawerk in his second volume of Capital and Interest, Positive Theory of Capital, first released in 1889.  In it, he states “Present goods are, as a rule, worth more than future goods of equal quality and quantity“. Robert P. Murphy, Ph.D, in his doctorate dissertation, has defended Böhm-Bawerk’s work but also asserted that instead of comparing “present goods” to “future goods” it should be “Present Money is, as a rule, worth more than future money of equal quality and quantity.” Böhm-Bawark gives three causes for his statement:

1. Individuals believe that they will be wealthier in the future.
2. Future desires are more abstract and harder to imagine than present desires.
3. More roundabout methods of production are more physically productive.

Before exploring the causes Böhm-Bawark gives, it is important to again point out that individuals’ time and value preferences are subjective.  Also a good, say ice, is a different good depending on the time or location that good is available.  Ice in Florida is a different good than ice in Alaska as are ice in the summer and ice in the winter.  Depending on where and when you are, your cardinal values change.

“It (time) is in an irreversible flux the fractions of which appear in a different perspective according to whether they are nearer to or remoter from the instant of valuation and decision” ~Ludwig Von Mises’ Human Action

Back to Böhm-Bawark’s three causes:

1. “Individuals believe that they will be wealthier in the future.”  Thomas Sowell actually shows that, empirically, as individuals age they, generally, move into higher income brackets in his book “Basic Economics”.
2. “Future desires are more abstract and harder to imagine than present desires.”  How often has something happened exactly how you planned?  Something in the future is not a sure thing, psychologically, we tend to pick the sure thing.  To really make this statement ring true, how do you know you will live to see tomorrow?  Life is uncertain.
3. “More roundabout methods of production are more physically productive.“  Which does not mean that a longer production for the sake of longer production is valuable. Instead, it means that a machine (capital good) or process (labor or service) increased the production’s quality and/or quantity more than the cost of implementing or hiring said capital good or service.

These three statements show why, even without taking inflation into consideration, money loaned today will, generally, reap a positive interest rate.  Great so now we know why there is an interest rate.  Interest is utilized, when individuals who have longer time preferences engage on the market with those who have shorter time preferences, both seeming to benefit from the exchange. Each rate of interest is unique to each exchange, the individuals involved, each of their time preferences as well as the supply and risk of those loaning and those receiving the loans.