Interest: the price of money

When a book is €7 in France, what does that mean? If it is $8 in the United States, is it more expensive there than in France? It depends on the exchange rates of the dollar and the euro. If the dollar is worth €0.80, then $8 equals €6.40, which is less than €7. The exchange rates of the euro and the dollar depend on supply and demand in the foreign exchange market. However, the price of money is not the same as the price of currencies.

When economists talk about the price of money, they mean the interest rate. The supply and demand for funds determine the interest rate, as well as the available funds for lending and the demanded funds for borrowing. When many want to borrow and few plan to lend, the interest rate rises. When only a few want to borrow, or when a lot of funds are available for lending, the interest rate drops.

Economists distinguish between money and capital markets. Money markets provide short-term funding, typically less than a year, whereas capital markets provide long-term financing. Several factors affect the supply and demand of funds in the money and capital markets. These are:

• Ordinary people value the present over the future, and the degree to which we do affects the interest rate. They suffer from time preference.
• Capitalists are very special people. They save and invest anyway, even at low interest rates. They are endowed with a capitalist spirit.
• Returns on other investments affect the money and capital markets because they must be attractive relative to alternatives.

Time preference

Suppose you are a hatter and have just sold a hat for €50. You could rush to the nearest phone shop and buy that fancy phone cover you saw yesterday. Alternatively, you could save up to buy a new smartphone later, once you have sold more hats. You could even save for your retirement. The odds are that the money will be gone before the month is over, and that you have acquired a phone cover or some other gewgaw. If this applies to you, economists will diagnose you with a condition called time preference.

Economists assume that we have a time preference, meaning we prefer to satisfy our desires now rather than later. You want the latest smartphone model now rather than later, and you may even wish to borrow money to buy it now. Individual time preferences vary. Your time preference is the degree to which you value the present above the future, which you can express in an interest rate. If the market interest rate is above your time preference, you save, and if it is below, you borrow.

Time preferences differ for different people. Mary may save if interest rates are above 4%, and borrow once they are lower. John may save as long as interest rates are above 6% and borrow when they are below 6%. Alex might save if interest rates are above 5%, but may not borrow if interest rates are below 5%. The result is that as interest rates rise, the supply of funds for lending increases and the demand for funds for borrowing decreases. The market interest rate will be where supply and demand are equal.

Capitalist spirit

Time preference is an ailment plaguing ordinary people. Their designated role in the economy is to consume. Other people think differently. Economists have diagnosed them with a condition called a capitalist spirit, which is the opposite of time preference. They are the capitalists. Capitalists believe that money spent on a frivolous item is money wasted. That is because if you save and invest your money, you will end up with more money to reinvest.

Capitalists don’t suffer from time preference. Their designated role is to invest. And so, they end up with a lot of money when they die. What’s the point of that? Capitalists invest in businesses that make the frivolous items ordinary people consume. Ordinary people wouldn’t have invested their money. They would have spent it on frivolous items instead, so that these items wouldn’t have been there in the first place.

Capitalists have a lot of money. They don’t stop investing when interest rates are lower. They can’t help themselves. They have a capitalist spirit, just as ordinary people can’t help themselves because of their time preference. When they run out of things to invest in, they lend their money at lower interest rates. Again, it is the law of supply and demand at work. If capitalists have a lot of money while other people cannot borrow because they can’t afford to pay the interest, interest rates drop.

Investment returns

There is no point in investing if you don’t get more in return. These returns end up as corporate dividends or as rent from real estate. If these returns are high, you may prefer investing over lending. Investing is risky. If sales are sluggish, corporations may cut their dividends, but lenders still get their interest. When a business goes bankrupt, lenders receive their money first, while investors get what’s left over. And that could be nothing.

When someone wants to borrow money from you, the interest rate must be attractive compared to the investments you can make. Otherwise, you may prefer to invest and receive dividends and rents despite the risks. In this way, interest rates on other investments affect those on loans. Banks dominate the markets for borrowing and lending, so we choose between investing and keeping a deposit at a bank.

Risk

When you lend out your money, the borrower may not repay. So, if a stranger wants to borrow some money from you, she could offer you a high interest rate so that you might think, ‘I don’t know her, but she may pay back, and the interest rate is attractive, so I’ll do it.’ Money can lose value due to inflation, so inflation is another risk for the lender. If the money that buys a smartphone today only buys a phone cover a few years later, you spend that money on a smartphone right now. That is, unless someone wants to borrow your money from you and offers a high enough interest rate, so that you save for a newer model that you expect to need a few years down the line.

A bank’s business is to know its customers, so lending to a bank is usually less risky than lending to an individual or a company. When you have money in a bank account, you have lent it to your bank. Banks are supposed to be good at managing risk, so you accept a lower interest rate on your deposit than you would on a loan to an individual or a corporation. Banks know their customers well and lend to many different customers, so they can manage their risks and lend at lower interest rates than you could. Interest is the price paid for distrust. If investors trust the debtors and the value of the money, they expect inflation to be low, which means interest rates are lower.

The government and the central bank play a central role in limiting banking risk. Banks charge interest on loans, which leaves debtors short of money. That is, unless depositors spend their money or someone else borrows the principal plus the interest. Like other Ponzi schemes, the usury scheme collapsed from time to time, leading to defaults and economic hardship. To prevent that, the government borrows money, and the central bank prints it into existence, bringing it into circulation so debtors can repay their debts with interest. But with governments and central banks propping up the usury scheme, debts continue to grow, which may eventually lead to a usury-financial apocalypse.

Convenience

When you lend your money to someone else, you can’t use it yourself. There may be a new smartphone you want to buy, but alas, you have lent out your money. That is inconvenient. Then you remember with a smile that you will have the phone and a hip phone cover next year because you received interest. So, if you don’t receive interest on your money, you may not bother lending it out because you may need it.

When you deposit money at a bank, you lend it to the bank, but you can still use it at any time. If you use that money to pay for legal advice, it ends up in the lawyer’s account, and the bank borrows it from the lawyer until she uses it to pay the barber. Having cash on hand is convenient. Economists call this liquidity preference. We accept low interest rates on current accounts because they are as convenient as cash.

Properties of money

The properties of money can affect interest rates. Imagine that apples are money, and you save to buy a house. If someone wants to borrow 1,000 apples from you and promises to pay back 1,000 apples after 5 years, when you plan to buy the home, you probably accept this generous offer. You may even accept an offer of 900 apples, since that is better than letting your apples rot. In this case, you would settle for a negative interest rate.

You would only do so if you have no better alternatives. If you can make 10% per year in the stock market with Apple stock because their gadgets are in great demand and outrageously expensive, you would exchange your apples for Apple stock. It doesn’t matter if the apples rot. If someone wants to borrow money from you, you demand interest. Our money rots, even though not as much as apples. We call it inflation.

If the money had been gold, you wouldn’t accept the offer, even when the stock market is doing terribly. You can keep your gold in a safe deposit box, and you have 0% interest. Similarly, you wouldn’t accept negative interest rates on euros or dollars because you can take banknotes and store them in a safe deposit box. If many people do so, that interrupts the circular flows, and the economy may suffer.

Discounting

Discounting is about determining the present value of future money using the interest rate. When interest rates are above zero, one euro in the present is worth more than one in the future. That is because you can receive interest on that euro. If the interest rate is 5%, one euro turns into €1.05 in a year. In other words, €1,050 over a year is worth €1,000 today, so the present value of €1,050 over a year is €1,000.

How much is a cash flow of €1,000 in a year worth in the present? That is the reverse calculation. The formula for the present value of a single future cash flow is:

Present Value = Future Cashflow / (1 + (Interest Rate / 100)) ^ Number of Years

If there are multiple future cash flows, you add up their present values. An example can illustrate this. Assume that the interest rate on government bonds is 3%, and you own a 5% government bond that still has two years to go before the principal of €1,000 will be repaid. You will also receive €50 in interest after one year and another €50 in two years when the principal is due.

If you plan to sell the bond today, you want to know its present value. There are two cash flows. You will first receive €50 after one year. The present value of that cash flow is: €50 / (1 + (3 / 100)) ^ 1 = €48.54. After two years, you will receive an additional €1,050. The present value of that amount is: €1,050 / (1 + (3 / 100)) ^ 2 = €989.73. And so the present value of the bond is €48.54 + €989.73 = €1,038.27.

At higher interest rates, the value of the bond declines. If the interest rate is 5%, its present value is (€50 / (1 + (5 / 100)) ^ 1) + €1,050 / (1 + (5 / 100)) ^ 2 = €47.62 + €952.38 = €1000 exactly, which is to be expected. At lower interest rates, the bond will be worth more. At an interest rate of 2%, the present value is (€50 / (1 + (2 / 100)) ^ 1) + €1,050 / (1 + (2 / 100)) ^ 2 = €49.02 + €1,009.23 = €1,058.25.

At lower interest rates, bonds are worth more. That is also true for other assets that generate cash flows, such as stocks and real estate. The present value of the future dividends and rents increases when interest rates decline. When interest rates are lower, people can borrow more for a home, so that house prices may go up.

Engine of growth

Credit means trust. When you invest, you expect to receive a profit. You anticipate something that isn’t there yet. You imagine that it will be there in the future. In the past five hundred years, trust in the future mostly paid off. If you don’t trust the future, you put your money in a piggy bank or invest in something that keeps its value during an economic collapse, such as gold or land. Banks create money out of thin air, believing that the debtor’s future revenues will pay for the principal and the interest.

That is why the economy must grow. It is the growth imperative promoted by interest charges. When expectations fail to materialise, investors stop investing, and interest payments on existing debt damage the economy by sucking money out of the circular flows. When growth is lacking, governments and central banks keep the economy afloat by going into debt or printing currency and bringing these funds into circulation. When money circulates, businesses profit, employ people, and pay interest.

Interest keeps the economy going by making those with a surplus lend it to those with a deficit. That is why economists think that banning interest will cause an economic disaster. When economic growth is low and expectations aren’t met, investors stop investing, and the money stops flowing. Had the money been perishable like apples, they would still invest, even when returns were low, or lend their money at a negative rate. We see that happening. After accounting for inflation, interest rates are often negative.

Featured image: Ara Economicus. Beverly Lussier (2004). Wikimedia Commons. Public Domain.