19: Money, Credit, and Interest
This chapter means to be an exploration of the connection between the amount of money in circulation and the rate of interest demanded for loans - independent of the quality of money, the availability of goods, and other factors.
Specifically, there is the notion that interest rates are arbitrary, and that banks can set them as high or low as they like, subject only to competitive offers of credit. But the availability of money and the demand for credit are common factors that would be inflicted on each competitor equally.
There is also an important distinction to be made between money and credit in exchanges: money constitutes the trade of an immediate value, whereas credit constitutes the trade of a future value, which is necessarily discounted by the receiver's preference for immediate value and the risk, however slight, that the credit obligation will not be fulfilled.
And further, money itself is merely a reflection of the existence of capital: if there is a plentitude of production, there is plentitude of goods to be traded - and typically, plenty of money to be used in an increased number of transactions. Germane to the present consideration, if there is not an increased amount of money, the money itself may gain greater unitary value, or traders may seek another medium of exchange.
Credit and fiduciary media are considered as a remedy to the latter problem: enabling individuals to trade on the basis of future money rather than money that is presently available.
There is also a common misconception, not only among laymen but among economic theorists, that the availability of money is correlate to the availability of goods: that an entrepreneur who wishes to expand his business beyond the demand that exists in the market need only obtain money on credit to build his business, and demand for his product will rise as well. The two are largely independent and, except in the case of shortage, it has never been demonstrated that increased supply creates increased consumption (without adjustment to price).
And yet, such thinking results in legislative interference in markets in order to inject a stagnant market with additional money and cheap credit in the belief it will stimulate economic activity. This has been attempted repeatedly, and it has repeatedly failed to create a lasting stimulus in a stagnant market. As stated in an earlier chapter, money is merely the token of exchange - the economic welfare of a people can only be improved by production of goods.
In terms of credit, there is the notion that the demand for credit can be influenced by the interest rate: borrowing money to produce goods makes sense only so long as the interest rate does not consumer the profit of the production activity. However, there is a limit to the amount of production that can be encouraged by lending chiefly, the availability of other factors of production (labor and natural resources), without which no amount of money or credit can evoke production.
There is also validity to the notion that the demand for credit is tied to the supply of money - in that if a person has sufficient money to purchase the goods he requires, he has no need of credit. As money itself has no subjective use-value, there is no rationale to borrowing to make purchases while maintaining a stock of idle money. Such behavior would only make sense if creditors paid debtors interest rather than the other way around.
(EN: Quite some attention is given to the arguments of other economic theorists, but I'm less interested in the author's rebuttals to others as opposed to an explanation of his own perspective.)
The Rate of Interest as Relative to Fluctuations in Demand for Money
The balance between the stock of money and the demand for it exert an influence on interest, though not in the way that is "popularly imagined."
Interest rates are directly derived from the balance of supply and demand only when money is based on commodities. That is, just as the supply and demand of gold influence the value of gold, so does supply and demand impact the value of gold coins or certificates that represent a given quantity of gold. The less that is available, the higher the price paid for it, and the higher the cost of interest to borrow it.
But where money exists by credit, the supply of money is flexible. Again, money is needed in proportion to the volume of goods that are exchanged. If credit is extended to the producer of a good, and the good is eventually purchased with the redemption of that same credit, the two demands largely cancel one another out in terms of their impact on the supply and demand for non-credit money. (The portion unaccounted for, which constitutes a profit to the producer in excess of his costs and the interest for the loan, remains after the credit has been redeemed.)
It's also worth considering that, in such a case, the money borrowed by the producer is not take out of circulation: as he pays his suppliers and his laborers over the course of time, the credit-backed money enters the market and remains in circulation until the debt is repaid. And even the portion that is reserved as profit is returned to circulation as it is spent on other goods (one does not make money merely to have it).
Ultimately, money is not consumed by the acts of production, credit, and exchange: it is merely displaced. Money is passed from lender to the producer, then to the market (suppliers and labor), then from the market to the producer, then from producer back to lender in repayment of the loan.
On the topic of wealth, it is generally true that individuals with greater capital resources value future goods over present goods (their need for present goods being filled within their means, there is excess purchasing power) whereas individuals with less resources value present goods over future goods. This is the basis of the willingness of the first group to sacrifice the immediate use of money in order to have more ability (in terms of interest earned) to purchase future goods and of the second to make a greater payment in future (in terms of interest paid) in order to have immediate purchasing power.
(EN: This would be an interesting rebuttal to the Marxist objection to charging interest. Seen in that perspective, the wealthy creditor is taking advantage of the desperation of the poorer debtor - but when you consider the utility each receives instead of counting the coins, it becomes clear that credit is beneficial to the debtor rather than exploitive of him.)
Because money has no use-value, the sole consideration when considering the stock of money is the desire of some parties to save money and the desire of others to spend it. Saving money removes it from circulation, decreasing the quantity that is in use in the market for exchange purposes - though this is "saving" in the sense of warehousing money (e.g., locking it in a vault) rather than depositing it into a bank where it may be lent to others.
As such, when a significant amount of money is saved in a manner that takes it out of circulation, this practice impacts interest rates in an indirect manner: to coax the money out of a vault, a banker must offer the saver sufficient interest to be willing to give the banker use of the money to loan to others. And because the banker's cost of obtaining capital is higher, so must he increase the rate of interest he charges to those who wish to borrow it.
There is reference, as an aside, of the impact on fluctuations in interest rate upon the producer, whose general practice is to borrow large sums of in advance of a long-term, process of production (e.g., the farmer who borrows to plant carries the debt until the harvest). An increase in interest rates in the market constitutes a benefit to the debtor (he holds "borrowed" funds at a lower rate than the market offers), and a decrease in interest rates constitute a loss to the debtor. This risk is an inherent component of entrepreneurship.
(EN: My sense is the opportunity to refinance mitigates this risk for the entrepreneur: should interest rates fall, he can take out a loan at a lower rate, to pay off his loan at a higher rate. While it's generally accepted that the creditor cannot compel a debtor to pay a debt before it is due, it is also generally accepted that a debtor may do so at his own discretion, when it is in his interest to do so. As such, the risk of rising interest rates falls to the banker rather than the entrepreneur, who may regret the profit he did not earn by lending at a higher rate at a later time. And taken together, it seems reasonable to assert that the potential to refinance is a mitigating factor against rising interest rates.)
So ultimately, the variation in interest rates do not arise directly from the demand and supply of money, but may be seen to arise indirectly from it, as the desire of some to warehouse money is mitigated by an increased interest rate that must be offered by those that wish to make immediate use of it, as brokered by the banking industry.
The Equilibrium Rate and the Money Rate of Interest
The increase in the stock of money caused by fiduciary media constitutes a displacement of purchasing power from future to present. In effect, the bank creates money substitutes without requiring actual money, and collects interest in "real" money as the loan is paid, and must redeem the media with "real" money only upon its maturity.
A significant point: there is no direct relationship between an increase or decrease in the issue of fiduciary media and the rate of interest. Specifically, fiduciary media is not subject to the effects of issuance on supply, as are consumer goods whose consumption decreases a limited stock.
There follows a somewhat roundabout explanation of the reason that a zero interest rate is not sustainable. It's a bit convoluted, but I take it to imply that having immediate use is of greater value to the borrower than having future use, hence his willingness to pay interest for the use of money he does not have. Were it not so, the borrower would not seek to obtain credit at all - he would merely wait to act until he had the capital resources to do so, immediacy being unimportant.
The author then considers competition. The absolute lowest interest rate a bank can sustain is a rate at which the interest merely covers its operating expenses. And in a competitive environment, where borrowers seek the lowest possible interest rate from competing banks, the banks must strive to maintain as allow an interest rate as possible to attract borrowers.
The problem of the "gratuitous nature of credit" is considered to be the chief problem in the theory of banking. However, it remains a theoretical problem, as in practice, banks seek to maintain the highest level of interest they can charge (to maximize their own profit), such that in even highly competitive markets, the market rate of interest has been above a level that could be considered gratuitous.
As such, the problem has not received much attention from economists, at attempts at its solution have been superficial. Von Mises presents a few of the untenable theories that address this issue, and arrive at some rather specious conclusions about the nature of credit and interest. (EN: My sense is that this is driven by the negative perception of any interest as usury, and the attempt to justify or denounce it is driven more on the grounds of ethics than economics.)
The author turns to Wicksell, whose attempt did not derive a satisfactory answer, but has better defined the question: Wicksell considers the rate of interest that might "naturally" exist if money were set aside and actual capital goods were loaned. That, in effect, a merchant who lends goods to another merchant is not concerned with the rate of interest that other merchants might charge for the same loan, but for the profit that the merchant must forego by lending the goods rater than selling them himself. As such, the cost of credit would be driven by estimation and subjective valuation rather than competition.
The problem with this theory is in the nature of fiduciary media - which, unlike physical goods, is not limited by the physical existence of anything - as well as by the fact that, in setting a price for goods (including credit), a merchant does in fact consider the prices set by his competitors as guidance to what level of return he may fairly expect.
In the end, the author asserts that such a theory "does not bring us a step nearer to the solution to our problem."
Influence of Credit on Production
There is the notion that the extension of credit can have a direct impact on production of goods in an economy: in fact, the provision of credit makes it possible for a producers to produce (and consumers to consume) in greater quantity than they would if they were restricted to their immediate resources.
It's recalled that fiduciary media may remain in circulation until it is redeemed - and that if the fiduciary media is accepted with full faith in the market, and utilized in exchange as a money substitute, there remains the possibility that the media would never be redeemed, but remain in circulation indefinitely. It is even possible for fiduciary media to entirely replace money, such that a market could conduct the business of transactions based entirely on fiduciary media.
(EN: It's more than theoretical, as I believe that to be the very nature of currency in the modern economy. Since 1965, US currency has consisted entirely of bills that cannot be redeemed with the issuer and remain in circulation, used in commercial transactions, indefinitely.)
In such a situation, a bank that does not expect ever to redeem its fiduciary media may loan it as cheaply as possible, seeking to earn only a modest margin (as well as covering modest operating expenses) and maximizing profit by issuing a greater quantity of fiduciary media at a low rate (rather than a small amount at a high rate).
Essentially, this would remove the limiting factor on the amount of fiduciary media a bank could issue (if it is never to be redeemed, the bank need not keep any stock of money to redeem it), which further refutes the notion that the rate of interest is derived from the stock of money available.
Where fiduciary media is issued in response to a need to have resources for production, the intention of the producer is to borrow the money he needs to produce his goods and repay it when the goods are sold. This sets the lifespan of fiduciary media, and is the reason that fiduciary media does not remain in circulation indefinitely: the debt repaid, the media is retired.
There is the notion of the ability of the lifespan of fiduciary media to be increased by lengthening the production process, which seems a bit unusual (and not in the interest of the debtor to accommodate). However, when one considers that most businesses are ongoing concerns whose productive activities are to be carried on repeatedly (the factory constantly produces product), then it would make sense for a borrower to retain debt to increase his production capacity beyond his means.
So long as the interest level remains below the profit he makes on his productive activity, it remains in his interest to maintain a leveraged operation rather than seeking to operate a "cash" business without capital debt. (EN; Trying to make sense of this - and the best I can do is to imagine a farmer who, rather than repaying his debt upon harvest, renews his debt to purchase additional acreage and hire more hands, to produce additional crop yields and additional profit.)
In such a situation, the demand for credit would not be restricted by its supply, but in the ability to make productive use of borrowed funds. From the previous example, the farmer would be interested in obtaining additional credit and expanding his operations until there market for his own product was exhausted (or the effects of supply and demand on his goods make it unprofitable to increase supply.)
It's suggested that the interest rate on capital for production causes an increase in the price of goods (suppliers increase prices if their own costs are increased), but this is not necessarily so, and such an assertion ignores the negotiating power of the buyer to refuse a price that exceeds their valuation of the good.
As such, the ability of producers to profit from the increased sale of goods is dependent on the equilibrium price for the sale of those goods in the market. Hence, as quantity increases, the price must decrease - and as the price decreases, the profit margin decreases - and as the profit margin decreases, the amount of interest the producer is willing to pay on a loan to finance production decreases.
This chain of causation encourages the interest rate of loans to find a point of equilibrium, such that the negotiation of interest between creditor and a producer who seeks to borrow for production is derived from profitability at the level of supply that would be facilitated by the extension of credit.