The Interest Rate Fallacy

There is a widespread assumption that interest rates represent the cost of borrowing money. In the narrow sense that it is a rate paid by a borrower, this is true. Monetary policy planners enquire no further. Central bankers then posit that if you reduce the cost of borrowing, that is to say the interest rate, demand for credit increases, and the deployment of that credit in the economy naturally leads to an increase in GDP. Every central planner dreams of consistent growth in GDP and they seek to achieve it by lowering the cost of borrowing money.

The origin of this approach is mathematical. William Stanley Jevons in his The Theory of Political Economy, first published in 1871, was one of the three discoverers of the theory of marginal utility and became convinced that mathematics was the key to linking the diverse elements of political science into a unified subject. It was therefore natural for him to treat interest rates as the symptom of supply and demand for money when it passes from one hand to another with the promise of future repayment.

Another of the discoverers of the theory of marginal utility was the Austrian, Carl Menger, who explained that prices were subjective in the minds of those involved in an exchange. He argued it was fundamentally a human choice and therefore could not be predicted mathematically. This undermines the assumption that interest is simply the cost of money, suggesting that some sort of human element is involved, separate from pure cost. Eugen von Böhm-Bawerk, who followed in Menger’s footsteps saw it from a more capitalistic point of view, that a saver’s money, which was otherwise lifeless, was able to earn a saver a supply of goods through interest earned upon it.

Böhm-Bawerk confirmed interest produced an income for the capitalist and was a cost to the borrowing entrepreneur, but agreed with his mentor there was also a time preference element, the difference in the value of possessing money today compared with the promise of possessing it at a future date. The easiest way to understand it is that savers are driven mainly by time-preference, while borrowers mainly by cost. This was why borrowers had to bid up interest rates to attract savers into lending, the explanation for Gibson’s paradox.

In those days, money was gold, and currencies were gold substitutes, that is to say they circulated backed by and freely exchangeable into gold. Gold was the agency by which producers turned the fruits of their labour into the goods and services they needed and desired. Its role was purely temporary. Temporal men valued gold as a good with the special function of being money, but as a good, its actual possession was worth more than just a claim on it in the future. But do they ascribe the same time preference to fiat currency? To find out we must explore the nature of time preference as a concept.

- Source, Goldmoney