Interest Rates From An Austrian Viewpoint

Interest rates all over the world are at historic lows or even negative in some instances.The recent interest rate cut by the European Central Bank brought the interest in Europe to its lowest level ever. The US is going through its fifth consecutive year of almost zero interest rates, which is the longest period ever in times of “peace.” People should question what the longer-term implications are for our economies and for society as a whole. An answer to this question is given by Claudio Grass who wrote about the matter in his latest outlook report (Global Gold Outlook Report)

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In this piece we will look at what interest actually is from the viewpoint of the Austrian School of Economics and how the setting, or rather manipulation, of the interest rate by central banks negatively impacts the economy in the long run. In essence, interest is the ratio between the value assigned to specific goods today, to be exact, the goods themselves are irrelevant but rather the underlying want satisfaction, in comparison to the identical goods at a future point in time (this is called originary interest). The reason that identical future goods trade at a discount is that people  in general have a time preference, meaning they want to reach their goals sooner rather than later.

Originary interest

This originary interest is in our view the origin and main component of interest or the reason why interest is paid, however the supply and demand of capital goods also play a role in the level of the interest rate. It can be said that in general interest rates tend to be higher when the supply of capital goods (savings) are lower and vice versa.

Interest holds two further components: entrepreneurial profit and the price premium. Entrepreneurial profit, or as it is more commonly called default risk, is basically the compensation for the risk one is engaging in when one loans out money. Because every loan is speculation and the creditor takes on the risk of a partial or total loss he will expect to be compensated for this risk. The price premium on the other hand is the premium (or discount) applied to the interest rate to account for the expected change in the purchasing power of money. Under our current monetary system price premium is mainly an inflation premium, because fiat currency in general continually loses value. Under a gold standard however, prices would tend to decrease turning this premium into a deflation discount.

Concentrating on originary interest we would like to look at the effect of different interest rates on asset prices. If the real originary interest rate were 0%, which doesn’t seem to require too much imagination under current circumstances, this would mean that present and future goods would be valued exactly the same. Imagine a piece of land (example borrowed by Mises) or a piece of real estate, which after deducting all costs and maintenance repairs would generate a yearly income of let’s say 10’000 USD indefinitely. What would the fair value of this piece of land be? The fair value would be the sum of all infinite future earning streams (undiscounted), meaning that no amount of money would be enough to buy the piece of land. In general we can say that the closer the interest rate gets to 0% the higher the asset price becomes and the higher the interest rate the lower the asset price. The fair value of the above mentioned piece of land would be 100’000 USD if the interest rate is 10% or increase tenfold to 1’000’000 USD if the interest rate were 1% (10’000/1%).

Under normal circumstances the originary interest, which as a reminder is the discount of future goods to present goods would never fall to zero and would likely also be somewhat higher than the rates we have seen in recent years. In the likely case that the interest rate set by the central bank deviates from the originary interest, there is either a deflationary or inflationary effect on asset prices from their “true” or un-manipulated prices.

The tendency of central banks leans towards having too low interest rates, which leads to higher asset prices or even the formation of asset bubbles such as the real estate bubble, which was mainly brought forward by low interest rates. We should also hold fast to the fact that central banks, even with their armies of economists, have no knowledge of what the correct interest rate should be, meaning that it will always deviate from its’ “true” value. So why not just leave it to the free market?

Misallocation of resources

Another closely connected issue is that too low interest rates lead to a misallocation of resources in the economy. Let’s assume that the originary interest rates, as defined by the subjective want-satisfaction preference of each individual, would be 5% and the dictated rate by the central bank is 1%. At the same time we have an investment, which requires an initial investment of 1’000 USD and would yield 50 USD infinitely. With the manipulated rates of the central bank, this endeavor seems to be lucrative because the project would have a positive present value, with the “real” interest rate, however, the present value of project would be 0 USD making an investment pointless.

The real estate bubble in the US not only lead to an increase in asset prices, but made the American dream affordable for  everyone, simply because the rates were artificially low. When rates however started to rise, many Americans were hit hard with the reality that their “investment”was simply not financeable under normal market conditions and the artificial boom of the real estate prices came to an abrupt end.

Taking the above mentioned into consideration it becomes evident that we would have less asset bubbles and a better allocation of scarce resources if interest rates were left to the free market. However we live in a world where money is “born” both from the central bank and private banks through credit, which makes the setting of the interest rate by the central bank inseparable from our current fiat monetary system. While living in a world of manipulated interest rates we urge our readers to scrutinize investment “opportunities” to verify they would still seem attractive in a world of “real” interest rates and to hold part of one’s assets outside of this corrupt and manipulated paper money system, ideally in physical precious metals, which we consider to be the only real currency. The value of fiat money can be manipulated at the whim of central bankers to the detriment of normal savers and to the advantage of bankers who get newly created money first.

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