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Further Considerations in the Theory of Interest (lecture 22 of 32)
These notes are from the lecture Further Considerations in the Theory of Interest, given at the Mises University. Any errors are mine, feel free to point them out so that I can correct them. This lecture was given by Prof. Hülsmann.
Profit vs. Interest
- Classical view — just profit
- Modern (Austrian) view:
- Interest — survives even in the ERE (evenly rotating economy).
- Profit — pure product of disequilibrium.
- The following is a situation of disequilibrium:
- Company A: $100 ==> $120 : $30 interest, -$10 loss.
- Company B: $90 ==> $130 : $30 interest, $10 gain.
- In such a situation, there is a tendency towards equilibrium via arbitrage — the reallocation of factors of production until all return is the same:
- Company A: $95 ==> $125
- Company B: $95 ==> $125
- However, you can’t really say that the first situation is disequilibrium, because you have to consider psychic revenue, which could be higher in A than B.
- Interest is the spread that subsists in general equilibrium, $20 in the second case.
- Now, we can define profit and loss.
- The ERE allows us to see the difference between profit and interest.
- Frank Knight:
- Risk, Uncertainty, and Profit.
- Profit can only exist in a world in which we have error.
- Mises wrote a lengthy article clearly explaining and improving upon Knight.
- What we’ve called interest so far is total interest
- Components of total interest:
- Pure interest.
- Price premium — compensation for predicted inflation.
- Entrepreneurial component — compensation for risk and uncertainty.
- Risk: class probability, characterizeable risk.
- Uncertainty: case probability, something we don’t know.
Non-Austrian Interest Theories
- Marxist theory of interest — exploitation of the employee by the employer.
- Interest theory of production — productivity theory of interest:
- time 1: 100t ==> time 2: 250t
- 5oz ==> 125oz since
- This is wrong, because it assumes that prices are constant — price are not stable.
- The idea is that productivity of a thing determines the interest: must assume that there is something in the thing itself that
determines its value innately, which is non-sense since value is subjectively determined.
- Schumpeter said profit, or interest, can only exist in disequilibrium, and arbitrage eliminates it in equilibrium — so there is really no interest. This is wrong.
Böehm-Bawerk’s Theory of Interst
- Present goods are always more valuable than some future goods temporally displaced.
- Time-preference for the present.
- Why time-preference? Future needs under-estimated.
- Explanation of interest as a difference that is dependant on value-difference in time.
- Problems: Hard to test and contradicts intuition:
- In all product-possibilities, we never have a product that is homogenous with the factors of production. This is problematic
because Bawerk’s theory mandates that they be the same good temporally displaced.
- This theory contradicts, in fact, the liberty of choice that we have, because we can always make bargains inconsistant with the
Mises’ Theory of Interest
- Time-preference is something that does exist.
- Mises: by the very fact that I do certain things, I demonstrate that I prefer doing it now rather than later, that it’s more important to do it now than later.
- All actions have this feature.
- So far, this doesn’t explain interest, just that we prefer now not later.
- Mises’ and Bawerk’s point of view is that interest is entirely determined by the price consumers pay and the costs of the factors of production.
Modern Austrian Theory of Interest (Hülsmann)
- If you cannot obtain interest, you go out of business.
- Interest comes from the fact that entrepreneurs from outside seek a spread between output and factors of production.
- Interest payments subside in the market only in those businesses where the interest rate cannot be arbitrated away, because people enjoy doing the activity (e.g., opera).
- For a more detailed explanation, see A Theory of Interest. Hülsmann, Jörg Guido. QJAE, vol 5, num 4.