The Rate of Interest

Everyone knows that most borrowing isn't free. Lenders ask you to pay back more than you initially borrow. How much more is normally expressed in percentage points and calculated from the amount owed. These percents are what we usually call the rate of interest.

Obviously there are many rates of interest in the economy, because there are many different credit transactions taking place. Borrowing from your friend to buy a beer will probably have a different interest rate than when you go and take out a mortgage to buy a house.

But why do we usually pay back more than we borrow?

"Inflation causes the value of money to go down over time."

Yes and no. Inflation certainly affects the interest rate of the credit transaction, but it is not the fundamental reason for interest. What if we completely forgot about money? What if we loaned 10 000 apples for 30 years(we're going to assume that the enjoyment we get from apples will stay the same, even though this is quite improbable)? Would you simply accept 10 000 apples back 30 years later? I'd say it's very unlikely that anyone would accept that kind of deal.

"Lenders need to make a profit."

Yes and no again. The amount of profit lenders aim to make certainly affects the interest rate. If we take our previous example and assume we don't want to make a profit; would we now make that deal? It still seems that something is off.

"Debtors might not pay back, so we need interest to make up for the risk the lender takes."

Yes and no again. Especially with banks, who have many customers, it is very likely that some will not pay back. The perceived risk indeed affects the interest rate. If we build on our example and assume that the debt is now guaranteed by all the governments in the world, would interest become meaningless? After all we don't need to make a profit, we're not worried about inflation and the debt is certainly going to be paid back.

It would not.

"We prefer present goods over future goods."

Or to be more precise, we prefer current enjoyment more than the same amount of enjoyment later. For example someone during the winter might say that he'd rather wait for summer before having some ice cream. The only reason for this is that he thinks he'll enjoy it more during summer. If he didn't, he'd eat the ice cream during winter already.

Actually we're not even comparing the same good, because ice cream in the winter is not the same as ice cream in the summer. Just like an orange in Spain is a different good from an orange in Finland. People in Finland are ready to pay more for an orange in Finland than for a claim to an orange in Spain(for obvious reasons).

Physical properties are meaningless; what matters is the subjective valuations of consumers. For example a physicist might say that out of two bottles of water the other one has 0,007l less water in it. The consumer wouldn't even notice or care, so if those two bottles are next to each other in a supermarket, they would (from the point of view of economic theory) be considered the same.

An orange in Finland and a diamond are also different. But a diamond is obviously "more different" than an orange in Spain. This is because the oranges are different units of the same good. If we magically swapped the oranges with each other, the consumer wouldn't notice a thing. But if we swapped either orange for a diamond, it would be quite obvious to the consumer that he has a completely different good now.

It is interesting to note that if we didn't prefer the present more, we'd never do anything. After all we show our preferences through our actions, which means that every time we act, we are proving that we prefer to do so now instead of later. I prefer to write this right now and I do not need to answer a poll or gallup(the usual ways with which people's preferences are measured) to know this. I know it because I'm writing this.

What I've described is called time preference.

The natural rate of interest(how much we prefer present vs. future goods or that rate which exactly balances the demand for loan capital and the supply of savings) is not what we observe in the economy, because the rate of interest is tightly linked to money, and the monetary system is controlled by central banks and the banking system. In fact central banks often manipulate the money supply in accordance with what they think the proper rate of interest should be, not the other way around.

Not to mention the interest charged by lenders, as was discussed earlier, is affected by other factors as well(value of money over time, profits and risk).

"Excuse me, what?"

If we want to consume more in the present, the rate of interest goes up. If we want to consume less in the present, the rate of interest goes down. Another way to look at it is that when we save more, the banks have more to lend(we usually save by depositing our money in a bank), so they'll ask less for it when they lend it to someone(=lower interest rates). If we consume more(i.e. save less), then the opposite obviously happens.

You might think that this beautiful harmony is screwed up big time when a central bank arbitrarily sets interest rates somewhere where they no longer reflect society's time preference. Well, that's exactly what it does. I'll cover that when I talk about the Austrian Theory of the Business Cycle.