With public opinion in this state, the creditor’s unfavorable chance of being harmed by anticreditor measures is not balanced by a favorable chance of being privileged by antidebtor measures. This unbalance would bring about a unilateral tendency toward a rise of the entrepreneurial component contained in the gross rate of interest if the political danger were limited to the loan market, and would not in the same way affect today all kinds of private ownership of the means of production. As things are in our day, no kind of investment is safe against the political dangers of a general expropriation of all private property. A capitalist cannot reduce the vulnerability of his wealth by preferring direct investment in business to lending his capital to business or to the government.
The political risks involved in moneylending do not affect the height of originary interest; they affect the entrepreneurial component included in the gross market rate. In the limiting case—i.e., in a situation in which the impending nullification of all contracts concerning deferred payments is generally expected—they would cause the entrepreneurial component to increase beyond all measure.2
3. The Price Premium as a Component of the Gross Market Rate of Interest
Money is neutral if the cashinduced changes in the monetary unit’s purchasing power affect at the same time and to the same extent the prices of all commodities and services. With neutral money, a neutral rate of interest would be conceivable, provided there were no deferred payments. If there were deferred payments and if we disregard the entrepreneurial position of the creditor and the ensuing entrepreneurial component in the gross rate of interest, we must furthermore assume that the eventuality of future changes in purchasing power is taken into account in stipulating the terms of the contract. The principal is to be multiplied periodically by the index number and thus to be increased or decreased in accordance with the changes that have come to pass in purchasing power. With the adjustment of the principal, the amount from which the rate of interest is to be calculated changes too. Thus, this rate is a neutral rate of interest.
With neutral money, neutralization of the rate of interest could also be attained by another stipulation, provided the parties are in a position to anticipate correctly the future changes in purchasing power. They could stipulate a gross rate of interest containing an allowance for such changes, a percentile addendum to, or subtrahendum from, the rate of originary interest. We may call this allowance the—positive or negative—price premium. In the case of a quickly progressing deflation, the negative price premium could not only swallow the whole rate of originary interest, but even reverse the gross rate into a minus quantity, a rate to be passed on the debtor’s account. If the price premium is correctly calculated, neither the creditor’s nor the debtor’s position is affected by intervening changes in purchasing power. The rate of interest is neutral.
However, all these assumptions are not only imaginary, they cannot even hypothetically be thought of without contradictions. In the changing economy, the rate of interest can never be neutral. In the changing economy, there is no uniform rate of originary interest; there only prevails a tendency toward the establishment of such uniformity. Before the final state of originary interest is attained, new changes in the data emerge which divert anew the movement of interest rates toward a new final state. Where everything is unceasingly in flux, no neutral rate of interest can be established.
In the world of reality all prices are fluctuating and acting men are forced to take full account of these changes. Entrepreneurs embark upon business ventures and capitalists change their investments only because they anticipate such changes and want to profit from them. The market economy is essentially characterized as a social system in which there prevails an incessant urge toward improvement. The most provident and enterprising individuals are driven to earn profit by readjusting again and again the arrangement of production activities so as to fill in the best possible way the needs of the consumers, both those needs of which the consumers themselves are already aware and those latent needs of the satisfaction of which they have not yet thought themselves. These speculative ventures of the promoters revolutionize afresh each day the structure of prices and thereby also the height of the gross market rate of interest.
He who expects a rise in certain prices enters the loan market as a borrower and is ready to allow a higher gross rate of interest than he would allow if he were to expect a less momentous rise in prices or no rise at all. On the other hand, the lender, if he himself expects a rise in prices, grants loans only if the gross rate is higher than it would be under a state of the market in which less momentous or no upward changes in prices are anticipated. The borrower is not deterred by a higher rate if his project seems to offer such good chances that it can afford higher costs. The lender would abstain from lending and would himself enter the market as an entrepreneur and bidder for commodities and services if the gross rate of interest were not to compensate him for the profits he could reap this way. The expectation of rising prices thus has the tendency to make the gross rate of interest rise, while the expectation of dropping prices makes it drop. If the expected changes in the price structure concern only a limited group of commodities and services, and are counterbalanced by the expectation of an opposite change in the prices of other goods, as is the case in the absence of changes in the money relation, the two opposite trends by and large counterpoise each other. But if the money relation is sensibly altered and a general rise or fall in the prices of all commodities and services is expected, one tendency carries on. A positive or negative price premium emerges in all deals concerning deferred payments.3
The role of the price premium in the changing economy is different from that we ascribed to it in the hypothetical and unrealizable scheme developed above. It can never entirely remove, even as far as credit operations alone are concerned, the effects of changes in the money relation; it can never make interest rates neutral. It cannot alter the fact that money is essentially equipped with a driving force of its own. Even if all actors were to know correctly and completely the quantitative data concerning the changes in the supply of money (in the broader sense) in the whole economic system, the dates on which such changes were to occur and what individuals were to be first affected by them, they would not be in a position to know beforehand whether and to what extent the demand for money for cash holding would change and in what temporal sequence and to what extent the prices of the various commodities would change. The price premium could counterpoise the effects of changes in the money relation upon the substantial importance and the economic significance of credit contracts only if its appearance were to precede the occurrence of the price changes generated by the alteration in the money relation. It would have to be the result of a reasoning by virtue of which the actors try to compute in advance the date and the extent of such price changes with regard to all commodities and services which directly or indirectly count for their own state of satisfaction. However, such computations cannot be established because their performance would require a perfect knowledge of future conditions and valuations.
The emergence of the price premium is not the product of an arithmetical operation which could provide reliable knowledge and eliminate the uncertainty concerning the future. It is the outcome of the promoters’ understanding of the future and their calculations based on such an understanding. It comes into existence step by step as soon as first a few and then successively more and more actors become aware of the fact that the market is faced with cashinduced changes in the money relation and consequently with a trend oriented in a definite direction. Only when people begin to buy or to sell in order to take advantage of this trend, does the price premium come into existence.
It is necessary to realize that the price premium is the outgrowth of speculations having regard for anticipated changes in the money relation. What induces it, in the case of the expectation that an inflationary trend will keep on going, is already the first sign of that phenomenon which later, when it becomes
general, is called “flight into real values” and finally produces the crack-up boom and the crash of the monetary system concerned. As in every case of the understanding of future developments, it is possible that the speculators may err, that the inflationary or deflationary movement will be stopped or slowed down, and that prices will differ from what they expected.
The increased propensity to buy or to sell, which generates the price premium, affects as a rule short-term loans sooner and to a greater extent than long-term loans. As far as this is the case, the price premium affects the market for short-term loans first, and only later, by virtue of the concatenation of all parts of the market, also the market for long-term loans. However, there are instances in which a price premium in long-term loans appears independently of what is going on with regard to short-term loans. This was especially the case in international lending in the days in which there was still a live international capital market. It happened occasionally that lenders were confident with regard to the short-term development of a foreign country’s national currency; in short-term loans stipulated in this currency there was no price premium at all or only a slight one. But the appraisal of the long-term aspects of the currency concerned was less favorable, and in long-term contracts a considerable price premium was taken into account. The result was that long-term loans stipulated in this currency could be floated only at a higher rate than the same debtor’s loans stipulated in terms of gold or a foreign currency.
We have shown one reason why the price premium can at best practically deaden, but never eliminate entirely, the repercussions of cashinduced changes in the money relation upon the content of credit transactions. (A second reason will be dealt with in the next section.) The price premium always lags behind the changes in purchasing power because what generates it is not the change in the supply of money (in the broader sense), but the—necessarily later-occurring—effects of these changes upon the price structure. Only in the final state of a ceaseless inflation do things become different. The panic of the currency catastrophe, the crack-up boom, is not only characterized by a tendency for prices to rise beyond all measure, but also by a rise beyond all measure of the positive price premium. No gross rate of interest, however great, appears to a prospective lender high enough to compensate for the losses expected from the progressing drop in the monetary unit’s purchasing power. He abstains from lending and prefers to buy himself “real” goods. The loan market comes to a standstill.
4. The Loan Market
The gross rates of interest as determined on the loan market are not uniform. The entrepreneurial component which they always include varies according to the peculiar characteristics of the specific deal. It is one of the most serious shortcomings of all historical and statistical studies devoted to the movement of interest rates that they neglect this factor. It is useless to arrange data concerning interest rates of the open market or the discount rates of the central banks in time series. The various data available for the construction of such time series are incommensurable. The same central bank’s rate of discount meant something different in various periods of time. The institutional conditions affecting the activities of various nations’ central banks, their private banks, and their organized loan markets are so different, that it is entirely misleading to compare the nominal interest rates without paying full regard to these diversities. We know a priori that, other things being equal, the lenders are intent upon preferring high interest rates to low ones, and the debtors upon preferring low rates to high ones. But these other things are never equal. There prevails upon the loan market a tendency toward the equalization of gross interest rates for loans for which the factors determining the height of the entrepreneurial component and the price premium are equal. This knowledge provides a mental tool for the interpretation of the facts concerning the history of interest rates. Without the aid of this knowledge, the vast historical and statistical material available would be merely an accumulation of meaningless figures. In arranging time series of the prices of certain primary commodities, empiricism has at least an apparent justification in the fact that the price data dealt with refer to the same physical object. It is a spurious excuse indeed as prices are not related to the unchanging physical properties of things, but to the changing values which acting men attach to them. But in the study of interest rates, even this lame excuse cannot be advanced. Gross interest rates as they appear in reality have nothing else in common than those characteristics which catallactic theory sees in them. They are complex phenomena and can never be used for the construction of an empirical or a posteriori theory of interest. They can neither verify nor falsify what economics teaches about the problems involved. They constitute, if carefully analyzed with all the knowledge economics conveys, invaluable documentation for economic history; they are of no avail for economic theory.
It is customary to distinguish the market for short-term loans (money market) from the market for long-term loans (capital market). A more penetrating analysis must even go further in classifying loans according to their duration. Besides, there are differences with regard to the legal characteristics which the terms of the contract assign to the lender’s claim. In short, the loan market is not homogeneous. But the most conspicuous differences arise from the entrepreneurial component included in the gross rates of interest. It is this that people refer to when asserting that credit is based on trust or confidence.
The connexity between all sectors of the loan market and the gross rates of interest determined on them is brought about by the inherent tendency of the net rates of interest included in these gross rates toward the final state of originary interest. With regard to this tendency, catallactic theory is free to deal with the market rate of interest as if it were a uniform phenomenon, and to abstract from the entrepreneurial component which is necessarily always included in the gross rates and from the price premium which is occasionally included.
The prices of all commodities and services are at any instant moving toward a final state. If this final state were ever to be reached, it would show in the ratio between the prices of present goods and future goods the final state of originary interest. However, the changing economy never reaches the imaginary final state. New data emerge again and again and divert the trend of prices from the previous goal of their movement toward a different final state to which a different rate of originary interest may correspond. In the rate of originary interest there is no more permanence than in prices and wage rates.
Those people whose provident action is intent upon adjusting the employment of the factors of production to the changes occurring in the data—viz., the entrepreneurs and promoters—base their calculations upon the prices, wage rates, and interest rates as determined on the market. They discover discrepancies between the present prices of the complementary factors of production and the anticipated prices of the products minus the market rate of interest, and are eager to profit from them. The role which the rate of interest plays in these deliberations of the planning businessman is obvious. It shows him how far he can go in withholding factors of production from employment for want-satisfaction in nearer periods of the future and in dedicating them to want satisfaction in remoter periods. It shows him what period of production conforms in every concrete case to the difference which the public makes in the ratio of valuation between present goods and future goods. It prevents him from embarking upon projects the execution of which would not agree with the limited amount of capital goods provided by the saving of the public.
It is in influencing this primordial function of the rate of interest that the driving force of money can become operative in a particular way. Cashinduced changes in the money relation can under certain circumstances affect the loan market before they affect the prices of commodities and of labor. The increase or decrease in the supply of money (in the broader sense) can increase or decrease the supply of money offered on the loan market and thereby lower or raise the gross market rate of interest although no change
in the rate of original interest has taken place. If this happens, the market rate deviates from the height which the state of originary interest and the supply of capital goods available for production would require. Then the market rate of interest fails to fulfill the function it plays in guiding entrepreneurial decisions. It frustrates the entrepreneur’s calculation and diverts his actions from those lines in which they would in the best possible way satisfy the most urgent needs of the consumers.
Then there is a second important fact to realize. If, other things being equal, the supply of money (in the broader sense) increases or decreases and thus brings about a general tendency for prices to rise or to drop, a positive or negative price premium would have to appear and to raise or lower the gross rate of market interest. But if such changes in the money relation affect first the loan market, they bring about just the opposite changes in the configuration of the gross market rates of interest. While a positive or negative price premium would be required to adjust the market rates of interest to the changes in the money relation, gross interest rates are in fact dropping or rising. This is the second reason why the instrumentality of the price premium cannot entirely eliminate the repercussions of cashinduced changes in the money relation upon the content of contracts concerning deferred payments. Its operation begins too late, it lags behind the changes in purchasing power, as has been shown above. Now we see that under certain circumstances the forces that push in the opposite direction manifest themselves sooner on the market than the price premium.
Human Action: A Treatise on Economics Page 78