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What Determines Interest Rates? Comparing Mainstream Economics to the Austrian School

The conventional view among mainstream economists, as presented by Milton Friedman, is that three factors determine market interest rates: liquidity, economic activity, and inflationary expectations.

In this viewpoint, whenever the central bank raises the growth rate in the money supply by buying financial assets such as Treasurys, this pushes the prices of Treasurys higher and their yields lower. Note that this is the monetary liquidity effect, which inversely correlates with interest rates.

An increase in the money supply after a time lag strengthens economic activity and this sets in motion the economic activity effect, which exerts upward pressure on interest rates. After a much longer time lag, the increase in the growth rate of money supply affects prices of goods and services. Once prices begin to move higher, inflation expectations begin to emerge. Consequently, this exerts further upward pressure on the market interest rates.

Liquidity, economic activity, and inflation expectations are seen as key factors in the interest rate determination process. Observe again that this process is set by central bank monetary policies, which influences the monetary liquidity. The monetary liquidity effect gives rise to the other two effects.

According to Milton Friedman, the market interest rate ends up higher than where it was before the central bank increased the monetary liquidity. Writes Friedman:

The initial impact of increasing the quantity of money at a faster rate than it has been increasing is to make interest rates lower for a time than they would otherwise have been. But this is only the beginning of the process not the end. The more rapid rate of monetary growth will stimulate spending, both through the impact on investment of lower market interest rates and through the impact on other spending and thereby relative prices of higher cash balances than are desired. But one man’s spending is another man’s income. Rising income will raise the liquidity preference schedule and the demand for loans; it may also raise prices, which would reduce the real quantity of money. These three effects will reverse the initial downward pressure on interest rates fairly promptly, say, in something less than a year. Together they will tend, after a somewhat longer interval, say, a year or two, to return interest rates to the level they would otherwise have had. Indeed, given the tendency for the economy to overreact, they are highly likely to raise interest rates temporarily beyond that level, setting in motion a cyclical adjustment process.

Furthermore, according to Friedman:

Let the higher rate of monetary growth produce rising prices, and let the public come to expect that prices will continue to rise. Borrowers will then be willing to pay and lenders will then demand higher interest rates—as Irving Fisher pointed out decades ago. This price expectation effect is slow to develop and also slow to disappear. Fisher estimated that it took several decades for a full adjustment and more recent work is consistent with his estimates. These subsequent effects explain why every attempt to keep interest rates at a low level has forced the monetary authority to engage in successively larger and larger open market purchases.2

The popular explanation for the interest rate determination, then, is that it is derived from observations and not from an economic framework that “stands on its own feet.” It is questionable, however, to claim from observations that it is possible to establish a theory for the interest rate determination.

In The Ultimate Foundation of Economic Science, Ludwig von Mises argued:

What economic history, observation, or experience can tell us is facts like these: Over a definite period of the past the miner John in the coal mines of the X company in the village of Y earned p dollars for a working day of n hours. There is no way that would lead from the assemblage of such and similar data to any theory concerning the factors determining the height of wage rates.

Thus, the popular theory of interest rate does not explain, but only describes. The followers of this theory are likely to have hard time explaining the interest phenomena in a world where the central bank is absent.

Time Preference and Interest Rates

For most individuals, maintaining their life and well-being is the ultimate goal. We know that to stay alive an individual must consume goods in the present. This means that the individual must prefer the consumption of an identical basket of goods at present rather than in the future. This also means that the individual is likely to assign to the basket of goods in the present a greater importance than to the same basket of goods in the future.

According to Carl Menger:

To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period…. All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.

Consider a case in which someone has just enough resources to stay alive. This individual is unlikely to lend or invest his paltry means. The cost to him of lending or investing is going to be very high—it might even cost him his life if he were to consider lending part of his means.

On this Mises wrote,

That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction, which one must forego in order to attain the end aimed at.

Once an individual’s wealth starts to expand, the cost of lending, or investing, starts to diminish. Allocating some of his wealth toward lending or investment is going to undermine the person’s life and well-being at present.

From this we can infer, all other things being equal, that anything leading to the expansion of someone’s wealth likely will result in the lowering of the premium of present goods versus future goods, leading to the decline in the interest rate.

Conversely, factors that undermine real wealth expansion will increase the premium of present goods versus future goods, leading to an increase in the interest rate. Note again, increases in wealth tend to lower individuals’ time preferences whereas decreases in wealth tend to raise time preferences.

Individual responses to changes in wealth in relation to time preferences are not automatic. Every individual based on his ends decides how much wealth will be allocated for the present consumption versus the future consumption.

Contrary to the mainstream framework, the time preference theory does not require the existence of money as such in order to ascertain the interest phenomena. Also, note that by the popular framework, changes in economic activity are positively associated with interest rates. However, if the increase in economic activity is due to wealth expansion, this likely will produce a decline in time preferences and thus result in lowering of interest rates, not increases as suggested by popular thinking.

Interest Rates and the Increase in Money Supply 

When money created out of “thin air” is injected into the economy, this sets results in an exchange of nothing for something. (For instance, when banks expand unbacked by savings lending this raises the money supply out of nothing. Once the borrowers of this money employ it for transactions, this sets an exchange of nothing for something). The recipients of the injected money can now divert wealth from wealth generators to themselves.

Similar to the counterfeiter, by diverting wealth to themselves, those receiving of money out of “thin air” have now become wealthier than before the increase in money took place. This means that the receivers of money can now increase the purchases of various assets thus pushing those prices higher and their yields lower. The exchange of nothing for something weakens the process of wealth generation. Notwithstanding the exchange of nothing for something as long as the pool of wealth is growing, individuals’ time preferences are likely to decline, so a decline in the market interest rates takes place.

Conversely, once the pool of wealth declines, individual time preferences will likely increase, leading to an increase in market interest rates. In the framework of an expanding pool of wealth, interest rates are expected to decline, while a declining pool of wealth likely sets off a rising trend.

When the central bank attempts to counter the rising interest rate trend by injecting monetary liquidity into the economy, this only increases the rising trend, all other things being equal. Because the increase in the monetary liquidity sets in motion an exchange of nothing for something, the wealth generation process becomes weaker, leading to an oscillation of interest rates along the rising trend.

The fluctuation emerges because the central bank by pushing monetary liquidity temporarily lowers interest rates. However, the rising trend on account of the decline in the pool of wealth pulls the rates up—hence the oscillation.

Observe that interest rates in a free unhampered market will correspond to people’s’ time preferences. When individuals lower their time preferences, this signals businesses to arrange a suitable infrastructure in order to be ready for the increase in the demand for future consumer goods.

Hence, a businessman who wants to succeed in his business must abide by consumers’ instructions. In this sense, the market interest rates are indicators. The policies of the central bank, however, distort where interest rates should be in accordance with individuals’ time preferences, thereby making it much harder for businesses to ascertain what is really is happening.

According to mainstream economists, there is no logical connection between individuals’ ends and the market interest rates. How could one then conclude, using the popular framework, that central bank’s monetary policies can cause distortions in financial markets leading to a misallocation of resources? The Austrian School framework points out that central bank policies cause market interest rates to deviate from the interest rates as dictated by individuals’ time preferences, which, in turn, causes businesses to disobey individuals’ instructions, resulting in the misallocation of resources.

Causes in Economics Emanate from Individuals

Because people pursue conscious purposeful actions, it implies economic phenomena emanate from individuals and not from outside factors. To the extent that individuals respond to various outside factors, such a response is not automatic. Every individual assesses changes in various factors against his ends and acts accordingly.

We hold that neither monetary liquidity, nor economic activity nor inflation expectations are the essence of interest rates determination. It is individuals’ decisions regarding the present consumption versus the future consumption that determine interest rates. Monetary policies that result in changes in the quantity of money only distort interest rates signals, thereby setting the misallocation of resources.

Conclusion

By popular thinking, market interest rates are determined by changes in monetary liquidity, economic activity, and inflationary expectations. In this way of thinking, an increase in monetary liquidity pushes the interest rates lower, while increases in economic activity and increases in inflationary expectations push interest rates higher.

This framework depicts individuals as unconscious entities. In this framework, the causes originate from outside factors and not from within individuals. It depicts individuals as robots that mechanically react to monetary liquidity, economic activity, and inflationary expectations. We conclude that individuals’ conscious and purposeful action regarding present consumption versus future consumption is the key determinant of interest rates. We also hold that easy monetary policy undermines the process of wealth generation. Consequently, if the pool of wealth is declining, easy money policy reinforces the increase in interest rates.

2. Ibid.