moneyFYI
Financial Freedom Is Merely Organized Common Sense
What Can Knut Wicksell Tell Us About Interest Rates?
Knut Wicksell had quite a lot to say about how interest rates work. He was born in 1851, died in 1926 and was an economist who influenced both the Austrians Hayek and Von Mises and at the same time Keynes. He is a resource in at least six economic schools of thought. Clearly a useful thinker.
He might be able to tell us a little about the current situation. Why do near-zero rates fail to stimulate the economy as much as our politicians expect?
In economics there is a concept of the “Market Clearing Price.” The price at which all of the production will be sold and all of the people who wish to buy a product are able to do so. If there is too much production, the price falls until it is sold. If there is too little, the price rises until demand matches.
Interest rates are the price for money, so why is there so little demand for the product when the price is so low?
Wicksell proposed that there are two interest rates. The “Natural Rate” which is the rate that arises based upon the expectation that people can profit in the future as the result of borrowing at the rate. There is another rate, the “Financial Rate” which is what lenders actually charge.
Wicksell believed that if the financial rate was less than the natural rate, then people would borrow almost infinitely to take advantage. They compare their price to the natural rate – the fair price for the opportunity to earn in the future and see a bargain.
Why is there no investment today given that in some cases the guaranteed financial interest is near zero?
The answer is just common sense. Because the natural rate today may be even lower than zero. There is little demand for the money because if you borrow money, at any price, even zero percent, you have to pay back the interest and the principal. To pay them back, you need to know that:
- in a business or an investment situation, what you invest the borrowing into will supply sufficient income to pay the loan off in the required time, or
- in a personal situation that your future take home income will be enough to make the necessary payments.
Today we find that many people do not as yet have the confidence in either of these two conditions to undertake significant obligations. It is not the interest rate that is troubling, it is the principal payment that is troubling.
If you could borrow at 0% interest and had to pay back only 90% of the principal, would you borrow? Some people would say no today. How about 75% of the principal?
We find that the market clearing price for money is irrelevant as long as lenders want the capital back. A 0% loan is not attractive if you cannot see how to pay the principal.
Clearly the policy approach is to pay less attention to the price of money and more attention to economic expectations.
Business people, and I suppose everyone else, are avoiders of uncertainty, so the solution for the policy folks is reduce the uncertainty. Have a clear economic path that government follows. Avoid trivial regulation. Do not disparage those who invest and profit. Promote reality instead of illusions like having a degree provides you with a great living. Keep your word. Be transparent. Give indications of proposed changes in direction.
The best incentive to economic growth is removing disincentives to economic growth and personal prosperity. Without that there will be no price that induces people to borrow or invest. At least not here.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
don@moneyfyi.com | Twitter @DonShaughnessy | Follow by email at moneyFYI
moneyFYI 
Pingback: Why Stocks Are Volatile | moneyFYI
Pingback: How Do Negative Interest Rates Work? | moneyFYI
Pingback: Time To Take Stock Of The Stock Market – moneyFYI