"Most people are in arrested development and cannot use logic." Jacob.
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Monday, July 11, 2011

The Dark Side, Interest, and Hazlitt to the Rescue.

The respected Austrian, Bob Murphy, has come out and said Keynes is brilliant in one part of his book, and actually [shudder] better than Mises.
This has started a lot of back and forth, with Bob being accused of crossing over to The Dark Side. The discussion is incredibly technical, about one of the most tangled subjects in all economics, interest.

What better opportunity for Smiling Dave and his Merry Men and Women to get out there and learn something? My mentor from the next world, Henry Hazlitt, explains it all to us, in his famous book about Keynesian economics.

We smooth right in to the first of five theories about interest, the Productivity Theory. This theory was written before there were credit cards and insane consumer borrowing. It assumes that the fellow borrowing is a businessman. It makes the obvious but profound observation that you don't borrow money to fill your swimming pool with, but to buy things for your business so you can make profits.

With some exceptions.
Assuming all profits in all businesses to be equal [for reasons we need not go into], say 5%, you are willing to borrow the money at a slightly less than 5%. So that the interest rate is set by the productivity of business.

Hazlitt doesn't like this theory. The main flaw seems to be that the real question has been swept under the rug. Yes, the interest rate is 5% because the profits from business are 5%. But why are the profits from business stubbornly 5%? Why can't every businessman get 10% profits?

Which leads to the Time Preference Theory of interest, the second of the five theories. It states that interest is paid to gain time. You want $100 now instead of having to wait a year for it? That will cost you $5. Let me add that this makes a lot of sense when you are discussing consumer credit, such as credit cards and car payments home mortgages and the like.

The third theory [Fisher and Hayek] combines the first two; the fourth adds on top of all that the fact that there is a central bank printing money. Hazlitt goes on to say that Mises in Human Action Chapters 18, 19 and 20 gives the most mature exposition of this last theory.

Note that all these four theories focus on the guy who is going to use the money, the borrower. They all try to figure out why he is willing to pay what he pays.

The fifth and last is Keynes' theory, the one that Bob Murphy considers a work of genius, and Mises considered laughable. Mises says it is
"...a view, indeed, of insurpassable naivete. Scientific
critics have been perfectly justified in treating it with con-
tempt; it is scarcely worth even cursory mention. But it is
impossible to refrain from pointing out that these very views
on the nature of interest hold an important place in popular
opinion, and that they are continually being propounded

What is this controversial theory, and what are the arguments for and against it?
Keynes called it the Liquidity Preference Theory. The idea being that people like to have their money safe in their wallets, where they can spend it instantly if need be. The thought of having to hand it over to someone, despite a thousand promises of getting it back, and being given sound collateral to boot, is repulsive. To convince them to hand over, even temporarily, their hard earned moolah, you have to pay them interest.

Note that this theory focuses on the lender, saying the interest rate is determined by him.

Sounds pretty good, no? Why is it laughable? Hazlitt says because it neglects to take into account many factors that obviously influence the interest rate.

OK, so now we at least know what we don't know. Our work is cut out for us. First step, and one that it looks like Smiling Dave will not be doing anytime soon, good intentions notwithstanding, is to read Chapters 18, 19, and 20 of Human Action.

Second is to take a good look again at the one paragraph Bob Murphy quoted from Keynes in his blog, and try to see if it is genius or unsurpassed naivete. But the hour is getting late.

Continued in next article; click here.

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