Wednesday, May 31, 2017

Fisher's Theory of Interest #3

Fisher makes income central to his theory of capital. The value of capital must be computed from the value of its estimated future net income, not vice-versa. (He isn't clear about which kind of income he means here, but I assume it is money income.)  Income is derived from capital, but it is from capital goods, not the value of capital. The value of capital is derived from the discounted value of income.

The scheme is:  Capital goods ---> Flow of income ---> Income value ---> Capital value.

"It is true that that the wheat crop depends on the land which yields it. But the value of the crop does not depend on the value of the land. On the contrary, the value of the land depends on the expected value of the crops" (The Theory of Interest, p. 15).

Suppose an orchard yields 1000 barrels of apples a year and this annual crop is expected to be worth $5,000 per year. The physical productivity of the orchard does not by itself imply the value of the orchard. It is valued at $100,000 when the annual crop is valued at $5,000 net per year, and the rate of interest is 5 percent. The $100,000 is the discounted value of the expected annual income (The Theory of Interest, p. 54-5).

Fisher regarded that $5,000 as a perpetuity. He could have arrived at the same $100,000 by assuming the orchard could be sold for $100,000 after any number of years. However, that would look like circular reasoning by assuming a future sale value of the orchard itself. Which of the following is a more reasonable assumption? $5,000 per year with no variation forever? $5,000 per year for several years and selling the orchard for $100,000 at the end (which makes the cash flow akin to a bond)? I am inclined toward the latter.

It is clear from this that Fisher's use of "interest" is much broader than explicit interest on a loan or the implied interest rate of a bond. It includes observable market interest rates, but also subjective rates used to discount future values. Observable market interest rates result from market transactions; discount rates used in subjective valuations are not. This dual usage of the term interest is not confined to Fisher. Böhm-Bawerk and other Austrian economists do likewise. Moreover, the more heterogeneous the capital, the more opaque must be subjective discount rates (except possibly to the person doing the discounting).

Saturday, May 27, 2017

Fisher's Theory of Interest #2

As said in my previous post, Irving Fisher regarded income as the central concept of economics. For much of the spending of income, or the cost of living, there is little time difference between expenditure and its enjoyment or use. For example, there is little difference between buying a movie ticket and seeing the movie, paying the monthly rent and having a place to live, buying food and eating it.

The time difference worth noting is that when money is spent not simply for a short-term use, but for all its possible future uses.  If a house is bought, we do not count the purchase price as all spent for this year's shelter. We expect to live in the house for years. Only a portion of the purchase price is regarded as the cost of the current year's use. The same applies to other durable goods such as an automobile, and most furniture and appliances. The true real annual income from such goods is the approximate equivalent of the cost of services they give each year.

Fisher said nothing about a home mortgage, car loan or car lease. This was likely due to their being uncommon when he wrote this more than a century ago. In any case, his focus was on money payments for consumption goods, or money outgo. Money income includes all money received whether spent or not. The part of money income not spent is saved or reinvested.

Several pages later Fisher says capital gains are not income. That seemed odd initially. Maybe he meant unrealized capital gains are not income, and he would have regarded realized capital gains as income. He did not use the italicized words, but they fit an example he gave. It was about a bond, whose price grows with accrued interest between coupon dates. "That growth in its value is not income but increase in capital. Only when the coupon is detached does the bond render, or give off, a service, and so yield income" (The Theory of Interest, p.26). The phrase "the coupon is detached" is archaic (link). Substitute "interest is received" to modernize it.

"If Henry Ford receives $100,000,000 in dividends but reinvests all but $50,000, then his real income is only $50,000, even if his money income is $100,000,000. And if he ...  received no dividends and yet spent $40,000 in that year for living expenses and all other satisfactions, then his real income was this $40,000 even if his money income that year was zero.
   "Thus the income enjoyed in any year is radically different from the ups and down of ones capital value in that year--whether this is caused by savings or the opposite, or by changes in the rate of interest or by so-called chance" (The Theory of Interest, p.27).

Monday, May 22, 2017

Fisher's Theory of Interest #1

American economist Irving Fisher published The Theory of Interest in 1930. The subtitle is as Determined by Impatience to Spend Income and Opportunity to Invest It. These two factors sound very fitting to me for describing the nature of interest. He dedicated the book to the memory of John Rae and Eugen Böhm-Bawerk who laid the foundations upon which he endeavored to build.

The first chapter is a summary of his The Nature of Capital and Income published in 1906. He regarded income as the central idea of his economics. Enjoyment income, real income, and the cost of living are three different stages of income. They run in parallel but are not synchronous in time. Enjoyment income is psychological and can't be measured directly. It can be approximated indirectly by real income. Real income consists of those final physical events in the outer world which give us our inner enjoyments.  Real income includes having shelter, the use of clothes, the eating of food, reading, entertainment, and all those other events that contribute to enjoyment.

Like approximating an individual's enjoyment income by real income, an individual's real income can be approximated by his cost of living, the money measure of real income. "The total cost of living, in the sense of money payments, is a negative item, being outgo rather than income; but it is our best practical measure of the positive items of real income for which these payments are made" (The Theory of Interest, p.7).

Wednesday, May 17, 2017

Pure Time Preference Theory of Interest #6

In my latest post, I claimed there is more to "originary interest" than mere time preference. While in his critique of productivity theories Böhm-Bawerk downplayed the relevance of productivity to interest, at other times he overtly acknowledged it. An example is in his evaluation of the work of John Rae. "For I consider it entirely correct to think of interest as having its ultimate roots in a difference in our estimation of present and future goods. I also consider it quite correct to say that the purely psychological reasons that Rae sets forth for this difference in evaluation are a very material factor. But I consider it equally unquestionable that these reasons cannot supply an exhaustive explanation of the phenomenon of interest as it in fact exists. ... [T]here are also technological methods of production which influence interest. I am referring to those factual experiences which reduced one group of interest theorists which we have already discussed to postulate an independent 'productivity of capital.'" (Capital and Interest, Volume 1, p. 227). 

Friday, May 5, 2017

Pure Time Preference Theory of Interest #5

"This interest income, then is not derived from the concrete, heterogeneous capital goods, but from the generalized investment of time" (Murray Rothbard, Man, Economy, and State, 319).

"The difficulty is—and indeed, I think it is at once the greatest and the most stimulating difficulty of the whole problem of interest—the difficulty is, to explain in what manner, and by the employment of what intermediary processes those heterogeneous component elements (they include objective technical factors, and highly subjective psychological motives) combine and cooperate to produce that end result which we know as the homogeneous phenomenon of interest" (Böhm-Bawerk, Capital and Interest, 227).

Clearly heterogeneous factors are combined to often produce a positive outcome, but what exactly is homogeneous about interest? Interest rates vary by duration – short, intermediate, and long-term debt and the credit risk of the borrower. 

The purity of the PTPT seems to have been obtained by eliminating productivity and the entrepreneur.

In Volume 1 of Capital and Interest Böhm-Bawerk critiques the interest rate theories of others. In Volume 2 he presents his own. "The natural difference in value between present and future goods, the existences and causes of which I have set down in the preceding chapter, is the fountainhead from which all interest takes its origin." He presents the chief instances of interest and claims the same causative force is at work, that is, the force is the difference in value between present and future goods.

The simplest instance is the loan. The second instance is "originary interest", the result of activity carried out by the entrepreneur. He buys goods of remoter order -- raw materials, tools, machinery, and labor, and via the production process converts them into goods of the first order, products ready for consumption.  The third instance is interest on durable goods used in production. Why he chose to put this in a separate category is beyond me. 

Further about "originary interest", which is also called "profit" and "surplus proceeds," Böhm-Bawerk wrote: "Of course, for future goods to become present goods it is not sufficient that time march on." The production process transforms them into end products.

So there is more to "originary interest" than mere time preference. Being that "originary interest" is so different from loan interest, using the word interest for the former muddles rather than proving essential similarity. The price of future goods when they are eventually sold is typically very contingent. The future amount received on a loan is typically not. Yet Böhm-Bawerk asserts: "the market price of the production good called "labor" must always be lower than the future value and price of the finished product."

I think not. The future value and price of the finished product is contingent, so his use of "must always" is unjustified. He did not say expected future value and price, which would make a very different proposition.

Böhm-Bawerk even denies the relevancy of contingency (uncertainty). "Very frequently, however, our valuation of future and/or immediate goods is modified by the operation of an additional element which causes us to evaluate them somewhat or even considerably below their future marginal utility. But I wish to add here immediately that this element has absolutely no connection with the rise of the phenomenon of interest. The element I am referring to is uncertainty" (Capital and Interest, Volume 2, 263).