What Is Interest?

There is a large consensus among microeconomists that “messing with” prices is not good. Among these prices, there is greatest consensus that rent control distorts the efficient allocation of resources.

Despite the relative consensus among economists about price controls, there is seemingly no recognition that tinkering with interest rates will similarly distort the efficient allocation of resources—but across time. This Slate article alerts us that the Federal Reserve is planning to suppress interest rates until at least 2014.

What exactly is interest? Keynesians and many laypeople believe that interest is the “price of money.” When you hold money, you are foregoing the interest that you could have earned by placing it in an interest-bearing account. However, this view is too narrow to explain the phenomena of interest. The true price of money is whatever you could purchase with it. Of course, this differs from person to person depending on subjective values.

In reality, interest is the premium paid to obtain present money for future money. All humans, due to their finiteness, prefer the same good in the present as opposed to the future. In order to part with present money, the seller must be compensated according to the strength of his time preference. Thus, we see that interest is a fundamental element of human existence. For a detailed exposition of this phenomena, see the new The Pure Time-Preference Theory of Interest edited by Jeffrey Herbener.

When central banks tinker with interest rates, they can change the interest required to borrow, but they cannot change society’s fundamental time preferences—individuals’ general preferences for future vs. present satisfaction. As we’ve explained elsewhere, this fundamental disconnect will eventually reveal itself in economic disaster.

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