Boulding on Interest

Kenneth Boulding, reviewing Maurice Allais’s  Économie et intérêt in 1951:

Much work on the theory of interest is hampered at the start by its unquestioned assumption that “the” rate of interest, or even some complex of rates, is a suitable parameter for use in the construction of systems of economic relationships, whether static or dynamic. This is an assumption which is almost universally accepted and yet which seems to me to be very much open to question. My reason for questioning it is that the rate of interest is not an objective magnitude… The rate of interest is not a “price”; its dimensions are those of a rate of growth, not of a ratio of exchange, even though it is sometimes carelessly spoken of as a “price of loanable funds.” What is determined in the market is not strictly the rate of interest but the price of certain “property rights.” These may be securities, either stocks or bonds, or they may be items or collections of physical property. Each of these property rights represents to an individual an expected series of future values, which may be both positive and negative. If this expected series of values can be given some “certainty equivalent” … then the market price of the property determines a rate of interest on the investment. This rate of interest, however, is essentially subjective and depends on the expectations of the individual; the objective phenomenon is the present market price… 

It is only the fact that the fulfilment of some expectations seems practically certain that gives us the illusion that there is an objective rate of interest determined in the market. But in strict theory there is no such certainty, even for gilt-edged bonds; and when the uncertainties of life, inflation, and government are taken into consideration, it is evident that this theoretical uncertainty is also a matter of practice. What is more, we cannot assume either that there are any “certain equivalents” of uncertain series for it is the very uncertainty of the future which constitutes its special quality. What this means is that it is quite illegitimate even to begin an interest theory by abstracting from uncertainty or by assuming that this can be taken care of by some “risk premium”; still less is it legitimate to construct a whole theory on these assumptions … without any discussion of the problems which uncertainty creates. What principally governs the desired structure of assets on the part of the individual is the perpetual necessity to hedge — against inflation, against deflation, against the uncertainty in the future of all assets, money included. It is these uncertainties, therefore, which are the principal governors of the demand and supply of all assets without exception, and no theory which abstracts from these uncertainties can claim much significance for economics. Hence, Allais is attempting to do something which simply cannot be done, because it is meaningless to construct a theory of “pure” interest devoid of premiums for risk, liquidity, convenience, amortization, prestige, etc. There is simply no such animal. 

In other words: There are contexts when it is reasonable to abstract from uncertainty, and proceed on the basis that people know what will happen in the future, or at least its probability distribution. But interest rates are not such a context, you can’t abstract away from uncertainty there. Because compensation for uncertainty is precisely why interest is paid.

The point that what is set in the market, and what we observe, is never an interest rate as such, but the price of some asset today in terms of money today, is also important.

Boulding continues:

The observed facts are the prices of assets of all kinds. From these prices we may deduce the existence of purely private rates of return. The concept of a historical “yield” also has some validity. But none of these things is a “rate of interest” in the sense of something determined in a market mechanism.  

This search for a black cat that isn’t there leads Allais into several extended discussions of almost meaningless and self-constructed questions… Thus he is much worried about the “fact” that a zero rate of interest means an infinite value for land, land representing a perpetual income, which capitalized at a zero rate of interest yields an infinite value… This is a delightful example of the way in which mathematics can lead to an almost total blindness to economic reality. In fact, the income from land is no more perpetual than that from anything else and no more certain. … We might draw a conclusion from this that a really effective zero rate of interest in a world of perfect foresight would lead to an infinite inflation; but, then, perfect foresight would reduce the period of money turnover to zero anyway and would give us an infinite price level willy-nilly! This conclusion is interesting for the light it throws on the complete uselessness of the “perfect foresight” model but for little else. In fact, of course, the element which prevents both prices from rising to infinity and (private) money rates of interest from falling to zero is uncertainty – precisely the factor which Allais has abstracted from. Another of these quite unreal problems which worries him a great deal is why there is always a positive real rate of interest, the answer being of course that there isn’t! … 

Allais reflects also another weakness of “pure”interest theory, which is a failure to appreciate the true significance and function of financial institutions and of “interest” as opposed to “profit” – interest in this sense being the rate of growth of value in “securities,” especially bonds, and “profit” being the rate of growth of value of items or combinations of real capital. Even if there were no financial institutions or financial instruments … there would be subjective expected rates of profit and historical yields on past, completed investments. In such a society, however, given the institution of private property, everyone would have to administer his own property. The main purpose of the financial system is to separate “ownership” (i.e., equity) from “control,” or administration, that is, to enable some people to own assets which they do not control, and others to control assets which they do not own. This arrangement is necessitated because there is very little, in the processes by which ownership was historically determined through inheritance and saving, to insure that those who own the resources of society are … capable of administering them. Interest, in the sense of an income received by the owners of securities, is the price which society pays for correcting a defect in the otherwise fruitful institution of private property. It is, of course, desirable that the price should be as small as possible – that is, that there should be as little economic surplus as possible paid to nonadministering owners. It is quite possible, however, that this “service” has a positive supply price in the long run, and thus that, even in the stationary state, interest, as distinct from profit, is necessary to persuade the nonadministering owners to yield up the administration of their capital.

This last point is important, too. Property, we must always remember, is not a relationship between people and things. it is a relationship between people and people. Ownership of an asset means the authority to forbid other people from engaging in a certain set of productive activities. The “product” of the asset is how much other people will pay you not to exercise that right. Historically, of course, the sets of activities associated with a given asset have often been defined in relation to some particular means of production. But this need not be the case. In a sense, the patent or copyright isn’t an extension of the idea of property, but property in its pure form. And even where the rights of an asset owner are defined as those connected with some tangible object, the nature of the connection still has to be specified by convention and law.

According to Wikipedia, Économie et intérêt,  published in 1947, introduced a number of major ideas in macroeconomics a decade or more before the American economists they’re usually associated with, including the overlapping generations model and the golden rule for growth. Boulding apparently did not find these contributions worth mentioning. He does, though, have something to say about Allais’s “economic philosophy” which “is a curious combination of Geseel, Henry George and Hayek,” involving “free markets, with plenty of trust- and union-busting, depreciating currency, and 100 per cent reserves in the banking system, plus the appropriation of all scarcity rents and the nationalization of land.” Boulding describes this as “weird enough to hit the jackpot.” It doesn’t seem that weird to me. It sounds like a typical example of a political vision you can trace back to Proudhon and forward through the “Chicago plan” of the 1930s and its contemporary admirers to the various market socialisms and more or less crankish monetary reform plans. (Even Hyman Minsky was drawn to this strain of politics, according to Perry Mehrling’s superb biographical essay.)What all these have in common is that they see the obvious inconsistency between capitalism as we observe it around us and the fairy tales of ideal market exchange, but they don’t reject the ideal. Instead, they propose a program of intrusive regulations to compel people to behave as they are supposed to in an unregulated market. They want to make the fairy tales true by legislation. Allais’ proposal for currency depreciation is not normally part of this package; it’s presumably a response to late-1940s conditions in France. But other than that these market utopias are fairly consistent. In particular, it’s always essential to reestablish the objectivity of money.

Finally, in a review full of good lines, I particularly like this one:

Allais’s work is another demonstration that mathematics and economics, though good complements, are very imperfect substitutes. Mathematics can manipulate parameters once formulated and draw conclusions out which were already implicit in the assumptions. But skills of the mathematician are no substitute for the proper skill of the economist, which is that of selecting the most significant parameters to go into the system.