The Natural Economic Order/Part V/Chapter 7
Basic Interest, Premium for Risk and Hausse-Premium
Those who seek to test the correctness of the above theory of interest by statistics will frequently come upon apparent contradictions. The reason is that besides basic interest the rate of interest usually contains components which have nothing to do with interest.
In addition to insurance against risk, the rate of interest often contains a peculiar component dependent upon variations in the general level of prices of commodities. To emphasise the connection with rising prices, and to provide a term which can be used outside Germany, I shall call this component a Hausse-premium. This means the share of the profit from an expected rise of prices (Hausse) falling to the giver of money.
To understand the nature of this component of interest one need only observe the conduct of borrowers and lenders of money when a general rise of prices is expected. A characteristic feature of a general rise of prices is that borrowed money can be paid back with part of the commodities that have been bought by means of the money and then sold. An extra profit, over and above the legitimate profit of commerce, a surplus, therefore remains. This surplus must of course provoke a universal appetite for buying proportionate to the probable amount of the surplus and, above all, to the degree of certainty with which the continuation of the rise of prices can be expected.
Those who work with borrowed money then increase their requests for money from the banks to the extreme limit of their credit (which, as a rule, increases, since the rise of prices favours debtors); and those who have previously lent money prepare to start business independently, foregoing their intention only if borrowers, by raising the rate of interest offered, make them sharers in the expected gain.
Through the general rise of prices (trade-boom, business prosperity) the possessor of ready money and claims to ready money (Government loans, mortgages, etc.) is threatened with loss, since he receives less and less commodities for his money. The only way in which the possessor of money can protect himself against this loss is to sell the threatened securities, and with the money realised to buy industrial shares, commodities, houses, as the prices of these things, it is commonly expected, will increase. After this double transaction the trade-boom can no longer injure the individual in question; the loss falls on the purchaser of the threatened securities. But as these purchasers also understand the situation, they buy the Government securities only at a reduced price, and they increase the deduction (discount) which they make when buying bills of exchange. In this way a kind of equilibrium is established.
But now suppose some clever person says to himself: "I have, indeed, no money, but I have credit. I shall borrow money upon bills of exchange and buy commodities, industrial shares and the like. And when the bills of exchange fall due, I shall sell, at the higher prices, what I have bought, and pay my debt, keeping the difference for myself." Clever persons of this kind are plentiful, and they are all to be found at the same time, in the same place, namely in the banker's waiting-room. Small manufacturers, small merchants and the richest in the land are there in company. They have all an insatiable appetite for money. But the man of money sees the throng and knows that his money is insufficient to satisfy them all. (If he did satisfy them, they would return next morning and ask for double the amount). To reduce the throng he raises the rate of interest (discount) and he keeps raising it until the clever persons are uncertain whether the profit from the transaction they have planned can cover the increased amount of interest. Equilibrium is then established; the appetite for money disappears; the throng in the waiting-room of the man of money melts away. What the possessor of money loses through a rise of prices has then gone over into the rate of interest.
Thus the rate of interest must replace what money-capital loses through a rise of commodity prices. If, for instance, the expected rise of prices amounts to 5 % annually, and basic interest is 3 or 4 %, the interest upon loans must rise to 8 or 9 %, to leave money-capital unaffected. If the capitalist deducts from this 9 % the 5 % corresponding to the rise of prices and adds it to his capital, his position is as strong as before the rise of prices. 105=100, that is, for 105 he now receives the same amount of commodities as he used to receive for 100.
It would not be surprising if a closer examination revealed that in spite of the higher dividends and the higher rate of interest during the last 10 or 15 years, German capitalists (with the exception of landowners) had received, on the average, an abnormally low rate of pure interest. Prices during this period have risen sharply. 1,000 marks fifteen years ago purchased quite as much as 1,500 marks at the present day. If a capitalist makes the above calculation, what becomes of the profit from the high dividends and the increase in the price of shares? Where is the so-called increase of value ? And a capitalist must so calculate, for the amount of his money, expressed in figures, is immaterial, otherwise a millionaire would only have to travel to Portugal to become a multi-millionaire.
The greatest sufferers from a rise of prices are the holders of securities bearing a fixed rate of interest; for if they sell such securities they lose through the fall in the selling-price, and if they keep them, they receive less commodities for the interest. If the great rise of prices had been foreseen fifteen years ago, the price of consols would have fallen still further perhaps to 50.
It is therefore clear that the expectation of a general rise of prices will increase the requests for loans of money, and that the owners of money will consequently be in a position to exact a higher rate of interest.
The rise in the rate of interest is therefore caused by the universal, or almost universal, belief that prices are about to rise, and it depends ultimately upon the fact that borrowers hope to meet their liabilities with part of the commodities that owe their existence to the borrowed money. During a rise of prices the rate of interest admits a foreign component that has nothing to do with capital interest. We call this component a hausse-premium, that is, the money-giver's share in the profit expected from a rise of prices.
This component of the rate of interest disappears of course at once when the expected general rise of prices has been realised. It is not the realisation of a rise of prices, but the hope of a future rise of prices that stimulates people to purchase commodities, to invest their money in new enterprises and to besiege the bank with requests for loans. When the hope of a further rise of prices has dwindled away, there is no stimulus to purchase, and money returns to the banks. The rate of interest then falls; the hausse-premium withdraws from the rate of interest. Obviously when a general fall of prices is expected every trace of hausse-premium disappears from the rate of interest.
The amount of the hausse-premium depends of course entirely upon the amount prices are expected to rise. If a sudden large jump of prices is expected, the claims of the banks will advance at the same pace and there will be a sudden large jump in the rate of interest.
When a general rise of prices was expected in Germany a few years ago, the rate of interest rose to 7%. Shortly afterwards a fall of prices was expected and the rate of interest fell to 3 %. The difference can be ascribed with certainty to the hausse-premium. In Argentina the rate of interest sometimes stood at 15 %, namely at times when the continuous increase of the stock of paper-money drove prices up by leaps and bounds. When, afterwards, the increase of paper-money ceased, interest fell to 5 %. We have here a hausse-premium of 10 %. Henry George states that there was a time when 2 % monthly was not considered an exorbitant rate of interest in California. This was during the great Californian gold discoveries.
As there is no limit to a general rise of prices (a pound of candles at one time exchanged for 100 livres in assignats at Paris), there is no limit to the hausse-premium. It is easy to imagine circumstances in which a hausse-premium would drive the rate of interest up to 20, 50 or 100 %. The increase in the rate of interest is determined simply by the amount prices are expected to rise before the date of repayment. If, for example, a rumour gained currency that gold deposits of immense richness had been discovered under the ice-fields of Siberia and if, in confirmation of this news, great shipments of gold were reported, the inevitable result would be a universal zest for buying which would increase to infinity the requests for loans made to the owners of money. Such a discovery of gold would cause an unparalleled rise in the rate of interest. The hausse-premium could never, of course, quite equal the surplus expected from the general rise of prices, since in that case, the expected gain would at once be completely absorbed by the discount. But the more reliable and certain the estimate of the expected rise of prices, the more nearly would the hausse-premium equal the surplus.
In consequence of pressure from the creditor-class laws have been passed from time to time in many countries with the purpose of reducing the prices of commodities to an earlier lower level. (By the withdrawal from circulation of paper-money which had been issued overabundantly, or by the demonetisation of silver, for example). A few years ago (1898) such a law was passed in Argentina by which the general level of prices was reduced from 3 to 1.
If any country at the present day were, on the contrary, to yield to the wishes of debtors and to drive prices step by step upwards by increasing the stock of money in such a way that prices annually increased 10 %, the certainty of the expected surplus would bring the hausse-premium very near this 10 %.
The recognition of the hausse-premium as a special component of the rate of interest is essential for the explanation of most phenomena in connection with interest. How, for instance, can we otherwise explain the fact that the rate of interest and the amount of savings-bank deposits as a rule increase simultaneously — unless we abandon the theory that interest is deducted from the proceeds of labour?
The division of the rate of interest into interest, premium for risk and hausse-premium gives a completely satisfactory explanation of what appears to be an inexplicable anomaly. For only pure capital-interest is deducted from the proceeds of labour; the hausse-premium is resolved into the higher prices. The worker, whose wages also follow the rise of prices, is consequently unaffected by the higher rate of interest. He pays higher prices and receives a higher wage; equilibrium is here established. The borrower pays a high rate of interest but receives a higher price for what he sells, here also equilibrium is established. The capitalist receives back his money scourged and mutilated, but is compensated by the higher rate of interest. Here again there is equilibrium. Only the explanation of the increase of savings is wanting, and it must be sought in the fact that during a general rise of prices (a trade-boom) unemployment disappears.
It is only the rate of interest, therefore, not interest itself, that increases simultaneously with savings-banks deposits.
- I have substituted "Hausse-premium" for "Ristorno", the word formerly used by me, as it better expresses the meaning: the money-giver's share in an expected rise of prices.
- All this was written before the war. See also: Gesell, Die Anpassung des Geldes an die Bedürfnisse des Verkehrs. Buenos Aires, 1897.
- At the end of the German paper-money swindle (1923), interest was paid at the rate of 100 % per diem; the capital doubling in this way daily!