The Free Market Rate of Interest

In reference to my first blog, where I describe how the rate of interest derives directly from the subjective value scales of individuals, I will now describe where the market rate of interest arises from.

Within the structure of production we find various stages of the production process, starting with land and labor, and resulting in the final consumer product. During the free market process, the price spreads shrink and expand according to an array of market signals.

Buying prices can rise faster than selling prices, which will result in shrinking price spreads. This process is unknown, it is subjective and only perceived by the entrepreneur. In nominal terms it may be clear, but in real terms it is opaque.

When price spreads are high, capitalist-entrepreneurs apportion savings to this higher earning sector. On the other hand, when price spreads are low, capitalist-entrepreneurs pull their money out of this sector and advance savings to the other higher earning sectors. Rothbard calls this advancing factors to the various stages of the production process.

Be aware that within this theory, a capitalist-entrepreneur can invest in stage 5, higher order goods, mix land and labor to create a new capital good, which can then be sold in stage 3, a lower order goods sector. This process occurs over time, so stage 3 will happen at a later point in time than stage 5.

These price spreads, the difference between buying and selling prices of factors of production, are the going rate of interest in the market. The mainstream scholars would subscribe their idea of the market rate of interest as manifested in the Federal Funds Rate.

Mainstream scholars believe that the rate of interest derives from the producers loan market. It does not. Their models desire convincing us that it does by seducing us with hypostatization. Since, to them, their idea of a market rate of interest is ultimately so abstract and unknown, they feel there must be a monopolized rate of interest to dictate the amount of debt issuance.

They miscalculate and misunderstand how the private capital markets work in a competitive free society. They are ultimately forcing spreads toward the equilibrium they attempt to design. As an outcome, all expansion occurs simultaneously.

The central bank purchases assets at a certain contractual price, this in essence results in a change in yields. As a process new money enters the market. Unlike the rest of us who have to build savings, they can enter a debit and credit out of nowhere. Some coin this, money out of thin air. It causes a rise in the money stock.

For Austrians, we understand how the free market works, so there is no need for us to attempt to design a society. Our method is a priori. It is a value free science.

Referencing the description above about the price spreads of the various factors of the production process, if one were to average these spreads, one would arrive at what is termed the natural rate of interest. This is the market rate of interest.

What is most important to understand is that this theory of the natural rate of interest is simply theory. It is abstract, conceptual and unknown. Albeit subjectively we know it exists at all times. Even with numerical calculation, arriving at the exact price precludes making a mere assumption within the confines of what happened in the past; historical data.

Figuring out a method of actually averaging them out can only be done intuitively. Nobody has complete information. This is essentially a theoretical concept.

As a result of having limited information, capitalist-entrepreneurs on the free-market may only attempt to gauge this rate of interest within their proprietary framework. There would effectively be many competing benchmarks. Contractual rates of interest would be decided contractually.

The results of attempting to gauge the rate of interest with a monopolized benchmark are always disastrous. The monopolized benchmark will always be wrong, and in most cases tend to be below the natural rate constantly causing chaos. Credit expansion will ensue, and excessive malinvestments will amount.

As mentioned before, there will always be bad choices, which implies that there will always be malinvestments. Not even the capitalist-entrepreneur knows if his choices will result in monetary losses until after the choice has been made. Only free-market signals can quell excessive malinvestments, and ultimately vast amounts of monetary losses.

Conclusively, we arrive at where interest rates are born, or where they evolve from. The rate of interest is a subjective value that derives from individual human action.