Mind you, I have been reading Mises for quite a while now - almost a year, if not more. I am well versed that interest rates cannot be tampered for malinvestments will occur, etc.
It is only recently I found the reading list on this forum (see the sticky =D). I thought, "Hey, I need this more than anything," after all, you can't base your knowledge on economics solely on daily articles. :P
So, I have been reading Economics for Real People as my start. That being said, I was doing fantastic in understanding - daily articles do benefit understanding, after all!
However, I got befuddled on page 111 - 114. This is in Chapter 7, when he began talking about economic roles and historical types. Under the section, "Capitalists/Landowners", I began to become confused. Let me quote exactly what he wrote and what part he I began to fell apart trying to place the pieces of the puzzle together:
"Let’s consider, in the evenly rotating economy, a machinethat we know will be rented for $1,000 for the next ten yearsand then break down, having produced a $10,000 return. (Bydefinition, we have absolute certainty as to future prices in theevenly rotating economy—they will be the same as today’sprices.) The price paid for such a machine will be less than$10,000. How do we know that? No one will give up a goodtoday in order to receive the same good back in the future, allother things being equal. (And in the evenly rotating econ-omy, all other things are, of course, equal!) So no one will pay$10,000 today for a machine that will give him $10,000 overthe next ten years.Let's say the machine sells for roughly $6,144. The capital-ist who buys it can rent it out for $1,000 per year, so he earnsa 10 percent annual return. Where does that 10 percent returncome from?The answer is apparent from our discussion above: it is areturn for the capitalist’s time, for the patience to forgo cur-rent consumption and allow one’s resources to be devoted tofuture production. If the return on capital is 10 percent in theevenly rotating economy, that means that 10 percent is themarginal time preference of the buyers and sellers of futuregoods against present goods."
It continues on and I began to understand it better a little in the next paragraphs, however it caught me again on two examples:
"...Let us say that an entrepreneur buysthe rights to next year’s grape harvest from some vineyard for$1,000. If the risk-free rate of interest is 5 percent, the entre-preneur will not consider that he has made a profit unless hecan sell the grapes for more than $1,050. This is because hecould, with less effort and risk, simply lend the money out at 5percent and have $1,050 at the end of the year...."
and:
"Arbitrage—simultaneously buying and selling goods totake advantage of price discrepancies between different mar-kets—will tend to establish a single interest rate for the econ-omy as a whole. Let’s say that the interest rate on money loansis currently 5 percent per year. Meanwhile, cattle futuresmaturing in one year are selling at a discount to spot (current)prices, so that for $90.90, an investor can contract for thedelivery of $100 of cattle a year from now. For simplicity’ssake, we will assume there are no transaction costs, no carry-ing costs for the cattle, and no possibility of demand or sup-ply changes in the spot cattle market. Given those assump-tions, there is a pure arbitrage opportunity available. Investorscan borrow money at 5 percent. They can buy cattle futuresthat will return 10 percent. (We have taken as a given that spotcattle will still be $100 next year, and the $9.10 they will earnis 10 percent of $90.90.) Investors net the 5-percent difference.Since they are borrowing the money and making no capitalinvestment themselves, such arbitrageurs are essentially pick-ing up money that has been left on the sidewalk. Once thatopportunity has been noticed, investors will rush to takeadvantage of it.
The effect of their actions will be twofold. Their demand toborrow money now to buy the cattle futures will drive theprice of present money higher against future money: themoney interest rate will rise. Conversely, their demand forfuture cattle will drive the price of future cattle up against thatof present cattle. Soon enough, the money interest rate willrise to, say, 6 percent, and the price of the cattle futures to$94.34. ($94.34 + $5.66 [6 percent of $94.34] = $100.) The arbi-trage opportunity will vanish."
That entire section on arbitrage threw me off totally from the first definition to its vanishing, as did the parts I bolded, as did pretty much everything I quoted. Can anyone better explain to me the basics of interest rates, perhaps guide me to another example, or perhaps to another article's explanation? I am a little lost here, and it's annoying me like hell due to the fact that I understood everything else totally. Can someone help?
EternalMind: I am a little lost here, and it's annoying me like hell due to the fact that I understood everything else totally. Can someone help?
The idea behind interest is very simple. If I want to borrow $5,000 from you, and you know I am good for it [no risk], would you lend it to me? As a personal favor, maybe, but what about to a total stranger [again, assume no risk, that you will for sure get the money back].
Probably your answer is "Why should I?"
"But you don't lose anything," says the starnger. "You will get your money back."
"Sure I lose something. I lose not having it for a year. What if I need it? What if a bargain comes up? What if I feel llike partying suddenly? Whatever, I am losing something by letting it out of my hands for a year."
"OK, what if I made it worth your while? At years end, I'll give you back $5,500 instead of the 5 thou you lent me."
"Now you're talking."
All the examples he gives are just complicated ways of saying this.
And now for the free lecture. When George Boole was studying Math, and he got stuck, he would read the piece over and over, line by line and word by word if neccesary, till he got it. Hint hint.
The arbitrage thing is just a complicated way of saying the following:
What if word gets out that you are willing to lend money, and there are long lines at your door. They are all willing to pay an extra dime for every dollar they borrow. You agree, and start making money hand over fist.
One day you realize you have no more momey to lend, but the line is just as long. So you go to the bank. They are willing to lend you tons of money, cause you provide good collateral, at 5% interest.
So you think, "Hmm. For every dollar I borrow from the bank, I give the bank back an extra nickel, but I get an extra dime from the guys waiting outside my door. So I still make a nickel on every dollar. Better than nothing."
Your neighbors see the long lines outside your door, and they too go to the bank for loans. They offer their services to the guys on line. The guys on line, seeing that there are a few people to choose from, start bargaining about interest rates. The bank, seeing so money people are coming to borrow from them, start raising their rates.
So there is a tendecy for the bank rate to rise and the loan rate to the guys on line to fall, all because of this increased competition. So that the bank interst rate will rise and the street rate will lower till they meet.
My humble blog
It's easy to refute an argument if you first misrepresent it. William Keizer
Thanks so much, Dave. That cleared up a lot. I'll remember the free lecture, too. xP
Here's my take on it: Of Time and Marshmallows.
In that article, I explain the phenomenon of originary interest (but I don't go into the price premium and the entrepreneurial components of market rates).