1.1.20 interest rates

Interest rates are considered in the classical theory the price of capital, what is actually, in classic theory, the same as money. This is a cornerstone of classic theory. If interest rates are not the price of money, but, as Keynes stated, the price paid for liquidity, the whole classic and neoclassic system break down.

A second cornerstone of classical theory is the Law of Say. Following the link, the reader can see that this 'law' is embedded in a larger context, and it is not clear that the version we found in textbooks is correct, but here we will discuss this short version..

Let's start with the interest rates. In the classical theory, the interest rate is a price, has, therefore, the function of a price in a market economy. It signals scarcity and give an incentive to reduce the scarcity; it works like any other price.

If the supply of capital is lower than the demand for capital, interest rates will rise. This has the effect, which more people will 'produce' more capital, in other words, they will save more because saving is more rewarding. At the other side demand for capital will decrease because the higher the interest rates, the fewer the investments able to pay these higher interest rates. As in any other market, in this theory, the price will balance supply and demand.

This makes only sense if we consider 'capital', money disposable for inventive use, as something that only can be obtained by a sacrifice. Sacrifice, in this case, means renunciation to a consumer in the present to consume more in the future. The idea is that people prefer consumption in the present to consumption in the future and only if the consumption in the future is higher than the consumption in the present, they will save, or 'produce' capital. The higher the interest rate, the bigger the postponed consumption.

If we follow this theory, what we have obviously no intention to do, capital is scarce. Everything that depends on a sacrifice or renunciation is scarce. If we want to use a ressource in one use, we can't use it for something else. We have to renounce to somenting in order to get something else. In this case we have to renounce to consumption in the present in order to get more consumption in the future, but an incentive is needed to induce us to do so. That's, in the classic theory, the interest rate.

It is stunning that in such a simple theory there can be so many errors. The first error is that saving in the sense of non consumed income of the past is not needed for investments. In the classical theory there are only two uses for income. It can be consumed or saved and invested. The problem is, that for investments money is needed, not capital in the sense of non consumed income of the past. We address this problem, a very fundamental one, in the little book about Keynes the reader can dowonload from the entry page of this website.

We have to understand that in classic thinking, supply equals demand because the interest rates equal saving and investment. If saving equals investment and the rest is consumed, unemployment due to a lack of demand is impossible. The people will spend all their money. The scenario described by Keynes, people, earn money, but don't spend it, is not possible in this world.

However, besides the problems addressed by Keynes, there are other problems. Keynes mentions as well that people save money to cope with eventual calamities in the future, but he didn't really discuss this issue and considered not very important.

It can be questioned if this point is really irrelevant. If people, for instance, know, that they need a certain amount of money to live on after their working live, what can they do, if the interest rates fall? They have to save more, not less, as it is assumed by the classical theory. This is not a theoretical fantasy; this is something very concrete and a real problem.

It was thought twenty years ago that the pension system could be stabilised if more people create their own capital stock during their working life from which they can live if they retire. It turns out that this doesn't work. Insurance companies who collected this money, have serious problems to invest it and to meet the commitments.

If people save more and more, they consume less, and no investor will invest more today if he is confronted with a shrinking demand. For the individual, it seems rational to save more during his lifetime in order to consume his savings in the future. However, if everybody does that, he will lose his job, and there will be no saving at all.

Besides that, the law of Say is no guarantee for full employment even it were true. The logic of the law of say is simple. If everybody only produces something in order to get the money to buy something, in other words if the basket of goods someone produces equals the basket of goods he demands, there can be no lack of demand. What is produced is sold. The problem is, that Say assumes that capital is a productive factor. It might be true, that everything that is produces is sold as well, but the level of production depends, in the classical theory, on the disposable capital for investment and if there is not enough capital to employ anybody, some people are unemployed. We will return on the topic in the chapter of the law of Say.

The example with the pension system is only one example, although one with a heavy impact on the real economy. However the same argumentation is valid for every kind of saving motivated to cope with risks in the future or to save money for certain purpose. In this case the interest rate is almost irrelevant.

The simple logic we find in any textbook about economics, the higher the interest rate the more people save, assumes that the only reason for saving is to renounce to consumption in the present for a higher consumption in the future. In this case the interest rate is an incentive to save more. If the interest rate is low, people prefer the consumption in the present. Even if we disregard the fact that the whole logic is wrong, because money is needed for investments, not captital in the sense of non consumed income of the past, the classical logic is weird.

We do not even need the most sophisticated argument of Keynes, see the little book about Keynes downloadable from the entry page of this website, to see that interest rate doesn't have the function the classics assume because the central bank simply fixes the interest rate.

In order to get a meaningful debate, we have to determine very exactly what we mean by saving and what is a meaningful definition of saving.

Saving means produce capital goods instead of consumer goods. This definition makes sense.

Saving DOESN't mean or is not a meaningful definition, not consumed income of the past that can be used for investment purposes. This is not a meaningful definition for several reasons. Investments are not financed with the result of saving in this sense, capital, but with money. Capital is scarce because a sacrifice is needed to produce it. Money is only scarce at a microneconomic level, where it can be produced, but not at a macroeconomic level, where it can be produced at any amount.

All other definitions of saving leads to many errors and Keynesian theory can't be understood if this difference is not understood. We need a definition which allows us to the impact of saving in the case of full employment and the case of unemployment.

The definition of saving as the production of capital goods instead of consumer goods makes sense and allows us to get to right conclusions. In a case of full employment, a situation we actually never have and especially not in highly industrialised countries, one can increase the production of consumer goods only at the expense of the production of capital goods and the other way round. If there are no idle resources, it is not possible to increase both at the same time. A person who works 16 hours a day has to decide what is to be done first and what are the most important tasks. A person who has nothing to do the whole day don't have to make a choice. They can do just anything.

That's valid as well for the economy as a whole. In a situation of full employment, the production of consumption goods must be reduced if more capital goods are needed. In this case, saving makes sense. People consume less and the resources used before for the production of consumer goods can be used for the production of capital goods. In this case saving makes sense from an individual point of view. People consume less in the present, but due to an increased productivity more in the future. The type of interest must be high to increase saving and reduce consumption. In this case, but only in this case, the definition of saving as non-consumed income of the past makes sense. In this case, but only in this case, capital is scarce and has a price. However, we don't need a definition that makes only sense in one situation; we need a definition which is always correct and not a definition which is misleading in another situation.

In a situation of unemployment, the situation is entirely different. In this situation saving, a reduction of consumption is not needed, because there is no trade-off between the production of consumer goods and the production of capital goods.

[If we use the term unemployment, we mean an idle productive potential. We don't mean that people are just unemployed. The mere fact that people are unemployed doesn't mean that there is a productive potential.]

We see that immediately if we define saving correctly. It is useless to renounce to something if there is no need to do it. What is needed for investments is money and not capital in the sense of non-consumed income of the post.

The definition of saving as non-consumed income of the past as a condition for more investments would be misleading in this case. In this case, people would save more in the case of unemployment but nobody would invest because no entrepreneur will invest if demand is declining and can be satisfied already with the existing capital goods. Saving in the sense of non-consumed income of the past is not needed and would even worsen the situation.

If we want to understand why Keynes called his theory GENERAL THEORY of Employment, Interest and Money and not just Theory about Employment, Interest and Money, we have to understand this point. The Keynesian theory is compatible with both situations, full employment and unemployment, the classic theory only with full employment. For more details see the little book downloadable from the entry page of this website.

En una situación de subempleo la situación es distinta. Si todo el mundo ahorra por ejemplo porque espera que en el futuro estarán en paro y necesitarán este dinero, van en un esfuerzo común crear la situación que querían evitar. La falta de demanda va a producir el desempleo.

The argumentation of Jean-Baptiste Say is more intelligent and is not based, at least in its original form, see law of Say, on the type of interest. Jean-Baptiste Say wanted to prove, in the original version, that the reason for low demand is not a lack of money as assumes by the entrepreneur, but a lack of supply and money is only a means of payment. The reason people don't buy things is due to the fact, that they produce enough goods. In order to buy something, people must sell something otherwise, they don't have the money to buy things. The more they produce, the more they can buy and money is only a means of payment.

From the original statement, were drawn further conclusions, which were not present in the original text. In the original text, Say only states that money is a mere means of payment and a lack of money is actually a lack of supply.

The interpretation we found in modern textbooks goes further. If everybody only produces things in order to buy something, for consumption or investment purposes, if everyone, in other words, only produces the value of the basket he wants to consume or invest there will never be a lack of demand.

There are two problems with that theory. The first problem is that money has only one function in the law of Say. Money is only used for transaction purposes and has no impact on the real economy. We have already seen and we will discuss it more in detail in the chapter about Keynes, that money has a crucial effect on the economy because investments are financed with money, not with capital.

However, even if we accept that money is only needed for transaction purposes, what we have actually no intention to do, the law of Say is wrong. Say assumes that people only produce the value they wanted to consume or invest afterwards. This is true for the incomes deriving from work. Nobody will work, produce things, get the money for those things if afterwards he doesn't have the intention to do something with that money. That's obvious. However, this is only true for incomes that doesn't depend on luck and fortune. Which are not casual, as it is the case for income deriving from entrepreneurial activities and capital. In this instance, a decision how to use this income must be made afterwards, after having earned the money, and not before. If the income is casual, and in great part it is casual, the logic of Say doesn't work anymore.

Many people believe that the law of Say is a good argument against Keynesian theory. The author would say, that it is a good illustration, most of all in its original form, of all the problems of classic thinking.

1) The fact, that supply equals demand doesn't mean that supply is high enough to guarantee full employment. Implicitly, capital is needed to create jobs and capital is considered as a scarce production factor.
2) Money is only needed for transaction purposes. Actually, the type of interest which is formed on the money market is the hurdle real investments has to overcome and not the condition of the creation of capital.
3) Say assumes that income depends on a consciously taken decision. That is only true for the income deriving from work, but not for the income deriving from entrepreneurial activities and capital.

Besides Keynesianism, all economic tendencies assume that the interest rate is a recompensation needed to transfer present consumption to the future, in other words, reduce consumption and the production of consumption goods in the present in favour of the production of capital goods that allows an increase of consumption goods in the future.

This is only true for the individual market player, households or entrepreneur. For a single household or an entrepreneur, money is actually capital, something scarce and the only way to get it is to consume less than what they earn. For a single household, it is even true that capital, actually money, is scarce and has, therefore, a price. It is scarce because it can only be obtained by making a sacrifice and the type of interest it the recompensation for this sacrifice. He will borrow it to the person who promises him the highest return and for the single household or entrepreneur, it makes sense to discriminate less profitable investments. Classic theory is perfectly compatible with personal experiences; that's the reason people find it so difficult to understand the Keynesian theory.

What we have to understand is that capital is actually money and money is not scarce from a macroeconomic point of view. It can be produced at any amount by the central banks. Today, we are still in 2015, the central bank of Europe produces one billion of it in one year. However, if it is not scarce, it doesn't have a price in the sense of a market economy, see natural price/market price. There is no need to discriminate between profitable and less profitable investments, when both can be realised.

At a macroeconomic level, the interest rate is not a price in the sense of a market price. Individuals will use their resources in the most profitable way. That's obvious. At a macroeconomic level, prices guarantee that the resources are used to eliminate scarcities in the most efficient way. A high price indicates that something is scarce and the resources will, therefore, be used to eliminate this scarcity because it is the most profitable use. If programmers, for instance, are scarce, wages for programmers will be high and people will qualify for these jobs.

However, the interest rate is not a price in this sense because the most profitable investments can attract the needed resources anyway through a higher remuneration. Interest rates are just a cost factor but have no function, because money is not, as assumed by the classics a productive factor at a macroeconomic level.

There is only one situation, where the type of interest has really the function of a price in the sense of a market economy: Full employment. In case of full employment, there is a trade-off between the production of capital goods and the production of consumer goods. In this case high-interest rates would induce people to save more and consume less, the production of consumer goods would decrease in favour of the production of capital goods.

Besides, the two situations already discussed, full employment and unemployment, there is a situation in between, the bottlenecks. In this situation, a central bank can be induced to raise the interest rates before full employment is reached. It is possible that an increase in the economic activities leads to a bottleneck in some areas of the economy. If for instance an increase in industrial productions leads to an inflow of people the rent for housing increases, if it is not possible to construct new houses, because there are no more resources in this sector. This can have an impact on all other prices and lead to a general increase in inflation. In this case, the central bank may be induced to slow down the economic growth by increasing the interest rates.

If we consider the last thirty years, however, this phenomenon seems to have disappeared from the earth. In a global economy, there are no bottlenecks because any demand can be satisfied at any point on earth.

In a situation of unemployment, there are very little arguments in favour of saving in the sense the classic theory uses the term: not consumed income of the past. A possible reason could be that the alternative to saving, borrowing money, is not very prepared to take risks. It is possible that some people take more risks if they just lose money they already have instead of going bankrupt. Risky investments are financed more and more by venture capital.

Another argument could be that the amount of money doesn't change if the investments are financed with savings in the classical definition of the word, but increases if they are just financed with money. If the lender doesn't pay back the credit, the amount of money increases, because the money created at the moment the credit is granted, will not be eliminated afterwards.

Besides that, there are effects on the distribution of the national income. If the central banks financed all the investments, a larger part of the earnings would go to the banks and the banks would decide about the allocation of resources and this would lead to secure investments and avoidance of risks. Not the most profitable and innovative investments would get money, but the most secure and traditional ones.

To the author, this seems to be the strongest argument for saving in the classical sense of the term. If any kind of investments depended on banks, the dynamic of innovation would decrease quickly.

The definition of saving given in classic theory is not really convincing and actually misleading, but there are other errors as well. Savings in the real economy are mostly due to deserved depreciation. (If the investment was 1,000,000 dollars and the earnings 100,000 dollars a year no taxes are paid if the period of use is ten years. In ten years the entrepreneur gets his money back and can substitute the machine.)

The crucial question, therefore, is: What is the function of the interest rates? If we assume that the major part of the savings is just used to substitute old machines, it has no impact at all. It has no impact either if the motive for saving is to protect against future calamities.

A stationary economy, an economy without growth, doesn't need any increase in the amount of money. The entrepreneurs spent money for investments, get the money back and substitute the investments. In this case, the interest rates have no function at all and banks are not needed.

In a growing economy, the amount of money has to increase. (We disregard the possibility of falling prices, because that rarely happens and would have other side effects.) Classical thinking assumes that capital can increase by the surplus squeezed out of the workers and it is to suppose, that they assumed implicitly that the capitalists get this squeezed out surplus in the form of money. Now we have a real riddle: How can the surplus be added to the already existing capital if the amount of money remains the same? Actually, the 'capital' can only increase if there was an increase in the amount of money BEFORE. It is the demand for money that induces an increase in the amount of money and not the supply.

We repeat the definition of classical theory of saving as not consumed income of the past leads nowhere and is the beginning of the confusion. This definition is only useful in a stationary economy without growth. In a growing economy, the amount of money has to be increased and can't derive from not consumed income of the past. Money can be produced in any amount and the amount of money depends on the demand for money. The classic theory assumes that capital is the condition for growth. It is the other way round. Capital, actually money, follows growth.

We see that money is not scarce and has not been scarce in the time of the classics because economic growth without an increase of money is not possible. In the time of Adam Smith there was an inflow of gold from South America as described by his friend David Hume, see balance of trade, and Adam Smith himself described several ways allowing the banking system to increase the amount of money.

Classical monetary "theory", it is hard to name it a theory, because actually there is none, is very often described as an equation, the so-called quantity theory of money. This is a nice example of a wrong economic thinking.

Q * P = M * U

Q is the real national income, in other words, the national income measured with a certain arbitrarily chosen price level. P is the actual price level in relationship to the original price level. M is the amount of money and U the rotational speed of the money.

The meaning is simple. Assume that we have one tonne of flour and for the sake of simplicity, our economy produces nothing but that. The price twenty years ago was 1,000 dollars and we multiply this with a value corresponding inflation, let's say 1.3 if the inflation was 30 percent, the amount of money must have increased as well with 30 percent or/and the rotational speed of one dollar must have increased.

What is the problem with this equation and with an equation like this in general? (Almost all equations we find in textbooks about economics are of this kind.) The problem is that it is a mere description of a relationship which is always true ex-post and doesn't contain a description of any causal relationship. The equation suggests for instance that either the national income or the prices must rise, classic economy assumes the first, because they assume full employment, if there is an increase in the amount of money. However, what happens, as it is the case today, if this increase in money is invested in the stock markets? Then we have no effect at all. Furthermore, the equation suggests that Q and M could be arbitrarily changed. That would be nice. We could get just any level of national income.

The equation suggests furthermore that money is only used for transactional purposes. Only if money is actually used, it can have an impact on the national income. If it saved and not invested, it has no impact at all.

We admit that the equation shows the possibility that an increase of money could lead to an increase in social income, but actually the causal relationship is unclear. Does an increase in the national income leads to an increase in the amount of money or does an increase in the amount of money leads to an increase of the national income? Actually, the second is true. An idle productive consumption can be activated with money as well as the money market and high-interest rates can impede the activation of an idle productive income.

If we want to understand the logic of the equation and how growth is possible, under the conditions of this equation, we have to focus on the composition of Q. Q is the real national product, but no assumption is made about the composition of this social impact. If 80 percent is consumption and 20 percent investment, or 90 percent consumption and 10 percent investment and so on. Q stands for the productive potential, but not how this productive potential is used. The higher the percentage used for the production of capital goods, the bigger the growth of the economy.

This logic makes sense in the case of full employment; the situation classic theory supposes to be the normal situation. In this situation, it doesn't make sense to pour in more money because that would only lead to an increase in P, to inflation. The only way to promote growth is by changing the composition of Q.

The economy would then produce, let's say for ten years, roads, bridges, machines, telecommunication services, railroads, etc. and if all that would be done they would start to produce consumer goods in a highly efficient way. Q and M could remain the same, but after the hard ten years, Q would be 100 percent consumer goods. Saving would decide about the composition of Q. The more people save, the less they consume, the more resources would be used to produce consumer goods.

There is no need to increase the amount of money in this scenario. The first five years the 100 workers produce capital goods, we have a very small economy here, and after that, the 100 workers produce consumer goods. (Let's assume that wages are the only earnings we have.)

It is obvious that for ten-year people would have a very hard live and, therefore, the question arises how to convince them to do that. Working hard for, let's say ten years, and living in poverty. In socialist states, that can be achieved with a mix of pressure and propaganda. In any other type of society, they must be an incentive for people to reduce consumption and this incentive is the interest rate.

[The logic of David Ricardo, the workers always remains at subsistence level implicitly argues in a similar way. Workers will only work at the subsistence level if there is police strong enough to dominate them. Otherwise, they would hang the capitalists on the trees.]

The higher the interest rate, the higher the saving, in classical theory, and the lower the consumption. The lower the consumption, the more resources are available for the production of capital goods.

In this situation the interest rate is really a price in the sense of a market economy and every single saver will invest his money in the most profitable way so that only the most profitable investments will be realised and the optimal allocation of resources is granted. This is what Keynes called the classical situation. In case of full employment, all the money is used for transactional purposes, see Keynes.

However, the equation above, Q * P = M * U, is true as well in case of unemployment. In this case, we have let's say 50 workers employed and 50 unemployed. This fifty workers, all of them at subsistence level, because they produce almost nothing else than capital goods, can perhaps in ten years reach to a point where they can feed the other fifty, but it is doubtful, that they will accept this solution. All the money is spent to pay the wages for these fifty workers. In this case, it would be much more intelligent, to double the amount of money and to employ the other fifty workers as well. In this case, the first fifty workers must produce a little bit more of consumer goods, but the whole 100 together would produce more capital goods.

To put it short, money is not mere veil, money can activate idle resources.

We have to understand that classic theory is actually a microeconomic position. From a micrcoeconomic position, capital is the same thing as money. It is scarce and can only be obtained through a sacrifice, by consuming less in the future and things that are scarce have a price. In a situation of full employment, this perspective is even true. In the case of full employment, it is necessary to get to an equilibrium between producing capital goods and producing consumer goods and we reach to this equilibrium through the interest rate. The higher the interest rate, the more people will save, the less they will consume and the more resources will be used to produce capital goods. In case of full employment, it is necessary as well to allocate the resources in an optimal way and that will happen. The market player will invest in projects that yield the highest possible return. Less profitable projects will not be realised, something necessary in the case of full employment. It doesn't make sense to build to use resources in project A with a profit of 5 percent if there is a project B with a profit of 6 percent. We will see later that in case of full employment Keynesian theory and classic theory get, although for very different reasons, to the same results.

In the case of unemployment, the situation is entirely different. The market players will still invest their money in the most profitable way, money and capital, for them the same thing, will still be scarce and the interest rate will still be, at microeconomic level, be a price in the sense of a market economy. In other words, the market player will not invest in a less profitable investment if there is a better option.

The question which raises is whether this is rational as well from a macroeconomic point of view. If a private investor has the choice between an investment which yield 6 percent and another one which yields 5 percent, he will invest in the first one. That's obvious. However, why not realise the investment which only yields 5 percent if the resources needed are there? Why keep people unemployed if they can do something profitable?

In the case of full employment capital and money, the same thing in classic thinking, are actually a scare productive factor. However, in the case of unemployment, money is not a scare productive factor and the interest rate is not a price in the sense of a market economy anymore. In this case, it would be useful to increase the amount of money until all projects that can pay back the credit and covers the administration costs of the bank and the risk could be realised.

We will see later on, in the chapter about Schumpeter, that even in the case of full employment money is relevant and not only a veil, because the one who gets the money, can attract the resources and change the structure of the economy. Schumpeter was well aware that distinguish him from the classics, of the importance of money, but like the classics, he assumed that the market economy will always lead to full employment.

Classic and neoclassic theory consider the interest rates as price that equals saving and investments. That is a useful question only in case of full employment or from a microeconomic perspective. It is not a useful concept in case of unemployment. The question already is wrong. What we actually want to know is the interest rate necessary to produce the amount of money needed to get to full employment.

We are not going to explain here all the existing methods of money supply. We will only describe one method how the banks system can create money in order to continue our discussion. The only thing we have to understand is that the bank system can create money. If one person transfers 3000 dollars from his bank account at the beginning of the month, when he get his wage, and if he consume 100 dollars a day, we simplify for the sake of simplicity, than in average he has 1500 dollars on his banc account. 3000 the first day, 2900 the second, 2800 the third, ....., 1400 the 16th, 1300 the 17 day and so on. If they know that on average they need only 1500 dollars of the money given to them at the beginning of the month, they can borrow this money to other people. If millions of people do that, than they have a lot of money they can borrow.

[As already mentioned, we have no intention to discuss the organisational procedures of the money supply. In reality, it is a little bit more complicated. We only want to show taking this channels of money supply as an example that the bank system can create money.]

The money supply depends on the demand for money. It is pretty clear that banks borrow any amount of money they can if they get it back with interest. That's their business and that's what they are living from.

We can assume that in the case of full employment, the most profitable investments are already realised and that they are no resources left. In this case, banks won't extend the amount of money because no investor can pay them higher interest rates like the ones they already have. Only an investor with a more profitable project can pay higher interest rates and reallocate the resources needed to realise it. In this case, interest rates make sense. It doesn't make sense to reallocate resources to a less profitable use.

In the case of unemployment, the situation is different. In this case, the realisation of a less profitable project cannot be realised only at charge of a more profitable project. Both can be realised. The interest rates doesn't have the function of a price.

In a situation of unemployment, interest rates should fall until full employment is reached. There is no need to impede investments provided they are profitable enough to pay back the credit, the administration costs of the banks and the price to pay for the risk.

[If a bank grants a credit to 10 people for 10,000 dollars and one goes bankrupt, the other nine has to pay pay back the 100,000 dollars. Otherwise, the amount of money would eternally increase. The nine left have to cover the risk.]

In other words, a project that fits these criteria creates a demand for money, it is to suppose that someone will realise it and the bank system can supply this money. The fact that right now they don't do it has several reasons.

Banks are interested in high interests rates; that's obvious and the competition between the banks, actually there are very few, is not strong enough to induce them to lower the interest rates.

Secondly, that is a topic we will discuss later, in the chapter about Keynes, they have an alternative to investing in real projects. The stock market and other listed securities.

So we have two different situations, and it is crucial for the understanding of Keynesian theory to clearly distinguish between these two situations.

In a situation of full employment, saving is needed. Economic growth can only be achieved by a reduction in consumption and the reallocation of the resources used for the production of consumption goods to the production of capital goods. The production of capital goods is only possible in charge of the production of consumption goods. In order to induce people to save more, we need high-interest rates. Capital and money is the same thing, and the classic theory, that assumes full employment doesn't distinguish between these two terms. Capital and money for investment purposes can only be achieved by saving, by a sacrifice and is, therefore, scarce and things that are scarce have a price. Personal interest induces people to invest in the most profitable project, and this is good as well for the whole of the economy. In the sense of full employment capital, in other words, money used for investment purposes, depends on an individual sacrifice. This is the world of the classics, which is included in the GENERAL theory of Keynes, see the booklet downloadable from the entry page of this website.

In a case of unemployment, actually the normal situation, this is no longer true. We can even say; the exact opposite is true. In the case of full employment, a hight interest rate induces people to save more and provide this way the capital needed for investments. In the case of unemployment, high-interest rates impede the investments needed to reach full employment. Capital in the sense of non-consumed income of the past is not needed. What is needed is money and money can be produced by the bank system without any sacrifice.

Classic theory is a strange mix of two completely different things. Capital is a term that refers to the real sphere of the economy, money is a term that refers to the monetary sphere of the economy. Actually, these two things have nothing in common, and the misleading concept is because in one situation, full employment and/or from the perspective of the individual market player they are seen to be the same thing. Individuals get money or capital for investment purposes by consuming less than what they earn.

If we put aside this special situation capital and money is not the same at all. People get their income in the form of money, and if they spend less of this money than what they get, they will have some money for investment purposes. That's what the classics call capital. However, the bank system can produce any amount of money, without any problem. The European Central Bank will print in 2015 one TRILLION of extra money and nobody made any sacrifice to produce it. The hope is, that this will lower the interest rates, make possible more investments and create jobs.

This is a point that needs to be understood. In both situations, in full employment or unemployment, the interest rates wouldn't be necessary if there were another possibility to induce people to save more. The interest rate doesn't have a direct impact on the allocation of resources. A more profitable project can always attract the resources needed, for instance qualified labour, by a higher remuneration. The point is that in case of full employment, an increase in investment is only possible if the interest rates increase and people save more.

Marxism supposes that the "capitalists" can force the workers to save, they only pay them wages at subsistence level. Actually, they can not do that. Qualified work is scarce and earn much more than the subsistence level.

In case of unemployment, the situation is completely different. No reduction in consumption is needed and therefore no saving. In case of unemployment, the the interest raste loses the price function.

In the situation we have nowadays, we are still in 2015, the savers and the institutional investors complain because the European Central Bank and the Federal Reserve System of the United States is flooding the market with money with open market operations. Nobody needs the money of savers if the central banks print it. What they don't understand is that at the current stage it doesn't make sense to keep money artificially scarce and interest rates high.

What they want is that some investments are impeded from being realised in order to give them the possibility to earn money, something not scarce, with money. It is perfectly comprehensible that they want that, but it is equally comprehensible that this is not in public interest.

That leads us to a very fundamental statement we will discuss in detail in the chapter about Keynes. The interest rate is not the price to be paid for a sacrifice, is not the recompensation needed for this sacrifice. The interest rate is the price to be paid to give up security. Wherever the money comes from, not consumed income of the past or freshly printed by the central banks, there is always the risk to lose it if the investment doesn't meet the expectations. If it is money from non-consumed income of the past, this money is lost in this case, and if the banks invest with money borrowed from the central banks, they will be unable to pay back this money.

This leads to another important conclusion. Contrary to what we can hear and read every day Keynes focuses on INVESTMENTS. Indeed, a possible conclusion that can be drawn from his theory though not the basic affirmation is that in certain cases the government must increase the aggregate demand. But not by consuming more, but by investing more. A risk is only involved in an investment. Only in an investment, it is plausible that the results don't meet the expectations and only, in this case, the interest rates are relevant. Consumption can be mad, but mad consumers never care about interest rates.

What savers and institutional investors like banks and insurance companies want is obvious. High-interest rates and little risk. The problem is that entrepreneurs want the opposite: Low-interest rates and participation in the risk. In other words, they want more equity capital. If the growth of the economy doesn't depend on knowledge already acquired in the past, as it happens after wars or natural catastrophes, but on new knowledge and innovation, economic growth is slow and risky. There is a lot of experience if only an economy that once existed must be reconstructed. The risk is low and entrepreneurs can evaluate the level of interest rates they can afford.

The return on investment of innovative products is much harder to prognosticate. The business concepts of the banks doesn't work anymore and in the future, we will see that they are more and more substituted by venture capitalists. Venture capitalists participate with equity capital, assume therefore part of the risks, but earn more in case of success. They invest in highly risky projects. The major part of the companies they finance will go bankrupt, but the few companies who are successful, are very successful.

The business concept of banks and institutional investors is different. They only invest in predictable projects. The problem is that the market for the services and products this kind of companies produce and offer is already satisfied and will be more and more satisfied.

Another form of financing we will see appear in the future is crowd funding.

Adam Smith and all the classics assume that saving is the result of a consciously take a decision that depends on the interest rates. That has little to do with reality. People save money in general in the form of a long-term schedule through an institutional investor, banks or insurance companies. A balancing of investment and saving through the interest rate is not possible this way because saving is in large part independent of the investment opportunities.

Classic thinking is based on the assumption that unemployment due to a lack of demand is impossible, see the law of Say. This means that all the income that is not consumed is saved and invested and the type of interest balance investment and savings. This doesn't work if the decision for savings is made independently from the demand for capital.

[Actually, the discussion can be simplified. Capital in the sense of non-consumed income of the past is not the condition for investment. Investments are financed with money. However, for a while we will discuss the classic ideas accepting some basic assumptions, although they are wrong.]

Secondly, a large part of the income, most of all income from capital and entrepreneurial activities is casual and not planned. In the logic of the classics, people must change every few month their consumer behaviour in order to consume or invest all what they earned. That's an unrealistic assumption.

It is not very realistic that saving, not consumed income of the past, is the condition for investments, but it is very realistic that people will save more if they have to pay back the credit and credit is actually money that can be created by the banking system and must be eliminated afterwards. An investment leads, if everything works like expected, to an increase of income and part of this income is used to pay back the credit and not for consumption. "Saving" happens in the future, not in the past. This is more realistic because no responsible entrepreneur will take a loan if he doesn't believe that he can pay it back and eliminate the money created before.

The idea of the classics that capital is scarce but not labour has another strange implication. The classic authors believed that labour is disposable every time, everywhere in any amount and the competition between the workers reduces wages to the substantial level. We put aside for the moment that this is obviously not true because qualified work is very scarce in other words, know how is always very, very scarce, and assume that this is true. If we assume therefore that capital is scarce and labour abundant, all the surplus will go to the owners of capital. The one who possesses the scarce and critical resource can demand almost anything for this ressource and there is nothing left for the ressources that are not scarce. (Beside the subsistence level in the case of work.)

The scarcity gives the power to the capitalists. If we change that, if capital is actually money and not scarce at all, the question raises how the surplus of the work should be distributed and why there must be a compensation for a resource which is actually not scarce.

The problem arises in both concept, in the marginal view of the neoclassics and from the accumulation perspective of David Ricardo and Karl Marx.

In the marginal view, every productive factor is paid with his marginal revenue. No entrepreneur will employ another unit of a productive factor is the yield of this last unit is lower than the price he has to pay for it. However, if capital is actually nothing else but money, then he will use it until the marginal revenue of money is zero or just enough to cover the administration costs of the banks and the risk (see above). Money resembles more to the sunlight. It is used until the marginal revenue is zero.

From the accumulation perspective, there is no need to squeeze out the surplus from the workers because what the capitalists gets is money and there is no need to accumulate it step step. They can get as much as they want immediately. For David Ricardo, the profit is needed because otherwise, the capitalists wouldn't accumulate their capital; they would consume it. However, if capital is actually money, they can accumulate as much as they want.

[We put aside for the moment the problem that it is unclear how the capitalist get a surplus in a situation of competition. Competition will lower the prices to a level where no surplus remains.]

All what have been said until know is summarised by Keynes himself this way.

[There is one point in this paragraph we have not addressed until know. The interest rates are actually determined on the money market and not, as the classics assumed, on the market for saving and investment, because a market like that actually doesn't exist.]

It is much preferable to speak of capital as having a yield over the course of its life in excess of its original cost, than as being productive. For the only reason why an asset offers a prospect of yielding during its life services having an aggregate value greater than its initial supply price is because it ist scarce; and it is kept scarce because of the the competition of the rate of interest on money. If capital becomes less scarce, the excess yield will diminish, without its having become less productive - at least in the physical sense.

I sympathise, therefore, with the pre-classical doctrine that everything is produced by labour, aided by what used to be called art and is now called technique, by natural resources which are free or cost a rent according to their scarcity or abundance, and by the result of past labour, embodied in assets, which also command a price according to their scarcity or abundance. It is preferable to regard labour, including, of course, the personal services of the entrepreneur and his assistants, as the sole factor of production, operating in a given environment of technique, natural resources, capital equipment and effective demand.

John Maynard Keynes, General Theory of Employement, Interest and Money, Chapter 16, II

What does that mean? (1) Capital goods yield more that it cost if everything works as expected, but this is not due to its productivity, but to the fact, that it is scarce. If there is one plant which produces something, fruit juices, bicycles, cars, CD player whatever or thousands of them, the PHYSICAL product is always the same, if the same technique is used and if we can see on a daily basis, in the long run, the techniques are the same, because in the long run the know how is the same everywhere. The productivity regarding revenue is measured in MONEY, however, decreases with the amount of plants. The rentability, therefore, depends on the scarcity of the plant. If there is only one demand exceeds supply and the prices are high and the profit, therefore, high. However, if there are 100 hundred of these plants the prices will fall, because the market can only absorb a higher supply at lower prices. Only if the prices fall more people can afford to buy it and only if prices fall, the price to pay for the item corresponds to the preferences of people.

With the sentence "... and it is kept scarce because of the competition of the rate of interest on money..." we reach the Keynesian part of the affirmation. It is the money market that where the interest rates are fixed and not the capital market, as the classics assumed. To put it simple, for details see the booklet downloadable from the entry page of this website: If institutional investors, banks, insurance companies, etc. can earn more money with listed securities and by investing in the stock markets, they will invest in the stock market and not in real assets. The same thing will happen if money is kept artificially scarce. Alternatively, still more easy, if the central banks lower the interest rate on real investments, investments will increase. The only reason "capital" is scarce is the fact that someone keeps it scarce.

(2) In the classic theory, there are three production factors: Capital, labour and land. Land has vanished in the course of history as a production factor. The real problem is water. Capital is actually money and can be printed at any amount. There is therefore only one productive factor left which actually needs a remuneration: labour: "It is preferable to regard labour, the sole factor of production...". This seems to be right if we consider labour as a bundle of know-how, technical and organisational skills, the result of training and not as a homogeneous factor like the classics and Marxism do.

The crucial difference between the classic and neoclassic theory on one side and the Keynesian theory must be understood. The first one is completely wrong and the second one correct. Money market has substituted the classic capital market. That has three consequences.

Firstly, interest rates don't balance saving and investments, because savings depend on the income, actually, in the Keynesian theory, from the income of the FUTURE and the interest rates depend on the preference for liquidity, from the preference security. If everybody believes that there is a high probability to lose his money if invested in a real investment, they keep their money in a liquid form, in other words, they keep their money or they invest it in something, listed securities, that can be reconverted at any moment in money. A very high profit is needed to induce people to leave the secure harbour of liquidity. If saving depends on the income and interest rates from the preference for liquidity the type of interest can't balance saving and investment.

Secondly, capital for investment purposes is nothing scarce and, therefore, shouldn't have a price. It only has a price if it is kept artificially scarce. If capital for investment purposes doesn't have a price, there is no reason to pay something for it and there is no reason for impeding investments to be realised for the mere fact that they are not profitable enough to pay the interest rates. This is important in the context of unemployment. If we stick to the classical theory capital is scarce and a bottleneck. That means that only part of the workforce can be used and only the most profitable investments can be realised leaving unemployed the less qualified workforce which works in less profitable and less innovative sectors. If capital for investment purposes is not scarce, if it is actually money, there is no need eliminate the less profitable investments until full employment is reached.

The third consequence is that in the long run saving money, at a macroeconomic level, is not profitable. It never makes sense to save something; that is not scarce. It doesn't make sense, for instance, to save sand in the desert. (We abstract from the other motives for saving: to take precautions for eventual calamities, risky investment, to leave something to someone (see above).

A fourth consequence is that the law of Jean Baptiste Say, the baskets produced equals the baskets demanded and, therefore, unemployment due to a lack of demand is no longer possible, is not true. This would be only true if consumption and investment, with prior saving, would be the only possible use of income. Actually, people can invest as well in the stock market. This is kind of an investment as well but has no impact on the labour market.

Under this perspective, it is a strange kind of phenomenon that the public debate is always about the remuneration for one productive factor; labour. There is never a discussion about the remuneration of capital. Actually, money which is actually much more critical is because the function of interest rates is not very clear, while the function of the price of labour, the wages, is very clear and wages have without any doubt the function of a price in the sense of a market economy.

There is, therefore, a fundamental difference between the classic/neoclassic theory and all the lines of thought and schools like the Austrian school, Marxism or neoliberalism which are based on classical/neoclassical concepts and Keynesianism.

They first believe that part of the profits must be used for the remuneration of capital at the expense of labour. This is the logic consequence of the idea that "capital" is scarce and an incentive is needed to produce it.

In this logic the only way to increase employment is lowering the wages, this reduces the costs and increases rentability. To make it more concrete: If the return on investment in the housing sector is low, houses can only be constructed at low costs. That means that labour must be cheap. A problem that becomes even more relevant, if in some sectors of the economy have a high profitability and all the scarce money is already invested there. In this case, the wages in the less profitable sectors must be still lower.

Keynes assumes that "capital", actually money, is not scarce at all and therefore, there is no need in a situation of unemployment to impede an investment that can't compete with highly profitable investments. In other words, the interest rates are lower until full employment is reached. It is doubtful that the owner of money understands the Keynesian theory, but it is pretty sure that they have a lot of reasons to be against Keynesian theory.

Although Keynes completely refuted the basic idea of classic theory and Marxism and the idea that capital is scarce, a lot of authors like Hayek, for instance, Hayek on Keynes's Ignorance of Economics, who didn't understand Keynesian theory at all, affirms that Keynesianism is kind of socialism. That is hard to believe. The big volume of Karl Marx are called THE CAPITAL. Keynes said that Karl Marx wrote a book about something that not even exists. To keep it short, the source of money are the central banks, not the workers.

Hayek and many others, as well as textbooks on economics, committed a very, very fundamental error. He believed that the interest rate is a price in the sense of a market economy, which it leads the resources in the most efficient use.

That is true for the wages, the price of labour. If someone earns more working in the industry than in agriculture, the return in the industry is higher, because industry produces products which are more needed. If an engineer earns more than a baker, then the economy needs more engineers, because they pay more and it is an incentive for people to study engineering. The function of prices will be illustrated with two easy understandable examples.

However, that is not true for the interest rates. Even if the interest rates are zero, the most profitable investment will be able to attract the needed resources, especially qualified work. We can even say that the interest rates are a hurdle. If we have two competing countries, one with high-interest rates and the other with low-interest rates, the country with the high-interest rates can pay less to the resources needed, for instance to the highly qualified people. This country risks to lose them.

Resources that exist in abundance doesn't have any impact on the optimal allocation of resources. Different plants, for instance, need a different amount of sun, but this is irrelevant, because whatever they need, they get it. (If we remain in a certain area of the globe.)

The real problem with an expansive monetary policy, that's what we see at the moment, we are still in 2015, is that the central banks flood the market with money, but the interest rates private investors have to pay for the loans don't lower. In a situation like this, it is not possible to promote economic activity by lowering the interest rates.

If it is not possible to reduce the interest rates, Keynes discusses the possibility of a direct governmental intervention: expansive fiscal policy. This means that the government invests directly constructing bridges, roads, schools, hospitals, telecommunication networks etc. Being the most secure borrower, the government gets loans for a lower interest rate than private companies.

In this case, there is the risk that the government competes with private company and attracts more and more power. It is therefore crystal clear that the government should never intervene in sectors where the market leads to a satisfying result. It shouldn't produce for instance cars, bicycle, cheese and clothes.

However, if there are idle resources which are not used by the private sector because the profitability is too low for them, the government can activate these idle resources. If the private sector, for instance, is not willing to construct houses for the low-income part of the population, the government can do that. This hurts, of course, the interest of the housing sector, the rents fall, but nobody can demand that something is kept artificially scarce for the only reason that this serves his interests.

This kind of governmental intervention would only mean that it is not accepted that something is maintained artificially scarce because the owners of this item want to keep it scarce. It is perfectly compatible with a market economy that prices signals the actual scarcity of something and not an artifical scarcity. Money is not a scarce good, but there are a lot of people who have an interest in keeping it scarce.

This can be useful in a situation of full employment, see above, but less useful in a situation of underemployment.

There is no doubt that there is a risk if the government intervenes. Governments can always attract any amount of resources. However, as long as the government competes under the same conditions as private companies, there is an inherent control. If this is not the case, there are other way to control it, see governmental activities.

It is to suppose that the Austrian school assume that the famous German economic miracle is because the Germans saved a lot. However, if ten years after world war II the GDP per capita of the Germans was twice higher than before the war, starting from zero because almost all the plants were destroyed, Germans would have saved more than what they earned. Something impossible. The reason is much simpler. Germany reached quickly the level that corresponded to their training and after having reached this level growth slowed to the normal path. Reconstruct something that already existed is quite straightforward because the result is predictable. Doing something completely new is more difficult.

It is often said that the European Recovery Program (better known by the name of Alfred Marshall plan) had a decisive impact on the German economic miracle. In reality, the size of these aids were to small to have a big impact and most of these aids were loans.

The neo liberals and the adherents of the austrian school see expansive monetary policy as the cause of the increasing endebtments of the nations and establish a relationship between this kind of expansive monetary policy and the Keynesian theory. They believe that they tell sutil truths to the world by telling it that endebtment will increase if consumption is financed by loans. It is not very difficult to find thousands of videos, comments and articles explaining that, here is one Keynesian Theory in 5 min.

The basic error is that they confuse consumption and investment. There are situations, where the private sector doesn't invest enough to reach full employment. In this case, the only one who can still invest, for different reasons, is the government. We will address this issue several times throughout this website.

To illustrate this point with an example: Private companies will never invest in basic research, research where it is not foreseeable that it ever leads to a market ready product. Nevertheless, most of the innovations in the last thirty years, the internet, mp3 players, biotechnology, etc. are based on this basic research. Without governmental intervention, growth would have been inferior. The assumption that governmental spending equals consumption is completely wrong.

It is admitted however that a general reduction in the interest rates is the less problematic measure because it doesn't interfere with the allocation of resources. Whatever the interest rate, the more profitable investment is more profitable being the interest rates high or low.

It is true that high debt of states is not possible if the central bank restricts the amount of money. That's obvious. However, it is not true, that government a better of in this case. If the central banks, for instance, raise the interest rates to 40 percent, there will be no governmental debt and only highly profitable investments will be realised. In this case, it will be very attractive to save money in the classical meaning of the term, but unemployment will increase dramatically. There is no debt, but high unemployment.

The same logic used by the Austrians, for instance, is that an easy money policy leads to debt and can be used in illustrating the error n other sectors of the economy. If a farmer had his land near a big sea with fresh water, we could put as much salt in this lake, that the water can't be used anymore to irrigate his land. His harvest will be very low and prices for food very high and the people who own fresh water will earn a lot of money.There is no risk that the farmer uses the water of the sea to drown his plants, but we see that keeping water scarce is not a good idea. If a farmer is so made that he drowns his plants if he has water in abundance, he will find another way to ruin himself.

It is often said the countries of the south of Europe, Spain, Portugal, Greece, Italy are indebted because the introduction of the Europe allowed them to borrow money at low-interest rates what induced them to higher indebtment. This is obvious. If there is no milk at all, there is no risk that it get spoilt. There is always the possibility to avoid the chances and the risk.

The fact that these countries were not able to take advantage of the low-interest rates doesn't mean that it is a good idea to reduce the options.

Keynesian politics requires intelligence and that is the critical point of the Keynesian theory. That means that at least, in the long run, governmental investments has to be profitable; they must be able to pay back the credit. That means that it doesn't make any sense to increase more and more the number of public employees. It is necessary to invest in sectors which have at least in the long run a positive impact on the economy: research and development, public education, improvement of the infrastructure, housing. (The last one is not profitable if it has to compete with other investments, but very profitable, if the time it can be used is considered.)

Even if public investments in infrastructure leads to higher debt and the loans cannot be paid back by the present generation, the present generation will inherit the fortune and the debts. If an increase in debts has financed the consumption, the next generation will only inherit the debts.

For the Austrian school, low-interest rates are the cause of economic cycles, see Austrian business cycle theory. The basic error is that they don't have a clear understanding of the difference between capital and money. They assume that money for investment purposes must have been saved before and if the interest rates fixed by the bank system is too low, entrepreneurs will be induced to invest in project that are not sustainable and that resources will be reallocated away from the production of consumption goods to the production of investment goods. The truth is, that in the case of unemployment that will not happen because there are idle resources which will be activated, but not reallocated.

The reality is much more simple. Any investment able to eliminate the money created before that happens if the credit is paid back is sustainable. The Austrian school doesn't distinguish clearly between a situation of full employment and a situation of unemployment, see above.

The Keynesian logic is easy and straightforward. The interest rates must cover the administrations costs of the banks and the risk, see above.

The logic of Hayek and the Austrian school is less logic. Hayek assumes that interest rates can be too low, but he doesn't define really how low. Besides that, it's hard to see that people would invest or consume more because interest rates are low. They have to pay back the credit.

With the same logic, it could be argued that the prices for anything should be high. If prices are high, there is no risk that people buy things the actually can't afford. It is true that with high-interest rates the risk of bad investments is lower and zero, if interest rates are very high. If nobody invests, there is no risk of bad investments. That's obvious.

The question the Austrian school must answer is very simple. If there is an idle productive potential which can activated with money, even if the profitability is low but high enough to pay bay the credit, why it shouldn't be done? The answer of Keynes is very simple. It should be done and if the interest rates is higher than the profitability of this project, the interest rate must be lowered.

Bubble in the stock markets are without any doubt the result of an increase in the amount of money, but this has little to do with Keynesian theory. On the contrary. No economist was so well aware of the fact that speculation present a risk for market economies. If the market player only had the choice between consumption and investment, both increasing aggregate demand, unemployment due to a lack of demand would be impossible. The problem is, they have a third option. Speculating on the stock markets.

If we put aside the classical and neoclassical theory about the interest rates and address the real world situation, another problem arises. The central banks actually fix the amount of money through several mechanisms we will not discuss here, but one instrument is the interest rate. The central banks can increase the amount of money by lowering the interest rates and reduce it by increasing the interest rates.

If competition between the banks is sufficiently strong, what is not the case, private investors get credits for a lower interest rate if the private banks have to pay a lower interest rate if they borrow money from the central banks. By lowering the interest rates, the central banks can, therefore, stimulate the economy.

In no industrialised country, the government can borrow money directly from the central bank. Just as any private investor, he has to finance itself on the money market. That leads to the strange situation that private banks can borrow money from the central banks, at present, 2015, for almost nothing, and lend it to the government at 3 percent. Due to the fact that the government takes big credits, banks can therefore earn a lot of money in a very short time with almost no work.

The taxpayer must pay the interest rates to the banks. That doesn't seem very logical at first glance and still less logical if the government have to save banks, as in the today's crises, with money borrowed from the banks.

Some people think that it would be a good idea, if the government could borrow money directly from the central bank and that there is no need to pay the banks for this "service". But although the classics believe the opposite, the believe that only money as a result from not consumed income of the past is real money, the truth is, that even with freshly printed money one gets access to a part of the productive potential. In other words: If the government had a direct access to the money printing machines of the central bank, he would be able to dominate the whole economy.

The risk that the government kicks off private investments is lower if has to pay the same interest rates.

The problem with this logic is the assumption that the government is a "normal" investor as any company and that its investments will be discriminated if it is less profitable than a private investment. This is obviously not true because the government can offer much more securities, the tax payer, than any company. The government is always the last entity that goes bankrupt because the government can always raise taxes to service its debts.

If private companies would suffer more from high interest rates than the government, interest rates are not the right level to control the amount of money. Governmental expenditures must be controlled by other means, for instance transparency, see preliminaries.

If there is only one interest rate for the whole economy the government can still kick out of the market, but, at least, it must compete with private companies although the difference is not very big compared to the first system where he can borrow money directly from the central banks.

Besides that, it doesn't make a big difference if the private sector floods the market with money or the government. In the last ten years, the amount of money has more than doubled without any inflation. However, this increase of money was driven by the private sector, not by the governments.

There is no doubt that the costs for the taxpayer raises it the only government can borrow money only on the private money market. The actual impact on inflation and allocation is less clear and the separation of central banks and governments is due to historical experiences.

It is hard to see why the population in a democracy shouldn't decide by a democratic decision process how the government finances its expenditures. If it really happens that the possibility that the government can borrow directly from the central banks leads to inflation or if the government creates more demand than the economy can satisfy, then the voter can stop excessive expenditure.

The basic error of Adam Smith and the classics is that he assumed that money is scarce. He assumes that money for investment purposes is the result of prior sacrifices: "But as the use of money can everywhere make something, something ought everywhere to be paid for the use of it.". No, not at all. The mere fact that everywhere something can be done with money doesn't mean that something has to be paid for it. All over the world, people make a lot of the sun light, but everybody agrees that there is no need to pay for it. The very basic error that underlies most of classical thinkings and all the lines of thought based on this thinking is the idea that money for investment purposes, somethings called capital by the classic authors and sometimes money, is the result of previous sacrifice and therefore scarce.

In some countries, the interest of money has been prohibited by law. However, as some things can be made by the use of money, something bought everywhere has to be paid for when using it. This regulation, instead of preventing, has been found from experience to increase the evil of usury. The debtor being obliged to pay, not only for the use of the money but for the risk which his creditor runs by accepting compensation for that use, he is obliged, if one may say so, to insure his creditor from the penalties of usury. In countries where interest is permitted, the law to prevent the extortion of usury fixes the highest rate which can be taken without incurring a penalty. This rate ought always to be somewhat above the lowest market price, or the price which is commonly paid for the use of money by those who can give the most undoubted security. If this legal rate should be fixed below the lowest market rate, the effects of this fixation must be nearly the same as those of a total prohibition of interest. The creditor will not lend his money for less than the use of it is worth, and the debtor must pay him for the risk which he runs by accepting the full value of that use. If it is fixed precisely at the lowest market price, it ruins, with honest people who respect the laws of their country, the credit of all those who cannot give the very best security, and obliges them to have recourse to exorbitant usurers. In a country such as Great Britain, where money is lent to government at three per cent and to private people, upon good security, at four and four and a half, the present legal rate, five per cent is perhaps as proper as any.

The central error with this paragraph is that if money is not scarce, any kind of interest rate is usury. The idea of a market economy is that scarce resources are used in the most profitable way and in order to make that happens, scarce resources must have a price. However, if something is not scarce at all, it can't have a price in the meaning of a market price.

Interest rates are to be discussed in an entirely different context. Interest rates are needed to control the amount of money something needed in case of full employment, but they have only an indirect impact on the allocation of resources.

If usury is possible, it is because the amount of money is kept artificially low. The only reason to keep interest rates is a high risk, but never something ought "to be paid for the use of it". The reason that the risk must be priced isn't either the fact that someone must be compensated for the risk. The reason is, that only if the risk it priced in it is guaranteed that the money generated when the credit was granted will be eliminated when the credit is paid back. However, that doesn't mean that the individual risky investment has to pay higher interest rates, but the other investors. What is actually to be paid are the administration costs of the banks.

The discussion about the interest rates is somehow strange. The Islam, Protestantism and Silvio Gesell condemned the taking of interest rates. In such an abstract way the discussion is useless. In case of full employment, interest rates have a useful function. High-interest rates reduce the amount of money and prevent inflation.

From the perspective of an individual market player, there is little to say about interest rates. The only way for the individual market player to get money for investment purposes is by consuming less. He made a sacrifice to get it and recompensation is needed. In case of full employment, this is even useful, because consumption must be reduced.

However, in case of unemployment high-interest rates have a negative impact. Saving should be reduced and not promoted.

However, high-interest rates are no guarantee for optimal allocation of resources not even in case of full employment. The government is always the best lender, who can offers most securities, something that Adam Smith realised already: "In a country such as Great Britain, where money is lent to government at three per cent and to private people, upon good security, at four and four and a half, ...". He realised that the government has to pay fewer interest rates than private people. This means that even in case of full employment, where growth is only possible if the production of consumption good is reduced in favour of capital goods, the government can increase consumption. That would lead to inflation.

The rest of the paragraph is easy to understand, although completely wrong because the basic assumptions are wrong. If the government fixes the interest rates below the level a borrower with optimal solvency can lend money than borrowing money is simple interdicted. If the interest rate is fixed at a level corresponding to the market equilibrium, something that actually in the meaning of a market economy doesn't exist, no project that presents a risk would be realised. Therefore, the interest rate must be fixed, in order to avoid usury, a little bit above this equilibrium.

The statement that interest rates would be higher if the government interdicts the borrowing of money is true. The same logic applies to drugs. Drugs would be much cheaper if they were allowed. That's the reason why in more and more countries Marijuana can be bought now legally. The problem is that the conclusions drawn by Adam Smith are wrong. Adam Smith concludes that interest rates fixed beyond the market equilibrium are the problem. That's not true. As in the case of drugs the artificial reduction of the supply is the problem.

Interest rates are a nice example of the fact that a wrong and basic assumption leads to an infinite number of errors.

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Does the interest rate has an impact on the allocation of resources?

The concept of capital / money is the basic error of classical economic thinking. It is of crucial importance for the understanding of keynesian theory and reality why this concept is wrong.

The interest rates are not prices in the sense of a market economy, because capital / money is not a scarce resource

In a situation of unemployement it is enough that the interest rates cover the administration costs of the banks and the risk

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