Interest rates are the key idea which unites economics and finance. Economic conditions are what drive interest rates. Real interest rates are basically a function of economic growth and the difference between real rates and nominal rates rooted in inflation calculations. The higher the rate of growth, the higher the rate of interest should be. There are two reasons for this:
First, businesses can afford to pay higher interest rates when they are in faster growing economies. When a corporation sells a bond and agrees to pay, for example, a 6% interest rate, they are betting that they can invest that money in their operation in such a way as to grow profits by greater than 6%. After all, if they thought that whatever expansion they were considering would only yield an internal rate of return of 5%, they would conclude that they should not engage in the expansion since it would cause them to lock in a guaranteed loss of 1% per year.
This effect reflects the demand side for capital. Entrepreneurs and internal managers are constantly evaluating their environments and assessing the growth prospects and their bottom-up evaluations merge up into the financial markets in either higher demand for growth capital (causing higher real interest rates) or lower demand (causing lower ones) for capital. Growth drives capital demand.
Second, the demand for capital would all be in vain if there no one was willing to supply capital. Somebody has to say “no” to themselves (they have to say “no” to their present consumption desires) in order for there to be any financial market at all. The only way I would be willing to give up present consumption to invest in somebody else is because I believe I can increase my wealth by doing it. They have to pay me to defer my gratification.
This idea, called ‘time preference,’ is a universal principle of human nature. I prefer to have my money now, and will only be willing to wait if I get more money as a reward for waiting. But I can only be paid interest, dividends, capital gains, etc. if the entity in which I’ve invested has some kind of internal rate of return themselves. They have to grow; otherwise our money can’t, at least not for long. So the supply of capital, like the demand for capital, both depend on the creative process of entrepreneurship.
But the business in which I invest does not just need to give me a return; it needs to give me a better return than I can get elsewhere. The investment will have to yield at least as much money as I could get by investing in another business with the same risk level. This idea is called ‘opportunity cost’, which means that I must be compensated for the lost earning opportunity of the investment which I forego.
If I can open a frozen yogurt stand for 10,000 dollars and get a 10% rate of return, then I will prefer the yogurt stand investment to a bond of similar risk which is offering 6%. In this case the corporate borrower is competing for my money with the yogurt stand.
In aggregate all the corporations are in a constant state of competition with one another and with governments as well as with the yogurt stands, and rental properties and innumerable other small businesses in America. If corporate bonds, for example, consistently paid interest rates that were lower than the overall GDP growth rates of the economy, we would all invest in yogurt stands and other small businesses that track with general growth levels. In that case corporations would have to bid up their offers. Higher GDP growth rates force borrowers toward higher interest rates over time.
In short, growth rates set real interest rates. The productive entrepreneur is the source of yields who must compete with other entrepreneurs for my investment money and who can only pay for the use of my money in the long run out of his or her ability to grow faster than the economy as a whole.
The things I said above are obviously theoretically true; I’ve explicated the steps in the reasoning process step by step. Other economists far greater than I have been unfolding the mystery of interest rates at least since the days of Knut Wicksell and Carl Menger in the mid-19th century. Furthermore the data bear them out.
I’ve spent the last several months testing various interest rates as economic forecasters and (without giving away the secret sauce), they work quite well. The economic role of interest rates is, in short, theoretically well established and empirically verified, so why don’t we hear anything about it? Because it is forgotten and it is forgotten because it was suppressed by the major ideologies of the 20th Century.
The various isms, Keynesiansism, Marxism, Islamism, Medieval Catholicism, refuse to see interest rates for what they are: a reflection of who we are as a people. Whether we are savers or spenders, promise keepers or promise breakers, innovators or stagnators, gratification grabbers or deferrers: the interest rates reflect our national character.
But Keynes doesn’t see a mirror when he looks at the market rate of interest, he sees a lever; the master manipulator sees a way to manipulate people by the millions. Marx doesn’t see the truth of all of us, but only an instrument of oppression, money for nothing for the capitalist class. He looks at the interest rate, and does not see a mirror which reflects a nation’s character, not a lever which he can control, but rather a monster which he must kill. And of course, since for him that monster is simply a reflection of the Saving Class, it is that class which must be liquidated.
The various medieval religious responses see not the specific rate of interest as a reflection of our character, but the very existence of interest as a reflection of our sin. Interest for them is a disruption of the Divine order of things, an attempt to make something out of nothing, an abomination to be suppressed, and while the Catholic church has (largely) abandoned that form of thinking, it is still rife in Islamist circles and in Western circles, too, among large financial institutions who want to cash in on the bonanza in ‘Sharia compliant’ finance.
What the various clashing isms share in common, however, is their desire to suppress the gift of data. People’s actions will tell you who they are. Capital markets take all those individual spending, saving, borrowing, producing, procreating decisions and incorporate them into themselves. But people can only tell us who they are and what they know, when they’re permitted to act freely and we’re willing to hear what they say.
Mr. Bowyer is the author of "The Free Market Capitalists Survival Guide," published by HarperCollins, and a columnist for Forbes.com. This article orginally appeared at Forbes.com