Austrian Theories of Interest

0:00Before I start, I want to offer an explanation for those of you who might be puzzled. In a conference like this, it might have been more appropriate for me to speak on something from American history. But unfortunately, my living memory only goes back to the first Reagan administration, and so therefore, it was deemed more appropriate for me to talk on Austrian interest theory. So today I'm going to be focusing mainly on the work of Eugen von Boehm-Bawerk, who is a pioneer not only in the Austrian school for interest theory, but in general in economics. And he has this massive three volume work, Capital and Interest. Now before I get going, I should make some remarks on this. I think a lot of Austrians, even who are very well read, tend to shy away from Boehm-Bawerk because he is admittedly a bit intimidating.

0:47His writing style at times is difficult. It's a very dense book. And so I think a lot of Austrians shy away in particular because they know that much of his work is controversial. And so I think the thought is, well, why should I get hit deep into this stuff if it turns out that in the end he's not even right? And that's a valid concern. However, I would say the first volume of his work, the History and Critique of Interest Theories, doesn't offer Boehm-Bawerk's own thoughts. It just has him giving a systematic survey of all preceding theorists and he offers a critique of them. So I would urge you that if you are a serious student of Austrian economics that you at least look over some of his critiques of other theorists because at times they're brilliant and I think also depending on your preferences for writing style, I think at times it can be funny.

1:35Just to give you one of my personal favorites. This is a passage where he is about to talk about the work of an American economist, Henry Carey, and this is how he begins. Carey offers one of the very worst examples of confused thinking on our subject, where there has already been a great deal of confusion. What he says on interest is a tissue of incredibly clumsy and thoughtless mistakes of such a nature that it is almost inconceivable how they could ever have won such esteem in the scientific world. I should not express his opinion in such severe terms if it were not that Kerry's interest theory, even now, in 1884, enjoys a reputation which I consider very ill-deserved. It is one of those theories which, to my mind, cast discredit not only on their authors, but on the science that is misled in the credulous acceptance of them.

2:21His theory is to be condemned not so much because of its errors as because of the unpardonable kind of errors it contains. as it contains. My readers may decide on the basis of what follows whether or not I'm judging too harshly. So as I say if you find that funny and witty then you would love this first volume if you think it's pompous and arrogant then don't bother reading it. But so anyway that's Boehm-Bawerk's thought and now I'll get into the heart of the matter. To understand the Austrian approach to interest you need to realize what Boehm-Bawerk thought the problem was needed to be explained and And specifically, he wanted to know why is it that a capitalist, apparently without exerting any effort, can just sit back and earn an income on his capital year after year?

3:06In contrast, a laborer can earn wages year after year, and that seems to make sense because he goes to work, he exerts his labor, it's irksome, and the labor is productive. And so it seems to make sense that a laborer earns wages in exchange for his labor. But why is it, Boehm-Bawerk wondered, that a capitalist can earn an income off of his capital funds? So that was what needed to be explained. Now the first step to understand Boehm-Bawerk's solution to the problem that we need to realize is that you can view a loan contract or the interest phenomenon as an intertemporal exchange. So let me illustrate this by first drawing up a typical loan contract. So suppose that Smith, in the current year, has $100 in financial capital and that he lends it out to Jones, who's the borrower, and then Jones, one year later, pays him back $110.

4:08Okay, now that's a standard loan contract and we would say, okay, the interest rate on this loan is 10% and that seems straightforward. But we can also view the same transaction equivalently if we say that in this period, rather than Smith lending $100, he buys a promise from Jones. So Jones is selling him a claim on future dollars. So it's an IOU for $110 in the year 2004 issued by Jones. So Jones is selling Smith this piece of paper rather than saying he's borrowing the $100. And if it so happens that the price of this claim is $100, well then we've just mimicked this more standard loan contract.

4:55$100 passes from Smith to Jones in the year 2003. We wait one year and then Smith takes this claim and redeems it and gets his $110. So it's the same transaction really, but viewed in this way we see how the interest earned is just an inter-temporal exchange. Now, what von Boehm-Bawerk focused on was called originary interest. And he contrasted this with the more commonplace loan or contract interest.

5:40Now, originary interest is another way that someone can earn money on his financial wealth. So we've seen here that one way that Smith with his $100 can increase it is by lending it out to Jones. Another way is to just to buy an IOU or a bond is really what this is. So that's another way to earn an interest return. But there's a third way and that's to invest in a productive process. So, if Smith takes his money and buys inputs of land, labor, and capital goods and he transforms them into output goods one year later he can also earn an interest return because if these goods, let us just suppose they sell for $110 to consumers, so consumers pay a total of $110 for this output.

6:40And if Smith initially spent $100 total on all these inputs, well then we see that that's another way that Smith can take his initial $100 and one year later turn it into $110. And so this is an example of originary interest. And so what that means is it's interest you earn on your capital when it's invested in goods rather than merely being lent out on the loan market. Now, again, let me just point out that here the fact that this $100 is lower is what's allowing us to earn the interest return. Also, let me just point out that I'm neglecting the differences in risk in these different operations. So in the real world, the credit worthiness of the borrower would be an issue and the certainty with which you thought these goods could be sold to consumers would also come into consideration.

7:33But if we assume that the risk is the same in these lines, well then in equilibrium, the return, the percentage return has to be the same. Nobody would lend out on the loan market for 5% if he could invest in this line of production and earn 10% on his money. So these returns, these rates of returns have to be the same. And at the time, this was a fairly revolutionary concept. Other thinkers had realized this, but von Boehm-Bawerk was very systematic to see that interest isn't merely about the premium that you earn on contractual loans, but it's also implicit in the production process itself. Because production takes time, the interest phenomenon has to occur in all processes. One more final point. Let me just mention an accountant who looked at this operation might say that there was a $10 profit, Profit. But that would just be considered an accounting profit. So it's true that the total amount spent on inputs is $100 and the total revenues is $110, but you also need to consider the fact that it took one year of investing that capital.

8:37And so because there's an opportunity cost on that, because you could have just lent it out in the loan market, there's no economic profit involved here. So this is just representing the money spent on the inputs and the opportunity cost, the interest interest return on the capital, and that equals the $110 that's sold to the consumers. Okay, so now we've seen how Boehm-Bawerk, by viewing interest as an intertemporal exchange, can see it from a different point of view. Now in this new framework, we can once again ask his question as to what is interest or what causes interest, but rather than saying why is it that the capitalist earns an income, we can ask the question, Why is it that the price of these inputs doesn't get bid up to this full price of the expected sale of the output?

9:25Because the only way to earn originary interest is if these prices in total are lower than what the capitalist will receive once he sells the product. So to ask why can the capitalist earn an income off his capital is equivalent to saying why is it that these capital goods or these inputs or why is it that this piece of paper doesn't get bid up to $110 when everybody knows the next period it's going to be worth $110. So that's now the question. Boehm-Bawerk hasn't yet given us an answer. He's just rephrased the question. Why is it that these goods are apparently given a lower market value than they ought to be? Now before I go on with what Boehm-Bawerk's solution was, let me take a detour and explain what an answer isn't.

10:13So, in other words, one of the theories that he attacked in his first volume, let me explain that because it's very important for the history of the Austrian School. This was what was called the Naive Productivity Theory. okay now the naive productivity theory said that the reason someone who invests in capital goods can earn originary interest is that the goods are physically productive and I think thinking in terms of a natural example is perhaps the most intuitive to understand why someone could believe this let me just point out that for Austrians a natural good resources are typically considered land while other things are considered capital goods but don't worry Let's not worry about that for the moment. Let's just think about why someone could believe the Naive Productivity Theory.

11:11Let's think about someone who buys an apple tree. So what we know is that people earn interest on their money. And so if someone invests in an apple tree, we know from experience that that means the person who invests his capital in an apple tree, year after year, will earn a return on that investment because the tree produces apples, the person harvests them and sells them in the market, in the market and that's how he earns dividends on his investment and the naive productivity theory explains this interest return quite simply by saying look the tree is productive the tree takes the sunshine and the minerals from the soil and the rainwater which by themselves are not productive on the margin or not valuable on the margin and it produces apples which people value and so isn't it obvious that year after year the owner of this apple tree can earn an interest return on his investment But actually that's not a good explanation. So let me just, so this is a tree in the year 2003 and we know it's going to produce apples next year. Those are supposed to be apples in the year 2004.

12:21Now let's just suppose that these apples sell for $1,000 on the market and that the tree is initially priced at $10,000. Now this happens every year. The apples every year are harvested and so $1,000 is earned by the owner of the apple tree every year. So if this is what we're assuming, well then yes, someone who buys the apple tree in 2003 first invests $10,000. Then next year, he harvests his apples and sells them for a thousand, so he's earned ten percent on his money. And then in 2005, he picks the apples again, sells them for a thousand, so he's earned another ten percent. And so that's why someone who buys the tree can make ten percent per year on his money. And the naive productivity theory, just to remind you, says that that's perfectly natural.

13:07Look, the trees are physically producing these apples. So what's the problem? Well the problem is, I just asserted that the market price of this tree is $10,000. But suppose instead the market price is $20,000. Now all of a sudden, even though I haven't changed the physical facts of the situation, even though this tree is still producing $1,000 worth of apples every year, now the implicit originary rate of interest is only 5% because the person who wants to invest in this tree has to first put up $20,000 $100,000 in order to earn $1,000 per year in dividends. And of course, if it cost $100,000, the percentage return would be even lower, and so on. Now, it's a bit confusing because the tree technically gives you an infinite stream of dividends, but if we think in terms of the more typical example where the goods are physically depreciated and completely spent in the production process, we can see what I'm talking about, that if these inputs were priced at $110. Well then there would be no implicit interest return at all in this process.

14:13Now this is true even though the capital goods are physically productive. Now what does that mean? Well it means if I took away the capital goods and so just had land and labor, the output here would be much lower. So let's say I took away the capital goods and we had a much smaller output that could only be sold for $50. And then I add the capital goods and now we have more output that can be sold for $110. So clearly, these capital goods are productive. They're adding value even at the end of the process. But the point is, that fact by itself doesn't tell me that someone who invests in this will earn a return on his money. Because the only way to earn a return is if this number is lower than that number. So the fact that adding capital here increases the total amount you can sell at the end by itself doesn't show why someone who invests in this will earn money.

15:03Because to get the capital goods in the first place, you have to pay for them. And if what you pay for them here is exactly taking into account the surplus they will earn you here, well then there's no interest return. And it's the same thing with the tree. The higher this dollar value, the lower the rate of interest on this investment. And I can make it any rate that you want. So the mere fact that the tree produces valuable apples by itself doesn't explain to me why someone who invests in trees can earn an interest return. So that was the naive productivity theory and Boehm-Bawerk, I think, decisively showed why it was an inadequate explanation for the phenomenon of interest. Incidentally, I think that that's a brilliant critique and I think it ranks up there with, for example, Mises' argument against economic calculation under socialism.

15:51I think it's just an absolutely brilliant critique and you really wouldn't understand it unless you went back and read von Boehm-Bawerk in the first section of his work. Now let me just take a brief digression here to explain something for those of you who may have studied graduate level economics. You might have seen equations in mathematical models that look like this.

16:21Okay, you'll see r equals f prime of k, where r is the real interest rate and f is the production function and k is the capital stock. And so what this relation here is saying is that in equilibrium, the real interest rate is equal to f prime of k, the marginal product of capital. They also write it like this, marginal product of capital. So this is saying it's the first derivative of the production function with respect to the capital stock. So what that means in words is the real rate of interest is equal to the increment in production that you can get from an incremental input of capital. Now what's odd about that is that seems to be literally the naive productivity theory. It seems on the face of it to be saying that if you want to increase the rate of interest, all you have to do is increase the product of capital and therefore increase the rate of interest, as I say.

17:12as I say but it seems that that is making exact confusion that apparently Boehm-Bawerk showed was wrong and so for a while I was puzzled by this because it seems Boehm-Bawerk's verbal logic is correct so I agreed with him in reading his words that the naive productivity theory had to be wrong but at the same time when I was in graduate school these models seemed to be right as I looked them over there was no error in the derivation from the axioms it wasn't that and they committed an arithmetical error and so for a while I couldn't reconcile these two things and I think what it is after a while is I figured this out that in these models they assume that there's only one good and they do this for simplicity. So in these models the capital good and the consumption good are the same thing.

18:00So, in Boehm-Bawerk's case, we had a tree that produced apples, but in a case where there's only one good, what they often say to motivate that apparently unrealistic assumption is, I'll suppose it's something like sheep. So somebody who owns a sheep now, and that's supposed to be a sheep, he can consume it now. So you can eat the sheep or use it, but kill it and use it in whatever way gives you utility, or you can postpone your consumption for one year, in which time it will multiply into two sheep.

18:53Now, of course, in reality, it would be something like two sheep would turn into four sheep, but not that I know about sheep and how they reproduce. So the point is, this is the sort of way that they motivate their models, which again, as I say, they only assume that there's one good, and that's done for simplicity. Of course, in the real world, there's billions of goods, but they say, well, we'll assume there's one and we'll see if we can learn something about the real world that way. Now, what happens in this sort of instance, it's particularly dangerous to assume one good, because let me show you why. It just so happens that if there's one good, if the capital good is the same thing as its output good, then in that case only, this physical fact that one unit now will turn into two units next year does make the real rate of interest have to be 100% in equilibrium.

19:44And the reason for that is clear. If there's only one good, and I ask how wealthy is someone, Well, the only way to answer that is to tell me how many sheep he owns. To put it another way, someone's real financial wealth is just a measure of how many sheep does he own, because there's no other goods in the economy. And so if you tell me that someone who starts out with one sheep now, if he saves it, can turn it into two sheep next year, well, that means he can have his financial wealth double every year. And that's another way of saying that the real rate of interest is 100%. So this approach eludes the problem that Boehm-Bawerk worried about because it assumes away the problem. Here, where there's a tree that produces apples, where apples are the good that gives utility, the question becomes how do we relate the market value of the tree to the market value of the apple?

20:34So over there I said that the apples were worth $1,000 every year, and so the question was how many dollars was the tree worth? If I want to do it in real terms, I can say, in the year 2003, how many present apples does the tree exchange against? Okay, so if the answer is 10,000 apples, and then we know that every year 1,000 apples gets produced, then I can tell you, okay, the rate of interest in terms of apples is 10% per year for this process. But if I tell you that the purchase price of a tree in the year 2003 is 20,000 apples, Well, then again, it's what I was just doing over there, but now I'm doing it in terms of apples. The apple rate of interest, if that's the way you want to think about it, is now 5% and so on. But you don't run into that problem if the goods are the same thing, because if I ask in the year 2003,

21:23how many sheep does one sheep exchange for? Well, the answer is one. No one's going to sell one sheep now for two sheep, because that would be stupid. One sheep is worth one sheep. But you don't have that here. If I say how many apples does one tree trade for, well I don't know. It could be a thousand, it could be five hundred. We just don't know. You need to know more about the situation, about people's preferences. So the whole point of this is just to show you that in these mainstream models where they have these equations, I think technically they are correct. They're not committing a logical fallacy. But what's going on is they're assuming away the whole problem of how do you value the capital stock in terms of the output good. because since there's only one good they happen to be the same thing. Okay, so now that I've explained why the naive productivity theory isn't a good explanation for the interest phenomenon,

22:18let me tell you what Boehm-Bawerk thought the answer was. Boehm-Bawerk said that, on the margin, present goods are more valuable than future goods of like, kind and number. So what he's saying is that the reason, for example, the person doesn't pay $110 for this piece of paper, even though it will yield him $110 in the year 2004, is that $2,003 are more valuable than $2,004, Because the 2003 dollars are available in the present, 2004 dollars aren't available until next year. So to say, well, how come the price of these things doesn't get bid up to 110 dollars is a bit like saying, how come the price of hamburger meat doesn't get bid up to the price of steak?

23:07Well, the answer is because people value steak more than they value hamburger, and that's why the market price is lower for hamburger meat. And the same thing here, at this point in time, this only represents a claim to 110 future dollars, and since future dollars are less valuable the market price of this piece of paper is less than the face value and in the same way these inputs in a sense represent a technological claim on this future revenue but its current price is lower because again you're buying this with present dollars and you're only being promised the prospect of future dollars and so if in general present goods are more valuable than future goods that explains why the prices of things that are claims to future goods will be lower in terms of present values. And that's why, as Boehm-Bawerk has already shown, once we can explain that, why these present goods have a lower market price than the expected market price of their products, once we know that, we can explain interest.

24:04Because it's merely a differential in the values inter-temporally. Okay, now Boehm-Bawerk didn't stop there. He had now analyzed the problem and gotten to the point where he said interest is an inter-temporal exchange or is due to inter-temporal exchange phenomena and it's due to the fact that present goods on the margin are more valuable than future goods but he wanted to explain why is it that present goods are more valuable than future goods and he offered three reasons I'm not going to go into them because they're controversial and they're not exactly relevant for the But let me just mention the third reason that he offered was the fact that present goods are technically more productive than future goods. Now this alarms some people, and that's going to be the next economist I'm going to talk about, in particular Frank Fetter.

24:56Now, Feder was a member of what was called the Psychological School, and by that they just meant that he believed that subjective valuations were pivotal, not material conditions. And so he was very sympathetic to the Austrian School, and many Austrians claim he's an Austrian. And so Feder thought that Boehm-Bawerk had done a great job. He exploded the Naive Productivity Theory. He showed us that interest was just an intertemporal exchange phenomenon, but inexplicably, Feder thought, Boehm-Bawerk, right at the last moment, slipped back into the productivity fallacies. And so, Feder couldn't understand why Boehm-Bawerk, in Boehm-Bawerk's own positive explanation, had as a component the fact that present goods were more technically productive.

25:46So, what Feder did is he wanted to say interest is solely due to time preference. Now, positive time preference for Federer referred to the fact that present goods were more valuable than future goods, and Federer offered what he called a capitalization theory. So what Federer said is that the way to understand interest is to first distinguish the concept of rent. Rent isn't what you think of as land rent, but also the rent that you earn from renting out capital goods.

26:35So someone who owns a tractor can rent it out every year and earn an income, and that's because the tractor is productive. And the same thing with the tree, if you want to think about it this way, Someone who owns the tree every year can sell the apples and earn $1,000 a year, and so in a sense, that's rents on the ownership of the tree. And so what Federer's capitalization theory set is, when someone owns a capital good that is a promise to a future stream of revenue, you need to consider, okay, where are the rents going to be every period, and then discount those rents to the present based on the person's degree of time preference. And then once you do that, you can come up with the current present market value of the capital good. And that will be less than the total expected future stream if there's positive time preference.

27:22So here, these capital goods, they will yield a rent. The fact that once I add capital goods to the process, this goes up, explains why they're productive. But in order to figure out the current market value, you need to discount this back to the year 2003. And so the person now who's buying all these products, he thinks ahead and says, okay, they're going to yield me $110 next year, but because I have a time preference, I may only value that $110 of future money right now at $100, and that's why I spend $100, and that's why I earn 10% on my money one year later. So that was, that's briefly, that's Federer's Capitalization Theory. The next economist to discuss is Ludwig von Mises.

28:13Now, Mises advanced what he called the pure time preference theory. Now, Mises pretty closely followed Federer, except Mises first of all thought that he showed that time preference is something that is just a priori true. that everybody by the mere fact that they engage in human action exhibits positive time preference. In contrast, Federer thought that it was just an empirical claim that for biological and psychological reasons people did prefer present to future goods, but Federer thought there could be extreme cases where the reverse might be true. For Mises, that isn't the case. Mises thinks, no, everywhere and always the mere fact that people act shows that they prefer present satisfactions to later satisfactions.

29:07So, again, Mises adopted Federer's view. He thought that interest was essentially about time preference, and he completely rejected anything having to do with the productivity of capital goods. Now, most Austrians have adopted the pure time preference theory. For example, Murray Rothbard, of course, that's what he expounds in Man Economy and State. and Roger Garrison also has advanced a version of the pure time preference theory, Peter Lewin also, Walter Block is a staunch defender of it. And in more recent times though there have been some revisionists. So earlier in this week you've heard about historical revisionists.

29:52Well now I'm going to tell you about interest theory revisionists. It's a much smaller market. And let me first focus on the work of Guido Holzman, and he's offered, is it a realist theory? Is that what you call it? okay all right so he's offering a realist theory of interest and what Hulsman focuses on the the crucial part in his analysis is the means-end Non-Framework Ever since Menger, Austrians have realized or have had the framework that someone values a means based on how much value they give to the end.

30:51So for example, if I have a lottery ticket that's a winner and it entitles me to a million dollars, I'm going to value that piece of paper a lot, unless I'm a pacifist or something. If someone tries to take it from me, I'm probably going to use violence to defend it. If we want to understand why is someone fighting over this little piece of paper, we say, oh, because it's a means to a valuable end, that the lottery ticket entitles someone to a million dollars, and so that's why people are fighting over this intrinsically worthless piece of paper. So that's why Austrians think the causality runs this way, that ends are valued in and of themselves or based on a person's value scale, and then the means to the end attain their value because it flows this way. The actor recognizes, if he recognizes this framework, will then assign value to the means because of the end.

31:43But what Holtzman has done is pointed out what should be an obvious fact, but apparently he's eluded people for some time, is that actually we don't assign the full value of the end to the means. Because always what we end up doing is we exchange the means for the end. So at some point I'm going to take that ticket and go turn it in and get my million dollars. So the very fact that I've turned in the means in order to achieve the end shows that I must have valued the end more than the means. And so even though we can say that the means is valued because of the end, we can't say that it achieves its full value or the full value of the end. of the End. There must be a gap in that valuation and so it's that gap that Holtzman uses to explain originary interest. Okay so to make the analogy here these inputs are means to this output to these ends or if you want to

32:38think in terms of dollars these these dollars that are being spent are a means to this end but you would never expend a hundred and ten dollars on the means to to achieve $110 as an end because, as I've just argued with you, means must be valued more lower than the end. Now, okay, I don't know much more about Hoelsman's theory, so I'm going to move on to my own. I'm sure it might come out in the question and answer period. So lastly, this is my own work. What I have advanced, I haven't really given what I'm calling a theory of interest, but in the last essay of my dissertation, I give what I call a monetary approach to interest theory.

33:41So what I'm arguing here is that what Boehm-Bawerk did was right from the beginning, he made a wrong move, is that he tried to transform the interest that we see on money loans or the appreciation in financial dollar terms. He tried to relate that to the underlying real commodities and that's what I claim was his fundamental mistake. And so ever since Boehm-Bawerk, even in the mainstream and also among Austrian theorists, that's just been taken for granted that when someone earns 10% on a money loan, Austrians as well as most neoclassicals will say, okay, that's just a symptom. Really what's going on is that real goods are being traded at a premium in the present for future goods.

34:27And for example, if you read Human Action, you'll see Mises talk about it, that interest isn't about money. It's about the fact of time preference and the fact that present goods are more valuable than future goods. The fact that present satisfactions as such are more valuable than the same satisfaction not available until later. So my claim is that that's not a good approach at all. And that if you want to understand interest, we should just stick to the fact that it's about money. And just to illustrate one of the problems, what you'll have, what you'll see in the pure time preference literature, is the claim that the preference for present goods over future goods must become uniform across all goods. So for example, if there's a 10% money rate of interest, a PTPT, a pure time preference theory, theorists might say, well that means that present goods are 10% more valuable on the margin than future goods.

35:20and that initially it might be different that some goods might be 12% more valuable and others 6% more valuable but because of arbitrage capitalists will shift their funds until in equilibrium the expected rate of return is the same. Murray Rothbard says this in Man Economy and State and Ludwig Lachman specifically has several passages where he makes these sorts of arguments. Now the problem with that is that it's only true if the spot prices of the goods remain the same over time. So let me just give you a little example to show what I'm talking about. I'm going to just talk about two goods, apples and oranges, and I'm going to list their prices for two years.

36:06So initially, apples and oranges sell for $2 each for a certain quantity. or a certain quantity, or in the year 2003 you can buy futures, which is just a claim to the same quantity of apples but not to be delivered until next year. Okay, and then the next year, I just need to put the present prices, the spot prices. We'll assume that apples are the same. But for some reason, the price of oranges goes up to $8 per unit.

36:55Okay, now if you want to say, well, why did that happen? I don't know, maybe there's a frost or something. But the point is, and I don't want to be confusing on this, these are all anticipated changes, okay, so I'm not here talking about the fact that everyone thought oranges were going to remain at $2 and all of a sudden they're 8 and so people suffer losses and some people earn profits. I'm not talking about that. These prices are perfectly known to everyone in the year 2003. Now, the pure time preference theory normally says that the ratio or the premium placed on present goods The ratio of goods over future goods has to be the same for all goods, and that ratio is what we see in money transactions. But here, if you ask what's the natural rate of interest, that's another way of putting it, what's the natural rate of interest in this economy, you can come up with two different answers.

37:46If you look at apples, you could say, okay, someone in 2003, if he wants to buy a quantity of apples in the present, for present apples, he has to spend $2. If he's willing to wait one year, if he's willing to buy an apple future, he only has to pay $1. And so from these, it looks as if the natural rate of interest in this economy is 100% because present apples are twice as valuable on the margin as future apples. But if we look at oranges, we see just the opposite. Present oranges sell for $2. But if you want to buy pieces of paper that say this will entitle you to a certain quantity of oranges next year, you have to pay $4 for that claim. So, from this consideration, present oranges are actually less valuable than future oranges.

38:31And in fact, the natural rate of interest, if that's the way you want to think about it, would be negative 50% from this, if you just looked at oranges. Now, the pure time preference theorist would normally say this is possible in the beginning, but after arbitrage, this can't remain. So that these relative ratios would have to be equalized because people would just shift from the lower to the higher valued investment. But that's not true because the spot price has changed. So let me just show you an example. Suppose someone right now in 2003 has $4 to invest. So if he invests in apples, he wants to invest his money in apple futures. So with his $4, he can buy four of these claims because they cost $1 each.

39:16Then he waits one year, redeems his four claims, and then, so he has now four units of apples and sells them for the spot price of $2. So that means he can have $8 now. Okay, so again, just to review what's going on, just as back here someone who had money could invest it in futures on dollars or could invest it in this, So, too, in this world, someone who has $4 in wealth, who wants to invest it, can put it in Apple futures. With his $4, he buys four claims. Next period, he gets the four, sells them for $2 a piece, he has $8. So, he's earned a 100% nominal return on his money. But, he earns the same return if he invests in orange futures. With his $4, he can buy one future because it costs $4 each.

40:04He waits one year, he turns it in, he gets his oranges, and then he sells them for the now higher spot price of $8. So once again, he's turned his $4 in 2003 into $8 in 2004 for a 100% nominal return on his money. So what's happening, as I said, is that the spot price of oranges is going up. If we kept the spot prices the same, then the PTPT theorist would be correct, that you could just figure out what the rate of the real rate of interest is by looking at these ratios but if we allow the spot prices to change then there's no reason that the ratio of spot prices to future prices has to be the same for different goods because the relative price ratios between the goods might change over time so if you look at a lot of the pure time preference theory literature you'll see the claim that these underlying real exchange ratios These things need to be equalized, but that's only true in what's called the evenly rotating economy, where everything stays the same year after year.

41:05So this is one of the reasons that I don't think a real, not a real list, but a real approach to interest theory, meaning a real goods approach, is very fruitful. I'm not intending a pun there, because again, in the real world where things change, you have to consider these sorts of possibilities. And again, let me just emphasize because there's a lot of confusion when I tried to show this to people before. This is not about pure profit opportunities. These changes, we're just stipulating, are completely anticipated. So everyone here knows apples are going to sell for $2 and oranges are going to sell for $8. But nonetheless, on the margin, present apples are twice as valuable as future apples, but oranges are half as valuable as future oranges. Incidentally, if you don't like the fact that it looks like there's a negative rate of interest here, if that seems impossible to you, Well, I could have just made this $1.50, and then it still would have been a different ratio, but it still would have been positive.

41:59So if you don't like that, I just did this to make nice round numbers. But you can still get the fact that on some goods there could apparently be a 20% rate of originary interest, while on others, you know, a 14% rate. And there's no reason for those rates to be equalized. So if your theory of interest says that when the money rate of interest is 10%, that means that present goods have a 10% premium on future goods, I think that's a very problematic statement because you're committed to saying the relative price ratios of those goods must remain the same over time and since Austrians tend to emphasize the fact that things change, I think that's a very serious problem for an Austrian theory of interest.