Monday, May 21, 2012

The price of renting money

Over at Skepticlawyer, I participated in a thread on why interest rates are the price of credit, not the price of money.  It turned into a classic example of why the best way to learn is to teach. A commenter queried my example of borrowing cows (for a consideration) as credit without money. She said that was just renting the cows. Which, of course, it would be. But so is an interest rate.

Interest rates are the price of renting money. So, interest rates are the price of credit (of money being rented). Someone borrows money and they are charged for using the money. The longer they use it, the more they are charged. Just like rent.

Of course, different forms of renting money get charged different interest rates, depending on the risk level involved. But, where landlords differentiate in the quality of the housing offered (low rent means lower quality), money is money.  So, the more risk, the higher the rent. Not least because it is easier for money to disappear than a house. Differentiation gets put into the rent (i.e. the interest rate) because the basic product is not variant in quality, only the conditions under which it is offered.

Money is, however, useful only for its swap value, which is the price of money--what you can get for it. And if the level of money in-use-in-transactions rises faster than output, the average swap value of money will decline. So expectations about the future path of the average swap value of money are built into interest rates. After all, people don't want to lose by renting out their money.

What is particularly useful about thinking of interest rates as rent-for-using-money is that it makes it very clear that interest rates are not the price of money. No more than rent is the price of a house.

And if rents are high, do we think housing is plentiful or scarce? (Relative to demand.) If rents are low, do we think housing is plentiful or scarce (relative to demand)? The same with interest rates and money-for-rent (i.e. credit).

Conversely, if there is lots of money for credit does that suggest people are holding money or spending it? Holding it. If people are holding it rather than spending it, does that suggest money-for-transactions is easy or tight? Tight. [And if money is tight, will the demand for credit be high or low? Low.] After all, low interest rates usually reflect confidence that money will retain its swap value [so that money is expected to be tight relative to is use purchasing output]. (Mostly low interest rates suggest tight money; there are some weird possible cases with interest rates, but we can leave that aside.)

Which is another way of saying both quantity (money supply) and velocity (average rate at which money is used) matter since they both affect the level of money-for-transactions. Hence interest rates are not the price of money and it is highly misleading to treat interest rates as the only indicator of monetary policy.

It also points to a difference between monetary instruments, such as bonds, compared to other assets.  A bond has no value apart from its expected (rental) income. But houses, for example, can reach prices well above their expected rental value. Why that is so is a genuinely interesting question.

But at least I now have a good response to "interest rates are the price of money".  No, they are the price of renting money.  After all, folk generally want their money back, plus a charge for not having use of it themselves. (Or whatever the next best use of it is.) Sounds like renting to me.

5 comments:

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  2. Money is credit.

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    1. But you can have money without credit and credit without money, so clearly your claim is false.

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