Wednesday, February 16, 2011

The "Two-Tiered" Interest Rate, Part II: Using Money

As we saw in yesterday's posting, there are two views of money and credit, and thus two views of interest. Within the Currency School, all loans and investment come out of the "supply of loanable funds," and thereby determine the "production possibilities curve." In this view, the only source of investment and consumption funds consists of whatever has been withheld from consumption in the past and is now available for reinvestment. In some of today's schools of economics, if this supply is too large or businesses and consumers are not borrowing enough, the government lowers the interest rate to encourage investment and borrowing, and discourage saving. If the supply is too small, the government raises the interest rate to discourage investment and borrowing and encourage saving.

Within the Banking School, there are two sources of funds. Financing for sound capital investment can be obtained in any amount by drawing bills on the present value of future marketable goods and services, as long as the total of bills drawn does not exceed the present value of the future marketable goods and services (a process called "overtrading" that results in "fictitious," that is, fraudulent bills), and the bills are adequately collateralized. Strictly speaking, such "pure credit" loans (that is, loans not based on existing accumulations of savings) do not carry an interest rate. They carry a discount rate representing the present value of the bill at maturity (the time value of money), and a "risk premium" based on the soundness and creditworthiness of the drawer of the bill. As noted above, these bills can be used directly as money, or discounted at a commercial or central bank and exchanged for the promissory notes of the bank, a more convenient and recognized form of money.

The other source of funds in Banking School theory consists of the present value of existing inventories of marketable goods and services — existing accumulations of savings, if we define "existing savings" as "unconsumed marketable goods and services." Because this supply of funds is limited at any point in time, it can, in a sense, be treated as a commodity, and the interest rate (if allowed to do so) can respond to changes in the supply and demand for the pool of existing savings. If we are consistent with our pure theory, the existing supply of funds should only be used for consumption, government spending, speculation, and capital projects that have a low present value, even zero or less, due to the risk involved.

Thus, within the Just Third Way, pure credit loans should never bear interest, while loans made out of existing accumulations of savings should bear an interest rate reflecting market-determined levels set by the laws of supply and demand. Dr. Norman G. Kurland of the Center for Economic and Social Justice has formalized this understanding of the two sources of loanable funds in his proposed "two-tiered" interest rate. All loans made for sound capital investment by discounting bills drawn on the present value of the future goods and services to be produced by the new capital would not bear interest, being limited to the discount rate reflecting the time value of money, and a risk premium reflecting the creditworthiness of the drawer of the bill. All loans made for any other purpose must come out of existing accumulations of savings, either by cutting consumption and accumulating money savings, or by drawing bills on the present value of existing inventories of marketable goods and services. Such loans would bear an interest rate reflecting the market-determined cost of capital, plus risk premium, regardless for what purpose the loan proceeds were used.