Welcome back to the Deep Dive. This is where
we take your entire stack of sources, the dense
articles, the complicated research, your personal
notes, and synthesize it all into the deep knowledge
you need, delivered efficiently and engagingly.
That's right. Today, we are undertaking a deep
dive into a concept so fundamental, it dictates,
well, the growth of civilization, the state of
global trade, and even your personal spending
habits. It really is the single most pervasive
price in the entire financial world. And our
sources today, they really reflect that breadth.
We're looking at a remarkable historical sweep
moving from, you know, 5000 year old Sumerian
documents right up to 21st century theories of
liquidity. And what's our mission here? Our mission
is critical to move beyond just calculating interest
and to truly understand the historical, moral,
and mathematical underpinnings of why we pay
or receive the price of money. Okay, let's unpack
this. We use the word interest constantly, but
I think it sometimes gets conflated with other
financial terms. So to start, let's nail down
the core, pure definition. Fundamentally, interest
is the cost of borrowing money. It's a payment
made by a debtor. or a borrower to a lender,
or sometimes a depositor, of an amount that is
specifically above the repayment of the principal
sum. OK, above the original amount. Exactly.
And crucially, this payment is predetermined
and paid at a particular rate over a specific
period. And the roles here can sometimes be confusing.
If I put, say, $10 ,000 into a savings account,
who is the lender and who is the borrower? That's
a great question because it feels backwards.
In that case, you, the customer, are the lender.
You are supplying the bank with your capital.
So the bank is the borrower. The bank is the
borrower. They pay you interest for the use of
your money, which they then, of course, lend
out at a higher rate. The interest rate itself
is merely the amount paid or received over that
period divided by the principal sum, and it's
usually expressed as an annual percentage. We
absolutely must distinguish this from other common
financial terms. Otherwise, you know, the accounting
gets messy. For example, interest versus a fee.
Yes, a crucial distinction. Interest is entirely
dependent on the principal amount, the rate,
and the time the money is used. A fee, by contrast,
is a fixed charge. It's paid to a lender or a
third party, usually for processing, administering,
or underwriting the loan. So like a loan origination
fee. Exactly. A loan officer's fixed commission
is a fee. The 7 % annual charge on the remaining
balance is the interest. And what about equity?
If I invest in a successful company and I get
a quarterly payout, that's a dividend. Why is
that not considered interest? Because the nature
of the relationship is entirely different. Interest
is received by a lender based on a contractual
preset rate. A dividend is received by a shareholder
who is, by definition, an owner of the company.
As an owner, you assume risk. Ah, so there's
risk involved. A huge amount of risk. The dividend
is paid out of the company's actual profits and
its amount is determined after the fact based
on how well the company performed. It's a pro
-rata share and the reward for that risk taking.
So the core distinction is interest is fixed
and contractual. paid to a lender. A profit or
a dividend is variable and it's paid to an owner
or an investor who shared in the actual risk.
Exactly. It separates the idea of lending capital
from the idea of risking capital. And once we
understand interest as the price of time and
capital, we have to immediately discuss the dynamic
engine that drives that price. Compounding. Here's
where it gets really interesting. Compound interest,
which Albert Einstein may or may not have called
the eighth wonder of the world. Right. That's
probably apocryphal. Probably. But it's a great
line. It's the idea that you earn interest not
only on the original principle, but also on all
the interest that is already accumulated. It
creates exponential growth. If your savings account
compounds quarterly, the second quarter's interest
is calculated on a slightly larger principle
than the first. It just it snowballs the growth.
And it works the other way, too, with debt. Oh,
absolutely. On the debt side, if you miss a credit
card payment, the interest from that missed month
is immediately added to your principal and your
next interest charge will be calculated on that
larger inflated amount. And this exponential
nature of compounding is so central to our understanding
of finance that, as you noted, its mathematical
study led to the discovery of the fundamental
constant E. Yes, we are absolutely going to dive
into that deep math later. But first, let's establish
the context, because the story of interest is,
I mean, it's older than democracy. Is it really?
Oh, yeah. And it's a story rooted in surprising
necessity. The sources make it clear that credit
the ability to loan and borrow predates coinage
by millennia. Millennia. The first concrete written
evidence of systematic credit comes from Sumerian
documents, specifically cuneiform tablets, dating
back to 3000 BC in Mesopotamia. 3000 BC. That
is staggering. What were they loaning? I mean,
it wasn't cash. No, the loans were primarily
in grain. the agricultural staple in silver,
which served as the standardized metal. And what's
crucial is that these were systematic, institutionalized
loans used to manage the cyclical nature of agriculture.
A farmer might need grain for planting season,
and they'd promise repayment after the harvest.
So what was the early justification for charting
interest on a bag of seeds or a piece of silver?
The theory likely arose from the most practical
observation. productivity. If you loan a shepherd
10 sheep, those sheep will reproduce. If you
loan a farmer 10 measures of grain, those seeds
will multiply in the field. So the lender felt
they deserved a cut of that natural growth. Exactly.
The lender argued, quite reasonably, that they
deserved a share of that natural multiplication,
arguing the acquired goods could multiply themselves.
This established the idea of a natural yield
or interest. That makes perfect sense for productive
assets like livestock, which literally reproduce.
But what happens when that same rate, the sources
say it was around 20 % annually, is applied to
something that doesn't reproduce, like silver.
And that is precisely where the philosophical
tension and moral objections began, almost immediately.
The first written evidence we have of compound
interest dates to roughly 2400 B .C., where that
standard annual interest rate of about 20 percent
was codified and it was often applied to both
grain and silver. And while that system was obviously
essential for urbanization and managing harvests.
It was. The fairness of charging 20 percent on
what they called sterile silver money that doesn't
inherently grow. That became a massive point
of contention. Huge. And this contention leads
us directly into the concept of usury, which
for most of history didn't just mean excessive
interest, but often any interest at all, especially
when you were lending to a co -religionist. That's
right. The strong moral and religious prohibitions
appeared very early. They did. For instance,
in the ancient Jewish faith, there were prohibitions
against charging neshek or usury to other Jews.
This reflected a necessity -based tribal view
where lending money to a neighbor, well, it should
be an act of charity, not a commercial transaction
designed to profit from that neighbor's misfortune.
And that prohibition was powerfully adopted and
then expanded by early Christianity during the
Roman Empire. Dramatically so. The First Council
of Nicaea in 325 AD strictly forbade clergy from
practicing usury, and they defined it as lending
above 1 % per month. Which works out to, what,
about 12 .7 % a year? Roughly, yes. And later,
the moral condemnation expanded to the laity,
culminating in the powerful arguments of St.
Thomas Aquinas in the 13th century. What was
Aquinas' specific theological argument against
charging interest? He argued it was intrinsically
wrong because it constituted double charging.
He used Aristotle's definition that money is
sterile. It's just a medium of exchange, not
a productive asset like a farm or a workshop.
OK, so how is it double charging? By charging
interest, you are effectively selling the buyer
the principal sum and then charging them separately
for the use of that sum. But since the use and
the principal are inseparable when you're dealing
with sterile money, you're basically selling
the same thing twice. That really reflects the
economic reality of the time, doesn't it? If
you needed a loan in the medieval period, it
was almost always a tragedy. Your house burned
down, your sheep died. It was a loan of necessity
for consumption. Exactly. It wasn't a productive
investment that would yield a profit for the
borrower. So the moral reproach was based on
the fact that the lender was profiting from someone
else's necessity and distress, and the money
itself wasn't creating any new goods or services.
There was no productive value. None at all, in
their view. So if the moral framework was so
rigid, How did the West eventually transition
to a world where charging interest is, I mean,
it's just standard practice? The catalyst was
the Renaissance. It was the explosion of commerce,
of trade, of mobility. Money stopped being primarily
a cushion against poverty and started becoming
a tool of production. Ah, so when borrowed money
was used to finance a new voyage or equip a printing
press. Or start a new business activities that
generated significant wealth. The moral perception
shifted entirely. The interest became compensation
for the lender's opportunity cost and the risk
of the new enterprise rather than just profiting
from distress. The philosophical justification
changed from the lender profits from my need
to something like the lender deserves compensation
because their money enabled my profit. That's
the intellectual jump that eventually legalized
and normalized interest across the secular economies
of Europe. However, that moral objection, RIBA,
it remains central to Islamic finance today.
Let's look at that framework because it's a powerful
modern example of how to run a complex financial
system without the mechanism of predetermined
interest. The modern Islamic banking movement
grew significantly in the later 20th century,
and the central prohibition remains. Making money
out of money is unacceptable. Predetermined loan
repayment or REBA is prohibited. This means a
standard loan contract with a fixed interest
rate is impossible. So if a bank can't charge
a fixed rate, how does a financial institution
profit and how do savers get a return? They share
the risk. The financial institution acts as a
partner, not a lender. This is achieved through
profit loss sharing schemes. For instance, instead
of lending you money to buy a house and charging
6 % interest, the bank might enter a joint venture,
a musharaka, or a cost -plus -profit contract,
a murabaha, to finance the purchase. Can you
give us a specific example of how that might
work? Sure. Let's say you're purchasing a piece
of equipment for a business. Under an Islamic
banking model, the bank might purchase the equipment
outright and then lease it to the business for
a fixed agreed -upon period. The lease payments
would be determined by the asset's use and depreciation,
not a floating interest rate. Or they could become
partners. Or, more commonly, they act as partners,
mudarba, investing capital and sharing the eventual
profits according to a pre -agreed ratio. But,
and this is key, they also share in any eventual
losses. What's fascinating is that this requires
all transactions to be asset -backed. They can't
just lend cash against nothing. Precisely. The
money has to be tied to a real -world productive
asset or enterprise. This inherently forces financial
institutions to focus on the productivity of
the economy, the very justification that helped
lift the usury ban in the West, but without reverting
to a predetermined contract rate. It emphasizes
that money must be used to create wealth, not
just be extracted from debt. That provides an
incredible transition. If the philosophical justification
hinges on productivity, then the mechanical growth
of that productive wealth is what we need to
focus on next, the mathematics of interest. Right.
Let's move from philosophy to pure math, starting
with the distinction between simple and compound
interest. Simple interest is what we first look
at in school, and it's calculated only on the
original principal amount, completely excluding
any compounding effect. Okay, so if a listener
has a loan or credit card that charges, say,
12 .99 % annually, let's walk through how simple
interest would be calculated on a $2 ,500 balance.
Okay. If that 12 .99 % annual rate, or .1299,
is applied over one month, and we assume 12 payment
periods in a year, you just calculate the simple
interest for that month. It's the annual rate
times the principal. Divided by the number of
periods. So that's 0 .1299 times 2 ,500 divided
by 12. Which comes out to approximately $27 .06.
So if the borrower paid exactly that amount,
their principal remains at 2 ,500. And if they
did this for three months, the total simple interest
would be just three times that amount, so about
$81. The calculation stays flat? It stays completely
flat, exactly. It ignores any interest that might
have accrued. That sounds wonderfully manageable.
But as we know, the real world is almost entirely
dominated by compound interest, which is where
things become exponential and, well, potentially
far more punitive if you're borrowing. Compound
interest is what happens when the interest earned
or charged is added back to the principal, and
subsequent interest calculations are based on
that newly inflated balance. The frequency of
compounding daily, monthly, semi -annually is
what determines the effective rate of growth.
Let's use a quick comparison to show the impact
of that compounding frequency. Imagine two investments,
both with a 6 % simple annual rate. One is an
annual CD. It pays 6 % once a year. The other
is a bond that pays 6 % semi -annually so, 3
% every six months. Okay. On a $10 ,000 investment,
the annual CD simply pays you $600 at the end
of the year. The semiannual bond, however, pays
$300 after the first six months. This is the
crucial moment for the compounding effect. Because
the bondholder can immediately reinvest that
$300. Yes. They now have a principle of $10 ,300
for the next six months. So when the second coupon
is paid, it's 3 % of that larger amount, which
is $309. So over the full year, the investor
has earned $300 plus $309 for a total of $609.
Right. So even though the stated rate was 6%,
the investor's effective annual rate, the AER,
is actually 6 .09%. That extra $9 is the direct
result of the compounding frequency. And this
leads us to the formal mathematical expression
for that annual equivalent rate. It does. It's
1 plus r divided by n, all raised to the power
of n minus 1, where r is the nominal annual rate
and n is the number of compounding periods per
year. In our bond example, that's 1 plus 0 .06
over 2 squared minus 1, which gives you 6 .09%.
This simple realization... that increasing the
frequency of compounding increases the rate of
return is what led jacob bernoulli to his profound
discovery of the constant e this is a perfect
example of how finance drives pure mathematics
it truly is an aha moment in history bernoulli
back in 1683 was pondering what happens if you
take that compounding process to its logical
extreme he devised a thought experiment Start
with $1 and offer a 100 % annual rate. Okay,
so compounding annually gives you $2. Right.
Compounding semi -annually yields $1 times 1
.5 times 1 .5 again, so $2 .25. If you compound
monthly, the return jumps to about $2 .61. Bernoulli
wondered, what happens if we compound infinitely
often? Every second, every nanosecond, does the
result become infinite? You would intuitively
think that, yeah, if you divide the interest
rate by an infinite number of periods, you get
an infinitely growing return. But Bernoulli proved
that it doesn't. As you increase the frequency
of compounding n toward infinity, the calculation
approaches a finite fixed limit. Why is that?
Because the increase in frequency is offset by
the corresponding infinitely small division of
the rate. The gain from the frequency increase
is exactly balanced by the rate dilution. Wow.
Precisely. And that specific finite limit...
where continuous compounding occurs, is the mathematical
constant E, approximately 2 .71828. It is the
limit as n approaches infinity of 1 plus 1n to
the power of n. That's amazing. The drive to
understand the best way to earn interest led
to the discovery of one of nature's most fundamental
numbers. And it now governs everything from population
dynamics to pricing complex financial derivatives
today, which rely on the concept of continuous
compounding. Now, moving from the purely theoretical
math to the practical back of the envelope math,
we need to share some rules of thumb for the
listener. The first is the famous rule of 72.
The rule of 72 is perhaps the most useful piece
of financial shorthand for approximating how
long it takes for an investment or a debt to
double. You just take the number 72 and divide
it by the annual percentage interest rate. So
if you manage to find an investment yielding
a steady 6 % annual return. 72 divided by 6 is
12. It takes approximately 12 years for your
principal to double. This is enormously useful
for retirement planning. And on the flip side.
On the flip side, if you are struggling with
a high interest credit card at 18%, 72 divided
by 18 means that debt principal will double in
only four years, assuming you pay nothing down.
Our sources know that this rule works incredibly
well for interest rates up to about 10%. But
what about outside that range? It's still a very
good approximation. For a very low rate, say
4%, the rule of 72 suggests 18 years, while the
actual doubling time is closer to 17 .7. For
a very high rate, like 36%, the rule suggests
two years, but the actual time is closer to 2
.25. It's an easy rule to memorize, and the error
is generally small enough to be useful for quick
decisions. Rule 72 is helpful for the future,
but we have to issue a serious warning about
a historical rule of thumb that actively punished
borrowers, the Rule of 78s. This is a truly dark
and frankly exploitative chapter in consumer
finance history. The rule of 78s, also called
the sum of digits method, was used widely for
calculating interest allocation on flat rate
consumer loans in the U .S. and Canada before
computational power became ubiquitous. The name
comes from the fact that the sum of the integers
from 1 to 12 is 78, reflecting a one year loan.
How was this method used to disadvantage the
borrower? Well, first, the total interest due
over the entire life of the loan was calculated
up front. Then, that interest was allocated using
a weighted system, but in reverse. For a one
-year loan, the lender deemed 1 ,278 of all the
interest to be due in the first month, 1 ,178
since the second, and so on until the last month
where only 1 ,178 was allocated. So the interest
payments were severely front -loaded. You might
pay the same dollar amount every month, but the
allocation meant you were paying off the interest
component first. Precisely. For a borrower, the
practical effect was brutal. For a one -year
loan, approximately three -quarters, or 75%,
of the total interest owed was collected by the
lender within the first six months. So if you
came into some money and wanted to pay off your
loan early. You'd be shocked to find you were
entitled to almost no refund on interest, having
already paid the vast majority of it. It effectively
made early payoff financially punishing, trapping
borrowers into paying interest for the full term.
That's predatory. It was recognized as such.
Thankfully, legislative action was taken. The
U .S. outlawed the Rule of 78s for mortgages
and other long -term consumer loans, specifically
those over five years, starting in 1992. It's
a stark reminder that the methodology of calculation
is just as important as the stated rate. One
final quick note on calculation. How do instruments
like T -bills or treasury bills calculate interest?
They're different, right? They are. T -bills
are known as discount instruments and use a specialized
method. They don't pay periodic interest payments.
Instead, the interest is calculated based on
the difference between the face value and the
price you paid when you bought it. So if a $1
,000 T -bill is sold for $980, the $20 difference
is the interest you earn when the government
pays you the full $1 ,000 at maturity. Correct.
The buyer is discounting the future value to
arrive at the current purchase price. And that
interest is prorated using a simple interest
calculation based on the number of days until
maturity. It's an inverted calculation method,
but the principle remains the same. Okay. With
the history and the math covered, we now shift
our focus to the macro view. How are these rates
determined in the actual market? Economically
speaking, interest is the price of credit. And
like any price in a market economy, it's driven
by the scarcity of the commodity, in this case,
loanable funds, and the intersection of supply
and demand. The fundamental reason interest rates
are generally above zero is that loanable funds
are scarce and there's always competing demand
for them. But the price of credit isn't uniform.
I mean, a bank might offer 0 .1 % on a savings
account, charge 5 % on a mortgage, and demand
25 % on a credit card. Why the massive variation?
Because the nominal rate that the borrower sees
is a compound of several distinct factors. We
can break the nominal rate down into four essential
components. The first is the real rate. which
you can think of as opportunity costs and deferred
consumption. This compensates the lender for
giving up the use of their money now. Exactly.
The lender is deferring consumption. They need
to be compensated not just for the delay, but
also for the foregone return they could have
achieved by investing in the next best alternative.
If a 1 % risk -free return is possible elsewhere,
the real rate has to be at least 1%. The second
factor, and the one that feels most immediate
to consumers, is inflation. Right. Since we're
dealing with time and loans often span years
or decades, the lender faces the risk that future
dollars will buy less than current dollars. If
inflation is 3 % and they charge 3 % interest,
they are simply preserving their purchasing power,
not making a profit. So how does the market typically
handle the uncertainty of future inflation? Three
main ways. Some governments issue real return
or inflation index bonds where the principal
value is continually adjusted for inflation,
which removes the guesswork. But that's not common
for most loans. No. So most other lenders must
either estimate the expected inflation rate,
which is inherently risky, or they use variable
floating rates that can be reset periodically
to adapt to changing price levels. And that estimation
is tough. We've seen periods like during the
2011 commodity spike or the high inflation in
the 1970s where the real rate of return on government
bonds was actually negative. A painful lesson
that market expectations are not guarantees.
The third crucial factor is default risk. or
creditworthiness. This is the risk that the specific
borrower will fail to repay the principal and
interest. This risk demands a risk premium, a
higher rate to compensate the lender for the
chance of total loss. This premium is heavily
dependent on the integrity of the borrower and
the collateral they offer. Which explains why
a consumer with a low credit score pays a much
higher rate than a large corporation. And why
loans to developing nations carry significantly
higher risk premiums than loans to established,
stable governments like the U .S. or Germany.
And collateral, as you mentioned, matters immensely.
A secured loan, like a mortgage where the house
is collateral, will always carry a lower rate
than an unsecured line of credit. Okay. And finally,
the fourth factor is the term and liquidity of
the loan. Term refers to duration. Generally,
shorter terms have lower default risk because
the near future is easier to predict. This typically
results in an upward sloping yield curve. You
get paid less to lend money for three months
than for 30 years. Liquidity refers to how quickly
the lender can resell or liquidate the asset.
A U .S. Treasury bond is highly liquid and can
be sold instantly, so it offers a lower return.
A highly illiquid loan, like seller -financed
debt on a specialized piece of equipment, demands
a significant liquidity premium to compensate
for being locked into that agreement. So if we
synthesize these four components, we arrive at
the nominal rate, I, that the consumer sees.
And there's a formula for this. There is. You
can express it as... I equals R plus pi plus
C. So the nominal rate equals the real rate R
plus expected inflation pi plus the credit risk
yield spread. Walk me through a real example,
a 30 -year mortgage. Okay. A bank assesses the
underlying real rate required by investors, say
1 .5%. They estimate the average annual inflation
pie over 30 years, say 3%. And then they add
a credit risk and liquidity premium C for that
specific borrower, say 1%. The resulting nominal
rate I is 1 .5 % plus 3 % plus 1%, which is 5
.5%. That's the rate you're quoted. That framework
provides perfect clarity on how the price of
money is constructed piece by piece. Yeah. Now
we touched on default risk. But we must clarify
default interest. Right. Default interest is
a highly specialized risk premium. It is a much
higher rate, sometimes dramatically so, that
is contractually triggered only if the borrower
commits a material breach of the loan agreement,
like failing to make a payment. It is essentially
a penalty rate. It compensates the lender for
the fact that the borrower has now become high
risk. The interest rate on the remaining principal
might jump from 5 % to 15%. However, many jurisdictions
have complex laws regarding default interest.
If the rate is deemed excessive, if it penalizes
the borrower far beyond the actual loss incurred
by the lender courts can deem the clause unenforceable.
All these market factors determine the rate in
a theoretical free market. But the biggest influence
on rates worldwide is not demand for mortgages,
but government intervention via the central bank.
Absolutely. Central banks, like the Federal Reserve
in the U .S. or the European Central Bank, hold
immense power over short term rates. It's their
primary lever of monetary policy. They do this
by targeting what the U .S. calls the federal
funds rate. The rate banks charge each other
for overnight loans. And the main tool they use
to hit that target rate is called open market
operations. Could you walk us through the actual
mechanism? I mean, how does the Fed... Buying
a bond affect my car loan rate six months later.
It's a chain reaction. When the Fed decides it
wants to lower rates to stimulate the economy,
it buys U .S. Treasury securities from the market.
Wait, so the Fed is buying bonds. Where does
the money come from? Are they just creating it?
In essence, yes. They are crediting the accounts
of the banks they buy the bonds from. When the
Fed buys a billion dollars in treasuries, it
injects a billion dollars of new money into the
financial system, specifically into the bank's
reserve accounts at the Fed. So the banks suddenly
have excess cash lying around in reserves. Precisely.
They are now sitting on excess reserves, money
they must use or lend to maximize their return.
To get rid of this excess liquidity, they lend
it aggressively to other banks in the overnight
federal funds market. And more supply means a
lower price. Exactly. An increased supply of
funds in that market causes the price, the federal
funds rate to drop. And since that rate is the
base cost of borrowing for the entire banking
system, the lower rate then ripples out, making
everything from mortgages to corporate bonds
cheaper. And conversely, if they want to raise
rates, they sell treasuries, which pulls cash
out of the system. It pulls cash out, tightens
reserves, increases the demand for overnight
lending and forces the federal funds rate higher.
It proves that while rates are determined by
real factors, they are heavily managed by monetary
policy targeting liquidity. That brings us perfectly
to the final, deepest section of our dive, the
great debates. We have now defined interest,
calculated it, and seen how the market prices
it. But we still haven't fully explained why
interest must exist. This is where economists
have fought for centuries. This is where the
core ideological conflicts lie. If you ask Turgot,
Keynes or Rothbard why interest exists, you get
three completely different yet compelling answers.
Let's start with the earliest scientific explanation
from the Enlightenment, the French economist
and Robert Jacques Turgot in 1770 and his fructification
theory. Turgot, moving away from moral arguments,
saw a scientific rationale for rates being greater
than zero based on opportunity cost. A key concept
we discussed earlier. He compared the loan rate
to the inherent reproducible return on agricultural
land or capital. He argued that if money wasn't
invested in a loan, it could be invested in productive
land. Yes. And his genius was providing a mathematical
proof for the necessity of a positive interest
rate. He focused on the concept of land value
as a perpetuity, a piece of capital that yields
revenue indefinitely. How does that math work?
The value of any perpetual income stream is calculated
by taking the annual yield and dividing it by
the prevailing interest rate. If your land yields
$100 per year and the interest rate is 10%, that
land is worth $1 ,000. Okay. Turgot argued that
if the interest rate mathematically approached
zero, the denominator in that equation would
approach zero and thus the value of the land
would approach infinity. A piece of land that
yields $100 a year would be worth an infinite
amount of money if the interest rate were zero.
Turgo argued this was economically and mathematically
absurd. Therefore, for the entire economic system
to make sense and for capital assets like land
to have a positive and finite price, the interest
rate must remain above zero. Moving forward a
century, we have a classical theory championed
by economists like John Stuart Mill, David Ricardo
and Irving Fisher. They saw the interest rate
as a market clearing mechanism. The classical
school argued that the interest rate adjusts
to maintain equilibrium between the supply of
loanable funds driven by people saving and the
demand for loanable funds, which is driven by
businesses investing. So the interest rate is
merely the price that balances the desire to
save with the desire to invest. Correct. And
the primary regulator of this rate, they argued,
was the marginal efficiency of capital, or MEC.
The MEC is the annual revenue yielded by the
next or extra increment of capital investment
expressed as a proportion of its cost. So if
a business expects a new project to yield a 10
% return, the MEC... They will only borrow money
as long as the interest rate is below 10%. Precisely.
They'll keep investing until the borrowing rate
equals that marginal expected return. The equilibrium
is achieved when the desired saving function
intersects the investment schedule. But John
Maynard Keynes, during the Great Depression,
famously leveled two major critiques against
this seemingly neat classical picture. Keynes'
critique was fundamental. First, he noted that
the classical theory fails to explain a clear
real -world observation. Why does an increase
in the money supply tend to reduce the interest
rate, at least initially? In their framework,
money supply is separate from real saving and
investment. He called this a circular argument.
Yes. And his second critique was structural.
The classical theory requires you to know the
interest rate to determine the scale of investment.
But the scale of investment is needed to calculate
the marginal efficiency of capital. He found
it was a circular dependency that was unsatisfactory
for explaining real economic cycles. So Keynes
shifted the focus entirely away from productivity
and saving towards something purely monetary,
liquidity preference. Keynes argued that interest
is determined not by the supply and demand for
capital, but by the demand for money for liquidity
and the supply of money created by the central
bank. Money, unlike a bond, provides immediate
flexibility and safety. It holds a liquidity
advantage. And interest, therefore, becomes the
reward you have to receive for parting with that
advantage. That's the essence. People demand
money for three primary motives. The transactionary
motive, money for day -to -day purchases, the
precautionary motive, holding cash for emergencies,
and the speculative motive. holding cash to take
advantage of future investment opportunities.
The higher the rate of interest offered, the
more willing people are to give up their liquidity
and buy a less liquid asset, like a bond. And
you mentioned he built on the work of Silvio
Gassel. We have to acknowledge Gassel. He was
a 19th century economist who theorized that interest
is a purely monetary phenomenon. He observed
that interest existed in monetary economies,
but seemed absent in pure barter economies. And
his theory was that money doesn't spoil. Right.
Unlike grain or milk, money doesn't incur storage
costs, which gives it a significant advantage.
Keynes recognized this insight, but clarified
the specific advantage of money as liquidity,
the ease of exchange and reduced risk, which
is why people are willing to pay a premium or
interest to borrow it. Moving on, we have the
Austrian School of Economics, represented by
Murray Rothbard, who rejected the entire focus
on the loan market as being, well, secondary.
The Austrian theory argues that the loan market
rate is merely a symptom, a manifestation of
a far deeper pre -existing economic reality,
the natural phenomenon of time preference. Time
preference being the psychological reality that
humans prefer goods in the present over the exact
same goods in the future. Absolutely. If I offer
you a glass of water now or two glasses of water
next week, most people will take the single glass
now. That inherent preference for present satisfaction
is reflected in all economic decisions. Rothbard
argued that focusing solely on bank loans misses
the fundamental point. So where do they see the
real rate of interest reflected, if not in a
bank contract? They see it in the price spreads
between the various stages of production. Think
of it this way. Consumers goods, like a finished
cake, are present goods. Producers goods, like
the oven and the flour, are future goods used
to create the present good later. The cost difference
between buying the finished product today versus
buying the means to produce it reveals the time
preference of society. That's the Austrian insight.
The price spread between the raw material stage
and the finished product stage is the true natural
rate of interest. This rate, driven by human
psychology, then trickles down and determines
the rate banks must charge. They criticized Keynes
for ignoring this fundamental psychological reality.
Finally, let's bring in Nutwicksell. whose work
provided a comprehensive theory linking the real
economy to the monetary one, distinguishing between
the natural rate and the nominal rate. Wicksell,
writing around 1898, introduced a crucial distinction.
The natural rate is the hypothetical equilibrium
rate of interest that would exist in a purely
barter economy. The rate determined purely by
real factors like productivity and time preference.
It's what the rate should be. And the monetary
rate is what banks actually charge in a cash
economy. Yes. And Wicksell's major insight was
that when the monetary rate diverges from the
natural rate, economic instability results. If
the central bank pushes the monetary rate below
the natural rate, making borrowing too cheap,
it encourages excessive investment and credit
expansion, causing inflation to rise. And conversely,
if the central bank holds the monetary rate above
the natural rate, it stifles investment and saving,
leading to economic contraction and deflation.
Wicksell's work was hugely influential. It provided
the conceptual framework for later theories and
demonstrated how the actions of a central bank
can either stabilize the economy by aligning
the monetary natural rates or destabilize it
by creating divergence. It is truly fascinating
that the same phenomenon interest can be attributed
simultaneously to Turgot's mathematical requirement,
to King's concern about liquidity, or to Rothbard's
deep psychological theory of time preference.
It underscores the complexity. Interest isn't
just one price. It's a reflection of productivity,
risk, expectation, and human psychology all rolled
into one. That brings us to our conclusion. We've
navigated a journey from a simple definition,
tracing its moral struggle back to Sumerian grain
loans, through the precise mathematics that led
to the discovery of the constant E, detailing
how market risk and central bank intervention
construct the final price, and finally, examining
the deep, conflicting economic theories that
still drive global policy decisions today. And
before we wrap, let's just revisit the idea of
an interest -free economy like modern Islamic
finance. While they successfully remove ruba,
the pure predetermined component of interest,
it is important to remember that financial institutions
still incur costs and risks. Right. We established
earlier that the total interest rate is actually
composed of four parts. Pure interest, a risk
premium, inflation expectations, and administrative
costs. In a Sharia compliance system, the pure
risk -free interest component vanishes by definition.
But the financial institution still needs to
cover its administrative costs and still deserves
compensation for sharing in the risk, which is
the risk premium. This compensation is simply
structured as a profit share or a lease payment
rather than a fixed interest rate. So financial
activity continues just under a different shared
risk. which brings us back full circle to the
philosophical and psychological root of all these
debates. the value of time. The theories we explored,
from the need to compensate a lender for deferred
consumption to the innate desire for immediate
satisfaction, they all boil down to pricing time
itself. Indeed. It's not just about money. It's
about human nature. Every economic decision you
make, whether to take a lump sum now or wait
for a larger annuity later, whether to pay off
debt early or stretch out the payments, is an
expression of your personal time preference.
So we leave you, the listener, with this final
provocative thought. Given that interest is rooted
in the intrinsic human desire for instant gratification,
preferring a good now rather than later, every
time you accept or charge an interest rate, you
are putting a tangible dollar value on your willingness
to pay or be paid to wait. What does your own
personal preference for time reveal about your
economic philosophy? And how will that dictate
your financial choices moving forward? Thank
you for joining us for this deep dive.