Taking the risk premium seriously

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One of the main obstacles to gain insights to the economic subject is rooted within the dogma of "methodological individualism". Therefore as one might expect, any theory about interest rates have something to do with the introspection of individuals, how the time preference today after shaving and having breakfast appears. This may be a nice journey of self-exploration but with these considerations you lose a significant function of interest rates for a monetary system. Although the interest rate is mostly cited what one might expect as the risk premium, but the focus of reasonig is with the enhancement of income while the immediate consequences with respect of simple accounting are mostly missing. The course has its reason because the postulate of "methodological individualism" prevents to consider something non individual as economic relevant. Behind there is nothing more than the simple postulate hidden, that everything apart from the choice of an individual decision will not explain any economic matter; the art of economics depends on the outcome of choices, no more no less. With such a flaccid postulate, for example, is explained, why the DSGE models should be the nonplusultra economic theory or why arguments that are derived from balance accounting are discredited with the remark: "That's balances mechanics" with the accusation to ignore the ‘true’ foundations of economics. Completely ridiculous acts such accusation against the background that, according to "methodological individualism" an adequate analysis of macroeconomic processes should be ensured by the fact that only the micro-economics-based choice decisions of a "representative agent entity" are to be considered. (This is the logically inconsistent demand for a "micro-foundation of macroeconomics"!) As many times before, the question must be raised of how the relationship from the part to the whole is structured. The warning from Bateson might give some impression of the shortfall of a whole science: "Insofar as the behavior scientists still ignore the problems of 'Principia Mathematica', they can claim to be 60 years behind. "(The book where this quote comes from is from 1972!)

Now indeed a characteristic of interest is to be an indicator of the risk of an investment decision, that proposition is relatively uncontested. It's not that individualistic issues were not economically productive use. What is at issue here, however, is the question of what is to be derived from this property. Somehow the consequence of the existence of a risk premium should be accepted because it has to have a specified function and can not only be an argument for defining interest as risky source of income. This means that the interest component, which is linked to the risk premium, has to be connected to another consequence than that to stylize interest as an income item. This is about the despicable fact that - to avoid the well known mistake of mixing up gross income and net income - to calculate income it is necessary to compensate the losses, which are due to written-off receivables. This means that interest, as well as all other income must serve first and foremost to cover the expenses from credit losses. The inevitable consequence of this is that interest immediately help to offset realized losses of the banks from credit write-offs.

„If the individual cannot make the repayment, they, the bank - not those who have supplied him with goods - bear the loss. They know, of course, that there are certain contingencies in which the individual will not be able to repay the indicated amount; and they accordingly charge him an insurance premium: When he can repay, he repays more than he would if there were no risk associated with his repaying. It is not an easy matter to provide appropriate incentives for information providers to evaluate accurately what the appropriate insurance premium should be and to communicate that evaluation. Functions of providing insurance and obtaining information about the borrowers’ riskiness are linked so that the supplier of information (the bank) bears the cost - the loss in returns resulting from default - for any failure to obtain accurate information.“ (Stiglitz/Weiss 1988, S. 15f)

This has direct consequences for a theory whose focus is mainly seen in an interest income for savers, which is what is also suggested by the prevailing monetary theory. It is this theory that the savers are the source of money for lending and therefore would have to be "incited" the provision of savings, the godfather theory for the rock-solid conviction that savers would have to take an interest. Of course this idea is also suggested by the central theory of capitalism (by the way socialism fits better into it), the general equilibrium theory, where the private agents lend their resources (the initial equipment) to a company against a premium, which has to be refunded later. In the same direction aims the theory of multiple creation of money, whose credo is fed from the believe, that money is handed over from the deposits of savers to the deposits of firms, over and over again. (The “money multiplier” does not exist, ist is essentially a credit multiplier while the amount of money in this process does not alter a penny.)

What are the consequences which follow from the perspective of interest income as compensation for failed credit exposures? For this purpose one must first of all realize what a loan amortization means. It means that a borrower has taken a quantity of money to activate resources to some use, where his competitive offer of produced goods was successfully presented at the market. This means that the mechanism which gives the credit its "value" - that is interest and principal (re)payment are delivered - has worked. For this it is essential to recognize that debt service alone is enough pressure for firms to offer real benefits (goods and services) against an intrinsically worthless money, because it has to cover costs, achieve interest, amortization, and (hopefully) a profit from the loan. Contrary a credit which cannot be served means that the loan which financed the hopeful investment has proved later to be a mere consumer of resources and a waste of money - well the money itself is not lost, it is “only” in somebody elses pocket. This results in a loan volume which is "too much" within the economic framework, which does not contribute to the creation of a sufficient amount of social valued supply of goods. The neutralization of this "excess (wasted) credit volume" is ensured, when earned interest payments are used to compensate for this consumptive loan. This means, that the interest payments received must compensate for the not paying “receivables” to restore at least the principal paid out at the beginning of the loan.

This means, however, since even successful entrepreneurs pay interest, that interest rates partly can be viewed as an overall social insurance premium which must be paid by all borrowers, even though only (hopefully) individual borrowers go into bankruptcy, leaving unpaid credit lines. This can be compared very nicely with the car insurance, as this example is for most people best known as risk insurance. A risk insurance is characterized in that it uses the premiums of the policyholders, to cover the damages caused by individual accidents caused by members of this insurance community. The principle is that all contributions of all policyholders pay for all accidents of all community members. It is essential to consider another special aspect with regard to the interpretation of interest payments as an insurance premium: whenever the risk or likelihood of damage increases, the premiums for this insurance tends to rise, as a higher claims volume must be covered. Taking this into account and transmitted to the conception, to see interest rates as insurance premiums, it becomes clear at once that if the probability of loan defaults rise (typically in a crisis / recession), the corresponding risk premiums / interest charges tend to rise as well. (This may take the form of higher collateral or longer repayment periods, which result in higher interest costs.) In this respect, it seems quite touching, that unisono the postulate appears that the central bank in a recession must cut rates in order to "make the money cheaper" to generate the effect that companies will therefore invest more. That the central bank can indeed do this is clear, but still in a crisis have a negligible effect with respect to the probability of credit losses, while a positive probability accompanied with positive expectations with regard to future profits is an essential prerequisite for the transmission of the cut of the central bank rate to a lower interest rate for borrowers. (In effect mostly banks are profiting from interest cuts of the central bank - a subsidy to compensate the credit write-offs.)

When banks start to cut their interest rates, then for another reason: namely, when the prospects for profitability of investment returns improve and the competition for the "best" borrower begins which is normally accompanied with ever better interest rate bids. The reason for this is, that the reduction in the probability of credit losses (something like the "financial damage") makes room for these improved interest rates. The latter, however, works only if the covered "financial losses" from former engagements are largely offset by sufficient future interest income and not yet stored in the books latent risks, which make a provision for "damage prevention" virtually impossible. Unfortunately, a declining discount rate does not translate automatically into a generous cut in interest rates in loans and is to be interpreted according to the above findings as well as blue-eyed wishful thinking only of central banks. That the usual justifications for the widespread reluctance in lending then the effect be that the business is located in a constellation of the "liquidity trap", only proves that the prevailing macroeconomic thinking has not yet progressed beyond the consideration of intrinsic motivations of individual economic agents.

This perspective on the true nature of interest also sheds light on the theory that attempts to derive interest from the interaction of supply and demand. For what - to get away from times of crisis - happens in a recovery? The money supply would fall, driving up interest rates on loans in the amount due to the higher propensity to spend and the corresponding decline in propensity to save, as well as a higher money demand due to a higher propensity to invest, the interest rates would be rising. Although one can econometrically pretty much deduce everything, but the rate cut trends in banks in a recovery are relatively obvious, while the rate hike tendencies of a central bank, supported by a motivation to prevent "overheating of the economy", however, but seem relatively cute and their intended effects regularly miss. Conversely, vice versa.

Perhaps a final word to the initially mentioned criteria for what is economic and what is not. The view presented here is therefore never be accepted as economically, because what is presented here is a departure from the "methodological individualism" and is therefore prohibited in the "mainstream economics” from the outset to be taken seriously. Now a methodological principle is no divine law engraved on a stone tablet, but a specific type of production of knowledge, which of course not prevents that non-individualistic recognition methods can provide valid evidence for new knowledge bits. Although the prospects for this aspect of the theory of interest may not seem as rosy one thing will surely not happen: that the principle of risk insurance is rejected from the economy, because it can hardly be derived from individual preferences. Although, one knows economists can deduce anything if the set of assumptions is twisted in the “right” way…