Red Hot Chili Peppers

Since mid-day yesterday, and the release of the current FOMC notes, Mr. Market has been doing a Norman Bates berserker. Therein lies a tale.

A few miles from the drafty garret in which I type this deathless prose lies the remains of Scovill Corporation. Scovill was the spawn of Mr. Wilbur Scovill. Scovill, the company, made brass widgets and from there some consumers goods. Scovill, the person, is better known for his scale of chili pepper heat. The way I've come to know the Scovill Scale is thus: people are asked to compare two glasses of water, one of which is pure (or with sugar) water, the other of which is water that's been doused with chili pepper. The ratio of water to chili when the tasters can't tell the difference is the Scale number for that sample. Simple enough.

The same could be said of interest rates, in the pure sense: what is the amount of interest needed to persuade people to forgo payment today until some time in the future? Of course, the simpleminded answer is: "more, lots more". But to get the real number, one has to either intuit, or experiment; find the Scovill Number (in the heads of savers) for money. Economists call this the time value of money, or more accurately, rate of time preference. Finance folks tend to view the definition the other way round: the available no-risk interest rate, take it or leave it. Note that this has nothing to do with deciding what to do with the money twixt now and then. Interestingly, WikiPedia falls down this time. The article is written, I suspect, by a finance graduate, not an economist, since it *assigns* earned interest as value. That's not what the time value of money is, which is the premium that must be paid for time not holding the money.

Long term interest rates on no-risk (do such exist?) bonds (typically, government) is most often taken as a proxy for this time premium. By that measure, how are we doing? Here's a section from WikiPedia on interest rates. And a short quote: "...the Austrian School of Economics sees higher rates as leading to greater investment in order to earn the interest to pay the depositors." The problem with that assertion, of course, is that fiduciary manipulation doesn't, and never has, generated real returns in the economy. No amount of fiduciary meddling will create another Edison or Einstein. Real returns come from technological improvements; new plant and equipment yield more bang for the buck and thus generate real returns on real investment. No matter what the Right Wingnuts say, that last clause is all one needs to know.

What we know now, without question, is that it is much, much easier to generate higher monetary returns through financial corruption than it is by inventing new, superior technology. The former requires only stealth, while the latter requires intelligence. One is more common than the other.

Once again, back to the Wiki; here's a precis of 19th century US monetarism. I don't know the provenance of this page, but it provides a list of interest rates going back to 1800. It does show, although to a lesser extent than I recall reading elsewhere, that long term interest rates in the 19th century were at times below short term. Orthodox economists deny that can happen. It was true that much of 19th century USofA was deflationary. Why? The usual suspect is gold. It is in limited supply, so as economies grow, deflation has to occur; only so much to go around. The Right Wingnuts don't wish to understand that, of course.

The basic notion that long term interest rates are necessarily higher than short term has been debated. On the face of it, it isn't the term of the investment which determines the value (rate of return), but the quality of the technology weighted by its market control (monopoly and monopsony; oligop- versions as well). A short term investment which enables a high return quickly is more valuable than a cruder, but longer lived, investment. In the world of IT these days, a couple of fiscal quarters is all one gets.

So, what then is the time value of money? It seems to be about 2 to 3%. Current rates, with near deflation, aren't so far out of bounds.