October 6, 2015

Objective determinants of profit and interest

Comment on Peter Radford on ‘Interest Rates’

Blog-Reference

You write ‘Banks would be more profitable if rates were higher.’ This is not correct. The profitability of a single bank depends on the spread between the rate it receives on the asset side and the interest it pays on the liability side (plus nonmonetary profit/loss from changes of value). In principle, the absolute height of the interest rate as set by the central bank is not decisive. The spread is decisive.

Secondly, if the spread (times volume) covers exactly the costs the profit of the bank is zero. Therefore, there is no direct relationship between the absolute height of the rate of interest and the profitability of a bank.

In addition, it is the term structure of assets and liabilities that influences the spread. Example: if a bank makes a loan with a fixed interest rate for ten years and refinances this loan with a bond of ten years it secures a fixed spread for ten years. However, if the bank refinances the loan with a bond with a fixed interest for five years it can increase the spread and by consequence profit for the first five years.

The crucial point is that, in the given example, the bank deliberately produces risk. Because, if the rate of interest is higher after five years the spread is reduced. It may even happen that the bank makes a loss or goes bankrupt in the worst case. On the other hand, if the market rate after five years is lower than in the initial period the spread widens. In other words, by setting the actual rate to zero the central bank immediately helps all banks with an incongruent term structure.

Strictly speaking, the term structure of both sides of a bank’s balance sheet should be identical. In this case there is no risk other than normal credit risk which is covered by the spread. A well organized banking system is defined by a legal framework that secures a congruent term structure. The first thing to notice is that the monetary system of the U.S. is not well-organized. The banks increase their spread on a regular basis by taking in ‘cheap’ short term liabilities and giving out ‘dear’ long term loans. This worked fine in the last decades with a continuously falling interest rate. Now, if the market rate increases the banking system automatically faces troubles which are ultimately due to a poor institutional design.

The institutional setup of the U.S. monetary system is a historical accident. Theoretical economics, though, is concerned with the essentials of the monetary order in general. Therefore, the first task is to clarify the interrelationship between profit and interest for the monetary economy as a whole (2011a).

Economic theory does not consists in second guessing bankers or the FMOC (greedy, bonus oriented, corrupt, stupid, etc). Folk psychology, moralizing, or reading the Fed chair’s mind does not tell us whether the rate of interest is ‘too low’ or ‘too high’.

The first mistake of monetary theory is to start with a single bank and then to generalize. This is the fallacy of composition. Theoretical economics has to start with the economic system as a whole and the creation/destruction of money by the consolidated banking sector (central bank plus all other types of banks) (2011b; 2011c). The development of the respective stocks of credit/debt crucially depends on saving/dissaving of private/public households.

Loosely speaking, the nominal rate of loan interest depends in the most elementary zero-profit case on the (average) wage rate and the productivity of the banking sector. In this benchmark case the interest on deposits is zero. The money of savers is — in a well-organized economy with a money/credit creating banking sector — not needed to finance investment.

In sum, because profit theory is false, interest theory, too, is false. This holds for Orthodoxy but, unfortunately, also for traditional Heterodoxy.

Egmont Kakarot-Handtke


References
Kakarot-Handtke, E. (2011a). The Emergence of Profit and Interest in the Monetary Circuit. SSRN Working Paper Series, 1973952: 1–22. URL
Kakarot-Handtke, E. (2011b). Reconstructing the Quantity Theory (I). SSRN Working Paper Series, 1895268: 1–28. URL
Kakarot-Handtke, E. (2011c). Reconstructing the Quantity Theory (II). SSRN Working Paper Series, 1903663: 1–20. URL