We wish to remove some of the mystery surrounding a) interest rates, b) the circulation of interest payments, and c) the ambiguity about the utterance rate of return associated with an investment.
In this initial section on interest rates and payments, key subtopics will be
- the rate of interest-return negotiated and charged on an individual loan – one type of “rate of return”
- the rate of circulatory returning of pure surplus income for re-investment – another distinct type of “rate of return”
- the functional flow of interest payments themselves as payments to the lender for the services the lender provides, functionally not different from payments to wage earners, managers or suppliers of materials for the services and goods they provide.
Clues from Webster regarding certain meanings relevant to an internal relation among functional flows of money. Functional Macroeconomic Dynamics calls this internal relation the “macroeconomic interest rate”:
- belonging to the essential nature or constitution of a thing
- not forming part of a thing, or on the outside of, a thing
- originating outside a part and acting on the part as a whole
- caused by factors or an agent outside the economic process;
- introduced from or produced outside the organism or system
We identify and equate the growth rate of an entire economic system or subsystem with the macroeconomic interest rate of that system or subsystem. The natural normative macroeconomic interest rate is intrinsic to the system. It is a relation among functional flows. It is a relational aspect of the essential nature of the system. As intrinsic, it is not extrinsic; i.e. it is not“ not forming part of “the system. It does not, either marginally or totally, “originate outside the system.” It is a normal aspect or normativity intrinsic to the system of which it is intrinsic.
If the real economy is growing at 3% per year, the real macroeconomic interest rate is 3%. This 3% can be divvied up among financiers into tranches receiving less or more than 3% depending upon the degree of risk assumed.
Any exogenous manipulation of any of the several relationship elements of the integral economic functioning would exogenously distort the natural interest rate intrinsic to the system. Conversely, any distortion of the intrinsic, natural interest rate would resonate to distort the entire system of interdependent flows of which it is an intrinsic part. The distortion would work its way through the system through a complex of stresses and strains.
The natural normative interest rate, as intrinsic and natural and normative, is not to be – marginally or totally – artificially dictated or effected or affected or modified by factors or agents outside the system. For central authorities to do so would indicate a misunderstanding of the economic process, or a careless contempt for the rules of the process, or a desperate move in the face of failure to utilize prior and more effective methods.
The formal cause of the economic process is the immanent intelligibility of the process. This formal cause is expressed in a coherent set of relational forms. This set constitutes the primary relativities of the system. As a unified and fully comprehensive set, it explains the system. It tells how the functional elements of the system interact. It tells how the system works. It is “a set of intelligible relations linking terms which are implicitly defined by the relations themselves; it is a set of purely relational forms. The form of any element is known through its relations to all other elements.”
Ought there not to be introduced a technical term to denote this type of intelligibility? The trouble is that the appropriate technical term has long existed but also has long been misunderstood. For the intelligibility that is neither final nor material nor instrumental nor efficient causality is, of course, formal causality…what we have called the intelligibility immanent in sensible data and residing in the relations of things to one another, might be named more briefly formal causality or rather, perhaps, a species of formal causality. [CWL 3, 78/ 101-102]
… again, as to the notion of cause, Newton conceived of his forces as efficient causes, and the modern mechanics drops the notion of force; it gets along perfectly well without it. It thinks in terms of a field theory, the set of relationships between nobjects. The field theory is a set of intelligible relations linking what is implicitly defined by the relations themselves; it is a set of relational forms. The form of any element is known through its relations to all other elements. What is a mass? A mass is anything that satisfies the fundamental equations that regard masses. Consequently, when you add a new fundamental equation about mass, as Einstein did when he equated mass with energy, you get a new idea of mass. Field theory is a matter of the immanent intelligibility of the object. [CWL 10, 154]
So, What is the macroeconomic interest rate? It is a relation intrinsic to a unified set of functionally related velocities. Our macroeconomic interest rate is the monetary growth rate correlated with the growth rate of productive output. Alternatively stated, it is the interest rate the lender can achieve by financing the growth rate of productive output.
Lonergan’s analysis fully appreciates the purpose, or end, of the economic process. His initial premise is the nature of the economic process as, simply, a concrete process of production and exchange, rather than a process of “exchange and self-interest, or later, exchange and a vaguely defined psychological situation.”
He adopts a heuristic to understand this particular concrete dynamic process and he orders his analysis accordingly. (See Why Analyze Production First)
But I must note immediately how intimately the ordering is within the perspective: “as the hypothesis is the principle in mathematics so the end is the principle in praxis”. 27 The movement of Lonergan’s analysis might be described as a paradigmatic descent from a concrete heuristic of the productive process determined by the end of that process. The monetary order is conditioned by, and correlated to, the rhythms of production adequate to the end. [McShane 1980, 125]
our inquiry differs radically from traditional economics, in which the ultimate premises are not production and exchange but rather exchange and self-interest, or later, exchange and a vaguely defined psychological situation. Our aim is to prescind from human psychology that, in the first place, we may define the objective situation with which man has to deal, and, in the second place, define the psychological attitude that has to be adopted if man is to deal successfully with economic problems. Thus something of a Copernican revolution is attempted: [CWL 21,42- 43]
Questions cannot be put in any order whatsoever. Some questions simply cannot be answered until others have been resolved. And sometimes the answers to one question immediately provide the answers to others. [CWL 12, 23]
… putting things in their right order is the special talent of the wise person, and so the wise person will start with the problem that is first in the sense (1) that its solution does not presuppose the solution to other problems, (2) that solving it will expedite solving a second problem, (3) that solving the first and second problems will lead right away to solving a third, and so on through all consequent connected problems. [CWL 12, 23]
Lonergan, first, observes dynamic interconnections, interdependencies, mutualities, and correlations within the productive process. He identifies productive rhythms determined by dependencies involving time lags; he formulates the dynamics of the current, purely dynamic economic process; then he analyzes the monetary circulations which meet the rhythms of production and sale; so that, finally, he can formulate the immanent intelligibility, i.e. the primary relativities, of velocitous flows of quantities and their prices, including the interest-price or opportunity-price of money. From this he can reasonably conclude that active manipulations of one particular flow among several constituent flows, in this context interest payments are inadequate strategies of adaptation.
Only later in the analysis can one arrive at an adequate account of the monetary distributions commonly called wages and profits. That account springs from a characterization of possible types of productive rhythms which lead to the specification of the adequate human adaptation to the demands of the process, and also to a determination of inadequate strategies of adaptation such as variations of interest rates, varieties of taxation and monetary policy. [McShane 1980, 125]
McShane hints at misconceptions regarding interest rates and their manipulation stemming from failures to analyze the functional process as current, intrinsically cyclical, having laws prior to and independent of human psychology, and including government as we-individuals-collectively. The conceptual errors of the flawed theories of academic economists are many and they include
that investments equal savings; that interest rates call the play; that retained earnings are key; that gold grounds confidence; that government is the mother of progress. [McShane 2017, 67]
… please do not slip into that cloudy zone of some economists, the reward of waiting, turning interest and its fluctuations into mysteries of expectations or animal spirits or monetary policy. [McShane 2017, 55]
McShane attributes particular conceptual errors proclaimed as true every day by schools of macroeconomics:
A range of difficulties can occur to you at this stage, especially if you are versed in the strategies of Keynesians or /Friedman, or share common clouded notions: that investments equal savings; that interest rates call the play; that retained earnings are key; that gold grounds confidence; that government is the mother of progress. [McShane 2017, 67]
Consistent with our insistence on functional macroeconomics as an explanatory science, rather than simply describing all interest rates as a sum of a risk-free component plus risk-filled premiums for inflation, business risk, political risk, and foreign-exchange-rate risk, we shall distinguish between
- the quantity called the microeconomic contractual interest return negotiated and agreed to on a particular loan, and
- the explanatory aggregate identified as the expanding and tapering flow of macroeconomic investment principal returning to the entrepreneurial group as a whole.
We shall explain the latter as the current normal circulatory returning of investment funds to entrepreneurs as a group as normal in an economic expansion.
The reader may be familiar with various conventional formulae embodying the microeconomic interest rate charged on a loan or bond, where P stands for principal, i stands for the interest rate, (r = 1+i) stands for “interest factor”, tis the subscript for time, and e is the base of the natural logarithm.
Simple interest: Pt= Pt-1r
Compound interest: Pt = P0rt
Continuous interest: Pt= P0eit
These conventional microeconomic formulae are not made up of explanatory conjugates of the entire system; they are isolated microeconomic calculations by and for investors, borrowers, and speculators; they do not explain all, or even part, of the entire system; they do not constitute all or part of the immanent intelligibility of the economic process; they do not fully explain the current, purely dynamic economic process:
The flows called interest payments are not functionally different from the flows of payments for labor, legal fees, paper clips, etc.
The explanation of the whole functioning process must be based upon terms of systematic significance, scientific significance, explanatory significance. The isolated microeconomic calculations of bankers, businessmen, and speculative investors do not qualify as elements of systematic, scientific, and explanatory significance. Instead, the whole process must be understood as an intelligible unity of interconnected elements; it must be formally explained by a cluster of explanatory relations forming a single unified understanding. Terms must cohere in individual equations; and equations must cohere with one another in a comprehensive unified explanation. And the unified set of relationships will constitute a theory.
If, in contrast, the productive and monetary functionings were a mere congeries of isolated pieces, there would be no organic whole being explained.
Now the general theorem of continuity is that this (organic whole) has a nature that must be respected. … to violate this organic interconnection is simply to smash the organism, to create the paradoxical situation of starvation in the midst of plenty, of workers eager for work and capable of finding none, of investors looking for opportunities to invest and being given no outlet, and of everyone’s inability to do what he wishes to do being the cause of everyone’s inability to remedy the situation. Such is disorganization. Continuity, on the other hand, is the maintenance of organization, the stability of the sets and patterns of dynamic relationships that constitute economic well-being in a society. [CWL 21, 74]
The utterances “return” and “rate of return” are used to denote several different economic phenomena. We will mention four. The reader is, no doubt, familiar with the first three phenomena; the fourth is specialized and unfamiliar to all but a few.
Each of the first three is an income-statement, microeconomic, periodic money payment associated with a specific investment. It is usually called interest:
- the specific type of contractual interest – as a charge of rent for the use of money (and, virtually, for denial of what the money could otherwise finance) – charged on a loan for current working capital or a loan for the financing of a long-term project,
- the broader types of the “interest return” commonly called either “retained earnings” or “dividends” allotted to shareholders for rent of their assets previously-installed, and now continually owned and rented out, by these shareholders,
- in the financing of a non-interest-bearing bond sold at a discount, the realizable contractual price appreciation is the specific type of interest-return
The next conceptually different type of return can be understood only within the theory of Functional Macroeconomic Dynamics. We may call it ”macroeconomic return.” It is by nature a current “circular return” of current investment monies to entrepreneurs in the aggregate. They are not receiving simple interest on a loan or equity investment; rather in their responsibilities as entrepreneurs they are receiving monies to be reinvested.
In this case, we have taken the utterance “return” and used it to denote the phenomenon of income whose sole purpose is investment in expansion. We have added another meaning and employed it to denote a determinate, current, aggregate, functional flow of pure surplus income for expansionary investment. In our somewhat narrow distinguishing sense, it is not a contractual return on past investment. It is a current flow to entrepreneurs as a group for reinvestment by entrepreneurs. It is the pure surplus income which finances an expansion redounding to the material and social benefit of society.
Since the monies return to entrepreneurs, they may be misinterpreted as returns on past entrepreneurial investment. They are no such thing. Macroeconomic return is a flow of so much per period; it is a rate; it is a ratio; it is a dx/dt or Δx/Δt. Therefore, this circulating pure surplus income called the “macroeconomic rate of return,” is a specific technical and explanatory meaning of the general utterance “return.”
Rather than speak of a rate of return and risk ambiguity from misinterpretation, we might, using a time interval as the denominator, give it a specific name such as the Lonergan-Burley Ratio. A new name should perk up and prompt politicians, journalists, and academics to recognize a new explanatory concept; and it might prompt them to seek a scientific understanding of the velocitous functional relations, intrinsic to which is the “macroeconomic rate of return” of the current, purely dynamic process.
So, our fourth meaning of “return” is
d.) each period’s current return of pure surplus income to entrepreneurs-investors (as a group) for further expansionary investment
We should note here that this last meaning is a staple in Burley’s analyses. But it is not commonly used in the everyday parlance of TV talk shows’ so-called experts. This explanatory concept gets no currency.
Now it is true that our culture cannot be accused of mistaken ideas on pure surplus income as it has been defined in this essay; for on that precise topic it has no ideas whatever. [CWL 15:153]
This pure surplus income is quite an interesting object. When vis greater than zero, it is a rate of income over and above all current requirements for the standard of living, since that is provided by I’, and as well over and above all real maintenance and replacement expenditure, since that is provided by (1-v)I”. Thus one may identify (current) pure surplus income as the aggregate rate of (current) return (of current) capital investment: [CWL 15, 146]
Yet, as explanatory, it deserves understanding, recognition, emphasis and respect. It is a special functional macroeconomic meaning for the bare utterance “return” to designate “current return for reinvestment”. And, since the return is at a rate with respect to time, there is a rate of return.
Key notions include the notions of
- current circular return
- current circular return to for the purpose of reinvestment.
In order to understand macroeconomic return with respect to its source, its purpose, and its manner of circulation, we present a simple table. In the table, credit is issued by the banking system each period for expansionary investment; previously-issued expansionary credit goes from outlays to incomes to expenditures to receipts; i.e. it circles back for reuse. However, two brakes get applied gradually to the expansion: First, marginal productivity declines as the field of opportunities for expansion gets saturated; second, the repair and maintenance requirements of the accumulated expansion mount with mounting investment to make accumulating monetary claims in the process. In the limit there are a) no further expansionary opportunities, b) the credit money outstanding getting directed to R&M just to maintain capacity.
We must be careful not to confuse the recircling of principal amounts, which we call either pure surplus income or returning growth money, with the charged interest (return) on the principal amount. With this proviso in mind, we will pursue throughout this section a scientificunderstanding of a) the nature and purpose of credit, and b) the nature of the phenomenon of the macroeconomic return, including
- The norm and rule of expanding the money supply in an expanding economy by properly infusing the productive process with interest-bearing credit money; i.e. we seek to understand the nature and purpose of new credit money
- The repetitive circulation in the surplus circuit of the aggregates of principals of loans-for-investment
- The circulation in the operative circuits of the interest-payments associated with credit money
- The formulation of the nature of the macrodynamic return; i.e. the natural macroeconomic rate of return as normative and intrinsic to the economic process
- Artificial exogenous manipulation of endogenous normal and normative macroeconomic interest rates as double-edged, distortive, and counterproductive
- The concept of the rate of the current circular returning of pure surplus income for investment as the current macrodynamic rate of return
To anticipate and preview one future conclusion: To avoid or correct the divergences and distortions colloquially called a “bubble-boom” or “recession-slump,” the managers of the economy should implement “factors that are prior to changing (transitive) interest rates and more effective.” As McShane said above, manipulation of charged interest rates is an inadequate strategy. Interest rates do not call the play. They are not the quarterback.
Traditional theory is faulty and deceptively ineffective. There are factors that “are prior to changing interest rates and more effective.”
Traditional theory looked to shifting(i.e. actively manipulating market) interest rates to provide suitable adjustment. In the main we shall be concerned with factors that are prior to changing interest rates and more effective. [CWL 15, 133]
Manipulation of interest rates, in an attempt to adjust savings upward or downward, so as to damp an inflationary economy or to stimulate investment in a slow economy, is based on a misunderstanding of both the double-edged nature of changing rates and the prior and more effective strategy of adjusting savings directly through the income flows in conformity with the requirements of the process.
The purpose of this section is to inquire into the manner in which the rate of saving wis adjusted to the phases of the pure cycle of the productive process. [CWL 15, 133]
The manipulation of interest rates is doomed to involve adverse effects.
Traditional theory looked to shifting interest rates (to manage the economy). The difficulty with this theory is that a.) it lumps together a number of quite different things and b.) it overlooks the order of magnitude of the fundamental problem… [CWL 15, 141-144]
Manipulation of interest rates “overlooks the order of magnitude of the fundamental problem.” In a surplus expansion, much money which should be saved for investment gets misdirected into the basic circuit for purchase of consumer goods to cause inflation therein and, thus, to reduce purchasing power.
it would take enormous interest rates backed by all propaganda techniques at our disposal to effect the negative values of dwi (where w symbolizes the propensity to consume of an income stratum i) that are required interval after interval as the surplus expansion proceeds; what is needed is something in the order of ‘incentives to save’ that is as rapid and as effective as the reduction of purchasing power by rising prices. … [CWL 15, 141-144]
The ineptitude of manipulating interest rates::
The ineptitude of the procedure arises not only from its inadequacy to effect a redistribution of income of the magnitude required (in the current phasic configuration of the process) … the effect of raising interest rates to encourage savings (for investment) is not to keep the rate of saving and the productive process in harmony as the expansion continues but simply (and counterproductively) to end the expansion by eliminating (by discouragingly higher interest costs) its long-term elements. [CWL 15, 141-144]
Conversely, the effect of reducing interest rates when savvy entrepreneurs find little reason to invest would be to stimulate an expansion of unsound investments by the non-savvy and opportunistic which are economically unjustified and, in the longer run, destined for default.
There are “factors that are prior to changing interest rates and more effective.” And perhaps we should say that these factors are mandated by a purely scientific Functional Macroeconomic Dynamics rather than by psychopolitical dispositions.
To increase the rate of saving (in a capital-goods-expansion phase), increase the income of the rich (who have a lower average propensity-to-consume percent). … to decrease the rate of saving (in a consumer-goods-expansion phase), increase the income of the poor (who have a higher average propensity-to-consume percent). … The foregoing is the fundamental mode of adjusting the rate of saving to the phases of the productive cycle. It reveals that the surplus expansion is anti-egalitarian, … but it also reveals the basic expansion to be egalitarian, for that expansion postulates that increments go to low incomes … [CWL 15, 135-37]
(In a capital expansion,) unless the quantity of money in circulation expands as rapidly as prices rise and, as well, as rapidly as the productive expansion of quantities requires, there will result a contraction of the process: then, instead of adjusting the rate of saving to the requirements of the productive cycle, the productive cycle is arrested to find adjustment to the rate of saving. [CWL 15, 135-37]
Proper cyclically-aligned shifts – antiegalitarian and egalitarian – in the distribution of income are “prior to changing interest rates and more effective.” But the egalitarian shift to higher basic incomes must be effected rather than resisted. Otherwise there occurs recession. Prior and more effective than manipulating interest rates is the proper cyclically-aligned shift in the distribution of incomes. This is not in any way a mere politically motivated statement; it is scientific, functional, macroeconomic dynamics.
… the root of the failure of the (macrodynamic) mechanism is the failure to obtain the anti-egalitarian shift in the distribution of income (so that aggregate basic incomes provide adequate demand for the increased quantity of consumption goods). [CWL 15, 138]
Again, the manipulation of market interest rates is, by its double-edge, ineffective and counterproductive.
Rates of interest, when increasing (by artifice), encourage saving (but perhaps assymetrically discourage borrowing). This double edge is not the per se means of effecting the enormous shift in saving to bring about the transition from a slump or a basic expansion to a surplus expansion. What is needed is a contraction of purchasing power that will direct spending from the basic market of the poor to the surplus market of the rich. The surplus phase is anti-egalitarian…….
Similarly a(n artificial) lowering of interest rates may encourage the expansion of basic industry; but it also will encourage the expansion of well-intentioned but not well-thought-out innovations, the number of bankruptcies, etc. What is needed is the egalitarian shift in incomes, that will compensate for the previous and shorter anti-egalitarian shift, and will (use recently-expanded capacity to) produce the things that people really need and can learn to purchase. [CWL 15, 141 ftnt 198]
The daily or weekly impact on operations of a changed annual rate of interest is small (di/365 or Δi/52) but the n-year operating cost is large (n(di)). The short-term affect is weak; the long-term affect is strong and significant in analyzing investment prospects.
When the rate of savings is insufficient, increasing interest rates effect an adjustment. This adjustment is not an adjustment of the rate of saving to the productive process but of the productive process to the rate of saving … it does not deserve the name adjustment. It is delayed because the influence of increasing interest rates on short-term enterprise is small. It does not deserve the name ‘adjustment’ because its effect is not to keep the rate of saving and the productive process in harmony as the expansion continues but simply to end the expansion by eliminating its long-term elements. [CWL 15, 144]