 Well, good morning. It's time for us to start this session on theories of the rate of interest. You've covered a lot of ground in two and a half days, and hopefully you've seen that the causal realist or Austrian, the Hungarian, Misesi, and Austrian approach, emphasizes or holds up as the basis for economic analysis the real human person engaged in real human action. And the study of economics is what laws of operation of the human mind are in motion through action to organize the elements of the real world external to the mind as means for the attainment of ends. And this becomes particularly interesting when we're talking about a society where we have lots of different people, right, who interact with divergent skills and goals and so on. So we've covered a lot about this week so far about these laws of utility, the laws of valuing things and choosing, and you talked some about how the human mind through human intelligence is able to perceive how objects in the world can be used as means to the attainment of the things that they value, the ends that they value. How as human beings we have the ability to make judgments and to prefer one course of action to another, one set of means to pursue an end as opposed to another set of means. We have the creative imaginative ability to anticipate the outcome of particular courses of action into this entrepreneurial element that you've heard about and arrange for an economizing result. So this is the groundwork that we've built up to this point. What we haven't spent too much analytical time discussing though is the element of time. And some things have been said about this, but in this talk we'll flush this out to a greater degree. And just like with these other elements that I've spoken about, we want to begin with the human person. We just want to think about how is it relevant, how do we see it in the logical sense, how is it logically related to the way in which we act through our valuations of things. And then we'll see how this manifests itself on the market. And so this is always the way that we proceed in economic analysis. Now let me introduce a few terms just so we can make distinctions that are necessary in this process. When we talk about the human valuing of action with respect to time, there are two distinct elements of this, two distinct aspects of valuing action with respect to time. The first we'll call, by the way, this terminology I'm following Frank Fetter, who was the great American economist of the Austrian school in the early 20th century. And Fetter says that on the one hand we have what he calls time value, and by that he means the timing of an action. So a given action might have different value for us depending on when we take the action in time. And so we can value the action with respect to its temporal placement in time, today or tomorrow or the next week or at 11 o'clock or at 12 o'clock or 9 o'clock or that sort of thing. And then the second valuing aspect of time is what is called time preference, and hence we get the title here of our talk. And time preference is obviously related to the interest rate, or this is the argument that you'll entertain here. But anyway, time preference does something different. Time value again says I have a given action that I can possibly take at different moments in time, and then I value taking that action with respect to my judgment as to how much value I would get or satisfaction I would get from taking the action today or tomorrow or at 11 o'clock or 12 o'clock or whatever my choice parameters are. So it's a given action that might have different value at different moments in time. Time preference does something else. It's entirely separable conceptually. Time preference says, suppose I take an action and I get a given satisfaction no matter when I take the action, no matter when I get exactly the same satisfaction. I can take the action today or tomorrow or the whenever, but the satisfaction is exactly the same. Then the question is, for a given satisfaction, would I prefer to have this satisfaction sooner in time or later? If I can act to get a given benefit in the abstract now, would I prefer this benefit sooner as opposed to later? Now this we call the inter-temporal dimension of time. So we have a temporal dimension and an inter-temporal dimension. This is just terminology. So we're just defining the relevant concepts. Okay, so now let's go on to the analytical part. We're not going to spend very much time with the temporal aspect of action as I've defined it, the timing of an action. This is a very interesting area and we would cover this actually in financial markets. This is the basis for forward transactions in financial markets. And so this is a very important area of economic analysis, very important area of the real world. We have financial markets and futures and so on and we want to be able to analyze all this. But here we're just going to mention this for contrast to inter-temporal valuing. Just so we're very clear that we're not mixing these things together, right? It's very important that we keep them analytically separable. Okay, so we mentioned already that the temporal aspect of action has to do with taking a given action at different moments in time and getting a different value. Just to give you a simple illustration, my wedding anniversary is August 18th. August 18th, 1983. Okay, so my wife and I will celebrate our anniversary. Now, we could choose to celebrate the anniversary. I could choose to kind of surprise her and have an anniversary party for her any day of the year. Right, I could do it tomorrow. But I know that the value of doing it will not be the same. If I do it on July 28th, she would look at me. She might think that's sweet or something, but it's more meaningful on the anniversary date. So that's what we're speaking about. We have a given action, but the value that accrues to us is different depending on when we take it. Okay, and so what we do, of course, is we allocate then our resources with this in mind. There are other aspects of valuing with respect to action as well. If we're just thinking about this element of time, the timing of an action, we'll tend to take an action at that moment in time when we think the value is the greatest. There may be other things that we consider when we actually choose, right? But that would be part of the decision-making aspect. Now, when we do this, if it's possible for us to engage in additional action, in my example, that wouldn't be, well, it would be silly for me to try to do that, right? We'd celebrate our anniversary, let's say, at five o'clock in the evening on August 18th, and then when we got done, I'd say, let's do it again at 10 o'clock. So that would be silly, but the reason it's silly is because of diminishing marginal utility, right? The utility diminishes for the same unit of the good, an additional unit of the good. So you've dealt with that principle before. So that's what happens when we allocate with respect to timing, right? The diminishing marginal utility occurs, and so we allocate through time this temporal aspect in such a way that we balance the marginal utilities across time, just like we would balance the marginal utilities across goods, right? So it's the same principle that you've heard already is just now applied with respect to time. Now, I mentioned how this manifests itself in the market is in forward prices. Let's say, for example, I'd say the speculators in the oil industry think that the cheap oil's over and the next six months the demand's going to go up or there's going to be supply disruptions or something. And so they think that six months from now the price of oil will be much higher. Well, then they can engage, you know, if the actual forward price was pretty close to the spot price of oil, then arbitrage that difference, right? Because they think the price six months from now will be much higher. They can engage in forward contracts. This is what they would do to acquire oil in the future at that lower price that the market is assessing the oil. And then they think it's going to occur, right? But as they do that, they bid the price up. The increase in demand and then the forward price would be bid up. As the forward price is bid up, then the suppliers will supply more into the future, right? They'll agree to these forward contracts and they won't supply the oil today. They'll supply it six months from today. They'll enter into these contracts because, again, they're arbitraging this. They're earning profit by doing this, right? They're just arbitraging the oil. And so that process is constantly going on in financial markets. This process of temporal arbitrage, right? And this is bringing about efficient allocation of the resources for temporal allocation. So the market is even efficient in this respect. But, again, as I said, this is just an ancillary point to our talk. We want to focus on intertemporal action. And this is intertemporal action comes from time preference, which we've already pointed out is a separate valuing aspect of action with respect to time. Here's the definition, again, of time preference. The satisfaction of an end, a given satisfaction from attaining an end, sooner is preferred to the same satisfaction later. This is an abstract point, right? It's a Seder's Paribas claim. It's a conjectural claim. Now, it should be pointed out that this claim is embedded, though, in the logic of action. We're not talking about psychological dispositions. We're not talking about whether people are impatient or something. People can be impatient, but some people are not impatient. What we're talking about is not a psychological aspect of action, which can vary from one person to another, but a logical aspect of action that must be true for all people. This is the claim, anyway, about time preference. Now, it's true that impatient people, their intensity of time preference is affected by their patience. So, patient people tend to be what we call low time preference people and impatient people tend to be high time preference people. But that's just a question of variation, right? By the way, it's exactly the same thing with the concept of preference. We prefer one thing to another is a logically necessary feature of human action. Everybody has preference when they act. So, we can have different degrees of preferring one thing to another, and that's based on our psychology and our circumstances and so on and so forth. But the idea of preference is logically necessary, really, to understand human action itself. So, we're making the same claim. Mises makes the same claim about time preference. Let me try one last, you know, this is, when you first hear this, it's sort of hard to grasp this at first. But let me try this one other way. We know that because of the finitude of human existence or of all material existence, it's finite and not infinite, that when we act we only get, we don't get indefinite effects, right? When we eat one time, it doesn't satisfy our hunger forever more. It's true of every action because we're finite and it follows directly from that we always prefer more of a good to less of a good. We always do. It can't be otherwise. Because we always have unmet ends that more goods could satisfy because we're unable with our goods to act once for all to satisfy every end. Only, you know, a super human being could do such a thing. Maybe it's impossible conceptually, but we can't do it as human beings. So, it's the same thing about our temporal existence. If we exist in time, if we're temporarily bound in time, then it just logically follows that sooner satisfaction is always preferred to later. It's just necessary. It's a necessary feature of preference expressed intertemporally. Just like more is always preferred to less, sooner is always preferred to later. It couldn't be otherwise. This is how the argument runs anyway. So, it's very, you kind of have to grapple with this a little bit to wrap your head around it, right? It's a quintessential praxeological area, right? This distinction between what's logically necessary in action and what's just contingent, circumstances and psychology and so on and so forth. Okay. One of the things about time preference, we want to make sure that we understand that time preference, just like preference, is always forward-looking. So, when we talk about time preference, what we're saying is just like with preference, we're always saying a person is anticipating the future state of affairs when they make their choice and the end is realized in the future, right? Time preference has nothing to do with looking backward. And so, just like preference, it's always entrepreneurial. It's always looking forward. And so, that's important to keep in mind. Okay. So, this then generates in the market the pure rate, what we'll call the pure rate of interest where some people with lower time preference then can satisfy the higher time preference of other people by lending present money to these high time preference people so that they can satisfy their more intense present desires. And as long as they're willing to pay an interest payment to the low time preference people, the low time preference people can be mutually satisfied, right? Because they get greater future satisfaction than they get present satisfaction, than the present satisfaction they give up. So, this is the idea. The intertemporal allocation of resources among people can be improved by this mutually advantageous trade through credit markets or through what we more generally call the time market. So, that's what we want to explore in this period. Okay. Now, let me try to encapsulate this in a kind of systematic framework way for you to consider. So, in the top line of this schematic, I've just put out the logical flow of the argument about preference and how it affects the price of a consumer good. So, let's say, for example, we're looking at the market for apples. And so, people have preferences for apples. There's some people who don't have these apples and they desire to acquire them and there are other people who have maybe grown the apples in the past or maybe they bought some apples somewhere and now they wish to dispose of a few or at least at some price they'd be willing to do this. So, we have different preferences and our preference is in lead to demand and supply. Consumer good, apples in my example. And then, as you've learned already, the argument is that since it's mutually advantageous for people to trade, they'll negotiate or find the price at which they can make their trades. And we call this the market clearing price at which all their trades are feasible. All the feasible trades can be made, right? So, the market price for a bag of apples or an apple would emerge. Now, I put this up again just so you can consider what you've already learned. It's a little bit easier to grasp that part than the time preference part. When we say we have this schematic running in this direction, this cause and effect chain of logic, we're not saying that circumstances and psychology and so on don't affect the outcome, at least quantitatively they do. What we're saying is that they affect the outcome only through the judgment of human minds who establish a preference with respect to these circumstances. So, let's say there could be fewer apples available that people have. And this doesn't have some sort of mechanistic implication for prices. The effect on prices depends on how people judge those changing circumstances. So, this is always the way we argue from the causal realist perspective because our focus is always on the human person. Everything is generated from the human person, the human mind. And so, the same thing with time preference. We have time preference, people prefer sooner to later, satisfaction. And so, there can be demand and supply for present money. This is how we trade on intertemporally. We'll talk about this more in just a second, why we trade money intertemporally. But then the low time preference people, as I suggested before, can lend present money to the high time preference people. And then the interest rate would adjust to clear this market. So, it's the same argument that we have for any market. There's no categorically or logically it's the same. And notice, once again, this is why I want to emphasize this. We're not saying that circumstances and psychology and so on and so forth don't affect the interest rate. We're saying the effect on the interest rate comes through our preference. We have to choose differently in the face of these changing circumstances, right? And then, when we choose differently, when we make a mental judgment and we say, oh, now I prefer to save more because something has happened or I need to spend more to attain this goal in the present. So, my time preference goes up because of this circumstance. The effect on the interest rate depends on that change of mind. And that's something we can't quantify, right? We can't model this. We're human beings. Okay, now, I just wanted also to show you, as long as I put this up I thought it was useful to just show you the rest of how this integrates how this discussion then integrates into a full-blown theory of prices. We have the price of a consumer good, let's say, again, apples, and then we have an interest rate that would be generated in this market economy, whatever, you know, into a 5% interest rate or whatever. And then, given the price of the consumer good, a marginal revenue product will be generated for hiring factors of production to produce this good. So, the prices that are determined here for apples will then impact, along with physical productivity, the revenue that can be earned by an entrepreneur from selling the apples that are produced by Apple workers, let's say, or by buying seedling trees or whatever the productive factor would be, right? The entrepreneur can now estimate or appraise what this revenue will be in the future if labor is hired to prune the apple trees or to pick the apples or whatever the entrepreneur's production process looks like. And then, if the entrepreneur pays the workers in advance of receiving the revenue from the sale of the output, he'll discount the payment that he makes. His demand for the producer good will be discounted by the period of interest because he's advancing money to the worker and then he's getting his payback in the future, right? So, the entrepreneur, if he pays in advance for his factors of production, is always considering the interest rate as a discount on what he'll pay in the present. He's giving up present money in order to, through production and then the sale of the good to get future money, right? So, that leads us into then demand for producer goods and then there's an opportunity cost by the suppliers of the producer good. So, the Apple orchard workers would have an opportunity cost, alternatives that they could do, right? And then they self-select into this occupation or the tree seedling growing company has an alternative entrepreneur who has an orchard they could sell to and so they consider this the opportunity cost, right? They consider that as, you know, in establishing their preference to either sell to this orchard owner or to, you know, withhold the seedlings for a while and sell into the future to a different orchard owner and so on. And then we get the price of the producer good. So, we get the wage for the worker, the Apple orchard pruner and, you know, the price for the seedling trees and so on and so forth. This too is all generated by our preferences, generated by nothing but our preferences and the given, you know, real physical circumstances of the world. How we, as human beings, judge those things mentally and then make preferences on, you know, establish a judgment of value with respect to the options available to us in the real world. Okay. Now, let's deal, well, let me just show then this, this would be the summary graph of what we'll call the time market and the time market involves all trade of present money on the horizontal axis. And the price of this trade of present money for future money is the interest rate. And we'll use a little R to represent the pure rate of interest which is what we want to work with first and then we'll move on to complications. So there are higher time preference people who demand present money, lower time preference people who supply it. Obviously, the graph indicates, right, there's a law of demand, a law of supply. So the degree to which people demand or supply depends upon the interest rate itself, right? So it's just like demand and supply of any good. And then the interest rate would emerge that clears the market. So that's what establishes the interest rate. We're saying the pure rate of interest, the time preference discount of the future or premium for the present. And as we'll mention in a minute, this pure rate of interest would then permeate all trade of present money for future money. We'll talk about some of the nuances of this in just a second. But before we do that, we want to talk about why it's important to recognize that this trade of present money for future money, this inter-temporal trade is done in money. Of course, we know that this is true, right? We just look out into the world and we see that, in fact, all lending and borrowing is done in money. People don't lend and borrow in apples or in the backhoes or land or whatever. They may again have forward contracts for these things, but they don't trade inter-temporally in those things. There's no inter-temporal barter. I mean, maybe in history, primitive conditions may have started out with inter-temporal barter. But we quickly move to a money economy, then all the inter-temporal trade is done in money. And it's an interesting question to think about why that's so. And one of the things that Frank Federer brings out about this is that money isolates the inter-temporal aspect of valuing. It allows us to separate the timing or time value aspect from the inter-temporal, the time preference aspect. And the reason this is so... Again, we're not going to go into a long, detailed argument about this. You have to ponder this for a while to grasp the nuances. But let me just state the conclusion. Federer points out that just like with money being used as a medium of exchange to buy all the different goods in the market economy, each unit of money is equally serviceable in buying any good in the market economy. It doesn't matter which dollar bill I use, right? Or which dollar in my checking account. It's entirely equally serviceable as a medium of exchange across all the goods that I can buy. And Federer points out this is also true inter-temporally. This is because money is the unit of account. It is the unit of economic calculation. And so timing doesn't matter. Just like if I spend money on different goods, it doesn't matter for its usefulness as a medium of exchange. It's useful regardless of that, right? And Federer points out it's also useful regardless of whether these goods are temporarily displaced. That's a very interesting point. It explains why people trade inter-temporally only in money. And then forward transactions are done in goods, right? Goods against money. But inter-temporal trade is present money for future money because the present money and the future money are equally serviceable as a medium of exchange across that time span. Now, there's some nuances to that that we'll get to in just a second. But fundamentally, that's the claim that's made. Okay, so that's a very... We'll see that this is a very robust claim that Federer makes. Okay, so we mentioned already that this pure rate of interest would then permeate all trade of present money for future money. Whether this was a credit transaction, whether it was just say a mortgage in consumer loan market or sovereign government debt or a junk bond of a company or whatever it might be, right? Or production in the capital structure. So for a given time period of present money exchanging for future money, let's say a one-year time period where present money is being given up for future money, the underlying pure rate of interest for all of the activity in the economy that has a one-year time structure would be exactly the same. At least in equilibrium, right? There could be changes that entrepreneurs haven't anticipated and errors made, but maybe would be for this pure rate of interest to be the same everywhere. Notice this is very important for the business cycle. You've already been introduced, right, to business cycle theory, but because what the Fed does through credit expansion is swell the supply of credit. They supply just credit market funding and they push interest rates down in the credit market. But then there's arbitrage opportunities because in production, the rate of return will be greater. And so very quickly, entrepreneurs begin and capitalists begin to arbitrage that credit into real production processes. And that's where we get the distortions of the business cycle. So this, again, is an important conclusion to a draw from this. Okay, now let's get to the nuance that I mentioned. The pure rate of interest can be uniform across all similar duration lending of present money for future money, but that doesn't mean that every market rate of interest of all sorts, depending on the different circumstances of the loans, are the same, right? We know that this is not so. We know that, for example, that AAA corporate bonds of 10-year duration have lower interest rates than junk bonds of 10-year duration and so on, right? We can find all sorts of illustrations of this. So how do we square all that? How do we explain that? Where does that come from? If there are arbitrage opportunities, we said before, why don't the capitalists just arbitrage away from the low interest rate return areas and into the high ones and eliminate this difference? Well, one factor, of course, that I've already alluded to involved in the earning of the rate of return in different projects of the same duration is not the same. So shale oil drilling, right? It might command a higher rate of return than apple orchard growing if they have the same duration. Simply because of the greater uncertainty, the savers are less willing to lend into these processes and therefore command higher rates of interest. And the entrepreneurs, the borrowers, are willing to pay the higher rates of interest so they can generate this rate of return in the sale of their output. This all, again, depends, as we suggested before, on the relationship between input and output prices. So this is a question for economic calculation of the entrepreneurs. But if they can't generate that extra return, of course, then they won't engage in this production. They just bypass it. And then there are two different... The last two elements have to do with purchasing power of money over time. So we know that over time the purchasing power of money can change and when we talk about the pure rate of interest, we're assuming it's the same. That today, the purchasing power of money, what if it were exactly the same a year from today? Well, then we wouldn't have to worry about changes in the purchasing power of money. But, of course, the interest return will depend upon... The actual interest return in real markets will depend upon the changing purchasing power of money from the lending of present money to the payback in the future. And there are two separate aspects of this. One is called the price premium, and the price premium has to do with what we like to call canty on effects. So as the money supply or the money relation changes over time, the prices of some goods will go up to a greater extent than the prices of other goods over this period. And the prices of some goods will go up sooner in this period and the prices of other goods later, right? So if you're an entrepreneur producing in a production process where you're getting a greater extent of price increase from changes in the money relation or you're getting a sooner increase in your output prices, you paid for your inputs, right, and now your output prices suddenly jump up very quickly, then the interest return that you would get is higher. This would be embedded rate of interest. That is the rate of return. You pay for your inputs and then you generate output prices, right? And that's the rate of return that you get. We're setting aside again profit as an element of this. And then finally there'll be unanticipated changes in the purchasing power of money. The overall purchasing power of money could change over time because, again, of changes in the money relation. Now, notice if entrepreneurs perfectly predict this, if they say, look, we're going to engage in this production process, we're ready to buy inputs right now, but we think that the price of our output, the money that is the price of our output relative to just the purchasing power of money will be 5% higher than the purchasing power of money today, then they will adjust their demand for the inputs today, right? And when they do that, if they do that, if they correctly anticipate changes in the purchasing power of money, it will have no effect on the interest rate. If they think that prices of output will be going down in the future, then they'll just pay less for their inputs today. And as long as they all think this, right, we would get no effect, prices would simply adjust today and we'd get no effect on the interest rate. But if they don't anticipate this correctly, then it'll wind up in the interest return. Right? They'll get a lower interest return if the purchasing power of money has lower, you know, has changed the price of their output, has lowered the price of their output below what they anticipated. Not because demand has changed, just for their good, but just because the purchasing power of money has changed. Then their interest return will be lower, their rate of return will be lower. They realize rate of return, right? Okay, so again, these are nuances that you have to kind of grapple with, right? And think this through and think, you know, are there objections and and so on that enter into this. Okay, so now we've come to the point of looking at critics. And it's useful to use Boombavar's approach in thinking about alternative arguments about the rate of interest. And so Boombavar was the great proponent of and economic analysts of interest rates, right? Write a three-volume work on capital and interest. And the first volume was devoted to nothing but the history of interest rate theories where he smashes them all. And then the second volume, right, was he presented his own theory. And then the third was devoted to just nuance arguments, you know, arose in the debate that this inspired. But in any case, he analyzed the alternative interest rate theories by posing what he called the interest rate problem. And this is the statement, this is one way of stating the interest rate problem. He says, why is the price of a capital good today not bid up by the entrepreneurs and the capitalists? Why don't they bid the price of it up to be equal to the stream of revenue that that capital good generates in the future? Why don't they do that? Because after all, if they don't do that then there's going to be a gap between the sum of the stream of the revenue, right, and the price that they pay today. And wouldn't that be profit? Why don't they just jump in to get that? Why don't they arbitrage that away? That's an excellent question, right? That's a really brilliant way of putting the problem. How do you explain this? And, of course, we've already seen how the pure time preference theory would explain it. By the way, Bumbavrak himself was not a pure time preference theorist. We'll talk about his, if we have enough time, we'll mention his theory as we go. But the pure time preference theorists, Frank Federer, Ludwig von Mises, and Murray Rothbard, and they all argue that this difference between what is paid for a capital good or an asset today and the full stream of marginal revenue product, the full revenue stream that using that asset generates in the future, the reason why the sum of that revenue stream is greater than what's paid for the asset today is because present money and future money are not equivalent. Present money is worth more than future money. And so less of it has to be paid, right, to buy this asset. And this surplus then is just the difference between the marginal revenue product earned in the future and the discounted marginal revenue product paid today. It's just an inter-temporal difference of the value of money. A thousand dollars in your hand today is worth more than a thousand dollars in your hand of equal purchasing power five years from today. That explains it. By the way, this explanation then covers all the cases, as we mentioned before, it's important to point this out because one alternative theory of course is the productivity theory. But this case illustrates that the pure time preference case points out that or explains, I should say the case where there's no production at all. Even if we just have consumer loans. There's an interest, a positive interest rate, right? There's no production here at all. So how would the production theory explain that? If the interest rate is generated by the productivity of capital, how does it explain interest rates of consumer loans? Maybe they have an explanation. I'm not saying they wouldn't necessarily have an explanation. But it seems, you know, that seems a problem. It seems sort of a week that they can't explain it directly. They sort of explain it indirectly. Again, that's for your more advanced reading on these issues. Okay, well, let's start with the exploitation theory just because Boombavarok famously smashed the exploitation theory of Marx that he developed from Ricardo, right? And here the argument is that interest is just a surplus value of labor that's extracted by the capitalist. So the capitalist can underpay, can pay just subsistence to the worker and then gets the full marginal revenue product of the productivity of the worker. So that's the basic argument. And as Boombavarok pointed out, of course, since this is based on the fallacious labor theory of value, it's not, you know, it all falls to the ground once the labor theory of value is smashed, which, again, he famously did. In fact, this is one of the cases in the history of economic thought where a prominent theory was just entirely smashed and left for rubble. Right? I mean, nobody, no economist of any, even Marxist don't believe in the labor theory of value anymore. It's all been totally demolished. So that's a very rare thing. Okay, so anyway, the other line of criticism would be, again, the one we mentioned, right, simply to point out that labor, in fact, is paid the full value of its productivity. It is paid the discounted marginal revenue product that it generates, that its labor productivity generates in production. And of course, if a worker wanted to be paid its full, if a worker wanted to be paid his or her full marginal revenue product, they could do so by going to their, going to the entrepreneur that employs them and saying, I'm willing to wait until you sell the output that I'm producing over the next month. I'm willing to wait to be paid. And then the entrepreneur would be happy to pay the full marginal revenue product, right? Because in that case, the entrepreneur's not lending money to the worker up front. He's not paying them in advance of the value that they produce. The entrepreneur can just wait until the customer pays the worker, and the entrepreneur will be happy to do that. In fact, a worker could even earn the full marginal revenue product outside of that by just taking his pay that he gets up front and then lending it out in interest. But of course, the worker doesn't want to do that, right? The worker wants to get his income and then spend it on consumption. That's why he's willing to take a lower pay. So this is not exploitation. This is just in the sense of, you know, taking the productivity of the worker. It's a discount of that productivity for intertemporal exchange. Okay, so I mentioned the productivity theory. Let's see if we can go through this somewhat expeditiously. So the productivity theory argues that the rate of return depends upon the physical productivity, fundamentally the physical productivity of capital. And of course, no one denies that capital is physically productive, right? This is just an obvious fact of the world. Well, I mean, not every particular capital good might be physically productive but it's possible to experience physical productivity. This would be the same, by the way, the same would be true of land as a factor of production. It's physically productive. But physical productivity affects the marginal revenue product, right? It affects what entrepreneurs are willing to pay to buy the input. It doesn't even address this question of what about the intertemporal nature of the payment. The marginal revenue product will be higher and hence the pay up front for buying that input will be larger by the entrepreneur. But this has nothing to do with whether or not the payment up front is equal to the sum of the future revenue that's generated by the productivity of this asset. It doesn't really even address this question, right? To put the point the other way around there's a different productivity, a different physical productivity for all the different capital goods. So backhoes have their own productivity and apple trees have their productivity and different land sites have their productivity. But the rate of return on investing in all these things is the same. It's the same. For a given duration and a given entrepreneurial uncertainty and so on. That's because the rate of return is based upon the difference between what the entrepreneur pays to buy the input and then what the entrepreneur receives by selling the output. It depends upon the value spread between these things and not the physical productivity. So a more physically productive input will be paid a higher price up front because the entrepreneur can use it to generate more valued output in the future. And entrepreneurial competition for the input will push its price in the present up to its full marginal revenue product and then that would be discounted and that's where the surplus comes from. Another way to think about this by the way I have sheep in this example because this was the example offered by Irving Fischer the famous American economist the founder of American Monetarism and he held this view in part at least had this line of argument against a pure time preference theory and he used sheep as an example he said hey look if you have a herd of sheep is it a herd? It's not a herd, it's a flock. If you have a flock of sheep say 100 sheep they'll just procreate and you'll have 110 you don't have to do anything they're just physically productive right? Okay, so they would generate a 10% real return but what Boombavrik is talking about what we're all talking about when we talk about interest is not that of course all sorts of production processes do that right? They're physically productive. The question is how much will investors be willing to pay for the 100 sheep? And the answer to that is what's the productivity what will the output be sold for in the future and what's the going rate of return on all the other investments that I could make besides sheep? So that's my example here the capital value if we assume that the sheep go on forever the sheep flock persists indefinitely then the capital value of the sheep today would be the marginal revenue product divided by the interest rate so for example if the marginal revenue product were $10 in other words if each extra sheep commanded a price in the future of $1 so that there was a $10 marginal revenue product for owning the flock and there was a 10% rate of interest then the sheep herd could be bought the sheep herd the sheep flock could be bought for $100 because that would just generate a 10% return but what if the return on all the other investments in the economy was 5% what if you could get 10% as an investor going into the sheep flock but only 5% on all other investments what would you do the answer is clear right you'd rush into sheep and the investors would bid the price of the flock of sheep up to $200 and then they would only earn 5% see it doesn't matter it doesn't matter how physically productive it is because what we're talking about is a price spread and prices are the implication of human action the result of human judgment with respect to what's going to happen in the future so this is also true of other cases that Fisher gives so he gives sheep hard tack of course never changes there's zero productivity of hard tack it's like beef jerky it lasts forever and it doesn't procreate or anything and so Fisher said well if you had hard tack in this example then the rate of interest would be zero because there's no gain, no physical gain but this is clearly not the case it just depends on what the other rates of return are on other investments it doesn't matter at all what the physical productivity of something is what matters for the rate of interest is how much investors are willing to pay today to buy the thing given that they think they can sell the output from it or in the case of hard tack they just sell the hard tack in the future the same hard tack they just buy it and sell it in the future what the price will be in the future so as long as they can pay a price below what they think the future price will be then at the rate of return that they can get on other investments that's what they would do and you would generate the same rate the same as for figs figs of course deteriorate so this is negative interest rate according to Fisher but clearly it wouldn't be a negative if we had a market for figs and the figs deteriorate over time that would not generate a negative rate of interest because entrepreneurs know that the figs are going to degenerate and they can estimate from that the remaining amount of the figs that are good that they can sell next year and they would price the whole buying of all the figs the whole group accordingly they would just under price in other words they would pay only a price lower than they thought that they could sell the residual output for in the future now since I've run a little bit long just end with it a couple things we're not going to get to you can look at the power point and ascertain some of the other points but I think it's interesting to raise this issue with respect to negative interest rates that we claim the people claim exist now on the market so we had this story just last week about how German sovereign bond rates have gone negative well think about this for a minute does it really matter what the coupon rate is on these bonds if the German government issues a 10,000 euro bond and they say a year from today we will pay the bearer of this bond 9,990 euros okay what will investors pay for this if that thing is bought and sold on the market what will investors pay and the answer is they'll pay something less than 9,990 dollars and the yield on this negative coupon rate bond will be positive unless they make a mistake of course it won't be negative market rates will never be negative by the way another aspect of this of course is another possibility would be there could actually be a holder of this bond that accepts the reduced payment right but they have to get something in exchange for it otherwise again they wouldn't buy the bond unless they were coerced into it somehow okay well think about that what group of entrepreneurs are required by law to hold government debt or given at least some sort of incentive differential incentive to hold government debt and the answer is banks have different capital ratios for different securities that they hold their ratios are lower for government debt and so they can actually issue more fiduciary media and get a differential gain right by holding government debt even if they have to pay a little bit even if they lose a little bit of the capital value of that asset sorry for going along but alright thanks