I have a question about interest rates that are discussed in Chapter 9 of the Wealth of Nations. Smith says that there is a direct relationship between high interest rates and the profits that are made from stocks. I do not understand his reasoning here. Besides, I thought that interest rates really measure risk involved not the amount of money people make from stock. Is Smith wrong on this?
Woops! I misread your question.
There is a tendency for profits in different ventures to equalize, this is as true for ‘potato farming’ and ‘money lending’ as it is for ‘potato farming’ and ‘toy manufacturing’.
if you super simplify and say that ‘brokering a loan’ outside from the cost of the loaned amount is otherwise costless, then the interest rate on such loans would tend to equal profits. Because it does cost to ‘broker loans’ (be in the loans business) this will tend to open up a numerical spread between the interest rate of the loans you make, and the profit rate for you. for example. if you make a $1000 loan for a year, at 5% but it costs you $10( i.e. 1%) in other costs, your profit on the whole deal would be 4%(assuming away inflation). If there was inflation, of 2% say and it still cost you )1% to broker, and you were earning imaginary equalibriated rate of profit of 4%, the interest rate on the loan deal you struck would be 7%.
if this interest rate on loan figure rises, not because of inflation, and not because of rising brokerage costs, then it must be rising because the imaginary equalibriated rate of profit has risen (note: a synonym for ‘profit’ is ‘originary interest’)
I will be somewhat embarrassed to have gotten this wrong, but more embarrassed to not be corrected and go on thinking wrong things. comments ? criticisms ?
The yields on securities, including government debt, is not the actual rate of interest. But, in equilibrium, the yields on securities should equal the actual rate of interest because of arbitrage. In fact, and this was already mentioned, the rate of return on any investment should, in equilibrium, match the actual interest rate (be it coal mining, wheat production, bonds, whatever). If the rate of return on securities is greater than the interest rate, then funds will flow towards securities and away from other investments. This will push security yields down as there is an inverse relationship between the demand for securities and their yields.
In addition to this, uncertainty/risk and expected inflation also influence yields. But the actual interest rate has nothing to do with risk or expected inflation; it has to do with time preference. The Austrians distinguish between “natural/originary interest” and “money/market interest.” The Keynesians believe that the interest rate is solely a function of the demand for money, and the classical’s believe that the interest rate is the marginal productivity of capital. Mainstream neoclassicism basically holds onto all three theories.
In the theoretical evenly rotating economy there is perfect information, and therefore there is no “supernormal” profit (above natural interest).
I think it’s correct.