The Structure of an Interest Rate, Part 1
To begin this analysis, we need a very important, basic idea from the core principles of economics, and we'll introduce this idea with the story of Irwin Hornflocker, an average guy who worked as a furniture delivery man at Doolick's House of Furnishings over in the old Town & City strip mall on Maple Rock Street about a block from the new, three-story professional building that went up last year. Irwin had been working at Doolick's for eight years, ever since he got out of high school, where he was a first-string wide receiver his Junior and Senior Years at Tri-County Consolidated High School. He didn't get any offers for college scholarships, and that was due in no small part to Tri-County's two-and-twelve record during his Senior year, when he had no fewer than seventeen fumbles to his credit along with a two-game suspension for putting so much stick-'em paste on his hands that, during a tackle in Tri-County's game against the Haley Valley Panthers, his hands stuck so fast to a Panther player's jersey that he ripped the sucker clean off the boy. Irwin has lived a modest life ever since those glory days, and his job at Doolick's hadn't provided him much discretionary income until recently. At $10.25 an hour last year, Irwin pretty much just barely got by. But then Ned Forrell, the old dock manager since Doolick's started business in 1969, had a heart attack while he was having dinner with his wife at Claire's Family Restaurant. Ned went down for the count and passed to the hands of Jesus right there in his hot roast beef and mashed potatoes special.
Irwin saw daylight the next day. He got called into the business office at the request of Fanny Doolick, who took over when her own husband, the late Clyde Doolick, died the very same way as Ned did at Claire's, except that Clyde was having the liver and onions Blue Plate with a side of green beans and cornbread when the Lord called him home. Irwin went in to Fanny's office not knowing what to expect; but much to his shock, Fanny told him that he was now the loading dock manager, what with his eight years of experience and a "damn fine set of muscles any healthy, lonely woman could appreciate." With that one conversationadmittedly a little uncomfortable for Irwin, what with his history of being known around town as something of a lady's man in his youthIrwin's wage went from $10.25 to $13.45 an hour right there on the spot.
Irwin saw his life turning around. On his way home that afternoon, he thought about all the things he was going to do with that extra money. He was okay with where he lived, and he was okay with the furniture he had and all that. He was thinking more about his hobbies. He liked to work out, and with the extra money, he could buy himself a set of weights instead of using his sofapurchased with his employee discount at Doolick's Factory Outletfor his nightly bench presses. More importantly, Irwin had always wanted to go to college, and with plenty of extra money, he could start with a three-hour course at the local community college, which charges $50 per credit hour: that'd be only $150.
Life was turning good. Irwin bought a set of weights for $120 at Sven's Bulge Barn, and he signed up for Econ 101. The course ended up costing a little more than he had thought because of the textbook, which ran $85 for a used copy. Still, for only $235, Irwin was on his way to that college degree he never got because of those lousy last two football seasons when he was in high school.
Irwin did live better even if not everything went according to plan. After a few hour-long work-outs the first week with his new weights, he never touched them again. And that college course didn't really work out because the teacher was one of those air-headed academic liberals he'd heard about and the whole subject had nothing to do with the real world that real people live in; and so Irwin stopped going after the third week of the sixteen-week semester.
But Irwin is now making a lot more than $10.25 an hour, and since his promotion, he's been working 50 hour weeks quite often. He's happy with his life, even if he has had to compromise his principles on two occasions with Fanny; but even there, he found that the pay raises have come more frequently, and they've been more than fair. These days, Irwin's pulling $15.80 an hour, and he does some work in the business office as well as running the loading dock every bit as well as Ned did. In fact, the guys he supervises say he's better than Ned because he's there all the time, and he keeps everything running smoothly. Irwin's life is a case study in the American dream coming true.
Irwin bought weights, but he didn't use them, even though he'd been working out with the sofa for years. Irwin dropped out of college, even though it was something he'd wanted to do ever since high school. In fact, if the truth were to be told, Irwin was even shopping for groceries at the "snooty people's" store, Emerald's Fine Foods, instead of at the old Famous Foods for Less mega-store over by the county fairgrounds about a mile outside of town. Irwin had his reasons for all the things he was doing differently; and once in a while, he even mentioned in passing the real reason: "I don't have time for nonsense anymore; I got responsibilities."
Yes, Irwin does.
In economics, the term is opportunity cost: the value of the best alternative given up to carry out a given action. This is one of the implicit costs an activity carries. Implicit costs are those that don't have a bill that's paid with cash money; the cost is part of the activity, itself. Opportunity cost has to do with what a person gives up; that means it necessarily doesn't have any visible bill or receipt or charge.
A person's wage rate is the opportunity cost of leisure: when Irwin is doing something other than work, what he's doing excludes earning his wage rate at work. When Irwin's wage rate rose, the cost of doing things other than work rose with it.
Consider his weight lifting. When Irwin was making $10.25 an hour, two hours of work-out a week cost him $20.50 in foregone wage; but when he was making $13.45 an hour, the opportunity cost of those two hours of workout a week rose to $26.90. Over the course of a year, the opportunity cost of working out rose from
Notice that the explicit cost (or direct cost) of those new, fancy weights Irwin bought were actually a small part of the total costthe sum of the explicit costs and the implicit costs. Irwin's annual opportunity cost of working out two hours a week had jumped by $332.80 ($1,398.80 minus $1,066.00), but the weights cost him only $120! That means Irwin, looking at only that $120.00 direct cost, didn't see the far larger, permanent annuity of costs of an extra $332.80 per year to which he was committing himself by buying and using the weights.
The situation was even worse with that college course. The first night Irwin went to class, the professor said that, for every hour in class, a student would have to study for two hours outside of class. And that was just to get a "C" in the course! That meant Irwin was going to spend three hours in class every week and six hours outside of class every week studying economics, and he was going to have to do this for 16 weeks. Now, Irwin had looked only at the direct cost, which at first he thought was $150.00, but which he had to revise upward to $235.00, including the cost of the textbook for the course. But even at that, Irwin was simply blindsided by the far larger opportunity cost of undertaking just one college course: nine hours every week (three in class and six outside of class) for 16 weeks is a total of 144 hours. Irwin would have to forego $13.25 for every one of those hours, which means his opportunity cost for that course was
which put his total cost at
for just that one course.
When Irwin was making a measly $10.25 an hour, the opportunity cost of that 144 hours committed to the college course would have been only
putting the total cost at
for that same course.
With the workouts and with the college course, Irwin faced the classic law of demand: as the price of a good or service falls, consumers and firms tend to want more of it; as the price of a good or service rises, consumers and firms tend to want less of it. For Irwin, even though the explicit costs of the goods and services didn't budge, the opportunity cost of everything that precluded him making his hourly wage became more expensive overnight; hence, Irwin wanted less of those things, even if he didn't see the prices of the goods and services rising.
And about Irwin, the fellow who always used to make fun of others who went to the "snooty people's" grocery store, the same thing was happening. The cheap prices attracted longer lines of people at the checkout counter. Irwin, himself, was constantly grousing under his breath about people standing there checking out, trying to figure out how the debit card slider worked or fishing for change in their pockets or taking forever to write a check. There were times when Irwin almost lost it because some hoehandle with five unruly kids simply had to put into her shopping cart the one item on the racks that didn't have a price tag on it, thereby prompting the cashier to bawl out, "Price check on Line 29," to which a floor manager would respond sometime within the next several hours. But the prices were always great at the Famous Foods for Less mega-store, even though it was something of a drive to get clear out there. But then, as if all of a sudden, there was Irwin, standing in a nice, short line at Emerald's Fine Foods, paying sometimes 30 percent more for the same things he used to buy at Famous Foods for Less. Had Irwin stuck with his economics course, it might have occurred to him that the line, itself, at Famous Foods was part of the cost of the groceries. The longer a person stood in the line, the greater the cost. But for someone making more money per hour, the cost of a given line was higher than it was for someone making less per hour. That's why people earning more were willing to pay a higher direct cost for groceries at Emerald's: they were simply avoiding an implicit cost that was being driven by people who made less per hour.
In his own way, Irwin came to understand all of this. In fact, during one of his rants with his friends about liberals, he said that the only reason liberals want a higher minimum wage is so they won't have competition for their jobs that require a college education. He had the economics exactly right: as the minimum wage goes up, the opportunity cost of going to college increases, which means more high school graduates will enter the work force directly out of high school, in part because the cost of giving up full-time work to attend college rises. As fewer people attend college, fewer college graduates enter the labor market with the skills to compete with those already in the labor market with college degrees. Hence, a rising minimum wage ensures a tighter supply of college-educated workers, ensuring higher wages and salaries for them.
Irwin's friends just sort of looked at him when he explained the logic. Irwin said, "Don't argue with me about it: I had three weeks of economics at the community college; an' besides, every now and then, I read these long-winded articles about economics on the Internet. The guy calls himself the Dark Wraith, an' he sure explains things good... except sometimes he goes five times around the barn to get to the outhouse. I'm still tryin' t' figure out what that story about the furniture loading dock guy had to do with the structure of an interest rate."
Irwin was right. It seems like the concept of opportunity cost is far removed from the financial world of interest rates and what determines them; but opportunity cost is the driving force at the very base of every interest rate.
When a person puts money into a savings account, he or she is necessarily giving up the right to use that money for immediate consumption. To induce a person to put money in the bank, there has to be an incentive to forego current consumption. That's where interest rates come into play. Now, some investments are risky, some investments are safe; but every inducement to get people to do something other than to use their money for consumption must include a core, basic reward for the immediate consumption that is given up. Every interest rate, then, includes a compensation for not spending money in the here and now, and that core interest ratecall it the real interest rateis the opportunity cost of immediate consumption. If investors really like to use their money right away, then giving it up will require a big incentive. If people don't get really worked up about using their money right away for consumption, then it won't take a lot to induce them to put money away instead of using it.
This real interest rate, which we designate by rreal, is driven by a number of factors. One big one is the supply of and demand for liquid money. Recall from Part 1 of the Pulp Economics series, "A Brief Story of Money," that liquidity is the speed and efficiency with which an asset can be transformed into another asset. Dollar bills are highly liquid: when there are a lot of those highly liquid dollars floating around in an economy, it won't take very much of a reward to get people to squirrel a few of them away in savings; but when greenbacks are not in abundant supply, it will take a higher real interest rate to induce people to put some of them in the bank. At the same time, when people are very worried about their immediate financial prospects, they won't be too thrilled with the idea of sticking money in a savings account. That means, when people are worried about their circumstances and those of the economy as it affects them, they'll need more incentive to put money into a savings account instead of using it; on the other hand, when people are confident about their own immediate prospects, and they see the economy as being strong, they'll tend to be willing to put money into savings without as much inducement in terms of the real interest rate.
To put it in the context of Irwin, if he were to have more hours in a day, he'd be willing (all other things being equal) to commit time to the economics course or to that workout regimen. With money, if there's more of it swirling around in an economy, the real interest rate doesn't have to be as high to get people to commit some money to savings. But if Irwin has something very important to do right now with the hours he has in a day, he's going to commit fewer of those hours he has to things other than the most valuable thing he can use them for. In the same way, when the greenbacks in an economy are limited, their value goes up.
But all of this leads to something even more important. Yes, there is a basic component of every interest rate that represents the opportunity cost of immediate consumption; but perhaps more fundamentally, a short-term interest rateone that doesn't have all the extra "premiums" added in that we'll explore in later parts of this seriesis in some very material way the price of a dollar!
Now, this "real" interest rate is never seen. It hides below the surface, buried in every interest rate that gets quoted in the actual economy. Every interest rate starts with this real interest rate, and then those premiums mentioned above are tacked on, each to its extent necessary for the instrument on which that interest rate is bearing. The first interest rate that any market would actually form for use would be one very close to the theoretical risk-free rate, designated rf, which is the sum of the real interest rate, rreal, and a short-term expected inflation premium, πe, that represents the reward for investors' expectation of lost purchasing power of the money while unavailable for consumption. Take care to notice that the expected inflation premium rewards an expectation: what has already happened with inflation is irrelevant. Investors must be induced based upon what they expect to happen.
The real interest rate rewards foregone consumption; the expected inflation premium rewards lost purchasing power due to the current dollars getting "watered down" by a rise in the aggregate price level, and that's a fancy way of describing plain, old inflation. This sum of the real interest rate and the expected inflation premium is called "risk free" because it doesn't include any rewards investors would have to be provided for bearing various types of risk, one of which is that of losing part or all of their investment through default of the borrower. The so-called "default premium" is but one of several layers of reward stacked on top of the risk-free rate. Each of these risk premiums will be investigated in detail in a subsequent article in this Pulp Economics series. It should be noted at least in passing that the risk-free rate is the one over which the central bank (the Federal Reserve in the United States) has control, but that risk-free rate is also affected over time by forces beyond the central bank's control. In particular, the amount of borrowing by the federal government drives all interest rates because the government will drive interest rates up to induce investors to lend it money; and the expected inflation premium rises and falls through time based upon whether or not the central bank has previously pumped too much or too little money into the economy compared to the growth of that economy's actual need for greenbacks.
Describing too many of the factors affecting observable interest rates in one article can lead to all kinds of undesirable outcomes. In fact, the very last economics class Irwin attended before dropping out was the one where the professor was describing this very subject of the structure of an interest rate. The professor had decided he should lay the whole thing out in one, 90-minute lecture. Irwin actually stayed with him through the risk-free rate, although Irwin was a little suspicious about the part where the professor said that the risk-free rate is theoretical, but a close approximation of it is found in the interest rate the government pays on very short-term loans it gets from investors by selling them what are called "Treasury bills," or "T-bills." The professor explained that, since T-bills are highly liquidthat is, they are easy to selland have no chance of default, they are virtually risk free, meaning that the investor gets rewarded only for the basic surrender of immediate consumption and for the expected erosion of purchasing power over the term of the loan. No reward is paid for bearing the risk of default, nor is any reward paid for the risk of longer-term surrender of consumption, nor for the possibility that it would be difficult to sell the T-bill to another investor.
Irwin got worked up because he'd heard his very own President say something about how the Social Security Trust has about two dozen Treasury instruments representing huge loans the Trust has made to the federal government. According to the way Irwin interpreted the President's words, those Treasury instruments in a drawer at the Trust offices were just pieces of paper, and there was no guarantee that they'd be worth anything at all when the Social Security Trust needed them cashed in to pay benefits to retirees. "So," Irwin challenged the professor, "the President says there's a good chance of default on them Treasury borrowings, an' you're sayin' there's no chance of default. An' I'm supposed to believe you instead of the President of these United States, huh?"
The professor answered, "Yes, but that's because the President is irresponsible for even suggesting that the United States Treasury could default."
Irwin shot back, "How can you get by with calling President George W. Bush names?" to which the professor answered, "You're right. Bush is too stupid to be irresponsible."
Irwin left, never to return, never to learn the rest of the story of interest rates, never to learn that he could be smarter with one economics course than his President could be with all of his neo-conservative political and economics advisers.
And absent that economics course, when he's not at work, Irwin now spends the nights hanging out in cyberspace, where he reads the articles at The Dark Wraith Forums, enduring as he then must the gruesomely long stories that only occasionally and randomly ever get around to making a point clearly, lucidly, and interestingly.
For those readers who have made it this far and want more of this series, the next installment will cover the so-called "maturity premium" impounded in some interest rates. That article will be published after Part 2 of the series, "A Brief Story of Money," coming soon to this very blog.
The Dark Wraith trusts that readers will come away from this series understanding not just more about interest rates, but also more about why economics is the science of common sense made obtuse.