Sunday, July 10, 2011

Are we entitled to the risk-free rate of interest?

Yesterday I asked why there is a risk-free rate at all. Today I shall ask whether we have a moral entitlement to it. You might say that we don't, arguing syllogistically as follows.

1. Getting a risk-free profit is consistently getting something for nothing.
2. You are not morally entitled to consistently get something for nothing.
3. Therefore, you are not morally entitled to a risk-free profit.

In a comment on the previous post, Brandon questioned 2*.  Perhaps there are circumstances when you are morally entitled to receive something for nothing, on a consistent basis?  I shall not discuss this here. I shall simply assume that premiss 2 is correct.  It is the first premiss I am concerned with today.


In defence of the first premiss, it might be argued that investing money at the risk free rate, so that you are guaranteed to get your money back after a period of time, plus an extra component corresponding to the risk-free return, seems like a consistent way of getting something for nothing.  You haven't done anything to get the return, and you ran no risk in doing so.  The only thing that got you the return was the ownership of the principal amount. Thus you have earned something for nothing.

I reply: premiss (1) is trivially false. In the previous post, I argued that the root cause of the risk-free rate is mere time preference.  A farmer wants to sell £100 worth of crop in a year's time.  He sells that future crop to someone now for £95.  Time preference explains the discounting, and the discounting explains the risk-free rate.  And so you are not getting something for nothing.
In earning the discounted amount (i.e. the £5) you have to wait for one year.  Thus, the £5 pays you for the waiting.  In lending at the risk-free rate, you are getting something (the risk-free return) for something (waiting until the loan matures). 

As to whether there is a non-trivial sense in which the first premiss is true (perhaps by qualifying 'nothing' in some way - perhaps mere waiting is not a genuine 'something'), I will leave that for Brandon to comment, and I may say something about it later.

Note that modern financial theory only allows two kinds of interest rate, namely the risk-free and the risky rate.  The other kinds that Brandon mentions in his original post (administration charges, social value) are not interest rates at all, at least not in the modern sense.  We should not confuse the various charges and costs built into a loan, with an interest charge itself.

* Or rather, he questioned something like 2.  I'll leave him to comment here if he disagrees.

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6 Comments:

Blogger Brandon said...

Moral entitlement is an extraordinarily strong category; so strong that we can pretty much guarantee that there will be no general moral entitlement to risk-free profit, only (at best) to a risk-free profit under certain circumstances that would have to be specified.

I questioned, or intended to question, both 1 and 2. Children are morally entitled to receive certain things for free from their parents, for instance, and on at least one moral view the poor in general (not necessarily any particular individual) are morally entitled to some free things from others; and the only sort of 'getting something for nothing' that is relevant here has to do with whether the exchange was fair, not with the profit as such. Even to make (1) plausible here, I think, would require restricting it to a particular class of exchanges.

Modern financial theory only considers two interest rates under the rubric of 'interest'; there is no logical impossibility in a system in which other things are expected to be taken into account in the interest rate rather than in a separate fee. Indeed, this is precisely what we often have in spontaneous lending by non-bankers, and it once was standard practice. And since usury is concerned with fair exchange, and it is impossible to determine whether a loan is a fair exchange if parts of the return (not just the rate but all payment to the lender) on the loan are kept out of the analysis, this actually shows how limited the value of modern financial theory is for assessing whether the exchange is just -- it implies that we will never be able to determine on the basis of interest rates alone whether the loan was a fair exchange, and therefore never be able to determine whether or not the loan was usurious. If the mob gives you a zero-interest loan but charges you ten times the loan in administrative fees, this is usurious. For that matter, given that the mob coerces borrowers to loan or to pay more than they agreed, if the mob charges nothing more than the risk-free rate on a loan it is being usurious; borrowers are not in a position to refuse and can do nothing to give reasonable guarantee that the loan will be fair. Certainly it's the case that nobody has moral entitlement to risk-free profit when lending under mafia conditions. And under other conditions, too: mortgages with fine rates of interest that gouge borrowers in closing costs are as usurious as anything else; they are just using the semantics of not calling it 'interest' to hide the unfairness of the exchange.

Thus a better question would perhaps be, "Under what conditions is it morally permissible to charge the risk-free rate of interest?" Given such conditions, and a fair contract, moral entitlement would follow.

4:10 pm  
Blogger Edward Ockham said...

>>Modern financial theory only considers two interest rates under the rubric of 'interest';

This seems to be the whole source of confusion in this discussion. Modern financial theory only defines these two things as 'interest'. None of the other things you are talking about are interest, properly so-called, but rather hidden charges concealed under the term 'interest'.

An analogy would be the way that people used to call dolphins 'fish'. Under the modern definition of 'fish', dolphins are not fish.

>>there is no logical impossibility in a system in which other things are expected to be taken into account in the interest rate rather than in a separate fee.

But then that would not be interest, properly speaking, but a charge falsely called 'interest'. Rather as some people call dolphins 'fish'. I'm really failing to understand your point, given my explanations before (sorry).

>>it is impossible to determine whether a loan is a fair exchange if parts of the return (not just the rate but all payment to the lender) on the loan are kept out of the analysis

The risk-free rate (as I have already said) is publicly available (look in the Financial Times) and the credit spread can be determined - or at least estimated - based on the credit standing of the borrower. Any surplus is therefore an excess over 'fair value' as defined by financial theory. Reasonable costs to add on (but these are costs, *not* interest) are administration costs (around half a percent) and sales cost (these can be excessive, but UK law requires them to be specified as part of the contract.

>>this actually shows how limited the value of modern financial theory is for assessing whether the exchange is just

I am not following you. Modern financial theory can determine exactly that, as I have explained a few times. I really am not following you.

>>it implies that we will never be able to determine on the basis of interest rates alone whether the loan was a fair exchange, and therefore never be able to determine whether or not the loan was usurious.

I'll assume you mean "on the basis of the quoted rate alone". Yes we can. See above.

>>Thus a better question would perhaps be, "Under what conditions is it morally permissible to charge the risk-free rate of interest?"

I am still uncertain that you have understood the concept of 'risk-free rate of interest'.

6:22 pm  
Blogger Edward Ockham said...

>>Moral entitlement is an extraordinarily strong category

I was avoiding 'entitlement' as not being strong enough. Legal entitlement is clearly too weak. Surely it is clear what I am aiming at.

6:23 pm  
Blogger Brandon said...

Surely it is clear what I am aiming at.

I don't think it is; at least, I don't quite see it. Are we talking bare moral permissibility? Or are we talking an actual right here? And if the latter, is it a right deriving from lending itself, or is it a right deriving from negotiated lending contracts?

On the rest, I think you're playing semantic games with the word 'interest', which, after all, was first defined by the scholastics and is, in any case, the only sense that is relevant in discussing their comments on it; if you are going to use the term in another sense when criticizing them, it is you who need to qualify what you are saying. Since the argument against usury is not an argument against interest rates but an argument against a particular kind of unjust profit, it doesn't matter what you call it: call it jeeble-weeble, if you don't like calling it interest.

3:43 am  
Blogger Edward Ockham said...

>>I think you're playing semantic games with the word 'interest'

The burden of proof, when it comes to non-standard uses of the word, is to explain the meaning of the non-standard use. The word 'interest' has a perfectly precise and standard use in modern financial theory. It means time value of money or ‘risk free rate’. It can also mean, less standardly, the credit spread.

Any other charge slapped on in the name of ‘interest’ by dubious promotion of financial products does not count. As to what the scholastics meant by the term, it is up to you to explain. I often fall afoul of this principle when I use the word ‘proposition’ in its scholastic or traditional logical sense. Modern philosophers use the term differently, and they are probably right to complain about my usage.

1:13 pm  
Blogger Edward Ockham said...

I also paid some attention to your 2009 post, where you talked about the apparently scholastic idea that “money on its own never carries an intrinsic title to interest” and that usury exists "when gain is sought to be acquired from the use of a thing not fruitful in itself, without labor, expense, or risk on the part of the lender." Or that “money does not breed. It carries no intrinsic potential for profit”. It all sounds as though they are talking about time-value here. What else?

I think – given the simplicity and clarity of the modern sense of ‘interest’, that it is up to you to explain what the scholastics meant by both ‘interest’ and ‘usury’.

1:27 pm  

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