Interest Rates and Uncertainty

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Bagehot, Walter, Lombard Street

Bentham, Jeremy, Defence of Usury

Böhm-Bawerk, Eugen V., Capital and Interest

    "The loan is a real exchange of present goods against future goods." With this much-quoted summary from this path-breaking 1890 book, Eugen von Böhm-Bawerk cut through a morass of previous flawed interest-rate theories to give us the definition used in every economics classroom today.

    In this first of his series of two books on capital and interest rates, Böhm-Bawerk exactingly critiques existing theories of interest rates, highlighting how spare the serious thought given to them by personages as respected as Smith, Ricardo, Turgot, Say, Bastiat, Senior, and later economists who relied on them; and how halting the subsequent historical developments. The chapter-by-chapter critiques are sometimes so embarrassing to economists that they seem pedantic, yet the end result is undeniable: it is easy to claim glib understanding of interest rates, but hard actually to explain them.

    Not only does this work lead the way to the modern understanding of interest rates, but it also provided some scathing critiques of late 19th-century Socialism. Böhm-Bawerk's chapter on Rodbertus simultaneously shows the holes in the some of theories of capital and interest at the foundation of Socialism, while developing the use of discounted present value in language clear enough for today's college classrooms. Hints of academic developments later accepted generally by economists, such as a nice description of the stream of services given off by capital goods in Book III, Chapter V, real business cycle theory, and intertemporal trade appear in scattered sentences throughout.

    Böhm-Bawerk's focus on the importance of clear thinking about interest rates, the capital investment process, and intertemporal dynamics; his stylistic bridging of the period when mathematics and logical attention to detail were clearly beneficial but only at the verge of introducing into a textbook; and his implicit vision of a macroeconomics dealing with the aggregate as opposed to the microeconomics of the individual, changed economics forever. Difficulty Level 2: Graduate School

    Contrasts in Economic Thought. For a substantive reading project: Contrast Clark's The Distribution of Wealth (on which see also the Brief Review) with Böhm-Bawerk's Capital and Interest and The Positive Theory of Capital. In their lifetimes, John Bates Clark and Eugen von Böhm-Bawerk presented nearly contemporaneous theories on the accumulation and productivity of capital that collided head-to-head. The collision was exciting and lastingly productive for economics both then and today. The determination of wages, rent, and interest were, additionally, politically critical in the last years of the 1800s because of recent publications and public arguments suggesting that Socialism had respectable theoretical economic foundations for how income should be distributed among the various factors of production. Clark addressed the question of the distribution of income from the perspective of labor and wages; Böhm-Bawerk from the perspective of capital and interest. Squaring up these two approaches, which have to be consistent with the same unifying arithmetic budget constraints when added up, and sorting out the various logical errors that made the theories at odds, took economists on exciting paths and into new realms of analysis. Although Böhm-Bawerk's specific proposal of average periods of production lost out to John Bates Clark's marginal productivity theory, each author left wonderfully lasting contributions to the economics of wages, of interest rates, of the importance of careful studies of factors of production and capital accumulation, of the benefits of economists' working out theoretical inconsistencies in terms of mathematics and logic, and of the importance of separating statics (and the long-run) from dynamics (and intertemporal trade).

Fama, Eugene, Foundations of Finance

Fama, Eugene, and Miller, Merton, The Theory of Finance

Fisher, Irving, The Theory of Interest

Hume, David, "Of Interest," from Essays, Moral, Political, and Literary

Knight, Frank, Risk, Uncertainty, and Profit

Mackay, Charles, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds

Wicksell, Knut, The Influence of the Rate of Interest on Prices

    Can a forced reduction in the nominal rate of interest cause an increase in the price level; and if so, how does that square with the observation that inflations are empirically accompanied by high interest rates? Wicksell's 1906 lecture, presented before the existence of the Federal Reserve or international monetary coordination, was one of the first expositions of a Central Bank's potential ability, via interest rate policy alone, to affect the price level. Wicksell's thoughtful analysis remains influential today. Difficulty Level 2: Graduate School