What Is Interest?

A craftsman wants to expand his workshop. He must pay for the new machine today, but expects additional income only over the coming years. At the same time, an employee is setting money aside. She wants to live on it later while also being prepared for unexpected expenses. Both face the same question: how much of the present are they willing to give up for the future? Once a loan or an interest-bearing investment enters the picture, that question acquires a number: the interest rate.

In everyday life, we encounter interest as the cost of borrowing or the return on an investment. But that does not yet explain why it arises. Ludwig von Mises and John Maynard Keynes start from different points: Mises from the valuation of present and future, Keynes from the decision to keep money available or part with it. Understanding this difference reveals two different explanations of economic decisions behind the percentage figure.

Mises: The present and the future have different values

For Mises, interest rests on time preference: other things being equal, earlier satisfaction of a need is preferred to later satisfaction. This means neither that people fundamentally neglect their future nor that they reject future obligations. Rather, they weigh up which opportunities today they are willing to surrender for advantages later.

Mises calls the resulting difference in valuation originary interest. In his theory, this is neither merely a bank charge nor simply a reward for thrift. It appears in the discount applied to future goods compared with equivalent present goods. Mises aims to explain a fundamental economic relationship that extends beyond a loan agreement. His derivation is a theoretical position; it should not be presented as an uncontested explanation of every observed interest rate. Mises, Human Action, Chapter XIX, sections 1–2

Böhm-Bawerk: Why roundabout production takes time

Eugen von Böhm-Bawerk focuses on the structure of production. Someone who first makes tools or machines can later produce more goods with them than with bare hands. Such “roundabout methods of production”, however, require inputs and time. This does not mean an unnecessary detour, but the creation of aids that enable more productive work. It does not follow that every longer process is economically superior. What matters is whether the additional output justifies the effort. Böhm-Bawerk, The Positive Theory of Capital, Book I, Chapter II

Our craftsman makes this easy to picture: he can continue with his existing tools or invest working time and materials in a new device. During the conversion, he initially has less time for customers’ orders. Later, the device may make his work easier. The expected benefit thus arrives only after a period he must bridge economically.

Böhm-Bawerk incorporates the technical advantage of production resources available earlier into his explanation of the premium on present goods. Someone with resources today can begin using them productively sooner. Böhm-Bawerk, Book V, Chapter IV Mises places a different emphasis here: higher physical productivity alone does not explain interest for him. It may already be reflected in the machine’s purchase price. He therefore locates the origin of interest in the valuation of time. Even within the Austrian school, then, there is no entirely uniform theory of interest. Mises, Chapter XIX, section 2

Saving means being able to sustain the wait

From this perspective, capital formation is more than having a sum of money available. While a machine is being built, the people involved must continue to live; materials and existing means of production are also needed. Böhm-Bawerk therefore emphasises provision during the waiting period. It need not all exist as a finished stockpile. Ongoing production processes that yield consumer goods in time can provide it too. Only this provision creates room to direct labour and other resources towards outcomes further in the future. Böhm-Bawerk, Book II, Chapter III

For the workshop, this means that a loan commitment arranges financing. But the machine is built with available components, working hours and expertise. The Austrian perspective therefore connects monetary calculation with a tangible question: which present uses are being postponed so that this future project can actually be completed? Saving thereby acquires significance for production’s time structure beyond an individual bank balance.

Hayek: Interest helps coordinate plans

Friedrich August von Hayek examines how consumption wishes and production plans fit together over time. If people voluntarily consume less and make more available for investment, demand for consumer and producer goods changes, as do their relative prices. In his model, a lower interest rate and changed profit prospects can enable longer production processes. Interest is part of a price system through which many individuals’ plans are coordinated.

Hayek distinguishes this process from an expansion of credit without a corresponding voluntary shift in consumption wishes. If that initiates longer-term projects, they may later compete for resources with continuing consumption needs. This is the core of his explanation of possible miscoordination. It does not mean every low interest rate proves that something is wrong: what matters is how it arose and whether the projects begun can be sustained. Hayek, Prices and Production, Lecture II, sections 9–10, pp. 237–243 in the linked collection

Keynes: Savers also want to remain flexible

Keynes separates two decisions. First, a person decides how much income to consume and how much to save. Then comes the question of the form in which to hold those savings. Someone putting cash aside is saving too, but receives no interest for doing so. For Keynes, foregoing consumption alone therefore does not explain interest income.

His key concept is liquidity preference: the desire to hold wealth as immediately available money. For him, interest is compensation for surrendering that availability for a period. In the theory presented, its level arises from the interaction between liquidity preference and the available money supply. If the desire to hold money increases while the money supply and other conditions remain unchanged, this puts upward pressure on interest. A low interest rate is therefore not, in itself, evidence of unusually great uncertainty. Keynes, The General Theory, Chapter 13

Liquidity serves several purposes. People and businesses need money for ongoing payments, hold reserves for unforeseen events, and take account of their expectations about future interest rates and securities prices. In this view, holding money is a deliberate economic decision. Remaining flexible allows a response to new circumstances, though potentially at the cost of forgone returns. Keynes, Chapter 15

Where Keynes explains the relationship differently

The contrast is especially clear in saving. An individual’s decision to consume less does not yet amount to a concrete order for a machine. Nor does buying an existing security automatically create an additional production facility.

Keynes accordingly distinguishes an individual’s financial investment from investment in the economy as a whole. Saving denotes the unconsumed part of income; real investment concerns the formation of capital goods, including inventories. In his aggregate accounting, realised saving and investment are equal. But it does not follow that every additional desire to save immediately triggers an equally large planned investment. Adjustment can occur through changed income and output. Keynes, Chapter 7

What interest tells us about investment

The craftsman compares financing costs with the machine’s expected returns. If interest rises, the hurdle for the project becomes higher. It does not follow that his business prospects have improved. He may still expect exactly the same income and now abandon the expansion. Conversely, a cheap loan may help little if he expects no additional orders.

For Keynes, therefore, the expected profitability of an additional investment stands alongside the interest rate. He calls it the marginal efficiency of capital. Expected future returns relative to acquisition costs are decisive. A higher interest rate raises required profitability; it does not create that profitability. Claiming that high interest rates automatically indicate high profit expectations or strong willingness to invest thus confuses a financing hurdle with a business opportunity. Keynes, Chapter 11

Two perspectives on the same decision

The contrast can be sharpened as follows: Mises asks about the value of earlier versus later command over goods. Keynes additionally asks why people want to hold their wealth specifically as money and what compensation induces them to give up liquidity. The approaches emphasise different things and contradict each other in their explanation of interest. They can neither simply be equated nor reduced to the slogans “free market” and “state direction”. Böhm-Bawerk and Hayek add production’s organisation over time to the Austrian perspective: the future must be prepared with real resources, not merely financed. Keynes, by contrast, emphasises that the desire to save and the availability of resources do not guarantee sufficient investment demand. Put this way, the dispute becomes more concrete: under what conditions do postponed consumption, financing and production plans actually fit together?

Who pays for cheap credit?

Here the theoretical dispute takes on direct social significance. If additional money creation and credit stimulate demand without a corresponding increase in goods supplied, supposedly supporting the economy may come at the expense of other people’s purchasing power. Mises emphasises that new money does not reach everyone simultaneously. Early recipients can make additional purchases before all prices have adjusted. People who first pay higher prices and receive more income only later, or not at all, lose real room for manoeuvre. In Austrian criticism, this unequal distribution is a central objection to inflationary monetary policy. Mises, The Theory of Money and Credit, Part II, Chapter 12, section 2

For the employee in our example, this is not abstract. If her salary falls behind her living costs, she can afford less. If her savings grow more slowly than prices, her provision for the future also loses purchasing power. A simplified numerical example: €10,000 becomes €10,200 at two per cent annual interest. If prices rise by five per cent in the same year, that is equivalent to only about €9,714 in the previous year’s purchasing power. Despite the interest credit, the real loss is about €286, before taxes and fees. These figures are illustrative; the relationship follows from inflation’s erosion of money’s value. ECB: What is inflation?

Not everyone loses equally. Unexpected inflation can benefit debtors with fixed nominal payments at their creditors’ expense because the real value of repayments falls. The state can benefit as a debtor too. Whether a household gains or loses overall, however, also depends on income, assets and contractual terms. It is precisely these differences that make inflation a distributional issue. Mises, Part II, Chapter 12, section 1

This criticism can apply to a Keynesian-inspired policy of demand stimulation once it becomes inflationary. It is not proof, however, that every such measure inevitably makes everyone else poorer. Keynes himself distinguishes between unused capacity, where additional demand can bring greater output and employment, and bottlenecks, where it results more strongly in price increases. Upward pressure on prices can arise even before full capacity is reached. His theory of interest alone is therefore not a programme for monetary debasement. Keynes, The General Theory, Chapter 21

Austrian criticism thus puts an uncomfortable question to every promise of cheap financing: who bears the real cost? To the extent that policy causes price increases to outpace wages, pensions and savings interest, people who neither took out additional loans nor consented to lost purchasing power contribute too. Their accounts may show more money — yet it buys them less of a life.

Source note: The links point to English editions of the original works by Eugen von Böhm-Bawerk (The Positive Theory of Capital, English edition 1891), Ludwig von Mises (Human Action, 1949, and The Theory of Money and Credit, first published in German in 1912), Friedrich August von Hayek (Prices and Production, 1931, revised edition 1935, here in a later collected edition), and John Maynard Keynes (The General Theory of Employment, Interest and Money, 1936). The European Central Bank’s explanation of inflation is used additionally. This article translates our German summary and interpretation; it is not a verbatim reproduction of the original works. The workshop scenario is illustrative, not a documented case.

Not financial advice.