§1. More than One Rate of Interest

THE great shortcoming of the first and second approximations, from the standpoint of real life, is the complete ruling out of uncertainty. This exclusion of the risk element was made in order to make the exposition simpler and to focus the reader's attention on the factors most relevant to the theory of interest. But in real life the most conspicuous characteristic of the future is in its uncertainty. Consequently, the introduction of the element of chance, or risk, will at once endow our hypothetical picture with the aspect of reality. The foundation for our study of risk in relation to interest has already been laid in Chapter IV where the relation of risk to time preference was noted.

One consequence of changing our assumption as to the certainty of future events is to compel the abandonment of the idea of a single rate of interest. Instead of a single rate of interest, representing the rate of exchange between this year and next year, we now find a great variety of so-called interest rates. These rates vary because of risk, nature of security, services in addition to the loan itself, lack of free competition among lenders or borrowers, length of time the loan has to run, and other causes Edition: current; Page: [207] which most economists term economic friction. The very definition of loan interest as one implying no risk must now be modified so as to imply some risk that the loan may not be repaid in full according to the contract. Practically all of them are varieties of risk. Even in loans which theoretically are assumed to be riskless, there is always some risk. Modern corporate finance makes no pretence that risk is completely absent, but merely concerns itself with providing a more or less safe margin of protection varying with each specific case.

Furthermore, for our present purposes, contract or explicit interest is too narrow a concept. We now include not only the implicit interest realized by the investor who buys a bond, but the implicit interest realized by the investor who buys preferred stock. We may even include the rates realized on common stock, real estate, or anything else. Thus extended, the concept of interest becomes somewhat vague. And yet, if we exclude exceptional cases, there tend to emerge, at any time, several fairly definite market rates of interest according to the character of the security.

We find quoted rates on call loans, four months prime commercial paper, prime bankers' acceptances, first mortgages, second mortgages, as well as rates given by savings banks, rates allowed on active checking accounts, pawn shop rates, Morris Plan bank rates, rates realized on government bonds, railroad bonds, on other bonds, whether mortgage, debenture, or income bonds (all of which bond rates vary according to the character and credit of the issuer as well as in accordance with other circumstances), rates realized on preferred stock, and sometimes even the rates realized on common stocks. Wherever there is a sufficiently definite rate per cent per Edition: current; Page: [208] annum to be quoted as an expression of the current market, whether the quotation be in print or a verbal quotation in a broker's or banker's office, it seems proper to call it in a broad sense a rate of interest. Even when confined to such market rates, and excluding exceptional or individual rates, the rate of interest ceases to be the ideal, imaginary, single-valued magnitude hitherto assumed and takes on the myriad forms which we find in actual business transactions.

As indicated, this profuse variety is brought about chiefly by the introduction of risks of various sorts. The rate on call money is affected by the chance of the loan being "called" by the lender, or the sudden reduction of the total of such loans outstanding and the raising of the rate for those remaining. The rate on a loan-shark's loan is high because of the risk of non-payment by the borrower; the rate on a debenture and the rate on a second preferred stock of a moribund corporation are affected by the risk of inadequate corporate assets in event of liquidation; the rate on a government bond of a nation at war is affected by the chance of that nation's defeat; the rate of dividends on common stock is affected by the risks of the business; and so on in an infinite number of different cases.