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8. The Entrepreneurial Component in the Market Interest Rate
In the ERE, as we have seen, the interest rate throughout the economy will be uniform. In the real world there is an additional entrepreneurial (or “risk”) component, which adds to the interest rate in particularly risky ventures, and in accordance with the degree of risk. (Since “risk” has an actuarially “certain” connotation, we may better call it “degree of uncertainty.”) Thus, suppose that the basic social time-preference rate, or pure rate of interest, in the economy is 5 percent. Capitalists will buy 100 ounces of future goods to sell less remotely future goods one year later at 105 ounces. Thus, a 5-percent return is a “pure” return, i.e., it is the return assuming that the 105 ounces will definitely be accruing. The pure rate, in other words, abstracts from any entrepreneurial uncertainty. It gauges the premium of present over future goods on the assumption that the future goods are known as certain to be forthcoming.
In the real world, of course, nothing is absolutely certain, and therefore the pure rate of interest (the result of time preference) can never appear alone. Now suppose that in one particular venture or industry it is fairly certain that 105 ounces will be earned from the sale of a product one year in the future. Then, with a social time preference rate of 5 percent, the capitalist-entrepreneurs will be willing to pay 100 ounces for factors and reap a 5-percent return. But suppose that there is another possible venture considered very risky by entrepreneurs. The product is expected to sell for 105 ounces, but there are definite possibilities that the price of the product might plummet. In that case, the entrepreneurs will not be willing to pay 100 ounces for factors. They would have to be compensated for the extra risks that they run; the price of the factors might finally be 90 ounces. Thus, the riskier a given venture appears ex ante, the higher will be the expected interest return that capitalists will require before they make the investment.
On the market, then, a whole structure of interest rates will be superimposed on the pure rate, varying positively in accordance with the expected risks of each venture. The counterpart of this structure will be a similar variety of interest rates on the loan market, which, as usual, is derivative from the goods market.38 In the long run, of course, the tendency, given no changes of data, will be for people to realize that such and such a venture is pretty consistently yielding a higher than 5-percent return. The risk component for this venture will then fall, other entrepreneurs will enter this type of venture, and the interest rate will tend to fall back to 5 percent again. Thus, the varying risk structure of interest does not invalidate the tendency toward uniformity of the interest rate. On the contrary, any variety is something of an index of the various “risks” of uncertainty which still remain in the market and which would be eliminated if data were frozen and an ERE were reached. If data did remain constant, then the uniformity of the ERE would ensue. It is because data are always changing and thus setting up new uncertainties in place of the old that we do not have the uniformity of the ERE.
- 38. The loan market will diverge from the “natural” market to the extent that conditions for repayment of loans, etc., establish such differences. The two would be the same if the loans were clearly recognized as entrepreneurial, so that in cases where there was no deliberate fraud, the borrower would not be considered criminal if he did not repay the loan. However, if, as discussed in chapter 2 above, there are no bankruptcy laws and defaulting borrowers are considered criminal, then obviously the “safety” of all loans would increase in relation to “natural” investments, and the interest rates on loans would decline accordingly. In the free society, however, there would be nothing to prevent borrowers and lenders from agreeing, at the time the contract is made, that borrowers would not be held criminally responsible and that the loan would really be an entrepreneurial one. Or they could make any sort of arrangement in dividing gains or losses that they might choose.