Low Interest Rates: A Schumpeterian View

by Dirk Ehnts, Econoblog101

I am just about to finish reading Schumpeter’s “Theorie der wirtschaftlichen Entwicklung” (The Theory of Economic Development: …) in the original first edition in German. Schumpeter was Austro-Hungarian, and one of the most clever economists of his time, some say. I would like to focus on a single issue which Schumpeter brings up:

Interest is paid out of entrepreneur profits.

This is a fundamental insight. Schumpeter imagines the economic process of development like this. Entrepreneurs have ideas on how to combine inputs in a different way than is usually done, so that they can sell at higher profits, produce at lower costs, sell more, or combinations of the before. Entrepreneurs are willing to pay an interest rate because they believe that there will be enough profits out of which this cost of business can be paid. The cost of capital is the cost for being able to command purchasing power without which it would be impossible to start production, given that the entrepreneur is not already rich.

In the light of this insight, which I find hard to refute, what can be said about the current situation of low interest rates? At this moment in time, potential entrepreneurs do not judge their profits to be high enough to even afford paying very low interest rates. Whereas central banks hold interest rates at the zero lower bound, the interest rates that entrepreneurs face is still positive. I would think that it must be somewhere between 3-8% for projects that are risky, but only moderately so and in which some collateral is present to help the bank expand a loan.

Schumpeter is very clear in pointing out that a loan creates deposits for the entrepreneur, but does not take away deposits from anybody else. This function of the banking system is one of the main pillars of capitalism as he sees it (the other two are innovation and entrepreneurs). Let me add a bit to Schumpeter by expanding on the monetary circuit. If banks do not lend because entrepreneurs judge their expected profits to be too low, then the economy faces a period of stagnation. It thus interesting to understand in a next step what determines the profits of entrepreneurs. The answer to this question can be found in due time here.

Summarizing this post, our Schumpeterian view of economic crisis has led us to understand that the reason why interest rates are low that expected profits by (potential) entrepreneurs are low to non-existent, so that these do not feel inclined to borrow. Modern central banks, to help entrepreneurs make the decision to invest, have subsequently lowered interest rates in order to adjust to the pessimistic expectations of entrepreneurs. This is where we are today and leads us to the next question: what determines entrepreneur profits?