# Yale - ECON-252-11 FINANCIAL MARKETS (2011) Lecture 8 - Theory of Debt, Its Proper Role, Leverage Cycles

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ECON-252-11: FINANCIAL MARKETS (2011)

Lecture 8 - Theory of Debt, Its Proper Role, Leverage Cycles [February 11, 2011]

Chapter 1. Introduction [00:00:00]

Professor Robert Shiller:. We're talking about the theory of debt and interest rates. So, I want to talk about a number of technical topics first. We're going to start with a model, an Irving Fisher model of interest. And then I'm going to talk about present values, and discount bonds, compound interest, conventional bonds, the term structure of interest rates, and forward rates. These are all technical things. And then, I want to get back and think about what really goes on in debt markets.

There are two assignments for this lecture. One is several chapters out of the Fabozzi manuscript. And then, there's a chapter from my forthcoming book that I'm currently writing, but that is the most meager chapter that I've given you yet. The book is not done, so I think the real reference for this is the Fabozzi et al. manuscript, at this point. And then, Oliver will give a TA section that will clarify, I think, some of the points.

Chapter 2. Theories for the Determinants of Interest Rates [00:01:24]

So anyway, what we're talking about today is interest rates. The percent that you earn on a loan, or that you pay on a loan, depending on what side of it you are. And interest rates go back thousands of years. It's an old idea. Typically, it's a few percent a year, right? The first question we want to try to think about is what explains that. Why is it a few percent a year? And why not something completely different? And why is it even a positive number? Ever think of negative interest rates? Well, these are basic questions.

So, I wanted to start with the history of thought and an economist from the 19th century, Eugen von Boehm-Bawerk, who wrote a book on the theory of interest in the late nineteen century. Actually it was 1884. And it’s a long, very verbose account of what causes interest rates. But basically, he came up with three explanations. Why is the interest rate something like 5%, or 3%, or 7%, or something in that range? And he said, there are really three causes. One of them is technical progress. That, as the economy gets more and more scientific information about how to do things, things get more productive. So, maybe the 3% percent, or the 5%, whatever it is, is the rate of technical progress. That's how fast technology is improving.

But that's not the only cause that von Boehm-Bawerk talked about. Another one was advantages to roundaboutness. That must be some translation from his German. But the idea is that more roundabout production is more productive. This isn't technical progress. If someone can ask you to make something directly right now, you've got to use the simplest and the most direct way to do it, if you're going to do it right now. But if you have time, you can do it in a more roundabout way. You can make tools first and do something else that makes you a more efficient producer of this. And so, maybe the interest rate is a measure of the advantages to roundaboutness.

And the third cause that von Boehm-Bawerk gave is time preference. That people just prefer the present over the future. They're impatient. This is behavioral economics, I suppose. This is psychology. That, you know, you've got a box of candy sitting there. And you're looking at it and you're saying, well, I should really enjoy that next year. Well, maybe it would spoil by next year. Next month. But somehow you don't.

Lecture 8 - Theory of Debt, Its Proper Role, Leverage Cycles [February 11, 2011]

Chapter 1. Introduction [00:00:00]

Professor Robert Shiller:. We're talking about the theory of debt and interest rates. So, I want to talk about a number of technical topics first. We're going to start with a model, an Irving Fisher model of interest. And then I'm going to talk about present values, and discount bonds, compound interest, conventional bonds, the term structure of interest rates, and forward rates. These are all technical things. And then, I want to get back and think about what really goes on in debt markets.

There are two assignments for this lecture. One is several chapters out of the Fabozzi manuscript. And then, there's a chapter from my forthcoming book that I'm currently writing, but that is the most meager chapter that I've given you yet. The book is not done, so I think the real reference for this is the Fabozzi et al. manuscript, at this point. And then, Oliver will give a TA section that will clarify, I think, some of the points.

Chapter 2. Theories for the Determinants of Interest Rates [00:01:24]

So anyway, what we're talking about today is interest rates. The percent that you earn on a loan, or that you pay on a loan, depending on what side of it you are. And interest rates go back thousands of years. It's an old idea. Typically, it's a few percent a year, right? The first question we want to try to think about is what explains that. Why is it a few percent a year? And why not something completely different? And why is it even a positive number? Ever think of negative interest rates? Well, these are basic questions.

So, I wanted to start with the history of thought and an economist from the 19th century, Eugen von Boehm-Bawerk, who wrote a book on the theory of interest in the late nineteen century. Actually it was 1884. And it’s a long, very verbose account of what causes interest rates. But basically, he came up with three explanations. Why is the interest rate something like 5%, or 3%, or 7%, or something in that range? And he said, there are really three causes. One of them is technical progress. That, as the economy gets more and more scientific information about how to do things, things get more productive. So, maybe the 3% percent, or the 5%, whatever it is, is the rate of technical progress. That's how fast technology is improving.

But that's not the only cause that von Boehm-Bawerk talked about. Another one was advantages to roundaboutness. That must be some translation from his German. But the idea is that more roundabout production is more productive. This isn't technical progress. If someone can ask you to make something directly right now, you've got to use the simplest and the most direct way to do it, if you're going to do it right now. But if you have time, you can do it in a more roundabout way. You can make tools first and do something else that makes you a more efficient producer of this. And so, maybe the interest rate is a measure of the advantages to roundaboutness.

And the third cause that von Boehm-Bawerk gave is time preference. That people just prefer the present over the future. They're impatient. This is behavioral economics, I suppose. This is psychology. That, you know, you've got a box of candy sitting there. And you're looking at it and you're saying, well, I should really enjoy that next year. Well, maybe it would spoil by next year. Next month. But somehow you don't.

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