Saturday, May 29, 2010

On why our bank deposits earn even less income than a Risk-free Government bond

This was a question that had been vexing me for quite a while. My savings deposit earns an interest of 3.5% a year. Whereas, the 90 day Government bill issued by the Indian Government earns about 5% p.a currently.

Shouldn't my salary account at a risk-ridden private bank yield me an income that atleast exceeds what can be earned by holding a "risk-free" 3 month government security?

Irving Fisher, the American Economist of the early 20th century, provides the answer in his opening chapter of The Theory of Interest published in 1930.

While any exact and practical definition of a pure rate of interest is impossible, we may say roughly that the pure rate is the rate on loans which are practically devoid of chance. In particular, there are two chances which should thus be eliminated. One tends to raise the rate, namely the chance of default. The other tends to lower it, namely, the chance to use the security as a substitute for ready cash. In short, we thus rule out, on the one hand, all risky loans, and on the other, all bank deposits, subject to withdrawal on demand, even if accorded some interest...

Reading this unpretentious prose is a bit like being present at the invention of something new - like the discovery of fire or the invention of the wheel. I love the way he uses the term "pure" instead of the cliched modern phrase "risk-free". Also, I love the very broad-minded definition of the term "chance". Back in B-school, we invariably used to think of sigma (the standard deviation of cash flows) when the word "chance" was mentioned. Fisher is delightfully free from all the jargon conventions that bind us.

Most importantly, he manages to answer the question posed in the beginning of the post. There is some merit in reading 80 year old classics once in a while



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