The Online Library of Liberty

A project of Liberty Fund, Inc.

• Errata
• Preface
• Suggestions to Readers
• Part I.: Introduction
• Part I, Chapter I: Income and Capital 2
• Part I, Chapter II: Money Interest and Real Interest
• Part I, Chapter III: Some Common Pitfalls
• Part II.: The Theory In Words
• Part Ii, Chapter IV: Time Preference (human Impatience)
• Part Ii, Chapter V: First Approximation to the Theory of Interest Assuming Each Person's Income Stream Foreknown and Unchangeable Except By Loans
• Part Ii, Chapter VI: Second Approximation to the Theory of Interest Assuming Income Modifiable (1) By Loans and (2) By Other Means
• Part Ii, Chapter VII: The Investment Opportunity Principles
• Part Ii, Chapter VIII: Discussion of the Second Approximation
• Part Ii, Chapter IX: Third Approximation to the Theory of Interest Assuming Income Uncertain
• Part III.: The Theory In Mathematics
• Part Iii, Chapter X: First Approximation In Geometric Terms
• Part Iii, Chapter XI: Second Approximation In Geometric Terms
• Part Iii, Chapter XII: First Approximation In Terms of Formulas
• Part Iii, Chapter XIII: Second Approximation In Terms of Formulas
• Part Iii, Chapter XIV: The Third Approximation Unadapted to Mathematical Formulation
• Part IV.: Further Discussion
• Part Iv, Chapter XV: The Place of Interest In Economics
• Part Iv, Chapter XVI: Relation of Discovery and Invention to Interest Rates
• Part Iv, Chapter XVII: Personal and Business Loans
• Part Iv, Chapter XVIII: Some Illustrative Facts
• Part Iv, Chapter XIX: The Relation of Interest to Money and Prices
• Part Iv, Chapter XX: Objections Considered 73
• Part Iv, Chapter XXI: Summary
• Appendix to Chapter I
• Appendix to Chapter X
• Appendix to Chapter Xii
• Appendix to Chapter Xiii
• Appendix to Chapter Xix
• Appendix to Chapter Xx
• Bibliography

PART IV.

FURTHER DISCUSSION

PART IV, CHAPTER XV

THE PLACE OF INTEREST IN ECONOMICS

§1. Interest Rates and Values of Goods

HAVING completed the exposition of the theory of the causation and determination of the rate of interest which is most acceptable to me, it now remains to show how this theory fits into a complete system of economic theory and what results must flow from its acceptance.

Interest plays a central rôle in the theory of value and prices and in the theory of distribution. The rate of interest is fundamental and indispensable in the determination of the value (or prices) of wealth, property, and services.

As was shown in Chapter I, the price of any good is equal to the discounted value of its expected future service, including disservices as negative services. If the value of these services remains the same, a rise or fall in the rate of interest will consequently cause a fall or rise respectively in the value of all the wealth or property. The extent of this fall or rise will be the greater the further into the future the services of wealth extend. Thus, land values from which services are expected to accrue uniformly and indefinitely will be practically doubled if the rate of interest is halved, or halved if the rate of interest is doubled. The value of dwellings and other goods of definitely limited durability will fall less than half if interest rates double, and will rise to less than double if interest is halved. Fluctuations in the value of furniture will be even less extensive, clothing still less, and very perishable commodities like fruit will not be sensibly affected in price by a variation in the rate of interest. In all the foregoing cases it is, of course, assumed that the expected services remain unchanged.

§2. Interest Rates and Values of Services

As to the influence of the rate of interest on the price of services, we first observe that services may be either final or intermediate.1 The value of a dinner about to be eaten involves no time of waiting and so no discount or interest. Nor does the irksomeness of labor about to be undertaken involve discount to the laborer. Both the dinner or its enjoyment and the labor are final items of income, the one positive and the other negative. The value of intermediate services ("interactions") is derived from the succeeding future services to which they lead. For instance, the value to a farmer of the services of his land in affording pasture for sheep will depend upon the discounted value of the services of the flock in producing wool. If he rents the land, he will calculate what he can afford to pay for it on the basis of the value of the wool which he would expect to obtain from his flock. In like manner, the value of the wool output to the woolen manufacturer is in turn influenced by the discounted value of the output of woolen cloth to which it contributes. In the next stage the value of the production of woolen cloth will depend upon the discounted value of the woolen clothing to which that cloth contributes. Finally, the value of the last named will depend upon the expected real income which the clothing will bring to those who wear it, in other words, upon the use or "wear" of the clothes.

Thus the final services, consisting of the use of the clothes, will have an influence on the value of all the anterior services of tailoring, manufacturing cloth, producing wool, and pasturing sheep, while each of these anterior services, when discounted, will give the value of the respective capitals which yield them, namely, the clothes, cloth, wool, sheep, and pasture land. The values, not only of all articles of wealth, but also of all intermediate services which they render, are dependent upon the values of final enjoyable uses. Capital values and values of final uses are linked by the rate of interest. A rise or fall in the rate of interest will be felt most by the links most distant from these final services. A change in the rate of interest will tend to affect but slightly the price of making clothing, but it will tend to affect considerably the price of pasturing sheep.

The theory of prices, so far as it can be separated into parts, includes: (1) explanation of the prices of final services on which the prices of anterior interactions depend; (2) explanation of the prices of intermediate interactions, as dependent, through the rate of interest, on the final services; (3) explanation of the prices of capital instruments as dependent, through the rate of interest, upon the prices of their final services. The first study, which seeks merely to determine the laws regulating the price of final services, is independent of the rate of interest.2

The second and third problems, which seek to show the dependence on final services of the intermediate services and of the capital which bears them, involve the rate of interest. Under this second study will fall, as a special case, the study of the determination of economic rent, the rent both of land and of other instruments of wealth. The rent of a pasture consists of the value of the services of pasturing. This value, in accordance with the principles expounded in Chapter I, is dependent through the rate of interest upon the discounted value of the future final services to which the pasturing contributes. It is clear, then, that the rent of the land is partly dependent upon the rate of interest, and that the same dependence applies to the rent of any other instrument.

§3. Interest Rates and Wages

Similar considerations apply to the determination of the rate of wages. From the standpoint of the employer, the payment of wages to a workman supposedly represents the value of his services. These services are interactions, or intermediate services, leading ultimately to some future enjoyable service. Thus the shepherd, hired by the farmer to tend the sheep in the pasture, renders services the value of which to the farmer is estimated in precisely the same way as the value of the services of the land which the farmer hires.

Consequently, if interest varies, wages will vary. Thus, if the land is used for farming, the wages paid for planting crops will be gauged in the estimate by the farmer by discounting the value of the expected crops and will vary somewhat according to whether the discounting is at 5 per cent or at 4 per cent. In like manner the workers engaged in bridge building are presumed to be paid the discounted value of the ultimate benefits which will be yielded by the bridge. The wages of those engaged in making locomotives normally represent the discounted value of the completed locomotives, and hence, as the value of a completed locomotive is in turn the discounted value of its expected service, their wages represent the discounted value of the ultimate benefits in the series.3 In all these cases, the rate of wages is the discounted value of some future product, and therefore tends to decrease as interest increases. But the effects in the different lines will be very unequal.

Wages of domestic servants and those engaged in putting the finishing touches on enjoyable goods will have their wages affected comparatively little by the rate of interest. On the other hand, for laborers who are engaged in work requiring much time the element of discount applied to their wages is a considerably more important factor. If a tree planter is paid $1 because this is the discounted value at 5 per cent of the $2 which the tree will be worth when matured in fifteen years, it is clear that a change in the rate of interest to 4 per cent will tend materially to increase the value of such work. Supposing the value of the matured tree still to remain at $2, the value of the services of planting it would be not one dollar but $1.15. On the other hand, for laborers engaged in a bakery or other industry in which the final satisfactions mature early, the wages are more nearly equal to the value of these products. If they produce final services worth $1, due, let us say, in one year, their wages would be 95 cents when the interest rate is 5 per cent and 96 cents if interest falls to 4 per cent.

It is clear, nevertheless, that such unequal effects coming from a reduction in the rate of interest, as an increase from $1 to $1.15 in one industry and from 95 cents to 96 cents in another, could not remain permanently. Labor will tend to shift from the lower paid to the higher paid occupations until equality of wages for workers of the same skill is re-established. In the end, therefore, the change in the rate of interest from 5 per cent to 4 per cent would effect a redistribution in the values of intermediate items of income and in final items of income.

Evidently then, the effect of a change in the rate of interest on the value of interactions will naturally be the more pronounced in a country where lengthy processes are usually employed than in one where the shorter ones are common. If, for instance, laborers in a given country are engaged largely in building elaborate works, such as the Panama Canal, or in digging tunnels and constructing other great engineering works, or in planting forests and otherwise investing for the sake of remote returns, a fall in the rate of interest will produce a considerable rise in wages, whereas, in a country where such lengthy processes are unknown and workmen are chiefly employed in tilling the ground and performing personal services, a change in the rate of interest will hardly affect wages or the values of other preparatory services at all.

What has been said, however, applies only to wages from the standpoint of the employer. The rate of wages is dependent upon supply as well as upon demand, that is, upon the willingness of the workman to offer his services, as well as upon the desire of the employer to secure them. From the standpoint of the laborer, wages constitute an incentive to exertion or labor. This exertion is a final disservice, or negative item of income, and its valuation by the laborer is not directly affected by the rate ofinterest, as are other services which are not final but intermediate. It is a great mistake to treat the subject of wages, as many authors do, exclusively from the employer's standpoint. The purpose here is not to undertake to outline a complete theory of wages, but merely to show why a complete wage theory must take cognizance of interest and must explain how the interest rate affects some wage rates and not others.

§4. Interest and Functional Distribution

In the theory of distribution interest must be assigned a quite different and much more important rôle than economists thus far have given to it. In classical economics the nature of interest and its place in distribution were not clearly understood. Distribution has been erroneously defined as the division of the income of society into "interest, rent, wages, and profits." Rent and interest are merely two ways of measuring the same income; rent, as the yield per acre or other physical unit, and interest as the same yield expressed as a per cent of capital value. The value of the capital is derived from the income which it yields by capitalizing it at the prevailing rate of interest. To reverse this process by multiplying the capital value by the rate of interest gives the original income, as long as the capital value remains stationary. It is not really a complex product of two factors, but, on the contrary, is the single original factor, namely, income, from which we started. As explained in previous chapters, it is this income which affords the basis for the determination of the rate of interest, and through the rate of interest, of capital value.

The final enjoyable income of society is the ultimate and basic fact from which all values are derived and toward which all economic action is bent. All of this income is derived from capital wealth, if land and man are included in that term, or if not, from capital and man, or capital, land, and man, according to the terminology adopted. This income may all be capitalized, and hence all income (excluding capital gain) may be viewed as interest upon the capital value thus found.

Viewed as above outlined interest is not a part, but the whole, of income (except for capital gain). It includes what is called rent and profits and even wages, for the income of the workman may be capitalized quite as truly as the income of land or machinery. Thus, instead of having interest, rent, wages, and profits as mutually exclusive portions of social income, interest may be regarded as including all four. If we prefer to exclude profits, the reason is because of the element of risk and not because profits are not discountable just as truly as rent and wages. The error of the classical economists and of their modern followers in regarding interest, rent, wages and profits as separate but coördinate incomes is partly due to the failure to perceive that, whereas all income is produced from capital wealth, capital value can emerge only from man's psychic evaluation and capitalization of that income in advance of its occurrence.

Another oversight closely associated with the last stated fallacy is that in which rent and wages are conceived as determined independently of the rate of interest, whereas we have just seen that the rate of interest enters as a vital element into the determination of both. The great defect in the theories propounded by the classical economists lay in their inability to conceive of a general equilibrium and the mutual dependence of sacrifice and enjoyment.

In discussing the theory of distribution, we shall, therefore, abandon the classical point of view entirely. The classical concepts of distribution are quite inappropriate to explain the every day facts of life and the economic structure. The phrase distribution of wealth, as understood by the ordinary man, implies the problem of the relative wealth of individuals, the problem of the rich and the poor. But the separation of the aggregate income into four abstract magnitudes, even if correctly done, has little to do with the question of how much income the different individuals in society receive.

Only on condition that society was composed of four independent and mutually exclusive groups, laborers, landlords, enterprisers, and capitalists, would the fourfold division of the classical economists be even partially adequate to explain the actual distribution of income. In fact, the four classes all overlap. The enterpriser is almost invariably a genuine capitalist and usually also performs labor; the capitalist is frequently a landlord and laborer, and even the typical laborer is today often a small capitalist and sometimes a landlord. It is true that a century ago in England the lines of social classification corresponded roughly to the abstract divisions proposed at that time by the classical economists. But this fact is of little significance except as explaining historically the origin of the classical theory of distribution.4

§5. Interest and Personal Distribution

The main problem of distribution, as I see it, is concerned with the determination and explanation of the amounts and values of capitals and incomes possessed by different individuals in society. It is astonishing how little economists have contributed to resolving the problems of distribution so conceived. A statistical beginning was made by Professor Pareto in his presentation of interesting "curves of distribution of income."5 For the United States, Professor W. I. King6 and the National Bureau of Economic Research7 , and for England, Sir Josiah Stamp8 have made and analyzed important statistical compilations on the amount and distribution of income and capital wealth by income groups and social classes. On the theory of distribution, especially the rôle of interest in distribution, John Rae seems to have contributed more than any other writer9 . He showed in a vivid way that persons who had naturally what we have called in this book a low rate of impatience or preference for present over future income tended to accumulate savings, whereas those who had the opposite trait tended to spend their incomes and even their capitals.

In previous chapters it is shown that the rates of preference among different individuals are equalized by borrowing and lending or, what amounts to the same thing, by buying and selling. An individual whose rate of preference for present enjoyment is unduly high will contrive to modify his income stream by increasing it in the present at the expense of the future. The effects upon incomes may be traced to capital by applying the principles explained in The Nature of Capital and Income, Chapter XIV.

If a modification of the income stream is such as to make the rate of realized income relative to capital value exceed the standard rate of income returns, capital will be depleted to the extent of the excess, and the individual, group, or class, under consideration will grow poorer. This condition may be brought about either by borrowing immediate income and paying future income, or by selling instruments whose returns extend far into the future and buying those which yield more immediate returns. Individuals of the type of Rip Van Winkle, if in possession of land and other durable instruments, will either sell or mortgage them in order to secure the means for obtaining enjoyable services more rapidly. The effect will be upon society as a whole that those individuals who have an abnormally low estimate of the future and its needs will gradually part with the more durable instruments, and that these will tend to gravitate into the hands of those who have the opposite trait.

By this transfer an inequality in the distribution of capital is gradually effected, and this inequality once achieved tends to perpetuate itself. The poorer a man grows the more keen is his appreciation of present goods likely to become. When once the spendthrift is on the downward road, he is likely to continue in the same direction. When he has succeeded in losing all his capital except his own person, the process usually comes to an end, because civilized societies in self-protection frown upon chattel slavery and involuntary servitude. Many examples, however, of forced labor and even slavery still survive. The negro farmers of the Southern States, the Mexican peons, the peasants of Russia until recently, the forced labor and slavery in many tropical colonies, such as Java,10 the Congo, and other African countries, are examples in point.

Reversely, when an individual has saved a considerable capital, his rate of preference for the present diminishes still further, and accumulation becomes still easier. Hence, in many countries the rich and poor come to be widely and permanently separated, the former to constitute an hereditary aristocracy of wealth and the latter, a helpless proletariat.

This progressive sifting, by which the spenders grow poorer and the savers richer, would go on even if, as assumed in our first and second approximations, there were no risk element. But it goes on far faster when as in actual life there is risk. While savings unaided by luck will ultimately enrich the saver, the process is slow as compared with the rapid enrichment which comes from the good fortune of those few who assume risks and then happen to guess right. Likewise, while millions of people lose their small properties by thriftlessness, the more rapid impoverishment comes from guessing wrong. This will often turn a rich man into a poor man within a few years and sometimes within a few days.

It should also be noted, especially when the element of uncertainty is taken into account, that borrowing may be the means of gaining great wealth quite as well as of losing it. The business borrower who borrows in order to invest always hopes to gain and often succeeds beyond his expectations.

The rates of return over cost in various investment opportunities play an important rôle in both. Henry Ford and others grew rich not so much because of thrift as because they took advantage of unusual investment opportunities, in which the rates of return over cost proved to be many times the market rate of interest.

Besides thrift and luck, with their opposites, there is another factor closely associated with the process of accumulation or dissipation. This is habit. It has been noted that a person's rate of preference for present over future income, given a certain income stream, will be high or low according to the past habits of the individual. If he has been accustomed to simple and inexpensive ways, he finds it fairly easy to save and ultimately to accumulate a little property. The habits of thrift being transmitted to the next generation, by imitation or by heredity or both, result in still further accumulation. The foundations of some of the world's greatest fortunes have been based upon thrift.

Reversely, if a man has been brought up in the lap of luxury, he will have a keener desire for present enjoyment than if he had been accustomed to the simple living of the poor. The children of the rich, who have been accustomed to luxurious living and who have inherited only a fraction of their parents' means, may spend beyond their means and thus start the process of the dissipation of their family fortune. In the next generation this retrograde movement is likely to gather headway and to continue until, with the gradual subdivision of the fortune and the reluctance of the successive generations to curtail their expenses, the third or fourth generation may come to actual poverty.

The accumulation and dissipation of wealth do sometimes occur in cycles. Thrift, ability, industry and good fortune enable a few individuals to rise to wealth from the ranks of the poor. A few thousand dollars accumulated under favorable circumstances may grow to several millions in the next generation or two. Then the unfavorable effects of luxury begin, and the cycle of poverty and wealth begins anew. The old adage, "From shirt sleeves to shirt sleeves in four generations," has some basis in fact. This cyclical movement is more likely to occur in countries like the United States, where, owing to the rapidly changing conditions, there is more chance either to rise or fall in the economic scale. Wherever, as in the older countries of Europe, conditions have become fixed and less subject to changes of any kind, incomes and wealth are likely to remain relatively unchanged in the same families, generation after generation. This tendency is strengthened in England, where the customs of inheritance have helped to keep large fortunes intact in the hands of the eldest son.

We are not concerned here with creating a complete theory of personal distribution and its changes. This would include the effects of many factors other than thrift. But here we are interested simply in the rôle of interest and thrift in distribution.

§6. The Loan Market Is a Highway for Re-Distribution

We see, then, that the existence of a market rate of interest to which the individual adjusts his rate of impatience supplies an easy highway for the movement of his fortune in one direction or the other. If an individual has spendthrift tendencies, their indulgence is facilitated by access to a loan market; and reversely, if he desires to save, he may do so the more easily if there is a market for savings. In like manner, the business man may, by recourse to loans, either lose or gain. The inequality of the distribution of capital is thus fundamentally caused in large part by exchanging present for future income. A rate of interest is simply a market price for such exchange. If all individuals were hermits, it would be much more difficult either to accumulate or to dissipate fortunes, and the distribution of wealth would therefore be much more even.

It is true, as the socialist maintains, that inequality is due to social arrangements, but these arrangements are not, as he assumes, primarily such as take away the chance to rise in the economic scale; they are, on the contrary, arrangements which facilitate both rising and falling, according to the choices made by the individual. The improvident sink like lead to the bottom. Once there, they or their children find difficulty in rising. Accumulation is usually a slow process, and especially slow because the great numbers of the poor competing against each other reduce the values of their services to so low a point that the initial saving becomes almost impossible. While it is true that waste begets poverty, it is equally true that poverty begets waste. Whole communities and peoples, for example, the Chinese and Indians, are steeped in misery not because of any inherent extravagance, but because they are so poor they must use up all they produce, leaving no margin of savings for bettering their methods of production. Occasionally a Rockefeller, a Carnegie, or a Ford rises from near the bottom and ascends to the top. But the great masses, once they get near the bottom, are likely to remain there. Their high rates of impatience manifested through generations have brought many if not most of them to poverty. A labor leader once said to me that few labor men have any acquisitive instinct. They are a self-selected group of those impatient by nature or habit or both. They tend to spend rather than to save. The great need and opportunity for education in thrift is manifest.

This is not the place to answer the many questions which arise in such an inquiry, such as, what is the effect of change in the rate of interest in stimulating or discouraging the accumulation or dissipation of capital?11 What is the effect on the poor of the luxurious habits of the rich? Nor are we concerned with the other factors which influence the distribution of wealth but which do not involve the rate of interest. We are at present content merely to prepare the way for their answer by indicating the nature of the problem and the relation of the theory of interest to it.

PART IV, CHAPTER XVI

RELATION OF DISCOVERY AND INVENTION TO INTEREST RATES

§1. The First Effect of Each Important Discovery and Invention Is to Increase the Rate of Interest

THE interplay of impatience and opportunity on the rate of interest is profoundly influenced by invention and discovery. The range of man's investment opportunity widens as his knowledge extends and his utilization of the forces and materials of Nature grows. With each advance in knowledge come new opportunities to invest. The rate of return over cost rises. With the investments come distortions of the investors' income streams. These distortions are softened through loans, so far as the individual is concerned, the distortion being thus transmitted from borrower to lender and so spread over society generally. This distortion means relative abstinence from consumption during the period of producing and exploiting the new devices, followed by greater consumption later. In the meantime human impatience is increased.

In the field of transportation, for example, man originally had to depend upon his legs and arms to carry himself and his burdens. Later he invested in domesticated animals, and secured large returns on his investment, by increasing the range, speed, and efficiency of locomotion. Still later the invention of the wheel introduced the use of vehicles drawn by horses. The invention of the steam locomotive for hauling vehicles on rails enormously increased movements of goods and men, while at the same time the range and diversity of opportunities to invest were extended. Today advance in technical knowledge has multiplied investment opportunities a thousandfold in the transportation field alone. There is the possibility of street transit by surface, elevated, or subway lines. On land, men and goods are moved by steam and electric locomotives, trolleys, busses, automobiles or motorcycles. On the sea, sailing ships have been superseded by steam ships, and the old fashioned marine engine is now giving way to the steam turbine, Diesel engine and the electric motor. Man's ancient dream of flying through the air has at last been realized.

At the early stage of these space-abridging inventions society temporarily sacrifices some of its income for the sake of the greater returns to be expected later. For two generations railway construction drained off labor and caused investors to skimp. In these, as in all pioneering days, interest was high. In such periods people live on great expectations.

§2. Invention Causes Dispersion of Interest Rates

Besides tending to raise the rate of interest, invention and discovery tend to widen the gap between the interest rates on the safest securities and the rates of return over cost to those who first take advantage of the investment opportunities offered by the new devices.

Early investors make sacrifices and take great risks in the expectation of ample rewards in the shape of enhanced income. When the rewards for their sacrifices are realized these investors often reinvest their larger incomes for the sake of yet greater and more remote re turns. For example, in the United States, throughout the period of national expansion from 1820 to 1880, while the growth of farming, mining and manufacture went hand in hand with canal and railroad building, social income increased sharply through investment, return, and partial reinvestment. Rising national income marks all periods of advancement in industrial arts and practices. The statistics of income recently made available by the National Bureau of Economic Research show just such rapid rise, concurrently with a period of great inventions in electricity, chemistry, automotive engineering, radio and aviation. Thus in the United States capital investment per worker rose from $560 in 1849 to $5,000 in 1919, with a greater yearly increase in capital employed than the increase in working population. Horsepower per industrial worker increased from 1914 to 1925 from 3.3 to 4.3.12 The increased prosperity of the United States, due largely to increased utilization of inventions and scientific management, is shown by an increase of about three-eighths in national income from 1921 to 1927, with an appreciable increase in real annual wages, while salaries showed a constant rise, as expressed in purchasing power, after 1919. The total realized national income of the nation rose from $35,700,000,000 in 1913, to an estimated total of $89,000,000,000 in 1928.13

§3. Invention Causes Revaluation of Capital

Those enterprisers and risk takers who are first to enter the new investment field, opened up by an invention, or, in the slang of business, "get in on the ground floor" often obtain as a consequence a return on their original investment far greater than the rate of interest. Commodore Vanderbilt, Andrew Carnegie and Henry Ford are examples in point.

The rate of interest on loan contracts will rise as a result of those operations but only slightly. The cause of the increase which will occur is the increase in the marginal rate of return over cost.

In consequence of the higher interest rates, there occurs a revaluation of investment securities, and, in fact, of all capital. The value of capital, assuming that the value of the income from the capital remains the same as is true of bonds, sinks as the rate of interest rises. Bonds tend to fall while common stocks tend to rise, unless counteracting influences prove to be dominant.

This revaluation applies also to the very capital in which the new invention or discovery is embodied. If it is found that $100,000 invested in a newly discovered gold mine will result in a yield of $1,000,000 a year, that mine will no longer sell for its original cost, but for a sum far above it. It is the relation of the $1,000,000 a year to the new value of the mine, and not its relation to the original investment value or cost which will reflect the true rate of interest. Original investors in The Bell Telephone Company realized returns far beyond the normal interest on their investment, but the present investor pays a price for Bell Telephone stock commensurate with its dividends.

New devices will also cause a revaluation of the older ones which they have displaced, but in this case the new values are lower than before. The adoption of the circular saw rendered nearly valueless the mill plants equipped with the old up-and-down saw, and the band saw lowered the value of mills equipped with the circular saws. Hand looms and hand printing presses were superseded, except for special types of work, by power looms and presses. The early forms of power machines have in turn been superseded by improved machines. The automobile ruined first the carriage industry and later hurt the bicycle industry and even the perambulator industry. It is supplanting, in short hauls of freight and passengers, the railway industry, and both of these, in turn, are bound to be supplanted, in a measure, by the aviation industry, through its possibilities for producing the means of more speedy transportaton.

The reasons for these reductions in value are simple. Each new process produces a larger supply of the particular kind of service rendered. The price of this service—e.g., sawing or printing—is reduced, and consequently the capitalized value of the given amount of such service which can be expected from the older devices is reduced, and often so far reduced as to make the reproduction or even the repair of these older instruments wholly unprofitable. Thus progress constantly requires the writing off of capital value because of obsolescence.14

§4. The Ultimate Effects of Invention on Interest Rate

It is important to emphasize the temporary nature of the effects of invention and discovery in raising the rate of interest. The effect in raising interest lasts only so long as the rate of return over cost continues to be high and so tempts society to distort greatly its income stream in time shape. This period is the period of development and exploitation, during which society is sacrificing or investing present income, or, as it is inaccurately called, investing capital. Society, instead of confining its productive energies to the old channels and obtaining a relatively immediate return in enjoyable income, as by producing food products, clothing, etc., directs its labors to great engineering enterprises, such as constructing tunnels, railroads, highways, subways, waterworks, irrigation systems, mining and manufacturing plants. These instruments cannot begin to contribute a return in enjoyable income for many years. In contemplation, future income during this period is relatively plentiful, and in consequence of these great expectations, the rate of interest will be high.

Later, however, there will come a time when, so far at least as the effect of that particular invention is concerned, the income stream ceases to ascend, when most of the necessary investment has been completed, when little further exploitation is possible or advisable, and when it is only necessary to keep up the newly constructed capital at a constant level. When this period is reached, the after effect of the invention will be felt. The net effect on society will then have been to put the income stream on to a higher plateau, not to boost it uphill any more. But such a mere increase in the size of the income stream, while its shape remains constant, tends, as we have seen, not to increase, but somewhat to decrease the rate of time preference. Therefore, the after effect of all inventions and discoveries is not toward increasing but toward decreasing the rate of interest.

Thus, though the railway inventions led to a half century of investment in railways, during which the income stream of society rapidly increased, today the limit of steam railway investment has been nearly reached in some places, and in others the rapidity of investment has perceptibly slackened. Railroads have been an outlet for the investment of savings, and have tended to supply for them a good return. As the necessity for new railroads becomes less, this outlet diminishes, and the rates of return as well as the rates of interest in general tend to fall so far as this one influence is effective.

But while the after effect of an old invention is to reduce the rate of interest, it may, of course, be true that new inventions, often the result of the old, will be made rapidly enough to neutralize this tendency. It is chiefly when there is a cessation in the world's output of new inventions that the rate of interest is thus likely to fall back, but whenever invention is active the interest rate may rise continuously. It thus rises and falls according as the introduction or the exploitation of inventions is active or inactive.

The same principles apply not only to invention in the narrower mechanical sense, but also to scientific and geographical discoveries. The opening up of new mines in West Virginia, Canada, Alaska, South Africa, Australia and California caused a considerable depression in the immediate income streams of those who engaged in the exploitation of the new territory. Consequently, the rate of interest in such instances tends at first to be very high.

§5. The Present an Age of Invention

The present is an age of rapid invention, especially since the World War. President Hoover's Committee on Recent Economic Changes finds the "tempo" of improvement in industrial arts the most striking characteristic of our times. This increased tempo tends toward a high interest rate because of the flood of new inventions, despite the opposing influence of the old and matured inventions, which have made us so much richer.

Some outstanding examples of recent inventions which greatly increase production and consumption are: the automobile; the radio; the airplane; motion pictures in all their many uses; the numerous applications of electric power in factories and on the farm; long distance telephone, which has finally solved the problem of sending messages across the Atlantic Ocean; the utilization of cellulose, formerly a waste and a nuisance, in the manufacture of building materials, paper, and rayon textiles; the use of cotton seed for oil and fertilizer; the pulverization of coal by which its fuel value is greatly increased; the liquefaction of coal which gives added supplies of much needed gasoline; the innumerable chemical and dye products made from coal.

New discoveries and inventions, by utilizing wastes from forests, fields and mines, and increasing the output of labor have greatly advanced the scale of living in America.

Furthermore, the use of a new invention spreads with lightning rapidity in this high speed and intercommunicating age, affecting the income streams with a much greater influence than formerly and, as it spreads, it leads to further inventions. This is a chief reason why today is increasingly an age of invention. Nations like Great Britain, the United States, Germany and France lead in civilization by taking the greatest advantage of this self-propagating principle of invention, and nations like China and India, so long as they give it little attention, will lag behind.

Improvements in transportation developed the world granaries of Argentina, Canada, and the Mississippi Valley. The acreage of cotton was increased to feed the New England and British mills from the Southern and Gulf States, from Egypt and India. The investments in mining stretched over continents. Chilean nitrates were brought to American farms, and fresh investments were made in works that extracted nitrogen from the air. The coal deposits of the world were made to release solar energy stored up for millions of years, and the oil wells of Oklahoma and Baku became sources of new wealth and investment to supply a motor-driven age. Investments in machines, factories, railways, highways, warehouses, sewers, and in the ramifications of urban and suburban development enlarged the opportunities for surplus funds to an almost limitless extent. Reconstruction of devastated countries after the World War gave opportunity for the investment of billions of American dollars abroad, with flotations of foreign loans in the United States, in 1927 and 1928, averaging a billion and a half each year.

§6. Mass Production of Inventions

Moreover today we are organizing invention and discovery as we organize everything else. Experimental laboratories have spread from universities to government bureaus and commercial concerns. Millions are now spent on research where thousands or hundreds were spent a generation ago. And inventors are thus led not only to more intensive effort but to coöperate and pool their ideas. Mr. Hoover, before he was President, took steps toward a greater organization of scientific work looking toward invention.

During 1929, the Engineering Foundation launched a drive for five million dollars to aid scientific research. Major General George O. Squier reported in the Nation's Business for January, 1929, that in the laboratory of the American Telephone and Telegraph Company alone, $15,000,000 yearly were being devoted to the work of research which employed four thousand specialists. With respect to research General Squier added:

A survey by the National Bureau of Economic Research revealed, in its announcement of May 4, 1929, the extent to which industrial research prevailed as a new trend in manufacturing progress in the United States. Of 599 manufacturing concerns supplying information, the report stated that 52 per cent recorded the carrying on of research as a company activity. Testing laboratories were conducted by 7 per cent, leaving a minority in which no research work was being done. Some 29 per cent reported that they were supporting coöperative research conducted through trade associations, engineering societies, universities or endowed fellowships. Especially in cement manufacture, leather tanning, and gas and electric utilities, coöperative research was highly developed.

Statistical research has added its quota to investment opportunities. There had been business depression in 1920-1921. Herbert Hoover's engineering committee on Elimination of Waste in Industry reported some of the causes of that depression. The committee had found throughout industry a faulty control of material and design, as well as of production and costs. For example, the loss from idleness in shoemaking occasioned by waiting for work and material amounted to about 35 per cent of the time. It was found that standardization of the thickness of certain walls might mean a saving of some six hundred dollars in the cost of the average house. There were six thousand brands of paper, of which half were more or less inactive, and the duplication of brands tied up money in unnecessary stock. A shoe factory with capacity of twenty-four hundred pairs a day had shortage of needed racks, reducing output to nineteen hundred pairs daily. Most plants were found with no cost systems, or with incomplete knowledge of general costs, and for this reason most of them lost money. A multitude of shops lacked modern personnel relations with their employees; the workers had no unbiased means of approach to employers, while employers lacked the means of treating with their own men. Few plants had effective employment records; the turnover of labor was high and expensive. Sales policies were defective. There were cancellations of purchases on long-term contracts ranging up to 14 per cent, and returns of goods up to 11 per cent in so-called normal years. Lack of scientific management and of scientific forms of organization found production restricted by both employers and men. Maintenance of high prices, collusion in bidding, and unfair practices contributed to limit output, as well as did the practice of "ca' canny" by workers and the restrictive rules of the unions. It was found that eighteen hundred million dollars a year might be saved in preventing illness and deaths among American workers, and eight hundred and fifty million dollars more in preventing industrial accidents.

With the publication of this report, and of the succeeding Hoover report on unemployment and business cycles, American industrial management awoke to the possibilities of economic savings and higher organization, and American investment management found its opportunities correspondingly enhanced. Loans were supplied by the banks in measured volume, according to the needs of industry. The vast American market, blessed with free trade between forty-eight state jurisdictions, was thoroughly surveyed, and the wonders of technique and research were systematically evoked in the large scale as well as in the smaller but rapidly merging industries.

§7. Effects on Investment

Because of these inventions, introducing economies which revolutionized industry, common stocks on the American exchanges have advanced in 1928 and 1929, so that the dividend yields of dividend paying stocks were lower than the interest yields of high grade bonds. As an example of the eagerness of the investing public to finance newly-evolving industries, the Daniel Guggenheim Fund for the Promotion of Aeronautics announced that it was no longer necessary to grant equipment loans to air-transport companies, because, it stated, the "investment public is now ready to supply the capital for enterprises of this kind." By the close of the third decade of the twentieth century America had already shot ahead of Europe in commercial aviation, and was operating more than eighteen thousand miles of airways, of which eight thousand miles were lighted for night travel. The New York Trust Company in its reports took note that airplane production for 1928 was about five times that of 1927, and that demand for almost every type of aviation market was rapidly expanding.

Among investors there was knowledge that many of the inventions and discoveries made by the agencies of research would quickly find practical use. With the certainty that epoch-making inventions and methods of higher organization were being applied in the arts, opportunities to invest were multiplied, and thousands of new investors increased the transactions of the stock exchanges.

This varied and exciting chapter in modern industrial expansion is summed up by the Hoover Committee on Recent Economic Changes in its review (p. 844):

§8. Importance of Invention

It has not been the purpose of this chapter to investigate the general effect of inventions, but merely their effect on the rate of interest and rates of return.

Before leaving the subject, however, it should at least be stated that invention is a chief basis for progress in civilization and for increase in the income of mankind. The inventions of fire, the alphabet, and the means of utilizing power—first of animals, then of wind and water, then of steam and electricity—and their manifold applications, especially to transportation and communication, have made it possible for the earth to support its increasing population, and deferred the Malthusian pressure upon the means of subsistence; they have made possible the stable existence of great political units such as the United States; and they have given opportunity for the presentation, diffusion, and increase of knowledge in all its forms of art, literature, and science. And thus it happens that invention is self-perpetuating. For not only has science sprung from inventions such as the printing press, the telegraph, and specific scientific instruments for observation, like microscopes and telescopes, or for measurements, like chronographs, balances, and micrometers, but modern science is now in turn yielding new inventions. Helmholtz's researches in sound led to the telephone; Maxwell's and Hertz's researches on ethereal waves led to wireless telegraphy and the radio.

The conditions for the most rapid multiplication of inventions are: (1) mental efficiency, dependent on heredity, hygienic habits, and the education (both general and technical) of human faculties, and for this the Greek motto "a sane mind in a sane body" is in point; (2) the ease of diffusion of knowledge; (3) the size of the population within which the diffusion occurs—the larger the population the greater being the number of inventive geniuses, the greater their incentive, and the wider their sphere of influence; (4) the encouragement of invention especially through the early discovery and approval of genius, and, to some extent through patent protection. Inventors are at once the rarest and most precious flower of the industrial world. Too often they are crushed by the obstacles of poverty, prejudice, or ridicule. While this is less so today than in the days of Roger Bacon or Galileo, it still requires far too much time for the Bells, Edisons, Fords, or De Forests to get their start. The decades in which these rare brains are doing their wonderful work are at most few, and it is worth many billions of dollars for their countrymen to set them to work early. As Huxley says, it should be the business of any educational system to seek out the genius and train him for the service of his fellows, for whether he will or not, the inventor cannot keep the benefits of his invention to himself. In fact, it is seldom that he can get even a small share of the benefits. The citizens of the world at large are the beneficiaries, and being themselves not sufficiently clever to invent, they should at least be sufficiently alive to their own interests to subsidize or employ the one man in a million who can.

PART IV, CHAPTER XVII

PERSONAL AND BUSINESS LOANS

§1. Personal Loans

IN this chapter, I shall try to show that the theory of interest elaborated in this book applies to every species of loan contracts.

From the standpoint of the borrower, loan contracts may be classified as follows:

Personal loans are loans of individuals for personal purposes rather than those arising out of business relations. Of these, the first class comprises loans contracted because of misfortune or improvidence. These constitute today a very small fraction of total indebtedness. It was against interest on such loans that the biblical, classical, and medieval prohibitions and regulations were directed, and it is chiefly against interest on such loans that today, in enlightened communities, regulations affecting the rate of interest still survive. It is such loans that supply a large part of the business of pawn shops and of "loan sharks," the patrons of which are too often victims of misfortune or of improvidence.

The theory of interest which has been propounded in this book applies to this species of loan. Sickness or death in one's family, or losses from fire, theft, flood, shipwreck, or other unexpected causes, make temporary inroads upon one's income. It is to tide over such stringencies in income that a personal loan is contracted. It ekes out the inadequate income of the present by sacrificing something from the more adequate income expected in the future. Similar principles apply to the spendthrift, who, though not a victim of accidental misfortune, brings misfortune upon himself. He borrows in order to supplement an income inadequate to meet his present requirements, while he trusts to future resources for repayment. It is evident, therefore, that the loans just described are made by the borrower for the sake of correcting an income stream the time shape of which is unsatisfactory.

The second class of personal loans comprises those growing out of such fluctuations in income as are not due to misfortune or improvidence. Some persons receive their money income in very irregular and unequal installments, while their money outgo may likewise have an irregular time schedule. Unless the two series happen to synchronize, the individual will be alternately "short" and "flush." Thus, if he receives his largest dividends in January, but has to meet his largest expenses, let us say taxes, in September, he is likely to borrow at tax time for the ensuing four months, in anticipation of the January dividends. That is, he borrows at a time when his real income would otherwise be low, and repays at a time when it would otherwise be high. The effect is to level up the fluctuations of his income. He could, of course, proceed in the opposite way, lending in January when "flush" and being repaid in the fall in time to help him when "short" because of tax payments.

In brief, either he borrows, when short, because his degree of impatience, in view of the flush time coming, is higher than the rate of interest, or he lends when flush because his degree of impatience, in view of the lean time coming, is lower than the rate of interest.

The third class of personal loans comprises those which grow out of large expected additions to income or income earning power. Heirs to a fortune sometimes borrow in anticipation of bequests coming to them, the prospect of which excites their impatience. A considerable volume of such loans are made perhaps most often in Great Britain. The borrower under these circumstances borrows so that he can enjoy in the present some of the income which otherwise he would have to wait for. The same motives actuate young men preparing for the earning period of life and explain the loans which are often contracted by them for defraying the expenses of education. It was for such persons that Benjamin Franklin left his peculiar bequests to the cities of Philadelphia and Boston in 1790. To each he bequeathed £1000 to be lent out in small sums at 5 per cent to young married "artificers". The sums repaid, including interest, were to be added to the fund and again lent. Modern building and loan associations are organized to accommodate young couples and others wishing to enjoy good homes in anticipation of their power to pay for them in full. Installment buying, now so widely used to finance the buying of dwellings, furniture, automobiles, radios and other long-lasting instruments, cater to the same desires. They all appeal to young people with small immediate incomes but great expectations for the future.

It is evident that all the foregoing cases, comprising personal loans, are taken care of from the viewpoint of the borrower in the theory of interest; they are all expressions of impatience for greater income expected in the future.

§2. Business Loans

Business loans are commonly called productive loans, in contrast with personal or consumption loans. Business loans constitute by far the most important class of present indebtedness. Mr. George K. Holmes, formerly of the U. S. Census, at one time estimated that at least nine tenths of the indebtedness in the United States then existing was incurred for the acquirement of the more durable kinds of property, leaving not more than one tenth, and probably much less, as a consumption debt. The overwhelming preponderance of business loans has led some economists to account for interest on personal loans as a reflection of the rate of return lenders can secure by lending for production.

From another point of view it might seem that the theory which has been given in this book, based as it is on the enjoyable income stream of an individual, can apply only to consumption loans.

It is also said, with some appearance of truth, that consumption loans are explained on principles quite other than are production loans. In personal loans the two principles of impatience are dominant, while in business loans the two principles of investment opportunity are dominant. But in either case both sets of principles play their parts. And, since the degree of impatience and the rate of return over cost both tend toward equality with the market rate of interest, each influencing the other in that direction, we reach the same result to whichever one of the two—impatience or investment opportunity—we give our main attention. Lest the rôle of impatience in business loans be overlooked, let us first fix our eyes on that.

While business loans differ from consumption loans in respect to investment opportunity principles, they do not really differ in respect to the impatience principles. Both are used to tide over lean times in anticipation of prosperity, and they are said to be contracted in order to rectify the distortion of the income stream which would otherwise result from business operations.

The truth is—and it should never be lost sight of—that the business man conducts his business with an eye always to ultimately enjoyable income whether for himself, his family or for others. In a sense it is his home that runs his business rather than his business that runs his home.

§3. Short Term Loans

Two classes of business loans may be distinguished, namely, short loans growing out of periodic income variations, and long loans for relatively permanent investment. The short or periodic loans are those which grow out of the change in the seasons and the ebb and flow of business. These loans are obtained usually but once a year at a specified time. The ultimate cause is the cyclical change in the position of the earth in reference to the sun. This gives rise to the cycle of the seasons, the effects of which are felt not only in agriculture, but in manufacturing, transportation, trade, and banking. The alternate congestion and thinning of the freight business, the alternate stocking and depletion of raw material in factories, the seasonal fluctuations of trade activity, both wholesale and retail, the transfer of bank deposits between New York and the West for moving crops, or for other uses, all testify to the seasonal rhythm which is constantly felt in the great network of business operations. Without some compensating apparatus, such as that for borrowing and lending, these seasonal fluctuations in production, trade, and finance would transmit themselves to the final enjoyable income streams of individuals, and those incomes instead of constituting an even flow would accrue by fits and starts, a summer of lavish enjoyment, for instance, being followed by a winter on short rations.

To show how borrowing and lending compensate for these fluctuations, we may consider first what is perhaps the most primitive type of the short term loan, namely, that contracted by poor farmers in anticipation of crops. In the South among the negroes this takes the form of what is called a crop lien, the cultivator borrowing money enough to enable him to live until crop time and pledging repayment from the crop. Here, evidently, the purpose of the loan is to eke out the meager income of actual enjoyments. The loan, in other words, is for subsistence. This case, therefore, clearly involves the impatience principles.

These same principles apply also to loans contracted in the commercial world at large. A short time commercial loan is contracted for the purpose of buying goods, with the expectation of repayment after their sale. A common form is what is called commercial paper. A ready-made-clothing house may buy overcoats in summer in order to sell them in the fall. If these operations were conducted on a strictly cash basis, the tendency would be for the income of the clothier to suffer great fluctuations. He could realize but little during the summer, on account of the enormous expense of stocking in for fall trade, whereas in the fall he could obtain large returns and live on a more elaborate scale. This would mean the alternation of famine and feast in his family. One way to avoid such a result would be to keep on hand a large supply of cash as a buffer between the money income and personal expenditure. In this case the fluctuations in his income would not affect his personal enjoyment, but would cause an ebb and flow in his volume of cash. But a more effective and less wasteful method for the merchant to take the kinks out of his stream of real income is by negotiating commercial paper. The clothier, instead of suffering the large cash expense of stocking up in summer, will make out a note to the manufacturer of overcoats. After the fall trade, this note is paid, having fulfilled its function of leveling the income stream of the clothier.

Sometimes business men contract short term loans, not for some specific transaction such as the purchase of stock in trade, but for general business purposes, as, for instance, improvement or enlargement. In this case, the extraordinary expense involved may be met by a species of loan called accommodation paper. Evidently its function is precisely the same, namely, to rectify the time shape of the income stream.

In Wall Street and other speculative centers a type of loan known as the call loan is common, subject to redemption at the pleasure of the lender or the borrower, and used by the speculator for the purchase of securities. The speculator borrows when he wishes to buy and repays when he has sold, and by adroitly arranging and placing his loans he prevents the sudden draining or flushing of his income stream which these purchases and sales would otherwise involve, if they were to be made at all.

In all the cases which have been described, the loan grows out of a purchase or group of purchases, and since the tendency of every purchase is to decrease one's income, and of every sale to increase it, it is clear that loans contracted for a purchase and extinguished by a sale may be said to have as their function the obliteration of these decreases and increases of the income stream. We see then that these commercial loans fit into the impatience part of the theory of interest which has been propounded.

§4. Long Term Loans

The second class of business loans is that of long term loans or permanent investments. In this class are placed mortgages, whether on farms or on urban real estate. As shown by the 1890 Census, almost two-thirds of farm mortgages are contracted to buy land, and the remainder principally for improving it, or for the purchase of farm machinery and animals, or for the purchase of other durable wealth and property. The Department of Agriculture found that 87 per cent of the mortgages of 94 North Carolina farms in 1922 was contracted to buy land, and almost 10 per cent more to make real estate improvements. These purchases or improvements, involving as they do large expenditures, would be difficult or impossible without loans. If the attempt were made to enter into them without recourse to a loan market, they would cause large, though temporary, depressions in the income streams of the farmers. The farmer who attempted to buy his farm without a loan might not be able to do so at all or at best might have to cut down his current living expenses to a minimum.

Mortgages on city lots are usually for the purpose of improving such properties by erecting buildings upon them. The expense involved would, if taken out of income, reduce the income of the owner temporarily. He naturally prefers to compensate for such extraordinary inroads by a mortgage loan which defers this expense to the future when he expects that his receipts will be larger.

We come next to the loans of business corporations and firms, such, for instance, as railroad bonds and debentures, the securities of street railroads, telegraph, and telephone companies, steel mills, textile factories, and other "industrials." These loans are usually issued for new construction, replacement, and for improvement of plant and equipment. The borrowers in this case are, in the last analysis, the stockholders. They may be said to contract the loan in order not to have the expenses of the improvement taken out of their dividends. Sometimes, of course, where the earnings are large enough they are actually applied, in part or wholly, to the making of improvements. Ordinarily, however, such a reduction in the stockholder's income stream is avoided by the device of inviting bondholders to bear the outgoes connected with the improvement, in consideration of receiving a part of the increased income which it is hoped will later follow from these improvements.

§5. Business vs. Personal Loans

Business loans therefore serve to reshape the income streams to conform to the time preferences of their owners just as truly as do personal loans. All financing may be considered as contrived to keep income flowing smoothly to serve human impatience.

The important difference between business loans and personal loans is not as to impatience but as to investment opportunity. In personal loans the opportunity principle plays a minor rôle or none at all. The personal borrower borrows not to invest but to remedy or prevent a present dearth of income because of illness or the desire to anticipate future income, the amount of which has little or nothing to do with the loan. The business borrower, on the other hand, borrows to remedy or prevent a dearth of present income because he wishes to invest and increase his future incomes. Each is impelled by impatience to fill a hole in his present income, but the one hole was cut by involuntary illness or voluntary spending, the other by voluntary investment.

Let us examine this difference more in detail. Let us suppose two borrowers, one a personal borrower, because of some misfortune such as an illness, and the other a business borrower, because of an investment. Let us suppose that, otherwise, they are alike in all respects affecting our present problem. Each has a prospective income of $10,000 this year and $12,500 next year, after allowing for the effects of the misfortune in one case and for that of the investment in the other, but before any loan is made.

Each will, let us say, borrow $1,000 this year and repay this with 5 per cent interest next year, making a total repayment of $1,050. Each, therefore, will have a finally adjusted income this year of $10,000 + $1,000 or $11,000 and next year of $12,500 - $1,050 or $11,450. The effect of the loan is thus identical on the income streams in the two cases. The difference is that the unfortunate, if deprived of his loan, could not escape from his lower income stream this year of $10,000 despite his higher income next year, whereas the business man, if deprived of his loan, could, if he chose, give up easily the investment altogether. That is, the merchant has another option which the unfortunate lacks. He has two options and therefore the opportunity to replace one by the other.

If the merchant did not have this extra option, the two cases would be so similar that not even a stickler for the distinction between a consumption loan and a production loan would assert any essential difference. For, suppose the merchant had already been committed sometime previously to the investment, not, perhaps, realizing that he would be unable to pay for it without borrowing or skimping. When the time arrives when he must of necessity pay in his money, he finds that a loan is badly needed to avoid pinching himself in income. He will now think of the loan not as enabling him to invest, for that has to be done anyway, but as enabling him to buy his bread and butter. In short, his loan, like the unfortunate's, is now a consumption loan! It is because ordinarily the merchant is not thus constrained to make the investment that the loan is connected in his mind with the investment rather than with his private necessities. Yet, in either case, it serves to relieve his needs. In a sense all loans are impatience loans, but in the production case he has another method of relief—not to invest at all. The essential contrast, then, between him and the unfortunate is simply that he has a possible course open to him which the latter does not have.

This is not to deny that the loan (and the investment which it makes possible) is also to be considered for the purpose of increasing his income. It is both. As stated already, had he wished, he might have refrained, ordinarily, altogether from making the investment. He would, then, let us suppose, have had an income of $11,000 a year both this year and next. He was attracted by the opportunity to invest $1,000 because while this would reduce this year's income by that amount—to $10,000—it would increase next year's by $1,500—to $12,500. The whole set of operations go together. If we separate them in thought, the true sequence is: of the two optional income streams ($11,000, $11,000, on the one hand, and $10,000, $12,500 on the other) the merchant selects the latter because it had the greater present value (or, what amounts to the same thing, because the rate, 50 per cent, of the return of $1,500 on the sacrifice of $1,000 is greater than the rate of interest, 5 per cent). That being done he then borrows because, although he will have the same present value, he will get a more desirable time shape. This description takes account of the whole series of operations, and corresponds to the principles propounded in Chapter VI. It is the extra option which gives rise to the contention that the loan produces a profit not possible or easy without it, and that it is, therefore, productive. And this is true in the sense that the loan carries with it the extra option. The loan is productive in so far as without it this extra option which is productive would not be chosen.

We have just seen that the loan phenomena can be resolved into two separate steps. Yet since it may often happen, as shown in Chapter VI, that the first step (choice of options) would not be taken unless the second step (loan) were already in contemplation, or even fully contracted, it is true that in a sense the choice of the loan includes the choice between the options. In this sense, and in this sense alone, is the loan productive. It is productive in that it gives to the merchant a productive investment opportunity. But it is better, or at any rate admissible, to say that it is this investment opportunity which is productive rather than the loan which makes it possible.

In practical life, however, the investment and the loan are not usually thought of as separate operations. Rather are they thought of as parts of the same operations. The investment, especially if a large one, would not, and often could not, be made unless the resultant distortion of the income stream is at once and by prearrangement, remedied by a loan. The loan is in fact often contracted for before any committal to the investment, and were it not employed, or something like it, the distortion of the income stream needed to make the investment possible would often reduce it to zero or below.

The point here is that if we do try to separate the rôles of the loan and the investment we cannot say that the loan by itself, without the investment, yields a business profit, but we can say that the investment by itself does. Adopting the latter mode of thought, we are free to think of a business loan as having, by itself, just the same function as any other loan—to even up the income stream in accordance with the principles of impatience.

§6. Purpose of Borrowing to Increase Present Income

We have now seen that the theory of interest which has been propounded is adequate to explain the motives which lead to borrowing in the actual business world.

The personal loan comes near to exemplifying our first approximation where there is a supposedly fixed income stream, while the business loan exemplifies the second or the full fledged third approximation where there are alternatives. Of course, even the unfortunate who needs a loan may have alternative ways to turn. No income stream in actual life is absolutely rigid. But the various opportunities open to the typical personal borrower are not very important or striking as compared with those open to a business man seeking a loan to finance some great enterprise.

The foregoing classification of loans is made from the standpoint of the borrower. From the standpoint of the lender, loans do not need to be so minutely classified.

§7. Public Loans

Public Loans need not be treated in detail since they have all the characteristics which belong to private loans for consumption and production. The public loan for consumption is exemplified in the war loans and the loans to anticipate future revenues. A government receives its income chiefly in taxes, and in some cases only once a year, whereas its outgo occurs day by day and month by month. It thus happens that a government is alternately accumulating a large surplus and suffering a large deficit. The inconvenient effects of this have often been commented upon, especially in this country, where the Treasury for half a century was relatively independent of such institutions of credit between the governments and certain central banks as have long existed in England, and exist now in this country. The government may correct the irregularities in its income stream by borrowing for current expenses in anticipation of taxes. The United States Government often sells short term Treasury certificates when government receipts are low, and redeems these certificates when funds come in from taxes or other sources. The opposite process may be employed. The Government may lend at interest by depositing surplus funds in banks to draw interest until needed for disbursements, or, what amounts to receiving interest, it may, by buying its own bonds or redeeming them for a sinking fund, save interest which would otherwise have to be paid. But this last operation is normally employed only when the funds are not needed later for disbursements.

The public productive, or business loan, is exemplified in loans for the purpose of constructing railroads, or other improvements which are intended to be business undertakings, such as the erection of government buildings, the improvement of roads, bridges, and harbors, the construction of municipal waterworks or schoolhouses. In all such cases it is usual to finance the enterprise by issuing bonds. The reason is that these improvements constitute an extraordinary cost, similar to the expense of a war, which if undertaken without the issue of bonds would cause a temporary and inconvenient depression in the income streams of the taxpayers. They, as a whole, could not afford any such first heavy drain, even with the prospect of substantial benefits to follow. They therefore prefer to avoid such a fluctuating income stream, and to secure instead a more uniform one. This uniformity is secured by the loan, which so far as they are concerned, spreads the expenditures over part or all of the period during which the public improvement is expected to last. We see, therefore, that this class of loans also exemplifies the theory of the relation of borrowing and lending to the time shape of an income stream. The motives which have been described as operating in the case of private loans operate in the same way with public loans. Borrowing by a public corporation shifts to the purchasers of bonds in first instance the burden of war expenditure or the cost of improvements. The taxpayers repay the bondholders when the bonds are finally paid. The effect is the same in public borrowing as in private borrowing, the shape of the income stream of the public borrower is changed in the same manner. There is present also a rate of return over cost, though one difficult to put in figures because public benefits are not usually reduced to money values.

PART IV, CHAPTER XVIII

SOME ILLUSTRATIVE FACTS

§1. Introduction

THIS chapter consists of a brief study of the chief influences affecting the rate of interest. It is impossible to present a verification of any theory of interest. The facts are too meager, too conflicting, and too intermixed to admit of clear analysis and precise interpretation. In all places and at all times the economic causes tending to make interest high are combined with others tending to make it low. The fact, therefore, that interest is high or low, rising or falling, in conformity with the postulates of a particular theory, does not prove that the theory is the only true explanation. The best that we can expect is to show that the facts as we find them are not inconsistent with the theory maintained.

The causes making for high or low interest rates tend to counteract themselves. For instance, the economic causes, which before the World War tended to make interest high in the United States, also tended to bring in loans from other countries, especially from Great Britain, where the rate of interest was then low. The introduction of the loans prevented interest from being as high as it otherwise would have been. High interest in one community tends to increase the borrowings of that community, provided there exists another community in which the rate of interest is lower. If borrowing from abroad is not practicable, other methods of adding to present at the expense of future income may be found. If such processes go far enough they will result in a dissipation of capital, or in a slower accumulation of capital.

Contrariwise, the causes which work toward lending may result, if lending is impracticable, in some other ways of postponing consumption, and may show themselves in a more rapid accumulation or in a less rapid dissipation of capital.

The same economic causes which tend to make interest high will tend also to encourage the production of the less substantial and durable instruments, whereas those causes which tend to make interest low will favor the production of instruments of the more durable and substantial types.

In general, high interest, borrowing, dissipation of capital, and perishability of instruments go together. Any cause which produces any one of the four will, in general, tend also to produce the other three. Likewise low interest, lending, accumulation, and durability of instruments, generally go together.

The theory enunciated is that the rate of interest depends on impatience and investment opportunity. As any cause increases or decreases our impatience for immediate income, it tends to increase or decrease the rate of interest. Any cause which increases our opportunity to secure returns on investments in excess of the existing rate of return tends to increase the rate of interest; and conversely when, for any cause, opportunities to invest promise only returns less than the existing return on investment the interest rate tends to decline.

In Chapter IV were enumerated the causes which in the nature of man tend to make interest high or low. It was there stated that foresight, self-control, and regard for posterity tend to reduce impatience for income and so tend to make interest low. We may expect to find therefore in a community possessing these qualities some or all of the four interrelated phenomena already mentioned—low interest, lending to other communities, accumulation of capital and construction of substantial capital instruments. In a community lacking these qualities we may expect to find some or all of the four opposite conditions.

§2. Examples of Influence of Personal Characteristics

The nations and peoples which have been most noted in the past for foresight, self-control, and regard for posterity are probably the Dutch, Scotch, English, French, Germans and Jews, and the interest rate has been relatively lower in general in the communities dominated by these peoples than in communities dominated by less thrifty peoples. They have been money lenders; they have had the habit of thrift and accumulation, and their instruments of wealth have been in general substantial. The durability of their instruments of wealth is especially seen in their buildings, both public and private, and in their ways of transportation—roads, tramways, and railroads.

John Rae observed of Holland:

On the other hand, among communities and people noted for lack of foresight and for negligence with respect to the future are India, Java,16 the negro communities both North and South,17 the peasant communities of Russia,18 and the North and South American Indians, both before and after they had been subjugated by the white man. In all of these communities we find that interest is high, that there is a tendency to run into debt and to dissipate rather than accumulate capital, and that their dwellings and other instruments are of very flimsy and perishable character.

It may well be that there are other causes at work to produce these results. We are here merely noting the fact that lack of foresight is one factor present. John Rae's characterization of the Indians both of North and South America as highly improvident and lacking in foresighted thrift is based on personal observation and the testimony of missionaries and travelers.19 The negroes of Africa are perhaps even less provident than the American Indians.

In many if not all of the cases which have been cited there are, of course, other elements which would tend to explain the facts besides mere mental characteristics. Thus, the high rate of interest among the negroes and the Russian peasants is undoubtedly due in part to their poverty, though their poverty is in turn due in varying degree to their mental characteristics. Where there is too little appreciation of the needs of the future, capital tends to disappear; and the pressure of poverty tends to enhance still further the demands of the present and to press down its victims from bad to worse.

Not only do we find examples of high rates of preference for present over future goods among the prodigally rich, but often we find low rates of preference for present over future goods among the thrifty poor. Examples are especially frequent among the Scotch, the French peasants, and the Jews, whose propensity to accumulate and to lend money even in the face of misfortune and social ostracism is well known.

The factor which has been designated as "regard for posterity" deserves special attention. Perhaps the most conspicuous example of extreme disregard for posterity is found in Rome during the time of its decline and fall. Rae stresses the decay of family affection, the growth of extravagant expenditure, and the high interest rates20 High interest rates in Rome were evidently the result of reckless disregard of the future. Before Rome had seriously depleted her capital wealth, at about the end of the republic, the interest rate was as low as 4 to 6 per cent.21

§3. Examples of Influence of Poverty

The characteristics of foresight, self-control, and regard for posterity are partly inherent and partly induced by conditions of the environment. Among the cases which have been given are conspicuous examples of both, although it is difficult here, as always, to disentangle the influence of heredity from that of environment. We are accustomed, for instance, to ascribe to the Jews a natural racial tendency to accumulate, though this characteristic is certainly re-enforced by, if not largely due to, the extraordinary influence of Jewish tradition. Of the Scotch it would be difficult to say how much of their thrift is due to nature and how much to training handed down from father to son. The American negro is regarded as by nature a happy-go-lucky creature, but studies of negro life in Africa indicate that under favorable conditions the negro is self-denying, while recent experience with industrial schools has demonstrated the fact that forethought and saving can be readily fostered by training. Reckless wastefulness has been created in large part among the negroes by tyranny and slavery.

The influence of conditions upon accumulation may be seen everywhere, even in the most advanced industrial countries. When postal savings banks were first introduced in England, it was objected that the English poor for whom they were intended were so spendthrift that they would never make use of them. But Gladstone insisted that habits were an arbitrary matter, and that the fashion of spending would be displaced by the fashion of saving as soon as opportunity and incentive were afforded and the principle of imitation had had time to operate. The experience with English postal savings banks justified his prediction.22

Rae remarks upon the flimsiness of the Chinese buildings and implements and explains this by saying that the people "think not so much of future years as of the present time."23 But the high interest rates of China are probably not due, as Rae seemed to think, to any native lack of industry, frugality, or parsimony on the part of the Chinese people, as is evidenced by the large accumulations of capital made by Chinese living abroad where they are freed from the exactions of arbitrary governors and from the tyranny of the clan-family system. Presumably the wastefulness and high interest so evident in China are most largely due to the action of poverty and uncertainty.

For, as has been emphasized in previous chapters, the rate of preference for present over future goods is not a question of mere personal characteristics, but depends also upon the character of one's income stream; on its size, shape, composition, and certainty. In respect to size, our theory maintains that the larger the income, other things such as habits, foresight and self-control being equal, the lower the rate of preference for present over future goods. If this is true, we should expect to find poverty and riches associated respectively with a high and a low rate of interest, or with borrowing and lending, or with spending and saving, or with perishable and durable instruments. That this characterization is in general correct is not likely to be denied.

It is true of course that the amount loaned to the poor is small because each individual loan is necessarily small, but the number of these loans is very great, and the desire of the poor to borrow, when such desire exists, is very intense. The many conspicuous exceptions to these rules are explainable on other grounds. It not infrequently happens that the poor, instead of being borrowers, are lenders, but in this case either they have unusual foresight, self-control, regard for their children, and other qualities tending in the same direction, or else their income stream has such a time shape as to encourage lending rather than borrowing. Reverse conditions apply likewise to the case of many wealthy men who are borrowers not lenders. In general, a rich man borrows not from lack of self-control and foresight, but because of exceptional opportunities to invest advantageously, including opportunities to protect and extend investments already made.

As a rule, however, the poor are more eager borrowers than the rich, and are often obliged to patronize pawn shops and other agencies in which the rate of interest is inordinately high. The dwellings and other instruments of the poor are generally of a very unsubstantial character. Their clothes are selected of necessity more for cheapness than durability. Such uneconomical expenditures are often even unavoidable, and reflect a very high estimate on present as compared with future goods. The deeper the poverty, the higher the rate which the borrowers are compelled to accept. Even pawnbroking is not available for the extremely poor, but is patronized rather by the moderately poor. Those who are extremely poor cannot give the kind of security which the pawnbroker requires. On this account they become the victims of even higher rates of interest, pledging their stoves, tables, beds, and other household furniture for the loans they contract. These loans are repayable in installments such that the rate of interest is seldom lower than 100 per cent per annum.24

Turning from social classes to countries, it is noteworthy that in the countries in which there are large incomes we find low interest, a tendency to lend as well as to borrow, to accumulate as well as to spend, and to form durable rather than perishable instruments. In countries where incomes are low the opposite conditions prevail. Thus, incomes are large and interest rates are relatively low in the United States, Holland, France, Germany, and England, whereas the reverse conditions hold in Ireland, China, India, Java, the Philippines and other less developed countries. In Ireland, for instance, especially in the early part of the nineteenth century, the rate of interest was high. The cotter was always in debt, and his hut and other instruments were of the most unsubstantial variety.25 Again in the Philippines the rate of interest on good security is often 2, 4, and even 10 per cent a month. The Chinese money lender frequently takes advantage of the Filipino's poverty.26 Many of these cases may be wholly or partly explained by other causes such as have been mentioned in the last section.

§4. Examples of Influence of Composition of Income

As to the influence of the composition of income, it is even more difficult to obtain any statistical confirmation of importance. Variations in the amount of that real income which takes the form of food has an effect on the rate of interest similar to the effect of variations in the total income itself. Scarcity of food tends therefore to cause high interest, and abundance of food, low interest. During the siege of Paris the rate of interest was high, although other causes than the scarcity of bread were doubtless largely accountable for the fact. While no statistics of interest rates appear to be in existence for such periods, the testimony of eyewitnesses agree that in Belgium when starvation threatened during the World War the rates of interest were extremely high. Likewise during the blockade of Germany when the food shortage was acute, abnormally high interest rates are reported.

§5. Examples of Influence of Risk

As to the influence of uncertainty or risk, we encounter similar difficulties in getting positive inductive evidence. But evidence that in general risk tends to raise the commercial rate of interest but to lower pure interest is abundant. The first part of this proposition is a matter of such common observation that no special collection of facts is necessary. Every lender or borrower knows that the rate of interest varies directly with risk. A bird in the hand is worth two in the bush.

The principle applies not only to the explicit interest in loan contracts, but to the implicit interest which goes with the possession of all capital. Where there is uncertainty whether income saved for the future will ever be of service, but the certainty that it can be of service if used immediately, the possessor needs the possibility of a very high future return in order to induce him to save. It is noteworthy that in time of war there is a ruthless destruction of crops and a tendency among the possessors of consumable wealth to enjoy it while they may. The same conditions are characteristic of communities which are in a perpetual state of political insecurity.27 "The rate of interest is everywhere proportional to the safety of investment. For this reason we find in Korea that a loan ordinarily brings from 2 to 5 per cent per month. Good security is generally forthcoming, and one may well ask why it is so precarious to lend. The answer is not creditable to Korean justice.... In a land where bribery is almost second nature, and private rights are of small account unless backed up by some sort of influence, the best apparent security may prove a broken reed when the creditor comes to lean upon it."28

There remains the second part of the proposition in regard to risk, namely, that, while risk tends to increase the rate of interest on risky loans, it tends at the same time to decrease that on safe loans. This proposition is not familiar to most persons. It has usually caused surprise that during a time of political stress and danger the rates of interest on perfectly safe loans were found to be so small. Many such instances may be cited. At certain periods during the Civil War when the greatest uncertainty prevailed loans with good security were contracted at nominal rates, and bank deposits tended to accumulate for lack of sufficient outlet in secure investments. The same conditions existed in Europe during the World War. Times in which public confidence is shaken are characterized not only by high rates on unsafe loans, but by efforts on the part of timid investors to find a safe place for their savings, even if they have to sacrifice some or all of the interest upon them. They will even hoard savings in stockings and safe deposit vaults. We may even occasionally find cases in which the desire to obtain a safe method of keeping capital is so keen and so difficult to satisfy that the rate of interest is negative. The investor is then thankful enough to receive the assurance that his capital, by being intrusted to another, will not be diminished, to say nothing of being increased.

§6. Examples of Influence of Time Shape

We still need to exemplify the most essential part of the theory, namely, that the rate of interest depends through the rate of impatience upon the time shape of the income stream. The time shape may be due either to natural or artificial causes, or to choice because of a high or low rate of return on investment. If the theory is correct, we should find, other things being equal, that when in any community the income streams of its in habitants are increasing, the rate of interest will be high, that when they are decreasing, the rate of interest will be low, and that when they alternate from one condition to the other, the rate of interest will alternate also in accordance with the period of the loan.

The most striking examples of increasing income streams are found in new countries. It may be said that before the World War the United States almost always belonged to this category. Were it possible to express by exact statistics or diagrams the size of American incomes, they would undoubtedly show a steady increase since colonial days. Statistics almost equivalent to these desiderata are available (though not very accurate) in the form of the United States Census figures of per capita wealth, as well as in statistics of production and consumption of staple commodities and of exports and imports. These, combined with common observation and the statements of historians, lead to the conclusion that American incomes have been on the increase for two hundred years. It is also true that during this period of rising incomes the rate of interest has been high. The simplest interpretation of these facts is that Americans, being constantly under the influence of great expectations from the exploitation of great natural resources, have been always ready to promise a relatively large part of their abundant prospective future income for a relatively small addition to their present, just as he who expects soon to come into a fortune wishes to anticipate its realization by contracting a loan.

Not only has the rate of interest been high in America as compared with other countries during this period of ascending incomes, but some of the other conditions having the same significance as a high rate of interest have also been in evidence. Thus, the country has been conspicuously a borrowing country, in debt to other countries. The proceeds of such loans from Europe have shown themselves in increased imports into the United States and diminished exports, creating a so-called unfavorable balance of trade. These phenomena have usually been expressed as a demand for capital, but, while it is quite true that the exploitation of our natural resources required the construction of railways and other forms of capital, this fact is better and more fully expressed in terms of income. We wanted, not the railways and machinery themselves, but the future enjoyable products to which this apparatus led. The labor of constructing these instruments necessarily tended to diminish the immediate enjoyable income of the country, but added to that of the expected future. It was to even up this disparity of immediate and remote income that loans were contracted. It does not matter whether the loans from the foreigner were received in the form of machinery and other instruments of production, or in the form of the comforts of life to support us while we ourselves constructed the instruments. In either case the essential fact is the transformation of the income stream rather than the need of capital, which is merely one of the means thereto.

Not only have we witnessed the phenomena of high rates of interest and of borrowing during this period of American development, but it is also true that the character of the instruments created was for the most part of the unsubstantial and quickly returning kinds. Our highways, as John Rae pointed out, were little more than the natural surface of the earth after the removal of trees and rocks; our railways were lightly ballasted, sometimes even narrow gauge, and crooked to avoid the necessity of excavations and tunnels; our earliest buildings were rude and unsubstantial. Everything was done, not in a permanent manner with reference to the remote future, but in order to save a large first cost.

During the last generation these conditions have been changed. The rates of interest in America are, in general, lower than formerly, and lower than in other countries, in many of which interest rates have risen.29 We have ceased to be a borrowing nation. We bought back many of our securities from abroad, and after the World War began to buy foreign securities. This was accomplished through the excess of exports of our abundant products over imports. We are now lending billions to Europe. Europe has become a borrower, the chief reason being that in her recovery from the War her income stream is rising. During that recovery from the impaired income wrought by the War, Europe in some places offers bigger returns over costs than America. That fact, combined with Europe's poverty, makes for high interest.

The interest rate has fallen in the United States since 1920. This agrees with, or at least is consistent with, the theory that raising the level of national income tends, other things equal, to lower the rate of interest.

Again, the character of the instruments which have been now for some time in process of construction in the United States is of the most substantial kind. Steel rails have long since taken the place of iron rails; railways have been straightened by expensive tunnels, by bridges, and by excavations; dwellings and other buildings have been made more substantial; first macadamized and later cement roads have rapidly supplanted the old dirt roads; and in every direction there has been an evident tendency to invest a large first cost in order to reduce future running expenses.

§7. Rising Income Means High Interest Rates

Thus, in America and in Europe, we see exemplified on a very large scale the truth of the theory that a rising income stream raises and a falling income stream depresses the rate of interest, or that these conformations of the income stream work out their effects in other equivalent forms.

A similar causation may be seen in particular localities in the United States, especially where changes have been rapid, as in mining communities. In California in the two decades between 1850 and 1870 following the discovery of gold, the income stream of that state was increasing at a prodigious rate, while the state was isolated from the world, railroad connection with the East not having been completed until 1869. During this period of isolation and ascending income, "... opportunities for investment were innumerable. Hence the rates of interest were abnormally high. The current rates in the 'early days' were quoted at 1½ to 2 per cent a month.... The thrifty Michael Reese is said to have half repented of a generous gift to the University of California with the exclamation, 'Ah, but I lose the interest,' a very natural regret when interest was 24 per cent per annum."30 After railway connection in 1869, Eastern loans began to flow in. The decade, 1870-1880, was one of transition during which the rates stimulated borrowing from the outside, which brought about lower interest rates even though income streams continue to increase. The rate of interest consequently dropped from 11 per cent to 6 per cent.31

The same phenomena of enormous interest rates were also exemplified in Colorado and the Klondike. There were many instances in both these places during the transition period from poverty to affluence, when loans were contracted at over 50 per cent per annum, and the borrowers regarded themselves as lucky to get rates so low. It was also conspicuously true that the first buildings and apparatus constructed in these regions were very unsubstantial. Rude board cabins were put up in a day. Thus, high interest, borrowing, and unsubstantial capital were the phenomena which attended these communities when undergoing their rapid expansion.

In Nevada in the seventies, when the mines were increasing their product and the income of the inhabitants was tending upwards, the rate of interest was high and the people in debt. The bonded state debt itself amounted to $500,000 and drew 15 per cent interest.32 In the next decade all these conditions were reversed. The mines were on the decline,33 the rate of interest fell, and the state and territorial debts were largely paid off.34 The fall of the rate of interest in this case could not have been due to the introduction of loans from outside, except so far as old debts were refunded at lower rates; fresh loans were seldom made, as the state had ceased to be a good place for new investments. At about the beginning of this century, new Nevada mines in the gold-field region were opened. Loans were again entering the state, and the same cycle of history, as above described, was repeated.

Lumbering communities often go through a somewhat similar cycle. The virgin forests when first attacked tend to increase rapidly the income streams of those who exploit them; then comes a period of decrease. Thus in Michigan two or three decades ago the lumber companies found a profitable investment, and borrowed in order to exploit the Michigan forests. After the exploitation was complete and the forests had been (often unwisely) exhausted, those regions ceased to be a desirable place for investment, and their owners came into the position, not of receiving, but of seeking investments.

After the trunk lines of railway were completed, connecting the Mississippi Valley with the East, there arose a great demand for loans to exploit the rich farming lands in that section of the country. The rate of interest frequently was 10 and 12 per cent and even higher. During much of this time the Northwestern Mutual Life Insurance Company up to 1880 made an average rate on all its mortgage loans, $10,000,000 in amount, of nearly 10 per cent. Another striking proof of the demand for loans in the Middle West is shown in the experience of the New York and Connecticut life insurance companies. New York up to 1880 had a law prohibiting the life insurance companies in that state from loaning on real estate outside of New York. Connecticut had no restriction in this regard, and her companies loaned extensively in the West. The result is seen in the rates of interest realized on mortgage loans of companies in the two states. Taking the period 1860-1880 as a whole, the Connecticut companies realized 1.2 per cent more than did the New York companies. Since 1880 the Middle West has developed less feverishly, and loans on farming lands have been made at lower rates.

Australia furnishes another example of a country which, through improvement in the means of transportation and consequent great investment opportunities, created a great demand for loans. The rate during the fifties on safe securities was rather low. This rate increased until during the seventies, 7, 8, and 9 per cent were usual. After 1880 the rates declined.35

England may perhaps be cited as exemplifying the same phenomena which we have seen in the case of Nevada, though in a less degree. Thus as Nevada has exhausted its mines of precious metals, so England is on the road toward exhaustion of its coal and iron supplies. As coal and iron lie at the base of England's commercial power their exhaustion must carry with it the reduction of the income stream from English domestic industries. This fact has been noted with considerable alarm by some English economists, especially Jevons. But it does not necessarily indicate that the economic power of Englishmen will be greatly or even at all lessened. Its significance shows itself in the tendency of England to become an investing country. It is the part of those who have property in mines or other investments yielding terminable income not to use all of the product as income, but to reinvest some of the earlier income in order to maintain the capital. This the Englishmen have done and are doing, and, being unable to make enough satisfactory investments at home, they have placed their loans all over the world.

The income stream produced for them by their native island is destined, perhaps, to decline, certainly not greatly to increase except during the next few years or decades of recovery from the World War. By saving from this declining income and investing in Canada, the United States, South America, Australia, South Africa, and other regions where the natural resources are being exploited and incomes are on the increase instead of on the wane, Englishmen may still maintain their capital intact or even increase it. The figures given by Giffen show that the national income increased for several decades, but that the rate of increase slackened for the decade 1875-1885 compared with 1865-1875. Whereas in the earlier decades there was a general increase in all directions, in the later decade there were many items of decrease,36 the most notable being of mines and ironworks.37 Among the greatest increases was that of foreign investments.38

§8. Effect of Catastrophes on Interest

The time shape of an income stream is determined, however, in part by other causes than natural resources. Among these causes, misfortune holds a high place in causing temporary depressions in the income stream, that is, in giving to it a time shape which is at first descending and afterwards ascending. The effect of such temporary depression is to produce a high valuation of immediate income during the depression period, as compared with the valuation of the income expected after the depression is over. It is a matter of common observation in private life that loans often find their source in personal misfortune. Investigations of pawnbrokers and small loan conditions among the poor39 show that the chief causes for borrowing are a death or birth in the family, or a protracted illness, the expense of which even when amounting to only $10 or $20 would, without the loan, make serious inroads on the daily necessities.

We may see the operation of the same principle on a larger scale in the examples of the San Francisco earthquake, the earthquake which wrecked Yokohama and Tokyo, the plague which destroyed whole communities in Russia, and the famines of China. Had it not been for the succor rendered by more fortunate communities and countries, the income stream of some of the stricken communities and provinces in Russia and China would have sunk so low that scarcely any would have been able to survive. In addition to the aid of tens of millions of dollars in gifts, large loans were made which enabled the afflicted communities to build themselves anew. Whether these loans were used to produce sustenance, which is direct income, or to offset the cost of rebuilding and replacing destroyed capital goods, which is outgo, the effect was the same; they were for the purpose of tiding over a temporary decline, or loss, in the income stream. The permanent effect of these catastrophes on the rate of interest was slight because of the opportunity to borrow heavily from outside. Had these opportunities not existed, the depression in the income stream could not have been mitigated, and the rate of interest would inevitably have risen to a level comparable with that which prevailed in primitive times or during a gold rush.

In much the same way the income stream of a nation is affected by war. The effects in this case, however, are more complex, owing, first, to the element of uncertainty which war introduces until peace is declared, and secondly, to the fact that wars are likely to be more protracted than most other misfortunes. The effect, according to previous explanations, should be that at the beginning of the war the rates of interest on risky loans would be high. This would be especially true of the short term loans which do not outlast war. On the other hand, the rate of interest on safe loans should be lowered for short term loans, and raised for long term loans. Under the conditions of a war in its early stages, a short term loan relates to a descent in the income curve. It is repayable at a time when income is expected to be less than when the loan is contracted. The descent in the income curve, or the element of uncertainty, tends, as has been seen, to lower the rate of interest on safe loans. On the other hand, for long term loans intended to outlast the war, the rate of interest is likely to be high, for the income stream at the time of repayment may be expected to exceed the income stream at the time of contract.

At the close of war, after peace is declared and the element of uncertainty introduced by it has disappeared, the rate of interest even on short term loans will, contrary to the common view, be high, for then the country is, as it were, beginning anew, and the same causes operate to make interest high as apply in the case of all new countries.

When the effects of war include the issue of depreciated paper money, the rate of interest is affected in a somewhat more complex manner, being then subject to the influence of depreciation, according to the principles explained in Chapter II and statistically treated in Chapter XIX.

§9. Examples of Influence of Periodicity of Income

We have considered supposed examples of the effect on the rate of preference exerted by those changes in the income stream due to the growth or waning of natural resources and to the temporary influence of misfortunes and inventions. There remain to be considered examples of more regular changes in the income stream of a rhythmic or seasonal character. Though most persons are not aware of the fact, it can scarcely be doubted that the annual succession of seasons produces an annual cycle in the income stream of the community. This is especially true of agriculture. Grains, fruits, vegetables, cotton, wool, and almost all the organic products flow from the earth at an uneven rate, and require for their production also an uneven expenditure of labor from man during different seasons of the year. Statistics of consumption show that the income enjoyed conforms in general to a seasonal rhythm. Food products are usually made available in the warm months when crops ripen; logs are hauled out of the woods in the winter, floated to mills in the spring, and made into lumber in the summer.

But the tendency to a seasonal rhythm is modified by the existence of stocks of commodities to tide over the periods of scarcity. The ice of winter is stored for summer, and the fruits of summer are canned and preserved for winter. Only so far as such storage and preservation are difficult and expensive, or impair the quality of the goods thus held over, or are impracticable, because of the perishable nature of the goods, does there remain any seasonal change in enjoyed income. The rhythm is different for different industries and for different classes of the population. The farmer is perhaps the most typical for the country as a whole. For him the lowest ebb is in the fall, when gathering and marketing his crops cause him a sudden expenditure of labor, or of money for the labor of others. To tide him over this period he may need to borrow. A whole group of other industries, particularly those connected with transportation, experience a sympathetic fluctuation in the income stream. In the parlance of Wall Street, money is needed to move the crops. The rate of interest tends upward.

Chart 39 shows, for the period 1869 to 1905, the monthly average of interest rates on prime, two-name, 60 to 90 day paper.40

The theory that interest rates vary with the seasons, rising during the late summer and autumn months and sinking during the winter and early summer months is borne out by Professor W. L. Crum's article, Cycles of Rates on Commercial Paper,41 which treats of monthly fluctuations in commercial paper rates over the period 1874 to 1913.

Chart 40 is a reproduction of Professor Crum's chart showing monthly deviations of interest rates from the annual average of monthly rates over the period 1874 to 1913. It will be noted that the fluctuations shown on Chart 40 are almost identical with those shown on Chart 39. No comparison of rates is possible because Chart 40 shows only monthly deviations above and below the average annual rate, while Chart 39 shows the average of actual rates. Both charts show a low for February, a rebound in March and April, a deeper depression in June, then a buoyant advance to the peak in September and October, followed by a slump when the autumn demand for money and credit to handle the crops is past.

In a community dominated by some industry other than farming the cycle would be different. The rates are of course a composite in which the cycles of the manufacturer and of other elements are superimposed upon the cycle of the farmer. The manufacturer's cycle is a little later than the farmer's and shifts the high rates from fall toward winter. Accordingly in England, which is more dominated by the manufacturer, the cycle, though similar to that just observed for the United States, is shifted slightly forward, as is shown in Chart 41.42

§10. Summary

Although the facts presented in this chapter do not prove the theory presented in previous chapters they are not in conflict with it. According to the theory, if there is a high degree of foresight, self-control, and regard for posterity and income streams are large and plentiful in food-element, or have a descending time shape, then, other things being equal, the tendency will be for the rate of interest to be low, capital will be accumulated, the community will lend to other communities, and the instruments it creates will be more durable. We find these results present in actual fact where the antecedent conditions enumerated are also present. Reversing the conditions, we find reversed results. Of course these statistical evidences are very general, since we never can assert that "other things are equal," and thus isolate and measure any one particular factor, as in the more exact inductions of physical science.

PART IV, CHAPTER XIX

THE RELATION OF INTEREST TO MONEY AND PRICES

§1. Price Changes and Interest Rates

No problem in economics has been more hotly debated than that of the various relations of price levels to interest rates. These problems are of such vital importance that I have gone to much trouble and expense to have such data as could be found compiled, compared, and analyzed. The principal result of these comparisons are given in this chapter.

The general theory of the relationship between the rate of interest and the buying power of money was summarized in Chapter II. The main object of this chapter is to ascertain to what extent, if at all, a change in the general price level actually affects the market rates of interest.

Since the theory of Chapter II presupposes foresight, the question arises at the outset: How is it possible for a borrower or lender to foresee variations in the general price level with the resultant increase or decrease in the buying power of his money? A change in the value of money is hard to determine. Few business men have any clear ideas about it. If we ask a merchant whether or not he takes account of appreciation or depreciation of money values, he will say he never heard of it, that "a dollar is a dollar!" In his mind, other things may change in terms of money, but money itself does not change. Most people are subject to what may be called "the money illusion," and think instinctively of money as constant and incapable of appreciation or depreciation. Yet it may be true that they do take account, to some extent at least, even if unconsciously, of a change in the buying power of money, under guise of a change in the level of prices in general. If the price level falls in such a way that they may expect for themselves a shrinking margin of profit, they will be cautious about borrowing unless interest falls, and this very unwillingness to borrow, lessening the demand in the money market, will tend to bring interest down. On the other hand, if inflation is going on, they will scent rising prices ahead and so rising money profits, and will be stimulated to borrow unless the rate of interest rises enough to discourage them, and their willingness to borrow will itself tend to raise interest.

And today especially, foresight is clearer and more prevalent than ever before. The business man makes a definite effort to look ahead not only as to his own particular business but as to general business conditions, including the trend of prices.

Evidence that an expected change in the price level does have an effect on the money rate of interest may be obtained from several sources. During the free-silver agitation of 1895 and 1896, municipalities could sell gold bonds on better terms than currency bonds. There was a strong desire on the part of lenders to insert a gold clause in their contracts, and to secure it they were willing to yield something in the interest rate.

The same tendency was strikingly shown in California during the inflation period of the Civil War.43 For a time, gold contracts could not be enforced, and in consequence interest rates were exceptionally high.

§2. United States Coin and Currency Bonds

A more definite test may be made where two standards are simultaneously used. An excellent case of this kind is supplied by comparing two kinds of United States bonds, one payable in coin and the other in currency. From the prices for which these bonds sold in the market it is possible to calculate the interest realized by the investor. The currency bonds were known as currency sixes and matured in 1898 and 1899. The coin bonds selected for comparison were the fours of 1907. The table on page 402 gives the rates of interest realized in the two standards, together with the premium on gold.

Several points in this table deserve notice. In 1870 the investor realized 6.4 per cent in terms of gold but was willing to accept a return of only 5.4 per cent currency. Why should a gold bond be thus inferior to a paper bond? This has become intelligible in the light of the theory which was explained in Chapter II. It meant the hope of resumption. Just because paper was depreciated below gold and there was a chance of bringing it up to par, there was in prospect a great rise in its value, as compared with gold. It was not until 1878, just before resumption, when the prospect of any further rise disappeared, that the relative position of the two rates of interest was reversed. After resumption in 1879, when paper money did reach par with gold, the two bond rates remained very nearly equal for several years, until fears of inflation from Greenbackism and Free-Silverism again produced a divergence. The quotations for 1894, 1895, and 1896 showed a considerably higher rate of interest in the currency standard than in the coin standard, as well as a higher rate in both standards than in previous years. The contrast is that between 2.7 per cent and 3.5 per cent in 1894, and between 3.2 per cent and 4.3 per cent in 1896. The divergence of the two rates is explainable as the effect of the fear of Bryan's free-silver proposal, incorporated (July, 1896) in the platform of the Democratic party. Had free coinage of silver been restored at the ratio of 16 to 1, since the bondholders had the option of demanding either gold or silver in payment, coin bonds presumably would still have meant gold bonds. Hence investors were ready to accept lower interest on these bonds than on currency bonds.

§3. Gold and Rupee Bonds

Having compared the rates of interest of paper and coin bonds, we may next compare those of gold and silver securities. The comparison, to be of value, must be between gold and silver contracts in the same market and with the same security. Fortunately such contracts have been available in the London market of government securities. The loans of India have been made partly in gold and partly in silver, and both forms of securities have been quoted in London.46 The interest on the silver bonds, or rather rupee bonds, was paid by draft on India. The sums actually received in English money depended on the state of the exchanges. The rate of interest in the silver standard was calculated47 in the same way as was shown for coin bonds in §2. The results follow:

From this table it will be seen that the rates realized to investors in bonds of the two standards differed but slightly until 1875, when the fall of Indian exchange began. The average difference from 1875 to 1892 inclusive was 0.7 per cent. Within this period, from 1884, exchange fell much more rapidly than before, and the difference in the two rates of interest rose accordingly, amounting in one year to 1.1 per cent. Inasmuch as the two bonds were issued by the same government, possessed the same degree of security, were quoted side by side in the same market, and were similar in all important respects except in the standard in which they are expressed, the results afford evidence that the fall of exchange (after it once began) was, to some extent, discounted in advance and affected the rates of interest in those standards. Of course investors did not form perfectly definite estimates of the future fall, but the fear of a fall predominated in varying degrees over the hope of a rise.

The year 1890 was one of great disturbance in exchanges, the average for the first six months being 17.6 and for the last six months, 19.3. The gold price of the silver bonds rose from an average for the first six months of 73.8 to 83.5 for the last six months, but the rise in their silver price was only from 100.6 to 103.7, showing that the increase of confidence in the future of silver was not great, and, in fact, only reduced the disparity in the interest from 1.0 to .8 per cent.

This great rise in exchange and the slight revival in silver securities occurred simultaneously with the passage of the Sherman Act of July, 1890, by which the United States was to purchase four and a half million ounces of silver per month. The disturbance was doubtless due in some measure to the operation, or expected operation, of that law.

This is not the only case in which the relative prices of rupee paper and gold bonds were probably affected by political action. One of the smallest differences in the two rates occurs in 1878, which was the year of the Bland Act and of the first International Monetary Conference.

After the closure of the Indian mints to silver on June 26, 1893, exchange rose from 14.7 to 15.9, the gold price of rupee paper from 62 to 70, and consequently its rupee price from 101.2 to 105.7.

From this point the exchange again dropped, much to the mystification of those who had predicted an established parity between gold and silver at the new legal rate of 16d per rupee. There was much discussion as to the reasons for the failure of the legal rate to become operative. The chief reason seems to have been that the closure of the mints to silver attracted into the circulation silver from other channels, especially old native hoards. Within a few years, however, this source of supply was dried up so that the legal par was reached in 1898 and was maintained thereafter, subject only to the slight variations of exchange due to the cost of shipping specie.

But until the par was proved actually stable by two or three years' experience, the public refused to have confidence that gold and the rupee were once more to run parallel. Their lack of confidence was shown in the difference in the rates of interest in gold and rupee securities during the transition period, 1893-1898, and the two or three succeeding years. From 1893 to 1900 inclusive the two rates averaged .5 per cent apart. From 1901 to 1906 inclusive, the average difference was only .1 per cent,51 showing that confidence in the gold value of the rupee had been established.

§4. Money Interest and Real Interest

The foregoing comparisons relate to simultaneous rates of interest in two contrasted monetary standards each actually used for loan contracts. We now turn to a comparison between money rates and real rates of interest, mentioned in Chapter II. Unfortunately no contracts in terms of real or commodity standards are available for quotation. All we can do is to note the changes in the price level, translate the actual rates in terms of money into real rates, and compare successive periods. Such comparisons are not very satisfactory, since no two periods, not even successive periods, are so alike industrially that we can say that they differ only as to the state of the monetary standard as reflected in the index numbers of prices. Of course, influences other than changes in money affect interest rates.

Detailed tables showing the average annual rate of change in the commodity price level,52 the rates of money interest, and the rates of real interest for London, New York, Berlin, Paris, Calcutta, and Tokyo are given in basic tables in the Appendix to this chapter. Wholesale commodity prices were used in computing these rates although cost of living indexes would have been preferable for this purpose and more in harmony with my theory of income. But cost of living indexes do not exist for the period covered.

Chart 42 shows the annual rate of change in the commodity price level (upper part) compared with the market rates of interest (lower part) in the London market over the period 1825 to 1927. The chart also gives the real rate by a dotted line, but this may, for the present, be overlooked.

It will be observed that the entire period is broken up into sub-periods, which conform to rather definite and successively contrasted price movements. These sub-periods were allowed to choose themselves, so to say. That is, they were so chosen that each period should show a rather distinct change in the rate of price change as compared with the preceding and succeeding periods. The periods were not chosen with any reference to, or indeed with any knowledge of, how the choice would affect the comparisons to be made. For example, the period 1825-1834 was a period during which commodities at wholesale fell at the average (annual) rate of 3.0 per cent per annum; this is plotted on the chart, in the usual way, by a horizontal line 3.0 points below the zero line. In the period 1834-1839 prices rose at the rate of 3.3 per cent per annum; this is plotted on the chart by a horizontal line 3.3 points above the zero line.

A brief glance at Chart 42 reveals that when the rate of price change falls from one period to the next, the money rate of interest usually falls, and when the rate of price change rises, the interest rate usually rises also. The comparison of each period with the one following may be designated as a sequence. In London eight such sequences out of ten for bank rates, and nine out of ten for market rates support the theory that money interest rates move in the same direction as the price level.

Comparisons of price change rates and interest rates have also been made for New York, Berlin, Paris, Calcutta, and Tokyo. The results, favorable and unfavorable, of all these comparisons are summarized in Table 13.

Of the sequences compared, 38 support and 15 oppose the theory propounded. Thus, the favorable sequences are two and a half times as numerous as the unfavorable sequences. This is a large preponderance, especially when we consider that there are so many inexactnesses in the statistical data and so many other causes affecting the rate of interest besides changes in the price level.

The same result may be expressed in terms of correlation coefficients. When we correlate interest rates with price changes for the important industrial countries (England, Germany, United States), fairly high coefficients (about +0.7) are obtained. Correlating the first differences, that is, changes in interest rates and rates of price changes, likewise, shows a fairly high relationship in accord with the theory. However, the correlation for the data of all countries combined is insignificant. For all the countries studied we find +.036; for the corresponding first differences, -.165. It is seen that the well defined movements of prices and interest in the principal countries are largely offset by the movements in the countries of lesser economic importance. To obtain more decisive evidence upon the relationship studied, it is necessary to resort to the more rigorous analysis given in subsequent sections.

The evidence obtained from the comparisons in this section indicate that there is a very apparent, though feeble, tendency for the interest rate to be high when prices are rising, and the reverse. The adjustment is imperfect and rather irregular, but in the great majority of cases the tendency is evident.

§5. Real Interest Varies More Than Money Interest

If perfect foresight existed, continuously rising prices would be associated not with a continuously rising rate of interest but with a continuing high rate of interest, and falling prices would be associated not with a continuously falling rate of interest but with a continuing low rate of interest, and a constant price level would be associated with a constant rate of interest—assuming, in each case, that other influences than price change remained the same.

This perfect theoretical relationship of interest rates to price levels, assuming perfect foresight, is shown in Chart 43, showing high (not rising) interest rates while prices are rising, and low (not falling) interest rates while prices are falling. The real rate would remain constant at, say, 5 per cent under the ideal conditions here assumed.

In this chart, i stands for interest rate and P' for price change, but the upper line indicates the price level. When in the first period the price level rises, the price change (P') is assumed to be at the rate of 5 per cent per annum. In the next period, the price level remains constant so that price change is zero, and so on as indicated. The lower curve shows the theoretical effects on the rate of interest. In the first period, it would be 5 per cent above normal; in the second period, normal; and so on.

One obvious result of such an ideally prompt and perfect adjustment would undoubtedly be that money interest would be far more variable than it really is and that when it was translated into real interest this real interest would be comparatively steady. What we actually find, however, is the reverse—a great unsteadiness in real interest when compared with money interest.

Real interest, however, as shown by the dotted lines on Chart 42, changed in the opposite way to money interest, due to the lack of foresight and adjustment. Attention is called to the period 1852-1857 in London, during which prices rose very fast (that is, money depreciated) simultaneously with, and mainly because of, the great gold production. The market rate of interest averaged 4.7 per cent, which was higher than in any subsequent or in any previous period. Yet during this period of apparently highest interest rates, lenders were receiving, in real interest, less than nothing for their savings. Also in the inflation period 1914-1920, bank rates reached their highest peak, 5.2 per cent, while average market rates, at 4.4 per cent, were but little lower than in 1852-1857. Yet in terms of real commodities those who saved and deposited or invested at the bank rates or market rates of interest were mulcted 9 to 10 per cent for their abstinence and sacrifices. In the following period, 1920-1927, however, the savers and lenders got back more than all they, or their predecessors, lost in the previous period. The tremendous fall in prices in 1920 and 1921 boosted the real interest rate above 15 per cent. Thus the computed real rate is exceedingly erratic during a serious inflation or deflation.

Chart 44 represents in a different way the same theoretical relationship between price change and the rate of interest as that depicted on Chart 43. In Chart 44, price change (P') is represented not by the slope of a line, but by distance measured above or below the zero line. Thus when the price level is rising at the rate of 5 per cent per annum, P' is represented by a horizontal line 5 per cent above zero. When prices are stationary, P' drops to zero, and so on. If men had perfect foresight, they would adjust the money interest rate so as exactly to counterbalance or offset the effect of changes in the price level, thus causing the real interest rate to remain unchanged at the normal rate.

The following table shows that the standard deviation from the mean is far greater for the computed real rate of interest than for the actual rate of interest.

This table shows that the real rate of interest in terms of commodities is from seven to thirteen times as variable as the market rate of interest expressed in terms of money. This means that men are unable or unwilling to adjust at all accurately and promptly the money interest rates to changed price levels. Negative real interest could scarcely occur if contracts were made in a composite commodity standard. The erratic behavior of real interest is evidently a trick played on the money market by the "money illusion" when contracts are made in unstable money. The computed real rate of interest was minus 7.4 per cent in New York in the period 1860-1865 and was still lower during 1915-1920. The rate was nearly minus 100 per cent in Germany during the period of most rapid inflation.

Another symptom of the same imperfection of adjustment is the fact that the adjustment is very slow. When prices begin to rise, money interest is scarcely affected. It requires the cumulative effect of a long rise, or of a marked rise in prices, to produce a definite advance in the interest rate. If there were no "money illusion" and if adjustments of interest were perfect, unhindered by any failure to foresee future changes in the purchasing power of money or by custom or law or any other impediment, we should have found a very different set of facts.

§6. Interest Rates and Rates of Price Change

The roughness of the comparisons between interest rates and price levels thus far made impels to further study of this important problem. For these more rigorous comparisons, the statistics of prices and of bond yields in Great Britain and the United States have been taken, being the only reliable statistics ready at hand which permit of long trend comparisons.

Since the theory being investigated is that interest rates move in the opposite direction to changes in the value of money, that is, in the same direction as price changes, the first analysis made is the same as that already made by rougher methods, the comparison of price changes with interest rates.

For the rate of change of prices, the customary link relative expression was at first used in a preliminary study of quarterly United States data for the period 1890-1904. But to ensure full comparability with my related studies of several years ago on price changes and trade variations, the symmetrical expression P' (rate of price change per annum) is used throughout. The precise derivation of P' is given in my paper, Our Unstable Dollar and the So-Called Business Cycle.53 The upper part of Chart 45 gives the correlation coefficient (r) obtained by correlating the long term interest rates as reflected in the yield of British consols with percentage changes in prices computed from the British wholesale index numbers of Sauerbeck and The Statist.54 The lower part of this chart gives the r's for bond yields and percentage price changes in the United States.55

In Great Britain, the price changes from 1820 to 1924 fall into three clearly defined periods, namely, 1820 to 1864, a period of fluctuating prices with no marked upward or downward trend in prices; 1865 to 1897, a period of declining prices; 1898 to 1924, a period chiefly of rising prices, including a big boom from 1915 to 1920, followed by a crash and more stable prices since 1922.

A very brief examination of the charts below indicates that there is little or no apparent relationship between price changes and interest rates in any of the periods studied in either country except for 1898-1924 in Great Britain. For the period 1820-1864 in Great Britain we obtain a maximum inverse correlation of -0.459, without lagging. For the period 1898-1924, we get as a maximum +0.623 when i is lagged 4 years and +0.678 when i is lagged 6 years. Lag means the time interval between a price change and the associated change in the interest rate. Chart 45 shows the results of lagging interest rates behind price changes on the one hand and lagging price changes behind interest rates on the other. For the United States, without lagging, r = +0.289, while the highest correlation is +0.406 when i is lagged 4 years. These results suggest that no direct and consistent connection of any real significance exists between P' and i.

The variations in r for different lags may be due to the zigzag cycles in the data correlated. The maximum value of r establishes definitely that, characteristically, movements in i lag behind corresponding movements in P'. The small numerical value of r suggests that the relation can be revealed only faintly by P' and i directly. But a little consideration suggests that the influence of P' or i may be assumed to be distributed in time—as, in fact, must evidently be true of any influence. This hypothesis proved quite fruitful in my studies several years ago, in the course of which the theory of distributed influence or, if we wish to avoid the implication of cause and effect, of distributed lag was developed in considerable detail.56

The reader may consult the references cited for details. It must suffice here to point out only the essence of the transformation of P' into the derived quantity , measuring the distributed influence of sundry P'. Arithmetically, is merely a certain weighted average of sundry successive P''s. (See (a) and (b) referred to in the footnote.) In any specific problem the number of successive P''s that enter into the average 's depends on the length of the time interval during which the influence of any P' is assumed to be perceptible. The weights used vary in a certain functional form, generally that of a skew probability curve. Thus, in applying the theory at least two parameters are involved: (1) the length of the influence interval (which determines the number of P''s that enter into the composite ), and (2) the form of variation of the weights. As indicated in reference (b) in the above footnote, the form of variation of the weights is exactly—but in reverse order—the form in which the distributed influence of any P' tapers off during successive periods of time.57

In the present study we must limit our investigation to only one type of distribution of influence and variation of weights. The form chosen is the simple straight line function or arithmetical progression which proved most effective and easily calculated in my 1925 study. Several periods of influence range, however, were tried. The results for the British and American yearly data are shown in Charts 46 and 47.

The figures at the bottom of Charts 46 and 47 refer to the number of years over which the effect of price changes is taken into account in the correlations between and i. For example, in Chart 46, the figures 1-16 mean that the effect of a price change is assumed to begin the first year after the change and to cease at the end of 16 years. The weighted average of the distributed lag is 5.3 years. The longest distribution shown at the right is from 1 to 32 years, or a weighted average of 10.7 years.

The charts picture only the effects of the distributed lag when interest rates follow behind price changes.

Experiment proved that when price changes were lagged behind the distributed influence of changing interest rates, the correlation coefficients were too small to have any significance.

The high and consistent correlations shown in the above charts are in striking contrast to the results previously obtained from correlating P' directly with i. The assumption that a change in prices occurring during one year exhausts its influence upon interest rates in the same year or in another single year is shown to be quite wrong, as might be expected. Our first correlations seemed to indicate that the relationship between P' and i is either very slight or obscured by other factors. But when we make the much more reasonable supposition that price changes do not exhaust their effects in a single year but manifest their influence with diminishing intensity, over long periods which vary in length with the conditions, we find a very significant relationship, especially in the period which includes the World War, when prices were subject to violent fluctuations.

The British figures for 1820-1864 give the lowest correlations of any included in this study. These low figures are possibly due in part to the less accurate price indexes in those early years. It is noteworthy that the correlation coefficients are distinctly lower for the United States in the period 1900-1927 than they are for Great Britain in the period 1898-1924. It is also interesting that for Great Britain in 1898-1924, the highest value of r (+0.980) is reached when effects of price changes are assumed to be spread over 28 years or for a weighted average of 9.3 years, while for the United States the highest r (+0.857) is for a distribution of the influence due to price changes over 20 years or a weighted average of 6.7 years.

Chart 48 shows graphically the smoothing effect of distributing the influence of P' over various periods.

By assuming a distribution of effect of price changes over several years according to the form described above, the relationship between price changes and interest rates which was only faintly revealed by the first direct comparisons is clearly revealed. The high correlation coefficients obtained by means of the method of distributing the influence of P' and i show that the theory tested in this chapter conforms closely to reality, especially during periods of rather marked price movements.

Furthermore the results and other evidence, indicate that, over long periods at least, interest rates follow price movements. The reverse, which some writers have asserted, seems to find little support. Experiments, made with United States short term interest rates, to test the alternative hypothesis of distributed influence of interest rate changes instead of price changes, gave results of negligible significance. Our investigations thus corroborate convincingly the theory that a direct relation exists between P' and i, the price changes usually preceding and determining like changes in interest rates.

§7. Short Term Interest Rates and Prices in the United States

A study of short term commercial paper rates in relation to short term price movements corroborates the evidence obtained from correlating long term interest rates and price changes. The New York interest rates on short term commercial paper have been correlated with changes in the quarterly wholesale price indexes computed from monthly indexes of the United States Bureau of Labor Statistics for the periods 1890-1914 and 1915-1927.58

On Chart 49 are plotted the curves showing the quarterly price indexes and the P' and P' derived from them, with the interest rates for the entire period 1890-1927. P' is shown for 120 quarters or 30 years.

These curves of quarterly data tell much the same story as is told by the curves representing yearly data, shown in Chart 48, for Great Britain. P' obviously corresponds much more closely to i than does P'.

Chart 50 shows the rather erratic variation of the r's computed from i and P' directly without distributing the effects of price changes.

Chart 51, on the contrary, shows, in sharp contrast, the steady increase in r computed from i and price changes with influence distributed over periods from 20 to 120 quarters. This chart shows that, in the period 1915-1927, r reaches its maximum (+0.738) only when a total of 120 quarters, or 30 years, is included in the period subject to the influence of price changes upon i.

The studies of both the long term and short term movements of prices and interest rates give very similar results. In both studies the r's are insignificant when P' and i are correlated directly, either with or without lagging, so long as we ignore the fact that the effects of price changes are distributed over many years. But when the effects of price changes are distributed, the r's take on an entirely different aspect with an entirely new meaning, especially during the War period when prices fluctuated widely and quickly. It would seem then that price and interest fluctuations are governed by one law, not, as has been suggested, by two different opposing laws, for short and for long periods of time.

It seems fantastic, at first glance, to ascribe to events which occurred last century any influence affecting the rate of interest today. And yet that is what the correlations with distributed effects of P' show. A little thought should convince the reader that the effects of bumper wheat crops, revolutionary discoveries and inventions, Japanese earthquakes, Mississippi floods, and similar events project their influence upon prices and interest rates over many future years even after the original casual event has been forgotten.59 The skeptical reader need only be reminded that the economic effects on the farmer of the deflation of 1920 are now, in 1929, sufficiently acute to make farm relief a pressing political problem and that these economic effects may be expected to persist for many years to come. A further probable explanation of the surprising length of time by which the rate of interest lags behind price change is that between price changes and interest rates a third factor intervenes. This is business, as exemplified or measured by the volume of trade. It is influenced by price change and influences in turn the rate of interest.

§8. Interest Rates and Price Indexes

Thus far we have considered the relation of changes in the price level and interest rates. It remains to study the relations of the price levels themselves to interest rates. The same basic data are used as in the preceding sections, but we now correlate the price indexes directly with the interest rates in Great Britain and the United States.

Chart 52 shows the British long term interest rates (bond yields) plotted with the wholesale price index for the years 1820-1924.

It is apparent that the P curve and the i curve, as plotted, conform very closely. Furthermore, lagging interest rates one year gives the highest obtainable degree of correspondence. The corresponding data for the United States, plotted on Chart 57 below without lagging i, shows the same close relationship between P and i.

On Chart 53 are plotted the curves of the correlation coefficients computed for P and i for Great Britain and the United States.

The r's for the whole period 1820-1924 for Great Britain are not shown on Chart 53 since they reveal nothing not shown by the r's for the shorter periods. These highly significant correlations seem to establish definitely that over long periods of time high or low interest rates follow high or low prices by about one year.

Comparison of short term interest rates with quarterly index numbers gives results of no significance for the period 1890-1914. On the contrary, the r's obtained from comparing these series over the period 1915-1927 are high; without lagging r = +0.709; lagging one quarter, r = +0.829; two quarters, r = +0.891; four quarters, r = +0.838. In both periods the coefficients of correlation grow smaller as the P's are lagged behind i, while they grow larger when i is lagged behind P. The results from the analysis of the short term data, while differing in some respects, may be said to confirm the results obtained from comparing the long term data.

§9. Elimination of Trends

These high correlations do not necessarily mean that the interest rate will always be high when prices are high and low when prices are low, but the tendency toward this is definitely established.

The correlations obtained for all periods and sub-periods considered are unusually high. It is necessary to guard against the possibility that these coefficients are of the familiar nonsense type, and are spuriously high because of the presence of secular trend forces that affect both P and i. Due consideration was given to the control devices that have wide acceptance in the literature of statistics, such as "elimination of trend" and "seasonal" fluctuations. The general methodology of analysis of time series is still in the process of formulation. The specific problem of trend analysis is still largely unsolved.60 In the present case, it is rather doubtful that trend forces are involved which should be eliminated. What is desired in all the preceding comparisons of price levels and interest rates is to discover what precise relation obtains between interest rates and prices in the long run. It is like giving the play of Hamlet without Hamlet to eliminate the secular trends of i and P from a study of long term relationships in which these very secular trends are most important and often dominant influences.

However, to anticipate possible criticisms and errors, the results of eliminating secular trends of prices and interest rates have been studied. These additional studies are also made for another and more important purpose, namely, to discover whether or not the shorter so-called cyclical movements of prices influence long-term interest rates in the same way as the long secular price movements have been shown to do. For simplicity, least square straight line and parabola trends were used. These will answer sufficiently the present purpose. In addition, a cubic trend was applied to the yearly data for the United States for the period 1900 to 1927 and to the British data for the corresponding period.

Charts 54, 55, and 56 show the curves of price levels and interest rates in Great Britain for the period 1820-1924 with straight line trends and parabolic trends plotted, while Chart 57 shows the corresponding curves for the United States for the period 1900-1927.

The results, after eliminating these secular trends, are interesting and amazing. The correlation coefficients with straight line trends eliminated are naturally smaller than when these trends are included, but they are still significantly high except for the period 1865-1897 in Great Britain. In the majority of cases, the characteristic lag of about a year of interest rates behind prices gives the highest correlation.

As a further test of the validity of the comparisons, the parabola trend deviations for the recent period, ending with the high point for both P and i in 1920, have been computed and plotted, though the charts are not here shown. It might be supposed that the elimination of a parabolic trend from these violently fluctuating series would leave only erratic wiggles in the P and i curves with little or no correspondence with each other. That price levels and interest rates are very closely related, even when great secular and cyclical forces are eliminated, is clearly demonstrated by the results of these investigations. The correlation coefficients obtained from the data for the period ending in 1920 with the parabolic trends eliminated are about +0.70, which certainly indicates that yearly fluctuations, as well as cyclical and secular trends, of prices and interest are generally in the same direction. The coefficients obtained from correlating P and i with straight line trends eliminated are plotted on Chart 58.

The reader will see that the r's for the latest period are much higher than for the other periods. For Great Britain in the period 1898-1924, r = +0.851 with i lagged one year. For the United States for the corresponding period 1900-1927, and with the same lag of i, we get r = +0.806. It is not worth while to plot the r's with P lagged behind i, since it is apparent at a glance that r decreases with the lagging of P.

When the parabolic trend is eliminated, the correlation coefficients for the cycles become insignificant except for the period including the World War. The highest r for the British data for 1820-1864 is +0.319 when i is lagged one year; for 1865-1897, the highest r is +0.045 with i lagged two years; for 1898-1924, r is +0.829 with no lagging, and +0.817 when i is lagged one year. The United States data give r's of +0.695 without lag, and +0.876 with i lagged one year. Even when a cubic trend is eliminated for 1898-1924 the r's still remain significantly high, namely, without lagging, r = +0.794 and with i lagged one year r = +0.790. For the United States without lagging, r = +0.525 and with i lagged one year r = +0.769.

The elimination of the secular trends from the comparisons makes the relationship of i and P depend solely upon the similarity of fluctuations in the shorter or cyclical periods. Even without Hamlet the play proves to be astonishingly informing and interesting. It is quite definitely demonstrated that, in times of marked price changes, as in the World War period, the effects of price movements are felt rather quickly upon the rates of interest, even in the case of long term bond yields.

§10. Relations of Prices and Interest Interpreted

The studies of P,P' and in relation to i have brought out four relationships:

(1) The rate of interest tends generally to be high during a rising price level and low during a falling price level;

(2) The rate of interest lags behind P' so that often the relationship is obscured when direct comparison is made;

(3) The rate of interest correlates very markedly with , representing the distributed effect of lag. For recent years in Great Britain, the close relationship is indicated by r = +0.98 when i is lagged and the effects of P' are distributed over 28 years;

(4) The rate of interest tends definitely to be high with a high price level and low with a low price level.

We have also seen that the first three sets of facts fit in with the analysis presented, the first corresponding, although only roughly, with the ideal assumption of perfect foresight and adjustment, the second and third corresponding to the more realistic assumption of imperfect foresight and delayed, but accumulated, adjustment.

Two facts have, I think, now been well established. The first, that price changes influence the volume of trade, has been shown in earlier studies made by me.61 The second, that the volume of trade influences the rate of interest, has been shown by Carl Snyder,62 Col. Leonard Ayres,63 Prof. Waldo F. Mitchell,64 and others.

The evidence for both relationships is not only empirical but rational. Rising prices increase profits both actual and prospective, and so the profit taker expands his business. His expanding or rising income stream requires financing and increases the demand for loans.

In my study of the so-called business cycle, the lag of volume of trade, T, behind price changes when the influence of P' was distributed over a range of 25 months, was found to have a modal value of 9½ months. The lag of i behind T using a simple lag was found by Carl Snyder to be 10 to 15 months, by Leonard Ayres to be about 14 months and by Waldo F. Mitchell about 6½ months.

If we add the lag of T behind P' which I found to be over all about 25 months, and the lag of i behind T of 14 months, found by Snyder and Ayres, we obtain a combined lag of i behind P' of 39 months. This combined lag obtained by simple addition is far shorter than the lags discovered in the calculations presented above, whether for yearly or for quarterly price changes in relation to i. Apparently the double distribution of the lag of T behind P' and again of i behind T may result in a greater lag than would be obtained by simple addition.

The fourth relationship stated above must be, I think, regarded as an accidental consequence of the other three. At any rate, it seems impossible to interpret it as representing an independent relationship with any rational theoretical basis. It certainly stands to reason that in the long run a high level of prices due to previous monetary and credit inflation ought not to be associated with any higher rate of interest than the low level before the inflation took place. It is inconceivable that, for instance, the rate of interest in France and Italy should tend to be permanently higher because of the depreciation of the franc and the lira, or that a billion-fold inflation as in Germany or Russia would, after stabilization, permanently elevate interest accordingly. This would be as absurd as it would be to suppose that the rate of interest in the United States would be put on a higher level if we were to call a cent a dollar and thereby raise the price level a hundredfold. The price level as such can evidently have no permanent influence on the rate of interest except as a matter of transition from one level or plateau to another.

The transition from one price level to another may and does work havoc as we have seen, and the havoc follows with a lag which is widely distributed. The result is that during a period of inflation the interest rate is raised cumulatively, so that at the end of this period when the price level is high, the interest rate is also high. It would doubtless in time revert to normal if the new high level were maintained, but this seldom happens. Usually prices reach a peak and then fall. During this fall the interest rate is subject to a cumulative downward pressure so that it becomes subnormal at or near the end of the fall of prices. Thus, at the peak of prices, interest is high, not because the price level is high, but because it has been rising and, at the valley of prices, interest is low, not because the price level is low, but because it has been falling.

Another consideration seems to complete the explanation of the close association between high and low price levels with high and low interest respectively. This is the necessity for banks to cope with maladjustments following inflation and deflation. Mr. R. G. Hawtrey has emphasized this point in a letter to me, and I have summarized his views almost in his own words:

The process of inflation boosts both prices and interest, until a still further boost of interest is made by the banks in order to stop the over extension, leaves a peak of prices with high interest before, at, and after that peak, while, contrariwise, the process of deflation reduces both prices and interest until a still further reduction of interest is made by the banks in order to stop the depression, leaves a valley of prices with low interest before, at, and after the valley.

Such considerations seem to be sufficient to explain the otherwise puzzling and apparently irrational coincidence which we have so often found to exist between high and low prices and high and low interest rates.

The only alternative interpretation of which I can think is that a high or low price level is not a monetary and nominal affair but a matter of real commodities. Sometimes, as in France and Italy just cited, the high prices may be closely associated with impoverishment. If it were true that a high price level usually signified a real scarcity of goods—a low income stream—while a low price level usually signified relative abundance, we could explain our puzzle by the relation of time preference to the size of the income stream. But the facts in general do not seem to justify such an interpretation,65 least of all in the United States in the War years when the correlations are the highest. During that period, incomes increased at a tremendous rate, and interest rates advanced pari passu.

§11. Relations of Interest to Business and Prices

As implied by what has just been said regarding banking policy, the relationships of P' and i are mutual. A change in i undoubtedly has an effect upon P' as well as the reverse. Our analyses have demonstrated that, in a decisive majority of instances, price changes precede changes in i. This does not mean that changes in the interest rate can never be used to forecast changes in prices and in business activity.66 In fact, an arbitrary increase in i at any time does tend to pull down the level of general commodity prices, while a decrease in i tends to increase P. This is a fact which has been quite well established and is made use of by central banks in formulating their banking and credit policies.

The influence of changes in interest rates upon prices and business activity is made use of also by forecasting agencies in making their prognostications of business and price movements for the near future.67 The fact that i follows P', in most instances over secular and cyclical periods, is not inconsistent with the other fact that every increase or decrease in i exerts an influence upon P in the opposite direction. Within limits, a fall in the rate of interest may and often does produce a rise in prices and in business activity almost immediately. This effect may be continued for many months until increased prices again become dominant and pull the interest rate up again.

In so far as the rate of interest is cause and the price movements are effect, the correspondence is just the opposite of that which occurs in so far as the price movements are cause and the interest movements effect.

It is outside the scope of this treatise, which has to do only with things which affect the theory of the rate of interest, to attempt to explain fully all the very complicated relations connecting interest and business. The studies completed or in progress in my office show some interesting results which I hope to publish later.

It is unfortunate that many students in this field seem to take it for granted that there is one and only one definite cycle, or that the cycle is controlled by one and only one definite influence. I have been accused of inconsistency for presenting several seemingly incompatible theories concerning the business cycle. As a matter of fact, I have never as yet studied the so-called business cycle as a whole. I have only studied a few of its elements or aspects.68

§12. Interest Rates and Bank Reserves

That there is a relationship between bank reserves and the rate of bank discount is perhaps self-evident. Every banker and business man is familiar with it. J. P. Nor ton69 found such a correlation and the relationship finds expression in practically every treatment of commercial banking.

This relationship furthermore carries over into the rates fixed on commercial paper. Mr. W. Randolph Burgess70 has made a study of this relationship which he expresses briefly as follows:

Mr. Burgess presents an impressive inductive verification of this theory for the period 1904 to 1909 by comparing the changes in the short term money rate with the changes in the average surplus or deficit in the reserves of New York City Clearing House Association Banks.

The same relationship, Mr. Burgess finds, obtains under the Federal Reserve System between the excess or deficit in reserves of twenty-three New York City Banks and the closing call money rate for intra-week periods between the balancing of the reserves by the Federal Reserve Banks. Over longer periods of time, the relationship is shown by the similarity in the movement of the open market interest rate for prime 4-6 months commercial paper and the average daily bills discounted for member banks by all Federal Reserve Banks.

The Federal Reserve Act requires the pooling of member banks' reserves with the Federal Reserve Banks. These reserves must average the minimum legal requirements and balancing periods are maintained once a week in large cities and twice a month elsewhere. Surplus and deficit reserves are, therefore, impossible for periods of more than two weeks at the very maximum under this system. But the influence of the banks on the money market rates are now effected through borrowings at the Federal Reserve Banks. Thus a period of member banks borrowing corresponds in its relation to the money market to a period of deficit reserves under the National Banking Act, and a period when member banks are paying off their loans at the Reserve Bank corresponds to a period of excess reserves.

A similar correspondence between commercial paper rates and gold reserves is shown by a recent study by Colonel Leonard Ayres, of the Cleveland Trust Company.71

Curiously enough, this well known and sound relationship between bank reserves and interest rates is often confused with the entirely different, generally incorrect, but commonly believed proposition that the rate of interest is high when money in general is scarce, and low when money in general is abundant. The thought seems to be if the rate of interest is called the price of money it is natural to conclude that abundance of money, like abundance of wheat or anything else, makes its price low, while scarcity of money makes its price high.

But the price of money in the sense of the rate of interest is a very peculiar kind of price. It is, as we know, the deviation from par of the price of present money in terms of future money. It is not very analogous to the price of wheat. The real analogy with the price of wheat is not the rate of interest but the purchasing power of money. In that sense it is perfectly true that the price of money is high or low with its scarcity or abundance. But in the other sense it is not true. Moreover, as we have seen, when the price of money, in the sense of the purchasing power of money, is low, that is, when the price level is high, and when, therefore, presumably the quantity of money is large, we do not then find the rate of interest low, as the theory outlined above requires. On the contrary, we find a high price level associated with a high interest rate.

That short term interest rates vary inversely with bank reserves, however, fits in with our theory of interest as related to real income. A low bank reserve is, among other things, a symptom of a prospective general increase in the income of the community. When business is optimistic, which means when future income looms large, there is an impatient desire to discount that big future and to make it even bigger by investing present income, provided the investment can be financed. Evidently the immediate effect is to increase bank loans and consequently to increase deposits. These results tend to lessen the ratio of bank reserves to liabilities. Thus the banker is led to raise his rate. It seems that the rise merely reflects his reserve situation. But back of this situation is the demand for loans, and back of that something more fundamental—the rising income stream, a period of increasing prosperity, of invention and progress, or of great financing. From these changes, rather than from a merely technical banking situation, come high rates of interest.

Thus the banker registers the effect of the increasing income stream. The reverse situation of descending income stream, lessened opportunity to invest, lessened loans and deposits, tend toward idle reserves and low interest.

Normally the banking function should do little more in relation to the rate of interest than to transmit the effects of the income stream. This would be substantially the case if we had a scientific adjustment of the ultimate source of bankers' reserves, the world's supply of monetary gold. If this were so adjusted as to maintain a constant purchasing power of that gold and so of money units, the banker could be trusted to adjust properly, even if unconsciously, the rates of interest to the income situation of the country.

Unfortunately, we do not yet have such a scientific currency system, but are still exposed to every wind that blows in the gold bullion market. The consequence is that superimposed on the normal credit operations are abnormal ones by which the rate of interest is perverted through the very banking machinery which should make it normal.

Banking thus becomes, in practice, not simply a register of fundamental economic influences, not merely their facilitator, but a most powerful independent influence. Practically, then, the banking machinery often interferes with, rather than transmits, the normal influence of society's income situation. If the gold mines become depleted, gold reserves become inadequate to support the growing inverted pyramid of credit based upon it and required by the expanding income of society. The banker then has no choice, under the law, but to raise his rates in self-defense. The result is a shrinkage of credit when an expansion is needed, a fall of prices and high bank rates at the very time that low money rates of interest are needed. The real rates are then doubly high—high because the money rates are high and still higher because of the appreciation of money.

These maladjustments are largely responsible for the so-called business cycle. When they are serious, not only are the consequences disastrous but there is little then left in the market figures of interest to register the influence of fundamental income conditions.72 The interest rate then registers, rather, a choking or stalling of the banking machinery. In an acute panic, scarcity of money itself has made interest high. Money of any kind brought into the market at such times will relieve the stringency and lower the rate of interest. To relieve the money stringency, the United States has, in times past, poured money into the channels of trade by prepaying interest on bonds, and clearing houses have accomplished it by issuing clearing house certificates.

The establishment of the Federal Reserve System has stabilized prices and interest rates in the United States, although the cataclysm of war in 1914-1921 upset the price level and the normal correspondence between real and money rates of interest as they had never been upset before.

At present, the Federal Reserve System exerts a normalizing influence and seems to be groping to apply the stabilizing principles which for many years have been suggested by Wicksell, Cassel, and other economists.

Even these efforts, while in the end they save us from price convulsions and real-interest convulsions, nevertheless themselves involve a slight interference with the natural effects of the income situation. The rediscount rate, when raised, restricts credit and stops price inflation; and when lowered, liberates credit and stops price deflation. As the effect, in either case, tends to be cumulative as long as the slight artificial raising or lowering is in force, the interference with the normal course of events need only be slight, almost negligible. It would not be surprising if a difference of one half of 1 per cent from an ideally normal rate should prove usually sufficient. Maintained sufficiently long, this deviation from a normal interest rate may prevent a very abnormal deviation in our monetary standard.

Some slight interferences are inherent in any such banking system, not only as an incident to the supremely important function of preventing inflation and deflation, but also as a necessary price to pay for the very existence of a banking system. In order to maintain a liquid condition and to avoid risk of bankruptcy, each bank must occasionally put its loan policy out of line with the ideal requirements of the income situation.

But, as we gradually perfect our banking technique and policies, we shall get closer and closer to a condition in which the rate of interest as a whole will reflect the income influences discussed in this book. The money rate and the real rate will become substantially the same, and any action of the banker which can be called an interference with, rather than a registering of, fundamental economic conditions will become almost negligible.

§13. Summary

We have found evidence general and specific, from correlating P' with both bond yields and short term interest rates, that price changes do, generally and perceptibly, affect the interest rate in the direction indicated by a priori theory. But since forethought is imperfect, the effects are smaller than the theory requires and lag behind price movements, in some periods, very greatly. When the effects of price changes upon interest rates are distributed over several years, we have found remarkably high co-efficients of correlation, thus indicating that interest rates follow price changes closely in degree, though rather distantly in time.

The final result, partly due to foresight and partly to the lack of it, is that price changes do after several years and with the intermediation of changes in profits and business activity affect interest very profoundly. In fact, while the main object of this book is to show how the rate of interest would behave if the purchasing power of money were stable, there has never been any long period of time during which this condition has been even approximately fulfilled. When it is not fulfilled, the money rate of interest, and still more the real rate of interest, is more affected by the instability of money than by those more fundamental and more normal causes connected with income impatience, and opportunity, to which this book is chiefly devoted.

PART IV, CHAPTER XX

OBJECTIONS CONSIDERED73

§1. Introduction

SINCE 1907, when The Rate of Interest was published, other students of the problem of interest have published their comments, objections, and criticisms. I have taken the opportunity to answer directly in various publications74 most of the criticisms. It would serve no useful purpose to reprint these individual replies in this place. Rather, in this chapter, I shall state my understanding of the criticisms of my theory and shall offer replies where reply seems called for. This procedure will serve two purposes. First, it will present to the reader points of view and approaches to the problem of interest other than my own. Secondly, it will provide occasion for the statement of my position on the principal controversial problems in the theory of interest still remaining unsettled among economists.75

§2. Income and Capital

Income, which, as I have stated before, is the most important factor in all economic theory and in interest theory in particular, resolves itself in final analysis into a flow of psychic enjoyments or satisfactions during a period of time. While this concept is the ideal, we can, for purposes of objectivity, approximate this ideal and at the same time impute to the income concept varying degrees of measurability by using in place of psychic income any of the following: real income, cost of living as a measure of real income, or money income.

One objection to the psychic concept of income as a basis for a theory of interest is that it is too narrow and restricted. It is held that the analysis of interest based on this concept "finds the cause of the changes in rates solely in the changed ratio between the stocks of present and of future consumption goods," while the "interest rate market is a funds market, not a machine or raw material or present consumables market."76

"Nor is it entirely clear," continues this criticism, "why, in Fisher's view, the consumption perspective should read the law in point of interest rates to all equipment loan contracts, rather than, as Böhm-Bawerk sometimes appears to assert, the other way about. Why should not both sorts of demands be regarded as of equal title in causal effectiveness in the interest adjustment on final loans?"77

I reply that I do not exclude "equipment loan contracts" from due consideration, but I do maintain that such intermediate loans are made for the purpose of securing larger incomes in the future, and larger incomes mean larger consumption. Production loans then are made only in contemplation of future consumption. Hence, though loans for the acquisition of intermediate goods do greatly preponderate in the loan markets, these loans have power to affect the interest rate only by changing the relative amount of future incomes compared to present incomes.

To the criticism that the consumption concept of income when used as the foundation of interest theory presents but a partial analysis of the supply and demand factors which are operative in determining interest rates, I make this reply: Interest rates are not a resultant of the supply of, and demand for, either capital goods or of capital values—sometimes conceived of as a loanable fund or funds, except as these signify the supply of and demand for income. An investment of capital, so called, is nothing more nor less than the sacrifice of income in anticipation of other, larger, and later income. It is a case of flexing the income stream, reducing it in the present or early future and increasing it in the remoter future. The income stream, so fundamental in the interest problem, includes incomes from all sources. It includes the value of the services of land, machines, buildings, and all other income-producing agents. Upon the value of these services, discounted at the prevailing rate of interest, the valuation of said land, machinery, buildings, and so on depends. What is properly called funds is this valuation of the income stream or portions of it. It should be evident that the approach to the problem of interest through the income stream and the supply of and demand for income gives to the problem the broadest possible basis.

The second indictment of narrowness of my concept of income denies my contention that savings are not income. One writer states this criticism as follows: "As a financial fact, there can be no saving and addition to capital value until there is first a property right to an income calculable in monetary terms (a financial present worth) to be saved. Hence to deny that monetary savings are monetary income is in simple common sense to deny a fait accompli; it is to assume the existence of the effect before its cause."78

In so far as our disagreement here is a matter of words, it may be that my terminology is at fault. I used the term earnings to include capital gain and the term income in the sense of the value of services rendered by capital. There is little objection to changing this terminology, if we are willing to give up saying that capital value is the capitalized value of expected income. We could then maintain that capital gain is income. But if income includes only those elements on the anticipation of which the value of capital depends, then the increase in the value of capital is most emphatically not income.79

In my reply to one critic,80 I pointed out that this criticism seems to overlook, or omit, the mutual relations of discount and interest which constitute the raison d'être for the concepts which I have called capital and income. It is chiefly because savings do not enter into these discount relations on equal terms with other items of income that savings do not form a part of what I have called the income concept. I do not think there are reasons of terminology alone sufficient to justify the inclusion of savings in income. But, if savings are to be so included, some other term must be applied to take the place of what I have called income. The justification of these statements must rest on my books themselves and on later papers devoted to this subject.

But it is held that even aside from the relation of savings and income, a concept of income as services is quite useless. Services are both heterogeneous and incommensurable.81 They cannot be summated to constitute a stock of services. They cannot be thrown together as if all were alike.

An examination of my The Nature Of Capital and Income (for example p. 121), will show that I do not treat all services as alike and capable of being added together. I have emphasized that miscellaneous services cannot be added together until each is multiplied by its price and all are thus reduced to a common denominator.

This criticism of my theory of income seems to overlook the fact that, while enjoyable services (psychic income) and objective services are themselves incommensurable, their values are not. Moreover, when the summation is completely carried out, the values of the physical elements cancel among themselves and leave as the net result only the values of the psychical elements.

It may be objected that, at one stage in this process, income appears to be more closely related to the expenditure of money than to its receipt and, as such, seems out of keeping with the ordinary idea of income. This seeming contradiction between money income and enjoyable income is readily resolved if we consider debits and credits. When money is spent, the expenditure itself is, it is true, outgo to be debited to the commodities bought with it. But these commodities afterward render a return in satisfactions. These satisfactions are certainly not expenditures, but receipts. Whether money spending is associated with outgo or income is entirely dependent on whether we fix attention on the loss of the money or the gain of the goods and services for which the money is spent.

These services, which constitute income, are related to capital in several ways. As income services, they flow from, or are produced by human beings and the physical environment. When I first came to the study of income and capital, I developed the concept of capital as a stock of wealth existing at an instant of time, and of income as a flow of wealth during a period of time, which concept I advanced in 1896.82 I found it necessary in 1897 to modify my concept of income, and so stated.83 Since then I have found no reason for further modification either of the concept of capital as a stock of wealth existing at an instant of time, or of the concept of income as a flow of services through a period of time, while the values of these are respectively capital value, and income value, often abbreviated into capital and income.

"It is not possible," it is objected, "to conceive of a literal stock of services at an instant of time; it is possible to conceive of their present worth as a financial fund at an instant of time. Services (taken in the sense of uses either of wealth or of human beings) may conceivably be delayed or hastened, but they are in their very nature a flow; they cannot be heaped up and constitute a stock of services. They can, at most, as they occur be 'incorporated' in durable forms of wealth. If this is so, then why this elaborate contrast between a flow of services, and a fund of something quite different? It is the vestigial remains of the older conception that Fisher has been obliged to discard."84

While, however, I agree that these concepts of capital (as a fund of wealth) and income (as a flow of services) are not commensurate with the theory of interest, it would be a mistake to conclude from the emphasis placed on capital value, not capital goods, in the The Nature of Capital and Income, which was written as an introduction to the theory of interest, that the concept of capital goods emphasized by me in 1896 has been shelved as useless.

In the first place, the goods concept is itself a step in the formulation of the value concept, and secondly, The Nature of Capital and Income does not attempt to cover all of the four different relations between capital and income but only that one relation, income value to capital value, which is of importance to the theory of interest.

This valuation concept of capital, which in my view is necessary to the solution of the interest problem, does not distinguish between land and "produced means to further production." Some writers,85 who hold this latter concept of capital, have contended that my treatment of land as typical of capital in general has led me to erroneous conclusions.

In particular, my criticism of the naïve productivity theories is said to fall down because of this consideration. But, as I have before written,86 "my strictures on the ordinary productivity theories are not dependent on the putting forward of 'land' as typical of all forms of capital" or the particular definition of capital which I have used, but are, for the most part, merely a résumé of the strictures of Böhm-Bawerk, whose definition of capital excludes land. In other words, these criticisms hold true quite regardless of whether land is included in the capital concept or not.

However, while I recognize certain differences which exist between land and so-called artificial capital, these differences are of degree only, and do not carry the importance in most phases of economic theory which adherents of this concept of capital attribute to them. Professor J. B. Clark has presented87 the similarities and dissimilarities of land and other durable agents so comprehensively and adequately that I shall not attempt to go over again this question at this point. However, one phase of this comparison is of importance. It is claimed by those88 who hold land to be non-reproducible and, therefore, to lack a cost of production, that its value is governed by factors quite different from those determining the value of reproducible agents whose production does involve costs of production.

In brief, the contention is that the discount or capitalization principle of valuation upon which my theory rests is applicable only to land, since land value is not affected by cost of production. "If land, the limited gift of nature," one critic writes, "were truly representative of capital, then Fisher's reasoning would be unassailable."89

But since land, it is implied, is not representative of capital in that it does not involve a cost of production, the valuation process which applies to land does not apply to those "produced means to further production" which do incur costs in their production. To a consideration of the relation of cost of production to capital value, therefore, we now turn.

§3. Cost of Production as a Determinant of Capital Value

The criticism that my views as to the relation of cost of production and capital value are invalid because of the use of land as typical of capital has been advanced by several writers.90 In its most concrete form, it applies to the example which I presented of the case where an orchard was held to be worth $100,000 because this sum represented the discounted value of the expected income from the orchard of $5,000 per annum. But even if we change the orchard to machines, houses, tools, ships (that is, "produced means to further production") the principle that the value of anything is the discounted value of its expected income stands unrefuted. This is not to say cost of production does not have an influence. But past costs have no influence on the present value of a capital good, except as those costs affect the value of the future services it renders and the future costs. Future costs influence this value more directly by being themselves discounted at the current rate of discount. It is certainly true that if the reproduction cost of the capital goods is lowered, their production will be stimulated, the supply of services they render will be increased, the valuation of these services, i.e., the income from these capital goods per unit will be lowered, and, therefore, quite aside from any effect on the discount rate, the capitalization of this reduced income will tend to be lowered. Furthermore, this fall in the value of the capital goods will be brought down to a point, through the operation of the opportunity principle, where it is brought into conformity with the new cost of production of the capital good plus a margin to represent the amount of interest.

But, although it is true, it is objected, that under the supply and demand analysis, an increase in the supply of a single commodity will lower its value, the same does not follow when applied to all goods. "Exchange values and prices are relations among goods. Increase the supply of one good and the ratio at which it exchanges for others or for money will change to its disadvantage. If, however, you increase at the same time the supplies of all goods, including gold, the standard money material, you affect simultaneously both sides of all ratios of exchange and consequently the ratios should remain substantially as before. It is just such an increase of goods of all sorts and descriptions that is denoted by Böhm-Bawerk's phrase, 'the technical superiority of present over future goods', or by the more familiar phrase 'the productivity of capital'. Admitting the physical-productivity of capital (and Fisher does not question it), the value-productivity of capital or, more accurately, an increase in the total value product as a consequence of the assistance which capital renders to production seems to me to follow as a logically necessary consequence.... Since there is nothing in the assumption that the productivity of all instruments is doubled that involves any serious change in the expense of producing the instruments, the productivity theorist certainly would claim that under these conditions there must be, if not a doubling, certainly a very substantial increase in the rate of interest."91

I can perhaps do no better than to repeat in part the reply which I made to this criticism in 1914.92 "But the increased productivity of capital will entail a decreased price, or value per unit, of the products of that capital. And in addition there may be an increase in the expense of producing the capital, if, for instance, it is reproducible only under the laws of diminishing returns or increasing costs. Evidently it does not follow that the net return on capital-value will be permanently increased. In short, the expenses of production, on the one hand, and the price of the product of the capital multiplied by the increased product itself, on the other hand, will tend to adjust themselves to each other and to the rate of interest. But this rate of interest, according to my philosophy, instead of being permanently raised, will be ultimately lowered, for to double the productivity of capital will mean ultimately a much larger income to society than before, and this larger income tends to lower the rates of impatience of those who own it. So long as the rate of interest does not fall to correspond with the lower rates of impatience, there will continue to be profit in reproducing the productive capital until adjustment is attained—whether by decrease in the price of the products or by increase in the cost of the capital, or both, does not matter. In any case this adjustment must be by lowering and not by raising the rate of interest, for the rate of interest cannot be raised if the rates of impatience are not raised, and the rates of impatience cannot be raised if, as is assumed, the income stream is increased in size without being altered in other respects."

Very possibly, Professor Seager and I may have been arguing at cross purposes, for, of course, in the transition period while productivity is being doubled, the rate of interest may be raised. This is amply provided for in my theory. But even during the transition period something more is required than increased productivity in order that the rate of interest shall rise; the cost of making the change must be reckoned with and deducted from the income stream. Mere physical productivity will not suffice.

Having stated my views, it will serve to present clearly the difference of opinion to quote an illustration which Professor Harry G. Brown has furnished me of his views on the matter.

I accept all of Professor Brown's reasoning and conclusions except his application to me. His contention that the cost of duplicating existing capital will influence the value of that capital is perfectly correct, but so is the discount formula.

The two are not inconsistent. If they were, by the same logic, the generally accepted formula by which the value of a bond is calculated in every broker's office is contradicted every day whenever a cheaper bond is available. The first axiom in economics is, naturally, to get anything the cheapest way whether that way is to make it oneself, buy a substitute or otherwise, for in Professor Brown's reasoning it is solely the existence of an alternative cheaper way which makes the supposed disturbance.

The reasoning proves too much. Suppose Jones offers Smith a bond at one price and Smith refuses because he can get another just like it for less. He would choose the cheaper and he would have a "curious mind" if the cheaper cost affected him only through first making him think elaborately of the discount process. All he needs to know is that if Jones' bond is worth the price offered the cheaper one is even more clearly worth while. And Jones will sit up and take notice, possibly reducing his price.

The cheaper bargain thus has in Professor Brown's sense a "direct" effect on the price of Jones' bond, not an effect solely on a revaluation of expected services. But we cannot here conclude that the usual mathematical formula for the price of a bond was incorrect.

There is no more definite and universally accepted formula in the whole realm of economics and business than that referred to. It is used every day in brokers' offices. It gives the price of a bond in terms of the interest basis, the nominal interest and the time of maturity. It is the type, par excellence, of the capitalization principle both in theory and practice. It is not impaired by any undercutting of the market.

The boat is, economically, a sublimated bond. If Jones offers it to Smith for $150, while Smith can get it cheaper the discount principle is not invalidated. There is simply a readjustment in the boat as in the bond market. Moreover in an individual transaction where there is no marginal point reached by repeating the transaction—only one boat, not a series—there are wide limits within which the buyer gets his consumer's surplus and the seller his producer's surplus. Only when there is a series of successive boats or bonds do we have a full fledged example of the margin where consumer's rent disappears and an equality replaces inequalities.

In the isolated case we should be content to say that Smith will not pay more than the capitalized value. In the case of the conventional series of boats, the marginal boat will be such that the capitalization principle and the cost principle will both apply. The seventh boat, let us say, will cost Smith $100 whether to make or to buy. Jones and other boat owners will have reduced their price from $150 and Smith will have found that to make so many boats will have cost $100 instead of $40, to say nothing of the important fact that he would have to wait much more than a week.

All these points are covered in my presentation, for Professor Brown's example is only one of the myriad examples of alternative opportunities. Smith, like everybody else, will use the cheapest way in the sense of choosing the income stream of labor and satisfaction having the maximum present worth at the market rate of interest.

Professor Brown has his eyes on the opportunity part of the picture and no one has stressed that part more than I. But interwoven with it and consistent with it, in the analysis of a perfect market in which the individual is a negligible factor, is the principle that every article of capital is valued at the discounted value of its expected services and costs.

I do not intend to underestimate the importance of the cost concept. The importance it holds in my mind is not to be measured by the number of pages devoted to it in my books, the main purpose of which was to study capitalizations of income. I believe that the position on cost which was taken by Professor Davenport93 is in general the correct one. What I attempted to point out was that those double-faced events, which I have called interactions, and which always have a double entry, a positive and negative entry, in social bookkeeping, are not ultimately cost any more than they are ultimately income. I also tried to emphasize that cost enters into capitalization on equal terms with income, when the cost is future. Past cost does not affect present valuations except indirectly, as it affects future expected income and cost.

No one would maintain that obsolete machinery, even in good condition, could be appraised on the basis of its cost. The only cases in which cost (with interest) is equal to value is where this value is also equal to the estimate of worth on the basis of future expectations; when, in other words, cost is superfluous as a determinant of value. That cost does influence value by limiting supply, thereby affecting the quantity and value of future services, cannot be questioned. It is natural that business men should not follow this roundabout relation, but connect directly cost with value. This, however, is no reason for economists to fail to analyze the relation in all its complications.

§4. Impatience as Determinant of the Interest Rate

Certain characteristics of The Rate of Interest led to the unfortunate deduction on the part of many readers94 of that volume that I regarded impatience as the sole and complete determinant of the rate of interest. While I have tried in this book to forestall similar misinterpretations of my theory, and while it does not seem possible to me that any reader could now charge me with being a pure impatience theorist, it will serve a useful purpose to consider the various factors involved in this question.

We may draw upon Professor Fetter's writings for a clear statement of the issue between the productivity theory and the time preference theory of interest. He states positively that time preference is the sole cause of interest, although he assumes that physical productivity is essential to the emergence of value productivity.95 He declares that his theory was new in assigning priority to capitalization over contract interest and in giving a "unified psychological explanation of all the phenomena of the surplus that emerges when undervalued expected incomes approach maturity, the surplus all being derived from the value of enjoyable (direct) goods, not by two separate theories, for consumption and production goods respectively."96 [Italics mine.]

I have no criticism to make of this statement of the operation and effect of time preference so far as it goes. It seems to me to coincide sufficiently with the treatment which I have presented under the first approximation. There incomes were assumed to exist and to be rigidly fixed in amount and in time without our bothering to ask how they were produced. Nature offered no options to substitute one income stream for another. One could modify his income stream only by borrowing or lending. Under the hypothetical conditions so assumed, time preference would cause interest without help from any rate of return over cost. But such assumed conditions never do or can exist in the real world.

Of course a constant rigid physical productivity, yielding unchanging physical income streams, is contrary to the observed facts of life, just as unchanging time preference for each individual at all times and under all conditions is an absurdity. In real life men have the opportunity of choosing among many optional income streams. When such opportunities exist, time preference alone does not and cannot explain the emergence of interest. As a mathematical problem, the rate of interest would under the conditions of the second or third approximations be indeterminate without introducing the influence of the opportunity or productivity factor.97

Productivity, that is, the possibility of increasing the present value of the income stream, introduces new variables which have to be determined as a part of the interest problem and every new variable requires a new equation or condition.

It happens that, for lack of applying this mathematical principle, writers have often thought themselves in greater disagreement on the explanation of interest than they really were. Wordy warfare has been waged among the various productivity theorists and the capitalization or time preference theorists. Each combatant seems to think that he and he alone has hit upon the correct and complete explanation and that, therefore, any other explanation is necessarily false. As a matter of fact, both productivists and time valuists are substantially right in their affirmations and wrong in their denials. Thus, theories which have been presented as antagonistic and mutually annihilatory are in reality harmonious and complementary.

§5. Productivity as a Determinant of Interest Rates

When the true nature of the income concept is grasped, it will be found that it includes within itself many special cases which have been advanced by various writers in explanation of the rate of interest. The relation of both impatience and opportunity to the rate of interest, in my opinion, can be comprehended accurately only by analyzing rigorously these concepts and determining the effect of each upon the income stream. By this procedure, we arrive at a fundamental explanation of the nature of impatience and of return on income invested and see how, by changes in the income stream, these rates are brought into conformity with the rate of interest.

I have always felt that John Rae came closer than any of the earlier writers to grasping all the elements of the interest problem. According to Rae, all instruments may be arranged in an order depending on the rate of return over cost. This amounts to saying that the formation of any instrument both adds to and subtracts from the preexisting income stream of the producer, its cost being the subtracted item and the return, the added one. The statement of Rae that for a certain cost of production an instrument will yield a certain return, is merely a form of my statement that a certain decrease of present income will be accompanied by a certain increase in future income. The relation between the immediate decrease and future increase will vary within a wide range, wherein the choice will fall at the point corresponding to the ruling rate of interest.

The same relationship was conceived by Adolphe Landry in his Intérêt du Capital. He states that one of the conditions determining the rate of interest is the "productivity of capital", in the peculiar sense which he gives to this phrase,98 which is, in effect, the rate of return over cost.

It has seemed to me that much of the criticism, both favorable and unfavorable, of my book, The Rate of Interest, has been based on the erroneous assumption that the so-called productivity element found no place in my theory. Much of the misunderstanding of my theory may have been fostered by the lack, in my first book, of a good term with which to express this productivity factor in interest.

As a consequence, one critic, Professor Seager, writes that I refuse to admit that what Böhm-Bawerk calls the "technical superiority of present over future goods", and what other writers have characterized more briefly as "the productivity of capital" has any influence on the comparison between present gratifications and future gratifications in which, as he believes, the complete and final explanation of interest is to be sought.

"The most striking fact about this method of presenting his factors", this criticism continues, "is that he dissociates his discussion completely from any account of the production of wealth. From a perusal of his Rate of Interest and all but the very last chapters of his Elementary Principles (chapters which come after his discussion of the interest problem), the reader might easily get the impression that becoming rich is a purely psychological process. It seems to be assumed that income streams, like mountain brooks, gush spontaneously from nature's hillsides and that the determination of the rate of interest depends entirely upon the mental reactions of those who are so fortunate as to receive them.... The whole productive process, without which men would have no income streams to manipulate, is ignored, or, as the author would probably say, taken for granted."99

My views are quite contrary to those here set forth. As I wrote in 1913:100

I do not assume, except temporarily in the first approximation, that "income streams, like mountain brooks, gush spontaneously from nature's hillsides", and this is temporarily assumed, precisely as physicists temporarily assume a vacuum in studying falling bodies, or, to take a better but still imperfect analogy, precisely as, in treating supply and demand, we first assume a fixed supply before introducing the supply schedule or supply curve. This assumption gives place in the second approximation and the third approximation to the more complicated conditions of the actual world. My method of exposition is here, as usual, to take one step at a time, which means to introduce one set of variables at a time. All other things, for the time being, are assumed to remain equal. I realize that this is not the only method and that it may not be the best one, but it is at least a legitimate method.

On the other hand, it does not seem to me that the theory of interest is called upon to launch itself upon a lengthy discussion of the productive process, division of labor, utilization of land, capital, and scientific management. The problem is confined to discover how production is related to the rate of interest.

It should not, however, be assumed from what has been said that I regard all productivity theories as sound. Mention was made in Chapter III of the "naïve" productivity theories which hold that interest exists simply because nature, land and capital are productive.

§6. Technical Superiority of Present Goods

Böhm-Bawerk is among those who sensed the inadequacy of time preference or impatience as the sole determinant of the rate of interest. Yet he calls his theory the agio theory of interest, since he finds the essence of the rate of interest in the agio, or premium, on present goods when exchanged for future goods.

Böhm-Bawerk presented the agio theory, or what is here called the impatience or time preference theory, clearly and forcibly, and disentangled it from the crude and incorrect notions with which it had previously been associated. It was only when he attempted to explain the emergence of this agio by means of his special feature of "technical superiority of present over future goods" that, in my opinion, he erred greatly.

Böhm-Bawerk distinguishes two questions: (1) Why does interest exist? and (2) What determines any particular rate of interest?

In answer to the first question, he states virtually that this world is so constituted that most of us prefer present goods to future goods of like kind and number. This preference is due, according to Böhm-Bawerk, to three circumstances: (1) the "perspective underestimate" of the future, by which is meant the fact that future goods are less clearly perceived, and therefore less resolutely striven for, than those more immediately at hand; (2) the relative inadequacy (as a rule) of the provision for present wants as compared with the provision for future wants, or, in other words, the relative scarcity of present goods compared with future goods; (3) the "technical superiority" of present over future goods, or the fact, as Böhm-Bawerk conceives it, that the roundabout or capitalistic processes of production are more remunerative than those which yield immediate returns.

The first two of these three circumstances are undoubtedly pertinent, and are incorporated, under a somewhat different form, in this book. It is the third circumstance—the so-called technical superiority of present over future goods—which, as I shall try to show, contains fundamental errors.

My criticism of this third thesis, however, does not, as some have implied, consist in denying the existence or importance of the "technical" element in interest but in denying the soundness of the way in which Böhm-Bawerk applies it. It was for the purpose of presenting what in my view constitutes the true character of this element that I have placed so much emphasis on the opportunity principles given in Chapters VII, VIII, XI and XIII of this book.

According to Böhm-Bawerk, labor invested in long processes of production will yield larger returns than labor invested in short processes. In other words, labor invested in roundabout processes confers a technical advantage upon those who have command of that labor. In the reasoning by which Böhm-Bawerk attempts to prove this technical superiority, there are three principal steps. The first consists of postulating an "average production period," representing the length of the productive processes of the community; the second consists of the proposition that the longer this average production period, the greater will be the product; and the third consists in the conclusion that, in consequence of this greater productiveness of lengthy processes, present goods possess a technical superiority over future goods.

Although the first two of these three steps are of secondary importance, the following remarks concerning them are in point. The concept of an average production period is, I believe, far too arbitrary and indefinite to form a basis for the reasoning that Böhm-Bawerk attempts to base upon it. At best, it is a special, and very hypothetical, case not general enough to include the whole technical situation.

Böhm-Bawerk himself, in his reply to my original criticism, asserts his agreement with my contention concerning the second step that, while long processes are in general more productive than short processes, this is not a universal truth. Of the infinite number of possible longer processes only those which are more productive than shorter ones are chosen.101 This is what was noted in Chapter XI when it was shown that the O curve is concave simply because the reëntrant parts are skipped!

It is the third step which is crucial to the theory of the technical superiority of present goods, namely, that the productiveness of long processes gives a special technical advantage to the possessor of present goods or present labor. This advantage produces, so Böhm-Bawerk asserted, a preference for present over future goods which is entirely apart from, and in addition to, the preference due to the underendowment of the present. Granting, for the moment, the validity of the concept of a production period, and that the longer the period, the greater its product, it may still be shown that no such technical superiority follows. Böhm-Bawerk regards this part of his theory as the most essential of all, and repeatedly states that the theory must stand or fall by the truth or falsity of that part.

Böhm-Bawerk supports his assertion of the existence of a technical superiority102 by elaborate illustrative tables.103 Each table is intended to show the investment possibilities of a month's labor available in any particular year. That longer processes are more productive than shorter ones, Böhm-Bawerk indicated by an increasing number of units of product for each successive year. The marginal utility of each year's yield when obtained is illustrated by a decreasing series, since the marginal utility of a stock of goods decreases as the number of units in the stock increases. Since the year 1888 was considered as the time of reference, or the first year in which the investment of labor was to be made, the numerical series representing the marginal utilities of the optional products as of the respective years of their production was reduced, by discounting, to a series of numbers representing the marginal utility of each year's yield as of the year 1888. The subjective value of each year's yield as of the year 1888, Böhm-Bawerk obtained by multiplying the number of units of each year's yield by its reduced marginal utility.

Of course, that investment of the month's labor available as of any particular year would be made which showed the maximum present value. When, however, the table of any one year is compared with that of any succeeding year, the maximum present subjective value selected is the greater the earlier the month's labor is available.

For example, a month's labor available in 1888 was shown to be most advantageously invested in the process which yielded the maximum present subjective value of 840 in 1890. But a month's labor available in 1889 yielded its maximum present value when invested so as to mature in 1893. In this latter case, however, the maximum was only 720 as compared with the maximum of 840 for a month's labor available in 1888.

Böhm-Bawerk therefore concludes that a month's labor available in 1888 is more productive than one available in 1889, 1890 or any succeeding year. In other words, entirely independent, according to him, of the perspective underestimate, and the under-endowment of the present, there inheres a technical superiority in present over future goods.

"This result", he writes,104 "is not an accidental one, such as might have made its appearance in consequence of the particular figures used in our hypothesis. On the single assumption that longer methods of production lead generally to a greater output, it is a necessary result; a result which must have occurred, in an exactly similar way, whatever might have been the figures of quantity of product and value of unit in the different years."

But Böhm-Bawerk is mistaken in ascribing any part of this result to the fact that the longer processes are the more productive. In his tables he assumes the existence of one or both of the other two factors—the relative under-provision for the present as compared with the future, and the perspective undervaluation of the future, due to lack of intellectual imagination or emotional self-control. It is these elements, and these alone, which produce the advantage of present over future goods which the tables display.

That the result does not at all follow from "the single assumption that longer methods of production lead generally to a greater output" and has nothing whatever to do with that assumption, we can see clearly if we make the opposite assumption from that of Böhm-Bawerk, namely, that the longer the productive process the smaller will be the return. The very same result would still follow. The labor would still be invested at the earliest possible moment. In other words, let the figures representing units of product decrease instead of increase. The only difference would be that the month's labor available in 1888 would now be so invested as to bring returns in that year instead of being invested in a two years' process as before. If calculations are performed for each year and the results are compared, it will appear that the investment in 1888 yields the highest return, just as it did on the previous hypothesis.

Again, the same result would follow if the productivity increased and then decreased in all the tables, or if the productivity should first decrease and then increase. As long as the figure representing reduced marginal utility decreases, the "units of product" may be of any description whatever, without in the least affecting the essential result that the earlier the month's labor is available, the higher is its value.

On the other hand, if the conditions are reversed and the reduced marginal utility does not decrease, the earlier available labor will not have a higher value, whatever may be the character of the "units of product."

Böhm-Bawerk, however, specifically denies this:105

In his table it is true that the month's labor available in the present is more highly valued than the same month's labor available at a later date. But Böhm-Bawerk carefully retained in his illustration one of the "two circumstances" which he told us could be discarded, namely, the relative overprovision for the future. To leave one of these two circumstances effective instead of both is merely to change slightly the series of "reduced marginal utility". The change in the particular numbers is quite immaterial so long as the series is still descending, and it does not matter whether the descent is due to perspective or to the relative underprovision for the present, or to both.

The only fair test of the independence of Böhm-Bawerk's third factor—the alleged technical superiority of present over future goods—would be to strike out both the other elements (underestimate and overprovision of the future) so that there should be no progressive decrease in marginal utilities; in other words, to make the numbers representing "reduced marginal utilities" all equal. Böhm-Bawerk, for some reason, hesitates to do this. He says:106

Even if this be true, and in my view it is not, it is no reason for refusing to push the inquiry to its limit. When this is done, however, the figures of present value of the various yearly products become absolutely alike; hence the maximum of the former, if there be a maximum, must be identical with the maximum of the latter.

Though Böhm-Bawerk did not consider this case in his tables, he speaks of it briefly in his text, but seems to be somewhat puzzled by it. He says:107

Böhm-Bawerk's confusion here is probably to be ascribed to his insistence on the indefinite increase of product with a lengthening of the production period. Practically we ought to assume that somewhere in the series the product decreases. We would then have a more practical illustration of the fact that the labor available this year and that available next year stand on a perfect equality.

The conclusion is that, if we eliminate the "other two circumstances" (relative underestimate of, and overprovision for, the future), we eliminate entirely the superiority of present over future goods. The supposed third circumstance of technical superiority, in the sense that Böhm-Bawerk gives it, turns out to be non-existent.

The fact is that the only reason any one does prefer the product of a month's labor invested today to the product of a month's labor invested next year is that today's investment will mature earlier than next year's investment.108 If a fruit tree is planted today which will bear fruit in four years, the labor available today for planting it is preferred to the same amount of labor available next year for the reason that if the planting is deferred a year, the fruit will likewise be deferred a year, maturing in five instead of four years from the present. It does not alter this essential fact to speak of the possibility of a number of different investments. A month's labor today may, it is true, be spent in planting slow-growing or fast-growing trees, but so may a month's labor invested next year. It is from the preference for the early over the late fruition of any productive process that the so-called technical superiority of present over future goods, as conceived by Böhm-Bawerk, derives all its force.

Böhm-Bawerk, however, attempts to prove that his third circumstance—the alleged technical superiority of present goods—is really independent of the first two, by the following reasoning:109

The argument here is that if "the other two circumstances" which produce interest, namely, underestimate of the future and underendowment of the present, are temporarily absent, they will be forced back into existence by the choice of roundabout processes. In other words, the technical superiority of present goods produces interest by restoring the other two circumstances. But this is tantamount to the admission that technical superiority actually depends for its force on the presence of these other two circumstances and is not independent. The essential fact is that the presence of technical superiority does not produce interest when the other two are absent.110

Although Böhm-Bawerk devoted many pages in the third edition of his book and the Supplements (Exkurse) to answering my criticisms,111 I can find nothing in his answers which affects the main argument as set forth above.112 I have omitted certain of the less important of my original criticisms to which Böhm-Bawerk has replied.

Perhaps the most interesting point about Böhm-Bawerk's failure correctly to formulate the "technical" feature which he thus vainly sought is that it is really much simpler than he imagined. It does not require his elaborate tables and comparisons among their many columns. Merely the first column of his tables contains implicitly the true "technical" feature in one of its many forms of choosing from among optional income streams. This shows the successive amounts of product obtainable for a series of production periods of different lengths. This series is exactly analogous to the successive ordinates in Chart 16 showing the lumber to be obtained from a forest at different dates. There comes a point in such a series or such a curve, where a further lengthening of the time by one year will add to the product over the preceding year (i.e., will yield a rate of return over cost both reckoned in kind) at a rate harmonizing with the rate of interest. Oddly enough Böhm-Bawerk does not mention this derivative from his table. Another form, more nearly what Böhm-Bawerk apparently was groping for, could have been presented had his table been extended to include not merely one dose of 100 days labor but many such doses and if "labor" and "product" were reduced to a common denominator. Then the product of the marginal labor would be the return while the labor itself would be the cost from which return over cost could be derived. But the comparisons which Böhm-Bawerk actually employed are beside the point.

§7. Interest as a Cost

From the foregoing criticisms and discussion it will, I hope, be seen that I have given full recognition, in this book, to the elements of productivity, technique of production, and cost, and that my chief objections to their treatment by many other writers is either that their treatment is inadequate and leaves the problem of interest indeterminate, or simply that they do not reduce the problem to its simplest terms.

In particular, it has been noted that the ultimate economic cost is labor and that all money payments and industrial operations intervening between labor and satisfactions may, in the large view, be dropped out. I have endeavored, in this and in other ways, to articulate the theory of interest with sound accounting principles, even when no great damage would be done to interest theory, as such, if unsound accounting were allowed to enter.

The most flagrant case of unsound accounting injected into this discussion is, in my opinion, when waiting is regarded as a cost.

This grows out of the common tendency to account for all economic values in terms of cost. When we cannot find the cost, we invent it. We feel sure interest must be fully accounted for in terms of cost. When we find inadequate the cost of producing capital or the cost of managing it or of organizing it or of investing it, we fall back on waiting, abstinence, or labor of saving.

It is true that these words are used by some writers to mean nothing more than what I have included in the phrase impatience or time preference. In these cases the question is merely one of terminology. In a large number of instances, however, the abstinence or waiting theory seems to me to differ from the impatience theory not only in words but in essence. In this the assumption is made that abstinence or waiting exists as an independent item in the cost of production, to be added to the other costs and to be treated in all ways like them.

If abstinence or waiting or labor of saving is in any sense a cost, it is certainly a cost in a very different sense from all other items which have previously been considered as costs. An illustration will make clear the difference between true costs and the purely fictitious or invented cost of waiting. According to the theory that waiting is a cost, if planting a sapling costs $1 worth of labor, and in 25 years, without further expenditure of labor, or any other cost whatever (except waiting) this sapling becomes worth $3, this $3 is a mere equivalent for the entire cost of producing the tree. The items in this cost are, it is claimed, $1 worth of labor and $2 worth of waiting.

According to the theory of the present book, however, the cost of producing the tree is the $1 worth of labor, and nothing more. The value of the tree, $3, exceeds that cost by a surplus of $2, the existence of which as interest it is our business to explain. Labor cost and waiting are too radically different to be grouped together as though each were a cost in the same sense as the other.

The cost of waiting can neither be located in time, independently of the item waited for, nor can it, like any other item, be discounted, for it is itself the discounting. If we discount the discounting, we would have to discount the discounting of the discounting and repeat the process indefinitely.

If we insist on calling waiting or abstinence a cost we reduce to absurdity all our economic accounting. Among other things, the simplest, purest type of income, a perpetual annuity, will be found, by such accounting, to be no income at all.

An able critic and correspondent, after admitting this fact, says simply, "What of it?"

Well, perhaps nothing vital as to the theory of interest itself. And since that is, after all, the sole subject of this book I shall relegate to the Appendix the discussion of What of it? as to accounting.113

§8. Empirical and Institutional Influences on Interest Rates

The problem of fully determining any specific market rate of interest is an intricate and baffling problem to solve just as is the problem of fully explaining any historical fact whatsoever. This volume makes no claim to being the monumental work necessary to analyze every possible influence that acts upon such a rate. The purpose of the book is rather to isolate the fundamental or basic forces which are operative in the interest problem.

The approach is theoretical, rational, or philosophic, if you like, as contrasted with the statistical, empirical, or quantitative approach. While it is true that in the discussion of the theoretical portions of the book, empirical evidence has been employed, this analysis is supplemental to rather than independent of the principles to be illustrated or tested.

The aim in view has therefore dictated the suppression of the innumerable secondary factors in order to focus the analysis upon the primary factors involved. It is these latter factors with which pure economic theory is concerned and this book is intended to be a study in pure theory.

As such, its ultimate objective is to explain how the rate of interest would be determined in vacuo or under the ideal operation of the assumptions. Outside this domain, there are literally thousands of forces which would have to be analyzed and allowed for before an adequate explanation of an actual market rate of interest could be made.

Thus, after presenting in Chapter II the theoretical relations of changes in the value of money to the rate of interest, we assume thereafter (until we reach Chapter XIX) a constant value of money and therefore the absence of any influence of a changing value of money. Yet we know that such an assumption is seldom realised in this actual world of incessant inflation and deflation.

Although this methodology of pure theory is at one with that employed in the whole range of scientific investigation, it may seem to some open to the criticism of being unreal and therefore presumably defective, if not useless, so far as practical affairs go.114 While it is impossible, because of the divergent approaches, to express succinctly the criticisms which revolve about this point, certain examples may be given to set forth their general content and character.

Professor Thorstein Veblen, for example, asserted that interest did not come into existence until a high state of development had been reached in business and in money economy and credit economy. He argued that credit economy giving rise to interest economy has existed for "only a relatively brief phase of civilization that has been preceded by thousands of years of cultural growth during which the existence of such a thing as interest was never suspected" (p. 299).

"In short", Professor Veblen continued, "interest is a business proposition and is to be explained only in terms of business, not in terms of livelihood as Mr. Fisher aims to do" (p. 299). He admitted that business may be the chief or sole method of getting a livelihood, but asserted that business gains are not convertible with the sensations of consumption, as he thought my theory requires (pp. 299 and 300). Any argument for convertibility, or equivalence, is fallacious because "habitual modes of activity and relations have grown up and have by convention settled into a fabric of institutions" (p. 300).

If, at the start, we grant the postulate that the market rate of interest as set on money loans under a money economy or credit economy is the only interest rate existent, we are confronted with the problem of explaining why such a rate of interest exists. Institutions of themselves do not explain it. Institutions and conventions, like business, have been created by men, not from some inexplicable purpose unconnected with their living and feeling, but in order to add to the gratifications they obtain from living. Institutions cannot make men act or think other than as men. These man-made, man-operated institutions are merely tools devised by man to create for him gratifications more readily and more abundantly.

In my analysis, I find man's impatience to enjoy today and his desire to grasp the opportunities to invest so as to provide future enjoyments the fundamental causes which account for the emergence of incomes and of interest. To start with business institutions and attempt to explain the existence of interest as a phenomenon created by banks is like trying to explain value as something created by produce markets and stock exchanges.

Impatience and opportunity are working themselves out in the activities of business institutions, and men cannot avoid the dominance of these impulses and situations when engaged in any activity that demands a choice between present and future income. Interest, therefore, cannot be restricted to an explicit or contractual phenomenon but must be inherent in all buying and selling, and in all transactions and human activities which involve the present and the future.

While I cannot accept the view which would cast overboard theory because it is theory, I am keenly aware of the fact that theory as such does not tell the whole story about an actual rate of interest. Pure theory is not called upon so to do.

But after pure theory has said its last word, there is a broad field for empirical study of omitted factors. While we assumed that the unstable dollar remained stable and worked no interference with the fundamental forces determining the rate of interest, we know that in actual fact, the interference of a changing money value with these forces is tremendous—because of the "money illusion."

Laws, gold movements, stock exchange speculation, banking customs and policies, governmental finance, corporation practice, investment trusts and many other factors work their influences on the so-called money market where interest rates are determined. Practically, these matters are of equal importance with fundamental theory. While theory, in other words, assumes a waveless sea, actual, practical life represents a choppy one.

§9. Conclusion

In the study of such a complex and many-sided problem as that of the rate of interest, it is natural (and in fact, very desirable) that there should be many different approaches, views, and methods. Unfortunately, however, this latitude for individual interpretation and analysis has many times invited misunderstanding, confusion, and magnification of non-essential differences.

I have attempted to set forth and analyze in this chapter those matters contained in the criticisms of The Rate of Interest which, to my mind, are of major importance, and concerning which there still exists considerable disagreement among students of the interest problem.

Many of these questions seem to me to be based on misunderstandings of my theory of interest. I have been greatly helped by criticisms of this kind to see the shortcomings of my first attempt to expound that theory. I am hopeful that my present efforts to set forth in sharper relief and with greater clarity one solution of the problem of interest will succeed in subordinating these secondary matters to the more important issues of fundamental theory.

This done, I am confident that economic theorists will find that they are not so far apart on matters of fundamental theory as their writings would seem to indicate. When mutual understanding is achieved, they will undoubtedly find that their differences are often more apparent than real, consisting chiefly in the methods of approach and of analysis.

PART IV, CHAPTER XXI

SUMMARY

§1. Interest and Purchasing Power of Money

We have seen that, theoretically, the rate of interest should be subject to both a nominal and a real variation, the nominal variation being that connected with changes in the standard of value, and the real variation being that connected with the other and deeper economic causes.

As to the nominal variation in the rate of interest, we found that, theoretically, an appreciation of 1 per cent of the standard of value in which the rate of interest is expressed, compared with some other standard, will reduce the rate of interest in the former standard, compared with the latter, by about 1 per cent, and that, contrariwise, a depreciation of 1 per cent will raise the rate by that amount. Such a change in the rate of interest would merely be a change in the number expressing it, and not fundamentally a real change. Yet, in actual practice, for the very lack of this perfect theoretical adjustment, the appreciation or depreciation of the monetary standard does produce a real effect on the rate of interest, and that a most vicious one. This effect, in times of great changes in the purchasing power of money, is by far the greatest of all effects on the real rate of interest. This effect is due to the fact that the money rate of interest, while it does change somewhat according to the theory as described in Chapters II and XIX, does not usually change enough to fully compensate for the appreciation or depreciation. The inadequacy in the adjustment of the rate of interest results in an unforeseen loss to the debtor, and an unforeseen gain to the creditor, or vice versa as the case may be. When the price level falls, the interest rate nominally falls slightly, but really rises greatly and when the price level rises, the rate of interest nominally rises slightly, but really falls greatly. It is consequently of the utmost importance, in interpreting the rate of interest statistically, to ascertain in each case in which direction the monetary standard is moving and to remember that the direction in which the interest rate apparently moves is generally precisely the opposite of that in which it really moves.

It should also be noted that in so far as there exists any adjustment of the money rate of interest to the changes in the purchasing power of money, it is for the most part (1) lagged and (2) indirect. The lag, distributed, has been shown to extend over several years. The indirectness of the effect of changed purchasing power of money comes largely through the intermediate steps which affect business profits and volume of trade, which in turn affect the demand for loans and the rate of interest. There is very little direct and conscious adjustment through foresight. Where such foresight is conspicuous, as in the final period of German inflation, there is less lag in the effects.

§2. The Six Principles

But the more fundamental theory of interest presupposes a stable purchasing power of money so that the real and nominal rates coincide. In that case the rate is theoretically determined by six sets of equations or conditions: the two Opportunity Principles; the two Impatience Principles; and the two Market Principles. The last pair may be said to cover prima facie supply and demand.

(A) The market must be cleared—and cleared with respect to every interval of time. (B) The debts must be paid.

The other two pairs represent the two sets of forces, one objective and the other subjective, behind supply and demand. The subjective pair expresses the influence of human impatience or time preference.

(A) The rate of time preference depends on the character of the various individuals concerned and on each individual's prospective income, its size, time-shape and risk.(B) Each individual's rate of time preference tends, at the margin of choice, to harmonize with the market rate of interest. Human impatience to spend and enjoy income is crystallized into the market rate.

The objective pair expresses the influence of investment opportunities.

(A) Each individual is encompassed about by opportunities to change the character of his prospective income stream. (B) At the margin of choice, any additions to an individual's future income at the cost of more immediate income constitutes a return over that cost, the rate of which return over said cost is also crystallized into the market rate of interest.

So the rate of interest is the mouthpiece at once of impatience to spend income without delay and of opportunity to increase income by delay.

Thus both from the subjective and the objective field appear prototypes, one of each for every individual, of the market rate of interest.

That rate, i, is equal to every individual's degree of impatience or rate of time preference, f, and also to his investment opportunity rate or rate of return over cost, r.

Yet these equations are not enough to make the problem determinate without those of the other four sets of determining conditions (clearing the market, repaying debts and empirical dependence of impatience and investment opportunity).

Much less is it possible to determine the rate of interest from the subjective side alone, through time preference, or from the objective side alone, through investment opportunity, or "productivity", or "technique of production".

The full explanation requires both (as well as the market principles) in order that there may be as many independent equations as unknown variables in the problem. Moreover there is not merely one rate of interest; there are many, one for each interval of time. And even so the explanation is full only under the theoretical conditions presupposed. If we pass beyond the presuppositions in order to approximate closer to the actual world, we find that, to be determinate, the problem requires more and more equations of a more and more empirical nature. This is especially true as (1) we introduce risk with its innumerable and omnipresent ramifications, involving in particular a multiplicity of rates of interest even for the same period of time; and as (2) we extend our view to admit variations in all other prices besides the rates of interest, involving thereby the whole economic equilibrium, not only of the loan market but of all markets, each interacting on every other; and as (3) we extend our view from one theoretical market to the actual markets of the whole world, involving thereby all the relations of international trade; and as (4) we take account of any other factors which may not be included in the foregoing specifications so as to take account, in particular, of all "institutional" influences, laws, politics, banking practices, government finance and so on to the end.

In the economic universe, as in astronomy, every star reacts on every other. From a practical point of view we cannot ignore the many perturbations. But from the theoretical point of view we gain clearness, simplicity and beauty, if we allow ourselves to assume certain other things equal, and confine our laws to a little part of the whole, such as the solar system.

From such a point of view, the second approximation is the most instructive, rather than the first which rules out the important element of investment opportunity, or than the third which becomes too complicated and vague for any complete theoretical treatment.

§3. The Nature of Investment Opportunity

In the second approximation—which, as we have just noted, contains all that is most typical in the theory of the rate of interest—the distinctive factor is the rate of return over cost or the investment opportunity rate. This is also the most difficult factor to picture, isolate, and disentangle from the rate of interest which it helps determine. Therefore, it is a matter of great importance pedagogically to make that distinction clear. The investment opportunity rate is distinct from the market or loan rate of interest because an investment opportunity is distinct from a loan. Investment opportunity, as here used, does not include a mere loan at the market rate of interest nor any other purchase-and-sale transaction made merely on the basis of the market rate. The definition of investment opportunity is specially framed to exclude mere loans. It is any opportunity of an individual to modify his prospective income other than by merely lending or borrowing (or the equivalent, buying or selling) at the market rate of interest.

Under this definition and the assumptions employed in the theory there can never be any doubt as to whether a given proposed transaction is an investment opportunity or a market loan or purchase. In the case of a market loan or purchase the individual cannot vary the rate of interest by any act of his, such as varying the size of his transactions. Under our assumptions of a perfect market his influence on the market rate is not only unconscious but infinitesimal and therefore entirely negligible in our analysis in which his motivity is of the essence. In the case of an investment opportunity, on the other hand, he can vary the rate of return by varying the size of his operations.

This contrast between the theoretical constancy of the one and the variability of the other, in relation to individual action, is due to the fact that in the public market the individual is a negligible element, while an investment opportunity is more private and personal to him or his group. The former is typified by the purchase, say, of a Liberty bond, or other standard securities. The latter is typified by building a factory, improving a sales organization, deepening the shaft of a mine—cases where the marginal rate of return is under the control of the individual since he sets the margin.

Of course it is true that, in almost every such operation, there are elements of purchase and sale in which the market rate of interest is an implicit ingredient, but as long as the operation is not exclusively a mere market interest affair and contains other ingredients, the rate is subject to variation with the extent of the operation and so is to be called a rate of return over cost. We are here interested in those other ingredients which produce the variability and thus differentiate such a rate from the market rate of interest. They are the non-commercial or non-trading ingredients; they concern production and technique rather than trade. They deal not with the market place, but with nature, environment, and the refractory conditions which surround and hamper us in our efforts to secure income. They exist even when no market exists, when a Robinson Crusoe, a hermit, or an isolated ranchman battles with soil and the elements for his daily bread.

The rate of return over cost, under the law of diminishing returns, is thus far more elementary and primeval than the rate of interest, and however incrusted that rate of return may become with other elements which grow out of modern market conditions it is still the basic objective condition underlying our problem.

Thus the rate of return over cost is distinguished from the rate of interest (1) by varying with the extent of the individual's investment; (2) by being consciously recognized, as thus variable115 and controllable, by the individual; (3) by being, therefore, a personal and individual matter and not altogether a public market matter; (4) by being directly related to producing as contrasted with trading.

§4. Investment Opportunity for Society as a Whole

In modern society hermits and self-supporting ranches are so rare that we cannot find any important cases where investment opportunities exist in pure primitive form and apart from the alloy of trading. In fact, the most typical investment opportunities are not only full of such alloys but are tied up with market financing operations. Almost every big investment opportunity is married to a productive loan.

The best picture on a big scale of investment opportunity, divested so far as may be of all ancillary market features, is to be found by considering society as a whole instead of the individual.

Society as a whole cannot borrow or lend as an individual can. This world can, for instance, add nothing to this year's income by a loan from elsewhere and subtract this amount with interest from future income. Yet it can and does vary and control the total income stream according to investment opportunity.

This picture, in the large, of society arranging, modifying, adjusting its total income stream as between this year and later years is the most important picture we can draw of investment opportunity not only because it automatically leaves out borrowing and lending, or buying and selling, but also because it automatically reduces the picture of income to its fundamental terms of real or, as I prefer to call it, enjoyment income and its obverse, labor pain. We do not have to think so vividly, as we do in the case of an individual, of money items and intermediate processes. We can without difficulty fix our attention on the final consumption. Society is like Robinson Crusoe picking and eating his berries, however complicated may be the apparatus which intervenes between the labor of picking and the enjoyment of eating.

Society may add to or subtract from its income stream at will at any period, present or future. But beyond a certain point every addition at one period must be at the cost of a subtraction at some other period. If future income is added, the increment so added is a return on and at the cost of a decrement in less remote income. The rate of return over cost is thus a social phenomenon of great significance. There are two and only two ways in which society may effect the present cost and the future return. It may effect the present cost by exerting more present labor or by abstaining more from present consumption; and it may realize the future return over that cost either in the form of more future consumption or of less future toil.

Both the present and the future adjustments are effected by changing the use made of capital instruments including land and human beings. That is, the labor, land, and other capital of society may be used in many optional ways and in particular may be invested for the early or remote future.

If the capital instruments of the community are of such a nature as to offer a wide range of choice, we have seen that the rate of interest will tend to be steady. If the range of choice is narrow, the rate of interest will tend to be variable. If the range of choice is relatively rich in future income as compared with the more immediate income, the rate of interest will tend to be high. If the range of choice tends to favor immediate income as compared with more remote future income, the rate of interest will tend to be low.

Thus, for the United States during the last century, its resources were of such a character as to favor future income. This is true, for a time at least, in every undeveloped country, and, as we have seen, gives the chief explanation of the fact that the rate of interest in such localities is usually high. The same is true of countries recovering from war. Today, for instance, Germany resembles a pioneer country. Her present income is necessarily low, but her prospect of a higher and increasing income in a few years is very great. The range of choice is dominated by "low today and high tomorrow."

The range of choice in any community is subject to many changes as time goes on, due chiefly to one or more of three causes: first, a progressive increase or decrease in resources; second, the discovery of new resources or means of developing old ones; and third, change in political conditions.

Under the first head may be noted the impending exhaustion of the coal supply in England, as noted by Jevons and other writers. This will tend to make the income stream from that island decrease, at least in the remote future, and this in turn will tend to keep the rate of interest there low. Under the second head, the constant stream of new inventions, by making the available income streams rich in the future, at the sacrifice of immediate income, tends to make the rate of interest high. This effect, however, is confined to the period of exploitation of the new invention, and is succeeded later by an opposite tendency. During the last half century the exploitation of Stephenson's invention of the locomotive, by presenting the possibility of a relatively large future income at the cost of comparatively little sacrifice in the present, tended to keep the rate of interest high. As the period of extensive railroad building is drawing to a close, this effect is becoming exhausted, and the tendency of the rate of interest, so far as this particular influence is concerned, is to fall.

On the other hand, the invention of the automobile, and the inventions and discoveries in electricity and chemistry have succeeded the railroads as a field for investment and have required new sacrifices of immediate income for the sake of future income. Thus, as fast as the first effect of any one invention, tending to raise interest, wears off and is succeeded by its secondary effect in lowering interest, this secondary effect is likely to be offset by the oncoming of new inventions.

As to the third head, political conditions which affect the rate of interest, such as the insecurity of property rights which occurs during political upheaval, as in Russia recently, tend to make the pure or riskless rate of interest low. At the same time it adds an element of risk to most loans, thereby diminishing the number of safe and increasing the number of unsafe loans. Hence the commercial rate of interest in ordinary loans during periods of lawlessness is likely to be high. Reversely, during times of peace and security, the riskless rate of interest is comparatively high, while the commercial rate tends to be low.

§5. Time Preference

We turn now to the remaining factor, namely, the dependence of time preference of each individual on his selected income stream. We have seen that the rate of preference for immediate as compared with remote income will depend upon the character of the income stream selected, but the manner of this dependence is subject to great variation and change. The manner in which a spendthrift will react to an income stream is very different from the manner in which the shrewd accumulator of capital will react to the same income stream. We have seen that the time preference of an individual will vary with six different factors: (1) his foresight; (2) his self-control; (3) habit; (4) the prospective length and certainty of his life; (5) his love of offspring and regard for posterity; (6) fashion. It is evident that each of these circumstances may change. The causes most likely to effect such changes are: (1) training to foster a realization of the need to provide against the proverbial "rainy day"; (2) education in self-control; (3) formation of habits of frugality, avoiding parsimony on the one hand and extravagance on the other; (4) better hygiene and care of personal health, leading to longer and more healthful life; (5) incentives to provide more generously for offspring and for the future generations; (6) modification of fashion toward less wasteful and harmful expenditures for the purpose of ostentatious display.

These various factors may act and react upon each other, and may affect profoundly the rate of preference for present over future income, and thereby influence greatly the rate of interest. Where, as in Scotland, there are educational tendencies which instill the habit of thrift from childhood, the rate of interest tends to be low. Where, as in ancient Rome, at the time of its decline, there is a tendency toward reckless luxury, competition in ostentation, and a degeneration in the bonds of family life, there is a consequent absence of any desire to prolong income beyond one's own term of life, and the rate of interest tends to be high. Where, as in Russia, under the Czars, wealth tended to be concentrated and social stratification to be rigid, the great majority of the community, on the one hand, through poverty and the recklessness which poverty begets, tends to have a high rate of preference for present over future income, whereas, at the opposite end of the ladder, the inherited habit of luxurious living tends, though in a different way, in the same direction. In such a community, the rate of interest is likely to be unduly high.

§6. Conclusion

From the foregoing enumeration, it is clear that the rate of interest is dependent upon very unstable influences many of which have their origin deep down in the social fabric and involve considerations not strictly economic. Any causes tending to affect intelligence, foresight, self-control, habits, the longevity of man, family affection, and fashion will have their influence upon the rate of interest.

§7. The Future

From what has been said it is clear that, in order to estimate the possible variation in the rate of interest, we may, broadly speaking, take account of the following three groups of causes: (1) the thrift, foresight, self-control, and love of offspring which exist in a community; (2) the progress of inventions; (3) the changes in the purchasing power of money. The first cause tends to lower the rate of interest; the second, to raise it at first and later to lower it; and the third to affect the nominal rate of interest, in one direction and the real rate of interest in the opposite direction.

Were it possible to estimate the strength of the various forces thus summarized, we might base upon them a prediction as to the rate of interest in the future. Such a prediction, however, to be of value, would require more painstaking study than has ever been given to this subject.

Without such a careful investigation, any prediction is hazardous. We can say, however, that the immediate prospects for a change in the monetary standard seem to be toward its stabilization; that this will tend toward a general prosperity, the main effects of which should be in the direction of lowering the rate of interest; that changes in thrift, foresight, self-control, and benevolence are for the most part likely to intensify these factors and thus to lower the rate of interest; and that the progress of discovery and invention shows now a tendency to increase in speed, the immediate result of which should be to raise the rate of interest but finally to lower it.

[1.][1] See Chapter I; also The Nature of Capital and Income, Chapter IX.

[2.][2] See my Mathematical Investigations in the Theory of Value and Prices. New Haven, Yale University Press, 1926.

[3.][3] This is, of course, highly theoretical; it assumes a competitive market free from legal and other restrictions.

[4.][4] See Cannan, Edwin, Theories of Production and Distribution. London, P. S. King & Son, 1903.

[5.][5] Pareto, Cours d'Êconomie Politique, Vol. II, Book III.

[6.][6] King, W. I., The Wealth and Income of the People of the United State, New York, The Macmillan Co., 1915.

[7.][7] Mitchell, W. C., King, W. I., Macaulay, F. R., Knauth, O. W., Income in the United States. New York, National Bureau of Economic Research, Inc., 1922.

Knauth, O. W., Distribution of Income by States in 1919. New York, Harcourt, Brace & Co., 1922.

Leven, Maurice, and King, W. I., Income in the Various States; Its Sources and Distribution, 1919, 1920, and 1921. New York, National Bureau of Economic Research, Inc., 1925.

[8.][8] Stamp, Sir Josiah, Wealth and Taxable Capacity. London, P. S. King & Son, Ltd., 1922. Also, British Incomes and Property. London, P. S. King & Son, 1916.

[9.][9] Rae, The Sociological Theory of Capital, Chapter XIII.

[10.][10] See Day, Clive. The Dutch in Java. New York, The Macmillan Co., 1904, Chapter X.

[11.][11] See Gonner, Interest and Savings.

[12.][12] Report on Recent Economic Changes, National Bureau of Economic Research, p. 87.

[13.][13] Ibid., Chapter XII.

[14.][14] The economic effects of invention, and particularly its effects upon the rate of interest, were well treated by John Rae, The Sociological Theory of Capital, Chapter IX, pp. 132-150; Chapter X, pp. 151-203.

[15.][15] The Sociological Theory of Capital, pp. 128-129.

[16.][16] My colleague, Professor Clive Day, finds that interest rates in Java have advanced rather than declined since the early years of the twentieth century. He cites as the best source for recent conditions the Great Investigation (Onderzoek naar der mindere Welvaart de inlandsche Bevolking op Java en Madoera. Batavia, 1912, IX bl Dl II. 1, page 66). The report states that on small loans under 5 florins unsecured, the annual rate runs to several hundred per cent. On secured loans, say of 25 florins more or less, the rate varies from 36% to 60%. These rates are notably higher than his estimate of 40% quoted in The Rate of Interest, p. 292.

[17.][17] Professor J. S. Lawrence, of Princeton University, informs me that needy negroes often pay at the end of the week, $7.00 for $5.00 borrowed at the beginning of the week, or more than 40% per week.

[18.][18] See Bloch, Ivan, The Future of War. Translated by R. C. Long. New York, Doubleday and McClure Co., 1899, p. 205. It appears that the peasant would sell a promise to labor a short time in the future at one third the current wages! See also Lanin (pseud.), Russian Finance, Fortnightly Review, Vol. LV, February, 1891, pp. 188, 190, 196, for typical and extreme cases. Inostranietz, L'Usure en Russie, Journal des Economistes, Vol. XVI, Ser. 5, 1893, pp. 233-243, states that the rates paid by poor peasants to well-to-do peasants are frequently 5 per cent per week.

[19.][19] The Sociological Theory of Capital, pp. 71-72.

[20.][20] The Sociological Theory of Capital, pp. 64, 95-99, 129. Rae's authority for Roman interest rates is Boucher, Histoire de l'Usure, p. 25.

[21.][21] Seligman, Edwin R. A., Principles of Economics. London, Longmans, Green and Co., 1907, p. 404.

[22.][22] Brown, The Development of Thrift.

[23.][23] The Sociological Theory of Capital, pp. 88-89 and 92.

[24.][24] For details as to thirteen typical loans of this character, see U. S. Bureau of Labor Bulletin, No. 64, May, 1906, pp. 622-633. Thus "loan 1," 143 per cent, "loan 3," 224 per cent, "loan 7," 156 per cent. For later facts see Ryan, Usury and Usury Laws; also the publications of the Russell Sage Foundation on Small Loans, especially Raby, The Regulation of Pawnbroking.

[25.][25] Longfield, Mountifort. The Tenure of Land in Ireland in Probyn's Systems of Land Tenure in Various Countries. London, Cassell, Petter, Galpin & Co., 1881, p. 16.

[26.][26] From a letter to the author from Professor E. W. Kemmerer; see also his article in The Business Monthly, Pittsburgh, April, 1907, p. 2.

[27.][27] On the uncertainties of Indian life, see Rae, The Sociological Theory of Capital, pp. 69 and 70.

[28.][28] Hurlbert, H. B. The Passing of Korea. New York, Doubleday, Page and Co., 1906, p. 283.

[29.][29] See Appendix to Chapter XIX, § 1.

[30.][30] Plehn, Carl C. Notes Concerning the Rates of Interest in California. Quarterly Publications of the American Statistical Association, September, 1899, pp. 351-352.

[31.][31] Plehn, p. 353.

[32.][32] See Message of the Governor of the State of Nevada, 1879.

[33.][33] Mines and Quarries, 1902. Special Report U. S. Census, p. 255.

[34.][34] See later Messages of the Governor of the State of Nevada.

[35.][35] Zartman, Lester W. The Investments of Life Insurance Companies. New York, Henry Holt and Co., 1906, p. 103.

[36.][36] Giffen, Growth of Capital, p. 44.

[37.][37] Ibid., p. 35.

[38.][38] Ibid., pp. 40-42.

[39.][39] See U.S. Bureau of Labor Bulletin, No. 64, May, 1906, pp. 622 ff.

[40.][40] The average rates for each month plotted on the chart were compiled from the daily rates published in The Financial Review.

[41.][41] The Review of Economic Statistics, January, 1923, pp. 17-27.

[42.][42] See Palgrave, Bank Rate and the Money Market, p. 97.

[43.][43] Moses, Bernard, Legal Tender Notes in California, Quarterly Journal of Economics, October, 1892, p. 15.

[46.][46] The silver bonds or "rupee paper" were issued to raise loans in India, but they were also enfaced for payment in England, and in 1893-1894 some Rx. 25,000,000 were on the London books. Burdett's Official Intelligencer (1894), p. 75.

[47.][47] Thus, in 1880 the average price paid in London for "rupee paper" of face value Rx. 1000 yielding 4 per cent, or Rx. 40 per annum, was £79. In order to find the rate of interest realized by the investor, we must translate £79 into silver. The average rate of exchange in 1880 was 20d. per rupee. Hence £79 were equivalent to 948 rupees. That is, speaking in terms of silver (or, more exactly, in terms of exchange on India), the price of a 4 per cent bond was 94.8, which, if the bond be treated as a perpetual annuity, yields the investor 4.3 per cent. In the same year, an India gold bond yielded 3.6 per cent.

[51.][51] The preceding comparisons serve only to establish the influence of the expected divergence between the two standards on the rates of interest, but afford no exact measure of that influence. In order to measure the extent to which the fall of silver was allowed for by investors, it would be necessary to examine the rates realized during specific periods. Somewhat unsatisfactory attempts to do this (both for the case above of American gold and "currency" bonds and for the case below of Indian gold and "rupee bonds") were made in my Appreciation and Interest, but are not reproduced here.

[52.][52] The basic tables for computing the rate of price changes and the method of computation are given in the Appendix to this chapter §1.

[53.][53] See Journal of the American Statistical Association. June, 1925, p. 81, footnote 3.

[54.][54] The British bond yields here used were taken from an article by A. H. Gibson, The Future Course of High Class Investment Values, The Bankers', Insurance Managers' and Agents' Magazine, January, 1923, p. 15. Reprinted in revised form in The Spectator, March 7, 1925.

[55.][55] The United States bond yields here used were taken from the Statistical Bulletin, 1928-1929, of the Standard Statistics Company. Percentage price changes were computed from the Wholesale Commodity Price Indexes of the United States Bureau of Labor Statistics.

[56.][56] The theory of distributed influence and lag was developed incidentally in the course of my studies of price-trade relations reported in several papers. See (a) The Business Cycle Largely a "Dance of the Dollar," Journal of the American Statistical Association, December, 1923, p. 5, top paragraph; (b) Fluctuations in Prive-Levels in The Problem of Business Forecasting by Warren M. Persons, William T. Foster, Albert Hettinger. Boston, Houghton Mifflin Company, 1924, pp. 50-52; and particularly, (c) Our Unstable Dollar and the So-Called Business Cycle, Journal of the American Statistical Association, June, 1925, pp. 179-202.

[57.][57] A price change P'm pertaining to the month tm exerts an influence, F(tm + l), whose intensity is proportional to 8 during tm+3, to 7 during tm+4,..., to 1 during tm+10, to 0 during tm+11.



Conversely the aggregate influence on the affected variable during the month tm consists of the various P'm-l which enter with the following weights tapering off in arithmetical progression; P'm-3 with weight 8, P'm-4 with weight 7,...., P'm-10 with weight 1, P'm-11 with weight 0. The numerical measure of this composite influence is:

[8 P'm-3 + 7 P'm-4 +... + 1P'm-10 + 0 P'm-11],

the divisor 36 being the sum of the weights,

36 = 8 + 7 +... + 1 + 0.

[58.][58] Interest rates were taken from The Statistical Bulletin, 1928-1929, of The Standard Statistics Co. The price indexes are computed from the United States Bureau of Labor Statistics. See Appendix to this chapter, §2, for these quarterly data.

[59.][59] In the form of distribution of influence used in this study, the remote price changes have comparatively little weight in the composite . For example, in the case of a 20 term influence-range straight line distribution,



It is evident, and I have tested it thoroughly, that the composite would be only slightly changed if the tail half of the distribution were omitted. The distribution in the above example would then be,



For the United States yearly data 1890-1927, the correlation of i and with an influence range of 20 years was r = + 0.857. For this distribution truncated by chopping off the end quarter, r = +0.843; the end half, r =+0.798; and the end three quarters r =+0.439.

[60.][60] See Pearson and Elderton, The Variate Difference Method, Biometrica, Vol. XIV, 1923, pp. 281-309; W. M. Persons, Statistics and Economic Theory, Review of Economic Statistics, Vol. VII, No. 13, July, 1925, pp. 179-197; Anderson, The Decomposition of Statistical Series into Components, Journal of the Royal Statistical Society, Vol. XC, pt. 3, 1927, pp. 548-570.

[61.][61] See especially Our Unstable Dollar and the So-Called Business Cycle, Journal of the American Statistical Association, June, 1925, pp. 181-202; A Statistical Relation Between Unemployment and Price Changes, International Labour Review, Vol. XIII, No. 6, June, 1926, pp. 785-792.

[62.][62] Snyder, Carl, The Influence of the Interest Rate on the Business Cycle, American Economic Review, Vol. XV, No. 4, Dec., 1925, pp. 684-699; Interest Rates and the Business Cycle, American Economic Review, Vol. XVI, No. 3, Sept., 1926, pp. 660-663.

[63.][63] Ayres, Cleveland Trust Co., Business Bulletin, June 15, 1928, and Aug. 15, 1928.

[64.][64] Mitchell, Interest Cost and the Business Cycle, American Economic Review, Vol. XVI, No. 2, June, 1926, pp. 209-221; Supplementary Note on Interest Costs, American Economic Review, Vol. XVI, No. 3, Sept., 1926, pp. 451-452.

[65.][65] See the author's The Money Illusion. New York, Adelphi Company, 1928, pp. 41-42.

[66.][66] Prof. Knut Wicksell was one of the first to recognize the influence of interest rates upon prices. See his book, Geldzins und Güterpreise; Prof. Alfred Marshall, Prof. Gustav Cassel, Rt. Hon. Reginald McKenna, Chairman of the Midland Bank of London, Mr. R. G. Hawtrey, of the Treasury of Great Britain, and many other well known economists, bankers, and business men have emphasized that business activity is influenced and may be largely controlled by manipulation of the discount rate.

[67.][67] Mr. and Mrs. K. G. Karsten, for example, in their forecasts, make use of commercial paper rates in computing their forecasts of wholesale prices and business activity. They find an r of—0.98 between (1) the logarithms of P' and (2) the logarithms of the deviations of commercial interest rates from bond yields.

[68.][68] For instance, Our Unstable Dollar and the So-Called Business Cycle, Journal of the American Statistical Association, June, 1925, pp. 179-202.

[69.][69] Statistical Studies in the New York Money Market, Chapters VII and VIII.

[70.][70] Factors Affecting Changes in Short Term Interest Rates, Journal of the American Statistical Association, Vol. XXII, New Series, No. 158, June, 1927, pp. 195-201.

[71.][71] Cleveland Trust Company, Business Bulletin, June 15, 1928.

[72.][72] Conditions of this type emphasize the importance of thorough study of the institutional factors influencing market interest rates such as that made by Mr. A. W. Marget in his doctoral dissertation The Loan Fund presented to the faculty of Harvard University in 1926-1927.

[73.][73] For historical development and detailed criticisms of interest theories the reader is referred to Böhm-Bawerk, Capital and Interest. A brief historical résumé is given in Cassel, The Nature and Necessity of Interest, Chap. I, pp. 1-67.

[74.][74] These articles are included in the general bibliography at the end of the book.

[75.][75] References to the authors of the views which I am stating impersonally in the text will be made, where possible, in footnotes. It is hoped that this procedure will prevent the impression that I am attempting any exhaustive critique of the interest theory of others.

[76.][76] Davenport, H. J., Interest Theory and Theories. American Economic Review, Vol. XVII, No. 4, December, 1927, pp. 636-656.

[77.][77] Ibid., p. 650.

[78.][78] Fetter, Frank A., Clark's Reformulation of the Capital Concept. Economic Essays Contributed in Honor of John Bates Clark, pp. 151-152, footnote on p. 153; cf. also Flux, Irving Fisher on Capital and Interest, Quarterly Journal of Economics, Vol. XXIII, Feb., 1909, pp. 307-323.

[79.][79] See my articles: Are Savings Income? Journal of the American Economic Association, Vol. IX, No. 1, April, 1908, pp. 1-27; Professor Fetter on Capital and Income, Journal of Political Economy, Vol. XV, No. 7, July, 1907, pp. 421-434; Comment on Professor Plehn's Address, American Economic Review, Vol. XIV, No. 1, Mar., 1924, pp. 64-67; and The Concept of Income in the Light of Experience, English reprint from Wieser Festschrift, Vol. III.

[80.][80] A Reply to Critics, Quarterly Journal of Economics, Vol. XXIII, May, 1909, pp. 536-541.

[81.][81] Fetter, Interest Theories, Old and New, American Economic Review, Vol. IV, No. 1, March, 1914, pp. 68-92.

[82.][82] What is Capital? The Economic Journal, Vol. VI, Dec., 1896, pp. 509-534.

[83.][83] The Rôle of Capital in Economic Theory, The Economic Journal, Vol. VII, Dec., 1897, pp. 511-537.

[84.][84] Fetter, Clark's Reformulation of the Capital Concept. Economic Essays Contributed in Honor of John Bates Clark, p. 152.

[85.][85] Seager, The Impatience Theory of Interest, American Economic Review, Vol. II, No. 4, December, 1912, pp. 834-851; Brown, Economic Science and The Common Welfare.

[86.][86] The Impatience Theory of Interest, American Economic Review, Vol. III, No. 3, September, 1912, pp. 610-615.

[87.][87] Clark, Distribution of Wealth, pp. 338-344.

[88.][88] For example, Seager and Brown, cited above.

[89.][89] Seager, cited above, p. 844.

[90.][90] Seager, Brown, and Flux cited above; also Loria, Irving Fisher's Rate of Interest, Journal of Political Economy, Vol. XVI, Oct., 1908, pp. 331-332.

[91.][91] Seager, cited above, pp. 842-3, 847.

[92.][92] The Impatience Theory of Interest, American Economic Review, Vol. III, No. 3, September, 1913, pp. 614-615.

[93.][93] Davenport, Value and Distribution.

[94.][94] Cf. Seager and Flux, cited above, and particularly Fetter, Interest Theories Old and New, American Economic Review, Vol. IV, No. 1, March, 1914, pp. 69-72.

[95.][95] Fetter, Interest Theories Old and New, American Economic Review, March, 1914, pp. 74, 76, 77.

[96.][96] Ibid., p. 77.

[97.][97] As is always possible in solving simultaneous equations we can, if we wish, express certain of the variables, such as those relating to productivity, or opportunity, namely the rates of return over cost, in terms of the other variables and thus seem to eliminate them. In my first book I tried, for the most part, thus to present the rate of return over cost, or as I then called it, the rate of return on sacrifice as determined through the rate of preference. But we can just as well in like manner eliminate time preference and present it in terms of rate of return.

[98.][98] Landry, L'Intérêt du Capital, pp. 66-95.

[99.][99] Seager, The Impatience Theory of Interest, American Economic Review, Vol. II, No. 4, December, 1912, pp. 835-837.

[100.][100] The Impatience Theory of Interest. American Economic Review, Vol. III, No. 3, September, 1913, p. 610.

[101.][101] Positive Theorie des Kapitales. "Meine These schränkt vielmehr diese Wirkung ausdrücklich auf 'klug gewählte' Verlängerungen ein und lässt überdies, indem sie ihr Zutreffen nur 'in aller Regel' oder, wie ich in der ersten Auflage sagte, 'im grossen und ganzen' behauptet, das Vorkommen von Ausnahmen offen." Exkurs I, p. 3.

"Wenn Fisher hiemit nicht mehr in Abrede stellen wollte, als was ich oben auf S. 3 des Exkurse I selbst in Abrede gestellt habe, dass nämlich nicht alle längeren Produktionsumwege nur deshalb, weil sie länger sind, auch produktiver sein müssen, so wären wir in vollem Einklang." Exkurs IV, p. 105.

[102.][102] The Positive Theory of Capital, p. 266.

[103.][103] In The Rate of Interest there is presented an exhaustive analysis of the validity of the proof presented by these tables of the theory of technical superiority advanced by Böhm-Bawerk. While it does not seem advantageous to repeat here this analysis, since it is available in my previous book to any reader who may be interested, it is pertinent to present the conclusions drawn therefrom.

[104.][104] The Positive Theory of Capital, p. 268.

[105.][105] The Positive Theory of Capital, p. 268.

[106.][106] Positive Theory of Capital, p. 269.

[107.][107] Positive Theory of Capital, p. 269.

[108.][108] This is true under the assumption, implied in Böhm-Bawerk's tables, that the product is the same except as to the time of its availability, namely, that the series of figures called "units of product" are identical as shown in his tables.

[109.][109] Positive Theory of Capital, pp. 269 and 270.

[110.][110] See von Bortkiewicz, Der Kardinalfehler der Böhm-Bawerkschen Zinstheorie. Jahrbuch für Gesetzgebung, Verwaltung und Volkswirtschaft, 1906, pp. 61-90.

See also von Schaposchnicoff, Die Böhm-Bauerksche Kapitalzinstheorie. Jahrbücher für Nationalökonomie und Statistik. Verlag von Gustav Fischer, Jena, Dritte Folge, Bd. XXXIII (LXXXVIII), pp. 433-451.

[111.][111] Positive Theorie des Kapitales. Dritte Aufiage, and Exkurse zur Positive Theorie des Kapitales. See especially Exkurse IV and Exkurse XII.

[112.][112] Böhm-Bawerk claims that merely to find out the factors operative in a given problem is not the same thing as to explain those factors. He thinks that my theory of interest would be adequate only if the mathematical solution of the problem by means of simultaneous equations, and what he calls the "causal" solution were the same, or at least somewhat similar.

Of course, these two types of solution are not the same. The causal solution cannot be so simply conceived as to make one factor solely cause and another solely effect. The advance of all science has required the abandonment of such simplified conceptions of causal relationship for the more realistic conception of equilibrium.

Here, all factors are considered as variables. Any disturbance in one factor reacts on all the others, and the variations in these other factors react upon the factor of original disturbance. The mathematical solution of the problem of interest by means of simultaneous equations recognizes the mutual interdependence of all the factors in the interest problem and, at the same time, yields a determinate solution for the problem.

[113.][113] See Appendix to this Chapter, §1.

[114.][114] Veblen, Fisher's Rate of Interest, Political Science Quarterly, Vol. XXIV, June, 1909, pp. 296-303. Marget, The Loan Fund, a doctoral dissertation at Harvard University, 1926; Schumpeter, Theorie der Wirtschaftlichen Entwicklung, p. 363. Criticisms of a similar character have been received in private correspondence from several of those who read this book in manuscript, particularly Professors L. D. Edie, B. H. Beckhart, and C. O. Hardy.

[115.][115] It is true that in the hard-tack case and some other extreme and hypothetical cases considered, it was assumed that for a certain interval the O curve was assumed to be straight. To include such a theoretical case, the statements in the text need a slight modification. But such extreme cases are not typical even in the theory and are probably never exemplified in practice.