Front Page Titles (by Subject) PART IV, CHAPTER XVII: PERSONAL AND BUSINESS LOANS - The Theory of Interest, as determined by Impatience to Spend Income and Opportunity to Invest it
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PART IV, CHAPTER XVII: PERSONAL AND BUSINESS LOANS - Irving Fisher, The Theory of Interest, as determined by Impatience to Spend Income and Opportunity to Invest it 
The Theory of Interest, as determined by Impatience to Spend Income and Opportunity to Invest it (New York: Macmillan, 1930).
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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.