Front Page Titles (by Subject) PART IV: TIME-VALUE AND INTEREST - Economics, vol. 1: Economic Principles
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PART IV: TIME-VALUE AND INTEREST - Frank A. Fetter, Economics, vol. 1: Economic Principles 
Economics, vol. 1: Economic Principles, (New York: The Century Co., 1915).
Part of: Economics, 2 vols.
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TIME-VALUE AND INTEREST
§ 1. Time as a condition in valuation. § 2. The time element in man’s provision for his needs. § 3. Cases where future use is preferred. § 4. Cases where present use is preferred. § 5. Biologic basis for most choice of present use. § 6. Hope and risk as affecting time-preference. § 7. Hastening the ripening process. § 8. Postponing the use and the readiness for use. § 9. Physical change accompanying time-change. Note on Present and future goods, uses, desires.
§ 1. Time as a condition in valuation. Let us recall here that every object of choice is characterized, or qualified, in some way with reference to its stuff, form, place, and time; and according as our attention is directed toward the one or the other quality we speak of the stuff-, form-, place-, and time-value. Time-value now calls for fuller consideration.
The luscious fruit on the table makes a certain appeal to us, is valued, as compared with anything else. Why? Partly because of the physical and chemical elements of which it is composed, partly because of the particular form in which those elements are combined, partly because the fruit is close at hand rather than in some distant place, and finally because it is available at the present moment rather than at some future time.
The man who is suffering the pangs of starvation desires food, and he desires it at once. The promise of a good meal at some time in the distant future makes no appeal to him. In great extremity he will pay for food any price within his power. “All that a man hath will he give for his life.” A loaf of bread put into his hands at the present moment would mean more to him than the promise of a whole bakery a year from now. A grasping person, willing to take advantage of him, might get from him a promise to pay almost any sum in the future for present bread. He might agree to pay back at the end of a year five loaves, or ten loaves, or almost any number of loaves in return for the single loaf now which will save his life.
We are dealing here with a case of time-preference. The food is preferred at one time rather than another, in this case at present rather than in the future. An extreme case has been cited for purposes of illustration, but it is possible every day and almost every hour to observe cases involving the same kind of preference, that for present goods as compared with an equal amount of like future goods, and other cases where like goods are preferred in the future rather than at present. In every conjuncture of human life, the timeliness of goods is an ever present factor in their valuation, and often it is of the very greatest significance. The demands of consumers always have reference to a particular time, and the business man is always seeking to supply goods at the right time as well as of the right stuff and form and in the right place. Palmleaf fans are not marketed in winter time, nor overcoats and furs in summer. The promissory note must be paid when due. The bond has a greater value just before an interest payment than just after. And from these limitations of time, as from those of space, there is no escape. A man can not be in two places at once, nor can he command the sun to stand still and halt the passage of time.
§ 2. The time element in man’s provision for his needs. If the needs of men were supplied from day to day by some outside agency, if the things we need fell like manna from the skies, or if man lived the uncalculating life of some animals, there would be no such thing as time-preference or time-value. The lowest animals live entirely in the present. Their whole activity consists in appropriating whatever agreeable things, or rejecting whatever disagreeable things, are at the moment within their reach.1 And with few exceptions even the higher animals live very largely from day to day, as did primitive men and as some men do still in the midst of modern civilization. For these the desires of the present engross almost the entire attention.
But even some of the animals are guided by their feeble intelligence or by instinct to make choices that do involve a relation between goods in the present and in the future. Squirrels, bees, and ants store up in the season of superfluity for the season of scarcity. Man, and especially civilized man, in a far greater measure, takes the future into account in his plans, his calculations, and his labors. He lives his economic life of choice, so to speak, both in the present and in the future. His economic life and his economic judgment comprehend a great number of periods at once. He attempts to provide for the needs of the future almost as carefully as for those of the present. This means a much more complicated adjustment of goods to desires. The typical animal-choice is lacking the time-dimension (the objects and uses are synchronous). The typical human choice is between goods in different periods (the objects and uses are non-synchronous).2
§ 3. Cases where future use is preferred. It should, however, be carefully observed that time-preference is not always preference for present goods as compared with future goods. We sometimes, indeed very frequently, prefer to have certain things in the future. After any meal, the present use of the remaining food in the pantry, the cellar, the granary, is worth less than its possibility of future uses, some of which are a few hours, others a few days, others perhaps weeks distant. (See above, Chapter 4, section 6 and section 7). The changes of the seasons with their effects on the abundance of plant and animal life cause a pretty regular cycle of valuations. When the crops are harvested in the fall, the farmer, while setting apart some of the fruits of the field to provide for the present nourishment of himself and family, yet stores up the rest for later use. His immediate needs are over-supplied, and his anticipated future needs induce him to save. In a fishing tribe after a great haul of fish a present fish is worth less than the certainty of a fish six months later when fish will be scarce. After a successful buffalo hunt, when all the members of the tribe are sated with meat, present meat is worth less than the chance of an equal amount of meat any time for nearly a year. Ice has less value in winter both because the need for ice in refrigerators is less, and because ice is more plentiful. In January one would gladly exchange a larger amount of present ice for a smaller amount to be delivered the following July. Crops of fruit, vegetables, etc., are on the average worth less per unit at the moment they are gathered than at any other time in the year until the next crop is due. Coal and wood are worth somewhat less in spring and summer than in the following winter. Fresh eggs in the months of April and May when most plentiful could hardly be exchanged for half the quantity to be delivered in November and December,—despite the attempts to keep them over and thus equalize conditions and values by cold-storage and preserving in enormous quantities.
Such seasonal changes within the year comprise a large proportion of the cases in which present uses are worth less than future uses. The present values of most goods as anticipated through a series of years are adjusted to a pretty regular scale. So far as men can see in advance, one year is going to be much like another. Differences can be allowed for on the average, but no one knows just when the greater crop or the crop failure is to occur. So all must be estimated in advance in relation to the average, or normal.3
The preference for future over present use appears in many other relations of life. A fire-engine is less valuable now than it will be when the fire breaks out; indeed its present value is but a diminished reflection of the value we anticipate it will then have. We would gladly exchange the useless engine now, with the trouble and expense of care it involves, for the certainty of a similar engine when the fire occurs. In like manner a warship is less valuable now than is the prospect of its use when war occurs. The gift of a trip to Europe this year is less welcome when one is unable to go than would have been the promise of a trip for next year when one expects a vacation. In countless cases may be heard the words, “I don’t care for it just now,” or “If only it had been later.”4
§ 4. Cases where present use is preferred. But with all his foresight, and with all his appreciation of future needs, even the most provident of men are, like the animals, compelled to live very largely in the present. There is no such thing as a future desire; there are only present desires for either present or future goods. The needs of the present and the desires for present goods are, in much the larger number of cases, the more insistent. It is not rational (or even possible) to provide for the future until a certain minimum provision, at least, is made for the present. The typical or average preference of men is for present goods or uses. This does not mean, of course, that there is not desire for future goods, but simply that a larger quantity of future goods will exchange for a smaller quantity of present goods. The smaller amount of present goods is regarded as worth as much as the larger amount of future goods. There are numberless illustrations of this type of preference. In the various cases mentioned in the preceding paragraph one would need merely to shift his position in point of time to reverse the order of preference. In the summer a quantity of present ice is valued more than the certainty of the same amount the next winter; in the winter present eggs are valued more than the trustworthy promise of an equal number the next spring. So with fruits and grains just before the new crop matures, the fire-engine when the conflagration is under way, the battleship when the war has begun.
§ 5. Biologic basis for most choice of present use. The different time-periods, present and future, and their different economic situations are brought into comparison either by instinctive choice (necessarily involving a ratio of comparison), or by conscious choice between the thing actually present and the future good more or less clearly pictured in the imagination. To take and enjoy things as soon as the desire arises and the means are present seems to be a fundamental trait of men. The impulse to seek immediate gratification is rooted deep in man’s biologic nature. It is found in the most elementary forms of animal life (see Chapter 2, sections 1 and 2) and continues to be a powerful guide to action as higher forms of life evolve. It has in the course of evolution been only slowly modified and supplemented by inhibiting instincts and by reason. This impulse is still dominant in the actions of most men, and is ever ready to reassert itself under unusual temptations even in prudent natures. With children and savages and with many civilized men the voluntary postponement of the gratification of desire is of very limited character. Powerful and universal impulses work in favor of present gratification; man’s provision for the future occurs only when imagination, reason, habit due to long training, and a strong will to pursue a distant object hold these impulses in check.5
§ 6. Hope and risk as affecting time-preference. Hope is a blessed gift to man to help him bear the ills of life, but hope does not always operate with great discrimination. Hope of future provision for future needs encourages the present use of goods, leaving the future to care for itself. As the successive years will bring recurring needs, they will, while health and strength continue, bring also recurring supplies of goods. If this were the unbroken rule of life, the most economic use of goods would be to consume each year’s products as they come. This, indeed, is the firmly fixed habit of life of a large portion of humanity, even under conditions where the results are clearly bad. In many provident and well-to-do families there are persons who are so sheltered from responsibility in caring for the future, that they blindly trust that good things will continue to come in unlimited quantities. Like the young robin with open mouth, ever eager to be fed, they accept unthinkingly the sacrifices of others. Business reverses, the illness or the death of the responsible member of the family, often leave all unprovided for, those in whom prodigality has thus grown into a habit.
The uncertainty of life likewise strengthens the preference for present over future goods. There are two possibilities of loss by waiting, one that the future goods may not be there (“A bird in the hand is worth two in the bush”), and the other that one may not be there himself to enjoy them. (“Eat, drink and be merry, for to-morrow we die.”) Life itself is uncertain, all but the present moment. Each of these risks involves a discount on the future uses as compared with the present. So large is this uncertainty of life among savages, so many die of accidents and wounds, that many tribes are said to have only the vaguest conception of a natural death. In semi-civilized and in rude pioneer days, it was almost the rule to “die with one’s boots on.” Even in the most regular order of things, to-day’s desires have the strongest claims of any desires in one’s life, simply because they are the most certain.
In the best ordered plans there is some bad judgment. With most men this is increased by the prevalent under-estimate of the future and by the ever pressing temptations of present desires as compared with the weakness of the appeal of the future. The steady pressure of these motives directs the larger part of the efforts and thought of men toward the providing of present goods, often leaving the future (ever becoming the present) unprovided for. Accident, robbery, fire, storm, war, disease, death, countless mishaps, may bring upon any man, family, or community this maladjustment. Wherever any particular kinds of goods become in this way unusually scarce, they rise in value compared with future goods of like kind and quantity. Time-preference appears, and shows itself in the uses made of all existing economic agents, both objective and human.
§ 7. Hastening the ripening process. A man or a family in an isolated economy would, when in urgent need, make efforts to convert future goods if possible into present goods. Sometimes this can not be done, e.g., the starving man in the forest can not hasten the ripening of wild fruits, and the desperate Richard III cries in vain, “My kingdom for a horse.” But in many other cases there are ways of converting future into present goods, tho rarely without making some sacrifice for the conversion. (For if they were indeed available at once they would be present goods.)6
Future goods of one quality may often be appropriated as present goods of a lower quality, e.g., the future ripe apple is a present green apple, the future matured wine is the present grape juice, the future seasoned lumber is present green lumber. In thousands of artificial ways in modern industry the time needed for acquiring the better physical quality and the higher value, is cut short. In times of siege and famine, goods may be changed entirely from their usual purposes; trees are dug up that the roots may be eaten, and leather is chewed for food. Again, future goods may be hastened into becoming present goods of nearly the same quality by being put through technical processes, e.g., the lumber may be kiln-dried, the fruit may be forced in a hothouse; but as in this process other agents must be used, the present goods and the future goods are somewhat different groups of things presented to choice. Again, to get more present goods the usual care of durable agents may be neglected and their future uses destroyed by taking more than the true present usufruct, as by using up a farm, or by driving a horse to death in going for a doctor, or by burning Indian corn or fruit trees for firewood.
In all these ways the adjustment of choice between present and future goods in the individual economy is constantly going on, reflecting a prevailing time-preference in some person’s mind. It will be noted that in every case this adjustment, even when made quite outside of a market and without exchange with other persons, requires a sacrifice of something, either in quality or in quantity, either in valuable labor or in materials taken from other uses. This sacrifice bears some value-ratio, more or less clear, to the time-value of the present good.
§ 8. Postponing the use and the readiness for use. If on the other hand there is preference at any time for future goods over present goods of like kind and quantity, adjustment is made as far as possible in the other direction.7 If the person has but one unit (good or use) to dispose of, the use can be either now or later, but not both times. Shall the lunch one has in his basket be eaten now, or kept until noon? Shall the rare flask of wine of romance be opened now, or kept for some future greater occasion? Often, however, the question presented is that of distributing a stock of like units, or of like uses, over two or more time-periods. In such a case as the bountiful crop, the surplus overflowing the usual demands of the present is held for the future. The anticipated future desires factor as present desires (more or less weakened by time or perspective it may be). They claim a portion of the present stock, that portion which if used at present would have a smaller value. Each unit of like goods, under the law of indifference, must have equal value at the moment whether to be used at the present or the future (tho it may have a higher value when later used). Until this adjustment is complete, units are shifted from one time period to another, according to the law of substitution. The possibility of using things later thus gives a valuation to each unit of any present stock of goods higher than it would have if the goods were entirely perishable and usable only in the present. In Figure 31 if the present stock of meat is eight units, the value would sink to one, represented by the line AB. But if four of these units can be kept for the future, the present takes but four units, and the value will be three (line CD) for each unit, whether used in present or in future. Note that units five to eight may be worth more later when they are used, and probably enter into present choice at a discount from their future magnitude.
On the whole it would seem that in a greater number of cases it is more easily possible to retain a surplus of present goods for future use, than to hasten a future (unripe, unfinished, or merely potential) supply, to meet present uses. It would seem that present value is more often, and in the case of more kinds of goods, and in a greater degree, raised by a chance shortage than it is unexpectedly reduced by a chance surplus. For usually the surplus can be kept as is often the case even with direct consumptive goods (such as grain, coal, textiles, carriages, etc.), and still more often the case with indirect durative agents, such as tools, machinery, buildings, stocks of metal, etc.
§ 9. Physical-change accompanying time-change. Some goods deteriorate physically by keeping, as fruit rotting in the bins; some remain almost unchanged for a long time, tho costing trouble and expense to store and care for, as cotton, grain, and fireworks. Still others improve physically with time, as newly brewed beer, newly vinted wine, bananas ripening on the stem, celery blanching in the cellar, fattening poultry, half ripe fruit on the tree, the violin seasoning and growing richer in tone.
It is difficult in studying the problem of valuation in such cases to keep clearly distinct the two ideas, that of the physical change that goes on, and that of the pure time-value change. When the object physically improves with time and at the same time increases in value, the physical change seems to account for the increase; but as great an improvement physically may in other cases be accompanied by a fall in value. It is evident that no change in value is to be attributed solely to objective changes in the good, without regard to complex conditions in the desires of men.
In all such cases and in so far as there is any conscious comparison whatever, it is the net desirability (net present value) of the future goods that is compared with the value of the present goods. If half of the apples probably will rot before it will be time to use them, the present value of the future apples, per bushel, must be somewhat more than twice as great as present apples to make a motive for keeping them, and further allowance must be made for trouble, expense, etc. But, as a part of the present apples are expected to spoil, they represent, and must be compared with, a smaller number of apples in the future. The physical change is an inevitable (or a practical) condition, of the time change. It is, so to speak, a function of time. It happens rarely, perhaps, that it is with respect solely to time, in simple, unadulterated form, that time-choice, time-preference, and time-value are presented to us. Time-value is the present value-difference between the possible uses of a thing or group of things at different times. If therefore the lapse of time is accompanied by increase or decrease of quantity, or by gain or loss in quality, this enters into choice at the present moment.8
Undoubtedly, the importance of time in many acts of business life is well understood. “Time is money,” is a business maxim. But neither in business nor in the philosophical study of value has the omnipresence of the time element been fully appreciated. This chapter has, perhaps, served to show how time is a factor in practically all economic choice and in practically all valuation. Indeed, time-value and time-preference have aspects that transcend economics; they are universal phenomena of life and conduct.
We have now to see in the next chapter how time-preference is expressed in the values of goods and how in these valuations necessarily a rate of preference, a premium for time, comes to be expressed in each person’s valuations.
Present and future goods, uses, desires. We may not the following distinctions to be kept in mind throughout our discussion.
Present goods are any goods actually available for choice at the present moment. These comprise not only goods that may be used directly, as immediately enjoyable, but indirect agents if present. Future goods are any goods that will not be available for choice until some future moment.
All ready durative goods contain either present or future uses, or both kinds. The uses contained in goods must be distinguished from the concrete goods themselves, e.g., the house from its use as a shelter, an ax from its cutting of the wood. (On this relation between the uses and concrete agents see above, chs. 11 and 12.) A future good when it arrives, may contain uses available at various economic periods. It is not unusual to speak of a choice between present goods and future goods when more exactly one should speak of a choice between present and future uses of goods. As any particular concrete good, as a field, a building, a machine, may be yielding indirect uses of many ranks, and of many degrees of futurity, the time differences involved in this process must be expressed in terms of the uses rather than in terms of the agents.
In every case the choice made is, at the moment when made, a present choice. We have no future desires tho we may have a present forecast of a future desire. “Future desires” means desires that will be present at some future time. Present desires are all those desires now being weighed in choice. Present desires may be either desires for present uses or for future uses (either in the same or in different goods). A present desire for future uses is but the anticipation of a future desire, tho the two may be of unequal magnitude. It appears therefore that all time-choices are, in the last analysis, reducible to choices between present desires for psychic-incomes occurring at different time-periods.
RATE OF TIME-PREFERENCE
§ 1. Subjective rate of time-preference. § 2. Time-preference showing in care and repairs. § 3. Time-preference showing in production of indirect agents. § 4. Time-preference rate pervading an economy. § 5. Time-preference and moral weakness. § 6. Beginnings of durative direct goods. § 7. Valuation of durative direct goods. § 8. Relation of technic to time. § 9. Examples of technical and time-differences. § 10. Degrees of roundaboutness ruled by time-preference.
§ 1. Subjective rate of time-preference. The fundamental ideas of value (developed in Part I) have application to the rate of time-preference. Wherever there is a good that offers a time-choice to its possessor, there arises valuation as regards time. One may eat the apple now (a typical direct good) or postpone its use, may shift it forward or backward in time. We know little of the absolute magnitudes of the desires that men may have for these things at the two different points of time. We infer only that if a man eats the apple now, his desire for its present use is greater than his present desire for its future use. The preference of the present may be due (case 1) to the prospect that apples which are scarce now will be much more plentiful in the future; there we feel almost warranted in saying that the absolute magnitude of the present value is greater than it will be at that future time. We at least feel that we can infer something as to this. But again (case 2) the present use is chosen when the prospect is that apples will be no more plentiful, indeed when it is certain that they will be less plentiful, but when our need and our desire for them will be greater. Again (case 3) when one eats a part and keeps a part of a large crop and the keeping involves no trouble or cost whatever, and no loss from decay, etc., there may be no difference whatever in the present values of the different units of the stock. The principle of indifference applies. But in almost every conceivable case the keeping of a good calls for some labor (thought and physical effort) and the use of agents valuable for other purposes (case 4). The present value of a future unit would have to be therefore at least enough greater than that of the present unit to make up this additional cost, otherwise it will not be kept. Present value plus estimated cost of keeping equals present value of future unit. There is time-preference for the future, exactly offset by costs. The marginal unit for each period would be in equilibrium with the marginal unit in the other period. (See Figure 32.)
In these cases, however, there is no element of pure timepreference, other than that offset by costs, no degree of preference for the present unit simply because it is present. The supposition involved is that of equality of value to the results of equal expenditures of labor and to equal amounts of other agents regardless of the time-distance at which various products would appear. Even in a Crusoe economy such a preference must exist. If Crusoe disregarded all time-differences he would take exactly the same thought of the products of fifty years distant as he did of present products and would put just as much of his labor and equipment upon them; that is, he would divide the year’s products into fifty (or more) parts, using only a fiftieth. Normally he uses all or nearly all of this year’s income, leaving to next year’s labor and equipment the task of providing for next year’s needs. Practical observation and all the considerations adduced above (Chapters 3, 10, and 20) regarding man’s nature, support the view that present desires will receive on the whole more attention than future desires. If any true time-preference whatever prevails, it must be at some rate, in each case, tho the rate may vary with the mood and the conditions in which Crusoe finds himself. One could, by watching different individuals working at their own affairs, form a general opinion, often a pretty accurate one, as to whether their rates of time-preference were high or low. It would show in many ways in their use of their own time and of their stocks of goods, in the qualities of thrift, industry, prudence, etc. But to express any general rate at all exactly would be most difficult so long as we observed only the choice among many objects, without any common standard of value in which to compare them.
§ 2. Time-preference showing in care and repairs. If Crusoe’s time-preference (for the present) were very high it would show in his use both of his stock of enjoyable goods and of his stock of indirect durative agents. (See Chapter 11, section 11, on the economy of repairs.) When he landed in his canoe he would let it lie on the beach at the risk of its being filled with water or dashed against the rocks, or carried out to sea. This act necessarily implies that at that moment he values his own effort to pull it up more than he values the dimly seen necessity of bailing it out to-morrow, or of repairing the injury done by the rocks, or of making a new one when this is lost. When his house leaks he would do as the proverbial Arkansas farmer (not peculiar to that state), who couldn’t mend his roof when there was rain and saw no need to mend it when there wasn’t. Crusoe’s use and management of his garden, of his fowls, and of his goats, their feeding, breeding and care, all would involve and express a certain comparison between present and future vegetables, grain, eggs, milk, cheese, goat meat and skins, his own labor, etc. In every economy, whether in Crusoe’s or in a larger community, the practice of each individual as to repairs and the efforts made by him to offset depreciation, inevitably embody that individual’s rate of time-preference in a thousand ways, tho it varies more or less with his mood, health, fatigue, etc., and tho he is quite unconscious of any arithmetic expression of it.
A rate would show itself among other ways, in the need of more labor and more materials later, than would suffice now. A handful of earth may stop a hole in a dyke, whereas a trainload would be insufficient later. Whenever it is true that a stitch in time (now) saves nine (next year) and the stitch is not taken, then the neglect involves a rate of 800 per cent in terms of present stitches (one now, increment next year eight). If one day’s labor now on the canoe is found by experience to save two days’ labor a year later and it is not taken, then the rate is over 100 per cent a year (one now, two next year; increment one, or 100 per cent of quantity). Plainly, however, two greatly diverse rates if recognized, could not long continue to exist side by side. For if the rate were even 99 per cent, not only would the canoe be mended but the stitch would be taken in time wherever it would save two or more stitches next year. And so, it would be if there were a thousand different kinds of repairs to be done. There would not be a thousand different actual rates of physical increments; for so far as there is any normal habit or consistency in the individual’s conduct these different rates of increments will be brought more or less into conformity with a prevailing rate of time-preference. Whatever that rate be, there is good reason to make the possible repairs that involve a greater rate. But those repairs, the neglect of which involve a smaller increment, ought not to be made. The rate of time-preference, like an isothermal line, marks off the repairs that hypothetically would involve a greater increment (and which now are made) from those which involve a less rate (which now are left undone).
Repair is nothing but a particular case of production presenting the peculiar problems of complementary agents. Even where time-preference is very great, repairs will be promptly made when the whole agent with all its usance-value may be put back into running order by replacing a single part (as by mending a hole in a canoe, putting a new string on a bow, etc.). It is the anticipatory repairs, the ounce of prevention that is most likely to be neglected in an improvident economy. When many repairs are needed, the repair becomes as difficult as the making of a new agent, or more difficult, and presents practically the case of new production.
§ 3. Time-preference showing in production of indirect agents. A rate of time-preference is reflected in the physical increment of goods in many cases. Suppose one hundred days of labor this year will produce one thousand fish, caught by wading the streams or will make a canoe which will enable one hundred days of labor next year to yield 1100 fish; and suppose that one day’s labor will obtain one thousand apples in the wild forest, and will plant a tree that will yield 1100 apples next year; then the choice of the relatively direct method results in a physical excess of products at the rate of 10 per cent. But the direct method is chosen and will continue only when the rate of time-preference is over 10 per cent, and is abandoned as soon as the rate of time-preference is less than 10 per cent. Whenever a Crusoe “gets ahead far enough” in his equipment to have a canoe, he no longer gets his fish by wading the streams (except at unusually favorable moments), and when he has got to the point of having an orchard he no longer plans to gather fruits in the forest (tho he will pick the few that are easiest to get). He continues this choice among all the possible present and future uses of his present labor and resources, till he has included all the time-consuming methods, whether direct or indirect, that involve increments as great as his rate of time-preference. That rate, as it falls to 9, 8, 7, etc., dominates the choice of technical processes. A man’s prevailing attitude of mind and habit of choice between present and future, in the use he makes of his present economic agents (labor and goods) marks, so to speak, an isothermal line between those savings which he makes (all tending to the same rate by the marginal law) and those which he fails to make (the excluded choices). Time-preference (a purely psychological fact) involves a rate of discount or of premium which thus would show itself here and there in a certain quantitative surplus or increment each year over the yield possible by the alternative methods. When, however, a better technical method is in use, and is warranted by the rate of time-preference, it is possible only at a loss to go back to the older method. For lack of a saving that involves but 5 per cent discount on next year’s goods, one might reduce production to an amount involving 100 per cent discount. Evidently this would be a maladjusted economy, and would call for a new adjustment of agents for present and future uses.
§ 4. Time-preference rate pervading an economy. The mere physical increments that result from any process or method of production are not necessarily value increments of the same magnitude. Indeed, we have no absolute standard by which to measure the magnitude of a person’s valuations in two different periods, any more than we have to measure the magnitude of values in the minds of two different persons at the same time. If one values 100 present fruit now as much as he values 110 next year, we can not say that the 110 when they come will have a value 10 per cent greater than they have now. This year there may be an unusually small crop, next year there may be reason to expect an unusually large crop. Under the conditions one hundred present fruit may have a present worth of two hundred future fruit at the same time that many other choices indicate a time-preference rate of not over 10 per cent. Again we must confess that we have no absolute standard of values that can be carried over from one time period to another.
However, when we stand outside of an individual economy, overlooking the seasonal variations within the years and the changes in productive methods due to science and invention, and we see how on the average, year after year, choice is made, we could form some judgment of the person’s prevailing or pervading rate of time-preference. Such a rate each individual has; and these rates of individuals unite into a time-price when two or more persons trade present for future possession of goods. Just as the subjective, individual choices between any two commodities (Chapter 7, sections 3-7) enter into a market-price of objective goods, so the rates of time-preferences of individuals trading in a market are adjusted to each other and result in a market-rate of time-preference.
§ 5. Time-preference and moral weakness. Economics touches frequently upon the borders of ethics, and it is well to observe here that abstinence is but an aspect of choice and will-power which has effects in the realm of moral as well as of economic values. If there were to be formulated an economics of personal conduct, it surely would give a large place to the comparison between present and future enjoyments.
The problems of abstinence and time-value appear in prodigality, in much heedless pleasure, and in many forms of vice. Prudence, always included among the virtues, is the faculty of recognizing not only future costs and dangers to be avoided, but the greater future joys that may be gained at the price of present sacrifice. It is not without reason that in the discipline of youth in civil and military life, the cultivation of thrift, order, and promptness are in every land deemed to be fitting means, when wisely employed, of developing moral virtues. Shiftlessness in the performance of tasks for one’s own good is almost certain to show itself in failure to fulfil agreements with others, resulting in excuses, falsehood, and degeneration of character.
Time-value is involved in prodigality. Often the estimate of the present good is unduly high, viewed in the light of wider experience. Goods that meet momentary desires make an exaggerated appeal to untrained minds. The child, the spendthrift, the savage, can not properly estimate the relative values of present and future. The drinker exchanges the hopes of a worthy life for the exhilaration of the spree. The reckless, underestimating the future penalties of disease, insanity, and death, barter health and happiness to gratify the moment’s impulse. Indulgence in social pleasures, if secured at the price of lost sleep, weakened health, and debauched character, are loans from the future made by youthful prodigals at usurious cost. If no one ever paid more than a moderate premium for the gratification of his present whims and impulses, most hospitals, drug-stores, and medical colleges would close, and half, if not all, the prisons would be empty.
§ 6. Beginnings of durative direct goods. The illustrations of time-value thus far have been of consumptive direct use of goods. (See the analysis in Chapter 11, section 1.) These are the nearest to psychic income, and in this class of cases time-value appears in its simplest form. Historically viewed, likewise, this is the starting point of time-value. The animals (with few exceptions) live only in the realm of value that contains present, direct, consuptive uses. The savage’s range of vision and choice is wider, but still is limited mainly to direct present uses gained with such aid as his simple tools and weapons afford. He leads necessarily “a hand to mouth” existence. He has no surplus stock except by lucky chance. Lack of success for a few days in the everlasting search for food means hunger, then famine, and the diseases which always follow in its train. The increase of wealth in early times, therefore, took largely the form of larger stocks of direct goods. Some of these were of a kind that could be kept, such as stores of vegetable food, flocks and herds of animals kept to be eaten, hoards of precious ornaments, more and better clothing and shelter, weapons of the chase, horses, dogs, etc., which were valued also as direct agents in sport, not merely as means of getting food.
§ 7. Valuation of durative direct goods. Let us now extend our study of time-value to more durative direct goods. (See numerous illustrations, Chapter 11, sections 2 and 3.) Take a dwelling as an example. Literally every moment’s use of a house is a separate use, but for convenience these infinitesimal uses are grouped into conventional units, as one day’s or month’s or year’s use, evaluated all at one date. The uses of a house for the next ten years may be practically the same in a physical sense but they are distributed in time. But it is not a stock of present, non-perishable goods which may be all treated as present uses or all as future uses subject to the leveling influence of time-preference. Each use is fixed in time and must be valued there or not at all. (See Figure 34.) If every future use were valued now without discount, the present values of the units would be represented by the top line. If this occurred in the case of a durable house that should last a hundred years, the total present value of future uses would be one hundred times this year’s use. A piece of real-estate kept up under the renting contract has an indefinite series of uses, which if not discounted would have an incredibly large present value, a thousand times, or an infinite number of times, the value of the annual use. But if the future uses (as usually happens) are discounted in the present, this might be represented by the descending line. Such regularity results, however, only in a market where the great variety of individual differences of conditions have been combined into a market-rate of time-preference. A (Figure 35) has a growing family and the uses of the house will steadily increase for the next six years, and then, as his children leave home, will decline. B is expecting to be away for a time, and the house will first yield uses of smaller, then of larger, value. If each of these persons or families were in a Crusoe economy such differences would affect the amount of labor and materials put upon a house, the year in which it would be built or improved, etc. But in a market for house uses many other adjustments are possible, through moving out and moving in, buying and selling, sub-letting, etc., by which these differences of individuals’ circumstances largely disappear, and only the general and persistent discount, reflecting a market-rate of time-preference, remains. A diamond necklace is a good example of an absolutely durative series of uses. If each year the value of the use is expected to mature as one hundred dollars, the necklace would have an infinite value if the future uses were not discounted.
§ 8. Relation of technic to time. Directness of use (technical) and timeliness are not the same. (See Chapter 10.) Of the thousands of forms of matter in the world, only a comparatively few ever will make an immediate impression on man’s senses. But many of them are in his life so connected with uses by instinct, association, and reasoning that he attaches an importance to them. In most cases it would require close thought to see that the service attributed directly to them is but a reflection of that performed by some other thing. To include indirect uses in choice, calls for something the same kind of wider vision that is needed to include future uses. Indirectness and futurity may be, and often are, united in a single concrete good. Indeed, these two qualities of goods are very commonly confused in thought, whereas their gradations are in different planes of thought; they are, so to speak, at right angles with each other but having a single point in common. This may be graphically represented as in Figure 36.
§ 9. Examples of technical and time differences. Mere technical indirectness per se has nothing to do with time-value. If a technical process involving a half-dozen or more steps is completed within an instant, then the most indirect agent must have all the value reflected to it from the product, subject to no discount on account of the lapse of time. The man can get the nuts by climbing the tree, or by taking a stick and knocking the nuts to the ground. The difference in the time of the two processes is negligible, the indirect method securing the product as soon as the direct method. Hence there is no choice between the two as to the time-remoteness of the product, but only as to the amount of the product per unit of labor (or ease of labor to get the same product). If sticks are free goods, the whole amount of the additional product is attributed to the labor; if sticks are scarce, a part of the product must be attributed to the usance of the stick. But that is a usance-problem, not a time-value-problem. But if the same amount of labor will plant another tree which will yield a much larger and better crop annually after twenty years, then time is an element. Or again: the coal heats the iron tubes, the tubes heat the water, the steam moves the piston rod, the piston rod turns the wheel, the wheel a belt, the belt turns a dynamo, the dynamo generates electricity, the electricity is carried through a wire to a filament in a glass bulb, and you are enjoying artificial daylight in your home. The coal is the first link in a chain of indirect uses the last link of which is at the same instant yielding a direct use. Whatever part of the value of the use is imputable to the coal on value-principles, as one of the various complementary agents, is, so to speak, payable on the instant. When, however, the roundaboutness of the process is necessarily time-consuming, then time-preference operates. For an interval of time divides the indirect use of the agent and the final psychic income from which its value must be reflected. If the coal has been mined for some time, time-value is involved in the relation between the present worth of the coal when it was mined and the time when it is turned into illumination. Various possible ultimate uses, at various degrees of distance in time from the present, some a year, some five years, some twenty years, may compete for some indirect agents. The various products are located at different points in the line of time, and because of this difference (besides other differences) appeal with varying degrees of force to desires. If this were not so time-preference would have a zero magnitude.1
§ 10. Degrees of roundaboutness ruled by time-preference. Nearly the whole of the great mass of indirect goods applied to making stuff-, form-, and time-changes require more or less the lapse of time to yield their uses. True, the indirect uses as well as the direct uses of goods (see Chapters 9 and 10) may be more or less hastened or delayed, but that is a time-change that involves the sacrifice of other agents. There is in each economy a certain normal time-point, a point of maximum economy for a product to appear. Rush orders are always costly. If a horse is worked beyond a certain point, the present use shortens the horse’s working life. If, to save another trip, a wagon is too heavily loaded it is strained or broken. If a machine is geared to run beyond a certain speed, it does poorer work or goes to pieces. A sudden rise in the value of the product may warrant the sacrifice of agents. To warn the inhabitants of the valley that the dam has broken, the rider may ride his horse to death. To keep from freezing, a man will use mahogany furniture as firewood. A war vessel going into action throws overboard the piano and other cabin fittings. The outbreak of war sets all the armories to working overtime.
What is the psychological change that happens in these cases? The present use suddenly becomes so much more valuable than the future use, is so much preferred, that the mode of use, or intensity of use, is altered. Time-preference dominates the technical processes. And this is so in normal as in abnormal times. The normal time-point, the point of maximum economy, at any period, is one where the uses of indirect agents are distributed along the path of time in accord with an existing rate of time-preference. If next year’s uses are now valued just as much as this year’s uses, there would be one choice of roundabout processes, if they are valued one tenth less, there will be a very different application of indirect agents. There is thus a relation between roundaboutness and time-preference, but it is one in which the mere mechanical method is passive and subordinate to human choice, time-preference.
MONEY AND CAPITALIZATION
§ 1. The functions of money. § 2. The standard of deferred payments. § 3. Property. § 4. Wealth and property rights. § 5. Origin of capital; its definition. § 6. Capitalization of direct durative agents. § 7. Capitalization of indirect durative agents. § 8. Time-price without loans. § 9. Present price and the discount on future uses.
§ 1. The functions of money. As trade among a number of traders is greatly facilitated and price is given a more exact expression when a common objective standard, money, comes into use, so a price paid for time-transfers of many kinds can be much better expressed in a common standard by the use of money.
Money is first a means of trade, a medium of exchange. (For preliminary definition, see above, Chapter 7.) It is some object which has value to all men and which, because of its convenience, comes to have the most general marketability of any good. It is thus selected because of certain qualities in which it excels any other good. It is always some object containing in the view of every one, a good deal of value in small bulk, most easily kept without physical decay and that has come, as markets develop, to be one of the goods in most trades.
The general medium of exchange is necessarily the most general price-good. As all other things are constantly exchanged for money, they can each in turn be compared with all the others in terms of money. It becomes the common denominator of prices. The price of any one thing in terms of another can be found from the money-prices of the two. This permits and cultivates habits of exacter conscious calculation of prices both by buyers and sellers than were before possible.
Whenever money is kept for an hour or a day, awaiting the fitting moment to complete the double exchange, it is serving the purpose of a storehouse of saving. Because of the same qualities that make it generally exchangeable (certainty of sale and physical durability) it is one of the best objects to keep for longer periods (to be saved, hoarded) against a day of need. It is a generalized means of abstinence, kept for a general purpose without choice as yet of the particular good for which it will be spent. The use of money as a storehouse of saving was more common formerly than it is now, for in advanced countries better ways than the hoarding of money are found for “laying up for a rainy day.” In some measure, however, even here money serves this use and in large parts of the world as in Egypt, China, India, this use is of very great importance. A thing ceases to be money, logically viewed, the moment its owner keeps it without the purpose that it shall be spent ultimately. The typical miser is a man who has lost his reason as regards the money use, has forgotten that it is a means to an end. Whether serving as a storehouse of saving or as a medium of exchange, in either case money is to be kept only till the moment when the owner believes it will best gratify his desires. Its use thus even as a medium of exchange involves a recognition, and a more or less conscious calculation, of time-value.
§ 2. The standard of deferred payments. But this connection with time-value is yet more important as money comes to be used more and more as a standard of deferred payments, a standard for prices over a period of time. A deferred payment is a payment made in fulfilment of a bargain made for goods delivered at an earlier date. It is the completion of a credit transaction. Credit means, first, trust or confidence reposed by a seller in a buyer, and hence the selling of things “on trust,” in exchange for a promise of pay at a later date. Now as money is the common price denominator, and the price of nearly all things whether they are sold for cash or on credit is expressed in money, it is the unit in which the comparison of goods is made when one chooses goods in different periods of time. It is not an absolute standard of value; a “dollar” is not necessarily of the same value-magnitude to any one person from year to year, much less to all persons together. Money is subject to fluctuations of its own (for example, those due to changes in gold production) having remarkable consequences in industry which must be separately studied. But money is taken as the objective standard in borrowing and lending to which the time-preferences of men are adjusted, as value is adjusted to price. This is to be treated under the subject of interest.
§ 3. Property. No trade of goods is possible unless the trader has possession of the goods, or can deliver that control over to the other party in the trade. The fact of possession is implied in all discussions of value, price, use, and rent. Possession is a legal fact. It is legal control, not physical hold of goods. In any settled community it must be regulated by law, the law of property. Property is ownership. It is an intangible right; only by a loose figure of speech has it come to be applied to the object owned (e.g., a man has a property in a house and lot—real estate; hence the house and lot are called his property). The law of property is the rule of the community determining control over economic goods. Economic goods are valuable; other persons would like to have them. A property right is either a claim upon some one else or a limitation of some one else’s claim. You say in various ways, this house with land is mine, it is my own, it is owned by me, it is my property, I have a property right in it, it belongs to me, etc. All these phrases express your right to have and use as against other men’s rights. But you may sell to another man a right to a method of use or to a limited period of use, in a written instrument, a lease. He then has a legal right in his leasehold, and your right is limited by his. He may have an “equity” in the house (a claim upon the income from the house which formerly was enforceable in a court of equity). At the same time you may get repairs made by mechanics who until paid have a legal claim for which the house itself is legal security (law of mechanics’ lien). And so there may be a score of overlapping and mutually limiting claims upon the income from one economic agent. There is a legal distinction between your legal claim to the fee simple of a landed estate, and the various legal claims upon you, or equitable interests in the house (when it is the security). But it is property rights that are traded rather than the things themselves, for legally each party in a trade can deliver the possession and use only of that limited part, aspect, or mode of use, of goods, which is his.
§ 4. Wealth and property rights. The valuable objects themselves, such as lands, houses, cattle, implements, and ships, are wealth. If there are no overlapping legal rights, the property right to a piece of wealth has the value of the wealth itself. In simple conditions of industry each piece of wealth had one owner who had the right to all the income of that wealth; or if others had overlapping claims (of landlord, sovereign, etc.), they were of a fixed sort, not objects of sale. Neither the objects of wealth (the lands, etc.) nor outsiders’ claims upon them were ordinarily bought and sold. Therefore their magnitude was usually estimated in terms of their rents, or incomes, and not in terms of their price if sold as a whole. In England, where land rarely changes hands except by inheritance, an income whether from land or other sources is still spoken of as worth so many pounds a year, rather than as worth so much as a whole. As there comes to be a network of property rights extending over the wealth, and mutually delimiting each other, it is evident that the total price of these rights can not exceed the total price of the uses (products) of the wealth. The different pieces of wealth have yields that are impersonal—the field yields its crop, the house its services, the ship its uses, and these impersonal yields are apportioned to different persons as incomes according to their property rights. Two or more men may be partners, one entitled to ½, another to ⅓ and another to ⅙ of the total usance; or before these incomes are apportioned, many other small prior claims may be first deducted. Corporate ownership with small shares of stock gives a much greater division of claims upon income.
More and more it is these claims to income that have come to be the objects of trade among men, rather than the concrete wealth itself. One may be a very rich man to-day and not own outright, in fee simple, any but small personal belongings. He does not own wealth in the old-fashioned way, he has capital, and is a capitalist.
§ 5. Origin of capital; its definition. Capital is from the Latin adjective capitalis (from caput, head) in the phrase capitalis pars, the chief part, principal part; hence principal, of a money-loan. The capital, or principal, of the lender was this amount of money, distinct from the usury (originally meaning the sum paid for the use) or interest, the amount in addition which was due him at the expiration of the loan. Money loans of this kind were rare except among merchants in cities, and the borrower on his part looked upon the capital as the amount he had to “invest” (literally, clothe) in various kinds of goods. Taking these goods to a distant market, or changing them by manufacture into more valuable forms, he expected to regain when he sold them not only his capital but more than enough to pay the interest.
Merchants, manufacturers, bankers, were constantly thus investing capital. They came to estimate in terms of capital not only the sums borrowed and lent but the value of all their own rights in the goods. Even now the capital-mode of expression is less common in the rural economy, tho it is increasingly used by farmers of the enterprising sort, who are borrowing and making improvements, getting better equipment, etc., in many cases in America going so far as to count also the original price of the land, or its present value, as a part of their capital. We may define capital in accordance with this modern view.
Capital is an expression of a person’s business power in terms of money, being the estimated price (with reference to market conditions) of the person’s property rights to income. These property rights may be composed in part of claims upon income arising from the labor of others; a promissory note given by a student of good credit, or by an inventor hoping to continue his experiments, is capital in so far as it is saleable, or bankable, tho the income from which it will be paid is to come from personal resources and not from any material agents.
Business- or industrial-capital is more specifically that part of a man’s capital which is invested in his business, from which to draw a monetary income. The value of his house, furniture, and personal belongings is capital, tho ordinarily not thought of as such, but as means of enjoyment. In an emergency they may be converted into money to be used in his business, and being part of the property available to pay his debts, they help to give him greater credit at all times. Nominal capital is the amount of shares of stock issued by a corporation, taken at their par, or nominal, amount. It may have little relation to the true investment. Where there is no regulation of stock issues, a company with no true capital may print shares of millions of dollars of nominal capital. In financial statistics, bonds as well as stocks are often included in the nominal capital (as in the reports on capital in American railroads).
§ 6. Capitalization of direct durative agents.Capitalization is the process of calculating the market-price of saleable incomes (whether sold now or not). It is the estimation of the present worth of marketable incomes. This gives us another way of defining capital: capital is any right to prospective income that can be capitalized. Capital can either be pledged, or sold outright at a price.1
Some expression of the present worth of future uses is involved in the choice made by the individual between any two uses that are not of the same time-period. It is easy to see that this is so in every case where a present stock of goods is kept for use in different periods; it is so in every case of repair of agents for future use; it is so in every case where goods are produced for the future.
Many of these choices involve the choice of an object containing a number of uses of different time-periods, which are summed up—capitalized. Take a direct durative good, such as a fan, a house, a pleasure boat, an article of clothing, etc. That on which the value of the good as a whole is based is a series of uses which can not all be present. The fan represents all the cooling drafts to be got from it not only to-day, but many days to come. Additional uses may be obtained from the house by crowding more people into it, possibly thus slightly increasing the wear, but in no way can next year’s shelter be obtained until next year. Each durative agent yields its uses through a period of time, a period usually not to be shortened except at a cost. The maximum economy of utilization (see Chapter 13) gives a series of uses at different times and of unequal present values. Each succeeding year’s use, until the agent is expected to wear out, is adjusted to the value of this year’s; that is, it is reduced to its present worth, and the sum of the present worths is the present value of the agent. Representing the total value as S (sum) and the annual incomes as a′ for the first year, etc., and the life of the agent as four years, we have:
S = present worth of (a′ + a″ + a″ ′ + a″ ″) and substituting an assumed present worth of a,
S = (10 + 9 + 8 + 7) = 34
§ 7. Capitalization of indirect durative agents. This process of valuing direct uses is extended to those indirect agents whose uses are more or less removed in time. Desires are so expansible that if the right kind and quality of direct goods could be had at will, enormously greater amounts would be used. But the continued income of present goods is dependent on durative agents. The psychic income of a civilized community is conditioned on a favorable and extremely refined environment: houses, libraries, theaters, the agencies of travel, as well as the sources supplying the more material needs. These agents, even in the richest community, are limited in variety, in quality, and in number. The present price of these goods is the capitalization of the expected uses they contain.
If a limited supply of agents could and did produce at any moment unlimited products, they would become free goods. The yield of the uses of most things depends, however, upon the lapse of time: an acre of land with the most perfect cultivation can not feed the world; but remove the limit of time, wait an eternity, and the acre would yield an infinite crop. Moreover, the economic return of agents in a given period is reached sooner than is the maximum physical return. If agents are forced to yield more bountifully, it is at the cost of other goods. A point of maximum net yield is found in any given period dependent on the rate of time-preference (see above, Chapter 21, section 10). Here also the lapse of time is the condition of the increase of the values derivable from limited agents.
§ 8. Time-price without loans. It is clear then that discounts of future uses are necessarily involved in an individual’s valuations of all his own goods which have any durativeness whatever—necessarily whether the person is conscious of it or not. The expression of this discount on the future (or premium on the present) may be and often is inexact and variable, but the fact of the discount (or premium) is always there. If this were not so and present uses in technical processes were not on the whole treated as more important than future uses, labor and resources of all kinds would be distributed impartially over the most distant periods of time. In the extreme case one might starve himself to death in youth while producing goods for his old age.
Now if these discounts are involved in valuations, they must play their part in determining the prices at which trades of objects containing different time-periods are made. Time-value bears the same relation to time-price that value of direct commodities does to their price. (See Chapter 7.) Generically the time-price problem is the same as the problem of commodity-price, and of usance-price (rent); specifically it is different only in as much as the particular value is that due to time. Collectively the valuations are the basis of price, but severally the valuations are socialized and modified by price. That is, the existence of the market gives new conditions of substitution of goods in point of time, and presents new motives and possibilities of using wealth.
Let us see how an arithmetic rate is involved in such trades, when the prices are expressed in money-terms. Trader A has a steer ready to market that will sell now for $100; he trades it to B for five calves that will sell for $102 each in three years, meantime costing to keep, including allowance for labor and trouble, $25 a year each (counted at the end of each year). A gives $100 now, plus $125 a year hence, plus $125 two years hence, plus $125 three years hence, total $475, to get a capital of $510 at the end of three years.2 In this trade there is involved a premium on the investment at the rate of 5 per cent. Do the two parties need to know this when they trade? Not exactly as an arithmetic expression, but approximately as to the outcome.
§ 9. Present price and the discount on future uses. Every exchange of a durable agent involves an estimate, rough and imperfect it may be, of that agent’s future. The practical traders, who in agreeing upon a price are thus involving a rate of capitalization of goods, are usually only dimly conscious of the logical nature of the process. In merely occasional trades the process usually goes on in a very empirical way, by the method of trial and error. The future changes are only roughly, not accurately, estimated. What each tries to do is to get as much as he can and give as little as he must, and, comparing one line of trades with another, shifts back and forth to the line that gives the best results. But the shrewd bargainer is the one who foresees more clearly than his fellows the complex changes to come or shows an intuitive sense of the net result that the common mind lacks. The ability and the inability to foresee such changes make men rich and poor. In all this bidding for capital the logical basis of the present value is the series of expected incomes. When the agent is bought outright, the very concluding of the bargain fixes a relation between the expected value of the income and the value of the capital invested. This discount on the future incomes (which is involved in the lower present price) evolves, as the agent is kept and yields the expected income, as a rate of premium on the purchase price, that is, as a rate per cent on the amount of invested capital.
There are, of course, different markets for time as for other things at the same moment and near each other. In these the time-rate varies, being high in poor economies and low in good ones. Temporarily, as in time of war, or a panic, the rate may become very high, as shown by the abrupt fall of prices in commercial centers, when prices throughout the country are but slightly affected. The communication between the different markets for investments is imperfect, and the adjustment between them of the rates of discount on future incomes is always more or less incomplete.
In the next chapter we shall see how the various kinds of monetary incomes are capitalized in the business world, how thus continuously a price on investments, or rate of return, prevails, and expresses a ratio of exchange between present and future capital (and incomes) in the market.
CAPITALIZATION OF MONETARY INCOMES
§ 1. Buying with money. § 2. Capitalization of agricultural land-incomes. § 3. Years’ purchase and rate of income on capital. § 4. Price and rate of income. § 5. Bonds and mortgages as saleable incomes. § 6. Price of variable terminable incomes. § 7. Depreciation funds. § 8. Corporate securities. § 9. Capital value of public franchises. § 10. Incomes sold in perpetuity. § 11. Bonds with fixed maturity.
§ 1. Buying with money. Where money is used the usual case is that of the sale of one good for money, which is then spent for another good. In all these trades time-preference is only one factor helping to fix the price, but the important thing to note is that it always is a factor and is logically and practically a matter for separate consideration. Wherever, to-day, there is a business income that has a market-value, that may be bought and sold, it may be capitalized. Men compete in the purchase of income-yielding agents. There is a continual contest in judgment among investors to secure the largest return for the smallest outlay. On the other hand, the owners of any income strive to secure the largest capitalization for it that they can. Buying as cheaply as they can the present goods they need, and selling as dearly as they can the future goods they offer, each man fits his valuation to the market. In any market the individual finds an established price (Chapter 7, section 6) and all he can do is to buy or to refuse to buy, sell or refuse to sell, at that price. A trader’s valuation may be such that he is an included buyer at one price, and at another price he ceases to buy and begins to sell.
§ 2. Capitalization of agricultural land-incomes. An interesting example and one of great historical importance, showing the capitalization of a series of incomes looked upon as perpetual and uniform, is agricultural land of western Europe since the latter part of the Middle Ages when money had come into more general use. Suppose the annual net income is $1000 (after deducting from rents all repairs, taxes, and other costs) and every one believes that it will continue at that amount indefinitely. The ownership of the estate represents the right to this annuity, and whatever price is paid for the ownership is the price of the whole series of incomes. As the series of incomes is looked upon as perpetual, if the future rents were to be counted as if they were already present, with no discount on their future value, the capital sum would be infinite. On the other hand, if the ownership is worth nothing just after a rent-payment when no more rents are due for a year, the discount on the future rents would be 100 per cent. Evidently either extreme is impossible, and as a fact of observation, just such purchases are made every day at a finite price bearing a pretty regular relation to the amount of the annual income. The practice is plainly indicated by the phrase in which the price for land is spoken of still in England and the continental countries—a phrase unfamiliar to American ears—as a certain number of “years’ purchase.” If an estate is sold for twenty or thirty times the annual net rental, it is said to be sold at twenty or thirty “years’ purchase,” as the case may be. This does not mean that the rental for twenty years only is sold, but that the rental in perpetuity is sold for twenty times the annual rent; that is, the land is sold outright for the amount of twenty years’ rent paid at once. The estate is looked upon primarily as providing a fixed income; the value of the permanent possession of the estate is thought of as a certain number of times the value of the income secured. “Years’ purchase” means, therefore, the length of time required for the incomes to amount to the purchasing price.
§ 3. Years’ purchase and rate of income on capital. Now at ten years’ purchase every piece of property yields 10 per cent on the capital invested (purchase price $10,000, annual income $1000); at twelve years’ purchase 8⅓ per cent; at twenty years’ purchase 5 per cent; at twenty-five years’ purchase 4 per cent, etc. Increase in the number of years’ purchase involves a reciprocal decrease in the rate of return which the original investment of capital will yield; that is, one divided by the years gives always the rate per cent of income, .10, .083, .05, .04, etc. The arithmetic process is the simple one of aliquot parts. The number of years’ purchase expresses a ratio of capitalization, thus: a : S :: 1 : 10, ten years’ purchase being a low ratio and 40 years’ purchase a high ratio. Corresponding with this is a rate of annual premium at which the price a year distant will appear in comparison with present price, the difference being a net income; thus, present principal is to future principal plus a year’s income as 100 is to 105, the rate being .05.1
Whatever the rate is, it is an arithmetical fact, entirely independent of any calculation by purchaser or lender, but necessarily resulting whenever the property changes hands at any price. Another arithmetical fact is that this rate of yield is that at which the annual income of a perpetual uniform series must be compound-discounted to produce the capital sum; that is, a perpetual series of $1000 discounted at 10 per cent gives a present worth of $10,000; or ten years’ purchase, a perpetual series of $1000 discounted at 5 per cent gives a present worth of $20,000, or 20 years’ purchase. The rate at which a perpetual series is compound-discounted to purchase a capital sum is always the rate of simple interest the investment will yield, and vice versa. The present income is worth most, next year’s less, and so on in a decreasing series. Whatever the rate prevailing, incomes infinitely distant became infinitesimally small when compound-discounted. The formula is S = when S is the present worth of all the incomes, a is the perpetual annuity, and r the rate per cent; e.g., 20,000 = ; this is equivalent to r = ; that is, the rate at which the future incomes are capitalized is the annuity divided by the capital sum; e.g., .05 =
§ 4. Price and rate of income. It may be shown by a price diagram how every price arithmetically involves a corresponding rate of premium on the present price (investment of capital) which will be unfolded as an income to the investor. Take the case of a house affording a net rent to the owner of $100 a year (after allowing for taxes, costs, depreciation). The price of the series of incomes is the amount at which the bids are brought to equilibrium, the marginal bidders being those just ready to drop out of the market if a slight change is made. This reflects the rate of time-preference in the individual economy, showing itself in the whole state of improvement and depreciation of agents in the possession of each man. B will prefer to rent so long as the house is priced at $2000 (involving a rate of 5 per cent) but prefers to buy when it is priced at $1800, a discount of 5.55 per cent. The expression of the price of time as a percentage is merely a convenience.
§ 5. Bonds and mortgages as saleable incomes. The modern corporation bond is a promise to pay an annual sum, expressed as a percentage of the principal, and to repay the principal at the definite date of maturity. A twenty year 5 per cent bond for $1000 thus is a promise to pay 19 annual incomes of $50 at the end of each year (but see note below) and one payment of $1050 at the end of the twentieth year. It could as well be termed a 20 payment $50 a year bond with a maturing value of $1000, without mentioning a rate of interest. The rate it truly yields the investor depends on the price he pays, which is fixed by market conditions. Such a bond does not necessarily sell at par (its denomination); usually it sells at a premium or at a discount. The investors treat a bond as so many incomes distributed at certain points of time, and bidding in the market fixes the market-price for future incomes of that type.2 A note secured by real-estate mortgage is like the bond, but not so marketable, and is ordinarily held by the same investor until maturity. It usually (but not always) is bought at its face value and the holder looks upon it as capital to that amount. But as it is not payable until the date named as maturity, he could, if he wished, convert it into ready funds before it is due, selling it at the best price he can get, which may be above or below par. Thus a ten year mortgage for $5000, bearing 5 per cent interest, may be looked upon as containing nine annual payments of $250 each and a tenth payment of $5250. The total undiscounted sum of all the payments is $7500; and if the mortgage is bought at par it yields an annual net income of 5 per cent on the investment; if bought above par it yields an income of less than 5 per cent (e.g., bought at $5406 it yields 4 per cent).
This is a good illustration of what is meant by capital as contrasted with wealth. If the mortgaged house will bring a price of $10,000, that is the price of the wealth; but the owner has a capital of $5000, and the holder of the mortgage has a capital of $5000—which together are the total value of the wealth.
§ 6. Price of variable and terminable incomes. Cases of entirely uniform and perpetual incomes (even in expectation) are very rare. Most incomes are variable and terminable. These are capitalized and made comparable as to present worth with a uniform and perpetual series. Incomes may change in an upward direction, more or less regularly from year to year; they may decrease or they may remain the same for a series of years and then terminate abruptly; or they may vary by any combination of these changes.
Especially in modern times real-estate rentals, formerly the type of stability, have been rapidly altered by social changes, and so far as these changes are foreseen, expected rents are made the basis for present capitalization. Investors and owners alike may foresee that a piece of land used only for agriculture will, within a few years, be taken up for city lots, or will be needed for a factory or as the site of a railroad station. A vacant lot may be held for a number of years at a good price while yielding nothing; in this case the incomes are all future, and the capitalization must be based upon the progressive series expected, beginning at zero. In some cases the physical output of any agent may decline while the price of the product increases, the resultant being perhaps a stationary yield or an increasing one. When foresters foresee that the selling price of the timber will be greater twenty-five years later than it is to-day, and they estimate the future yield of the forest on this basis, they advise expenditure that would be unwise if present prices were to continue. Again when the expected series of incomes is declining, as the royalties secured from mines, being certain to disappear at some more or less calculable date, the capital value of the mine is the present worth of a limited and degressive series of incomes.
The value of a short series may be calculated by simple arithmetical methods, and more easily by the aid of a table of present worth, when any rate of premium on the present is assumed. Suppose the rate to be .05 and the incomes expected are as follows: at the end of the 1st year, 100, of the 2nd year 75, of the 3d year 50, then ceasing. The present worth is the sum, = 95.238 + 68.027 + 43.192 = $206.46. Again it must be observed (see Chapter 22, sections 8, 9) that if the price is $206.46 it mathematically involves the rate of 5 per cent, quite independent of any thought; the calculation merely reveals and expresses exactly a rate inherent in the transaction.
§ 7. Depreciation funds. As a matter of practice the more difficult calculations of variable and terminable annuities are avoided by investors by taking the perpetual uniform series of incomes as the standard with which all the other series may be made comparable. They treat the original capital invested as a sum to be kept intact to be reinvested. The payments at the end of each year are treated as gross income to be divided between a depreciation fund sufficient to maintain the capital unimpaired at the end of the period, and net income which may either be spent or be saved (reinvested as an additional capital). In all bonds bought above par the amount to be treated as a depreciation fund is larger in proportion to the nearness of the maturity of the bond, and in turn, the more distant the date of maturity the higher the present price of a bond bought or sold above par.3 This method of calculating the capital investment as equivalent to a fixed sum of money is convenient, especially in distinguishing between income and principal. When losses are great they fall upon capital, and the income is a negative quantity. When prices of bonds rise, the income is larger than was expected, and (unless taken out in some way) is by a mere bookkeeping process counted as added to the capital, and the rate of income thereafter is reckoned on a higher basis of annual investment.4
§ 8. Corporate securities. Corporations are business enterprises which issue stock, or certificates of a share in their ownership and income. Doubtless the convenience of the sale and transfer of invested capital by the use of stock has been one of several reasons for the large increase of this form of organization since the beginning of the nineteenth century. Originally the stock of a company taken collectively represented all the capital invested, and each share entitled the owner to a given portion (called a dividend) of the total income earned. The shares are issued in regular denominations in terms of money; this amount expressed on the face of the share is the so-called nominal value, or par value, or face value.5 But as a business proves more or less profitable, the value of a share of its income rises and falls regardless of the nominal amount of stock issued. At once there is a divergence between the denomination and the market-price (often called value) of the stock. The nominal amount of stock is relatively permanent, the same year after year; it may be increased by further issues, or it may be decreased by cancelation after purchase with funds in the corporation’s treasury. But when stock is the only form of claim on the earnings that is issued, the fluctuations of the market-price of the stock record the market’s judgment of the business; that is, its expected dividends capitalized at a market-rate for investments of that grade of safety.
But in present practice there are several forms (of which stock is but one) in which corporate incomes are marketed and in which an investor may buy a share in the earnings of the business. Bonds, representing money loaned to a company and entitling their holder to regular interest payments, hold legal priority to the claims of any variety of stock. They usually do not give their owner a vote in the management or make him in the technical sense a part owner in the business. Next stands preferred stock, which entitles the owner to share first in the dividends, if there are any; and finally the common stock, which gets a share only when the other claims are satisfied. All of these are called corporate “securities,” tho they are in many cases far from “secure,” in the sense of being free from risk. By the multiplication and further variation of these readily saleable claims on industrial incomes, the investors’ desires are met more fully and with greater precision, and correspondingly the corporations more conveniently obtain the funds needed.
§ 9. Capital value of public franchises. Franchises for the use of public highways by railroad, gas, water, and lighting companies enable their owners to get incomes which can be capitalized. If a company is given the exclusive right to operate in a locality (with use of streets, alleys, public roads, and the right of eminent domain to condemn private property) any income above an average rate of return on the investment is capitalized either in the higher price of the stock or in additional stock issued without additional outlay upon the plant. If the franchise is unlimited, the income may be capitalized as practically perpetual; if the franchise is limited, and is to expire in thirty or forty years, only the limited series of privileged incomes can ordinarily be capitalized. When, however, the managers are able to exert influence enough to have the franchise extended, and the investors believe in the skill of the managers to influence the legislators by fair means or foul, the value of the stock continues higher than it could usually be under a limited franchise. Such circumstances becloud the question whether the exceptional income arising under the franchise should go to the public or to the company. The important question, however, is whether the company is entitled to the income, for if so, the capitalizing of the income somehow, as is done in every other business, is inevitable.
§ 10. Incomes sold in perpetuity. In creating any income-yielding debt, public or private, the seller is capitalizing the promise of regular incomes to be paid to the buyer. It is not essential that a debt agreement should call for the repayment of the capital sum advanced by the lender. Many if not all of the early “public stocks” were in form promises to pay an annual income perpetually (without specified date of maturity) as the “British consols” (national bonds) are to-day. They sold for whatever they would bring in the market as a means of borrowing money. They could be redeemed and canceled only by purchasing them at their price in the open market.
The sale, in the Middle Ages, of a “charge” on the rents of a landed estate, called a “rent charge,” was in very similar form.6 A landowner, wishing money to go on a crusade or to improve his estate or to invest in some other business, sold a rent-paper entitling the purchaser to receive permanently a given sum, to be paid out of the rent of the estate. The debt was a “charge” upon the rent, until it was paid. The seller gave up the right to retain that amount of rent as it came in year by year, and received a capital sum in hand. Generally he had the right to repay the sum whenever he wished and thus extinguish the rent-charge. Logically viewed, the purchaser, in buying an equitable part of the income, bought an equitable part of the rent-bearing wealth. In effect it was just like a loan except that the purchaser of the rent-charge could not demand the repayment of his money. He could, however, sell the rent-charge when he wished to get his capital out. Gradually it became usual to sell and transfer rent-papers just as is done to-day with mortgages and bonds. Rent-papers thus came in the fifteenth century to be negotiable paper in somewhat general use. There was a rise and fall of the value of the rent-paper with changes in the demand for investment in rent-charges or with changes in the security.
§ 11. Bonds with fixed maturity. The modern public and corporate bonds issued by nations, states, municipalities, and corporations, for war, public buildings, public works, such as wharves, canals, water supply, etc., are looked upon by both the borrower and the lender much in the same way as were the old annuities. The main difference is that the modern obligations promise to repay a stated capital after a stated number of years. If the income of a $1000 4 per cent bond (interest payable semi-annually) running for 20 years, is $40, and the bond sells for $900, it will yield an income of $40 each year for 19 years and an income of $1040 the 25th year, of which $900 equals the original capital invested, and $100 is the increment of value distributed over the whole period. Such a transaction would be said to net the investor 4.78 per cent. The incomes received from public bonds are paid from the proceeds of taxation and are a charge on the rents and incomes of all taxable property; and the incomes received from bonds of industrial and public service corporations are a charge on the earnings of the enterprises.
Even a deposit evidenced by an interest bearing “certificate of deposit” in a commercial bank or in a savings bank may be seen to have this same character. The bank is the borrower, exchanging the promise to pay each year, or half year, or quarter, an amount of interest proportioned to the amount deposited, and to repay the capital sum on certain agreed conditions. The life annuities sold by insurance companies preserve very closely the character of the old annuities and rent-charges, tho the annuity that can be bought for a present payment is proportionately larger than a perpetual annuity, because the number of payments is limited to the lifetime of the purchaser.
SAVING AND BORROWING
§ 1. Abstinence of the conservative kind. § 2. Cumulative abstinence. § 3. Spenders and savers. § 4. No common standard of abstinence. § 5. Saving without and with the use of money. § 6. Classes of borrowers. § 7. Victims of mischance. § 8. The chronic improvident borrower. § 9. Premium concealed in retail prices. § 10. The prodigal borrower. § 11. Students and apprentices. § 12. Becoming-owners as borrowers. § 13. The borrower for profit.
§ 1. Abstinence of the conservative kind. Abstinence is the name of that faculty of mind which enables present desires to be subordinated to future desires. Abstinence (the faculty) expresses itself in particular acts known as abstaining, or as saving. Conservative abstinence is that which keeps men from using up or invading their present stock of goods, and cumulative abstinence is that which impels them to add to that stock. There is no sharp dividing line, no abrupt break, between these two, yet on the whole they differ. Conservative abstinence is a quality of mind analogous to the inertia and momentum of physical matter, and makes men resist stubbornly a reduction of property, of income, and of an accustomed social position, even when there is little or no disposition to increase or advance them. It is this which makes nearly all men think that using up any part of their principal (when they have sold property or have collected loans) is a very different thing from regularly using up their free income. A large part of accumulation results from the operation of conservative abstinence. Through insurance for one’s family, purchase of annuities, laying up “for a rainy day” or for old age, etc., guided by the conservative quality of mind, men seek to maintain (rather than to increase) the standard of themselves or their families.
§ 2. Cumulative abstinence. Adding to wealth at the cost of a present lowering of long-accustomed standards of living is a rare occurrence; but in a large number of cases where there is no deliberate purpose to go beyond conservative abstinence, the uncertainties of life, insensible changes in the habitual standard of possession, desire to leave children a larger patrimony, etc., tend to the heaping up of wealth for heirs. It is much easier to accept a higher than a lower standard of living. Consequently, deliberate cumulative abstinence is most likely to appear at favorable times in the lives of men of rising fortunes, who, while maintaining or even increasing their scale of expenditure, are able to add to their riches. Accumulation comes to be to some men the one game they can enjoy. I recently met an old man who generously was bent on becoming richer so that, as he said, his attractive young wife might get a second husband as good as her first one.
Many successful business men evidently are accumulating not because of a desire to enjoy more material income themselves, excepting in so far as that is necessary to present success or is the evidence that they are succeeding in the present. Business has in it always something of the character of a game, and the game can not be won unless at one place and another the resources of the business are steadily enlarged. The older inexpensive equipment must be replaced by newer and more costly, the stock must be increased and the buildings enlarged, if the business is to maintain its place among competitors and outstrip them. The cumulative abstinence in such cases seems to be but an outgrowth and result, under favoring conditions, of an original conservative motive.
Abstinence of either kind is the guardian of the individual’s future against his present desires. Upon the conservative faculty depend the preservation, repair, replacement, and economic use of our environment; upon the cumulative faculty depend largely its growth and betterment. As the capital values in a community are many times as great as the savings in a single year, and as a large part of the savings result from conservative motives, it is evident that the pressure and resistance of conservative abstinence against present desires must be steadily many times as great as that exerted by cumulative abstinence.
§ 3. Spenders and savers. The uniform preference for present over future would lead a Robinson Crusoe to use up and wear out his wealth, and to apply all his labor to present enjoyment, even on the penalty of future misery. On the other hand, the excessive preference for the future over the present would condemn him to the miser’s fate of misery and starvation in the midst of wealth. Evidently somewhere between these two extremes he must settle upon some rule of life and habit of choice that involves a ratio of exchange of present and future uses. The world is made up of people each with his habit of choice, not absolutely fixed, slowly changing with years, with education and with circumstances, and occasionally broken into by impulse. Members of families and of groups show some likeness in their habits of choice. Each one having separate control over incomes through the institution of private property, is able to maintain his own standards. It is a matter of degree, ranging from those who spend all they can get hold of, to those who save nearly all. Thus at any time the community is made up of those who are spending more than their incomes, those who are spending just up to their incomes (the large class of conservative abstainers), and those who are spending less than their incomes (the cumulative abstainers). This psychological difference between abstainers and prodigals varies from one person to another, depending on natural temperament, on habit bred of family and community customs and training, and on states of health and on moods affecting the appetites, the imagination, the conscience, and the will.
§ 4. No common standard of abstinence. It must not be thought that any two men’s savings in terms of dollars express the comparative degrees of abstinence, sacrifice, suffering, deprivation, etc., of the two men. A poor man denies himself many simple comforts for years to pay $1000 for a little home; a rich man may be able to buy $100,000 of bonds with a fraction of the profits of a rising business or of a growing income from investments while increasing his living expenses in all directions. It is absurd to suggest that the latter has abstained a hundred times as much as the former in a subjective sense.
It might seem that it would be easier for a well-fed, well-clothed, well-housed man to exercise abstinence than for a hungry, ill-clad man with no roof over his head. But neither saving nor prodigality is regularly related to any particular state of fortune or is found exclusively among either rich or poor. A poor peasant living on the most meager fare may possess in high degree the quality of abstinence which is entirely lacking in the rich spendthrift. A man well on in life with a simple standard of living can easily save a large share of an increasing income.
Abstinence is a resultant of the opposing forces of desire in the one man’s will. Both of the poor man’s desires dependent on a dollar may be very strong (we have no psychic standard unit) but the desire for present enjoyment be the stronger; whereas both the rich man’s desires that are dependent on a thousand dollars may be very weak, yet the desire for the present good be the weaker. Natural differences in temperament combine with education, habit, and the imitation of prevailing standards to make desires mild or intense. Saving may result when a vivid imagination aids in making the future desire stronger than present strong impulse; or it may result when very simple tastes fixed by habit are combined with equally habitual and unreasoning frugality. The magnitude of 10 minus 8 is greater than that of 100 minus 99. Two men’s powers of abstinence can not be numerically compared, but the objective results appearing in the amounts saved can be compared.
§ 5. Saving without and with the use of money. Abstinence of the conservative sort shows its results in keeping in repair and providing for the replacement of fertile soil, ditches, fences, houses, tools, and equipment of every kind in the owner’s possession. Much of this does not need to take the money form, but much of it does, as in payment of wages and purchase of materials to keep up repairs, and in the laying aside of a depreciation fund, or the provision of insurance to replace the agents when destroyed. It calls for positive effort on the part of the owner to resist treating gross usance and receipts of his fields, tools and other equipment as a disposable income, in order to enjoy a more bountiful present at the expense of the future. In many ways one may “borrow from the future” without borrowing from any person (unless it be one’s self).
Abstinence of the cumulative sort likewise can and does in large measure take the form of saving in kind rather than in money. One has but to dispose of his labor and wealth so as to use in each period less than the full net income of the period and to put the surplus into durable forms yielding future incomes. The pressure of present desire is so great, and so many unexpected present needs crowd upon men, that few find it possible or think it possible to save much in this way, and fewer still find it easy.
When incomes are received in money, saving usually takes that form. Every clear dollar of money income (after providing for the maintenance of the principal) is disposable either as present enjoyment or as savings to constitute a new capital. This may be done by buying labor and materials to build new agents, “adding barn to barn,” or it may be by buying other durative direct agents, as a house to live in where one has been paying rent, or it may be by buying durative indirect agents, as a horse and plow which one has had to hire for use in his own fields. Or the money may be used to purchase a factory, or to hire laborers and to buy materials to create a new industry.
A large part of money savings, however, takes the contractual form. The saver may take out an insurance policy. He may deposit in a savings bank (or commercial bank with a savings department) and get from 2 to 4 per cent interest, the bank in turn buying bonds of corporations, or making loans on mortgage security at a higher rate of interest. He may loan to a business man or to a house builder, taking notes and mortgages, or he may buy bonds and mortgages from a corporation. In all these cases the money loaned is transferred to another, and if wisely invested, will produce new incomes. Money saved can be made to yield an income only by being spent—that is, invested in some way.1
§ 6. Classes of borrowers. A distinction is usually made according to the purpose of the borrower, between two main classes of loans: consumptive and productive loans. Consumptive is the adjective usually applied to a loan made for the direct use of one’s self (or of one’s dependents). It is borrowing by a spender, and virtually undoes, negatives, the act of the abstainer. This was almost the only kind of borrowing before the development of modern money markets. Among the many varieties of circumstances in real life several types of consumptive borrowers are distinguishable: (1) the victim of chance, (2) the chronic improvident, (3) the prodigal, (4) students or apprentices, and (5) abstaining users, or becoming-owners.
§ 7. Victims of mischance. Some kinds of misfortune are comparatively rare, are difficult if not impossible to provide against, and fall with overwhelming weight upon the unprepared victim. Such misfortunes are fires, floods, hurricanes, earthquakes, failure of crops through drought, excessive rain, pests, hail and windstorms; such are bodily accident through burns, cuts, falls, crushing weights and strains, which partially or completely, temporarily or permanently, disable from labor, or cause the death of a breadwinning member of the family. Such also are many industrial accidents as the cutting off of the usual employment through failure of the sources of materials, loss of vessels in transit, brigandage, war, etc. In all such cases the victim’s condition suddenly falls below the accustomed and the normal. Sometimes immediate food, fuel, and clothing are a necessity of bare existence. One standing face to face with starvation can not be worse off a year hence; nearly always there is some ground to hope that if the present misfortune can be relieved, fate will be kinder in future. One who expects to be better provided in the future will choose to pay a premium for a loan. When the present misfortune is far short of starvation, and is but a certain measure of inconvenience, the same kind of a motive exists, tho in a lesser degree. A loan at such a time, it must be remembered, is but the choice of the least of evils. If the person can not borrow he is tempted to increase his too small present income by converting, pledging, or selling, his control over future income. He may do this at great cost (equivalent to a large discount) by treating the present tangible wealth as if it were income, eating up the seed corn, and neglecting repairs on house and field and tools. Or he may exchange his durative wealth to get a larger present control of enjoyable goods. This, at a forced sale or in an unfavorable market, he can do only at low prices, much lower than must be paid to replace them.2
To one faced with such a choice the pawnbroker with his exacting terms must at the moment appear as a benefactor. He has not created the distress; he appears to offer the best way out of it. A defect of this alternative is that the loan is not made in a true market. There exists no true market for making such loans. The necessitous borrower usually is forced to make an isolated trade where he is in no position to higgle, where he must make the utmost concession to a hard bargainer. Such opportunities attract and develop a class of grasping usurers, “the loan sharks,” who hold the victims of chattel mortgages in a veritable serfdom. The hard bargain is made still harder by other arbitrary and dishonest exactions for renewing the loan. Tho the object pledged may be of little value to others, it often has a personal and sentimental value (as an heirloom or a keepsake) so that the borrower will make great efforts to prevent its forfeiture.
§ 8. The chronic improvident borrower. Another type of necessitous, would-be borrower is the chronic improvident. Not only mental incompetents and drunkards, but many honest families live always near the border of want. It needs no general catastrophe, or no very unusual bodily or industrial accident, to reduce them to distress. Such persons and families, it must be remembered, are always outside of the normal loan market. They are not able to borrow enough to bring their rate of time-preference into uniformity with the market rate of interest. The kind and amount of security (pledges of capital) they have to offer is not acceptable, small loans to them involve such elements of risk and trouble, that ordinarily they can not borrow at perhaps double the prevailing market rate. Within their own economies, therefore, all things are adjusted to a high rate of time-discount. When fortune frowns they too go to the usurer, taking with them the best pledge they can offer. An artist, now successful, tells that he and his wife have a peculiar affection for her engagement ring, because it paid their rent so many times—to the pawn shop at the beginning of each month, and back home again whenever any pictures were sold. Some struggling artists and inventors as well as gamblers and horsemen come to know the pawning value of every belonging—rings, stick-pin, watch, etc. In times of prosperity their saving takes the form of gold ornaments and diamonds (which make good pledges) as they dare not trust themselves to keep money until the time of dire distress. A struggling student of my acquaintance in New York walked twelve miles to exchange a Mexican dollar (his last coin) for forty-four cents with which to buy crackers. A very high rate of premium on present goods was involved in that action. The fact is that even the most improvident and ill-provided families have, involved in their domestic economies, a more or less definite rate of time-preference, and only when the pressure of present desire greatly increases, do they bring their scanty pledges to borrow money as the best way to adjust their incomes in accord with their time-choice.3
§ 9. Premium concealed in retail prices. The borrowing of goods without agreement to pay interest usually involves a premium on present goods. The high rate of time-preference among the chronically improvident is the foundation of the credit system in retail stores. In some cases merchants will not sell cheaper for cash than for credit, for fear of offending their main body of credit customers; but there are good reasons why such a difference should be made, and usually it is made if the buyer for cash quietly urges his proposition. In many stores there are two appreciably different prices, one for “slow pay,” the other for “spot cash.” Some stores specialize on the slow pay customers and sell on the instalment plan, assuring everybody, “Your credit is good here.” If a bill paid at the end of the month is 5 per cent more than what may be called the fair cash price, the difference is equal to 60 per cent per annum on the month’s average expenditure. This much is often paid by perfectly honest persons for the privilege of postponing payment. If a man with an income of $50 a month is always behind a month, and as a result pays 5 per cent premium on his purchases over cash prices, he is losing $2.50 a month, $30 a year, or 60 per cent of one month’s salary, the amount which he is always in debt. Such a premium is paid only by the improvident, but that is a large class with recruits as well from colleges as from factories. Shopkeepers are forced to make this difference to earn the equivalent of interest on the capital thus invested, and to recover the costs of bookkeeping and collections, and the risk and loss of unpaid bills. The high rate paid by the purchaser becomes only a low net rate, on the average, to the shopkeeper. The economical thing for the customer to do would be to retrench expenses rigorously until he “gets $50 ahead” and is able to pay cash. He would be able to use this so as to increase his real income by $30 worth of goods a year; and meantime, and in any case, he could gain $2.08 a month by borrowing $50 at 10 per cent interest (42 cents a month) exorbitant as that rate seems, and paying cash for everything. The obstacle usually is weakness of will power.
The notoriously high retail prices paid by the poor even for cash purchases when made in very small quantities, is a penalty of the same kind for lack of a little capital. They buy a pound of sugar, instead of a dollar’s worth, a bucketful of coal instead of a ton at a time, etc., a practice costly of their own time and of the small shopkeeper’s time who must get higher prices to make a bare living selling in that way. The time-premium outgo from the customer is usually not a corresponding time-premium income to the merchant, but merely pays for services and other store expenses.
Probably we should class as examples of the same type of loans, on a large scale, those made by governments in time of war. If the national territory, or the real or supposed national interests and honor, are threatened, the citizens often value them beyond any possible money-price. To win they are ready to sacrifice their lives, a fortiori they are ready to sacrifice a part of their material fortunes. The immediate need is large supplies to feed soldiers and to arm them with tools to burn, batter, and blow up the enemy. High rates of interest are offered by the government and large obligations are assumed for the future, to tempt its own citizens or those of foreign states to furnish the money to buy these supplies and instruments of destruction.
§ 10. The prodigal borrower. The peculiarity of the prodigal type of consumptive borrower is in the artificial, self-indulgent, subjective character of the desires that impel him to borrow. He has capital, relatively a good deal of it. A prodigal usually is one who has come into his fortune by chance—inheritance, gambling, a lucky stroke of business—and therefore is without discipline in thrift. With a habitual high rate of time-preference, he comes into sudden possession of incomes capitalized at a low rate. He is impatient at the slowness with which the incomes ripen, and he takes measures to hasten them to gratify desires long latent, and now upspringing, often in a favoring atmosphere of flattery, vanity, and false friendship. Sometimes he meets the difficulty by selling some property; or he temporizes and borrows money with a vague hope that some way may be found to retain his property. When interest is 10 per cent, a promise of a hundred dollars a year gives immediate control of a thousand dollars; when 5 per cent, control of two thousand dollars. Lacking business experience he is not likely to find the best form of loan. To secure an immediate loan he lightly agrees to pay an exorbitant rate of interest often made necessary by the prospect of his financial collapse. It is clear that the high rate of interest he pays is but a reflection of a time-valuation that already exists in his mind. The net result of such a course is a transfer of property from the prodigal to others, a wasteful transfer in which often scheming and avaricious men gain unjustly, and often the savings of true abstainers are transformed into riotous living and foolish display.
§ 11. Students and apprentices. We come now to some cases of consumptive loans with a more provident motive, that of increasing the future earning-power of the borrower. A student borrows money to spend for food, clothing, textbooks, tuition, etc., needed while taking a course in college. When he borrows he has little earning-power, but with that faith in himself which makes the young American so interesting, he pictures himself four years later, sheepskin in hand, drawing a munificent salary with which he can easily satisfy the most exacting Shylock. Apprentices, young lawyers waiting for clients, physicians slowly gaining a practice, business men “working up trade,” have enough faith in themselves to borrow meantime what they need to live on. They may be disappointed and suffer loss, but hope supplies their motive in borrowing.4
In this type of consumptive loans we see a very different motive from the former types. The borrower is looking to future needs, not to present indulgence, and the loan is useless for its purpose unless he supplements it with a true abstainer’s spirit, adding his industry, self-denial, and forethought to attain the end of his education. This type of consumptive loan is often economically better than one to spend upon material production.
§ 12. Becoming-owners as borrowers. The fifth type of consumptive borrower, the becoming-owner, has also a provident motive. He borrows not in order to consume more wealth than he otherwise could, but in order to pay for it by a different method, namely, under the interest contract instead of under the renting contract. To do this he borrows the money to buy the agent in use, and becomes its owner. His right is not absolute but is qualified by the equity of the creditor to whom the property is pledged. (Chapter 22, section 3.) This condition might continue without any effort of the borrower to save and thus reduce the debt; but so generally is this kind of loan prompted by motives of thrift and made in anticipation of and as an aid to saving, that such borrowers deserve to be called abstaining users.
Of this type are purchases on credit or on the instalment plan of sewing machines, typewriters, and many other laborsaving machines, not as added means of direct enjoyment (such as are automobiles, canoes, pianos) but as better means of obtaining direct goods without the sale of products. Of this kind also is the loan to build a house for the borrower, or to buy outright anything of a kind already used by him under the renting contract (as a farm considered as a direct good, a house to live in, a source of food for the family, etc.). If one who has been renting house, farm, machine, etc., ceases to rent and buys under the interest contract, he assumes a new responsibility as the legal owner of the wealth, but often he reaps a benefit by the change. The gross rent paid by a tenant (Chapter 15, section 2) must include not only taxes and repairs, but something to cover risk of bad collections, trouble of management, damage through carelessness of tenants, etc. Rent of a good grade of house built for tenants5 is therefore usually 10 per cent of the selling price, and not infrequently higher, being, it is said, as high as 25 per cent on bad tenements where risk, damage, and trouble are especially great. A man living in a $2400 house and paying $20 a month rent, and able to borrow at 6 per cent could buy the house, pay $12 a month interest, and out of the balance of $8, after paying taxes and repairs, have something left as a sinking fund. By saving a few dollars more each month he can, within a few years, become the absolute owner. His pride and pleasure as an owner often leads him to add further to the value of his investment by making improvements in yard and buildings which he would not make as a tenant.
The great capital in the building and loan associations, over a billion and a quarter dollars in 1914, is slowly becoming the absolute property of the borrowing owners, whose places are taken by others thus acquiring homes. This capital, large as it seems, is but a fraction of the amount constantly being acquired in this way by owners of homes mortgaged to savings banks, to corporations (universities, philanthropic endowments, etc.) and to private lenders, directly or through lending agencies.
§ 13. The borrower for profit. The term “productive loan”6 has generally been applied to the borrowing of capital to be used in carrying on of business either mercantile or manufacturing—that is, in buying goods to sell again. The borrower is a middleman whose motive is to get a “profit” by sale to an ultimate user. This type of loan must be more fully discussed in connection with the problem of enterprise and profit, and only the briefest indication of the relation of the interest-rate to capitalization need here be given. The borrower expects to pay the interest out of the surplus income (over and above the capital investment) which the sale of the products will put into his hands. This success in getting a surplus large enough to leave him a balance sufficient to pay interest depends on his investing the money in agents not capitalized too high; any balance of profit depends on his selecting a kind of agents and so directing their use, that he can make them earn more than the market rate of interest.
CAPITALIZATION AND INTEREST
§ 1. Interest subsequent to time-price. § 2. Origin and definition of the term interest. § 3. Interest versus income, or gross versus net interest. § 4. Concealed rate of interest. § 5. Commercial paper. § 6. Mercantile cash discounts. § 7. Long-time loans. § 8. Special markets for money loans. § 9. Capitalization, the clue to the general interest rate. § 10. Time-series of incomes, monetary and non-monetary. § 11. Present dollars and what they can buy. § 12. Blending of the investment premiums into a common rate. § 13. Indicative nature of the interest rate.
§ 1. Interest subsequent to time-price. There remains to consider that form of a price for time which is most prominent in the thoughts of men in the business world, which therefore often is the only form that is recognized—namely, interest on a loan of money, or on credit expressed in terms of money. The buying and selling of anything for a price expressed arithmetically was very unusual until some form of money came into use; and this was particularly true of the sale of timeliness in a barter economy. The loaning of money occurred in the commercial cities of ancient times, but for a long period, in the Middle Ages, was very unusual. The practice again became common in commercial cities of Europe about the fifteenth and sixteenth centuries. The deepest thinkers from Aristotle (bc 384-322) to Thomas Aquinas (1224-1274 ad) could see nothing in a money-loan but its superficial money-aspect, nothing of its underlying economic nature, and they studied the problem only as one of morals. When, despite all the disapproval of philosophic moralists of church and state, the practice of money loans had become common in commercial circles in cities, the earlier economists began to attempt an explanation of the phenomena. A prevailing rate of premium on money-loans appeared only where money was in use, and therefore at first was deemed to be peculiarly connected with the quantity of money in the country. This idea still widely persists, is indeed the naïve theory of every mind until it is corrected by some economic thought. Some economists began to see that the rate of interest on money-loans was somehow a reflection of the general state of wealth of the community, and was not in the long run dependent on the quantity of money in the community. Behind the problem of the rate on contractual loans was seen to be a more fundamental economic problem of value. The explanation of the problem was, however, still begun in the market for contractual loans, the so-called money market. We, having studied the nature of time-preference and of capitalization, are in a position from which to view money-loans in a different way, and to see them in their true character as merely forms in which time-preference sometimes appears in an economy where money is in general use and borrowing is common in commercial affairs.
§ 2. Origin and definition of the term interest. The term interest,1 applied in the Middle Ages to a payment for the use of a money loan, was first a substitute for the word usury. It was intended, by indicating that the lender had something involved in the business, to soften the general opposition of the church and of public opinion to such agreements.
The word interest will be here defined in its original meaning, still almost universal in business circles, to wit: Interest is the amount paid and received according to a contract for credit given in terms of money. Credit is the postponement of the right of either party in an exchange to require immediate delivery of the price agreed upon. The creditor puts faith (credence) in the promise of the debtor. The rate of interest is the percentage that the interest (usually for one year) makes of the principal. The principal is the amount loaned expressed in dollars as a capital sum estimated apart from the interest. Interest, in this sense, always is a price, and not simply an individual’s estimate. Its amount is always stipulated by a contract between persons (expressed or implied, as either the customary amount or the legal amount specified by statute law). The interest contract may not illogically be looked upon as a special case of the rent contract, the thing rented being a stated amount of money (the standard of deferred payments or things acceptable to the lender as of equal value) and the rent (interest) being a smaller amount of money. Interest is payable at stipulated periods until the money loaned is returned. The expression of the interest as a percentage (rate of interest) is of great practical convenience, permitting as it does payment of parts of the principal and for partial periods of a year without alteration of the contract. Moreover, the expression of interest as a rate per cent of the principal gives to the interest problem an aspect very different from any presented by the rent problem.2
§ 3. Interest versus income, or gross versus net income. The sum paid as interest on a loan and the rate specified contain other elements than a pure time-price. This is recognized constantly in practice and must be observed in theory. Gross interest must be distinguished from net interest. The lender does not, as in most cases of rent, have to make allowance for repairs and for physical depreciation of the objects loaned, for the borrower is bound to return the specific standard of payment; but allowance must be made first for risk, or the chance that the money will not be all returned or paid promptly. Risk and trouble are to interest what depreciation and repairs are to rent. (Chapter 15, section 2.) Money loaned in hazardous ventures must yield a higher contractual rate of interest to offset this, or the true rate realized will, on the average, be less than the market rate. The lender may in the end get either more or less than the usual interest, or even get negative interest through the loss of a whole or a part of his capital. A lender strives in making a number of loans to have the gains cancel the losses, so that the capital may be kept intact, besides yielding a net income (interest).
The lender must also count the cost of placing, supervising, and collecting the loan. A pawnbroker lends only small sums and spends much time and effort to keep at interest a moderate capital. The sum of $5000 loaned for a year in sums averaging $10 represents 500 transactions, yet if placed at 5 per cent it yields an income of but $250 a year.3 While, therefore, the borrower of a small sum may think he is paying an oppressively high rate of interest, the lender may find that the loan nets him a very small rate of income on the investment. Risk, labor, and the various costs of carrying on the business of lending money, are thus costs in exchanging things of different time-periods which are analogous to transportation charges in exchanging things at different places, narrowing the margin of advantage and excluding many from the exchange.
§ 4. Concealed rate of interest. Interest is often concealed under forms which make the real rate greater than the nominal, or apparent, rate. It is well known that usury laws fixing the legal rate of interest are often evaded. A simple method is for the lender to charge a commission for making the loan, or, if the lender is a bank, to charge for a pretended cost of exchange to bring the money from some other city. Sometimes the borrower is required to keep larger deposits with the bank than he voluntarily would, which he does by borrowing and paying interest on a larger sum that he is permitted to use. Again the borrower, in periods of unusual demands for money, may be forced to make a long loan instead of a short one. When a one month’s loan at 10 per cent would meet his need, he may be forced to borrow for twelve months at 6 per cent, during ten months of which time 4 or 5 per cent is the prevailing rate. In these and other ways the real amount and the real rate of interest are made different from those that are expressed.
§ 5. Commercial paper. Interest-bearing loans may be roughly divided into short-time and long-time loans, according as they run for less than a year or for a year or more. In short-time loans the creditor’s claim may rest either on a verbal agreement or on a written promissory note. Short-term interest contracts are implied in a large proportion of the transactions of modern commerce. A considerable number of short-time loans are made for direct enjoyable use to individuals whose money income is delayed or inconveniently apportioned in time. But a far larger number of such loans are made by banks on promissory notes given by manufacturers and merchants, frequently secured by bills of lading for goods that have been shipped to customers or by various other evidences of existing credits. Such documents are called commercial paper, or credit instruments.
§ 6. Mercantile cash discounts. When goods are sold on time (as thirty, sixty, or ninety days) the contract (except in rare cases where the terms are net cash) is an implied interest contract, for it specifies that the full sum shall be charged only when the full time elapses; otherwise the discounts for cash are at various figures, such as 1, 2, or 6 per cent or even higher for payment in ten days (giving time enough to examine the goods), and smaller rates for thirty days or other periods. This virtually makes two or more prices, one to customers that pay cash, and another to those letting bills run. The difference between cash in ten days and a discount of 1 per cent in thirty days is equivalent to a rate of 18 per cent a year on the amount of the bill, and is so great that it is impossible without taking advantage of the discount, for a buyer to carry on a business against strong competition. Such purchases on credit frequently are made, however, not only by dealers in small towns, but sometimes by large mercantile establishments when short of funds. “Slow collections” go along with increasing interest rates and “hard times.”
If the purchaser does not discount his bills, the seller has the choice either of waiting till the account is due and collecting the bills direct from the customers, or of discounting the customers’ acceptances (notes) for ready money at the bank. According to the conditions and needs of the particular business, either method may be chosen. A series of credits is then created, each resting upon the one below: manufacturer A sells goods to manufacturer B, who sells the finished product to the jobber C, who sells it to the retailer D, who sells it to consumer E, and all these credits for the same goods may be in existence at the same time, and every one may be represented by a promissory note that may be discounted at a bank. In most industries there is need for larger capital at the seasons when the product is put upon the market, and ordinarily a large part of these debts are converted into ready funds (discounted) at the banks. The merchant or manufacturer plans his business in the expectation of an average rate of interest at such times, and if it chances that the rate is abnormally high, he has no choice but to go on borrowing and paying the high rate of interest out of the expected profits of his business. This risk of a change in the interest rate is one of the many chances he has to run.
§ 7. Long-time loans. A large part of the debts in modern times are outstanding for a term of years and represent the lender’s purchase of a claim on income from public or private sources. The most familiar form of long-time loan is that made on the security of real estate, which is mortgaged to the lender for the term of the debt. Usually the debtor is obliged to pay the interest either annually or semi-annually, and often, but not always, is permitted to reduce the principal by partial payments. These real-estate mortgages rest on the security of the particular mortgaged wealth, and, unlike most short-time loans in bank, are not obligations resting primarily on the general credit of the borrower. Corporation bonds, issued by railroads and other public utility corporations, which have increased so greatly in recent years, yield an income fixed in advance, and are secured usually by mortgage on the entire property of the corporation issuing them. (The income on some special kinds of “preferred stocks” is so certain as to make them for investors almost the same as bonds, but they are legally not loans, payable at a certain time, but are evidences of ownership.) Another large class of long-time loans are those made by national, state, and local governments. Tens of billions of dollars of public debts are now outstanding, held by private investors in every walk of life.
The contract in the case of each kind of these loans provides for a fixed term after which the borrower must repay or renew, and for a fixed rate on the nominal or par value of the loan. Nearly all the securities (bonds, certificates, evidences of indebtedness) are saleable at a market rate. The incomes are fixed, the selling price (or capital value) fluctuating above or below the nominal sum except just at the moment when the debt falls due.
§ 8. Special markets for money loans. The choice of timeliness is possible in a market along any one of many series of incomes, but in commercial circles trade in timeliness most commonly takes the form of money-loans. Let us see how this would appear. Let lender A offer some dollars at 10 per cent interest (or more); let borrower B be ready to borrow some dollars at 16 per cent (or any less). Then there is a motive for trade (omitting fractions) for a loan at any rate between 15 and 11, let us say 13 per cent. But this motive exists only with respect to certain marginal units of money, not without limits. A could not give up all his control over income during the year for 13 per cent for that would mean greater present deprivation than he chooses to make; B would not borrow much beyond a certain amount even at less than 13 per cent, for he would have to pay interest either for less urgent personal desires (consumption loans) or to get control of incomes which to him will yield a smaller surplus.4
If there are numerous competing would-be lenders and borrowers there is a true lending market. The various preference rates (each regarding successive dollars, viewed with relation to the marginal valuation) unite into hypothetical bidders’ curves (as in the market for commodities, see Chapter 7) and a price results that establishes equilibrium between demand and offer.5 So in a market all the individual bids that are satisfied and enter into the making of the marketprice are modified by trade; the urgent bidder (or bidders) on either side are included on the marginal principle, the units most easily spared being loaned, the units most urgently desired being borrowed. As in the market for objective commodities, so in the market for loans, the valuations of the various individuals within a certain range are thus brought into conformity with the market-price. The earlier isolated valuations cease to be actual; they are, as we look back at them, merely of historical interest, and as we look forward, are only hypothetical, being the rates at which preference would appear under other conditions than the present. (See Chapter 7, section 7.)
Under these conditions the price of loans (expressed as a rate of interest) has to the superficial view an appearance of independence, as if the market for loans were a thing apart from the existing premium involved in capitalization. But this loan market could not exist apart from an existing status of prices. Money borrowed to keep would indeed be barren of any income; it would even cease to be money.6 The representative character of money makes a loan mean to the borrower the loan of whatever use-yielding, or whatever rent-bearing, agent can be bought with the amount of money borrowed; and makes it mean to the lender parting with the purchasing power to buy goods at their present prices. The loan market is meaningless and motiveless, if it be thought of as cut off from the existing system of prices (capitalization).
§ 9. Capitalization, the clue to the general interest rate. In agreeing to pay interest at a certain rate, the borrower is obviously selling to the lender the right to collect a series of future money incomes including the return of the principal, and is in return buying a present sum of money. The principal is the result of capitalizing the incomes, so discounted that they will emerge at the rate of interest specified on the investment of capital. A thousand dollars at 5 per cent will yield an income of $50 a year until the principal is repaid. The loan is in perpetuity unless a date of payment is named. The form of the loan at interest plainly is that of the exchange of a larger (future) sum of money for a smaller (present) one. From ancient times this has seemed on the face of things a moral wrong to the borrower and an economic mystery, therefore an economic absurdity. “Money is barren,” said Aristotle, and his thought is often echoed to-day in communistic arguments against the loan of money at interest. “The borrower pays interest and agrees to this unequal bargain because he is made to pay,” is declared on the one side; “he pays because he can afford to pay,” is answered from the other. Both statements may be right yet their very form indicates that the problem is looked upon as one of morality rather than of economics. The borrower doubtless would not make such an agreement unless he chose to do so; his choice, as every choice, may be thought of as due to economic pressure or to economic advantage, as a choice of evils or a choice of benefits. Why must he (can he be made to) pay interest if he is to get the loan? How can he afford to pay interest?
After the foregoing study of time-preference and capitalization we have not far to go to find the explanation of the contractual rate of interest at which incomes are yielded on money loans. No borrower would or could, for long, pay interest on money and let it lie in a chest. What does he do with it? He buys things. Everything he can buy has a price, is capitalized, and the explanation of the interest rate lies in the relation between the price of goods that present money will buy, and the price of the series of incomes which those goods will afford up to the time of the repayment of the loan.
§ 10. Time-series of incomes, monetary and non-monetary. Before ever a money-loan was made, before even money had come into existence in the world, time-preference existed. It lies in the very nature of choice by animals and by savages. (See Chapter 20, section 2.) In many ways it is interwoven into the valuations of every self-sufficing economy in the days of barter. It becomes generalized as a prevailing rate in each individual’s economy and as a price for timeliness in all exchanges of goods and uses of different time-periods. The rate becomes equalized as between different series of uses, as the rate of time-preference and of time-price can not consistently be greatly unequal within any circle where time-choice is possible.7 The use of money in trade gave much greater exactness to this time-price as embodied in goods and to their prices in relation to the times of their use. To-day in the innumerable valuations of many business enterprises where there is no monetary borrowing and lending time-preference expresses itself in the capitalization (price) of the durative agents of the environment. Every loan of money (or of goods in terms of money) at interest therefore occurs where the price of goods already embodies this premium on the present possession. Indeed it is simply this which would give a borrower a motive for a new loan. Here are many different agents and many series of yields, the price of all of them expressed in terms of the money unit (let us say the dollar). The money prices involve the rate of premium on present valuations (and correspondingly a discount on future prices).
§ 11. Present dollars and what they can buy. A present dollar is purchasing power that gives possession of future incomes at discounted prices. The market would present itself something like the (greatly simplified) illustrative table. Whoever has a disposable dollar which he does not need or choose to use for present desires, may either buy something and hold it for the expected increase, or he may by the method of money loans lend it to another person to do the same. It matters not how the dollar happened to be disposable, whether it was stolen, or was received in payment for some other property, or is new savings from interest on other loans, or from wages, etc.; in any case the dollar gets its power of earning interest from this prevailing discount on the future, involved in prices. Because of this fact the owner of a dollar possesses an economic power which he can assign by contract to a borrower. Interest then might be described as the price paid by a borrower for the right to buy goods at discounted prices. Money is a generalized present good, and when loaned at interest is exchanged for the promise of future goods at a ratio reflecting prevailing capitalization.
§ 12. Blending of the investment premiums into a common rate. Now given the existence of these parallel series of time-prices in different lines of agents and products, it follows that they must, so far as exchange takes place among men, tend to embody a common rate. Aside from differences in the difficulty of keeping, ease of management, etc., all these series must, by the law of substitution, be leveled toward a common rate of income. This would include money also, for in its function as a medium of exchange, money will be spent always for the thing which at the moment has the highest value. In the hands of an investor buying money incomes, the money will be spent in the way to buy (other things equal, trouble, risk, etc.) the largest net income. Therefore, the bidding of investors for whichever income is offered at the lowest capitalization tends to level (up or down) the investment-power of a dollar in all the options of present goods offered. The different choices blend, in a variety of ways, into the common rate of which the interest rate is the superficial expression. As happens in the exchange of commodities, the individual valuations vary from the market-price—as a result of different circumstances of age, health, ability for business and liking for it, particular tastes inclining to this or that business, etc. This variation of values from market-price leads men to become borrowers or lenders, in this or that line of investment. The individual takes the marketrate as a fact, and adjusts his own conduct to it.8 Money being at the same time the medium of exchange, the common denominator of prices and the standard of deferred payments, is the unit in which all these valuations are expressed. In one from preëminently, the interest contract, the rate of timepreference comes to a definite arithmetic expression. The rate of interest sometimes appears to be the determining factor, whereas it is but the reflection of the choice of timeliness in the whole economic situation.
§ 13. Indicative nature of the interest rate. We have now before us the broad outlines of the theories of time-value, of capitalization, and of the rate of interest on money-loans. We understand how these are but aspects of the same problem, and how the market-rate of interest (after due allowance for risk and other deductions) registers a prevailing price for timeliness, which pervades the whole economic structure of society. Money is the unit in which capital and interest are expressed, but money is no more their cause than the hands of the clock are the cause of the time of day. And the rate of interest is no more the cause of time-preference than the shadow on the sun dial is the cause of the rotation of the earth on its axis. The interest-rate is but an index of the ratio inherent in the equilibrium of psychological forces, desires for present and future incomes; that is, time-preference. A change in the mental habits, in regard to this choice, on the part of any considerable number of men, must change the general distribution in time of the entire series of incomes under the control of men, collectively. Future incomes are maintained only through the constant exercise of the faculty of abstinence. This conserving and dynamic influence of abstinence we shall study further in Chapter 38.
[1 ]Agreeable or disagreeable mean here only so in accord with (in agreement with) the nervous organization (or vice versa) that the animal reaches out toward, or withdraws from, the object.
[2 ]See note on “Present and future goods, uses, desires,” at end of chapter.
[3 ]But see ch. 21, sec. 7, for examples of individual differences in estimates.
[4 ]This proposition that present goods of specific kinds are often valued less than the prospect of like goods later has been so strongly emphasized here because a different statement is often met in economic writings, namely, that present goods are always worth more than future goods of like kind and quantity. The erroneous idea results from thinking in terms of money, the loan of which in a developed money economy comes to command a general prevailing premium, to which the prices of other goods are adjusted. But a piece of money itself may be worth less now than later.
[5 ]It is true that in the social insects (bees and ants) and occasionally among some higher animals (squirrels), the storing of food is an act of instinctive choice and is continued even in circumstances where the least forethought would show the futility of the process. But in man this choice seems to be possible only by the aid of forethought and reason, or of habit acquired by the individual through the earlier exercise of these faculties.
[6 ]Review ch. 10, sec. 4, on the use of indirect agents for hastening the uses of goods.
[7 ]Review ch. 10, sec. 3, on the relation of time to value, and sec. 5 on agencies for postponing the uses of goods.
[8 ]Each of the four types of value is presented in manifold combinations with the other three. Time-preference is interwoven in the choice of things with relation to place, stuff, form. Time-value as a matter of analysis may be deemed to be added (algebraically either as plus or minus) to the other values in determining the sum of value in a good.
[* ]The bars of different length represent repairs involving different rates of time-preference. If the rate is nine per cent, all the kinds of repairs here shown would be made. The same illustration applies to the choice of indirect processes, discussed in sec. 3.
[* ]The block A represents the comparatively small area of present psychic income. Over the threshold at B flow the direct uses of goods at each present moment. The rectangle A-Z represents all present goods, ranging from most to least direct. Their technical uses are being transmitted along the line, from Z to A. At the same instant man and all his possessions are being swept along by the stream of time. The indirect uses of goods thus are like swimmers moving toward an opposite shore and being carried along by the time-stream. They move across at different angles, for while time moves at the same rate for all, the swimmers move forward at very different rates. Some uses that are very indirect technically, are causing psychic income almost at once (line Z-B); other uses but slightly indirect, the slow swimmers, are not to attain the shore of direct use for a long time as they move through the successive technical stages. The course they describe would be represented by the straight line Z y 6; or if the early indirect steps are faster or slower than the later ones, the agents describe courses represented by Z x N and Z z N.
[1 ]This distinction between timeliness and roundaboutness must be kept clearly in mind, for confusion at this point betrays one into a false notion of the nature of interest.
[1 ]The value of a slave may be capital. A man, in our times, may not legally sell himself into slavery. Therefore, free men, in any full sense, are not capital, and it is misleading to speak of them as such, or to estimate their capital value as is sometimes done. But to a limited extent, carefully guarded by law, a man may borrow and pledge his future earning power, and thus capitalize it.
[2 ]Of course there are other reasons why the trade may be made, such as the better means that A has for feeding calves, the special use B has for fat steers, etc. Attention is limited here to the time-price problem, in cases where the prices and costs are the same to both parties.
[1 ]The rate of premium is reckoned on the basis of present worth as 100. This rate is ordinarily used to discount the future by dividing the future income by the rate plus 1. P = To express the true rate of discount on the future, however, the future value must be taken as a basis of 100; discount is proportional to premium, as present worth is to future worth; thus p : f :: 100 : 105 :: 95.238 : 100 :: 4.762 (the rate per cent of discount) : 5 (the rate per cent of premium). As a matter of convenience in business practice, the rate of premium (which becomes an interest rate) is generally employed in all banking, insurance, annuity, forestry, and other problems, and when used as a divisor, in the manner just explained, is for convenience spoken of as the rate at which the sums are “discounted”; e.g., in the next paragraph of the text. In the well-known method of bank discount, however, the premium (interest) rate is used as a multiplier, the interest being simply taken out in advance and the borrower receiving a smaller sum than that nominated in the note. This is equivalent to charging him interest at a somewhat higher rate, as interest ordinarily is payable at the end of the year. See ch. 25, note 2.
[2 ]In most cases the interest on bonds is payable semi-annually (at the end of each six months) and the bond tables showing the “rate of interest realized if purchased at prices named and held to maturity,” otherwise known as the investment yield, are usually prepared with this condition in mind. This is equivalent to a slightly higher rate of interest.
[* ]This shows graphically that, the net yield of a durative agent being given, every possible price (capitalization) arithmetically corresponds with and involves a rate, which evolves as a rate of income on the investment.
[3 ]E.g., in a circular issued in 1908 prices were quoted: “$100,000 City of Boston registered 4 per cent bonds, due June 1, 1928, price 106⅜, yielding 3.55 per cent; same kind due June 1, 1938, price 108¼ yielding 3.55 per cent; same kind due June 1, 1948, price 109½, yielding 3.55 per cent.” The gross yearly income is $4000, of which but $3550 would be treated as net income, and $450 would have to be reinvested each year to leave the capital undiminished at the end of the period for which the bonds run. The opposite is necessarily the case with bonds bought at a discount, the rate of net income on the investment being somewhat larger than the percentage that the annual payment is of the par value.
[4 ]The practice of counting the capital as equal to a fixed sum of money has suggested to some the idea that capital is, in its very nature, a permanent quantity of value. But this is an illusion, for the “sum of value” may be both increased and diminished, and may be utterly swept away. Capital is no more than the bookkeeping expression of the present worth of a person’s control over income, definite at the moment that the first investment has been made, and thereafter merely an estimate, until the property (right) is again sold at a price.
[5 ]This is an unfortunate use of the term value. It would be better to speak of the amount of a single share as the denomination, and of the product of the denomination by the number of shares outstanding as the nominal amount of stock.
[6 ]See ch. 14, sec. 4.
[1 ]Some reservoirs of small savings in the United States in 1914 are here indicated.
[2 ]Such cases of dire necessity are in primitive communities usually relieved by a neighbor as a friendly duty, without charge, tho the borrower is under moral obligation not only to repay the loan but to render like friendly accommodation if it should be needed. This view long continued to be accepted as ethical, and charging a premium (interest) on loans was condemned by moral and religious codes. The Jews (and not they alone) retained the prohibition of “usury” among themselves, but permitted “usury” from strangers.
[3 ]To serve this class, public pawnshops have been established by the governments of many European cities, and by private benevolence in some cities of America.
[4 ]Especially when such expenditure for self-improvement is directly in industrial lines, as learning a manual trade, or a profession (as dentistry, medicine, engineering, architecture, etc.) there is a temptation to call this “an investment of capital,” or a capitalizing of man’s earning power. But that is merely a figure of speech, tho it is true that the outlay for utilitarian training is made in order to increase the earning power of the learner. But the future incomes can not be capitalized, because man can not sell himself in sum. He can but earn a wage or salary for successive services.
[5 ]This proviso “built for tenants” is significant, for houses built by well-to-do owners for themselves are often so elaborately finished that they are notoriously poor investments when let to tenants.
[6 ]But some of the so-called consumptive loans above are productive in the sense which we recognize. The money borrowed to build a house, to buy a pump to supply water, or a machine to sew cloth, or even an automobile to produce psychic income for the owner, is productive. A clearer distinction can be made between the non-commercial and the commercial nature of the products, between loans by ultimate users of the goods (the occupant of the house, the user of the water from the pump, etc.), and loans by middlemen who produce to sell to ultimate users.
[1 ]The economists of the eighteenth, and early part of the nineteenth, century gradually broadened the term to include any income attributable to those goods generally bought and sold in terms of money. Later the term was extended to include, tho never consistently, a large part of the problem of time-value, the nature of which was beginning to be seen.
[2 ]When the amount of the loan is expressed as more than the borrower receives, the deduction being either in lieu of, or in addition to, an expressed percentage, the deduction, called discount, is interest taken in advance, and therefore is not exactly equivalent in rate to the same payment at the end of year, the time at which the usual rate is calculated; e.g., if a note for $1000 is discounted at 6 per cent the true principal is $940, and the true interest $60 at the rate of .06383. See ch. 23, sec. 3, note.
[3 ]The Provident Loan Association of New York is a corporation organized as a philanthropy to release the poor borrower from the jaws of the “loan-shark”; but it is conducted on business principles to pay expenses. It finds that the minimum cost of making a loan, even the smallest, is about 49 cents. Yet it makes a large number of loans of amounts less than $10, and for not over a month at the rate of 1 per cent per month (or 10 cents at the maximum). This loss must be made up by the larger loans.
[4 ]If B (having good security to offer) should bid a very high rate of interest (say 20 per cent) either through bad judgment or because of a chance to buy under-capitalized goods (or incomes) it might induce A to sell his goods which involve a premium of, let us say, only 10 per cent, to lend the proceeds to B; A meantime could escape any deprivation by renting the goods he had sold, for a little more than half of the interest he is receiving. A is then not using fewer present goods but is temporarily taking advantage of a chance to substitute a more advantageous mode of purchasing both present and future incomes.
[5 ]This may be traced on figure 11, showing how various bids meet in a common price. The excluded lenders on the line to the right of the price point are those who hold their present dollars (or a part of them) rather than lend further at the market-rate of interest; the excluded buyers are those to whom further loans at the market will cost more than the expected increment in incomes.
[6 ]Of course cases occur where after the loan is made, the money is kept for a while awaiting a better time to buy the incomes which are to yield the increment of price.
[7 ]This approximation to a common rate of yield on various investments may be illustrated by some such table as the following, showing the choices that present themselves to an investor.
[8 ]This aspect of the case is given further attention in ch. 27, sec. 7, 8.