Capital, Interest, and Rent: Essays in the Theory of Distribution

Fetter, Frank A.
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Murray N. Rothbard, ed.
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Kansas City: Sheed Andrews and McMeel, Inc.
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Collected essays, 1897-1937. First published as a collection in 1977.
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Part 2, Essay 6
Interest Theory and Price Movements

Reprinted from American Economic Review, suppl. 17 (March 1927). The discussants of this paper included Irving Fisher, Wesley C. Mitchell, Melchior Palyi, and Waldo F. Mitchell (ibid., pp. 106-113).


1. Purpose of this essay.


What is now usually known as "interest theory" will perhaps be conceded by all to be the subtlest and most difficult problem in the broad field of economic theory. Various opinions upon it and its solution have in turn been dominant, and probably every one of these still survives and is today held in some quarter, scientific or popular. Even in the narrower circle of experts and special students, the differences of conception are perhaps more fundamental and far-reaching than in any other subject of theory.


This problem being intimately related to many others having theoretical and practical bearings, the center of discussion has shifted greatly throughout the centuries. In ancient and medieval times, it was viewed as little more than a phase of just price, and attempts to explain the phenomenon of interest rates were merely incidental to arguments on the ethics of usury. Even the more recent discussions of the subject from Senior's abstinence theory to the work of J. B. Clark, of Böhm-Bawerk, of Wieser, and of others, reveal clearly this motive. The income taking the form of "interest" has borne and still has to bear the main shock of communistic attack upon the institution of private property, although Henry George's brilliant sally diverted a considerable part of the reforming zeal to the attack upon land rent. However, the notable development of a more truly detached scientific spirit in theory which has occurred, at least in a small esoteric circle, has shown itself in part by the ardent pursuit of a "theory of interest" as matter of pure reason, regardless of its bearings on any particular practical questions. This sort of "mere theory" has been not only ignored but deprecated by some of those economists, who, armed with new statistical weapons of correlation, are in pursuit of quantitative measurements. They for their part have been doing notable work in collecting, analysing, and charting the growing mass of banking and commercial data regarding price changes and rates of interest, as aspects of the business cycle.


There ought to be at this time no such mutual suspicion, but rather closer co-operation between the students of quantitative measurements and those dealing with the more philosophic phases of economic inquiry. Each method and each point of view is in turn needed—now to present working hypotheses, then to test them; now to relate newly discovered facts to the existing body of knowledge, again to reappraise older accepted views in the light of new evidence.


Especially in this phase of the study of the business cycle, to wit, the relation of interest rates and interest theory to general price movements, the interchange of thought between students with different methods has been lacking. Apparently most of those especially devoted to the study of the business cycle have remained indifferent to, and negligent of, the more recent novel studies and radical conceptions in this field of theory. There is, to be sure, still lacking agreement among economists both as to the theory and as to the terminology of interest. But it seems possible that a resurvey of interest history and theory, and a statement of some of the newer speculative aspects may result in some fruitful cross-fertilization of thought in this important subject.

2. Amount-of-money conception of the interest problem.


David Hume, writing around 1752, combatted prevailing opinion when he declared: "Lowness of interest is generally ascribed to plenty of money." This seems to be a fair statement of the notion implied at least, if not always clearly formulated, in the moral condemnation of interest on money loans from Aristotle through the era of the church canonists. Interest was thought of as paid for the use of money, as land rent was paid for the use of land. But money "cannot breed money," as land can breed crops and feed flocks; money is the "barren breed of metal." Even to scholars, as well as to the populace, the price paid for the use of money (quite like that of other things) seemed to depend on the plenty or scarcity of the precious metals. Certainly this notion still is the natural, naive, popular view, coming to the surface again and again, as in the Greenback program of the 70's and 80's, in the Populist movement of the 90's, in many contemporary pamphlets sent for the enlightenment of academic economists by amateur reformers, and even promulgated by distinguished inventors and manufacturers, who are novices in economic theory.


This erroneous notion Hume rejected, declaring at once: "But money, however plentiful, has no other effect, if fixed, than to raise the price of labor" ("and," he added a little later, "commodities"). After appealing to certain economic facts since the discovery of the Indies, he concludes: "The rate of interest, therefore, is not derived from the quantity of the precious metals." Before examining Hume's more positive thesis, let us observe that his negative thesis relates to static conditions as to the money stock, the quantity of monetary metals, in a country. He touches elsewhere only briefly on certain historical dynamic conditions, long-time rather than short-time in nature, in which he thinks that increase in a nation's money and a sinking interest (rate) go together. But, he says, it is a mistake to consider the greater quantity of money the cause of the lowness of interest. This is to mistake "a collateral effect for a cause."

3. Amount-of-riches conception; Hume's psychological germ.


What was Hume's positive thesis; what explanation of the rate of interest did he propose in place of the one he rejected? The real cause of lowness of interest, he says, is growth of industry in the state, etc., which same cause both attracts "great abundance of the precious metals" and lowers interest. "The most industrious nations always abound most with precious metals; so that low interest and plenty of money are in fact almost inseparable." The generally accepted interpetation of Hume's view was expressed more than a century later by Böhm-Bawerk in these words: "The height of the interest rate in a country does not depend on the amount of currency that the country possesses, but on the amount of its riches or stocks."*70


Since Hume's time until very recently that proposition, with various explanations and elaborations, has been the center of nearly all the theories of interest having a considerable following among liberal economists. It is the core of all the productivity and use theories. But Böhm-Bawerk's generally accepted summation of Hume's thought is far too simple to do justice to it, and Böhm-Bawerk's notion of "riches or stocks" is much narrower than is necessarily implied in Hume's words. One must, to be sure, beware of the temptation to read into Hume's language an attitude toward modern issues of which he was quite unaware. But Böhm-Bawerk himself has not escaped that error. His interpretation of Hume's essay is that of one holding firmly, as the Austrian economist did, to the tripartite division of the factors, and to the notion of capital as a distinct group of artificial agents—as he did after elaborate studies despite some inconsistences.*71


But there is required no undue stretching of Hume's words to find in them room for a broader thought of a psychological explanation of interest, though the dim outlines of this are only imperfectly sketched. Hume says: "High interest arises from three circumstances [and italicizes three]: A great demand for borrowing, little riches to supply that demand, and great profits arising from commerce.... Low interest, on the other hand, proceeds from the three opposite circumstances: a small demand for borrowing, great riches to supply that demand, and small profits arising from commerce." It is true that this merely states the problem rather than gives a full explanation, recognizing which, Hume says: "We shall endeavor to prove these points; and shall begin with the causes and the effects of a great demand or small demand for borrowing."


Our limits forbid following here his detailed argument. We would point out only that it abounds with references to psychological factors as causal and antecedent to the quantity of riches and to the rate of profits: different tempers, prodigals, misers, desire to consume, pursuit of pleasure, differences in habits and manners, and in customs; and along with these goes a penetrating discussion of the comparative influence of large landholding and commerce upon the motives of industry and frugality, determining whether or not money gathers into large stock into the hands of those who are willing to lend it at a low interest. The discussion of the third circumstance requisite to produce lowness of interest is, however, very superficial, dissolving into the agnostic proposition that the two things, low interest and low profits, "both arise from an extensive commerce, and mutually forward each other" but it is "needless to inquire which is the cause and which the effect."


Indeed, Hume's discussion, as a whole, never gets very far beneath the surface; it merely makes a beginning along lines in which little progress was made (excepting only in the abstinence concept) for nearly a century and a half. In one respect, however, Hume's essay indeed marks an epoch in the history of the interest theory; thereafter (except as a popular fallacy) the abundance-of-money-conception was definitely displaced by the abundance-of-goods-conception. The orthodox liberal doctrine (despite other differences) became Hume's proposition that we really and in effect borrow labor and commodities when we take money upon interest.

4. Turgot's limited capitalization theory.


Turgot's brilliant little essay in 1770 displayed in several respects an insight into the essential nature of economic problems, hardly to be equalled again for more than a century. Though he begins his discussion of interest with a narrow conception of "capitals" as consisting of "the accumulation of annual produce not consumed," otherwise called "moveable riches," he at once speaks of these riches as "advances" (not just when loaned—that is, "advanced" to a person—that comes later—but "advanced" when used on land, in industry or in commerce). He then gives throughout his treatment unusual prominence to the notion of time, using repeatedly the term "waiting" to describe what the advances enable workers of all kinds to do. He then turns his thought at once to the various "employments of capitals" among which a person may choose who has "accumulated value"; that is, funds available for investment. It is remarkable that he speaks first not of manufacturing, agriculture (i.e., capitalist farming), and commerce, and the loan of money at interest (these follow in order), but of "the purchase of an estate of land." Here he sketches, in scanty lines, to be sure, but clearly, a capitalization theory of land value, "what is called the penny of the price of lands," resulting from "the varying proportion between people who wish to sell or buy lands." Böhm-Bawerk in his critique dismissed this disparagingly as "a fructification theory of interest," "an explanation in a circle" because he believed Turgot was trying to explain "all forms of interest as the necessary result of the circumstance that any one who has a capital may exchange it for a piece of land bearing a rent."


But this seems to me to miss in Turgot's discussion its most significant and unique feature. Turgot is seeking to explain, as he says, the valuation of lands in accordance with the proportion which the revenue bears to the value for which they are exchanged, and he does this first without once referring to the current rate of interest on loans or to the current rate of profits in other business (or without taking a rate found in financial markets to use as a capitalization rate in explaining the price of lands). Turgot pretty clearly conceived of an investment rate in land (that is, a discount, or capitalization rate) as discoverable and usable by the simple adjustment of supply and demand of buyers and sellers of land. It is true that Turgot, as he proceeds, shows that the various employments of capital are mutually related in their rates of return by the possibility of shifting investments. But this is valid and does not conflict with his thought of the capitalization of land as occurring primarily through the working of forces independent of the market for monetary loans. Such a view of the possibility of the land capitalization process being prior to the contractual interest rate is not found again until after the beginning of the twentieth century. It is still quite rare. Turgot's view of capitalization, it should be observed, though clear, is limited to explaining the valuation of land. He does not go on to develop a general capitalization theory that would explain in an analogous way the valuation of other "capitals" such as houses, machinery, etc., as built upon and derived from the revenue (or series of future uses) contained in them. Such a conception seems never to have entered his mind. His discussion abounds, however, with references to the influence of waiting, and of time.


One other remark before leaving this question. It may be retorted to Böhm-Bawerk's characterization of Turgot's interest theory as one of "fructification," that more truly Böhm-Bawerk himself (and every other productivity theorist holding the conventional artificial goods capital concept) may be said to uphold a partial fructification theory, the very counterpart of that which he accuses Turgot of presenting. To wit: having explained the contractual interest rates superficially as arising in the market for monetary loans, and then having sought to carry the explanation deeper by tracing this contractual interest rate to the "productive services" of "artificial" man-made capital goods, the productivity theorist then has no other way of explaining the capitalization of land and natural agents, but to borrow the interest rate determined in the field of "artificial capital" with which to discount the rents and other expected incomes of "natural" agents.*72 This is done without the slightest misgiving or thought that in the individual valuation and the purchase or sale of natural durable agents there can reside an independent source of discount and capitalization rates.

5. Time and Senior's abstinence concept.


Many passages glimpsing the relation of time to the employment of capital could undoubtedly be collected from the economic literature of the nineteenth century, but they were nearly all ultimately fruitless of effects upon the development of interest theory. The outstanding exception is Senior's notion of abstinence (1836) which was a theoretical seed of a different, more psychological conception of the interest problem. It did, indeed, fall by the wayside, but it germinated and lived on there the stole sprig of psychological capital-theory until the new era of thought at the end of the century. It is a curious jumble of ideas as set forth by its author. Senior called abstinence variously a third agent, an instrument of production, a principle, a productive power, alongside of, but distinct from, "labour and the agency of nature, the concurrence of which is necessary to the existence of capital." He called abstinence "the conduct of a person," and "an additional sacrifice made when labour is undergone for a distant object"; he described it as "providence" united with "self-denial." But again he said the name was a substitute for "capital," defined as "an article of wealth," and he spoke repeatedly of labor, natural agents, and abstinence as the three instruments of production. This was very confused thinking, but at least it brought into the foreground of the problem the much neglected motives involved (in Senior's words) in "the production of remote rather than of immediate results" in undergoing labor "for a distant object," in abstaining "from the unproductive use" of what one commands, or, "from the enjoyment which is in our power." Incidentally, also, Senior discussed rather more than was usual "the average period of advance of capital," and recognized that before the capitalist can retain a profit he must see to "keeping the value of his capital unimpaired." But these ideas underwent no systematic or satisfactory development at his hands.

6. Influence of the artificial goods capital concept.


The history of interest theory among liberal economists for more than a century, from Adam Smith to Böhm-Bawerk, runs narrowly within the limits of the amount-of-goods ("riches or stocks") conception of Hume. But it was profoundly affected by the chance that the term "riches or stocks" came to be identified with the artificial goods concept of capital in the tripartite division of the factors of production, land, capital, and labor. A false symmetry was thus given to the structure of the theory of distribution, rent as a form of income being limited and bound to the natural factor land as its source, and interest as a form of income being viewed as coextensive with the "artificial" man-made factor capital. There was nothing in the inherent nature of the case to prevent the term "riches or stocks" from being taken in a broader sense, including in amount of goods everything to buy which borrowed funds might be used, such as lands for arable and other agricultural uses, and all natural agencies such as residence and business sites, mineral deposits, etc. But already with Adam Smith this linking of interest (and profits) with artificial stocks was apparent, and Ricardo's development of the labor-theory of value and its application to the capital concept (capital merely embodied labor) crystallized this notion that interest was a phenomenon and a form of return linked solely with "produced means of production," not with goods in general.


This conception of the economic factors and their related yields remained almost unquestioned until near the last decade of the nineteenth century. I uphold the opinion that both on theoretical and on practical grounds the attempt to classify material goods as artificial and natural according to the assumed source of their value is unsound. Enough that it involves the fallacy of the labor theory of value. But even those who still accept this classification must concede that it led to a very unreal and illogical restriction of the broader problem of interest. It quite obscured the significance of time as a general factor in the use of goods of every kind, though always in a vague way time was felt to have somewhat more to do with interest and artificial capital than with rent and land. The linking of abstinence exclusively with the origin of artificial goods dwarfed the development of that conception and prevented the recognition of "conservative"*73 abstinence as an essential form of conduct in the use, maintenance of and investment in, material resources and agents, no matter what their physical origin or the cause of their value. Such a narrow conception of the "riches or stocks" whose amount determined the rate of interest blocked the way to any general theory of capitalization applicable alike to "natural" land and to "produced" capital. All problems of capitalization of lands, i.e., natural resources in general, have by this conception to be treated as outside the realm of interest-fixing facts. Capitalization in all such cases can only be explained by the naive device of applying to land rents, mining royalties, and other future incomes from various sources, a rate of interest (or discount) that is supposed to be determined solely in the realm of artificial agents (in essence a "fructification" theory of the sort condemned, yet used, by Böhm-Bawerk.)*74

7. Böhm-Bawerk's promise and disappointment.


These notions were deeply imbedded in the "classical" economics and still continue to have a phenomenal influence on thought. A most striking example is seen in the case of Böhm-Bawerk. Though at one point in his studies he had the conviction that the interest problem was really the broad one of the "agio," or difference in value, of labor and of uses of goods of all kinds in relation to time, he finally relapsed into the old simple conception of interest as arising only in connection with "produced" capital. (But note his incidental and inconsistent treatment of land rent as a case of interest from durable agents.) Böhm-Bawerk in his great critical first volume saw, as the essential lack in all foregoing theories, the failure to explain adequately the rate of interest as a valuation relationship between the capital sum and the interest (income or yield). He condemned in principle all productivity and use theories. Likewise his elaborate preparatory work on the theory of prices in his second volume, "Positive Theory," seems to have been directed toward the end of explaining the valuation of capital as the sum of the expected values, the summation of the future uses and rents contained in stocks of economic agents. But he had closed the door to any solution in that direction by adopting the old Ricardian capital concept, "produced means of production," thus seeking to explain the origin of this group of durable artificial indirect goods and their valuation by means of a thinly disguised labor theory of value—in their past, not in their future uses. That is, he developed no theory of capitalization, though several times he seems on the point of doing so.*75 He relapsed into a productivity theory of interest, and he failed, just as he had shown so many others to have failed, in explaining the rate of interest as a percentage of a principal sum, as a surplus of price over and above the initial capital price of the series of future uses.

8. Clark's "pure capital" and timeless production.


J. B. Clark, like Böhm-Bawerk, became convinced of the inadequacy of past interest theory. But the beginning of his contribution lay at a very different point, namely, in exposing the ambiguity of the current capital concept, especially in his recognition of its neglected value aspect alongside of the conventional artificial concrete goods aspect.*76 Hardly second to this in significance and intimately connected with it, is Clark's broadening of the conception of the things comprising capital, making it inclusive of land and natural agents, indeed, logically, of every intangible right to income in which "a fund of pure capital" (as he calls it) may be invested. Pure capital as a private, business concept, became essentially an investment fund, though Clark gave it less practical expression. It cannot be said, though, that Clark succeeded any better than Böhm-Bawerk in explaining the genesis of capital valuations. He too seeks the answer in the past of goods rather than in the anticipation of future uses, and develops an abstinence theory to account for the technical, physical beginnings of "capital goods" in a manner inconsistent with his own inclusion of land together with artificial agents in the capital goods concept. He too accounts for the valuation of the pure capital by sacrifice incurred at the origin of artificial goods—a psychic cost concept. Clark too is wanting in any capitalization or recapitalization theory that relates capital value to anticipated incomes in general. He too concludes with a productivity theory of interest, in which the "interest" sum is looked upon as the specific product of the capital and is related to the capital-goods as a rent rather than as a rate per cent upon a capital-sum.


In one important feature Clark's treatment of this problem is reactionary just where the Austrian advanced the discussion most; that is, in the importance of the role assigned to time. Böhm-Bawerk, it is my belief, started on the right road toward an understanding of the time-factor, though he ultimately went astray on other paths without ever clearly recognizing how he had lost the road. But Clark never was on the right road and arrived at an explicit denial of any significance for time in the explanation of interest. It is the function of (pure) capital, he declared, to synchronize the outlay of labor and its fruits, and he attempted to prove this by an argument palpably fallacious.


It is one of the misfortunes of economic theory that Böhm-Bawerk and Clark, who had many theoretical virtues in common, could not have got together on their main differences. Böhm-Bawerk's initial conception of time needed to be combined with Clark's value concept of capital, and both freed from a labor theory of value influence. The results surely would have been much nearer a true solution than is either of the old-fashioned productivity theories of interest dressed up in new-fangled terminology with which these two pioneer thinkers terminated their arduous labors. Each was destined to give a new impulse to thought, and each disagreed with the main conclusions of the other; yet both came to results that seem singularly alike in certain respects. Böhm-Bawerk's interest theory after some early attacks upon it by the older school of economics, English and American, was adopted by them very generally with little modification, and is now the theory most widely accepted, in type, if not in all details; while Clark's notion of capital value has likewise gained wide vogue. Thus, views which their authors had expected to be revolutionary could be accepted and incorporated into the conventional system of thought of the orthodox school just because the original ideas had not been consistently developed. The doctrines at first novel were at last accepted not as strangers but as old, familiar friends.

9. Productivity interest theory.


The negative and critical work of Böhm-Bawerk and Clark raised issues which their positive theories did not suffice to settle. It is true that two dynamic decades of widespread discussion of this and related topics in economic theory were followed after about 1900 by an equal period of reaction, or at least a prevailing lassitude, in theory. The majority of economists were inclined to take the various more or less novel and conflicting notions that had appeared, and to merge them into an eclectic body of doctrine, which it was believed, or hoped, might be generally accepted and initiate an era of theoretical harmony. To a remarkable degree this policy seemed to succeed. Alfred Marshall, the leader of this eclectic movement as well as its most typical representative, took from the first this attitude toward the work of Böhm-Bawerk.*77 Marshall's eclectic formula of the two qualities in capital of prospectiveness and productiveness became the mode among English and American economists. To the influence of J. B. Clark, and perhaps in part to Wieser's general imputation theory, is traceable a related but more systematic formulation of a general theory of the specific productivity (or productive contribution) of each of the factors, a conception almost, if not quite, as widely favored in the text books as that of Marshall. In all these cases the "productivity" of capital (as a certain limited group of material artificial agents) is viewed as the cause and source of the yield or income called interest (implicit as well as explicit). It is assumed that this "productivity" (vaguely assumed to be a technological fact, but always shifting its character to value-productivity, a fact of private profit in the broader sense) serves to explain not merely the amount or price sum yielded by a group of "capital goods" but also the rate per cent of yield computed on the valuation of the principal, or capital value. It ought to be evident without argument to any one acquainted with Edwin Cannan's work*78 that when this shift is made the interest rate per cent of "productivity" of capital value becomes something quite unco-ordinated with the per acre amount or per man amount of productivity of the other factors. A rate per cent yield from the investment of borrowed "capital" is a fact of general bearing, not related solely to the "productivity" of artificial agents contrasted with that of land per acre and of labor per man, but related equally to the profit productivity of labor hired and of land and natural agents either hired or bought by the use of any investment fund (owned or borrowed).


All this relates solely to the explanation of interest on "productive" capital, used in business, but what of the case of interest on enjoyable goods ("consumption goods" so called)? When this problem is recognized at all (frequently it is not) in no case is the claim made that interest can be explained by "productivity." Another, supplemental, explanation is here conceded by the productivity theorist to be necessary, which is essentially that of time-preference. Thus every productivity interest theorist who has faced the whole question holds a dual theory, or, rather, two quite distinct theories, of interest, one to cover the case of indirect goods (sometimes limited to those employed in commercial ways) and another to cover that of direct (i.e., enjoyable) goods. Numerous further difficulties of the productivity theory have been discussed by the writer elsewhere, and need not be repeated here.*79

10. Sources of a general time-valuation theory.


Böhm-Bawerk and Clark, united, were more potent to arouse discussion of the interest problem than, divided, they had been to give it a satisfactory solution. This at least was the verdict of a small group of students who were not satisfied with the eclectic results just indicated. Though the subject claimed the attention of a much smaller proportion of economists after 1900, it continued to be studied with undiminished zeal by a few. They felt profound discontent with the outcome and they had hope of something better, of winning, so to speak, some purer metal from the rich nuggets of truth that had been unearthed by the newer criticism. Negative criticism of unprecedented keenness and quality had revealed the ambiguity or untenableness in logic of various of the older conceptions and thus had made deep breaches in the old structure of distributive theory, calling for some fundamental reconstruction. Yet with superficial repairs the old structure had been restored and reoccupied. The most brilliant flashes of insight by the pioneers in the interest discussion had faded into darkness and had not lighted the way to any constructive results.


Suggestions have been given above of some of these ideas that were glimpsed by Böhm-Bawerk and by Clark, especially those of a pervasive premium (agio) for time, of the true nature of the capitalization process in the case of any series of uses, of the capital value concept, etc. No one of these was consistently developed, and they were left as mere passing suggestions off the main line of economic thought. Besides these squandered or misprized resources of theory, there were many others waiting to be utilized. There was the abstinence concept, still, after nearly three-quarters of a century, in as crude a form as that in which Senior had left it, confused between technological and value or investment relationship, and tied to a narrow notion of artificial capital. There was the thought, given wide currency in the text by F. A. Walker (borrowed by him from some earlier source), that time change is a cause of value co-ordinate with stuff, place, and form. This thought, to be sure, was not developed by Walker, and he did not see in it the revolutionary possibilities of a general theory of time-valuation in relation to all kinds of goods. There was the new academic subject of accountancy beginning to attract attention to the exacter mathematical expression of time relations in investments, and especially to the process of recapitalization according to changes in earnings. There were certain elementary notions of actuarial science and practice that began to filter into the class rooms of theory, as insurance, forestry, corporation finance, valuation of utilities, and other related subjects were taking their place in the university curriculum. There was the increasing attention to the human and psychological aspects of economic problems, begun by "the marginalists" Jevons, Clark, and the Austrians. However faulty their technical psychology (ranking thus probably in the order just named) and however faultily applied, they had in this matter initiated a new era, whose broadening application of psychology to economics and sociology we are still witnessing.*80 And finally (for we can here touch only a few of the high points), there was the influence of the newer economic history in which, at least a few avid students of theory began to find rich suggestions for destructive critique of the conventional, orthodox, commercial system of economics (especially distributive theory). No eclectic can hope to begin to understand the continued discussion of the interest theory after 1900 unless he gives due consideration at least to these elements in the situation. Otherwise he catches only fragmentary glimpses of the movement and fails to see its broader implications. Many minds contributed some elements to this process of thought though the participation of some was either meagre or of short duration. Besides those whose names have repeatedly appeared above, noteworthy contributions were made by Ashley, Cunningham, Toynbee, Edwin Cannan, Carver, Veblen, Davenport, Turner, and others.


The positive outline of the time-valuation theory has been most fully presented in two versions—that of Professor Irving Fisher and that of the writer. These differ in the mode of approach and in emphasis, and in a number of details, some of them unquestionably of considerable importance.*81 But in regard to the larger issue, the two versions are in substantial agreement. Fisher's treatment is that of the mathematician and accountant, conceiving of the whole process as one of buying and selling future incomes. My approach and treatment has always been rather historical and genetic, with a greater stress on the psychological and human factors. Though begun and largely developed before the term "institutional economics" was coined, it might even be deemed to be in some respects an essay of that type. Especially, it treats the interest rate not as a thing apart from the general price system, but rather finds its explanation interwoven with the whole process of price formation, from its earliest beginnings to the complex price system of the modern world. Such a view of the interest problem is much more closely bound up with the business cycle than any productivity theory limited to artificial capital goods or to industrial profits could possibly be. We will therefore seek to restate the time-valuation theory with more definite regard to its use in this connection, in the hope that by the cross-fertilization of ideas ways may be found to make the statistical analysis of the business cycle yield larger fruits.


1. Individual time valuation without trade.


Contractual interest (as a rate per cent) is a relatively superficial phenomenon. It is also, in economic history a very recent phenomenon on any considerable scale. It appeared subsequent to the use of money and to a regime of monetary prices. If, therefore, any causal relation is historically traceable, interest appears as an effect rather than as a cause of prices. It is impossible to conceive of a general rate of interest, expressed as a percentage of the principal sum, antedating any system of prices; whereas it is possible to picture, as antedating both interest and monetary prices, a system of non-monetary, barter prices, involving ratios of exchange between commodities. Indeed early economic history shows us such systems on quite extended scales, interwoven more or less on the one hand with caste, status, feudal and manorial relations, and on the other with the embryonic forms of monetary trading. The ancient and medieval conception of justum pretium was deeply rooted in this notion of the fair and normal ratios of goods. However, after monetary prices do appear, they may become mutually related to barter prices, and somewhat modify them through causing changes in modes of trade and of production.


But we must go deeper still in tracing back historically and analysing logically into its simplest elements the modern complex relations of the time element to prices. Even the exchange ratios of goods in the simplest barter and in primitive barter markets appear subsequent in time, and must be logically subsequent to, long-prevailing schemes and systems of valuations of goods in terms of each other, in tribal, village, family, and individual life. In all the modern textbook expositions of price, it is assumed that the individual trader approaches a trade with some scheme of choice, or state of mutual valuations of goods, and the careful use of this notion will hardly be denied validity. But this must not be taken to imply that once the individual has access to barter and markets, his scale of valuation is unaffected by trading opportunities, by past experiences, and by habits formed, in the market.


In the very earliest pre-barter, pre-market choices of primitive man, time-valuation must have entered into the scheme of choice, as it must today in the most simple, isolated acts of men apart from markets and the developed apparatus of price adjustment. Except for a due recognition of the mutual influence of folks on each other's social standards, etc., it would be putting the cart before the horse to find the cause of the individual's time-preferences in the state of preference discovered by him and borrowed by him from other persons in the market. Rather we must seek an explanation outside of this circular, endless chain of causation, to wit, in the nature of man's desire for goods and in the particular circumstances of plenty, scarcity, and provision for need, as modified by intelligence, customs, training, habit, and social relations.


The fact that time differences in the availability of concrete goods (and also of their separate uses) do cause choice-differences cannot be disputed. Generally viewed, it appears that the more animal-like the stage and the more primitive the people, the greater the preferences for immediate appropriation and use over postponement. However, some curious exceptions are found in primitive communities, supported usually by religious tabus or sanctions. It is only slowly that this difference in choice is diminished, with the growth of social institutions, customs and habits. We cannot imagine, therefore, any individual, family, or larger group economy, either the most simple or the most complex, where there would not be involved in the system of valuations reflected by and implied in the relative valuations themselves, differences in choice due to time; that is, due to the differences in the desires for goods at certain time locations and not due to physical differences either in quality or quantity of the goods when they are ripe for use. It is a case where quality and kind are the "other things equal," and time preference reflects the unequal conditions of choice, such as appetite, mood, fatigue, companionship, etiquette, and many other things that affect merely the time of greater impulse, drive, or desire.


Experience and observation teach that in the vast majority of cases the preference is very marked for present goods over future goods (and vice versa as to present and future ills) with children, savages, and the masses of mankind. But the growth of the spirit of providence and frugality means the growth of power and readiness to inhibit this choice of present in relation to future goods. It is not doing violence to the facts to say that individuals and families have, involved in their schemes of valuations, more or less definite rates of time-preference. This changing nature and force of time-choice cannot fail to modify the actions of men, determining what, when, and how they do things, what material things they use and how they use them, determining in large part what are the kinds and amounts of durable agents with which men surround themselves. Observe that this is all conceivable and actually occurs in countless cases, before or without the expression of these valuations in terms of monetary price, or even without the simplest barter. It is a system of individual choices of goods with implicit ratios of time-preference.

2. Time-valuations under barter.


The beginnings of barter arise out of such a system of time-valuations operating in individual, family, and group economies. The essential motive for the simplest trade can be found only in the fact that the trading parties have at a given moment unequal valuation ratios between specific goods (at least implicit in their drives and desires), and by trading bring these ratios more nearly into accord. Time-value is not a quality separate and apart from the total value of a concrete object (wealth) or of a specific act (labor); it is merely that part of the total value which in the particular circumstances is due to time relations, just as other parts of the value may be logically attributable to conditions of place, stuff, form, proprietorship, and manifold subjective factors in men. The time-value may be negative or nothing or little or much or all of the value of a certain good in a particular situation. It requires no stretch of imagination to picture trader. A having no present use whatever for commodity m which he possesses, but an intense desire for immediate use of commodity z; while trader B has no present use whatever for commodity z which he possesses, but an intense desire for commodity m. Yet at a later time the attitude of these two traders in respect to these two commodities might be reversed. Barter in such a case is simply the exercise of choice, in social circumstances, as to time-relations of goods and uses. Even when the contrast in the traders' intensities of desire is less extreme than in the example, there must be usually some limit at which one or the other trader would cease to have a motive for trade, due to time-relations. These same differences in time-value explain likewise the simplest process of deferring payments, borrowing and lending, where the borrowed goods are returned later in kind, often because of tribal mores without bonus, but with usury exacted from a stranger. There appears no reason to doubt that time-differences are just as real and just as clearly the explanation of particular economic choices of wealth and of actions in the simple states of status and of barter, as are any other differences in the conditions of choice. When this time-valuation is not consciously expressed as to amount in a separate unit (as money) or as to rate per unit of time (discount or premium per annum), it may be very effectually embedded in a person's general system of contemporary valuations in the ratios of certain goods with others.

3. Time-valuation in a monetary price regime without loans.


Böhm-Bawerk, to whom we owe much for his emphasis of the psychological factor and for awakened thought on the interest problem, declared that "the kernel and center" of his own theory was the proposition: "as a rule, present goods have a higher subjective value than future goods of like kind and number."*82 He recognizes that this rule is subject to some exceptions but he considers these to be very rare.*83 In reality, many present goods may be worth less to any and every individual than a like kind and number of future goods, notably seasonal goods, as ice in winter, fruit in summer, etc., as well as in many other specific situations where present individual desire is small compared with anticipated need for particular goods at some later point of time.


Now, suppose that one finds that his relative valuations of present and future goods of a certain like kind and quantity expressed in the price unit are out of accord with his own relative valuation of the time element in certain other kinds of goods. Or, again, suppose that one finds that his own time-valuations of particular goods are out of accord with the market rate which reflects the time-valuations of others, their estimates of the ratios of the present and future prices of the specific goods. In either case the person (except as deterred by the trouble of choosing and trading) would buy some and sell other specific goods, giving up the money that he has left or acquiring the money that he will either spend at once or keep as a "storehouse of value." By this use of money evidently a person may often get some one else to supply him with more present goods or with a greater total of present and future goods of specific sorts than he could otherwise have, and at the same time the other person may gain by distributing his possessions better throughout time periods. In such cases money serves as a "storehouse of value" better than the other sorts of specific goods. And such a process of buying and selling (without lending or the use of credit) must tend to weave into the whole price fabric a certain general, average rate of premium of present dollars over future dollars which has resulted from leveling out and rounding off a great part of the individual differences, though considerable may remain. So, then, each unit of money would evidently buy durable goods which (barring mistakes and accidents) would rise in price throughout a given period in the ratio of the prevailing time-price embodied in the price of goods; and vice versa, the seller of durable goods to be used in the future would have to sell them for less than the price that would emerge in course of time. In other words discounts on future goods and uses, and premiums on present goods and uses, must interpenetrate into every corner of a price system and enter into almost every price quite apart from the use of credit in any form, to say nothing of lending money at interest.

4. Time-prices and time-shifts of goods.


In this process of price adjustment of goods in relation to time-periods many intricate practical problems must arise because of the different degrees of durability and preservability of goods, and because of the differences in the trouble and expense of keeping certain goods or of hastening the ripening of others. From the primitive eras of human industry, the shifting of goods in point of time was the purpose of many kinds of economic activities such as drying foods, smoking, cooking, salting, burying in the ground, storing, building caves and warehouses, oiling, painting or otherwise protecting many kinds of tools, agents, and supplies; and again the purpose is to ripen or otherwise hasten the time at which specific goods can be had for use. Some goods lend themselves readily to this process and others with difficulty. It is little trouble to keep some things, and they deteriorate little or none (e.g., the precious metals) while at the other extreme are things which defy all attempts to delay their use (or vice versa, to hasten it). Now almost every process of keeping things involves the giving up of labor and other goods which have value (or price) for alternative purposes; and besides there may be a loss in quality or in quantity, as in the rotting of fruit, the spoiling of meat, etc. All these subtractions from the physical quantity and quality of the goods to be kept, plus all the subtractions from other goods needed in the process, taken together, are charges upon the transfer of goods from one time-period to another quite analogous to freight charges for physical place change. (Conversely, there may be gains in physical quantity or quality.) This must give rise to many and complex adjustments in the relative prices of goods both contemporaneously and over periods of time. To take a comparatively simple case: suppose that apples may be kept in an ordinary cellar from September until March, but that one-half of those thus stored rot in the six months. A price per bushel in March twice as much as in September, plus the price (actual or alternative) of labor and storage space, might easily be three times as high as a September price. But at the ratio of three to one, March and September prices might not contain that prevailing premium on present dollar purchasing power needed to induce its investment for keeping these particular goods six months. The investment does not promise the prevailing increment of a higher net price in March while all around in the existing price system are alternative investments which do contain it. By choice the line is drawn between that time-shifting of goods which is warranted by time-price relations and that which is not. These differences may be reduced by shifting goods, but not to zero, any more than local differences in prices of goods can be reduced to nothing by transporting goods from the place of lower to place of higher valuations. Local prices of two exchanging markets still differ by the amount of the freights. The price system in any period of time viewed statically, contemporaneously, is linked up by countless acts of choice with the price system in succeeding periods of time, into a time-embracing price system. This is an unescapable conclusion from the phenomenon of individual time-valuations.

5. Capitalization in the pricing of durable agents.


We have spoken thus far of the price of concrete goods as wholes, having in mind, typically, goods that afford single uses (even though the goods may be preserved over a period of time). We now come to the price problem found in another more complex class of objects, which the older speculations on interest almost ignored. These are durable agents giving off a series of uses over a period of time. Such agents, as Böhm-Bawerk showed (without fully developing the thought in his interest theory) may be looked upon as containing separable uses arranged in time series which, like particular goods, often may be shifted forward and back in time in accord with differences in time-valuations. Around these durable goods, too, is built up a structure of time prices. The explanation of this process is the theory of capitalization that may fairly be said to be a product of twentieth century thought, so meager were the traces of it before.


It was one of the triumphs of the psychological marginal theorists, and pre-eminently the work of the Austrian school, to overthrow the old cost-of-production theory of prices and to replace it with an explanation beginning in the value of ultimate uses, and traced backward from them to agents. Every indirect agent derives its value (and its monetary price) from its products; it has not and cannot have ultimately any basis for its price except the price of its products, actual or expected; its price is simply the present price of the sum of all its future products (or of its separable uses). But in every existing price system the prices of like uses and of like ripe products differ according to time location; therefore the price (capitalization) of durable agents containing series of products equal in number and maturing price, must differ according to the maturing dates. For example, let one agent contain ten units of product yielded within a year (the agent being then used up) and another agent contain those same ten units yielded once a year for ten years, or once every two years for twenty years; clearly these various durable agents though they may contain equal sums of products (taken at their par, maturing valuations) would have unequal present (capital) values, if and whenever the present claims to the future products are taken as the sums they represent in the actual system of prices.


This way of looking at the origin and nature of the capitalization process is revolutionary of traditional and still widely current conceptions. The counting house and banking habit of mind has largely dominated economic thinking since the eighteenth century, and "interest theory" has been a phase of commercial economics with its disposition to regard as normal and permanent things just as they are. The economic man (still with us) is pictured as a merchant in a modern market, equipped with interest tables, aided by accountants, resorting every day to banks and the loan market, and consciously and mathematically estimating the present worth of durable agents and all other time series of products or incomes, by reference to the interest rate prevailing in his circles. So economists, even since they have begun to give attention to the capitalization process, continued to explain it by taking a mathematically expressed interest rate determined antecedently in the loan market and applying it as a discount rate to rents and future incomes to arrive at their present worth. The illusion persists even among some who in large measure accept time-valuation doctrines, that in no other way could capital values be arrived at by investors.


But our view of the capitalization process is utterly different. It is genetic and sees capitalization as a part of the earliest system of prices. It does not conceive of private property as "given in its finished scope and force" (as Veblen asserts is erroneously done in most current economic thinking). Rather it looks upon the price system of today and the habits of mind that go with it as comparatively recent developments, though having their origin before our banking and credit systems. The capitalization theory here outlined has been far more shaped by anthropology, economic history, and genetic psychology, than by continuing deductive, dogmatic, speculative studies.


Our thought is not that the earlier type of the capitalization process (which still persists in large measure today) involved the conscious recognition or explicit expression of a capitalization rate either derived from outside or inherent. But some rate becomes automatically involved in every price of durable goods (or series of incomes and of products) where time-location in any degree affects the valuation of the constituent elements making up the whole price of the thing. This phenomenon of discount of uses contained in any agent or source of incomes is correlated not with artificiality but with durability of the income bearer, because durability means continuance through time, and more or less extended periods between the present valuation and the maturity of the future use, product, or income, that is taken to be one of the constituent parts of the present agent. Thus the prices of ephemeral goods of present use contain little or no time discount, and durable goods (notably land and natural agents) contain more and more in proportion to the distance and time distribution of their uses.


The process of time-valuation is in large part one of trial and error, affected by imitation, habit, custom, social training, etc., and constantly adjusted in the light of experience within both the individual and the group economies. When, and to the extent that, competition operates, the persons who succeed, more or less gropingly or intuitively, in bringing their time estimates into some semblance of a true system of time-prices, are more successful buyers, holders, and users of wealth. Certainly after the use of money became common in medieval towns and markets, it was inevitable that time-discounts and premiums should permeate everywhere into the enlarging system of prices that was created. And these time-valuations (discounts) on future uses and products within the larger system of prices must themselves be built into a system reflecting a general rate, though varying just as prices do, in the various economies out-side the larger central markets. Such a price system as this is logically conceivable in a creditless, loanless, interestless community, and is indeed the kind of situation disclosed by economic history as existing before the rise of modern financial institutions and methods.

6. Capitalization and "the normal rate" of profits.


Such a price system embodying time discounts is not, however, conceivable without the accompaniment and result of a usual, normal rate of profit accruing to the buyers and owners of the durable agents. Since at least the days of Hume, a close connection has been seen to exist between the rate of profits secured by active enterprisers in their own businesses, and the prevailing rate of interest on commercial monetary loans.


However, from the first, it was seen that a distinction must be drawn between the usual, average or (as it came to be called) "natural" or "normal" rate of profits (which must be in the long run if the business is to attract enterprisers, and above which active competition will not for long periods permit it to remain) and the higher or lower rates which may prevail temporarily perhaps in particular places or branches of trade, and which may be attributed to accidental and unforeseeable causes, or to the presence or lack of special skill and of efforts by individual enterprisers.


It is therefore true that the close connection between the profit rate and the interest rate exists only at the moment of investment, as anticipated probable chance of profit (or income), and any additional profit (or loss) is either attributed to human effort or is absorbed in a recapitalization of the principal, the price of the enduring agents or property rights that give control of the income. The significance of this was, before recent capitalization theory, quite missed in the futile attempt to explain capital-values by cost of production. The long remarked "tendency of profits to equality" in various employments is rather more the result of the constant re-evaluation of existing durable agents and the tendency of their valuations to accord with revised estimates of their products than it is the effect of the cost of production of new agents of like kind, as held in orthodox doctrine.


At the moment of investment, however, the individual investor sees the two "normal" rates (of profits and of loan-interest) as mutually reacting and affecting each other, without having to think of their causal relations. Each offers to him a chance of gain and a choice for investment, and even economists' thinking has often seemed to rest at that point. But if the question is raised, there are three possible types of answer. The interest rate might be the cause of the "normal" profit rate; or the reverse might be the case; or both rates might be the results of a common cause. The last of these is implied in the capitalization theory; but heretofore only one or the other of the first two theories seems to have found adherents.

7. The general interest rate and the profits rate.


Here, at length, we have arrived at the interest problem in the strict sense. What is the cause of, what makes possible, the prevailing interest rates on monetary loans? If the questions have been put, is interest the cause of profits or are profits the cause of interest, the answer, yes, has generally been given to the latter. For the "productivity theory" of interest, which in its various versions and degrees has held an overwhelming predominance in this field of thought, is really, when examined, found to mean this if it means anything. The vague and ambiguous term "productivity" is at first assumed to mean some kind of physical creation of product; but this conception being utterly unusable in an explanation of an interest rate (ratio of the value of product to the value of the agent or source), it is always quietly abandoned in favor of the value conception. Productivity is taken to mean an increment of value (price). But what kind of value and where found? Even in the most elaborate recent attempts to apply the marginal analysis to this question, the outcome of the reasoning is simply this: capital (as an investment sum) is "productive" in the sense that one having capital has normally a chance of making profits at the average prevailing rate, by investing it. So-called "productivity" means profit yielding, and "product" means merely investors' profit. And what is the source and essential condition of this profit emerging at a rate on an investment? It is explained neither by physical productivity of agents nor by the value of products (or uses) taken at the time of their realization and maturity. It is explainable only by reference to the existing price system wherein goods containing postponed or future uses have been and are, when the loan is made, so priced (summed up, capitalized) in relation to time that as those uses mature and ripen they rise toward the parity of realized valuable uses. This normal profit-making "productivity of capital" is thus nothing but the reversal of the former discount-valuation applied to distant incomes. It is a psychological, valuation process, not a physical, technological process. Thus profits no more explain interest than interest explains profits. They offer alternative investment opportunities but neither is the cause of the other. Both opportunities result from discounts and premiums permeating the existing system of prices, and these are traceable to the fundamental factor of time-preference exercised by men individually and collectively in the complex environment of modern markets and prices.

8. Separate markets for time-prices.


A considerable usefulness cannot be denied to the notion of a general interest rate. But this notion, like that of a "normal rate of profits" is abstract; actually interest rates appear in great variety, and differ at any particular time among individual transactions, groups of traders, kinds of business, and types of loans. But, as in the case of profits, so of interest, the notion of a general, or normal, or prevailing rate is the result of analysing the various gross rates, attributing a large part of the differences to other causes (various kinds of chance, luck, individual skill, various service charges, and costs of making the loans, etc.), and looking upon the remainder as true or pure interest. Parts are thus imputed to costs, other parts to enterprise, and other parts perhaps for a time to rents (more or less permanent) which sums, in fact, enter into the recapitalized principal of the investment.


But if the safest, simplest and most marketable kind of loans, such as government bonds, give the index approximately to "pure interest," quite persistent differences are seen to prevail among the rates in various loan markets, for commerce, for urban real estate, for agriculture, etc. Many such differences can be readily explained as due to the special factors of cost. The gross, or apparent, rates of interest do differ far more than the true, net interest, both to the lenders and to the borrowers.


It is impossible by this analysis to reduce all the apparently different rates in a country to a single true rate, either to lenders or to borrowers. The problem is analogous to that of differences between the commodity prices of two localities; these to be sure, differ by costs of transportation and tend toward a net equality to actual shippers, i.e., marginally; but that does not change the fact that local sellers get and local buyers pay higher prices in the one market than do sellers and buyers respectively in the other market. The differences persist, on the whole, through long periods as our own economic history abundantly shows. So likewise it is evident that in many neighborhoods and among various economic groups, larger or smaller, real differences in the prevailing interest rates may and do persist indefinitely. This may be despite extensive loans and the constant import and export of merchandise. Evidently, too, in such cases, the whole structure of prices must be both reflected in, and reflect, these differences. Capitalizations, the relative prices of present goods and of durable agents, and normal rates of profit in active business investments, as well as rates of interest, must, through the operation of competition and substitution, be brought into some measure of consistency, as respects the time-discounts in various goods and employments. Crude tools, ephemeral structures, high business profit rates, low present prices (large discounts) on future uses, and high rates of interest go together. Even within countries, provinces, neighborhoods, and in particular employments, real differences in all these facts can arise and persist, moderated but not destroyed by borrowing or by trade in goods. A limit to the equalizing of the time-rates in different markets is set by the lack of purchasing power to buy goods, and by inability of borrowers to give security enough to lenders in other communities to induce them to keep on lending. But not infrequently lenders in regions of lower time-valuation lend up to the limit of the wealth that backward communities can pledge, and even beyond, until a collapse of credit teaches its lesson. In the same country within the markets for commercial, agricultural, and urban real estate loans, within loan markets affected by different tax laws, and among groups of borrowers and lenders affected by tax-free features, there must be differences in rates that persist and that are reflected in the whole set of economic choices and the whole system of prices in each market and group.


Whatever be the relative prices of particular classes of goods, these prices would all be interpenetrated more or less consistently by the time-discount rate peculiar to each market or group. Any such system of prices having become fairly stable at any time and in any country, may be disturbed and altered by changes originating (1) in the medium-of-exchange mechanism, affecting more or less alike all prices, i.e., the general level of prices as expressed in index numbers; or (2) in conditions of time-valuations, acting upon time-prices and capitalization; or (3) in special conditions of demand and supply determining relative prices. The last of these is not negligible, but is of least importance to our present theme and must be passed over here. The first is for our purpose the most important and it will be considered on the assumption that a change occurs from the side of money without any change originating in the psychological factor of time-preference. Finally and more briefly, will be observed the case of individual time-preference changes (so widespread that they affect the prevailing market rates of time-discounts, etc.) without any change originating in the money supply or other exchange mechanism. We say "originating in" not "occurring in" to avoid any suggestion that such changes may not and do not occur as a result of the repercussions of the particular price adjustments in the new situations taken as wholes. Neither of these two problems (1 and 2 above) is simple, and it may be questioned whether the true nature and full bearing of either had been clearly recognized until within the last thirty years.


1. Long-time changes in the general price level, and compensatory interest rates.


When, after 1873, the general price level had continued to fall for some years, the accompanying fall in interest rates on long-time loans attracted the attention of economists, notably that of J. B. Clark and of Irving Fisher, in the decade of the nineties. Alfred Marshall had briefly called attention, as early as 1886, and again in 1890,*84 to the phenomenon later designated by the title of Professor Irving Fisher's notable monograph, "Appreciation and Interest." Indeed it seems to have been glimpsed as early as 1802 by H. Thornton, and by Ricardo in his "Principles," 1817. The discussion of this problem has been in part deductive and in part inductive through the use of statistical data. Take a period of falling prices resulting, let it be assumed, from a decrease, absolute or relative, of gold production. Then it was shown that when this trend becomes fairly definite and generally expected, prospective borrowers become more wary and prospective lenders more eager; for each compares the purchasing power of dollars when the loan is made with that of dollars when payments of interest and of the principal, respectively, will fall due. The borrowers are warned by the outcry of the debtor class, and that group of capitalists that lives in the neutral zone between active and passive investment is tempted to shift over to passive money lending unless and until the interest rate falls to a degree that offsets the fortuitous advantage accruing to creditors from rising prices. (Of course, the converse of all this would be the case if prices were rising.) In principle this process is competitive adjustment, on both sides, of expected gains and losses from price changes, resulting in a compensatory rate of contractual interest. The "true" interest rate translated into terms of goods (the commodity interest rate) would be no higher or lower than under a regime of stable general prices, if this process operated without lag or friction. But of course it does not so operate. At the best, the uncertainties of price changes make this process, though good as far as it goes, but little better than a gamble. Several independent statistical tests*85 have shown that in part the compensation takes place, but only tardily, imperfectly, inequitably, unequally in the various branches of trade and in countless transactions. So far as it does occur, it can affect only newly made loans or old loans at the moment of renewal, and leaves the vast outstanding bulk of contracts in terms of dollars to be settled on the level of the new and ever-changing prices. In historical fact, no sooner has the downward trend of prices seemed to be established, and interest rates on newly made loans become more or less roughly adjusted to it, than general prices changed to an upward trend, and for years even the ignorant and unskillful among the active capitalists reaped unexpected profits on new loans still made at low interest rates. Then the whole "money lending" class, including as it does the many little lenders who are the equitable owners and beneficiaries of vast trust and insurance funds, endowments, and savings accounts, are the innocent losers.

2. Changing general prices in relation to particular prices and to industrial equipment.


Most of this doctrine is so generally accepted now that repetition is scarcely necessary. But there is another somewhat deeper-lying problem that calls for further attention from future students of prices. For is it not evident that during such a process of price change the whole scheme of relative prices would be disarranged, compared with what it would have been, or would be, under a regime of stable general prices? Where interest rates were compensated fully (or excessively) in relation to falling prices, there long-time investment in durable equipment would be "normally" large; while if interest rates are as yet compensated little or none, investment for the future must lag and even in renewing old loans many debtors would face ruin. Such things might raise some kinds of prices in the future by causing physical depreciation of existing wealth (lands, machinery, equipment) but reduce present prices in those industries by causing producers to continue to turn out goods under the pressure of need for ready funds.


The same uncertainty and chance that hangs over the whole process of borrowing from others to invest in particular ways, hangs over the process of employing one's own capital in active business. (We are concerned here only with the time-value and time-price aspects of these price relations.) There must be overinvestment at one place in durable goods, and underinvestment in others, compared with what would have been the case in a state of economy where general prices, as determined by the relation between the exchange mechanisms and the volume of exchanges, remained stable. While the contractual interest rate is out of accord with the profit rate, more or less, in different employments, both must be more or less out of accord with the "true" commodity interest rate, and at the same time the capitalizations of agents in various uses as well as the supplies and prices of various "ripe" goods must be greatly dislocated. A market rate of time-discount would in such periods cease to "prevail" with any precision, throughout any one of the structures of prices. The existing uncertainty as to price trends special and general, the inequality, the accidental gains and losses of enterprisers and investors, the resulting discouragements and prodigalities of individuals and large classes, extend even to the more fundamental psychological fact of time-preference. On the whole it would seem to have the effect of reducing abstinence and investment, though the factors must be varied and often conflicting.

3. Short-time general price changes, bank credits and discount rates.


In an historical chart of price index numbers, the long-time fluctuating curves, representing the greater tidal waves of general prices, may be as much as forty or fifty years from peak to peak; and they are broken up into a succession of uneven, shorter waves formerly thought to extend over eight to ten years but which some more recent studies indicate to run now nearer three or four years. In any case these briefer curves mark what are now called business cycles. Naturally the peaks and hollows of the long-time curves coincide with the high and low points respectively of certain of the shorter cycles, whereas between the greater peaks and hollows the shorter cycles may be pictured as superinscribed upon the long-time curves. At the few coincident points there might be a common cause, but the intervening divergences of the business cycle from the general trends certainly suggest the working of two somewhat independent causes.


Without committing ourselves to an inflexible theory, it seems now a good working hypothesis, in view of the known facts, to connect the long-time curves mainly with changes in the fundamental monetary conditions. Chiefly these relate to gold (and silver) production, together with the accompanying conditions as to the use of gold as the "standard" money and unit of prices in the world (if one likes, "the supply of and demand for" gold for use as the standard price unit in the monetary system). Since 1914 irredeemable paper money, crowding gold entirely out of circulation and becoming the sole fluctuating "standard," has a part even more important than gold in the explanation of the price levels of particular countries, and has a very significant part in the explanation of the value of gold throughout the world. Similarly we may find the larger part of the cause of those briefer fluctuations that diverge from the long-time trends, in the changes occurring in that part of the exchange-mechanism consisting of credit agencies (in relation, of course, to the accompanying psychological conditions of hope, fear, confidence, expectations, whether based on calculation or resting merely in emotion, in the business community).


Now it is well recognized that modern developed banking and credit systems, by the use both of bank notes and of discount deposits, permit of large and rapid expansion of the dollar-expressed purchasing power, without substantial changes or any increase whatever at once and at the same time in the amount of standard money in the particular community. Any bank or group of banks starting at the close of a period of depression with a good percentage margin of reserves above the legal (or popularly reputed safe) minimum, can rapidly increase its earning assets and earned income by expanding credits on the basis of the same (or even less) standard (or legal) money in its vaults. This additional purchasing power in the hands of bank customers and borrowers may be assumed to have somewhat, if not just, the same immediate effect on prices as would a per capita increase of money in the community. As soon as any considerable number of enterprisers begin to share the confidence and belief that prosperous times are in prospect, the number of borrowers increases. The earlier an individual acts, the greater, probably, will be his eventual profit from the transaction, as funds borrowed at the lowest rate of interest are used to buy goods and equipment (and labor) at the lowest levels of prices, to be held and used while they are advancing to higher levels. There follows, therefore, on a smaller scale, and over a shorter period, the same kind of compensation between prices and interest rates as when prices advance because of the relative increase of standard money throughout the world. Wages rise at first more slowly and then more rapidly than prices of most products, until the wide profit margins shrink. Discount rates then rise with the growing demands of customers. The relation of various particular prices in the general system of prices undergoes rapidly various modifications, notably the relation between capital-valuations of durable and indirect goods with near-finished direct goods. Then every miscalculation, especially the overestimate of capital values (based on the combination of low discount rates on borrowed funds and high expected product-prices) reveals itself, the margin of security shrinks or vanishes, and many bank credits are "frozen."

4. Public aspects of bank-credits in relation to stable prices.


As to the banks' part in the movement of the business cycle, public and economic opinion in the past has thought it should be guided only by individual (or corporate) self-interest and the motives of private competitive profit, limited only by the minimum legal percentage of reserves. The banks have accordingly acted independently and indeed had to do so or lose the chance of profits for their stockholders. Midway in the upward price movement, long before its culmination, other banks (and the country as a whole) would benefit if some of the banks would cease expanding their credits. But as a private competitor the individual bank could not afford to do this. Only by acting in combination, and therefore monopolistically, could the banks together share the gains and losses of early restriction of credit while yet having an ample reserve percentage margin and legal lending power. And in this matter, as for long years in respect to transportation, the public could see nothing but good in competition, and has been very reluctant to admit the good in any measure of monopoly, even with governmental control. Popular fear of combination of moneyed institutions is still great.


In the Federal Reserve System, two monopolistic features were incorporated (doubtless without recognition of all their bearings): virtually centralized rediscount, and centralized note issues, both under control of the Federal Reserve Board. Very fortunately also (in contrast with the plan proposed by the National [Aldrich] Monetary Commission and almost unanimously preferred by the bankers of the country), the Federal Reserve System was given a far more public character and control, notably in not granting to the member banks all the profits as the Aldrich plan proposed. As a result of limiting to 6 per cent the dividends from the Federal Reserve Banks going to member banks the attitude of the whole banking community toward the sacrifice of earning assets (and therefore profits) of the Federal Reserve Bank since 1921 has been very different from what it otherwise would have been. It would be difficult to exaggerate the contrast. If only in the period between 1918 and 1920 the Federal Reserve policy had not become entangled and confused, through the mistaken zeal of the treasury department, with the policy of low interest rates on bonds, the country might have been spared a large part of the loss of that period of ridiculous price inflation.


There has been revealed of late the possibility of stabilizing in considerable measure the minor swings of prices (business cycles), by increasing the percentage and even the amount of reserves of standard money (impounding gold), at the sacrifice of possible bank profits, instead of passively letting the speculative demands of business precipitate a period of inflation. It is at last seen by a few, though not as yet generally by the public (nor confessed by the Federal Reserve Board), that the paramount use for public welfare that can be made of surplus assets is not to inflate credit and raise prices, but to keep prices as nearly level as possible. The index number, not the reserve percentage, might better be the compass by which to guide the discount policy of the great central, noncompetitive bank. But such action has pretty definite limits which are frequently ignored. It cannot long control or defy the larger swings correlated with standard money production and use, but only or mainly the minor savings caused by bank credit expansion. Ultimately the balance between gold and production costs in marginal mines must determine the valuation of the standard unit and the level of prices on the gold standard throughout the world.

5. Various types of loans and divergent interest rates.


We have spoken*86 of the differences in interest rates existing side by side in different markets for loans. Such are seen in the higher interest rates long prevailing in the newer compared with the older states; in agricultural compared with urban districts; in the rates on bonds of long successful compared with doubtful enterprises; and in the varying rates for bank and mercantile credit, granted on poor, fair, or prime security. Such contemporaneous differences may be largely explained as due to risk (of losing principal and interest), to trouble of placing and collecting loans, etc., as seen from the standpoint of marginal lenders that are in a position to choose between the two forms of investment (vice versa as to borrowers). But evidently the true market net interest rate to non-marginal lenders within each territorial or other class of credit market must be genuinely different because of the prevailing competitive conditions (reflected in the particular system of prices in which they live and work). We are not now concerned primarily with these contemporaneous differences, connected either with geography or risk, but merely with time differences, the fluctuations over periods of time which occur in each of these kinds of loans, and more or less parallel with those in the other kinds of loans.


It has been a common observation that interest rates vary (in frequency and degree of change) somewhat directly with the shortness of the term of the loans.*87 This means, of course, the more frequent necessity of renewals, and the greater proportion of all the loans of that type becoming subject of bargaining for renewal at any one time or state of the loan market. Thus something like 75 per cent of all outstanding loans now are in corporation and government bonds and real estate, rural and urban, aggregating perhaps ninety to one hundred billion dollars.*88 On these the current rates for new loans and renewals are the most stable, following on the whole, most closely the general trend of long-time contractual (or nominal) and adjusted (commodity) interest rates. At the other extreme is the much smaller, quite elastic volume of fluid funds, consisting of call loans, commercial paper, bankers' acceptances and Federal Reserve rediscounts, on the average perhaps five billion dollars (say 4 per cent of all loans). The current rates on these are most fluctuating (extremest on call loans); for these are the marginal loans, on the frontier, so to speak, of speculative investment, and made with reference to the more ephemeral changes of prices and opportunities for profit.


Midway between these two classes of loans stands the very considerable class of the more ordinary bank loans to commercial borrowers, together with the casual business credit by manufacturers and merchants to customers, totaling perhaps something less than thirty billion dollars, or something more than 20 per cent of all existing credits. The nominal rates on these change little, but the actual effective rate is very considerably modified by altering terms of collateral, of customers' balances, refusal to renew, etc.

6. Underlying relationship of these various loan markets.


No doubt these three (and correspondingly their various subdivisions) are imperfectly connected markets, between which, because of legal restrictions, commitments, habits, lack of financial machinery, etc., there is a tardy transfer of funds by either borrowers or lenders. Moreover persistent average differentials in rates reflect risks and costs and trouble of placing and collecting loans. These markets to a large extent go their separate ways, and their time fluctuations of interest rates, be they large or small, manifest a considerable degree of independence. Long time real estate loans, continue to be made at about the same rates throughout periods when short time commercial loans are undergoing wide fluctuations. Likewise a large degree of independence must subsist at times in the several minor price systems, but fundamentally they are all connected and related to each other by the slow, though imperfect, transfer of marginally located funds until what may be called the "normal" differential is re-established. We might picture these various time-discount rates as the cars of a train hitched together by elastic couplings, all drawn along by the same engine. On a perfectly level track, moving at a perfectly even speed, they would keep the same relative positions and distances apart. But they would lag or catch up as the engine changed its speed and as, with varying grades of the track, gravity now retarded, now accelerated, their motion.


This view seems true of moderate or ordinary fluctuation of business; but some evidence indicates that in times of critical credit changes, the readily marketable, staple, long-time bonds (on the larger exchanges) may undergo notable swings of price (and reciprocally, their long-time yields).*89 Viewed as mere dips in price, likely to be followed in a few years, at most, by recovery, the changes of capital value plus the regular interest make a total sacrifice by the seller (and gain to the buyer) possibly commensurate with, if they do not exceed, the larger fluctuations of the rates on call loans. Is not the explanation to be found in the fact that in the periods of financial catastrophe, a considerable number of even the best bonds become, so to speak, the last line of reserves to be thrown into the battle by speculators and bankers, the one asset convertible into ready funds? Therefore bonds are brought out of strong boxes by wealthy market operators and by financial institutions. The "supply" of funds available for their purchase is so small that the "marginal price" registered by sales is very low. But the actual sales represent a very small proportion of the outstanding amounts. These securities are mostly held by more passive investors whose valuation is much higher than that of the market, who would not think of selling at the momentary prices but who yet have little or no new funds by which to add to their holdings.


7. Different kinds of inflation as affecting prices and interest rates.


In the foregoing comparison between long and short time changes in price levels, we may have a clue to the unraveling of an old puzzle (at least a trial may be worth while); that is, the contradictory effects upon interest rates that seem to follow changes in prices at different times. To survey the problem briefly: before Hume it seems to have been generally thought that if money increased (and prices rose) the interest rate would fall and stay there. Hume declared (he seems to have been considering only the effects after the adjustment to a new level was complete) that prices and interest rates were independent, and the rate the same after the price level had changed that it was before. Then the theory of appreciation and interest, though not contradictory to Hume's view of the problem he was examining, showed that just during the period of gradual general price change in one direction, interest rates are affected, but precisely opposite to the popular notion. Interest rates then fall while money and prices decrease and rise while they increase. Not only has the old notion persisted popularly, but it has from time to time appeared in the more professional economic circle. Certain facts as to foreign trade movements, rates of foreign exchanges, bank reserves, note issues, increase of bank credits, commercial prices and ease of commercial credit, refuse stubbornly to chime with the simple sweeping proposition that rising prices always cause (or at least accompany) rising interest and discount rates. At times the outstanding and anomalous fact is a rapid expansion of trade and rise of prices continuing for months (in rare cases even for years) with little or no increase, possibly some reduction, in discount and interest rates in commercial circles.


We are tempted to find the explanation in the contrast between long and short time price changes, and in the lag of the interest rate, as the effect, behind rising prices as the cause. There may be some truth here, but the larger part promises to be found in the contrast between the two main sorts of price inflation in respect to their origin or cause, the one resulting from an increase in standard money, the other from an increase of bank credits. Ordinarily the standard money is gold or silver which, following changes in physical conditions of mining output, comes into circulation and is paid out by mine owners and workers gradually to buy goods without having been at any time in the hands particularly of a lending class. Likewise (whether or not we designate it as standard money), the irredeemable, political paper money issued from the printing press by needy governments, comes into circulation day by day directly as means of payment of current expenses, not assuming even momentarily the form of a loan fund. The first and immediate effect of money coming into circulation directly thus as means of payment is to raise prices of commodities, whatever effects, if any, it may later have indirectly on interest rates (notably the compensatory adjustment of contractual rates, already discussed).


Quite otherwise is it in the case of price inflation by means of bank credit; it matters not immediately whether the particular form which the new purchasing power takes is deposit and discount or bank note issues (credit currency). Any surplus percentage of reserves above legal requirements is to banks potential lending power, (e.g., 80 per cent in a central bank when the minimum legal requirement is 35 per cent, or 25 per cent for member banks when the minimum legal requirement has just been reduced to 13 per cent). Viewed as private enterprises merely, the banks have at such times not only the power, but the profit motive, to expand their loans, to convert this useless, ornamental surplus reserve into earning assets as fast and as far as possible. If the central bank management has misgivings about letting this occur, these may be overridden by Federal fiscal influences because of a predetermined policy to float governmental loans at low rates of interest.

8. Abnormal bank-loan expansion and commercial discount rates.


Now what happens to prices and interest rates under these conditions? Note that if prices are to be affected, it is to be through putting into the hands of business men the purchasing power represented by this huge latent loan fund, and it cannot be until that is done. Let it be assumed that, dollar for dollar, purchasing power of that kind will at least for a while have the same effects as an increase of standard circulating money in raising prices in commercial circles (immediately and directly, no matter how the later adjustments may differ).*90 The latent inflating medium-of-exchange has no effect on prices until it becomes actual. It is first a huge loan fund concentrated in the hands of bankers and only after being loaned to bank customers does it increase the ratio of dollar purchasing power to goods for sale. The moment that it begins to be loaned, it tends to shift the balance of buyers and sellers of loan funds in the market for commercial credit, in favor of the borrowers, and to lower discount rates, or keep them low despite large borrowing. If the shift is sudden, if the potential amount of this loan fund is large, and if the movement, therefore, can be long continued (as between 1915-1920), it is easily understandable how bank (and other related commercial) discount rates would behave abnormally, and remain low while prices were steadily, and at last rapidly, advancing. Customers are tempted and, so to speak, bribed by the low discount rates, to borrow this new purchasing power, than as commodity prices rise, customers borrow more, and thus the vicious circle of loans raising prices which in turn increase loans continues so long as the discount rates remain level, or rise little. Only the approaching exhaustion of the surplus reserve percentages calls a halt.


Meanwhile, of course, there would have been the constant tendency not only for the discount rate, but for the whole price system in this banking and commercial world to get out of accord with the underlying forces of time-valuation, and with the previous (and in a sense more "normal") scheme of capital-valuations and prices. Commercial loans pretty closely connected with banking are barely one-fourth of all loans, and for the other three-fourths (now around one hundred billion dollars) little of these banking funds would be available. Further, the capitalization of several hundred billion dollars of existing wealth would be only very imperfectly adjusted to this artificial and temporary cheapness of banking credit. The whole situation is such as to deceive the judgment and demoralize the business policies in every line of enterprise. Political pressure may prolong this movement even after the banks, if left to their own judgment and self-interest, would have curtailed credit and raised discount rates. It is probably the most outstanding case in which contractual interest and discount rates on commercial loans appear to find their cause and explanation for considerable periods outside of fundamental time-valuation factors, and out of accord with them, though in the end those factors govern. This situation has served to mislead some economists into the development of a general theory of interest based on bank credit.

9. Bank loan elasticity and the needs of business.


The foregoing presents the extreme case of the expansion and contraction of bank loans in relation to prices but in principle quite small changes in the loan policies of banks affecting the volume of commercial loans, discount rates, and percentages of reserves, are of the same nature.*91 They cause and constitute inflation and deflation of the exchange medium and of commercial purchasing power, not originating in changes in the amount of standard money but in the elasticity of banking loan funds. This word "elasticity" has long been used in discussion of banking policy to designate a quality assumed to be highly and wholly desirable in bank note issues and in customers' credits, but with only vague suggestions as to what is the need, standard, or means, with reference to which bank loans should expand and contract.


Rather, it may be more exact to say, the tacit assumption has been that the bank loan funds should be elastic in response to "the needs of business." But "the needs of business" appears to be nothing but another name for changes in customers' eagerness for loans; and this eagerness increases when prices are beginning or are expected to rise, and often continues to gather momentum while prices rise and until, because of vanishing reserve percentages (and other factors), the limit of this elasticity and also the limit of price increase, are in sight. In this situation, the most conservative business operations become intermixed with elements of investments speculation, motivated by the rise of prices and the hope of profit that will be made possible by a further rise. Throughout this process the much esteemed elasticity of bank funds is the very condition causing, or making possible, the rising prices which stimulate the so-called "needs of business." Truly a vicious circle, to be broken only by crisis and collapse when bank loans reach a limit and prices fall. Then business failures, depreciation and losses written off, and the readjustment of capital values, bring the system of prices again into some semblance of self-consistency, and particularly bring the scheme of prices in active commercial markets which are most influenced by bank discount rates, into better accord with the larger, more inert volume of long-time loans and with the greater mass of the capital-valuation in owned wealth more rarely bought and sold.


Quite different would be the course of events if "the needs of business" were to be judged with reference, not to the speculative desires of individual traders (however "natural" and excusable) to expand operations because of and in expectation of rising prices, but were to be judged rather with reference to the "need" (or desirability) of a stable level of prices for the whole community. Then an official index number of general prices might better than customers' clamor indicate the social-welfare need of expanding bank loans. Given a bank reserve-percentage rate in excess of legal requirements, bank inflation would truly fill a (public) need when prices were falling, but not when prices were rising. If this index were followed, that portion of the fluctuations of prices and of the business cycle due to the vicious circle of bank inflation to meet the so-called "needs of business," would be minimized instead of caused or accentuated.


No doubt there must be a limit to the possible operation of such measures at either end of any legally enacted scale of reserve-percentage rates, and in any long-time movement of prices either up or down. It would seem that in principle the influence of such a policy of bank credit control upon price changes must be confined in the main within the short-time fluctuations of the business cycle, and must eventually in any country whose standard money is a precious metal, yield place to the major influences determining the world production and supply of the standard metal which influence the long-time swings.


We are not concerned here with the difficulties in the way of practical application of such a plan because of habits of thought, old usages, and administrative details; we are only indicating the nature of the problem and the possible contrasting policies. The whole subject has been viewed in the past in the light of the acquisitive, private-profit conception applied to banking, which, at least in part, defeats its own ends, as well as the ends of general welfare.

10. The Bank of England rediscount policy and the price level.


The nearest approach to a policy of deliberately manipulating bank loans in relation to national, rather than to individual, "needs" is the practice, originating with the Bank of England, of varying its rediscount rates. An adequate treatment of this highly technical subject would transcend our theme and our powers, but some aspects we may venture to glimpse. The purpose of raising the rediscount rate is quite definitely to protect the country's central reservoir of gold when a turn of foreign exchange rates threatens to deplete it by causing exportation. However, the purpose only one step removed (indeed bound together with main purpose as means to end) is to reduce commercial borrowing at home, thus reducing commercial purchasing power and thus checking the rise of, or deflating, English prices in commercial circles. Two results follow almost simultaneously: one, English commodity prices cease rising, or are slightly reduced relative to foreign prices, and thus English exports are stimulated and imports to England are discouraged; and two, the higher discount rates tempt back English assets held abroad as well as induce foreign bankers to extend or to increase finance bills and other credits to England. Both of these changes reduce, and may remove entirely for the time, the adverse foreign exchange rates calling for the net export of gold from England. The artificial raising of the rediscount rate really effects a lowering of commodity prices in England (both absolutely and relatively to those of other countries) and if it does not increase absolutely the amount of standard money in the country, it has at least the negative effect of preventing the decrease that otherwise would occur.


The plan really works. It is well to inquire carefully, however, whether this process shows more than a restricted, temporary, and superficial power to determine the level of prices or the form of the price system by changes artificially initiated in interest rates. In our view, in accord with the general theory of time-valuation, this process is nothing more than an anticipation of the bank-fund deflation that would otherwise be forced by the continued export of gold. Raising the rediscount rate merely puts springs under commercial prices to prevent their dropping later with a jolt. Moreover it is essentially a process of readjustment of relative price levels and of the stock of international standard money, in different geographical areas of the world, prices and money stocks in different national markets having become more or less out of alignment with world conditions. Fundamentally it is almost entirely unrelated to the problem of the long-time level of general prices either in the particular country or in the world at large.

11. Wicksell's startling doctrine of discount policy examined.


Such a role (however useful) is more modest than seems to be attributed by a good many economists here and abroad to the rediscount policy. The extremest view, that taken by the late Professor Knut Wicksell, has gained a wide hearing and some following loyal enough to claim "Wicksell as the originator of the modern theory of discount policy, which constitutes the chief advance of monetary theory since Ricardo."*92 Wicksell's thesis is this: If, other things remaining the same, the banks from any cause whatever together fix their interest rates somewhat below the normal level (assumed to be fixed by "marginal productivity") all commodity prices will rise and continue to rise without any limit whatever; and vice versa. There is an incredible rigidity in the claim of lasting effects from a temporary change of bank discount rates: "When commodities have risen in price, a new level of prices has formed itself which in its turn will serve as basis for all calculations for the future and all contracts. Therefore, if the bank rate now goes up to its normal height, the level of prices will not go down....there being no forces in action which could press it down"*93


Criticism of this proposition is difficult because of the elusive order and ambiguous nature of Wicksell's discussion. For at times he implies that the thesis has an important and useful application to real conditions and again confesses that "it is only an abstract statement," and even that it is one of such nature that it can have no meaning or use in the financial world as it is. However, it can be shown that in either case the proposition is unsound—even taking it most "hypothetically." A gross fallacy is contained in the very first phrase, "other things remaining the same," for this does not have its legitimate meaning and purpose of limiting to one (a change of the bank rate) the new conditions or causal factors assumed to be different from the normal reality. The attentive reader soon discovers that Wicksell is assuming, or confessing, in order that the thesis shall hold at all, that before the bank rate could have the effect indicated, several other very important things must be quite different from what they are. First, all the banks of a country must act together, the individual bank, even a strong central one, would be powerless; then, this not being enough, all the banks of the world must act together, the single nation would be powerless; then, there must be "no circulation whatever of coins or notes," or the attempt to maintain an artificially low discount rate would break down by the exhaustion of reserves; and it appears by this time that the thesis is meant to be defended only in the case of a complete regime of bank credit, with a zero reserve percentage.


Now in such a banking Utopia where bank credit were the only medium of exchange, if credit continued indefinitely to be extended to all applicants at an artificially (or arbitrarily) low rate of interest (not determined by the "normal" or usual forces), then there seems nothing to prevent constant bank credit inflation and a constant rise of prices, in turn creating a motive for more commercial loans, ad infinitum, just as in the case of Russian and German paper money inflation. Under such conditions the price of a shoe string or of a loaf of bread in terms of the nominal monetary unit may burst the mathematical tables. Either a regime of irredeemable paper money or a complete regime of bank credit without any money or any reserves, can be said to make possible a rise of general prices without assignable limits. But Wicksell's doctrine as a guide to practical banking policy is more to be shunned by stable money theorists than poisoned alcohol as a beverage. With the gold standard or some other definite standard of reserves, Wicksell's policy would be utterly unworkable, as he concedes quite casually. If he had presented his doctrine in a different order, introducing first the wildly unreal condition under which alone it could be imagined to operate, probably no one could have been deceived, not even its inventor, into thinking it could give any guidance in actual situations.


At times Wicksell's thought seems to be in a confused way that in the situation which he propounds prices rise indefinitely not because bank loans are continuously expanded, but because the discount is kept artificially low (while loans are restricted). But the superficiality of such a view is patent. It is simply unthinkable that all prices should rise continuously without continuous increase in the exchange mechanism either of standard money or of bank credit, or in the rapidity of turnover. If, however, discount rates were kept artificially low in Wicksell's imaginary banking regime, this would create a speculative "need" for loans (a demand for credit at a rate low compared with the time-discount rates pervading the general price system) and the amount of loans would steadily increase unless they were artificially restricted by rationing credit, or by favoritism, or by confining it to commercial purposes, or otherwise. Such a policy would affect unequally the prices and time-valuations involved in different kinds of goods. The notion that it would determine the time-discount rate embodied in the community's whole price system appears when viewed in the light of the capitalization theory, as foolish as "lifting one's self by one's bootstraps," or as "the tail wagging the dog." Bank loans are but a small proportion of all loans, and a much smaller proportion of the total wealth in private hands which is from time to time evaluated in terms of dollars. In all the durable sources of income are involved time-differences determining the shape in manifold ways of the whole system of relative contemporaneous prices. This system of prices itself rests upon, or grows out of, the totality of psychological time-valuation conditions. In the causal order of things the bank discount rates do not determine, they are in the long run determined by, these underlying conditions. With all their elements of artificiality, bank rates must, so far as competitive conditions prevail, tend to come into accord with the system of prices.*94

12. Fundamental conditions and government loans in war time.


We have mainly assumed the general underlying conditions of time-valuation to remain stable in the larger community, and have directed our attention almost entirely to changes originating on the side of the mechanism of exchange (either standard money or credits, banking, or other). A symmetrical treatment would require an equally full examination of the problems originating in changes from the side of time-valuation, assuming no change originating on the side of money and credit. But a few suggestions must suffice us here. Recall that in all the phases of time-valuation, from the most subjective in the simplest individual economy to the most objective in developed commercial markets where a general price prevails for time (interest rate, capitalization rate, etc.) differences may co-exist as between individual groups and different fields of investment. There are more or less distinct fields of time-valuation and time prices, only imperfectly connected. It must happen also, that changes even in relative prices in particular markets (e.g., through a sudden demand for certain kinds of ripe, direct goods, compared with others) may react on time-valuations of durable wealth, often profoundly. Some indirect durable agents that make up the larger part of the wealth in one branch of industry (e.g., agriculture) may suddenly become much more or much less in demand relative to other indirect durable agents (e.g., mines or railroads or some kinds of machines). Now this, because of friction and imperfect substitution, may for a while throw the time-discount rates of different trading groups even more out of accord with each other than they were before. The individuals within these groups are readjusted (and readjust themselves) marginally to the need situation, and even those of greatest frugality and thrift now buy and sell goods at the prevailing prices in their group. Whether or not the implicit rate of time-discount will be changed depends alike on transfers from outside as well as on the latter strength and prevalence of individual frugality and providence within the group. Conversely, changes in time-preference originating within smaller groups must slowly change their respective marginal (market) rates of capitalization, etc., up or down, and these rates in turn, by substitution of investments, would gradually modify the time-valuation levels everywhere else.


The occasion or cause of change may be of such a general nature as to affect in large measure the real and actual time-valuations of all individuals and groups within a country, as notably on the outbreak of war. Then the immediate need of the equipment and munitions of war, not present in adequate quantities, must be met with an almost utter disregard of the future and of premium rate, and a large and costly equipment of indirect agents must be rapidly created which will be of little or no use when the war is ended. The effect is to raise quickly the whole general level of time-discounts and time-premiums. Countries with large saleable or pledgeable assets may for a while retard such a rise by selling claims, securities, credits, against others or against themselves, to wealthy neutral nations, as Great Britain and France sold securities to and borrowed from the United States between 1914 and 1919. But this at the same time raises the marginal time-discount rates in the lending countries. Or it may happen (as in the period of the Napoleonic wars and in 1917 on our entry into the world war) that most of the capitalistic world becomes involved, and the fundamental marginal time-valuations are everywhere raised. At such times there is an inevitable competitive bidding and rivalry between the borrowing needs of the government for war purposes and those of private business (both in nonessential industries and in those directly and indirectly producing war supplies). Because of the pressure of business opinion and its political bearings, the administration always is betrayed into the illogical and self-defeating policy of trying to borrow at low rates and at the same time trying (one aspect of a price-fixing policy) to keep commercial interest rates artificially low by encouraging bank inflation. The enforcing of artificially lower bank discount rates to buyers of national bonds by giving them preference as collateral (as in the case of Liberty and Victory bonds) combined with patriotic pressure and quota bond selling, leads to bond purchases largely or purely by bank loans rather than from thrift and saving, and to the extensive pledging by business borrowers of whatever equities in national bonds they have.


Here is a place where, as to the general commercial discount rate, the consistent and practical policy would be laissez faire, as a high interest rate would be one effective means of cutting off the demand for loans by the "nonessential" industries, and thereby would prevent diverting labor and materials from the war industries. Higher interest rates as costs in "essential" industries could be directly and frankly compensated by higher prices of those particular products, rather than by a course which inevitably raises the prices of all commodities. Another policy always used more or less in connection with price fixing (both of commodity prices and of loans) is that of rationing and, by tcreditshe high hand of a governmental agency, apportioning only to "war-essential" industries. Despite the danger of mistaken judgment and the occurrence of abuses, this is potentially both more logical and more effective than price fixing in securing the real end in view, viz., to use for war purposes, not for private enjoyment, the all too inadequate stocks of goods and human labor at hand. There are deductive grounds, never yet shown to be unsound, for condemning as fallacious and self-defeating the ever-repeated attempts of governments to float loans at less than those warranted by the general state of the price system. The attempt always involves tinkering with the exchange mechanism (either currency or bank credits and notes, usually both), with the result of price inflation. This ultimately imposes upon the nation as a whole burdens and losses incomparably greater than the petty saving in interest charges on the public debt for a few years. To depress interest rates on public loans artificially and by governmental pressure to manipulate bank discount rates is to treat superficial symptoms while ignoring underlying conditions. Just so far as present purchasing power in greater amounts and at artificially depressed interest rates is, in wartime, put into the hands of those who clamor for "business as usual," so far is reduced and retarded the most needed shift of goods from present private use to capital equipment and to present goods for war purposes, paid for by public loans. Prices become inflated, war costs are increased, and the people really pay usuriously both as taxpayers and as the victims of the inevitable financial crisis.

13. Interest theory and after-war recovery.


Conditions in which time-valuations change in an opposite direction from that taken in wartime, occur at the close of a great war. These cannot be adequately discussed within the limits of this paper; but certainly recent events (1918-1926) as well as a broader theory of time-valuation, unite to discredit the belief of J. S. Mill, that a country devastated in time of war and from which "nearly all the movable wealth existing in it" has been carried away, will "by the mere continuance of that ordinary amount of exertion which they are accustomed to employ in their a few years" acquire "collectively as great wealth" as before.*95 The root of Mill's error (in fact and in theory) more clearly appears in his affiliated discussion of "government loans for war purposes." The amount borrowed (and spent for goods destroyed in war uses) "was abstracted by the lender from a productive employment" concedes Mill, and "the capital, therefore, of the country, is this year diminished by so much." But (here begins the error) he declares: "The loan cannot*96 have been taken from that portion of the capital (concrete goods) of the country which consists of tools, machinery, and buildings. It must have been wholly drawn from the portion employed in paying laborers.... But....there is no reason that their labor should produce less in the next year than in the year before." This is all wrong; there is no such "cannot have been," no such "must," and there is abundant "reason" to the contrary. The whole thought is tainted with the labor theory of value. For in truth, from the moment that war begins to raise time-discounts, and progressively until peace returns, physical depreciation proceeds, the normal peace time repairs, replacements, and improvements of many durable agents are curtailed, especially those in the non-essential industries, normal building operations and additions to industrial equipment are suspended, while current production is applied not only to procuring the materials to be immediately consumed in the war, but even more to building the elaborate equipment of indirect agents which are to become nearly worthless the moment the war is ended. This would be true even in a victorious uninvaded country. In a conquered land, from which "nearly all the movable wealth" had been carried away, the case would be far worse. Returning to the arts of peace, the population even with herioc self-denial and efforts, may for years be unable to obtain again the pre-war stream of commodity income. The peasant is lacking in beasts of burden and agricultural equipment; the artisan is forced to return to simpler tools and machinery; both are lacking in stocks of raw material; while highways, bridges, and other means of transport are in ruins. The mass of the population, even to exist, is forced to adjust itself to a lower standard of living, a condition which makes peculiarly burdensome any effective "abstinence" to create loanable funds and additions to the durable wealth directed toward future needs. These evils, it need hardly be said, are usually greatly aggravated by political disorders and by the monetary demoralization resulting from both paper money and bank credit inflation. In this situation no doubt large loan funds (to be used mainly to buy imported industrial equipment) could in many cases, if wisely chosen, be "profitably" borrowed from more prosperous nations. That is to say, the price system is such in the devastated country, that all sorts of goods with future uses are so priced that investors can "profit" (individually) by contracting to pay abroad high interest rates to buy, build, and increase the number of such long-time, durable bearers of future uses. The greatest difficulty is that borrowers lack good enough security and the moral factor of credit to obtain, even at high interest rates, the loans needed either for public or private uses.

14. Conclusion.


The foregoing are but illustrations of the practical questions, the answers to which presuppose and imply some general theory of interest. They vary widely in scope and nature as do also the answers that have been offered. There is but little evidence in the large volume of recent discussion of price movement and the business cycle that the implicit question of interest has been explicitly considered as an integral part of the price system. Interest theory receives attention only incidental to or aside from the price system. An interest theory is advanced which does not originally apply to all kinds of prices. Interest (so far as attributed to impersonal forces) is explained by an ambiguous technical "productivity" of a restricted group of "artificial" agents, the rate so determined being then thought to be applied in the capitalization of other agents; or it is explained as fixed in the realm of bank loan credit, and then somehow to permeate all other loans and prices. These are piecemeal interest theories which fail to find general cause for interest inherent in the relation of all kinds of goods to man's nature and needs. They are what Böhm-Bawerk called fructification theories, rightly condemned by him in principle,*97 as an attempt to stretch a partial explanation so as to make it appear to be a complete one. Such an attempt is an almost infallible sign that the explanation is not only incomplete but unsound. Not discovering the generally valid ground of explanation, it has chosen an invalid—not even partially valid—ground.


It may be too much to attribute to the lack of sound interest theory alone all the inharmonious and discordant ideas and policies regarding interest rates and prices that have lately stalked abroad. Human thought has a remarkable capacity to go wrong at many points and in many ways. But the thesis of this paper is that a unified time-valuation theory makes it clear that time-discounts and premiums enter into the formation of all prices both of direct and of indirect goods, and are an inseparable part of even the earliest price systems; that the price system is logically and chronologically antecedent to all forms of contractual interest, which is merely derivative from the capitalization process; that finally this view gives a clear, consistent criterion by which to test various notions with respect to price changes and policies with respect to the fixing of interest and discount rates by government or banks, and it shows the limits of their possible application. Our object will have been attained if theoretical discussion shall have been aroused, statistical inquiry stimulated, and in the end, practical efforts to stabilize prices helped to move along right lines.

Notes for this chapter

Capital and Interest, English translation, p. 47.
E.g., he speaks of political economy, "from Say's time to the present," as having been "captivated by the deceptive symmetry that exists between the three great factors of production—nature, labour, capital." Positive Theory, p. 1.
Many examples of this could be cited. Even Irving Fisher lapses into this thought at times; e.g., The Rate of Interest, p. 91; and Elementary Principles, pp. 229 and 336.
A term introduced by the writer in Principles of Economics, 1904.
See above, sec. 4.
Positive Theory, pp. 348-9.
Capital and Its Earnings, 1888.
Explicitly, first, it seems in his Principles, 3d ed., 1895, pp. 142 and 664, cited by Böhm-Bawerk in preface to his second edition of his Geschichte, etc.
History of Theories of Production and Distribution, 1894.
See "Interest Theories, Old and New," American Economic Review, vol. 4, March, 1914 [see above, pp. 226-255].
See the writer's paper on "Value and the Larger Economics," Journal of Pol. Econ., 1923, pp. 587, 790.
Some of these are indicated in "Interest Theories, Old and New," op. cit.
Positive Theory, p. 237. Of course this proposition is not itself a theory of interest, but merely the statement of a broad empirical fact whose explanation constitutes "the interest problem." The truth is that Böhm-Bawerk does not make and keep this "the kernel and center" of his "positive theory," for to do so would seem to require a consistent "agio" or time-preference theory such as he promised to give. But instead, as he went on, he made technical productivity of capital (in the roundabout process) more and more the kernel and center of his explanation, "the third reason why present goods are, as a rule, worth more than future." Positive Theory, p. 260. This becomes in his view "the principal form assumed by the interest problem." Ibid., p. 299. It is the circumstance giving "the phenomenon of the higher valuations of present goods an almost universal validity" whereas on the other merely psychological grounds "an overwhelming majority (of men) would have no preference for present goods." Ibid., 277. This prevailing preference becomes in his explanation almost entirely the result of technical productivity, presented as the chief cause of this premium on present goods (and therefore of interest) independent of any of the two already mentioned. Ibid., p. 270.
Ibid., e.g., pp. 250, 251, 297. The frequency of these exceptions seems to be greatly minimized in Böhm-Bawerk's view by his practice, in nearly every case where he seeks to test the matter by an example, of shifting from particular goods to a sum of money. E.g., ibid., pp. 250 ff., 255, 256, 276, et passim. It can happen much more rarely that a present dollar would be worth less than a future dollar, in a modern community with a developed financial system, with borrowing, saving accounts, etc.; in fact, it could occur only in periods of catastrophic changes in general prices, or because of some peculiar personal choice of particular goods that are undergoing great changes in their relative prices. This adjustment of particular prices to the general time-premium on money is in part touched on below.
Principles, 1st. ed., p. 627.
Prof. Waldo F. Mitchell alone, it seems, claims now to find in the statistical data no evidence of such a result.
Part II, Sec. 8.
See Mr. Carl Snyder's discussion and formulation in American Economic Review, December, 1925, pp. 684-699, esp. p. 690.
Approximately Snyder's estimates, op. cit.
See some data given by Waldo F. Mitchell, in American Economic Review, June, 1926, p. 216.
As shown by the statistical studies of Holbrook Working, Review of Economic Statistics, July, 1926, p. 120, "Bank Deposits as a Forecaster of the General Wholesale Price Level"; earlier article in Quar. Jour. Econ., Feb., 1923.
See Holbrook Working, op. cit., for striking statistical confirmation of the principle.
See Economic Journal, vol. 36, p. 503 (and especially p. 507) Sept., 1926, obituary notice of Knut Wicksell by Prof. B. Ohlin; Economic Journal, vol. 17, p. 213, "The Influence of the Rate of Interest on Prices," paper read by Prof. Wicksell before the economic section of the British Association; Jahrbucher, 1897, p. 228, "Der Bankzins als Regulator der Warenpreise," by K. Wicksell.
Econ. Jour., op. cit., p. 216.
As shown above in sections 5 and 6.
Book 1, Chapter V. Section VII.
Our italics.
See above, part I, sec. 4.

Part 3, Essay 1. The Passing of the Old Rent Concept

End of Notes

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