The Theory of Interest

Fisher, Irving
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New York: The Macmillan Co.
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§1. Opportunity Reduced to Lowest Terms


SINCE the second approximation contains the heart of the theory of interest, a further brief summary and discussion of the steps already taken will be helpful before proceeding to the third approximation.


Any opportunity to invest simply reduces itself to this: for a time there is more labor or less satisfaction than there would be in the absence of such opportunity, while there is expected later less labor or more satisfaction. The earlier item of labor or abstinence is less than the expected satisfaction or labor saving. This picture of temporary labor exerted, or abstinence from satisfactions which would otherwise be enjoyed, for the sake of later satisfaction or labor saving is the ultimate picture of cost and return.


When thus reduced to these lowest terms of labor and satisfaction, not only is our picture simplified, but with the simplification, we have rid it of a certain suspicion of begging the question of the interest problem. That is, as long as interactions, capital, and money were in the investment opportunity picture, interest was already implied in each of their valuations and there might remain a haunting fear that this new rate of return over cost as an interest-determining factor was simply involving us in a circle. The question might be asked: Is the rate of return a new influence? Is there really any important distinction between the rate realized on a bond, which is interest pure and simple, and the rate realized on any other investment? Are they not all simply interest, and is there anything else behind this interest besides human impatience? Is not the sum invested simply the discounted value of the return expected with due regard to the risk element, which has not yet been considered?


The answer, as should now be clear, is that the rate of return over cost really is a new element, not included in the first approximation, however mixed that element may be, in practice, with the elements considered earlier. When labor and satisfactions are concerned there is something more than exchange. The labor of planting a fruit tree is not the same thing as the discounted value of the fruit yielded by the tree, even though the value of the labor and the value of the fruit may be equal at a given time. The satisfaction from eating fruit is pleasure and the labor of planting it is pain, and these can be directly compared, despite the fact that in practice they are usually compared only indirectly in terms of their exchange equivalents.


Instinctively we feel the presence of this factor of rate of return over cost whenever we invest in a new enterprise. To invest in the original telephone enterprise, or in a railway under construction, seems somehow different from today buying telephone or railway securities. In the latter transactions we feel we are dealing with men—trading; in the former we feel we are dealing with Nature or our technical environment—exploiting. In fact, I came near selecting the term exploitation for a suitable catch word rather than investment opportunity to express the objective factor of a return over cost. Of course, even after the period of early exploitation is passed there are plenty of opportunities within the industry for variation in the rates of return over cost, but they are no longer so conspicuous.


Even when there is no exchange possible, as with Robinson Crusoe alone on his island, there will be dealings with Nature. Crusoe may plant trees or build a boat and balance his immediate labor against his future satisfactions without the presence of any exchange process. It would have been possible, of course, to have begun the presentation with Robinson Crusoe instead of ending with him. In that case, we should have first considered the primitive facts of labor exerted for the sake of future satisfaction, or their equivalent in berries. We could then bring in Man Friday, and proceed step by step to the complications of modern civilization. We should have seen how the primitive cost and return typified by labor and satisfaction became gradually hidden in a mass of exchanges until today we think of both in terms of money. The capitalist of today, instead of laboring for a future satisfaction, may simply abstain temporarily from a part of the satisfactions he could otherwise enjoy and, with the money which he would have spent for them, buy the labor to build a railway. The laborer is no longer the one who has to wait for the satisfactions to follow the completion of the railway. He is paid in advance and converts his pay into real wages very speedily, while the capitalist waits and receives the rewards for waiting.


In all these and the other manifold exchange relations the terms are partly set by the principles of discount in relation to impatience. But the primitive ingredients of labor and satisfaction, or their cost of living equivalents, with a time interval between, are never shuffled out of existence, however much they may be shuffled out of sight. They are ever present and exert their influence just as truly as they did with Robinson Crusoe.


In making the first of these two adjustments, the individual is not trading with other human beings, but is, as it were, trading with his environment—Nature and the Arts. That is why industry today maintains laboratories of research. These aim to improve products and service by scientific means, to develop new fields of application in by-products and materials, and to evolve new products and methods and so new investment opportunities. Trading with the environment is making the most of investment opportunity—of the future income returned per unit of present income sacrificed. Trading with mankind is making the most of impatience—of the preference for a unit of present income over a unit of future income.


When the individual sets out to trade with the environment he finds that the rate of return over cost varies with the extent to which he pushes this trading; he adjusts the trading so as to harmonize the marginal rate of return with the rate of interest. In his trading with other human beings, on the contrary, he finds the terms of the contract interest fixed, so far as any effort by him is concerned, but impatience varies with the extent to which he pushes this trading.

§2. Investment Opportunity Essential


Some economists, however, still seem to cling to the idea that there can be no objective determinant of the rate of interest. If subjective impatience, or time preference, is a true principle, they conclude that because of that fact all productivity principles must be false. But they overlook two important points. One is that, obviously and as a matter of practical fact, the technique of production does affect the rate of interest, and therefore cannot be ignored; the other, that their proposed solutions are indeterminate—i.e., they have more unknown quantities than determining conditions.


If, then, I am asked to which school I belong—subjective or objective, time preference or productivity—I answer "To both." So far as I have anything new to offer, in substance or manner of presentation, it is chiefly on the objective side.*69


In my opinion minute differences of opinion as to the relative importance of human impatience and investment opportunity are of too little consequence to justify violent quarrels as to which of the two is the more fundamental, although I shall here and later, as occasion offers, note certain differences between them. The important point is that the two rates, that of marginal time preference and that of marginal return over cost, must be equal, granted continuity of variation, that is, variation by infinitesimal gradations. If, as Harry G. Brown,*70 in a very interesting Robinson Crusoe phantasy, assumes as a theoretical possibility, the rate of return over cost is fixed immutably at 10 per cent, the rates of impatience must conform thereto and the rate of interest can only be 10 per cent. Later in this chapter an even simpler and more easily imagined case, while at the same time more startling in its conclusions, is presented in which the technical limitations impose a fixed rate of interest and of human impatience of zero per cent. There, investment opportunity dominates.


On the other hand, we could also imagine the converse case; we could assume, as a theoretical possibility, a society of persons having an obstinate constancy in their rates of impatience, all being 10 per cent. In such a case, the marginal rate of return over cost would be adjusted thereto.


A person's rate of impatience depends on the extent to which he modifies his income stream by loans or sales. It is evident that if loans can be used to any extent desired, impatience will vary continuously with them.


The rate of return over cost, on the other hand, depends on the extent to which a person modifies his income stream by altering the way in which he utilizes his capital resources. Such alteration, while partly continuous, is partly discontinuous, as when new machinery, buildings, personnel or systems are introduced.


It was to emphasize this distinction between impatience and opportunity that I chose to begin with the case of a supposedly rigid income stream, as in the first approximation, with no opportunity to substitute any other; then to proceed to the case of three optional uses of land (distinguished for convenience as farming, mining, forestry) affording opportunity to substitute for one of them either of the others and thus disclosing in such substitution two alternative rates of return over cost; and finally to reach the supposed case of an infinite variety of income streams differing from one another by infinitesimal gradations. Only in the last named case is the rate of return over cost as variable as the rate of impatience.


It should be noted that in the first approximation, where the income stream is fixed or rigid and there is no alternative income stream, there can be no comparative cost or return and therefore no rate of return over cost. But we cannot so easily imagine a similar disappearance of impatience. It would be quite impossible to have any exchange between present and future—any rate of interest—without the existence of time preference, as it would be quite impossible to have any exchange whatever without human wants. They are an omnipresent and necessary condition of all exchange and valuation.

§3. Options Differing in Time Shape Only


Options differ in three chief ways corresponding to the characteristics, already noted, of the income stream, namely, (1) in composition, (2) in risk, and (3) in size and time shape. Options which differ primarily in composition or the kind of services rendered are illustrated by the options of using a building as a dwelling, as a shop, or as a factory. Options which differ primarily in the probability or risk are exemplified by the use of a ship on a hazardous voyage or in safe river transportation. Options which differ in size and time shape of the income stream are illustrated by the innumerable uses of land and artificial capital to produce different kinds of goods (income) of different degrees of immediateness as to the satisfactions they render.


The third group of options (which differ in the size and time shape of the income stream) is the one which especially concerns us here. First, let us suppose only one degree of flexibility, permitting variation in the time when the income items arrive but no variation in their amounts. Let us suppose, then, that the income stream from any capital is fixed in aggregate amount, but that the times of receiving that income are controllable at will. This species of choice occurs approximately in the case of durable goods for consumption, which neither improve nor deteriorate with time. A stock of grain, for instance, may be used at almost any time, with little difference in the efficiency of the use and little cost except for storage. The same is true of coal, cloth, iron, and other durable raw materials, as well as, to some extent, of finished products such as tools and machinery, though usually deterioration from rust, or other injury by the elements, will set in if the use is too long deferred. Another simple example is a definite sum of money in a strong box which may be spent at any time, or times, desired. Thus a strong box containing $100,000 may be so used as to yield a real income of $100,000 for one year, or $10,000 a year for ten years, or $4,000 a year for twenty-five years.


Such options afforded by durable goods (as when to use them) are perhaps the simplest of all options. Since extreme cases are especially instructive, let us imagine a community in which the income from all capital is of the character just described. That is, we suppose the total quantity of income obtainable is absolutely fixed, but the times at which it can be obtained are absolutely optional. This community would then be endowed with a definite quantum of income as fixed as the quantity of money in a strong box. That is, every dollar of income sacrificed from one year's income would eke out any other income by that same amount, a dollar, no more and no less; conversely, every dollar of income enjoyed in one year would reduce indulgence elsewhere by exactly a dollar. The rate of interest would be reduced to zero.

§4. The Imaginary "Hard-Tack" Illustration


To fix our ideas, let us suppose these conditions to be realized on a desert island on which some sailors are shipwrecked and each left with a specified number of pounds of hard-tack and with no prospect of ever improving his lot. We shall suppose the use of this hard-tack to be the only real income open to these castaways, and that they have given up all hope of ever adding to it by accessions from outside or by cultivating the island which, for our hypothesis, must be barren. No change in their human nature need be assumed. We assume that they would react to the same income just as before the shipwreck. Merely their circumstances have changed. In consequence, the only possible variation of their income streams—consisting solely of the use of hard-tack—is that made possible by varying the time of its consumption. Suppose one of them has an initial stock of 100,000 pounds. He has the option of consuming his entire store during the first year, or of spreading its use over two or more years, but in any case he will eventually aggregate the same total income, measured in hard-tack, spread over the future, namely 100,000 pounds.


A little reflection will show that, in such a community, the rate of interest in terms of hard-tack would necessarily be zero! For, by hypothesis, the giving up of one pound of hard-tack out of present consumption can only result in an equal increase in future consumption. One pound next year can be obtained at the cost of exactly one pound this year. In other words, the rate of return over cost is zero. Since, as we have seen, this rate must equal the rates of preference, or impatience, and also the rate of interest, all these rates must be zero also.


This case is illustrated in Chart 21. One option is to consume the hard-tack at an even rate OA through the time OB. The total income will then be represented by the area OACB. Another option is to spread it over OB', double the above-mentioned time, and consume it at the rate of OA', half the rate first mentioned, so that the same total income will be represented by the area OA'C'B'. The choice of the second use rather than the first is at the cost of that part of the earlier income represented by the rectangle AD, and gives a return exactly equal in amount represented by the rectangle DB'. If the hard-tack is not consumed at a uniform rate, the alternative income streams will not be represented by rectangles, but by the irregular and equal areas OADB and OA'DB', shown in Chart 22. The substitution of the alternative OA'DB' for OADB increases immediate income by ADA' and decreases subsequent income by the exactly equal amount BDB'.

Figure. Click to enlarge in new window.

Figure. Click to enlarge in new window.


The conclusion, that the rate of interest, under such extreme conditions supposed in the hard-tack case, must be zero, is at first startling, but it is easy to convince ourselves of its correctness. It would be impossible for any would-be lender to obtain interest above zero on his loan for the only way in which a borrower could repay a loan would be to pay it out of his original stock of hard-tack. For assuming he had the impulse to borrow 100 pounds to consume today and pay back 105 pounds at the end of a year, he would instantly perceive that he could better consume the 100 pounds of his own hard-tack, thereby sacrificing next year not 105, but only 100 pounds out of his own stock. It is equally impossible that there should be a negative rate of interest. No one would lend 100 pounds of hard-tack today for 95 receivable a year later, when he had the option of simply storing away his 100 pounds today and taking it out, undiminished, a year later. Hence, exchanges of present for future hard-tack could not exist, except at par. There could be no premium or discount in such exchange.


Nor (to turn to the subjective side) could there be any rate of preference for present over future hard-tack. The sailors would so adjust the time shape of their respective income streams that any possible rate of preference for a present over a future allowance of hard-tack would disappear, and a pound of this year's hard-tack and a pound of next year's hard-tack would be equally balanced in present estimation. For, should a man prefer one rather than the other, he would transfer some of it from the unpreferred time to the preferred time, and this process would be continued, pound by pound, until his want for a pound of immediate hard-tack and his want for a pound of future hard-tack were brought into equilibrium. Thus, if through insufficient self-control, he prefers, however foolishly, to use up much of his store in the present and so to cut down his reserve for the future to a minimum, the very scantiness of the provision for the future will enhance his appreciation of its claims, and the very abundance of his provision for the present will diminish the urgency of his desire to indulge so freely in the present.


Provided each individual is free to apportion his share of the total stock of hard-tack between present use and future use as he pleases, and provided there is some hard-tack available for both uses, the present desire for a pound of each will necessarily be the same.


(Failure of such equilibrium of want could only occur when, as in starvation, the want for the present use was so intense as to outweigh the want for even the very last pound for future use, in which case there would be none whatever reserved for the future.)


All persons, however different in nature, would alike have a zero rate of impatience. They would differ simply in the way they distributed their income over present and future. The spendthrift and the miser would still spend and save respectively but both would value a unit of hard-tack today as the exact equivalent of one due a year hence. It is evident that some of the sailors, with a naturally keen appreciation of the future, would plan to consume their stores sparingly. Others would prefer generous rations, even with the full knowledge that starvation would thereby be brought nearer, but none of them would consume all of his stock immediately. They would, generally speaking, prefer to save out of such reckless waste at least something to satisfy the more urgent needs of the future.


In other words, a certain amount of saving (if such an operation can be called saving) would take place, without any interest at all. This conclusion coincides with conclusions expressed by Professor Carver in his Distribution of Wealth.*71 It shows also that the preference for present over future goods of like kind and number is not, as some writers assume, a necessary attribute of human nature, but that it depends always on the relative provisioning of the present and future.


The foregoing imaginary hard-tack case is of great help, therefore, in emphasizing the essential rôle of the rate of return over cost. This simple example, of itself, demonstrates that no theory of interest is complete which ignores the rate of return over cost. In the example we have both elements, investment opportunity and impatience, although both are at the vanishing point, that is, the rate of return and the rate of impatience are both zero, the former, rate of return, being fixed at zero by the technical conditions of the particular environment on the desert island, and the impatience rate being forced thereby to be zero also. In this case opportunity (or the lack of it) rules impatience.


It would be possible, of course, to make this illustration somewhat more realistic by adding to our supposed supplies of hard-tack supplies of other foods, as well as of clothing and sundry other real income. But the value of the illustration is not in any realism which can be made out of it. Rather does the fact that conditions in real life do not permit such freedom of shifting real income in time (because of change in quantity or quality) reveal some of the reasons why the rate of interest is not zero.

§5. The Imaginary "Figs" Example


Not only may the rate of interest conceivably be zero; it may conceivably be negative. Suppose our sailors were left not with a stock of hard-tack, but with a stock of figs which, like the hard-tack, can be used at any time as desired, but which, unlike the hard-tack, will deteriorate. The deterioration will be, let us say, at a fixed and foreknown rate of 50 per cent per annum. In this case (assuming that there is no other option available, such as preserving the figs) the rate of interest in terms of figs would be necessarily minus 50 per cent per annum, as may be shown by the same reasoning that established the zero rate in the hard-tack case.


More generally, this would be true if there were a world in which the only provisioning of the future consisted in carrying over initial stocks of perishable food, clothing, and so forth and if every unit so carried over into the future were predestined to melt way each year by 50 per cent.


One reason why we do not encounter such cases, with negative rates of return over cost, negative rates of interest, and negative rates of time preference is that we have other income available for the future besides what can be carried over from present stocks. Future figs will come into being from fig trees and even existing stocks of figs and other perishables may be carried over for future use by canning, cold storage, preservation and similar processes. Yet we do, even in our real world, occasionally have cases such as of spoiling strawberries, where, the rate of interest reckoned in terms of the strawberries is occasionally negative.


We see, then, that there is no absolutely necessary reason inherent in the nature of man or things why the rate of interest in terms of any commodity standard should be positive rather than negative. The fact that we seldom see an example of zero or negative interest is because of the accident that we happen to live in an environment so entirely different from that of the ship-wrecked sailors.

§6. The Imaginary "Sheep" Example


The next example is more like that in our real world. In the real world our options are such that if present income is sacrificed for the sake of future income, the amount of future income secured thereby is greater than the present income sacrificed. That is, the income which we can extract from our environment is not, in the aggregate, a fixed quantum like a storehouse of hard-tack; still less is it like a storehouse of dwindling contents. On the contrary, Nature is, to a great extent, reproductive. Growing crops and animals often make it possible to endow the future more richly than the present. Man can obtain from the forest or the farm more by waiting than by premature cutting of trees or by exhausting the soil. In other words, Nature's productivity has a strong tendency to keep up the rate of interest. Nature offers man many opportunities for future abundance at trifling present cost. So also human technique and invention tend to produce big returns over cost.


It is difficult to imagine a precise and simple case in which the rate of return over cost is fixed as in the case of the hard-tack or the figs but, instead of being zero or negative, is positive, say 10 per cent, neither more nor less. The best example is the ingenious one worked out by Professor Harry G. Brown in which fruit trees are planted at the cost of 100 units of fruit and automatically produce 110 units of fruit a year later and then die.*72 A simpler imaginary example, if we can forget certain obvious practical limitations, is that of the proverbial flock of sheep, which multiply in geometric progression affording alternately 100 units of mutton and wool today or 110 next year and ten per cent more each succeeding year. These examples symbolize a state of things in which it is always possible at the cost of 100 units out of this year's income to secure a return of 110 units next year, making a return over cost of 10 per cent. In such examples, just as in the hard-tack case with its zero per cent, or the fig case with its minus 50 per cent, the investment opportunity principles prescribe or dictate the rate of interest and the rate of time preference. These rates will in the present instance of the sheep all be 10 per cent.


We see then that, given the appropriate environment, the investment opportunity principle may dominate interest and force it to be zero, or minus 50 per cent, or plus 10 per cent, or any other figure. Under such conditions, the rate of impatience and the rate of interest will follow suit.


In actual life, however, any shoving of real income forward or backward in time can never be done without causing a variation in the rate of return over cost. The result is that the rate of impatience influences the rate of return quite as truly as the rate of return influences impatience.

§7. Opportunities as to Repairs, Renewals, Betterments


In the foregoing examples the options consisted of different employments of a particular instrument or set of instruments of capital which were assumed to retain their physical identities throughout the period of those employments. But now let us regard an instrument, or group of instruments, of capital as retaining only a sort of fictitious identity, through renewals or repairs, just as the proverbial jack-knife is said to be the same knife after its blade and then its handle have been replaced. This brings us to another large and important class of options; namely, the options of effecting, or not effecting, renewals and repairs, and the options of effecting them in any one of many different degrees. If the repairs are just sufficient for the up-keep they may be called renewals; if more than sufficient, or if involving improvement in quality, they may be called betterments. But it will be convenient to include in thought all alterations as to the form, position, or condition of an instrument or group of instruments affecting its stream of services. This will cover the whole subject of the production of reproducible goods.


This class of optional employments, when the employment involves sales from a stock, merges imperceptibly into the special case which we originally called the method of modifying an income stream by buying or selling. Thus, consider a merchant who buys and sells rugs. His stock of rugs is conveniently regarded as retaining its identity, although the particular rugs in it are continually changing. This stock yields its owner a net income equal to the difference between the gross income, consisting of the proceeds of sales, and the outgo, consisting chiefly of the cost of purchases, but including also cost of ware-housing, insurance, wages of salesmen, and so on.


If the merchant buys and sells equal amounts of rugs and at a uniform rate, his stock of rugs will remain constant and its net income to be credited to that stock will theoretically, that is, under our present assumption of a riskless world, be equal to the interest upon its value. It will be standard income.*73 This income to be credited to his stock in trade is, of course, to be distinguished from that to be credited to his own efforts—his wages of super-intending (neither need be called profits in a riskless world).


But the owner has many other options than that of thus maintaining a constant stock of goods. He may choose to enlarge his business as fast as he makes money from it, in which case his net realized income will be zero for a time, because all return is "plowed back" into the business. His stock will increase and eventually his income will be larger. In this option, therefore, his income stream is not contant, but ascends from zero to some figure above the standard income which constituted the first option.


A third option is gradually to go out of business by buying less rugs than are sold, or none at all. In this case the realized income at first is very large, as it is relieved of the burden of purchases; but it declines gradually to zero.


Intermediate among these three options there are, of course, endless other options. The merchant thus has a very flexible income stream.


If the expenses and receipts for each rug bought and sold are the same, whichever option is chosen, and if the time of turnover is also the same, it will follow that all of the options possess the same present value and differ only in desirability. We should then be dealing with what we have called modifications of the income stream through buying and selling. The reason for placing optional employments of capital on a different footing from buying and selling is that the optional employments do not all possess the same present value. In actual fact, the rug merchant, and merchants in general, would not find that all the optional methods of proportioning sales and purchases of merchandise possessed equal present values. For one thing, if the rug merchant attempted to enlarge his business too fast he would find that his time of turnover would be lengthened, and if he reduced it too fast he would find that his selling expenses per unit of merchandise would be increased. There is, for each merchant, at any time, one particular line of business policy which is the best, namely, that which will yield him the income stream having the maximum present value. Since, therefore, the various methods of renewing one's capital usually yield income streams differing in present value, they may be properly classed as optional employments of such capital.


The propriety of such a classification becomes still more evident when, instead of mere renewals, we consider repairs and betterments, for it is clear that the income from a farm has a very different present value according as it is tilled or untilled, or tilled in different degrees of intensity, that the income from a house so neglected that a leak in the roof or a broken window pane results in injuring the interior is less valuable than the income it would yield if properly kept up, and that real estate may be underimproved or overimproved as compared with that degree of improvement which secures the best results.


In all cases the "best" results are secured when that particular series of renewals, repairs, or betterments is chosen which renders the present value of the prospective income stream the maximum. This, as we have seen, is tantamount to saying that the renewals, repairs, or betterments are carried up to the point at which the marginal rate of return over cost which they bring is equal to the rate of interest. The owner of an automobile, for instance, will replace a broken part and so prolong the life of his automobile. The first repair may cost him $10 and may save him $200. But such a twenty-fold return cannot be expected from every repair, and beyond a few such really necessary repairs, it soon becomes a question to what extent it is worth while to keep an automobile in repair. Repainting the body and regrinding the valves are both costly, and though, in such instances, the service of the automobile is increased in quantity and improved in quality, the return grows less and less as the owner strives after increased efficiency. Under our present hypothesis in which risk is disregarded, he will spend money on his automobile for repairs and renewals up to that point where the last increment of repairs will secure a return which will just cover the cost with interest. Beyond this he will not go.


In practice, of course, the choice between the various possible repairs, renewals, or betterments will involve some corresponding choice between possible employment of labor, land, and every agent of production. But I have tried here to isolate for study the services and disservices of a physical instrument subject to repairs, renewals, or betterments.


Another case of optional income streams is found in the choice between different methods of production, especially between different degrees of so-called capitalistic production. It is always open to the prospective house builder to build of stone, wood, or brick, to the prospective rail-road builder to use steel or iron rails, to the maker of roads to use macadam, asphalt, wood, cobble, brick, or cement, or to leave the earth unchanged except for a little rolling and hardening. The choice in all cases will depend theoretically on the principles which have been already explained.


To take another example, the mere services of a house which has a durability of 100 years will be equivalent to the services of two houses, each of which has a durability of 50 years, one built today and lasting 50 years, and the other built at the expiration of that period and lasting 50 years more; yet the one house may well be better than the two. The difference between the one and the two will not be in the services but in the cost of construction. The cost of constructing the 100-year house occurs in the present; that of the two successive 50-year houses occurs half in the present and half at the end of 50 years. In order that the more durable house may have any advantage as to cost, the excess of its cost over the cost of the less durable one must be less than the present value of the cost of replacing it 50 years later.


The choice between different instruments for effecting the same purpose may, of course, depend on their relative efficiency, that is, the rate of flow of income, or upon their relative durability, that is, the time of the flow. It is true, however, as John Rae has pointed out,*74 that efficiency and durability usually go hand in hand. A house which will endure longer than another is usually more comfortable also; a tool which will cut better will usually wear out more slowly; a machine which does the fastest work will generally be the strongest and most durable.


The alternatives constantly presented to most business men are between policies which may be distinguished as temporary and permanent. The temporary policy involves the use of easily constructed instruments which soon wear out, and the permanent policy involves the construction at great cost of instruments of great durability. When one method of production requires a greater cost at first and yields a greater return afterward, it may be called, conformably to popular usage, the more capitalistic of the two. The word capitalistic refers to methods of employing capital which tend toward an ascending income stream. Although the term is not a happy one, it has a plausible justification in the fact that an ascending income stream means the accumulation of capital, or saving, and still more in the fact that only a capitalist can afford to choose a method of production which at first yields little or no income, or even costs some outgo. Capital involves command over income without which no one could subsist, or at any rate subsist with comfort. The capitalist, by using his capital, even to the extent of using up some of his accumulations, can supply himself with the immediate income necessary while he is waiting for returns on his new ventures. It is as a possessor of income that he is enabled to subsist while waiting. He is enabled to invest in an ascending, or slowly returning, income stream only by first having at command a quickly returning income stream. We may say, therefore, that a capitalistic method is a method resulting in an ascending income stream, and it is so called because it is open chiefly to those who have command of other—often descending—income streams, such persons being necessarily capitalists, that is, possessors of much rather than little capital.

§8. Opportunity to Change the Application of Labor


The best example of the choice between those uses of capital instruments affording immediate and those affording remote returns is found in the case of human capital, commonly called labor. Man is the most versatile of all forms of capital, and among the wide range of choices as to the disposition of his energies is the choice between using them for immediate or for remote returns. This choice usually carries with it a choice between corresponding uses of other instruments than man, such as land or machines. But the existence of optional employments of labor, however inextricably bound up with optional employments of other instruments, deserves separate mention here both because of its importance and because it usually supplies the basis for the optional employments of other forms of capital.


It is almost exclusively through varying the employment of labor that the income stream of society, as a whole, is capable of changing its time shape. The individual may modify the time shape of his particular income stream through exchange, but in this case some other person must modify his income stream in the opposite manner, and the two sorts of modifications, some plus and others minus, offset each other in the total of the world's income. On the other hand, if an income is modified in time shape merely through a change in the exertions of laborers, there is no such offset, and the total social income is actually modified thereby.


The labor of a community is exerted in numerous ways, some of which bring about enjoyable income quickly, others slowly. The labor of domestic servants is of the former variety. The cook's and waitress' efforts result in the enjoyment of food within a day. Within almost as short a time, the chambermaid and the laundress promote the enjoyment of house, furniture, and clothing. The baker, the grocer, the tailor are but one step behind the cook and laundress; their efforts mature in enjoyments within a few days or weeks. And so we may pass back to labor increasingly more remote from enjoyable income, until we reach the miner whose work comes to fruition years later, or the laborer on the Panama Canal or the vehicular tunnels, whose work was in the service of coming generations.


The proportions in which these various kinds of labor may be assorted vary greatly, and it is largely through varying this assortment that the income stream of the community changes its time shape. If there are at any time relatively few persons employed as cooks, bakers, and tailors, and relatively many employed as builders, miners, canal and tunnel diggers, there will tend to be less immediately enjoyable income and correspondingly more enjoyable income in later years. Thus, by withdrawing labor from one employment and transferring it to another, it is in the power of society to determine the character of its income stream in time shape, and also in size, composition, and uncertainty. This power is exerted through the "enterpriser," to use Professor Fetter's term, according to the enterpriser's estimate of what return will come from each particular employment taken in connection with the cost involved and the ruling rate of interest.

§9. Fluctuations in Interest Rates Self-Corrective


Since the choice, for an individual, among different options, depends on the rate of interest in the manner described in Chapter VI, it is clear that a low rate favors the choice of the more ascending income streams, but also that the choice of such income streams reacts to raise the rate of interest. If, on the contrary, the rate is high, the opposite of both these propositions holds true; the high rate favors the choice of the less ascending income streams, but that choice reacts to lower the rate of interest.


Thus, if we apply these principles to repairs, renewals, and betterments, it is evident that the lower the rate of interest, the better can the owner of an automobile afford to keep it in repair, and the better can the owner of a railroad keep up its efficiency, and the same applies to all other instruments. But it is equally clear that the very attempt to improve the efficiency of instruments tends, in turn, to increase the rate of interest, for every repair means a reduction in present income for the sake of future—a shifting forward in time of the income stream—and this will cause a rise in the rate of interest. Thus, it follows that any fall in the rate of interest will tend to bring its own correction.


Again, it is evident that a choice of the more durable instruments, as compared with those less durable, will be favored by a low rate of interest, and a choice of short-lived instruments will be favored by a high rate of interest. If the rate of interest should fall, there would be a greater tendency to build stone houses as compared with wooden ones. The present value of the prospective services and disservices of stone houses as compared with wooden houses would be increased, for although stone houses are more expensive at the start, they endure longer, and their extra future uses, which constitute their advantage, will have a higher present value if the rate of interest is low than if it is high. We find, therefore, as John Rae has so well pointed out, that where the rate of interest is low, instruments are substantial and durable, and where the rate of interest is high they are unsubstantial and perishable.


We see, then, that the existence of numerous options has a regulative effect. Beyond the margin of choice there always lie untouched options ready to be exploited the instant the rate of interest falls. Among these, as Cassel*75 has pointed out, are waterworks of various kinds. Not only works of stupendous size but hundreds of less conspicuous improvements are subjects of possible investment as soon as the rate of interest falls low enough to make the return upon cost equal to the rate of interest. The same is true of the improving, dredging, and deepening of harbors and rivers, the use of dikes and jetties, the construction of irrigation works for arid lands, and Boulder Dam projects.


There is still room for much improvement in our railway systems by making them more efficient and more durable, by making the roads straighter, the roadbeds more secure, the rolling stock heavier, the bridges larger and stronger, by further electrifications, and similar improvements. In a new country where the rate of interest is high, the cheapest and most primitive form of railway is first constructed. Very often it is a narrow-gauge road with many curves, costing little to construct, though much to operate. Later, when the rate of interest falls, or the traffic so increases that the rate of return on sacrifice is greater, the broad-gauge comes into use and the curves are eliminated. This is the kind of change which has been proceeding in this country with great rapidity during recent years. There is a transition from relatively small first cost and large running expenses to precisely the opposite type of plant, in which the cost is almost all initial and the expense of operation relatively insignificant.

§10. Wide Opportunities Stabilize Interest


The existence of a wide variety of available income streams, then, acts as a sort of governor or balance wheel which tends to check any excessive changes in the rate of interest. Interest cannot fall or rise unduly; any such fluctuation corrects itself through the choice of appropriate income streams.


We see here a reason why interest does not suffer very violent fluctuations. It is not only true that natural processes are regular enough to prevent sudden and great changes in the income stream; it is also true that man constantly aims to prevent such changes. Man is not the slave of Nature; to some extent he is her master. He has many ways to turn. He possesses, within limits, the power to flex his income stream to suit himself. For society as a whole, the flexibility is due to the adaptability and versatility of capital—especially human capital commonly called labor; for the individual, the flexibility is greater still, since he possesses a two-fold freedom. He is not only free to choose from among innumerable different employments of capital, but he is free to choose from among different ways of exchanging with other individuals. This power to exchange is the power to trade incomes; for under whatever form an exchange takes place, at bottom what is exchanged is income and income only.

Notes for this chapter

A somewhat similar treatment is that of Professor Harry G. Brown, Economic Science and the Common Welfare. Mathematical treatments substantially in harmony with mine are those of Walras and Pareto referred to in Appendix to Chapter XIII.
H. G. Brown, Economic Science and the Common Welfare, pp. 137-145.
p. 232. See also Carver, T. N. The Place of Abstinence in the Theory of Interest, Quarterly Journal of Economics, Oct., 1893, pp. 40-61.
Brown, Economic Science and the Common Welfare, pp. 137-147.
See The Nature of Capital and Income, Chapter XIV, No. 4.
Rae, The Sociological Theory of Capital, p. 47.
The Nature and Necessity of Interest, p. 122.

Part II, Chapter 9

End of Notes

14 of 34

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