Principles of Economics
By Alfred Marshall
Economic conditions are constantly changing, and each generation looks at its own problems in its own way. In England, as well as on the Continent and in America, Economic studies are being more vigorously pursued now than ever before; but all this activity has only shown the more clearly that Economic science is, and must be, one of slow and continuous growth. Some of the best work of the present generation has indeed appeared at first sight to be antagonistic to that of earlier writers; but when it has had time to settle down into its proper place, and its rough edges have been worn away, it has been found to involve no real breach of continuity in the development of the science. The new doctrines have supplemented the older, have extended, developed, and sometimes corrected them, and often have given them a different tone by a new distribution of emphasis; but very seldom have subverted them…. [From the Preface to the First Edition]
First Pub. Date
London: Macmillan and Co., Ltd.
The text of this edition is in the public domain.
- Appendix A
- Appendix B
- Appendix C
- Appendix D
- Appendix E
- Appendix F
- Appendix G
- Appendix H
- Appendix I
- Appendix J
- Appendix K
INTEREST OF CAPITAL.
BOOK VI, CHAPTER VI
§ 1. The relations between demand and supply cannot be studied by themselves in the case of capital any more than they could in the case of labour. All the elements of the great central problem of distribution and exchange mutually govern one another: and the first two chapters of this Book, and more especially the parts that relate directly to capital, may be taken as an introduction to this and the next two chapters. But before entering on the detailed analysis with which they will be mainly occupied, something may be said as to the position which the modern study of capital and interest holds in relation to earlier work.
The aid which economic science has given towards understanding the part played by capital in our industrial system is solid and substantial; but it has made no startling discoveries. Everything of importance which is now known to economists has long been acted upon by able business men, though they may not have been able to express their knowledge clearly, or even accurately.
Everyone is aware that no payment would be offered for the use of capital unless some gain were expected from that use; and further that these gains are of many kinds. Some borrow to meet a pressing need, real or imaginary, and pay others to sacrifice the present to the future in order that they themselves may sacrifice the future to the present. Some borrow to obtain machinery, and other “intermediate” goods, with which they may make things to be sold at a profit; some to obtain hotels, theatres and other things which yield their services directly, but are yet a source of profit to those who control them. Some borrow houses for themselves to live in, or else the means wherewith to buy or build their own houses; and the absorption of the resources of the country in such things as houses increases, other things being equal, with every increase in those resources and every consequent fall in the rate of interest, just as does the absorption of those resources in machinery, docks, etc. The demand for durable stone houses in place of wood houses which give nearly equal accommodation for the time indicates that a country is growing in wealth, and that capital is to be had at a lower rate of interest; and it acts on the market for capital and on the rate of interest in the same way as would a demand for new factories or railways.
Everyone knows that people will not lend gratis as a rule; because, even if they have not themselves some good use to which to turn the capital or its equivalent, they are sure to be able to find others to whom its use would be of benefit, and who would pay for the loan of it: and they stand out for the best market
Everyone knows that few, even among the Anglo-Saxon and other steadfast and self-disciplined races, care to save a large part of their incomes; and that many openings have been made for the use of capital in recent times by the progress of discovery and the opening up of new countries: and thus everyone understands generally the causes which have kept the supply of accumulated wealth so small relatively to the demand for its use, that that use is on the balance a source of gain, and can therefore require a payment when loaned. Everyone is aware that the accumulation of wealth is held in check, and the rate of interest so far sustained, by the preference which the great mass of humanity have for present over deferred gratifications, or, in other words, by their unwillingness to “wait.” And indeed the true work of economic analysis in this respect is, not to emphasize this familiar truth, but to point out how much more numerous are the exceptions to this general preference than would appear at first sight
These truths are familiar; and they are the basis of the theory of capital and interest. But in the affairs of ordinary life truths are apt to present themselves in fragments. Particular relations are seen clearly one at a time; but the interactions of mutually self-determining causes are seldom grouped as a whole. The chief task of economics then as regards capital is to set out in order and in their mutual relations, all the forces which operate in the production and accumulation of wealth and the distribution of income; so that as regards both capital and other agents of production they may be seen
mutually governing one another.
Next it has to analyse the influences which sway men in their choice between present and deferred gratifications, including leisure and opportunities for forms of activity that are their own reward. But here the post of honour lies with mental science; the received doctrines of which economics applies, in combination with other material, to its special problems
Its work is therefore heavier in that analysis, on which we are to be engaged in this and the next two chapters, of the gains that are derived from the aid of accumulated wealth in the attainment of desirable ends, especially when that wealth takes the form of trade capital. For these gains or profits contain many elements, some of which belong to interest for the use of capital in a broad sense of the term; while others constitute
net interest, or interest properly so called. Some constitute the reward of managing ability and of enterprise, including the bearing of risks; and others again belong not so much to any one of these agents of production as to their combination.
The scientific doctrine of capital has had a long history of continuous growth and improvement in these three directions during the last three centuries. Adam Smith appears to have seen indistinctly, and Ricardo to have seen distinctly, almost everything of primary importance in the theory, very much as it is known now: and though one writer has preferred to emphasize one of its many sides, and another another, there seems no good reason for believing that any great economist since the time of Adam Smith has ever completely overlooked any side; and especially is it certain that nothing which would be familiar to men of business was overlooked by the practical financial genius of Ricardo. But there has been progress; almost everyone has improved some part, and given it a sharper and clearer outline; or else has helped to explain the complex relations of its different parts. Scarcely anything done by any great thinker has had to be undone, but something new has constantly been added
§ 2. But if we go back to mediæval and ancient history we certainly do seem to find an absence of clear ideas as to the nature of the services which capital renders in production, and for which interest is the payment; and since this early history is exercising an indirect influence on the problems of our own age, something should be said of it here.
In primitive communities there were but few openings for the employment of fresh capital in enterprise, and anyone who had property that he did not need for his own immediate use, would seldom forego much by lending it on good security to others without charging any interest for the loan. Those who borrowed were generally the poor and the weak, people whose needs were urgent and whose powers of bargaining were very small. Those who lent were as a rule either people who spared freely of their superfluity to help their distressed neighbours, or else professional money-lenders. To these last the poor man had resort in his need; and they frequently made a cruel use of their power, entangling him in meshes from which he could not escape without great suffering, and perhaps the loss of the personal freedom of himself or his children. Not only uneducated people, but the sages of early times, the fathers of the mediæval church, and the English rulers of India in our own time, have been inclined to say, that money-lenders “traffic in other people’s misfortunes, seeking gain through their adversity: under the pretence of compassion they dig a pit for the oppressed
*61.” In such a state of society it may be a question for discussion, whether it is to the public advantage that people should be encouraged to borrow wealth under a contract to return it with increase after a time: whether such contracts, taken one with another, do not on the whole diminish rather than increase the sum total of human happiness.
But unfortunately attempts were made to solve this difficult and important practical question by a philosophical distinction between the interest for the loan of money and the rental of material wealth. Aristotle had said that money was barren, and that to derive interest from lending it out was to put it to an unnatural use. And following his lead Scholastic writers argued with much labour and ingenuity that he who lent out a house or a horse might charge for its use, because he gave up the enjoyment of a thing that was directly productive of benefit. But they found no similar excuse for the interest on money: that, they said, was wrong, because it was a charge for a service which did not cost the lender anything
If the loan really cost him nothing, if he could have made no use of the money himself, if he was rich and the borrower poor and needy, then it might no doubt be argued that he was morally bound to lend his money gratis: but on the same grounds he would have been bound to lend without charge to a poor neighbour a house which he would not himself inhabit, or a horse for a day’s work of which he had himself no need. The doctrine of these writers therefore really implied, and in fact it did convey to people’s minds the mischievous fallacy that—independently of the special circumstances of the borrower and the lender—the loan of money,
i.e. of command over things in general, is not a sacrifice on the part of the lender and a benefit to the borrower, of the same kind as the loan of a particular commodity: they obscured the fact that he who borrows money can buy, for instance, a young horse, whose services he can use, and which he can sell, when the loan has to be returned, at as good a price as he paid for him. The lender gives up the power of doing this, the borrower acquires it: there is no substantial difference between the loan of the purchase price of a horse and the loan of a horse
§3. History has in part repeated itself: and in the modern Western World a new reforming impulse has derived strength from, and given strength to, another erroneous analysis of the nature of interest. As civilization has progressed, the loans of wealth to needy people have become steadily more rare, and a less important part of the whole; while the loans of capital for productive use in business have grown at an ever-increasing rate. And in consequence, though the borrowers are not now regarded as the subjects of oppression, a grievance has been found in the fact that all producers, whether working with borrowed capital or not, reckon interest on the capital used by them as among the expenses which they require to have returned to them in the long run in the price of their wares as a condition of their continuing business. On this account, and on account of the openings which the present industrial system offers of amassing great wealth by sustained good fortune in speculation, it has been argued that the payment of interest in modern times oppresses the working classes indirectly, though not directly; and that it deprives them of their fair share of the benefits resulting from the growth of knowledge. And hence is derived the practical conclusion that it would be for the general happiness and therefore right, that no private person should be allowed to own any of the means of production, nor any direct means of enjoyment, save such as he needs for his own use.
This practical conclusion has been supported by other arguments which will claim our attention; but at present we are only concerned with the doctrine that has been used by William Thompson, Rodbertus, Karl Marx, and others in support of it. They argued that labour always produces a “Surplus”
*64 above its wages and the wear-and-tear of capital used in aiding it: and that the wrong done to labour lies in the exploitation of this surplus by others. But this assumption that the whole of this Surplus is the produce of labour, already takes for granted what they ultimately profess to prove by it; they make no attempt to prove it; and it is not true. It is not true that the spinning of yarn in a factory, after allowance has been made for the wear-and-tear of the machinery, is the product of the labour of the operatives. It is the product of their labour, together with that of the employer and subordinate managers, and of the capital employed; and that capital itself is the product of labour and waiting: and therefore the spinning is the product of labour of many kinds, and of waiting. If we admit that it is the product of labour alone, and not of labour and waiting, we can no doubt be compelled by inexorable logic to admit that there is no justification for Interest, the reward of waiting; for the conclusion is implied in the premiss. Rodbertus and Marx do indeed boldly claim the authority of Ricardo for their premiss; but it is really as opposed to his explicit statement and the general tenor of his theory of value, as it is to common sense
To put the same thing in other words; if it be true that the postponement of gratifications involves
in general a sacrifice on the part of him who postpones, just as additional effort does on the part of him who labours; and if it be true that this postponement enables man to use methods of production of which the first cost is great; but by which the aggregate of enjoyment is increased, as certainly as it would be by an increase of labour; then it cannot be true that the value of a thing depends simply on the amount of labour spent on it. Every attempt to establish this premiss has necessarily assumed implicitly that the service performed by capital is a “free” good, rendered without sacrifice, and therefore needing no interest as a reward to induce its continuance; and this is the very conclusion which the premiss is wanted to prove. The strength of Rodbertus’ and Marx’s sympathies with suffering must always claim our respect: but what they regarded as the scientific foundation of their practical proposals appears to be little more than a series of arguments in a circle to the effect that there is no economic justification for interest, while that result has been all along latent in their premisses; though, in the case of Marx, it was shrouded by mysterious Hegelian phrases, with which he “coquetted,” as he tells us in his Preface.
§ 4. We may now proceed with our analysis. The interest of which we speak when we say that interest is the earnings of capital simply, or the reward of waiting simply, is
Net interest; but what commonly passes by the name of Interest, includes other elements besides this, and may be called
These additional elements are the more important, the lower and more rudimentary the state of commercial security and of the organization of credit. Thus, for instance, in mediæval times, when a prince wanted to forestall some of his future revenues, he borrowed perhaps a thousand ounces of silver, and undertook to pay back fifteen hundred at the end of a year. There was however no perfect security that he would fulfil the promise; and perhaps the lender would have been willing to exchange that promise for an absolute certainty of receiving thirteen hundred at the end of the year. In that case, while the nominal rate at which the loan was made was fifty per cent., the real rate was thirty.
The necessity for making this allowance for insurance against risk is so obvious, that it is not often overlooked. But it is less obvious that every loan causes some trouble to the lender; that when, from the nature of the case, the loan involves considerable risk, a great deal of trouble has often to be taken to keep these risks as small as possible; and that then a great part of what appears to the borrower as interest, is, from the point of view of the lender, earnings of management of a troublesome business.
At the present time the net interest on capital in England is a little under three per cent. per annum; for no more than that can be obtained by investing in such first-rate stock-exchange securities as yield to the owner a secure income without appreciable trouble or expense on his part. And when we find capable business men borrowing on perfectly secure mortgages, at (say) four per cent., we may regard that gross interest of four per cent. as consisting of net interest, or interest proper, to the extent of a little under three per cent., and of earnings of management by the lenders to the extent of rather more than one per cent
Again, a pawnbroker’s business involves next to no risk; but his loans are generally made at the rate of 25 per cent. per annum, or more; the greater part of which is really earnings of management of a troublesome business. Or to take a more extreme case, there are men in London, and Paris, and probably elsewhere, who make a living by lending money to costermongers. The money is often lent at the beginning of the day for the purchase of fruit, etc., and returned at the end of the day, when the sales are over, at a profit of ten per cent.: there is a little risk in the trade, and the money is seldom lost
*67. Now a farthing invested at ten per cent. a day would amount to a billion pounds at the end of a year. But no one can become rich by lending to costermongers; because no one can lend much in this way. The so-called interest on the loans really consists almost entirely of earnings of a kind of work for which few capitalists have a taste.
§5. It is then necessary to analyse a little more carefully the extra risks which are introduced into business when much of the capital used in it has been borrowed. Let us suppose that two men are carrying on similar businesses, the one working with his own, the other chiefly with borrowed capital.
There is one set of risks which is common to both; which may be described as the
trade risks of the particular business in which they are engaged. They arise from fluctuations in the markets for their raw materials and finished goods, from unforeseen changes of fashion, from new inventions, from the incursion of new and powerful rivals into their respective neighbourhoods, and so on. But there is another set of risks, the burden of which has to be borne by the man working with borrowed capital, and not by the other; and we may call them
personal risks. For he who lends capital to be used by another for trade purposes, has to charge a high interest as insurance against the chances of some flaw or deficiency in the borrower’s personal character or ability
The borrower may be less able than he appears, less energetic, or less honest. He has not the same inducements, as a man working with his own capital has, to look failure straight in the face, and withdraw from a speculative enterprise as soon as it shows signs of going against him. On the contrary, should his standard of honour not be high, he may be not very keen of sight as to his losses. For if he withdraws at once, he will have lost all he has of his own; and if he allows the speculation to run on, any additional loss will fall on his creditors; and any gain will come to himself. Many creditors lose through semi-fraudulent inertness of this kind on the part of their debtors, and a few lose through deliberate fraud: the debtor for instance may conceal in subtle ways the property that is really his creditors’, until his bankruptcy is over, and he has entered on a new business career; he can bring gradually into play his secret reserve funds without exciting over-much suspicion.
The price then that the borrower has to pay for the loan of capital, and which he regards as interest, is from the point of view of the lender more properly to be regarded as profits: for it includes insurance against risks which are often very heavy, and earnings of management for the task, which is often very arduous, of keeping those risks as small as possible. Variations in the nature of these risks and of the task of management will of course occasion corresponding variations in the gross interest, so called, that is paid for the use of money. The tendency of competition is therefore not towards equalizing this gross interest: on the contrary, the more thoroughly lenders and borrowers understand their business, the more certainly will some classes of borrowers obtain loans at a lower rate than others.
We must defer to a later stage our study of the marvellously efficient organization of the modern money market by which capital is transferred from one place where it is super-abundant to another where it is wanted; or from one trade that is in the process of contraction to another which is being expanded: and at present we must be contended to take it for granted that a very small difference between the rates of net interest to be got on the loan of capital in two different modes of investment in the same Western country will cause capital to flow, though perhaps by indirect channels, from the one to the other.
It is true that if either of the investments is on a small scale, and few people know much about it, the flow of capital may be slow. One person, for instance, may be paying five per cent. on a small mortgage, while his neighbour is paying four per cent. on a mortgage which offers no better security. But in all large affairs the rate of net interest (so far as it can be disentangled from the other elements of profits) is nearly the same all over England. And further the divergencies between the average rates of net interest in different countries of the Western World are rapidly diminishing, as a result of the general growth of intercourse, and especially of the fact that the leading capitalists of all these countries hold large quantities of stock-exchange securities, which yield the same revenue and are sold practically at the same price on the same day all over the world.
When we come to discuss the Money Market we shall have to study the causes which render the supply of capital for immediate use much larger at some times than at others; and which at certain times make bankers and others contented with an extremely low rate of interest, provided the security be good and they can get their money back into their own hands quickly in case of need. At such times they are willing to lend for short periods even to borrowers, whose security is not of the first order, at a rate of interest that is not very high. For their risks of loss are much reduced by their power of refusing to renew the loan, if they notice any indication of weakness on the part of the borrower; and since short loans on good security are fetching only a nominal price, nearly the whole of what interest they get from him is insurance against risk, and remuneration of their own trouble. But on the other hand such loans are not really very cheap to the borrower: they surround him by risks, to avoid which he would often be willing to pay a much higher rate of interest. For if any misfortune should injure his credit, or if a disturbance of the money market should cause a temporary scarcity of loanable capital, he may be quickly brought into great straits. Loans to traders at nominally low rates of interest, if for short periods only, do not therefore really form exceptions to the general rule just discussed.
§ 6. The flow of investment of resources from their common source in production consists of two streams. The smaller consists of new additions to the accumulated stock. The larger merely replaces that which is destroyed; whether by immediate consumption, as in the case of food, fuel, etc.; by wear-and-tear, as in that of railway irons; by the lapse of time, as in that of a thatched roof or a trade directory; or by all these combined. The annual flow of this second stream is probably not less than a quarter of the total stock of capital, even in a country in which the prevailing forms of capital are as durable as in England. It is therefore not unreasonable to assume for the present that the owners of capital in general have been able in the main to adapt its forms to the normal conditions of the time, so as to derive as good a
net income from their investments in one way as another.
It is only on this supposition that we are at liberty to speak of capital in general as being accumulated under the expectation of a certain net interest which is the same for all its forms. For it cannot be repeated too often that the phrase “the rate of interest” is applicable to old investments of capital only in a very limited sense. For instance, we may perhaps estimate that a trade capital of some seven thousand millions is invested in the different trades of this country at about three per cent. net interest. But such a method of speaking, though convenient and justifiable for many purposes, is not accurate. What ought to be said is that, taking the rate of net interest on the investments of new capital in each of those trades [
i.e. on marginal investments] to be about three per cent.; then the aggregate net income rendered by the whole of the trade-capital invested in the various trades is such that, if capitalized at 33 years’ purchase (that is on the basis of interest at three per cent.), it would amount to some seven thousand million pounds. For the value of the capital already invested in improving land or erecting a building; in making a railway or a machine is the aggregate discounted value of its estimated future net incomes [or quasi-rents]; and if its prospective income-yielding power should diminish, its value would fall accordingly and would be the capitalized value of that smaller income after allowing for depreciation.
§ 7. Throughout the present volume we are supposing, in the absence of any special statement to the contrary, that all values are expressed in terms of money of fixed purchasing power, just as astronomers have taught us to determine the beginning or the ending of the day with reference not to the actual sun but to a
mean sun which is supposed to move uniformly through the heavens. Further, the influences which changes in the purchasing power of money do exert on the terms on which loans are arranged, are most conspicuous in the market for short loans—a market which differs in many of its incidents from any other, and a full discussion of their influences must be deferred. But they should be noticed here in passing, at all events as a point of abstract theory. For the rate of interest which the borrower is willing to pay measures the benefits that he expects to derive from the use of the capital only on the assumption that the money has the same purchasing power when it is borrowed and when it is returned.
Let us suppose, for instance, that a man borrows £100 under contract to pay back £105 at the end of the year. If meanwhile the purchasing power of money has risen 10 per cent. (or which is the same thing, general prices have fallen in the ratio of 10 to 11), he cannot get the £105 which he has to pay back without selling one-tenth more commodities than would have been sufficient for the purpose at the beginning of the year. Assuming, that is, that the things which he handles have not changed in value relatively to things in general, he must sell at the end of the year commodities which would have cost him £115. 10
s. at the beginning, in order to pay back with interest his loan of £100; and therefore he has lost ground unless the commodities have increased under his hands 15½ per cent. While nominally paying 5 per cent. for the use of his money, he has really been paying 15½ per cent.
On the other hand, if prices had risen so much that the purchasing power of money had fallen 10 per cent. during the year, and he could get £100 for things which cost him £90 at the beginning of the year; then, instead of paying 5 per cent. for the loan, he would really be paid 5½ per cent. for taking charge of the money
When we come to discuss the causes of alternating periods of inflation and depression of commercial activity, we shall find that they are intimately connected with those variations in the real rate of interest which are caused by changes in the purchasing power of money. For when prices are likely to rise, people rush to borrow money and buy goods, and thus help prices to rise; business is inflated, and is managed recklessly and wastefully; those working on borrowed capital pay back less real value than they borrowed, and enrich themselves at the expense of the community. When afterwards credit is shaken and prices begin to fall, everyone wants to get rid of commodities and get hold of money which is rapidly rising in value; this makes prices fall all the faster, and the further fall makes credit shrink even more, and thus for a long time prices fall because prices have fallen.
We shall find that fluctuations in prices are caused only to a very slight extent by fluctuations in the supply of the precious metals; and that they would not be much diminished by the adoption of gold and silver instead of gold as the basis of our currency. But the evils which they cause are so great, that it is worth while to do much in order to diminish them a little. These evils however are not necessarily inherent in those slow changes in the purchasing power of money, which follow the course of man’s changing command over nature: and in such changes there is generally both loss and gain. In the fifty years preceding the great war, improvements in the arts of production and in the access to rich sources of supply of raw material doubled the efficiency of man’s labour in procuring many of the things which he wants. An injury would have been done to those members of the working classes (now indeed rapidly diminishing in number) whose money wages are much influenced by custom; if the purchasing power of a sovereign in terms of commodities had remained stationary, instead of following, as it has, the increasing command by man over nature. But this matter will require full discussion in another place.
prospectiveness of its uses, men’s unreadiness to look forward, while the demand for it comes from its
productiveness, in the broadest sense of the term, is indicated in II. IV.
mutually govern one another. Attention has already been called to the fact that, though he excludes houses and hotels, and indeed everything that is not strictly speaking an intermediate good, from his definition of capital, yet the demand for the use of goods, that are not intermediate, acts as directly on the rate of interest, as does that for capital as defined by him. Connected with this use of the term capital is a doctrine on which he lays great stress, viz. that “methods of production which take time are more productive” (
Positive Capital, Book V. ch. IV. p. 261), or again that “every lengthening of a roundabout process is accompanied by a further increase in the technical result” (
Ib. Book II. ch. II. p. 84). There are however innumerable processes which take a long time and are roundabout; but are not productive and therefore are not used; and in fact he seems to have inverted cause and effect. The true doctrine appears to be that, because interest has to be paid for, and can be gained by the use of capital; therefore those long and roundabout methods, which involve much locking up of capital, are avoided unless they are more productive than others. The fact that many roundabout methods are in various degrees productive is one of the causes that affect the rate of interest; and the rate of interest and the extent to which roundabout methods are employed are two of the elements of the central problem of distribution and exchange that mutually determine one another. See Appendix I, 3.
Economic History, VI. VI.; and Bentham
On Usury. The sentiment against usury had its origin in tribal relationships, in many other cases besides that of the Israelites, perhaps in all cases; and, as Cliffe Leslie remarks (
Essays, 2nd Edition, p. 244):—It was “inherited from prehistoric times, when the members of each community still regarded themselves as kinsmen; when communism in property existed at least in practice, and no one who had more than he needed could refuse to share his superfluous wealth with a fellow-tribesman in want.”
hiring things which were themselves to be returned, and
borrowing things the equivalent of which only had to be returned. This distinction, however, though interesting from an analytical point of view, has very little practical importance.
Arcady, p. 214) tells us “there are hosts of small money-lenders in the purlieus of the cattle markets who make advances to speculators
with an eye,” lending sums, amounting in exceptional cases up to £200, at a gross interest of ten per cent. for the twenty-four hours.
Appreciation and Interest 1896: and
The rate of interest 1907, especially Chapters V, XIV and their respective Appendices.