The Theory of Interest
By Irving Fisher
THE tremendous expansion of credit during and since the World War to finance military operations as well as post-war reparations, reconstruction, and the rebuilding of industry and trade has brought the problems of capitalism and the nature and origin of interest home afresh to the minds of business men as well as to economists. This book is addressed, therefore, to financial and industrial leaders, as well as to professors and students of economics.Inflation during and since the War caused prices to soar and real interest rates to sag in Germany and other nations far below zero thus impoverishing millions of investors. In all countries gilt-edge securities with fixed return became highly speculative, because of the effect of monetary fluctuations on real interest rates. After the War the impatience of whole peoples to anticipate future income by borrowing to spend, coupled with the opportunity to get large returns from investments, raised interest rates and kept them high. Increased national income has made the United States a lender nation. At home, real incomes have grown amazingly because of the new scientific, industrial, and agricultural revolutions. Interest rates have declined somewhat since 1920, but are still high because the returns upon investments remain high. Impatience to spend has been exemplified by the organization of consumers’ credit in the form of finance companies specially organized to accommodate and stimulate installment selling and to standardize and stabilize consumption…. [From the Preface]
First Pub. Date
New York: The Macmillan Co.
The text of this edition is in the public domain.
- Suggestions to Readers
- Part I, Chapter 1
- Part I, Chapter 2
- Part I, Chapter 3
- Part II, Chapter 4
- Part II, Chapter 5
- Part II, Chapter 6
- Part II, Chapter 7
- Part II, Chapter 8
- Part II, Chapter 9
- Part III, Chapter 10
- Part III, Chapter 11
- Part III, Chapter 12
- Part III, Chapter 13
- Part III, Chapter 14
- Part IV, Chapter 15
- Part IV, Chapter 16
- Part IV, Chapter 17
- Part IV, Chapter 18
- Part IV, Chapter 19
- Part IV, Chapter 20
- Part IV, Chapter 21
- Appendix to Chapter I
- Appendix to Chapter X
- Appendix to Chapter XII
- Appendix to Chapter XIII
- Appendix to Chapter XIX
- Appendix to Chapter XX
- Appendix to Chapter XX
THE interplay of impatience and opportunity on the rate of interest is profoundly influenced by invention and discovery. The range of man’s investment opportunity widens as his knowledge extends and his utilization of the forces and materials of Nature grows. With each advance in knowledge come new opportunities to invest. The rate of return over cost rises. With the investments come distortions of the investors’ income streams. These distortions are softened through loans, so far as the individual is concerned, the distortion being thus transmitted from borrower to lender and so spread over society generally. This distortion means relative abstinence from consumption during the period of producing and exploiting the new devices, followed by greater consumption later. In the meantime human impatience is increased.
In the field of transportation, for example, man originally had to depend upon his legs and arms to carry himself and his burdens. Later he invested in domesticated animals, and secured large returns on his investment, by increasing the range, speed, and efficiency of locomotion. Still later the invention of the wheel introduced the use of vehicles drawn by horses. The invention of the
steam locomotive for hauling vehicles on rails enormously increased movements of goods and men, while at the same time the range and diversity of opportunities to invest were extended. Today advance in technical knowledge has multiplied investment opportunities a thousandfold in the transportation field alone. There is the possibility of street transit by surface, elevated, or subway lines. On land, men and goods are moved by steam and electric locomotives, trolleys, busses, automobiles or motorcycles. On the sea, sailing ships have been superseded by steam ships, and the old fashioned marine engine is now giving way to the steam turbine, Diesel engine and the electric motor. Man’s ancient dream of flying through the air has at last been realized.
At the early stage of these space-abridging inventions society temporarily sacrifices some of its income for the sake of the greater returns to be expected later. For two generations railway construction drained off labor and caused investors to skimp. In these, as in all pioneering days, interest was high. In such periods people live on great expectations.
Besides tending to raise the rate of interest, invention and discovery tend to widen the gap between the interest rates on the safest securities and the rates of return over cost to those who first take advantage of the investment opportunities offered by the new devices.
Early investors make sacrifices and take great risks in the expectation of ample rewards in the shape of enhanced income. When the rewards for their sacrifices are realized these investors often reinvest their larger incomes for the sake of yet greater and more remote re
turns. For example, in the United States, throughout the period of national expansion from 1820 to 1880, while the growth of farming, mining and manufacture went hand in hand with canal and railroad building, social income increased sharply through investment, return, and partial reinvestment. Rising national income marks all periods of advancement in industrial arts and practices. The statistics of income recently made available by the National Bureau of Economic Research show just such rapid rise, concurrently with a period of great inventions in electricity, chemistry, automotive engineering, radio and aviation. Thus in the United States capital investment per worker rose from $560 in 1849 to $5,000 in 1919, with a greater yearly increase in capital employed than the increase in working population. Horsepower per industrial worker increased from 1914 to 1925 from 3.3 to 4.3.
*12 The increased prosperity of the United States, due largely to increased utilization of inventions and scientific management, is shown by an increase of about three-eighths in national income from 1921 to 1927, with an appreciable increase in real annual wages, while salaries showed a constant rise, as expressed in purchasing power, after 1919. The total realized national income of the nation rose from $35,700,000,000 in 1913, to an estimated total of $89,000,000,000 in 1928.
Those enterprisers and risk takers who are first to enter the new investment field, opened up by an invention, or, in the slang of business, “get in on the ground floor”
often obtain as a consequence a return on their original investment far greater than the rate of interest. Commodore Vanderbilt, Andrew Carnegie and Henry Ford are examples in point.
The rate of interest on loan contracts will rise as a result of those operations but only slightly. The cause of the increase which will occur is the increase in the
marginal rate of return over cost.
In consequence of the higher interest rates, there occurs a revaluation of investment securities, and, in fact, of all capital. The value of capital, assuming that the value of the income from the capital remains the same as is true of bonds, sinks as the rate of interest rises. Bonds tend to fall while common stocks tend to rise, unless counteracting influences prove to be dominant.
This revaluation applies also to the very capital in which the new invention or discovery is embodied. If it is found that $100,000 invested in a newly discovered gold mine will result in a yield of $1,000,000 a year, that mine will no longer sell for its original cost, but for a sum far above it. It is the relation of the $1,000,000 a year to the new value of the mine, and not its relation to the original investment value or cost which will reflect the true rate of interest. Original investors in The Bell Telephone Company realized returns far beyond the normal interest on their investment, but the present investor pays a price for Bell Telephone stock commensurate with its dividends.
New devices will also cause a revaluation of the older ones which they have displaced, but in this case the new values are lower than before. The adoption of the circular saw rendered nearly valueless the mill plants equipped with the old up-and-down saw, and the band saw lowered
the value of mills equipped with the circular saws. Hand looms and hand printing presses were superseded, except for special types of work, by power looms and presses. The early forms of power machines have in turn been superseded by improved machines. The automobile ruined first the carriage industry and later hurt the bicycle industry and even the perambulator industry. It is supplanting, in short hauls of freight and passengers, the railway industry, and both of these, in turn, are bound to be supplanted, in a measure, by the aviation industry, through its possibilities for producing the means of more speedy transportaton.
The reasons for these reductions in value are simple. Each new process produces a larger supply of the particular kind of service rendered. The price of this service—e.g., sawing or printing—is reduced, and consequently the capitalized value of the given amount of such service which can be expected from the older devices is reduced, and often so far reduced as to make the reproduction or even the repair of these older instruments wholly unprofitable. Thus progress constantly requires the writing off of capital value because of obsolescence.
It is important to emphasize the
temporary nature of the effects of invention and discovery in raising the rate of interest. The effect in raising interest lasts only so long as the rate of return over cost continues to be high and so tempts society to distort greatly its income stream in time shape. This period is the period of development
and exploitation, during which society is sacrificing or investing present income, or, as it is inaccurately called, investing capital. Society, instead of confining its productive energies to the old channels and obtaining a relatively immediate return in enjoyable income, as by producing food products, clothing, etc., directs its labors to great engineering enterprises, such as constructing tunnels, railroads, highways, subways, waterworks, irrigation systems, mining and manufacturing plants. These instruments cannot begin to contribute a return in enjoyable income for many years. In contemplation, future income during this period is relatively plentiful, and in consequence of these great expectations, the rate of interest will be high.
Later, however, there will come a time when,
so far at least as the effect of that particular invention is concerned, the income stream ceases to ascend, when most of the necessary investment has been completed, when little further exploitation is possible or advisable, and when it is only necessary to keep up the newly constructed capital at a constant level. When this period is reached, the after effect of the invention will be felt. The net effect on society will then have been to put the income stream on to a higher plateau, not to boost it uphill any more. But such a mere increase in the
size of the income stream, while its
shape remains constant, tends, as we have seen, not to increase, but somewhat to decrease the rate of time preference. Therefore, the
after effect of all inventions and discoveries is not toward
increasing but toward
decreasing the rate of interest.
Thus, though the railway inventions led to a half century of investment in railways, during which the income stream of society rapidly increased, today the limit of
steam railway investment has been nearly reached in some places, and in others the rapidity of investment has perceptibly slackened. Railroads have been an outlet for the investment of savings, and have tended to supply for them a good return. As the necessity for new railroads becomes less, this outlet diminishes, and the rates of return as well as the rates of interest in general tend to fall so far as this one influence is effective.
But while the after effect of an old invention is to reduce the rate of interest, it may, of course, be true that
new inventions, often the result of the old, will be made rapidly enough to neutralize this tendency. It is chiefly when there is a cessation in the world’s output of new inventions that the rate of interest is thus likely to fall back, but whenever invention is active the interest rate may rise continuously. It thus rises and falls according as the introduction or the exploitation of inventions is active or inactive.
The same principles apply not only to invention in the narrower mechanical sense, but also to scientific and geographical discoveries. The opening up of new mines in West Virginia, Canada, Alaska, South Africa, Australia and California caused a considerable depression in the immediate income streams of those who engaged in the exploitation of the new territory. Consequently, the rate of interest in such instances tends at first to be very high.
The present is an age of rapid invention, especially since the World War. President Hoover’s Committee on Recent Economic Changes finds the “tempo” of improvement in industrial arts the most striking characteristic
of our times. This increased tempo tends toward a high interest rate because of the flood of new inventions, despite the opposing influence of the old and matured inventions, which have made us so much richer.
Some outstanding examples of recent inventions which greatly increase production and consumption are: the automobile; the radio; the airplane; motion pictures in all their many uses; the numerous applications of electric power in factories and on the farm; long distance telephone, which has finally solved the problem of sending messages across the Atlantic Ocean; the utilization of cellulose, formerly a waste and a nuisance, in the manufacture of building materials, paper, and rayon textiles; the use of cotton seed for oil and fertilizer; the pulverization of coal by which its fuel value is greatly increased; the liquefaction of coal which gives added supplies of much needed gasoline; the innumerable chemical and dye products made from coal.
New discoveries and inventions, by utilizing wastes from forests, fields and mines, and increasing the output of labor have greatly advanced the scale of living in America.
Furthermore, the use of a new invention spreads with lightning rapidity in this high speed and intercommunicating age, affecting the income streams with a much greater influence than formerly and, as it spreads, it leads to further inventions. This is a chief reason why today is increasingly an age of invention. Nations like Great Britain, the United States, Germany and France lead in civilization by taking the greatest advantage of this self-propagating principle of invention, and nations like China and India, so long as they give it little attention, will lag behind.
Improvements in transportation developed the world granaries of Argentina, Canada, and the Mississippi Valley. The acreage of cotton was increased to feed the New England and British mills from the Southern and Gulf States, from Egypt and India. The investments in mining stretched over continents. Chilean nitrates were brought to American farms, and fresh investments were made in works that extracted nitrogen from the air. The coal deposits of the world were made to release solar energy stored up for millions of years, and the oil wells of Oklahoma and Baku became sources of new wealth and investment to supply a motor-driven age. Investments in machines, factories, railways, highways, warehouses, sewers, and in the ramifications of urban and suburban development enlarged the opportunities for surplus funds to an almost limitless extent. Reconstruction of devastated countries after the World War gave opportunity for the investment of billions of American dollars abroad, with flotations of foreign loans in the United States, in 1927 and 1928, averaging a billion and a half each year.
Moreover today we are organizing invention and discovery as we organize everything else. Experimental laboratories have spread from universities to government bureaus and commercial concerns. Millions are now spent on research where thousands or hundreds were spent a generation ago. And inventors are thus led not only to more intensive effort but to coöperate and pool their ideas. Mr. Hoover, before he was President, took steps toward a greater organization of scientific work looking toward invention.
During 1929, the Engineering Foundation launched a
drive for five million dollars to aid scientific research. Major General George O. Squier reported in the Nation’s Business for January, 1929, that in the laboratory of the American Telephone and Telegraph Company alone, $15,000,000 yearly were being devoted to the work of research which employed four thousand specialists. With respect to research General Squier added:
“We hear of expenditures by the millions—$200,000,000 a year by some estimates, $70,000,000 through the Government, and $130,000,000 through commercial firms. Any comprehensive inventory of our research resources would include the bulky items of plant and equipment, and the incalculable intangibles reposed in the 300,000 physicists, chemists, engineers, mathematicians, and trained technicians. As for suggesting the substance of this tremendous adventure, we may turn to the structures erected by the General Electric Company, the United States Steel Corporation, General Motors, and the United States Rubber Company.”
A survey by the National Bureau of Economic Research revealed, in its announcement of May 4, 1929, the extent to which industrial research prevailed as a new trend in manufacturing progress in the United States. Of 599 manufacturing concerns supplying information, the report stated that 52 per cent recorded the carrying on of research as a company activity. Testing laboratories were conducted by 7 per cent, leaving a minority in which no research work was being done. Some 29 per cent reported that they were supporting coöperative research conducted through trade associations, engineering societies, universities or endowed fellowships. Especially in cement manufacture, leather tanning, and gas and electric utilities, coöperative research was highly developed.
Statistical research has added its quota to investment
opportunities. There had been business depression in 1920-1921. Herbert Hoover’s engineering committee on Elimination of Waste in Industry reported some of the causes of that depression. The committee had found throughout industry a faulty control of material and design, as well as of production and costs. For example, the loss from idleness in shoemaking occasioned by waiting for work and material amounted to about 35 per cent of the time. It was found that standardization of the thickness of certain walls might mean a saving of some six hundred dollars in the cost of the average house. There were six thousand brands of paper, of which half were more or less inactive, and the duplication of brands tied up money in unnecessary stock. A shoe factory with capacity of twenty-four hundred pairs a day had shortage of needed racks, reducing output to nineteen hundred pairs daily. Most plants were found with no cost systems, or with incomplete knowledge of general costs, and for this reason most of them lost money. A multitude of shops lacked modern personnel relations with their employees; the workers had no unbiased means of approach to employers, while employers lacked the means of treating with their own men. Few plants had effective employment records; the turnover of labor was high and expensive. Sales policies were defective. There were cancellations of purchases on long-term contracts ranging up to 14 per cent, and returns of goods up to 11 per cent in so-called normal years. Lack of scientific management and of scientific forms of organization found production restricted by both employers and men. Maintenance of high prices, collusion in bidding, and unfair practices contributed to limit output, as well as did the practice of “ca’ canny” by workers and the restrictive rules of the
unions. It was found that eighteen hundred million dollars a year might be saved in preventing illness and deaths among American workers, and eight hundred and fifty million dollars more in preventing industrial accidents.
With the publication of this report, and of the succeeding Hoover report on unemployment and business cycles, American industrial management awoke to the possibilities of economic savings and higher organization, and American investment management found its opportunities correspondingly enhanced. Loans were supplied by the banks in measured volume, according to the needs of industry. The vast American market, blessed with free trade between forty-eight state jurisdictions, was thoroughly surveyed, and the wonders of technique and research were systematically evoked in the large scale as well as in the smaller but rapidly merging industries.
Because of these inventions, introducing economies which revolutionized industry, common stocks on the American exchanges have advanced in 1928 and 1929, so that the dividend yields of dividend paying stocks were lower than the interest yields of high grade bonds. As an example of the eagerness of the investing public to finance newly-evolving industries, the Daniel Guggenheim Fund for the Promotion of Aeronautics announced that it was no longer necessary to grant equipment loans to air-transport companies, because, it stated, the “investment public is now ready to supply the capital for enterprises of this kind.” By the close of the third decade of the twentieth century America had already shot ahead of Europe in commercial aviation, and was
operating more than eighteen thousand miles of airways, of which eight thousand miles were lighted for night travel. The New York Trust Company in its reports took note that airplane production for 1928 was about five times that of 1927, and that demand for almost every type of aviation market was rapidly expanding.
Among investors there was knowledge that many of the inventions and discoveries made by the agencies of research would quickly find practical use. With the certainty that epoch-making inventions and methods of higher organization were being applied in the arts, opportunities to invest were multiplied, and thousands of new investors increased the transactions of the stock exchanges.
This varied and exciting chapter in modern industrial expansion is summed up by the Hoover Committee on Recent Economic Changes in its review (p. 844):
“By no means all the increase in efficiency took the form of a net gain in current livelihood. To use the technique founded on science, men had to build machines, factories, railways, roads, warehouses and sewers. In developing new resources, they had to dig mines; to break the prairies and fence the farms; to make homes in strange habitats. And this work of re-equipping themselves for making consumers’ goods was never done. Every discovery put to use on a commercial scale meant a new equipment job, often of great extent. But after all this work on the means of production was done, there remained an even larger flow of the things men eat and wear, house and amuse themselves with.
“The net gain in ability to provide for their desires brought men the possibility of raising their standard of consumption, of reducing their hours of work, of giving their children more education, of increasing their numbers. They took a slice of each of these goods, rather than all of one. They worked somewhat less hard as the decades went by; they raised their standards of consumption appreciably; they established compulsory education and reduced illiteracy; they added to the population….”
It has not been the purpose of this chapter to investigate the general effect of inventions, but merely their effect on the rate of interest and rates of return.
Before leaving the subject, however, it should at least be stated that invention is a chief basis for progress in civilization and for increase in the income of mankind. The inventions of fire, the alphabet, and the means of utilizing power—first of animals, then of wind and water, then of steam and electricity—and their manifold applications, especially to transportation and communication, have made it possible for the earth to support its increasing population, and deferred the Malthusian pressure upon the means of subsistence; they have made possible the stable existence of great political units such as the United States; and they have given opportunity for the presentation, diffusion, and increase of knowledge in all its forms of art, literature, and science. And thus it happens that invention is self-perpetuating. For not only has science sprung from inventions such as the printing press, the telegraph, and specific scientific instruments for observation, like microscopes and telescopes, or for measurements, like chronographs, balances, and micrometers, but modern science is now in turn yielding new inventions. Helmholtz’s researches in sound led to the telephone; Maxwell’s and Hertz’s researches on ethereal waves led to wireless telegraphy and the radio.
The conditions for the most rapid multiplication of inventions are: (1) mental efficiency, dependent on heredity, hygienic habits, and the education (both general and technical) of human faculties, and for this the Greek motto “a sane mind in a sane body” is in point;
(2) the ease of diffusion of knowledge; (3) the size of the population within which the diffusion occurs—the larger the population the greater being the number of inventive geniuses, the greater their incentive, and the wider their sphere of influence; (4) the encouragement of invention especially through the early discovery and approval of genius, and, to some extent through patent protection. Inventors are at once the rarest and most precious flower of the industrial world. Too often they are crushed by the obstacles of poverty, prejudice, or ridicule. While this is less so today than in the days of Roger Bacon or Galileo, it still requires far too much time for the Bells, Edisons, Fords, or De Forests to get their start. The decades in which these rare brains are doing their wonderful work are at most few, and it is worth many billions of dollars for their countrymen to set them to work early. As Huxley says, it should be the business of any educational system to seek out the genius and train him for the service of his fellows, for whether he will or not, the inventor cannot keep the benefits of his invention to himself. In fact, it is seldom that he can get even a small share of the benefits. The citizens of the world at large are the beneficiaries, and being themselves not sufficiently clever to invent, they should at least be sufficiently alive to their own interests to subsidize or employ the one man in a million who can.
The Sociological Theory of Capital, Chapter IX, pp. 132-150; Chapter X, pp. 151-203.
Part IV, Chapter 18