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
THIS chapter consists of a brief study of the chief influences affecting the rate of interest. It is impossible to present a verification of any theory of interest. The facts are too meager, too conflicting, and too intermixed to admit of clear analysis and precise interpretation. In all places and at all times the economic causes tending to make interest high are combined with others tending to make it low. The fact, therefore, that interest is high or low, rising or falling, in conformity with the postulates of a particular theory, does not prove that the theory is the only true explanation. The best that we can expect is to show that the facts as we find them are not inconsistent with the theory maintained.
The causes making for high or low interest rates tend to counteract themselves. For instance, the economic causes, which before the World War tended to make interest high in the United States, also tended to bring in loans from other countries, especially from Great Britain, where the rate of interest was then low. The introduction of the loans prevented interest from being as high as it otherwise would have been. High interest in one community tends to increase the borrowings of that community, provided there exists another community in which the rate of interest is lower. If borrowing from
abroad is not practicable, other methods of adding to present at the expense of future income may be found. If such processes go far enough they will result in a dissipation of capital, or in a slower accumulation of capital.
Contrariwise, the causes which work toward lending may result, if lending is impracticable, in some other ways of postponing consumption, and may show themselves in a more rapid accumulation or in a less rapid dissipation of capital.
The same economic causes which tend to make interest high will tend also to encourage the production of the less substantial and durable instruments, whereas those causes which tend to make interest low will favor the production of instruments of the more durable and substantial types.
high interest, borrowing, dissipation of capital, and perishability of instruments go together. Any cause which produces any one of the four will, in general, tend also to produce the other three. Likewise
low interest, lending, accumulation, and durability of instruments, generally go together.
The theory enunciated is that the rate of interest depends on impatience and investment opportunity. As any cause increases or decreases our impatience for immediate income, it tends to increase or decrease the rate of interest. Any cause which increases our opportunity to secure returns on investments in excess of the existing rate of return tends to increase the rate of interest; and conversely when, for any cause, opportunities to invest promise only returns less than the existing return on investment the interest rate tends to decline.
In Chapter IV were enumerated the causes which in
the nature of man tend to make interest high or low. It was there stated that foresight, self-control, and regard for posterity tend to reduce impatience for income and so tend to make interest low. We may expect to find therefore in a community possessing these qualities some or all of the four interrelated phenomena already mentioned—low interest, lending to other communities, accumulation of capital and construction of substantial capital instruments. In a community lacking these qualities we may expect to find some or all of the four opposite conditions.
The nations and peoples which have been most noted in the past for foresight, self-control, and regard for posterity are probably the Dutch, Scotch, English, French, Germans and Jews, and the interest rate has been relatively lower in general in the communities dominated by these peoples than in communities dominated by less thrifty peoples. They have been money lenders; they have had the habit of thrift and accumulation, and their instruments of wealth have been in general substantial. The durability of their instruments of wealth is especially seen in their buildings, both public and private, and in their ways of transportation—roads, tramways, and railroads.
John Rae observed of Holland:
“Hitherto the Dutch, of all European nations, seem to have been inclined to carry instruments to the most slowly returning orders. The durability given to all the instruments constructed by them, the care with which they are finished, and the attention paid to preserving and repairing them, have been often noticed by travelers. In the days when their industry and frugality were most remarkable,
interest was very low, government borrowing at 2 per cent, and private people at 3.”
On the other hand, among communities and people noted for lack of foresight and for negligence with respect to the future are India, Java,
*16 the negro communities both North and South,
*17 the peasant communities of Russia,
*18 and the North and South American Indians, both before and after they had been subjugated by the white man. In all of these communities we find that interest is high, that there is a tendency to run into debt and to dissipate rather than accumulate capital, and that their dwellings and other instruments are of very flimsy and perishable character.
It may well be that there are other causes at work
to produce these results. We are here merely noting the fact that lack of foresight is one factor present. John Rae’s characterization of the Indians both of North and South America as highly improvident and lacking in foresighted thrift is based on personal observation and the testimony of missionaries and travelers.
*19 The negroes of Africa are perhaps even less provident than the American Indians.
In many if not all of the cases which have been cited there are, of course, other elements which would tend to explain the facts besides mere mental characteristics. Thus, the high rate of interest among the negroes and the Russian peasants is undoubtedly due in part to their poverty, though their poverty is in turn due in varying degree to their mental characteristics. Where there is too little appreciation of the needs of the future, capital tends to disappear; and the pressure of poverty tends to enhance still further the demands of the present and to press down its victims from bad to worse.
Not only do we find examples of high rates of preference for present over future goods among the prodigally rich, but often we find low rates of preference for present over future goods among the thrifty poor. Examples are especially frequent among the Scotch, the French peasants, and the Jews, whose propensity to accumulate and to lend money even in the face of misfortune and social ostracism is well known.
The factor which has been designated as “regard for posterity” deserves special attention. Perhaps the most conspicuous example of extreme disregard for posterity is found in Rome during the time of its decline and fall. Rae stresses the decay of family affection, the growth of
extravagant expenditure, and the high interest rates
*20 High interest rates in Rome were evidently the result of reckless disregard of the future. Before Rome had seriously depleted her capital wealth, at about the end of the republic, the interest rate was as low as 4 to 6 per cent.
The characteristics of foresight, self-control, and regard for posterity are partly inherent and partly induced by conditions of the environment. Among the cases which have been given are conspicuous examples of both, although it is difficult here, as always, to disentangle the influence of heredity from that of environment. We are accustomed, for instance, to ascribe to the Jews a natural racial tendency to accumulate, though this characteristic is certainly re-enforced by, if not largely due to, the extraordinary influence of Jewish tradition. Of the Scotch it would be difficult to say how much of their thrift is due to nature and how much to training handed down from father to son. The American negro is regarded as by nature a happy-go-lucky creature, but studies of negro life in Africa indicate that under favorable conditions the negro is self-denying, while recent experience with industrial schools has demonstrated the fact that forethought and saving can be readily fostered by training. Reckless wastefulness has been created in large part among the negroes by tyranny and slavery.
The influence of conditions upon accumulation may be seen everywhere, even in the most advanced industrial
countries. When postal savings banks were first introduced in England, it was objected that the English poor for whom they were intended were so spendthrift that they would never make use of them. But Gladstone insisted that habits were an arbitrary matter, and that the fashion of spending would be displaced by the fashion of saving as soon as opportunity and incentive were afforded and the principle of imitation had had time to operate. The experience with English postal savings banks justified his prediction.
Rae remarks upon the flimsiness of the Chinese buildings and implements and explains this by saying that the people “think not so much of future years as of the present time.”
*23 But the high interest rates of China are probably not due, as Rae seemed to think, to any native lack of industry, frugality, or parsimony on the part of the Chinese people, as is evidenced by the large accumulations of capital made by Chinese living abroad where they are freed from the exactions of arbitrary governors and from the tyranny of the clan-family system. Presumably the wastefulness and high interest so evident in China are most largely due to the action of poverty and uncertainty.
For, as has been emphasized in previous chapters, the rate of preference for present over future goods is not a question of mere personal characteristics, but depends also upon the character of one’s income stream; on its size, shape, composition, and certainty. In respect to
size, our theory maintains that the larger the income,
other things such as habits, foresight and self-control being equal, the lower the rate of preference for present over
future goods. If this is true, we should expect to find poverty and riches associated respectively with a high and a low rate of interest, or with borrowing and lending, or with spending and saving, or with perishable and durable instruments. That this characterization is in general correct is not likely to be denied.
It is true of course that the
amount loaned to the poor is small because each individual loan is necessarily small, but the
number of these loans is very great, and the desire of the poor to borrow, when such desire exists, is very intense. The many conspicuous exceptions to these rules are explainable on other grounds. It not infrequently happens that the poor, instead of being borrowers, are lenders, but in this case either they have unusual foresight, self-control, regard for their children, and other qualities tending in the same direction, or else their income stream has such a time shape as to encourage lending rather than borrowing. Reverse conditions apply likewise to the case of many wealthy men who are borrowers not lenders. In general, a rich man borrows not from lack of self-control and foresight, but because of exceptional opportunities to invest advantageously, including opportunities to protect and extend investments already made.
As a rule, however, the poor are more eager borrowers than the rich, and are often obliged to patronize pawn shops and other agencies in which the rate of interest is inordinately high. The dwellings and other instruments of the poor are generally of a very unsubstantial character. Their clothes are selected of necessity more for cheapness than durability. Such uneconomical expenditures are often even unavoidable, and reflect a very high estimate on present as compared with future goods. The
deeper the poverty, the higher the rate which the borrowers are compelled to accept. Even pawnbroking is not available for the extremely poor, but is patronized rather by the moderately poor. Those who are extremely poor cannot give the kind of security which the pawnbroker requires. On this account they become the victims of even higher rates of interest, pledging their stoves, tables, beds, and other household furniture for the loans they contract. These loans are repayable in installments such that the rate of interest is seldom lower than 100 per cent per annum.
Turning from social classes to countries, it is noteworthy that in the countries in which there are large incomes we find low interest, a tendency to lend as well as to borrow, to accumulate as well as to spend, and to form durable rather than perishable instruments. In countries where incomes are low the opposite conditions prevail. Thus, incomes are large and interest rates are relatively low in the United States, Holland, France, Germany, and England, whereas the reverse conditions hold in Ireland, China, India, Java, the Philippines and other less developed countries. In Ireland, for instance, especially in the early part of the nineteenth century, the rate of interest was high. The cotter was always in debt, and his hut and other instruments were of the most unsubstantial variety.
*25 Again in the Philippines the rate
of interest on good security is often 2, 4, and even 10 per cent a month. The Chinese money lender frequently takes advantage of the Filipino’s poverty.
*26 Many of these cases may be wholly or partly explained by other causes such as have been mentioned in the last section.
As to the influence of the
composition of income, it is even more difficult to obtain any statistical confirmation of importance. Variations in the amount of that real income which takes the form of food has an effect on the rate of interest similar to the effect of variations in the total income itself. Scarcity of food tends therefore to cause high interest, and abundance of food, low interest. During the siege of Paris the rate of interest was high, although other causes than the scarcity of bread were doubtless largely accountable for the fact. While no statistics of interest rates appear to be in existence for such periods, the testimony of eyewitnesses agree that in Belgium when starvation threatened during the World War the rates of interest were extremely high. Likewise during the blockade of Germany when the food shortage was acute, abnormally high interest rates are reported.
As to the influence of uncertainty or
risk, we encounter similar difficulties in getting positive inductive evidence. But evidence that in general risk tends to raise the commercial rate of interest but to lower pure interest is abundant. The first part of this proposition is a matter
of such common observation that no special collection of facts is necessary. Every lender or borrower knows that the rate of interest varies directly with risk. A bird in the hand is worth two in the bush.
The principle applies not only to the explicit interest in loan contracts, but to the implicit interest which goes with the possession of all capital. Where there is uncertainty whether income saved for the future will ever be of service, but the certainty that it can be of service if used immediately, the possessor needs the possibility of a very high future return in order to induce him to save. It is noteworthy that in time of war there is a ruthless destruction of crops and a tendency among the possessors of consumable wealth to enjoy it while they may. The same conditions are characteristic of communities which are in a perpetual state of political insecurity.
*27 “The rate of interest is everywhere proportional to the safety of investment. For this reason we find in Korea that a loan ordinarily brings from 2 to 5 per cent per month. Good security is generally forthcoming, and one may well ask why it is so precarious to lend. The answer is not creditable to Korean justice…. In a land where bribery is almost second nature, and private rights are of small account unless backed up by some sort of influence, the best apparent security may prove a broken reed when the creditor comes to lean upon it.”
There remains the second part of the proposition in regard to risk, namely, that, while risk tends to increase the rate of interest on risky loans, it tends at the same
time to decrease that on safe loans. This proposition is not familiar to most persons. It has usually caused surprise that during a time of political stress and danger the rates of interest on perfectly safe loans were found to be so small. Many such instances may be cited. At certain periods during the Civil War when the greatest uncertainty prevailed loans with good security were contracted at nominal rates, and bank deposits tended to accumulate for lack of sufficient outlet in secure investments. The same conditions existed in Europe during the World War. Times in which public confidence is shaken are characterized not only by high rates on unsafe loans, but by efforts on the part of timid investors to find a safe place for their savings, even if they have to sacrifice some or all of the interest upon them. They will even hoard savings in stockings and safe deposit vaults. We may even occasionally find cases in which the desire to obtain a safe method of keeping capital is so keen and so difficult to satisfy that the rate of interest is negative. The investor is then thankful enough to receive the assurance that his capital, by being intrusted to another, will not be diminished, to say nothing of being increased.
We still need to exemplify the most essential part of the theory, namely, that the rate of interest depends through the rate of impatience upon the
time shape of the income stream. The time shape may be due either to natural or artificial causes, or to choice because of a high or low rate of return on investment. If the theory is correct, we should find, other things being equal, that when in any community the income streams of its in
habitants are increasing, the rate of interest will be high, that when they are decreasing, the rate of interest will be low, and that when they alternate from one condition to the other, the rate of interest will alternate also in accordance with the period of the loan.
The most striking examples of increasing income streams are found in new countries. It may be said that before the World War the United States almost always belonged to this category. Were it possible to express by exact statistics or diagrams the size of American incomes, they would undoubtedly show a steady increase since colonial days. Statistics almost equivalent to these desiderata are available (though not very accurate) in the form of the United States Census figures of per capita wealth, as well as in statistics of production and consumption of staple commodities and of exports and imports. These, combined with common observation and the statements of historians, lead to the conclusion that American incomes have been on the increase for two hundred years. It is also true that during this period of rising incomes the rate of interest has been high. The simplest interpretation of these facts is that Americans, being constantly under the influence of great expectations from the exploitation of great natural resources, have been always ready to promise a relatively large part of their abundant prospective future income for a relatively small addition to their present, just as he who expects soon to come into a fortune wishes to anticipate its realization by contracting a loan.
Not only has the rate of interest been high in America as compared with other countries during this period of ascending incomes, but some of the other conditions having the same significance as a high rate of interest
have also been in evidence. Thus, the country has been conspicuously a borrowing country, in debt to other countries. The proceeds of such loans from Europe have shown themselves in increased imports into the United States and diminished exports, creating a so-called unfavorable balance of trade. These phenomena have usually been expressed as a demand for capital, but, while it is quite true that the exploitation of our natural resources required the construction of railways and other forms of capital, this fact is better and more fully expressed in terms of income. We wanted, not the railways and machinery themselves, but the future enjoyable products to which this apparatus led. The labor of constructing these instruments necessarily tended to diminish the immediate enjoyable income of the country, but added to that of the expected future. It was to even up this disparity of immediate and remote income that loans were contracted. It does not matter whether the loans from the foreigner were received in the form of machinery and other instruments of production, or in the form of the comforts of life to support us while we ourselves constructed the instruments. In either case the essential fact is the transformation of the income stream rather than the need of capital, which is merely one of the means thereto.
Not only have we witnessed the phenomena of high rates of interest and of borrowing during this period of American development, but it is also true that the character of the instruments created was for the most part of the unsubstantial and quickly returning kinds. Our highways, as John Rae pointed out, were little more than the natural surface of the earth after the removal of trees and rocks; our railways were lightly ballasted, sometimes even narrow gauge, and crooked to avoid the
necessity of excavations and tunnels; our earliest buildings were rude and unsubstantial. Everything was done, not in a permanent manner with reference to the remote future, but in order to save a large first cost.
During the last generation these conditions have been changed. The rates of interest in America are, in general, lower than formerly, and lower than in other countries, in many of which interest rates have risen.
*29 We have ceased to be a borrowing nation. We bought back many of our securities from abroad, and after the World War began to buy foreign securities. This was accomplished through the excess of exports of our abundant products over imports. We are now lending billions to Europe. Europe has become a borrower, the chief reason being that in her recovery from the War her income stream is rising. During that recovery from the impaired income wrought by the War, Europe in some places offers bigger returns over costs than America. That fact, combined with Europe’s poverty, makes for high interest.
The interest rate has fallen in the United States since 1920. This agrees with, or at least is consistent with, the theory that raising the level of national income tends, other things equal, to lower the rate of interest.
Again, the character of the instruments which have been now for some time in process of construction in the United States is of the most substantial kind. Steel rails have long since taken the place of iron rails; railways have been straightened by expensive tunnels, by bridges, and by excavations; dwellings and other buildings have been made more substantial; first macadamized and later cement roads have rapidly supplanted the old dirt roads; and in every direction there has been an evident
tendency to invest a large first cost in order to reduce future running expenses.
Thus, in America and in Europe, we see exemplified on a very large scale the truth of the theory that a rising income stream raises and a falling income stream depresses the rate of interest, or that these conformations of the income stream work out their effects in other equivalent forms.
A similar causation may be seen in particular localities in the United States, especially where changes have been rapid, as in mining communities. In California in the two decades between 1850 and 1870 following the discovery of gold, the income stream of that state was increasing at a prodigious rate, while the state was isolated from the world, railroad connection with the East not having been completed until 1869. During this period of isolation and ascending income, “… opportunities for investment were innumerable. Hence the rates of interest were abnormally high. The current rates in the ‘early days’ were quoted at 1½ to 2 per cent a month…. The thrifty Michael Reese is said to have half repented of a generous gift to the University of California with the exclamation, ‘Ah, but I lose the interest,’ a very natural regret when interest was 24 per cent per annum.”
*30 After railway connection in 1869, Eastern loans began to flow in. The decade, 1870-1880, was one of transition during which the rates stimulated borrowing from the outside, which brought about lower interest
rates even though income streams continue to increase. The rate of interest consequently dropped from 11 per cent to 6 per cent.
The same phenomena of enormous interest rates were also exemplified in Colorado and the Klondike. There were many instances in both these places during the transition period from poverty to affluence, when loans were contracted at over 50 per cent per annum, and the borrowers regarded themselves as lucky to get rates so low. It was also conspicuously true that the first buildings and apparatus constructed in these regions were very unsubstantial. Rude board cabins were put up in a day. Thus, high interest, borrowing, and unsubstantial capital were the phenomena which attended these communities when undergoing their rapid expansion.
In Nevada in the seventies, when the mines were increasing their product and the income of the inhabitants was tending upwards, the rate of interest was high and the people in debt. The bonded state debt itself amounted to $500,000 and drew 15 per cent interest.
*32 In the next decade all these conditions were reversed. The mines were on the decline,
*33 the rate of interest fell, and the state and territorial debts were largely paid off.
*34 The fall of the rate of interest in this case could not have been due to the introduction of loans from outside, except so far as old debts were refunded at lower rates; fresh loans were seldom made, as the state had ceased to be a good place for new investments. At about the beginning of this century, new Nevada mines in the gold-field region
were opened. Loans were again entering the state, and the same cycle of history, as above described, was repeated.
Lumbering communities often go through a somewhat similar cycle. The virgin forests when first attacked tend to increase rapidly the income streams of those who exploit them; then comes a period of decrease. Thus in Michigan two or three decades ago the lumber companies found a profitable investment, and borrowed in order to exploit the Michigan forests. After the exploitation was complete and the forests had been (often unwisely) exhausted, those regions ceased to be a desirable place for investment, and their owners came into the position, not of receiving, but of seeking investments.
After the trunk lines of railway were completed, connecting the Mississippi Valley with the East, there arose a great demand for loans to exploit the rich farming lands in that section of the country. The rate of interest frequently was 10 and 12 per cent and even higher. During much of this time the Northwestern Mutual Life Insurance Company up to 1880 made an average rate on all its mortgage loans, $10,000,000 in amount, of nearly 10 per cent. Another striking proof of the demand for loans in the Middle West is shown in the experience of the New York and Connecticut life insurance companies. New York up to 1880 had a law prohibiting the life insurance companies in that state from loaning on real estate outside of New York. Connecticut had no restriction in this regard, and her companies loaned extensively in the West. The result is seen in the rates of interest realized on mortgage loans of companies in the two states. Taking the period 1860-1880 as a whole, the Connecticut companies realized 1.2 per cent more than did the New York
companies. Since 1880 the Middle West has developed less feverishly, and loans on farming lands have been made at lower rates.
Australia furnishes another example of a country which, through improvement in the means of transportation and consequent great investment opportunities, created a great demand for loans. The rate during the fifties on safe securities was rather low. This rate increased until during the seventies, 7, 8, and 9 per cent were usual. After 1880 the rates declined.
England may perhaps be cited as exemplifying the same phenomena which we have seen in the case of Nevada, though in a less degree. Thus as Nevada has exhausted its mines of precious metals, so England is on the road toward exhaustion of its coal and iron supplies. As coal and iron lie at the base of England’s commercial power their exhaustion must carry with it the reduction of the income stream from English domestic industries. This fact has been noted with considerable alarm by some English economists, especially Jevons. But it does not necessarily indicate that the economic power of Englishmen will be greatly or even at all lessened. Its significance shows itself in the tendency of England to become an investing country. It is the part of those who have property in mines or other investments yielding terminable income not to use all of the product as income, but to reinvest some of the earlier income in order to maintain the capital. This the Englishmen have done and are doing, and, being unable to make enough satisfactory investments at home, they have placed their loans all over the world.
The income stream produced for them by their native island is destined, perhaps, to decline, certainly not greatly to increase except during the next few years or decades of recovery from the World War. By saving from this declining income and investing in Canada, the United States, South America, Australia, South Africa, and other regions where the natural resources are being exploited and incomes are on the increase instead of on the wane, Englishmen may still maintain their capital intact or even increase it. The figures given by Giffen show that the national income increased for several decades, but that the rate of increase slackened for the decade 1875-1885 compared with 1865-1875. Whereas in the earlier decades there was a general increase in all directions, in the later decade there were many items of decrease,
*36 the most notable being of mines and ironworks.
*37 Among the greatest increases was that of foreign investments.
The time shape of an income stream is determined, however, in part by other causes than natural resources. Among these causes, misfortune holds a high place in causing temporary depressions in the income stream, that is, in giving to it a time shape which is at first descending and afterwards ascending. The effect of such temporary depression is to produce a high valuation of immediate income during the depression period, as compared with the valuation of the income expected after the depression is over. It is a matter of common observation in private life that loans often find their source in personal
misfortune. Investigations of pawnbrokers and small loan conditions among the poor
*39 show that the chief causes for borrowing are a death or birth in the family, or a protracted illness, the expense of which even when amounting to only $10 or $20 would, without the loan, make serious inroads on the daily necessities.
We may see the operation of the same principle on a larger scale in the examples of the San Francisco earthquake, the earthquake which wrecked Yokohama and Tokyo, the plague which destroyed whole communities in Russia, and the famines of China. Had it not been for the succor rendered by more fortunate communities and countries, the income stream of some of the stricken communities and provinces in Russia and China would have sunk so low that scarcely any would have been able to survive. In addition to the aid of tens of millions of dollars in gifts, large loans were made which enabled the afflicted communities to build themselves anew. Whether these loans were used to produce sustenance, which is direct income, or to offset the cost of rebuilding and replacing destroyed capital goods, which is outgo, the effect was the same; they were for the purpose of tiding over a temporary decline, or loss, in the income stream. The permanent effect of these catastrophes on the rate of interest was slight because of the opportunity to borrow heavily from outside. Had these opportunities not existed, the depression in the income stream could not have been mitigated, and the rate of interest would inevitably have risen to a level comparable with that which prevailed in primitive times or during a gold rush.
In much the same way the income stream of a nation is affected by war. The effects in this case, however, are
more complex, owing, first, to the element of uncertainty which war introduces until peace is declared, and secondly, to the fact that wars are likely to be more protracted than most other misfortunes. The effect, according to previous explanations, should be that at the beginning of the war the rates of interest on risky loans would be high. This would be especially true of the short term loans which do not outlast war. On the other hand, the rate of interest on safe loans should be lowered for short term loans, and raised for long term loans. Under the conditions of a war in its early stages, a short term loan relates to a descent in the income curve. It is repayable at a time when income is expected to be less than when the loan is contracted. The descent in the income curve, or the element of uncertainty, tends, as has been seen, to lower the rate of interest on safe loans. On the other hand, for long term loans intended to outlast the war, the rate of interest is likely to be high, for the income stream at the time of repayment may be expected to exceed the income stream at the time of contract.
At the close of war, after peace is declared and the element of uncertainty introduced by it has disappeared, the rate of interest even on short term loans will, contrary to the common view, be high, for then the country is, as it were, beginning anew, and the same causes operate to make interest high as apply in the case of all new countries.
When the effects of war include the issue of depreciated paper money, the rate of interest is affected in a somewhat more complex manner, being then subject to the influence of depreciation, according to the principles explained in Chapter II and statistically treated in Chapter XIX.
We have considered supposed examples of the effect on the rate of preference exerted by those changes in the income stream due to the growth or waning of natural resources and to the temporary influence of misfortunes and inventions. There remain to be considered examples of more regular changes in the income stream of a rhythmic or seasonal character. Though most persons are not aware of the fact, it can scarcely be doubted that the annual succession of seasons produces an annual cycle in the income stream of the community. This is especially true of agriculture. Grains, fruits, vegetables, cotton, wool, and almost all the organic products flow from the earth at an uneven rate, and require for their production also an uneven expenditure of labor from man during different seasons of the year. Statistics of consumption show that the income enjoyed conforms in general to a seasonal rhythm. Food products are usually made available in the warm months when crops ripen; logs are hauled out of the woods in the winter, floated to mills in the spring, and made into lumber in the summer.
But the tendency to a seasonal rhythm is modified by the existence of stocks of commodities to tide over the periods of scarcity. The ice of winter is stored for summer, and the fruits of summer are canned and preserved for winter. Only so far as such storage and preservation are difficult and expensive, or impair the quality of the goods thus held over, or are impracticable, because of the perishable nature of the goods, does there remain any seasonal change in enjoyed income. The rhythm is different for different industries and for different classes of the population. The farmer is perhaps the most typical for
the country as a whole. For him the lowest ebb is in the fall, when gathering and marketing his crops cause him a sudden expenditure of labor, or of money for the labor of others. To tide him over this period he may need to borrow. A whole group of other industries, particularly those connected with transportation, experience a sympathetic fluctuation in the income stream. In the parlance of Wall Street, money is needed to move the crops. The rate of interest tends upward.
Chart 39 shows, for the period 1869 to 1905, the
monthly average of interest rates on prime, two-name, 60 to 90 day paper.
The theory that interest rates vary with the seasons, rising during the late summer and autumn months and sinking during the winter and early summer months is borne out by Professor W. L. Crum’s article,
Cycles of Rates on Commercial Paper,*41 which treats of monthly fluctuations in commercial paper rates over the period 1874 to 1913.
Chart 40 is a reproduction of Professor Crum’s chart showing monthly deviations of interest rates from the annual average of monthly rates over the period 1874 to
1913. It will be noted that the fluctuations shown on Chart 40 are almost identical with those shown on Chart 39. No comparison of
rates is possible because Chart 40 shows only monthly deviations above and below the average annual rate, while Chart 39 shows the average of actual rates. Both charts show a low for February, a rebound in March and April, a deeper depression in June, then a buoyant advance to the peak in September and October, followed by a slump when the autumn demand for money and credit to handle the crops is past.
In a community dominated by some industry other than farming the cycle would be different. The rates are of course a composite in which the cycles of the manufacturer
and of other elements are superimposed upon the cycle of the farmer. The manufacturer’s cycle is a little later than the farmer’s and shifts the high rates from fall toward winter. Accordingly in England, which is more dominated by the manufacturer, the cycle, though similar to that just observed for the United States, is shifted slightly forward, as is shown in Chart 41.
Although the facts presented in this chapter do not prove the theory presented in previous chapters they are not in conflict with it. According to the theory, if there is a high degree of foresight, self-control, and regard for posterity and income streams are large and plentiful in food-element, or have a descending time shape, then, other things being equal, the tendency will be for the rate of interest to be low, capital will be accumulated, the community will lend to other communities, and the instruments it creates will be more durable. We find these results present in actual fact where the antecedent conditions enumerated are also present. Reversing the conditions, we find reversed results. Of course these statistical evidences are very general, since we never can assert that “other things are equal,” and thus isolate and measure any one particular factor, as in the more exact inductions of physical science.
Onderzoek naar der mindere Welvaart de inlandsche Bevolking op Java en Madoera. Batavia, 1912, IX bl Dl II. 1, page 66). The report states that on small loans under 5 florins unsecured, the annual rate runs to several hundred per cent. On secured loans, say of 25 florins more or less, the rate varies from 36% to 60%. These rates are notably higher than his estimate of 40% quoted in
The Rate of Interest, p. 292.
The Future of War. Translated by R. C. Long. New York, Doubleday and McClure Co., 1899, p. 205. It appears that the peasant would sell a promise to labor a short time in the future at one third the current wages! See also Lanin (pseud.),
Russian Finance, Fortnightly Review, Vol. LV, February, 1891, pp. 188, 190, 196, for typical and extreme cases. Inostranietz,
L’Usure en Russie, Journal des Economistes, Vol. XVI, Ser. 5, 1893, pp. 233-243, states that the rates paid by poor peasants to well-to-do peasants are frequently 5 per cent per week.
Histoire de l’Usure, p. 25.
Principles of Economics. London, Longmans, Green and Co., 1907, p. 404.
The Development of Thrift.
Usury and Usury Laws; also the publications of the Russell Sage Foundation on Small Loans, especially Raby,
The Regulation of Pawnbroking.
The Tenure of Land in Ireland in Probyn’s Systems of Land Tenure in Various Countries. London, Cassell, Petter, Galpin & Co., 1881, p. 16.
The Business Monthly, Pittsburgh, April, 1907, p. 2.
The Sociological Theory of Capital, pp. 69 and 70.
The Passing of Korea. New York, Doubleday, Page and Co., 1906, p. 283.
Notes Concerning the Rates of Interest in California. Quarterly Publications of the American Statistical Association, September, 1899, pp. 351-352.
Message of the Governor of the State of Nevada, 1879.
Messages of the Governor of the State of Nevada.
The Investments of Life Insurance Companies. New York, Henry Holt and Co., 1906, p. 103.
Growth of Capital, p. 44.
The Financial Review.
Bank Rate and the Money Market, p. 97.
Part IV, Chapter 19