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
We have seen that, theoretically, the rate of interest should be subject to both a nominal and a real variation, the nominal variation being that connected with changes in the standard of value, and the real variation being that connected with the other and deeper economic causes.
As to the nominal variation in the rate of interest, we found that, theoretically, an appreciation of 1 per cent of the standard of value in which the rate of interest is expressed, compared with some other standard, will reduce the rate of interest in the former standard, compared with the latter, by about 1 per cent, and that, contrariwise, a depreciation of 1 per cent will raise the rate by that amount. Such a change in the rate of interest would merely be a change in the number expressing it, and not fundamentally a real change. Yet, in actual practice, for the very lack of this perfect theoretical adjustment, the appreciation or depreciation of the monetary standard does produce a real effect on the rate of interest, and that a most vicious one. This effect, in times of great changes in the purchasing power of money, is by far the greatest of all effects on the real rate of interest. This effect is due to the fact that the money rate of interest, while it does change somewhat according to the theory as described in Chapters II and XIX, does not usually change enough to fully compensate for the appreciation or depreciation.
The inadequacy in the adjustment of the rate of interest results in an unforeseen loss to the debtor, and an unforeseen gain to the creditor, or
vice versa as the case may be. When the price level falls, the interest rate
nominally falls slightly, but
really rises greatly and when the price level rises, the rate of interest
nominally rises slightly, but
really falls greatly. It is consequently of the utmost importance, in interpreting the rate of interest statistically, to ascertain in each case in which direction the monetary standard is moving and to remember that the direction in which the interest rate apparently moves is generally precisely the opposite of that in which it really moves.
It should also be noted that in so far as there exists any adjustment of the money rate of interest to the changes in the purchasing power of money, it is for the most part (1) lagged and (2) indirect. The lag, distributed, has been shown to extend over several years. The indirectness of the effect of changed purchasing power of money comes largely through the intermediate steps which affect business profits and volume of trade, which in turn affect the demand for loans and the rate of interest. There is very little direct and conscious adjustment through foresight. Where such foresight is conspicuous, as in the final period of German inflation, there is less lag in the effects.
But the more fundamental theory of interest presupposes a stable purchasing power of money so that the real and nominal rates coincide. In that case the rate is theoretically determined by six sets of equations or conditions: the two Opportunity Principles; the two Impatience Principles; and the two Market Principles. The
last pair may be said to cover
prima facie supply and demand.
(A) The market must be cleared—and cleared with respect to every interval of time. (B) The debts must be paid.
The other two pairs represent the two sets of forces, one objective and the other subjective, behind supply and demand. The subjective pair expresses the influence of human impatience or time preference.
(A) The rate of time preference depends on the character of the various individuals concerned and on each individual’s prospective income, its size, time-shape and risk.(B) Each individual’s rate of time preference tends, at the margin of choice, to harmonize with the market rate of interest. Human impatience to spend and enjoy income is crystallized into the market rate.
The objective pair expresses the influence of investment opportunities.
(A) Each individual is encompassed about by opportunities to change the character of his prospective income stream. (B) At the margin of choice, any additions to an individual’s future income at the cost of more immediate income constitutes a return over that cost, the rate of which return over said cost is also crystallized into the market rate of interest.
So the rate of interest is the mouthpiece at once of impatience to spend income without delay and of opportunity to increase income by delay.
Thus both from the subjective and the objective field appear prototypes, one of each for every individual, of the market rate of interest.
Yet these equations are not enough to make the problem determinate without those of the other four sets of determining conditions (clearing the market, repaying debts and empirical dependence of impatience and investment opportunity).
Much less is it possible to determine the rate of interest from the subjective side alone, through time preference, or from the objective side alone, through investment opportunity, or “productivity”, or “technique of production”.
The full explanation requires both (as well as the market principles) in order that there may be as many independent equations as unknown variables in the problem. Moreover there is not merely one rate of interest; there are many, one for each interval of time. And even so the explanation is full only under the theoretical conditions presupposed. If we pass beyond the presuppositions in order to approximate closer to the actual world, we find that, to be determinate, the problem requires more and more equations of a more and more empirical nature. This is especially true as (1) we introduce risk with its innumerable and omnipresent ramifications, involving in particular a multiplicity of rates of interest even for the same period of time; and as (2) we extend our view to admit variations in all other prices besides the rates of interest, involving thereby the whole economic equilibrium, not only of the loan market but of all markets, each interacting on every other; and as (3) we extend our view from one theoretical market to the actual markets of the whole world, involving thereby all the relations of international
trade; and as (4) we take account of any other factors which may not be included in the foregoing specifications so as to take account, in particular, of all “institutional” influences, laws, politics, banking practices, government finance and so on to the end.
In the economic universe, as in astronomy, every star reacts on every other. From a practical point of view we cannot ignore the many perturbations. But from the theoretical point of view we gain clearness, simplicity and beauty, if we allow ourselves to assume certain other things equal, and confine our laws to a little part of the whole, such as the solar system.
From such a point of view, the second approximation is the most instructive, rather than the first which rules out the important element of investment opportunity, or than the third which becomes too complicated and vague for any complete theoretical treatment.
In the second approximation—which, as we have just noted, contains all that is most typical in the theory of the rate of interest—the distinctive factor is the rate of return over cost or the investment opportunity rate. This is also the most difficult factor to picture, isolate, and disentangle from the rate of interest which it helps determine. Therefore, it is a matter of great importance pedagogically to make that distinction clear. The investment opportunity rate is distinct from the market or loan rate of interest because an investment opportunity is distinct from a loan. Investment opportunity, as here used, does not include a mere loan at the market rate of interest nor any other purchase-and-sale transaction made merely on the basis of the market rate. The definition
of investment opportunity is specially framed to exclude mere loans. It is any opportunity of an individual to modify his prospective income other than by merely lending or borrowing (or the equivalent, buying or selling) at the market rate of interest.
Under this definition and the assumptions employed in the theory there can never be any doubt as to whether a given proposed transaction is an investment opportunity or a market loan or purchase. In the case of a market loan or purchase the individual cannot vary the rate of interest by any act of his, such as varying the size of his transactions. Under our assumptions of a perfect market his influence on the market rate is not only unconscious but infinitesimal and therefore entirely negligible in our analysis in which his motivity is of the essence. In the case of an investment opportunity, on the other hand,
he can vary the rate of return by varying the size of his operations.
This contrast between the theoretical constancy of the one and the variability of the other, in relation to individual action, is due to the fact that in the public market the individual is a negligible element, while an investment opportunity is more private and personal to him or his group. The former is typified by the purchase, say, of a Liberty bond, or other standard securities. The latter is typified by building a factory, improving a sales organization, deepening the shaft of a mine—cases where the marginal rate of return is under the control of the individual since he sets the margin.
Of course it is true that, in almost every such operation, there are elements of purchase and sale in which the market rate of interest is an implicit ingredient, but as long as the operation is not exclusively a mere market
interest affair and contains other ingredients, the rate is subject to variation with the extent of the operation and so is to be called a rate of return over cost. We are here interested in those other ingredients which produce the variability and thus differentiate such a rate from the market rate of interest. They are the non-commercial or non-trading ingredients; they concern production and technique rather than trade. They deal not with the market place, but with nature, environment, and the refractory conditions which surround and hamper us in our efforts to secure income. They exist even when no market exists, when a Robinson Crusoe, a hermit, or an isolated ranchman battles with soil and the elements for his daily bread.
The rate of return over cost, under the law of diminishing returns, is thus far more elementary and primeval than the rate of interest, and however incrusted that rate of return may become with other elements which grow out of modern market conditions it is still the basic objective condition underlying our problem.
Thus the rate of return over cost is distinguished from the rate of interest (1) by varying with the extent of the individual’s investment; (2) by being consciously recognized, as thus variable
*115 and controllable, by the individual; (3) by being, therefore, a personal and individual matter and not altogether a public market matter; (4) by being directly related to producing as contrasted with trading.
In modern society hermits and self-supporting ranches are so rare that we cannot find any important cases where investment opportunities exist in pure primitive form and apart from the alloy of trading. In fact, the most typical investment opportunities are not only full of such alloys but are tied up with market financing operations. Almost every big investment opportunity is married to a productive loan.
The best picture on a big scale of investment opportunity, divested so far as may be of all ancillary market features, is to be found by considering society as a whole instead of the individual.
Society as a whole cannot borrow or lend as an individual can. This world can, for instance, add nothing to this year’s income by a loan from elsewhere and subtract this amount with interest from future income. Yet it can and does vary and control the total income stream according to investment opportunity.
This picture, in the large, of society arranging, modifying, adjusting its total income stream as between this year and later years is the most important picture we can draw of investment opportunity not only because it automatically leaves out borrowing and lending, or buying and selling, but also because it automatically reduces the picture of income to its fundamental terms of real or, as I prefer to call it, enjoyment income and its obverse, labor pain. We do not have to think so vividly, as we do in the case of an individual, of money items and intermediate processes. We can without difficulty fix our attention on the final consumption. Society is like Robinson Crusoe picking and eating his berries, however complicated
may be the apparatus which intervenes between the labor of picking and the enjoyment of eating.
Society may add to or subtract from its income stream at will at any period, present or future. But beyond a certain point every addition at one period must be at the cost of a subtraction at some other period. If future income is added, the increment so added is a return on and at the cost of a decrement in less remote income. The rate of return over cost is thus a social phenomenon of great significance. There are two and only two ways in which society may effect the present cost and the future return. It may effect the present cost by exerting more present labor or by abstaining more from present consumption; and it may realize the future return over that cost either in the form of more future consumption or of less future toil.
Both the present and the future adjustments are effected by changing the use made of capital instruments including land and human beings. That is, the labor, land, and other capital of society may be used in many optional ways and in particular may be invested for the early or remote future.
If the capital instruments of the community are of such a nature as to offer a
wide range of choice, we have seen that the rate of interest will tend to be
steady. If the range of choice is
narrow, the rate of interest will tend to be
variable. If the range of choice is relatively rich in
future income as compared with the more immediate income, the rate of interest will tend to be high. If the range of choice tends to favor
immediate income as compared with more remote future income, the rate of interest will tend to be
Thus, for the United States during the last century,
its resources were of such a character as to favor future income. This is true, for a time at least, in every undeveloped country, and, as we have seen, gives the chief explanation of the fact that the rate of interest in such localities is usually high. The same is true of countries recovering from war. Today, for instance, Germany resembles a pioneer country. Her present income is necessarily low, but her prospect of a higher and increasing income in a few years is very great. The range of choice is dominated by “low today and high tomorrow.”
The range of choice in any community is subject to many changes as time goes on, due chiefly to one or more of three causes: first, a progressive increase or decrease in resources; second, the discovery of new resources or means of developing old ones; and third, change in political conditions.
Under the first head may be noted the impending exhaustion of the coal supply in England, as noted by Jevons and other writers. This will tend to make the income stream from that island decrease, at least in the remote future, and this in turn will tend to keep the rate of interest there low. Under the second head, the constant stream of new inventions, by making the available income streams rich in the future, at the sacrifice of immediate income, tends to make the rate of interest high. This effect, however, is confined to the period of exploitation of the new invention, and is succeeded later by an opposite tendency. During the last half century the exploitation of Stephenson’s invention of the locomotive, by presenting the possibility of a relatively large future income at the cost of comparatively little sacrifice in the present, tended to keep the rate of interest high. As the period of extensive railroad building is drawing to
a close, this effect is becoming exhausted, and the tendency of the rate of interest, so far as this particular influence is concerned, is to fall.
On the other hand, the invention of the automobile, and the inventions and discoveries in electricity and chemistry have succeeded the railroads as a field for investment and have required new sacrifices of immediate income for the sake of future income. Thus, as fast as the first effect of any one invention, tending to raise interest, wears off and is succeeded by its secondary effect in lowering interest, this secondary effect is likely to be offset by the oncoming of new inventions.
As to the third head, political conditions which affect the rate of interest, such as the insecurity of property rights which occurs during political upheaval, as in Russia recently, tend to make the pure or riskless rate of interest low. At the same time it adds an element of risk to most loans, thereby diminishing the number of safe and increasing the number of unsafe loans. Hence the commercial rate of interest in ordinary loans during periods of lawlessness is likely to be high. Reversely, during times of peace and security, the riskless rate of interest is comparatively high, while the commercial rate tends to be low.
We turn now to the remaining factor, namely, the dependence of time preference of each individual on his selected income stream. We have seen that the rate of preference for immediate as compared with remote income will depend upon the character of the income stream selected, but the manner of this dependence is subject to great variation and change. The manner in
which a spendthrift will react to an income stream is very different from the manner in which the shrewd accumulator of capital will react to the same income stream. We have seen that the time preference of an individual will vary with six different factors: (1) his foresight; (2) his self-control; (3) habit; (4) the prospective length and certainty of his life; (5) his love of offspring and regard for posterity; (6) fashion. It is evident that each of these circumstances may change. The causes most likely to effect such changes are: (1) training to foster a realization of the need to provide against the proverbial “rainy day”; (2) education in self-control; (3) formation of habits of frugality, avoiding parsimony on the one hand and extravagance on the other; (4) better hygiene and care of personal health, leading to longer and more healthful life; (5) incentives to provide more generously for offspring and for the future generations; (6) modification of fashion toward less wasteful and harmful expenditures for the purpose of ostentatious display.
These various factors may act and react upon each other, and may affect profoundly the rate of preference for present over future income, and thereby influence greatly the rate of interest. Where, as in Scotland, there are educational tendencies which instill the habit of thrift from childhood, the rate of interest tends to be low. Where, as in ancient Rome, at the time of its decline, there is a tendency toward reckless luxury, competition in ostentation, and a degeneration in the bonds of family life, there is a consequent absence of any desire to prolong income beyond one’s own term of life, and the rate of interest tends to be high. Where, as in Russia, under the Czars, wealth tended to be concentrated and
social stratification to be rigid, the great majority of the community, on the one hand, through poverty and the recklessness which poverty begets, tends to have a high rate of preference for present over future income, whereas, at the opposite end of the ladder, the inherited habit of luxurious living tends, though in a different way, in the same direction. In such a community, the rate of interest is likely to be unduly high.
From the foregoing enumeration, it is clear that the rate of interest is dependent upon very unstable influences many of which have their origin deep down in the social fabric and involve considerations not strictly economic. Any causes tending to affect intelligence, foresight, self-control, habits, the longevity of man, family affection, and fashion will have their influence upon the rate of interest.
From what has been said it is clear that, in order to estimate the possible variation in the rate of interest, we may, broadly speaking, take account of the following three groups of causes: (1) the thrift, foresight, self-control, and love of offspring which exist in a community; (2) the progress of inventions; (3) the changes in the purchasing power of money. The first cause tends to lower the rate of interest; the second, to raise it at first and later to lower it; and the third to affect the nominal rate of interest, in one direction and the real rate of interest in the opposite direction.
Were it possible to estimate the strength of the various forces thus summarized, we might base upon them a
prediction as to the rate of interest in the future. Such a prediction, however, to be of value, would require more painstaking study than has ever been given to this subject.
Without such a careful investigation, any prediction is hazardous. We can say, however, that the immediate prospects for a change in the monetary standard seem to be toward its stabilization; that this will tend toward a general prosperity, the main effects of which should be in the direction of lowering the rate of interest; that changes in thrift, foresight, self-control, and benevolence are for the most part likely to intensify these factors and thus to lower the rate of interest; and that the progress of discovery and invention shows now a tendency to increase in speed, the immediate result of which should be to raise the rate of interest but finally to lower it.
O curve was assumed to be straight. To include such a theoretical case, the statements in the text need a slight modification. But such extreme cases are not typical even in the theory and are probably never exemplified in practice.
Appendix to Chapter 1