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]

Book Cover

First Pub. Date

1930

Publisher

New York: The Macmillan Co.

Pub. Date

1930

Comments

1st edition.

Copyright

The text of this edition is in the public domain.

§1. Introduction

PART I, CHAPTER III

SOME COMMON PITFALLS

IN the last chapter we saw that the figure expressing the rate of interest depends on the standard of value in which present and future goods are expressed, and we saw how the rate of interest in one standard (such as the standard of real income) is to be derived from the rate of interest in any other standard (such as the actual monetary standard).

This translation of the rate of interest from one standard into another does not determine
the rate of interest in any standard whatever; for it assumes that the rate in
some one standard is already known, and merely enables us, on the basis of this known rate, to calculate the rates in other standards. The case is somewhat similar to the conversion of temperature from the Fahrenheit system into the Centigrade system. By such conversion we can calculate the Centigrade temperature, but only on condition that we already know the Fahrenheit temperature. The formula connecting the two does not enable us, in the least, to find out how hot or cold the weather is.

While the deviations of the money rate of interest from the real rate are of tremendous practical importance, they may be regarded as belonging more to the problem of money than to the problem of interest, and, in the chapters which follow, these deviations will, unless otherwise
specified, be disregarded. The reader may, therefore, in this theoretical study keep to the hypothesis that the monetary unit remains unchanged in purchasing power, with the result that the money rate of interest and the real rate coincide. That is to say, the rate of interest is assumed to be at once the premium on this year’s
money in terms of next year’s and the same premium on this year’s
real income in terms of next year’s.

This premium, that is, the terms of exchange of this year’s income and next year’s, may be said to depend, in brief, on the relative supply and demand of those two portions of the income stream; and this statement may be interpreted as including almost the entire impatience and investment opportunity theory of this book. But, like many brief statements, this supply and demand statement is crude and inadequate. Crude and inadequate notions beset this subject and some of them are so common and treacherous that it seems worth while, before proceeding with further analysis, to examine these notions in order to avoid falling into their pitfalls.

To say that the rate of interest is fixed by supply and demand is merely to state, not to solve the problem.
*23 Every competitive price is fixed by supply and demand. The real problem is to analyze the particular supply and demand forces operative in determining the rate of interest.

Nor are we greatly enlightened by saying that in one sense the rate of interest is the price of money. For it is
equally true, in another sense, that the purchasing power of money is the price of money. Yet the rate of interest and the purchasing power of money are two very different things.

Nor is it very illuminating to say that the rate of interest is the price paid for the use of money, especially as the money whose use is purchased is usually not money at all but credit—nor is either the money or credit literally used continuously during the loan. It disappears at the beginning and reappears at the end.

Enough has already been said to show that an increase in the quantity of money in circulation tends to raise the price level and consequently to depreciate the value of the money unit. This depreciation in turn tends to increase the rate of interest. Yet, there is a very persistent belief that an increase or decrease in the quantity of money in circulation causes a decrease or increase in the rate of interest. This fallacy seems to be based on a confused interpretation of the general observation that the rate of interest generally rises or falls with a decrease or increase in the reserve ratio of banks. While it is true that if new money first finds its way from the mint into the banks, it tends to lower the rate of interest, this effect is temporary. The maladjustment between the money in banks and in circulation is soon corrected as the demand for loans overtakes the supply. As far as the total supply of money is concerned, if this is doubled in amount and prices are thereby, in the end, doubled too, there is double the money to lend, but borrowers will require double the amount of money. At the doubled prices they will need twice the money to make the
same purchases. The demand is doubled along with the supply and the interest rate remains as before.

§2. The Exploitation Explanation of Interest

Another very persistent idea is that to take interest is, necessarily and always, to take an unfair advantage of the debtor. This notion is something more than the obviously true idea that the rate of interest, like any other price, may be exorbitant. The contention is that there ought to be no interest at all. Throughout history this thought recurs. It seems natural that only what was borrowed should be returned. Why any addition? Interest is therefore called unnatural.

The word used by the Greeks to signify interest, or usury, was
ròkos, “offspring”; and Aristotle declaimed against the taking of interest, on the ground that money, being inanimate, did not have offspring. The Mosaic law forbade interest taking between Jews, and, similarly in Rome, interest taking between Romans was prohibited. Many biblical texts show the hostile attitude of the writers, in both the Old and New Testaments, toward the practice. The Church Fathers, through the Middle Ages for over a thousand years, waged a ceaseless but fruitless war against interest taking. St. Thomas Aquinas stated that interest was an attempt to extort a price for the use of things which had already been used up, as, for instance, grain and wine. He also declared that interest constituted a ”
payment for time,” and that no such payment could be justified since time was a free gift of the Creator to which all have a natural right.

In fact, interest taking is often prohibited in primitive societies. Loans under primitive conditions are generally made for consumption rather than for productive purposes. Industry and trade being almost unknown, the demand for loans in such communities usually betokens
the personal distress of the borrowers. The loan negotiations take place between two persons under isolated conditions without a regular market. The protection which a modern loan market affords against extortionate prices is absent. Thus, there is, in many cases, a sound ethical basis for the complaints against interest. But experience shows that complete prohibition of interest cannot be made effective. Interest, if not explicitly, will implicitly persist, despite all legal prohibitions. It lurks in all purchases and sales and is an inextricable part of all contracts.

Today the chief survival of the exploitation idea is among Marxian Socialists. These assert that the capitalist exploits the laborer by paying him for only part of what he produces, withholding a portion of the product of labor as interest on capital. Interest is therefore condemned as robbery. The capitalist is described as one who unjustly reaps what the laborer has sown.

Suppose that a tree twenty-five years old is worth $15, and was planted at a cost of $5 worth of labor. The laborer was paid $5 when the tree was planted. The capitalist who pays him receives the $15 twenty-five years later and thereby enjoys $10 increase of value, which is interest on his $5 investment, the cost of planting the tree. Why does not the laborer who planted the tree get this increase of $10 instead of the capitalist?

The socialist exploitation theory of interest consists virtually of two propositions: first, that the value of any product, when completed, usually exceeds the cost of production incurred during the processes of its production; and secondly, that the value of any product, when completed, “ought” to be exactly equal to that cost of production. The first of these propositions is true, but the second is false; or, at any rate, it is an ethical judgment
masquerading as a scientific economic fact. Economists, strange to say, in offering answers to the socialists, have often attacked the first proposition instead of the second. The socialist is quite right in his contention that the value of the product does exceed the cost.
*24 In fact, this proposition is fundamental in the whole theory of interest. There is no necessity that the value of a product must equal the costs of production. On the contrary, it never can normally be so.

In attempting to prove that the laborer should receive the whole product, the socialist stands on stronger ground than has sometimes been admitted by overzealous defenders of the capitalist system. The socialist cannot be answered offhand simply by asserting that capital aids labor, and that the capitalist who owns a plow earns the interest payment for its use quite as truly as the laborer operating the plow earns his wages by his labor. For the socialist carries the argument back a stage earlier, and contends that the payment for the use of the plow should belong, not to the capitalist who owns it, but to the laborers who originally made it, including those who made the machinery which helped to make it. He is quite correct in his contention that the value of the uses of the plow is attributable to those who made it, and that, nevertheless, the capitalist, who now owns it, not the laborers who made it in the past, enjoys the value of these uses. The capitalist is, in a sense, always living on the product of
past labor. An investor who gets his income from railroads, ships, or factories, all of which are products of labor, is reaping what past labor has sown.
But the investor is not, as a necessary consequence, a robber. He has bought and paid for the right, economic and moral as well as legal, to enjoy the product ascribable to the capital goods he owns. The workers’ wages, under free competition, constitute payment in full for what they had produced at the time their wages were paid.

Take the case of the tree which was planted with labor worth $5, and which, 25 years later, was worth $15. The socialist virtually asks, Why should not the laborer receive $15 instead of $5 for his work? The answer is: He may receive it, provided he will wait for it 25 years. As Bohm-Bawerk says:
*25

“The perfectly just proposition that the laborer should receive the entire value of his product may be understood to mean either that the laborer should
now receive the entire
present value of his product, or should receive the entire future value of his product
in the future. But Rodbertus and the Socialists expound it as if it means that the laborer should
now receive the entire
future value of his product.”

Socialists would cease to think of interest as extortion if they would try the experiment of sending a colony of laborers into the unreclaimed lands of the West, letting them develop and irrigate those lands and build railways on them, unaided by borrowed capital. The colonists would find that interest had not disappeared by any means, but that by waiting they had themselves reaped the benefit of it. Let us say they waited five years before their lands were irrigated and their railway completed. At the end of that time they would own every cent of the earnings of both, and no capitalist could be accused of robbing them of it. But they would find that, in spite of themselves, they had now become capitalists, and that
they had become so by stinting for those five years, instead of receiving in advance, in the shape of food, clothing, and other real income, the discounted value of the railroad.

This example was almost literally realized in the case of the Mormon settlement in Utah. Those who went there originally possessed little capital, and they did not pay interest for the use of the capital of others. They created their own capital and passed from the category of laborers to that of capitalists. It will be seen, then, that capitalists are not, as such, robbers of labor, but are labor-brokers who buy work at one time and sell its products at another. Their profit or gain on the transaction, if risk be disregarded, is interest, a compensation for waiting during the time elapsing between the payment to labor and the income received by the capitalist from the sale of the product of labor.

§3. Interest Taking Survives all Opposition

Despite the persistence of the idea that interest is something unnatural and indefensible, despite the opposition to it by socialists and others who rebel against the existing economic system, despite all attempts to prohibit interest taking, there is not and never has been in all recorded history any time or place without the existence of interest.

Several centuries ago, as business operations increased in importance, certain exemptions and exceptions from the ineffectual prohibition of interest were secured. Pawn-shops, banks, and money-lenders were licensed, and the purchase of annuities and the taking of land on mortgage for money loaned were made legitimate by subterfuge. One of the subterfuges by which the taking of interest
was excused suggests the true idea of interest as an index of impatience. It was conceded that, although a loan should be professedly without interest, yet when the debtor delayed payment, he should be
fined for his delay (
mora), and the creditor should receive compensation in the form of
interesse. Through this loophole it became common to make an understanding in advance by which the payment of a loan was to be delayed year after year, and with every such postponement a
fine was to become payable.

Some of the Protestant reformers, while not denying that interest taking was wrong, admitted that it was impossible to suppress it, and proposed that it should therefore be tolerated. This toleration was in the same spirit as that in which many reformers today defend the licensing of vicious institutions, such as saloons, gambling establishments, and houses of prostitution.

Today interest taking is accepted as a matter of course except among Marxian socialists and a few others. But the persistent notion that, fundamentally, interest is unjustified has given the subject a peculiar fascination. It has been, and still is, the great economic riddle.

§4. Naïve Productivity Explanations

One of the most common superficialities in this field of thought is the naïve idea that interest expresses the physical productivity of land, or of nature, or of man. When the rate of interest is 5 per cent, nothing at first thought seems more plausible than that this rate obtains because capital goods will yield 5 per cent in kind. It is alleged that because fruit trees bear apples or peaches, and because a bushel of wheat sown has the power to multiply into 50 bushels, and because a herd of cattle
if unmolested may double in numbers every two years interest is therefore inherent in nature. As a matter of fact, this productivity, as we shall see, is a real element in the explanation of interest; but it is not the only one nor is it as simple as it seems.

In some degree, the theory elaborated in this book is a productivity theory. I am, therefore, not attempting to refute all productivity theories indiscriminately but merely to show the inadequacy of what Böhm-Bawerk called the “naïve” productivity theory. This theory, or fallacy, is not espoused by any careful student of the interest problem, but it exists in the minds of many before they begin to analyse the problem. It confuses physical productivity
*26 with value return.

Following the principles of Chapter I, we may take, as an illustration, an orchard of ten acres yielding 1000 barrels of apples a year. The physical productivity, 100 barrels per acre per year, does not of itself give any clue to what rate of return on its
value the orchard yields. To obtain the value return on the orchard, we must reduce both physical income and capital goods (the farm) to a common standard of value. If the net annual crop of apples is worth $5000 and the orchard is worth $100,000, the ratio of the former to the latter, or 5 per cent, is a rate of value return; and if this rate is maintained without depreciation of the value of the orchard, this rate of value return is also the rate of interest. But how can we thus pass from heterogeneous quantities to homogeneous values? How can we translate the ten acres of orchard and the 1000 barrels of apples into a common standard—dollars? May not this apparently simple step beg the whole question? The important fact, and the one lost
sight of in the naïve productivity fallacy, is that the value of the orchard is not independent of the value of its crops; and, in this dependence, lurks implicitly the rate of interest itself.

The statement that “capital produces income” is true only in the physical sense; it is not true in the value sense. That is to say,
capital value does not produce income value. On the contrary, income value produces capital value. It is not because the orchard is worth $100,000 that the annual crop will be worth $5000, but it is because the annual crop is worth $5000 net that the orchard will be worth $100,000, if the rate of interest is 5 per cent. The $100,000 is the discounted value of the expected income of $5000 net per annum; and in the process of discounting, a rate of interest of 5 per cent is already implied. In general, it is not because a man has $100,000 worth of property that he will get $5000 a year, but it is because he will get that $5000 a year that his property is worth $100,000—if the pre-existing rate of interest remains unchanged.

In short, we are forced back to the confession that when we are dealing with the
values of capital and income, their causal connection is the reverse of that which holds true when we are dealing with their
quantities. The orchard is the source of the apples; but the value of the apples is the source of the value of the orchard. In the same way, a dwelling is the source of the shelter it yields; but the value of that shelter is the source of the value of the dwelling. In the same way a machine, a factory, or any other species of capital instrument is the source of the services it renders but the value of these services is the source of the value of the instrument which renders them.

This principle is complicated, but not impaired, by the fact that the cost of production of further dwellings, machines, tools, and other capital plays a part. The principle which rests on future incomes, including, of course, items of negative future income (costs) applies to any existing capital at any stage of its existence. The value of anything (as indicated in Chapter I, and more fully in
The Nature of Capital and Income) is typified by the case of a bond whose value, as every broker knows, is calculated solely from the future services, or sums, expected and the rate of interest and the risk. The cost of producing other competing houses or other instruments so valued, in so far as that cost lies in the future, has an important influence. Past costs may also affect the value of the house by influencing through competition the value of the future services or disservices of that house, or the rate of interest, or the risk. Thus, cost plays an important rôle but not the simple one usually assumed.

Although business men are constantly employing this discounting process in the valuation of every specific item of property bought or sold, they often cherish the illusion that somehow, somewhere, there is capital which does not get its value by discounting future services but has already made value which produces interest. They persist in thinking of interest as moving forward in time instead of as discount moving backward.

The necessity of presupposing a rate of interest is re-inforced by observing the effect of a
change of the rate of productivity. If an orchard could in some sudden and
wholly unexpected way be made to yield double its original crop per acre, only its yield in the sense of physical productivity would be doubled; its yield in the sense of the rate of interest would not necessarily be affected at
all, certainly not doubled,
*27 because the value of the orchard would automatically advance with an increase in its value productivity.

The rate of physical productivity is evidently not the rate of interest. The rate of physical productivity is not ordinarily even the same kind of magnitude as the rate of interest. Bushels of wheat produced per acre is an entirely different sort of ratio from the rate per cent of the net value of the yield of land relative to the value of the land. Interest is a rate per cent, an abstract number. Physical productivity is a rate of one concrete thing relatively to another concrete thing incommensurable with the first.

§5. Two Other Pitfalls

In this chapter I have tried at least to mention, if not completely to remove in advance, the chief pitfalls or impediments to the understanding of the interest problem. Two other pitfalls, discussed elsewhere, may be here mentioned so that the reader may be on his guard against them also.

One is the idea that interest is a
cost. While an interest
payment, like any other payment, is a cost or outgo to the payer, it is income to the payee. But interest itself, as it accrues, is capital gain; and is neither negative income (cost) nor positive income. The fallacious idea that it is a cost is simply the other side of the fallacious idea, discussed in Chapter I, that it is income. There are two
kinds of economic gain, capital gain and income gain, the former being the anticipation or discounted value of the latter. Interest is the former kind. It gradually accrues, along a discount curve as the income which it anticipates grows nearer. But it is not itself income, nor is it cost.
*28

The other pitfall is the idea that interest is a certain part of the income stream of society, the part namely which goes to capital, the other parts being rent, wages, and profits. I shall, in Chapter XV, discuss the relation of interest to the whole problem of the distribution of wealth. But it may help if the reader is again warned at this point, as he has already been warned in Chapter I, against the idea that any one part of the income stream has an exclusive relation to the rate of interest. All income is subject to discount, or capitalization, that from land as well as that from (other) capital goods. And if the whole income stream of society, including all wages, all rents and all profits were capitalized, that whole income could still be regarded as a rate per cent, i.e., interest on its own capitalization, just as truly as can the income of the bondholder or rentier.

23.

In Chapters XI and XII supply and demand curves will be derived from the principles of impatience and opportunity. It will also be shown that impatience is not to be associated with demand to the exclusion of supply, nor opportunity with supply rather than demand, nor
vice versa.

24.

While this assertion is made dogmatically at this point, the proof of its soundness is contained in Chapter XX, §7, and in the Appendix to Chapter XX.

25.

Böhm-Bawerk,
Capital and Interest, p. 342.

26.

The Nature of Capital and Income, Chapter XI.

27.

It is true, however, as will become more apparent later, that if the
increase in productivity is
foreseen, the rate of interest will be temporarily raised. But after the transition period is over and the supposed doubled productivity is thereafter going on at a steady rate, the rate of interest will fall back; in fact, other things equal, it will fall below what it was before productivity was increased.

28.

For fuller discussion see
The Rate of Interest, pp. 38-51, and below Chapter XX, §7 and the Appendix to Chapter XX of this volume.

Part II, Chapter 4