CHAPTER 7 The Nature of Interest and Profits Introduction

The above discussion clarifies, I hope, the nature of capital and some of the issues that surround its characterization. It will be remembered that the rate of discount featured in considering the capital value of any plan. This is sometimes also referred to in the literature as the rate of interest or the rate of profit. The question arises then as to the nature of interest as a phenomenon, and the relationship between interest and profit. As basic as this is, it remains a source of confusion in economics. Once again, the role of time is central. What is the connection between interest and time? Many theorists have seen interest as being determined by the technological characteristics of production, by “productivity,” in relation to the willingness of consumers to abstain from consumption, to save. In the conventional wisdom, interest is the result of “productivity” and “thrift.” While there is a sense in which this is true, a closer and deeper examination reveals that, in a more fundamental sense, the phenomenon of interest per se has nothing to do with productivity. Rather, interest is the result of the essential nature of time and the way that we experience it. This viewpoint is sometimes called a pure time preference theory (PTPT) of interest. And interest is to be clearly distinguished from profit which, as we have tried to show, is the result of changes in capital values that reflect the implementation of successful capital investments in an uncertain world, where expectations differ.

In this chapter I re-examine and re-evaluate the PTPT of interest. While I endorse it in the main, it seems to me that some of its proponents have perhaps fostered confusion by the way in which they have presented it. I then turn to a discussion of profit.

The Pure Time Preference Theory of Interest

The Interest Problem and its Resolution in Terms of PTPT Restated

The PTPT is notable for its obscurity (from the viewpoint of modern rival theories)¹ and for its resilience. Interest in it has recently resurfaced as part of the development of Böhm-Bawerkian capital theory (see Faber 1979; Pellengahr 1986a,b, 1996) and has been periodically revisited in the process of the development of Austrian market process theory (Yeager 1979; Garrison 1979a,b, 1988), and most recently by Kirzner (1993). Murray Rothbard is well known for his defense of the PTPT (see for example Garrison 1988) derived from Mises. We begin here with a brief restatement.

If an income source (a capital asset) is known to yield a steady income for a finite period of time, why does the price of the source not equal the sum total of the incomes earned over the life of the asset? So, to be more specific, a “machine” may be assumed to yield a net income of $100 a year for ten years and then be replaced by a new model.² Why can the machine not be sold for $1,000? This is a simple way of formulating the generic problem. If the value of an income source is derived from the value of the income it yields, why is the source not valued at the sum total of the income yielded over its life? Surely, at any price below $1,000 someone could buy the machine and earn an income in excess of the price paid, a surplus. Why is this surplus not competed away?

The answer provides the identification, and indeed the definition, of interest as a phenomenon. One hundred dollars today is not valued the same as $100 a year from now. They are economically different goods. In terms of the consumer’s subjective preference ranking, the marginal utility of $100 today is greater than the marginal utility today of $100 a year from now. This is time preference whose expression is interest.³

We may note some assumptions and implications. The income at various dates must be that which would be valued the same at the same date. The only differentiating factor is time (although it may be admitted that the passage of time itself cannot be without significance, of which more below)—it is a pure time preference. Second, it is important to keep all notions of interest rates, such as we observe in the loan market, out of the picture. To admit them into the individual’s choice theoretic context would be to fall prey to an all too common circularity. We cannot explain interest rates in terms of individual time preferences if we assume an interest rate already to exist. This is no different in principle from realizing that individuals’ preference rankings exist “prior” to and independently of the prices of the items they are ranking. Time preference is a subjective phenomenon like individual preference rankings and as such is unobservable. But it is nevertheless quite real and exists even in the real world of uncertainty and inflation and is reflected (together with risk and uncertainty) in market interest rates, just as other prices express other aspects of individual preferences (interest rates being derived from a ratio of intertemporal prices). Third, it is apparent that interest does not depend in any way on the productivity of capital. It does not even depend on the existence of productive assets (whose combined value is identified as capital). Indeed the price of a capital asset, its capital value, would fully reflect the (discounted) value (by its owner and as expectedly evaluated by consumers) of its product, so that a more productive asset would cost more. The rental return to capital is conceptually quite distinct from interest. Interest is not the return on capital. Interest would exist in a pure exchange economy as long as there was a positive time preference. A positive time preference is a necessary and sufficient condition for the existence of interest. In fact, in this context, interest and time preference are virtually synonymous. Interest is thus “explained” by the propensity of individuals to discount the future. And, since interest, by definition and by intuition, would not exist in the absence of this propensity, it makes sense to say that the phenomenon of interest is due to and only due to time preference. The “essence” of interest is time preference.

So far so good. It would seem that, stated in these terms or similar ones (for example Kirzner 1993; Garrison 1988), PTPT would be clear, if not unobjectionable, and objections would be in terms of arguing for other conceptual schemes. It is apparent, at least to this author, that the PTPT account of interest is not well understood, even by eminent theorists. It seems that a plausible explanation for this is the way in which the PTPT has been developed in the literature. It may be helpful to examine certain aspects of the development of the theory. The most influential theorists are probably Böhm-Bawerk (1959), Fetter (1977), Mises (1966), and Rothbard (1970).

Böhm-Bawerk, Fetter, Mises, and Rothbard

Böhm-Bawerk’s exhaustive (and exhausting!) survey of interest theories establishes clearly the primacy of time preference. He effectively disposes of productivity accounts in explaining the phenomenon of interest. His account of time preference is much admired. But then in his later volume (1959), when he turns to an examination of the determinants of time preference, he advances three reasons for the existence of a positive rate of time preference. Two of these are “psychological” (impatience and myopia), while the third is “technological” (the “technical superiority” of present goods over future goods). What he meant by this third reason was the productivity of capital goods that represent the results of “roundabout” methods of production—because of productivity, present goods could be used to obtain a greater volume of future goods and so were demanded at a premium. In this way he involved himself in an unfortunate and celebrated contradiction.⁴ To many later theorists it appeared as though Böhm-Bawerk had come to embrace a kind of Fisherian eclecticism, one that established the duality of time preference and productivity in the determination of interest rates. In fact much of the recent mathematical work on “modern Austrian capital theory” seems to reflect this (Faber 1979, 1986). In a way the contradiction became obscured because the question changed. PTPT was never really about the determination of market interest rates; it was about explaining interest as a phenomenon (Kirzner 1993:183ff.). As we shall see, the fact that productivity may play a role in the former in no way diminishes its irrelevance for the latter.

Frank Fetter’s reputation as being unique among economists in his clear grasp of the PTPT owes a great deal to Rothbard (Rothbard 1977). But, according to Rothbard, while Fetter articulated a valid criticism of Böhm-Bawerk’s inconsistency, at the same time he failed to grasp certain important aspects that were valid in Böhm-Bawerk’s theory.⁵ It was left to Mises to establish a valid theory using what was valuable from Böhm-Bawerk and Fetter and putting it in his own unique framework.

The leading economist adopting Fetter’s pure time preference view of interest was Ludwig von Mises. . . Mises amended the theory, in two important ways. First, he rid the concept of its moralistic tone which had been continued by Böhm-Bawerk . . . Mises made clear that a positive time preference rate is an essential attribute of human nature. Secondly, and as a corollary, whereas Fetter believed that people could have either positive or negative rates of time preference, Mises demonstrated that a positive rate is deducible from the fact of human action, since by the very nature of a goal or an end people wish to achieve that goal as soon as possible.

(Rothbard 1987:421, italics added)

So, according to Rothbard, Mises has the definitive PTPT of interest. Rothbard claims (a) that Mises has demonstrated “that a positive rate is deducible from the fact of human action, since by the very nature of a goal or an end people wish to achieve that goal as soon as possible” and therefore (b) that time preference can never be negative.

It is these claims that render the PTPT of interest obscure. A closer examination of Mises’ work and Rothbard’s reveals that they are not so easily established. Mises and Rothbard wanted to establish (positive) time preference as a pure (nonempirical) category, like action; something that was impossible to deny. But because of its link to time and because of the connection of time to uncertainty (the gaining of new knowledge), the attempt to do so involved Mises (and by extension Rothbard) in a logical contradiction—that is, he assumed the absence of uncertainty in order to “prove” the necessity of time preference as an implication of action, when action in a world without uncertainty is, by his own definition, impossible (Lewin 1997b). The distinction between assumption and empirical judgment also seems to be blurred by Mises’ difficulty in establishing a clear definition of time preference (see also Pellengahr 1996).

The PTPT of Interest Reformulated

This is a difficult and controversial subject. No doubt others will interpret Mises differently and this is not the place for a lengthy defense of my own view (which is available in Lewin 1997b). Instead I will simply offer a reformulated account of the PTPT of interest, one that does not claim time preference as a “pure” category. Fetter’s and Böhm-Bawerk’s “empirical” approaches look much better from this perspective.

Time preference is difficult to define. The prospects being compared over time must in some sense be the same things but for the passage of time. What, then, makes them the “same things”? Are they the same goods? In this case the definition of a good is problematic—ice cream in summer versus ice cream in winter are not the same good. But then, are we talking about more “ultimate” goods, like “satisfaction obtained from eating ice cream”? If so, we are comparing a present satisfaction with the contemplation of an identical satisfaction in the future. How are we to calibrate these? An alternative way to express time preference, one that is purged of any “hedonic” elements, is as follows:

Comparing the purchase of (a) a prospect that is ranked 1 today with (b) a prospect that would be ranked 1 today if it were available today but is only available tomorrow; since (as indicated by the ranking) (a) is preferred to (b), time preference exists.

A key point can be made: time preference is strongly intuitively connected to the presence and type of uncertainty in the world. Consider the simple experiment that one often uses in teaching the concept of time preference. The teacher takes out a ten-dollar bill and asks the class which they would prefer: (1) the ten dollars right now or (2) the same ten dollars this time next week. He adds that the students may not earn any interest on the ten dollars. Of course, everyone opts for (1). Then the teacher changes option (2) to (2’), ten dollars plus i this time next week. At some level of i, (2’) will just be preferred (or the students will be indifferent between the two). This is then used as an indication of, and as a measurement of, time preference. Now if you change the choice a little by adding the assumption that the prospect often dollars next week is a certain prospect—the teacher is a perfectly safe bet, while the students’ ability to keep the ten dollars safe over the course of the week is less than certain (for example, we could imagine a dangerous society in which predatory behavior regularly threatens people’s savings) then (2) could very well be preferred to (1). Alternatively, if we assume that (2) and (1) are equally and completely certain, then a priori it does not seem to be possible to say that one will be preferred to the other. The knee-jerk preference of (1) over (2) seems to be crucially bound up with the fact that the students automatically realize that the passage of time brings with it unexpected events and that “a bird in the hand is worth two in the bush.” Resorting to constructs that banish the essential nature of time seems to hinder rather than help in understanding time preference.

It should be noted that among some writers sympathetic to the time preference approach there is no assumption that it need always be positive or that it is a logical rather than an “empirical” phenomenon. We have already noted Fetters’ contribution. In Kirzner’s recent article he implicitly expresses doubts about Mises’ treatment, when he says, “This theory solves the interest problem by appeal to widespread possibly universal positive time preference” (Kirzner 1993:171, italics added), and again: “PTPT accounts for this phenomenon [value productivity] by reference to widespread possibly universal preference for the earlier, rather than the later, achievement of goals” (ibid.:192, italics added). In considering why (market) interest rates cannot be negative, Lachmann explains:

The ultimate reason for this lies in the simple fact that stocks of goods can be carried forward in time, but not backwards. If present prices of future goods are higher than those of present goods, it is possible to convert the latter into the former unless the good is perishable or the cost of storing excessive; while future goods cannot be converted into present goods unless there are ample stocks not otherwise needed which their holders are ready to reduce for a consideration. And as there are always a number of goods for which the cost of storage would be small, money being one of them, a negative rate of interest would be eliminated by a high demand for present goods which are easy to store and a large supply of easily storable future goods, at least as long as the stocks carried are covered by forward sales.

(Lachmann 1978:78)

So, given that the passage of time is what it is, and given that (in our society) generally some goods can be transferred to the future intact (notably money), we would expect time preference and interest rates to be positive.

Conclusion: Interest is not Profit

Every production plan involves capital values. These depend crucially on the rate of discount used to obtain them. This rate of discount is an expression of a positive time preference, although it may be affected by other things. Time preference is its essential explanation. Since capital involves time it also involves time preference. Observed interest rates which, depending on the context, are sometimes used to obtain capital values, do not measure the return to capital. Capital is in this respect no different from any other input. The contribution of any and all inputs will be similarly discounted in any production plan. Payment to the inputs would tend to reflect their opportunity costs. Thus any surplus remaining after the payment to the inputs of “wages” and “rents” is profit. We now take a closer look at this.

The Nature of Profit

Profits In and Out of Equilibrium

One way to examine the nature of profit is to examine a hypothetical situation in which it would be absent. This has been the basis of a number of similar approaches in neoclassical as well as Austrian economics: in the former, the steady state and its extreme, the stationary state; in the latter the “evenly rotating economy.”

In an economy in which there was no uncertainty (if one could imagine such a world) there would be no profit. All production plans in such a world would be successful in the sense explained above. All capital values k_t would look the same from all points of view and to all individuals. In such a world the rate of discount would equal the uniform internal rate of return on all capital projects and this in turn would equal the rate of interest for the time period in question. This is the world of general equilibrium. If we assume no growth, no capital accumulation, it is a stationary general equilibrium and also an evenly rotating economy (ERE) (see Rothbard 1970:274ff.). In this kind of world it is possible to do some simple social accounting.

The structure of production will be constant and will reflect the best use of the generally known productive techniques. This is the state to which we are to imagine the economy will tend to move in the absence of any change. There are no profits and losses. The prices of capital goods—reflecting the value of their discounted marginal products—are fully captured by the prices of the original “primary” factors used to produce them. And there are only two such primary factors of production—(ground) land and (raw) labor. Everything else in the economy is ultimately produced using these two primary factors, either directly—at the highest stage—or indirectly, combining with already produced capital goods to add value to the next stage. All other incomes can be analytically “swept back” to those of the original factors. The incomes of land and labor are incomes in the nature of a rent, and in the ERE only labor and land earn pure rent.

A rent is the unit price of the service yielded by a long-lived asset. In the case of a nondurable good it is equal to its price. In the ERE the rent on a particular physical asset will equal its discounted marginal value product (DMVP). Thus all durable assets that have a value in production (and can be bought and sold) have capitalized values that will determine their prices. For a perpetual income stream the capitalized value will be equal to the rent divided by the discount rate. Since all rents, except those paid to land and labor, “balance out”—since the prices paid for capital inputs by a producer of capital goods at any stage of production must be offset against the prices of the goods produced—the only “pure” capitalized values are for land and labor. Since labor cannot be bought and sold in a free society—it can only be rented—the only pure capitalized value that would be observed is that of land.

Thus, in this world, there is a crucial distinction to be made between capital, land, and labor, since capital earns no net (pure) income and the distinction between land and labor has to do with the lack of a market for the latter—a matter we take up briefly below (and in detail in Chapter 11). To reiterate, capital goods refers to produced means of production, whereas land refers to the nonproduced resources of nature. This distinction is likely to trouble the modern reader who might find it difficult to imagine any productive land that has not been altered in some way in the interests of productive activity. Also the fact that at a certain time in the distant past unspoiled land entered into the production of a particular consumption good is, from an economic point of view, irrelevant. Economic agents take the world as they find it and look forward when making decisions—they inherit a variety of capital goods whose value depends not on their history but on their future usefulness. For both of these reasons the distinction between capital and land needs to be carefully formulated. Whether a piece of land is “originally” pure land is in fact economically immaterial, so long as whatever alterations have been made are permanent—or rather so long as these alterations do not have to be reproduced or replaced. “Permanence” is not really the key.

The key question is whether a resource has to be produced, in which case it earns only gross rents. If it does not or cannot, it earns net rents as well. Resources that are being depleted obviously cannot be replaced and are therefore land, not capital goods.

(Rothbard 1970:460 n. 15)

So land is any nonhuman resource that cannot be “produced” or “reproduced.” And capital goods are produced means of production that require (allow) maintenance or reproduction. As such, they include the structures on land, agricultural land, and valuable human-made features of the landscape that need to be maintained. Land, then, includes less than what we are accustomed in common usage to mean, one important element being “location.” “[This] concept of land . . . , then, is entirely different from the popular concept of land” (ibid.:415; see also Hayek 1941:ch. V).

An ERE at any time, then, will have as productive factors land, labor, and capital in the sense discussed. Land does not refer to the resources of nature in their pristine originality, but rather to any non-reproducible resources that may happen to exist at the time that the economy arrived at the stationary state of the ERE. (Rothbard is aware that the ERE cannot abide depletable resources—that would otherwise qualify as land—and bemoans this as an unfortunate shortcoming of an otherwise useful construct.) In this economy, the only net incomes earned will be the wages of labor, the rents of land, and pure interest. The value of the final product will be accounted for by the contributions of land (in the restricted sense explained), labor, and interest. So in this discussion, profits and losses (which are conceptually completely distinct from interest) have the necessary function to correct the ubiquitous malinvestments and misallocations that occur outside of the particular (zero profit) ERE to which the economy is assumed to be tending. “Profits are an index that maladjustments are being met and combated by the profit-making entrepreneurs” (ibid.:468, italics removed). And in a continually growing economy, land may earn an income in terms of an increasing capitalized value.

Theory and Reality

This approach is useful in sorting out some common but fundamental confusions, like the difference between interest and profit, and is strong, for example, on the explanation of the concept of rent. Careful readers come away with a much better understanding of fundamental categories like interest, wages, rent, and profit. They are thus able to demystify much of capital theory. Profit is seen as a disequilibrium phenomenon, a result of fluctuations in capital values in response to diverse entrepreneurial visions and actions. It is not interest, it is not rent, and it is not a return to any single factor of production, unless entrepreneurship be regarded as a factor (something that is hard to defend). We shall return to this. Once we leave the certain world of the ERE (or any steady state), however, it is useful to consider wages, interest, and rent as categorically separate from profits along the same lines as discussed above, in that they are contractual in nature, being the result of the fulfillment of (implicitly or explicitly) contractual arrangements between employers and employees or borrowers and lenders. Profits are familiarly understood, then, as the residual noncontractual payment to the equity holders in the production process. This is a valuable insight suggested from ERE steady-state type reasoning and, of course, also conforms to the vision of the modern property rights approach to the firm. (See Chapter 9.)

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[In this section I use material from Lewin (1997b).]

¹At the very heart of the terminological thicket is the use of the word “interest” in at least two different contexts. The same word is used for a description of the rates earned and paid on money loans in actual real-world economies and for a description of the value premium of present over future goods in a hypothetical world devoid of uncertainty and change, although in the case of the latter, qualifiers like “originary,” “pure,” “neutral,” and “natural” are sometimes added (notwithstanding that these qualifiers are used as well by different theorists to mean different things). See, for example, Rothbard (1975:17–18). On the one hand the phenomenon of “interest” is something with which we are all, in our everyday lives, very familiar. On the other hand, if we study economics we are told by PTPT theorists that “interest,” while ubiquitous and crucial to the functioning of any market economy, is nothing we can actually observe because it is hopelessly mingled with profits and losses, inflation (price) premiums, and uncertainty premiums (Mises 1966:253; Rothbard 1970:321).

²We leave aside the question of how we know that the “machine” is the source of the income. Strictly speaking, we should say that the use of the machine together with other production goods adds $100 to income each year. In familiar terms the marginal product of the machine is valued at $100 per year. This will be explored further below.

³‘Specifically, using a neoclassical approach, we may say that the interest rate is the ratio of the marginal utilities minus 1. Symbolically MU_t /MU_t+1 = 1 + τ where τ equals the rate of time preference. Or, more generally, MU_t/MU_l+n = 1 + τ_n, where T„ is the rate of time preference for time horizon n. Marginal utilities are understood to be as of time t. So MU_t+n is the marginal utility of the prospect in question to be enjoyed at time t + n but contemplated at time t.

⁴See, however, Maclachlan (1993:39-40) for a slightly different interpretation.

⁵So, for example, among other things, he “never fully realized the importance [of distinguishing] between land (the original producer’s good) and capital goods (created or produced producer’s goods)” (Rothbard 1977:6).