XII. Role of Interest

As was shown in The Nature of Capital and Income, the price of any article of wealth or property is equal to the discounted value of its expected future services. If the value of these services remains the same,·a rise or fall in the rate of interest will consequently cause a fall or rise respectively in the value of'all instruments of wealth. The extent of this fall or rise will be the greater the further into the future the services of wealth extend.1 Thus, land, from which services are expected to accrue uniformly and forever, will be doubled in value if the rate of interest is halved, Qr halved in value if the rate of interest is doubled. In the case of dwellings, however, the life of which is limited, if the rate' of interest is doubled, the price of 1 See The Nature 0/ Capital and Income, Chap. XIII. Q 225 226 THE RATE OF INTEREST [CHAP. XII dwellings will fall less than half, and if the rate of interest is halved, the price of dwellings will rise to less than double. In the case of furniture the fluctuations in value will be even less extensive, and so through the list of less durable commodities, such as clothing, to those of very perishable types, such as food, the value of which will not be sensibly affected by a variation in the rate of interest.

§ 2 AB to the influence of the rate of interest on the price of services, we first observe that services may be intermediate or final.1 The value of intermediate services or "inter actions" is derived from the succeeding future services to which they respectively lead. For instance, the value to a farmer of the services of his land in affording pasture for sheep will depend upon the discounted value of the serv ices of the flock in producing wool. If he rents the land, he will calculate what he can afford to pay for it on the basis of the value of the wool which he would expect to obtain from his flock. In like manner, the value of the wool-output to the woolen manufacturer is in turn in fluenced by the discounted value of the output of woolen cloth to which it contributes. In the next stage, the value of the production of woolen cloth will depend upon the discounted value of the income from the production of woolen clothing. Finally, the value of the last named will depend upon the expected income which the clothing will bring to those who wear it, - in other words, upon the use of the clothes.

Thus the final services, consisting of the use of the clothes, will have an influence on the value of all the anterior serv ices of tailoring, manufacturing cloth, producing wool, and pasturing sheep, while each of these anterior services, 1 See The Nature of Capital and Income, Chap. IX. The subject has already been referred to in the present volume, Chap. VIII.

SEC. 2] ROLE OF INTEREST IN ECONOMIC THEORY 227 when discounted,'willgive the value of the respective capital which yields them; namely, the clothes, cloth, wool, sheep, and pasture. We find, therefore, that not only all articles of wealth, but also all the intermediateservices (" interac tions") which they render, are dependent upon final enjoy able uses, and are linked to .these final uses by the rate of interest. If the rate of interest rises or falls, this chain will shrink or expand. The chain hangs, so to speak, from its final link of enjoyable services, and its shrinkage or ex pansion will therefore·be most felt by the links most distant from these final services.. A change in the rate of interest will affect but slightly the price of making clothing, but it will affect considerably· the price of pasturing sheep. A study, therefore, of the th~ry of price~ involves (1) a study of the laws which determine the Mil'! services on which the prices of anterior interactions depend; (2) a study of the prices of these anterior interactions, as de pendent, through the rate of interest, on the final services; (3) a study of the price of capital instruments and capital property as dependent, through the rate of interest, upon the prices of their services. The first study, which, seeks merely to determine the laws regulating the price of final services., is relatively independent of the rate of interest.

The second and third, which seek to show the dependence on final services of the anterior services and of the capitals which bear them, involve and depend upon the rate of interest. Under this second study will fall, as a special case, the study of the determination of economic rent, both the rent of land and the rent of other instruments of wealth. Thus, the rent of the pasture referred to, consist ing, as it does, of the value of the services of pasturing, is dependent, through the rate of interest, upon the dis counted value of the future final services to which the land contributes. It is clear, then, that the rent of the land is partly dependent upon the rate of interest, and that the same dependence applies to the rent of any other instru ment. \ !

228 THE RATE OF INTEREST § 3 [CHAP. XII Similar considerations apply to the determination of the rate of wages. So far as the employer is concerned, the payment of wages to a workman represents the value of his services. These services are interactions or inter mediate services leading to some future enjoyable service. Thus, the shepherd hired by the farmer to tend the sheep in the pasture renders services the value of which to the farmer is estimated in precisely the same way as the value of the services of the land which he hires. It follows that the rate of wages is dependent upon the rate of interest, and, conformably to the previous reasoning, the dependence of wages on the rate of interest is the more pronounced the more remote are the ultimate services to which the work of the laborer leads. As stated in Chapter IX, in a com munity where the workmen are largely employed in enter prises requiring a long time, such as digging tunnels and constructing other great engineering works, the rate of wages will tend to fall appreciably with a rise in the rate of interest, and to rise appreciably with a fall in the rate of interest; whereas in a country where the laborers are largely engaged in personai services or in other work which is not far distant from the final goal of enjoyable services, a change in the rate of interest will affect the rate of wages but slightly.

What has been said, however, applies only to wages from the standpoint of the employer. The rate of wages is dependent upon supply as well as demand; that is, upon the willingness of the workman to offer his services, as well as upon the desire of the employer to secure them. From the standpoint of the laborer, wages constitute an incentive to exertion or labor. This exertion is, as we have seen, a final disservice, and its value is not determined by the rate of interest in the manner of services which are intermediate. It is a great mistake to treat the subject of wages, as many authors do, exclusively from the employer's standpoint.

5:mo. 4]· ROLE OF INTEREST IN ECONOMIC THEORY 229 Our purpose here, however, is not to enter into an extended discussion of the theory of wages; but merely to show at what points in that theory the rate of interest enters, and at what points it does not enter. § 4 The second great branch of economics to which the rate of interest applies is the theory of distribution. - In the classical. political eco~omy,_tb-~...~~lation of the rate of in:- \ terest to distribution was entirely misconceived. Distribution was erroneously regarded as a separation of the income of society into it interest, rent, wages, and profits." By "interest" of course was meant, not the rate of interest, but the rate of interest multiplied by the value of the capi tal" yielding interest." But we have seen that the value of the capital is found by taking the income which it yields and capitalizing it by means of the rate of interest. To reverse this process, and obtain the income by multiplying the capital by the rate of interest, is proceeding in a circle.

The result of multiplying capital by the rate of interest, i.e. income, is not really a complex product of two .facto!s, but, on the contrary, is the single original factor,-income. We have seen in this book that it is this income which affords the basis for the determination of the rate of interest, and, through the rate of interest, of capital value. The income-stream of society is the ultimate and basic fact from which the whole economic fabric should be constructed. All of this income springs from capital-wealth, if land and ,man are included· in that term, or if not, from capital-and man, or capital, land, and man. It may all be capitalized, and hence, if we follow the definition of capital adopted in -this book, it may all be regarded as interest upon the capital value thus found. lIgnce It interest" is not a part. but the I wholeiof income. It includes what is called rentand profits, t and even wages; for the income of the workman may be capitalized quite as truly as the income of land or 230 THE RATE OF INTEREST [CHAP. XII machinery. Thus, so far from having "interest, rent, wages, and profits" as mutually exclusive portions of in come, we see that "interest" includes all four. The error of the classical economists and of their modern followers in distinguishing between interest, rent, etc., as separate but coordinate incomes, is partly due to the failure to perceive that whereas all income springs from capital wealth, yet capital-value springs from income.

Another oversight closely associated with the last is that by which rent and wages were conceived as deter mined independently of the rate of interest, whereas we have just seen that the rate of interest enters as a vital element into the determination of both. We shall, therefore, in discussing the theory of distribu tion, abandon the" classical" point of view entirely. And little regret should be caused by such abandonment, for the concept of distribution which the classical economists have given us is quite incompatible with the ordinary conception of the term. The phrase" Qjstribution of wealth" implies prdinarily, or should imply. the problem of the relative , wealth of individuals, - the problem of the rich aud the ~ But the separation of the aggregate income into four abstract magnitudes has little to do with the question of how much income the different individuals in society receive. Were it true that society consisted of four inde pendent and mutually exclusive groups, -laborers, land lords, entrepreneurs and capitalists, - the fourfold defi nition would have some connection with the actual dis tribution of wealth. But, in fact, the entrepreneur is almost invariably a "capitalist"; i.e. is the owner of other capital than land; the" capitalist" is frequently a landlord, or vice versa; and even the laborer is to-day often a small capitalist. It is true that a centnry Blga in England the \ lines of social classification correspondeuQughl)': and to some exte~t, at least, with the abstract divisions into whi~h---- ----1 Cf. Edwin Cannan, U The Division of Income," Quarterly Jo'Urnal 01 ECQ'nQmic8, May, 1905.

SEC.O] ROLE OF INTEREST IN ECONOMIC ·THEORY 231 economists separated inco~~_; but this fact is of interest ,.. only in explaining historically the origin of the classical th~ory of distribution. 1 § 5 Turning to the true problem of distribution, that of de termining the amounts of capital and income possessed.by different .individuals in society, we find that economists have contributed extremely little to its solution. A statistical beginning has been made by Professor Pareto in his interesting "curves of distribution of income," 2 in which he shows the surprising result that in all cases where figures are available, the relative distribution of incomes is fairly uniform in different times and places. So far as the philosophical theory of distribution is con cerned, the only writer who seems to have contributed materially to the subject is John Rae.s He showed that persons who had naturally what we have called in this book a low rate of preference for present over future income tended to grow rich, whereas those who had the opposite trait tended to grow poor.

We saw in a previous chapter that the rates of prefer ence among different individuals were equalized by borrow ing and lending or buying and selling. In the case of an individual whose rate of preference fot present enjoyment was unduly high, we found that he would contrive to modify his income~stream by increasing it in the present at the expense of the future. We were then intent on studying this phenomenon only on the side of income; but the effect on capital can be easily seen by applying the principles of The' Nature of Capital and Income, Chapter XIV. If a modification of the income-stream is such as to make the present rate of realized income exceed the '" standard" 1 Cf. Edwin Cannan, loco cit. :I COUTS d'Economie Politique, Vol. II, Lausanne, 1897, Book III. / S The Sociological Theory 01 Capital, Chap. XIII.

232 THE RATE OF INTEREST [CHAP. XII income,capitalmust be depletedto the extent of the excess, and the individual will grow poor. This may be brought about by borrowing immediate income and paying future income, or by selling those instruments the income of which is far distant, and buying those which have more immediate returns. Individuals of the type of Rip Van Winkle, if in possession of land and other durable instruments, will either sell or mortgage them in order to secure the means for · obtaining enjoyable services more rapidly. The effect will be, for society as a whole, that those individuals who have an abnormally low appreciation of the future and its needs will gradually part with the more durable instruments, and that these will tend to gravitate into the hands of those who have the opposite trait. By this transfer an in equality in the distribution of capital is gradually effected, and this inequality, once achieveq, tends to perpetuate itself. The poorer a man grows the more keen his apprecia tion of present goods is likely to become. When once the spendthrift is on the downward road, he is likely to continue in the same direction. When he has succeeded in losing all his capital except his own person, the process usually comes to an end, because society, in self-protection, decrees that it shall go no further. But where there is no such safeguard, the unfortunate victim may sink into even lower stages of debt servitude, as in Java 1 or Russia. Reversely, when the accumulator is well advanced in his accumulations, his rate of preference for the present diminishes still further, and accumulation becomes still easier. Hence, in some countries the rich and poor come to be widely and per manently separated, the former constituting a hereditary aristocracy and the latter a helpl~ss and degraded peasr antry.

/~ Fortunately, however, another factor enters which tends U~ t-D/ to counteract these tendencies. This is the effect of Jyilii.t,. (y .L Jb/lt has already been noted that one's rate of preferencelOr · v,<~ 1 See Prof. Clive Day, The Dutch in Java, New York '(Macmillan) , ¥S'~... v 1904, Chap. X. if,)'" , SEC. 5] ROLE OF INTEREST IN 'ECONOMIC THEORY 233 present over futur~ income, given a certain income-stream, will be high or low~'according to the past habits of the in dividual. If he has been accustomed to simple and inex pensive ways he finds it fairly easy to save and ultimately accumulate a little property. The habits of thrift being transmitted to the next generation result in still further accumulation, until, in the case of some of the descendants, affluenceor great wealthmay result. Reversely,if a man has been brought up in the lap of luxury he will have a lreener desire for present enjoyment than if he had been accustomed to the simple living of the poor. The effect of this factor is that the children or the rich, 'Who have been accustomed to luxurious living and who have inherited only a fraction .of their parents' means, will, in ,attempting to keep up the former pace, be compelled to check the accumu lation and even to start the opposite process of the dissipa tion of their family fortune. In the next generation this reverse movement is likely to gather headway and to continue until, with the gradual subdivision of the fortune and the increasing reluctance· of the successive generations to curtail their·expenses, in the third or. fourth generation there comes a return, to actual poverty. It thus often happens that there is a tendency for the accumulation and dissipation of wealth to occur in cycles. If there is the conjunction of favorable circumstances, as thrift,ability, and good fortune, a few individuals will rise from the lower ranks. They accumulate a few thousand dollars, which, under like favoring circumstances, in the next gen eration or two may become several millions. Then the unfavorable effects of luxury begin, and in an equal num ber of generations the majority of the heirs have returned to .the level at which their ancestors began. An old adage has stated this observation in the form, "From shirt sleeves to shirt· sleeves in four generations." This cyclical move ment is more apt to occur in countries like the United States, where, owing to the rapidly changing conditions, there ·.is a larger number of opportunities either for rising 234 THE RATE OF INTEREST ,", [CHAP. XII or falling in the economic scale. Where, as in the older countries of Europe, conditions have become fixed and less favorable to changes of any kind, the tendency of the distribution of wealth is to remain relatively unchanged.

This is especially true where, as in England, the customs as to the inheritance of property have tended to keep large fortunes intact in the hands of the eldest son. § 6 In the general causation of distribution which has thus been outlined, the central role is played by the individual rate of preference for present over future income, which, as we have seen, is the subjective prototype of the rate of interest. The study of the theory of interest, therefore, lays the foundation for a study of the theory of distribution. The objective rate of interest represents the norm to which the individual adjusts his rate of preference for present over future income, and in this adjustment he changes his economic status for better or worse. The existence of this general market rate of interest to which he adjusts his rate of preference supplies an easy highway for the movement of his fortune in one direction or the other. If an individual has spendthrift tendencies, their indulgence is facilitated by access to a loan market; and reversely, if he desires to save, he may do so the more easily if there is a market for savings. The irregularities in the distribution of capital are thus due to the opportunity to effect exchanges of parts of the income-stream separated in time. The rate of interest is simply the market price for such exchange.