XIII. Application to Actual Conditions

CHAPTER XIII APPLICATION TO ACTUAL CONDITIONS § 1 WE have now completed the formal statement of our theory of interest. It remains to show in what way this theory may be brought into connection with actual experi ence. For this purpose we need first to classify the various forms which interest takes. We have seen that the rate of interest discloses itself in two ways; namely, as explicit. and implicit interest. We begin with explicit interest, or the interest in a loan contract. From the standpoint of the borrower, loan con tracts may be classified as follows:For business purposes LOANS ( {TO offset misfortune or improvidence. For private To offset fluctuations in income and outgo. purposes To anticipate improvement in financial con dition. For public { For military purposes. purposes To, offset fluctuations in revenue and ex(municipal, penses. etc.) For public improvements. (Sh t {crop liens.or or .

eriodic CommercIal ~aper. roans AccommodatIon paper. Call loans. Mortgages on farms. Mortgages on city real Long or per-estate. manent loans Mortgage bonds of cor porations. Debentures of corpora tions. 236 Sma. 1] APPLICATION TO ACTUAL CONDITIONS 237 Private loans are loans of individuals for personal purposes other than those arising out of business relations, Of these, loans contracted because of misfortune or improvidence, though to-day constituting a very' small fraction of total indebtedness, represent probably the original type of loan. It was against such loans that the biblical, classical, and medireval prohibitions and regulations were directed, and ,it is only against them to-day that, in enlightened com munities, regulations affecting the rate of interest still survive. It is such loans that supply most of the business to pawn shops, the patrons of which are usually victims . of misfortuneor improvidence. It is clear that the theory of interest which has been .propounded applies to .this species of loan. Sickness or death in one's family, or losses from fire, theft, flood, shipwreck, or other causes, make temporary inroads upon one's income. It is to tide over . such a stringency in income that .the loan is contracted.

It ekes out the less· adequate income of the present by sacrificing something from the more adequate income ex pected in the future. Similar principles apply to the spend thrift, who, though nota victim of accidental misfortune, brings misfortune upon himself. He borrows in order to supplement an income inadequate to meet the require ments which he· has set himself, while he trusts for repay ment to the shadowy resources of a distant future. It is evident, therefore, that the loans just described are made for the sake of correcting an income curve the time-shape of which is inconvenient or intolerable. The second class of personal loans comprises those grow ing out of such fluctuations in income as are not due to misfortune or improvidence. Many persons receive their money-income in very irregular and unequal instalments, while their money outgo may likewise have .·an irregular time-schedule. Unless the two sides of the account happen to synchronize, the individual will be alternately "short 11 and '.'flush." Thus, if he receives his largest dividends in January, but has to meet his largest expenses, let us say 238 THE RATE OF INTEREST [CHAP. XIII taxes, in September, he is likely to borrow at tax time for the ensuing four months, in anticipation of the January dividends. That is, he borrows at a time when his incom~ stream would otherwise be low, and repays at a time when it would otherwise be high. The effect is to level up the fluctuations of his income.

The third class of personal loans comprises those which grow out of large expected additions to income. Heirs to a fortune sometimes borrow in anticipation of their bequests. A considerable volume of such loans has un doubtedly been contracted, especially in Great Britain. The borrower in this case is evidently trying to enjoy in the present some of the income which is promised for the future; in other words, to alter the time-shape of his income-stream in accordance with his desires. The same motives actuate young men preparing for life, and explain the loans which are often contracted by them for defraying the expenses of education. It was for such persons that Benjamin Franklin left his peculiar bequests to the cities of Phil adelphia and Boston in 1790. To each he bequeathed £1000 to be lent out in small sums at 5 per cent. to young married" artificers." The sums repaid were to be added to the fund and again lent.

§ 2 In the case of. public loans, we find the same general principles in operation which we have just seen to apply to private loans. By a public loan is meant a loan contracted by a public corporation or association, such as a state, county, municipality, school district, or other administrative unit, as well as such quasi-public institutions as churches, hospitals, and public libraries. Public loans may be sub divided into three classes: (1) those growing out of military exigencies; (2) those growing out of fluctuations in income; (3) those .growing out of need for public improvements. The first class, loans for war and war preparation, cor responds to the case first considered under private loans, SEC. 2] APPLICATION TO ACTUAL CONDITIONS 239 loans growing out of misfortune. Ordinarily the expenses of government are defrayed out of taxes, which constitute a regular deduction from the incomes of the taxpayers; but war brings with it extraordinary expenses which must be met by extraordinary means. If the cost of war were wholly defrayed by taxes, the taxpayers would suffer large and sudden reductions in their incomes for the time being.

They prefer instead to place some of .the burden on the future, - even upon posterity. This is accomplished by war loans, to be repaid many years after the war is over. Thus, so far as the taxpayers are concerned, the expense of the war· is spread over a considerable time, and the im mediate reduction in their income-stream, which would otherwise be caused by the war, is avoided. But for the world as a whole this is not true; for others than the tax; payers, namely, the bo~dholders, must bear the brunt of the reduction in the world's income-stream which the war has brought about. It follows that the issue of bonds has as its ultimate effect, not a postponement of the cost of the war, but its shifting from one class to another. We thus see that war loans clearly exemplify the theory of loans which has been elaborated. The need for such loans grows out of an impending depression in the income-stream of the taxpayers.

The second class of public loans, namely, loans due to fluctuations in public receipts and disbursements, corre sponds to the second class of private loans. A government receives its income chiefly in taxes, and only once a year, whereas its outgo occurs day by day and month by month. It thus happens that a government is alternately accumulat ing a large surplus and suffering a large deficit. The in convenient effects of this have been often commented upon, especially in this country, where the Treasury for half a century has been relatively independent of institutions of credit.1 This inconvenience may be largely avoided by 1 See David Kinley, The Independent Treasury 01 the United Statea, Boston (Crowell), 1893.

240 THE RATE OF INTEREST [CHAP. XIII a business relation between the government and some in stitutions of credit, as, for instance, in England, between the government and the Bank of England. The govern ment may correct the irregularities in its income-stream either by borrowing for current expenses in anticipation of taxes, or by lending at interest; that is, depositing the taxes when first received, in anticipation of the expenses which follow. The third class of public loans comprises those for public improvements, such as the erection of government build ings, the improvement of roads, bridges, and harbors, the construction of municipal waterworks or schoolhouses, or the prosecution of other government enterprises. In all such cases it is usual to finance the enterprise by issuing bonds. The reason clearly is that these improvements constitute an extraordinary cost, similar to the expense of a war, which, without the issue of bonds, would cause a temporary depression in income-streams. The taxpayers as a whole cannot afford the first heavy drain, even with the prospect of substantial benefits to follow. They therefore prefer, in place of such a fluctuating income stream, a more uniform one. To secure this uniformity is evidently the purpose of the loan. We see, therefore, that this class of loans also exemplifies the theory of the re lation of borrowing and lending to the time-shape of an income...stream.

§ 3 The third and last general class of loans is that of business loans. Business loans are loans growing out of trade. They are commonly, though not very felicitously, called "productive loans," whereas the loans which have thus far been considered would commonly be called "consumption loans." Business loans constitute by far the most impor tant class of present indebtedness. Mr. George K. Holmes has estimated that at least nine tenths of the existing inSmc.3] APPLICATION TO ACTUAL CONDITIONS 241 debtedness in the United States was incurred for the ac quirement of the more durable kinds of property, leaving not more than one tenth, and probably much less, asa "consumption debt," or a debt necessitated by misfortune. No theory of interest would therefore be complete which should fail to apply to business loans. At first sight it would seem that the theory which has been given, depending as it does on the enjoyable income stream of an individual, can apply only to consumption loans. Net income, as was shown elsewhere,l consists of one's personal satisfactions, - nourishment, clothing, shelter, and other enjoyable services. The loans of business seem too impersonal to be explained by a theory which depends wholly on personal satisfactions. In fact, it has often been said by economists, in ·treating this subject, that consumption loans are explained on quite other principles than loans contracted·in the regular course of commercial transactions. Even Bohm-Bawerk, in his Positive Theory of Capital, states that consumption loans are explained by the preference for present enjoyment over future, but that the loans of business are chiefly due to the "technical superiority of present goods," which grows out of the greater productiveness of lengthy pro cesses.

A little consideration will show, however, that business loans are not so different from consumption loans'; that they also a.re used to tide over lean. time.s in.anticipation of pros-). perity; and that they are contracted to r~tify the distortion of the income-stxefl,ID.which would otherwise result, from business operations. The truth is - and it should never be lost sight of - tbs·tbusinese; men conduct thei[ business with an ere always to enjQyable jncome This is the object of all their operations, though it may be ob.. scured by the interposition of the many intermediate steps, J or tl interactions." Business operations are not ends in tllemselyes, but means for ultimate personal enjoyment.. 1 The Nature of Capital and Income, Chaps. IX, X. It.

242 THE RATE OF INTEREST [CHAP. XIII A business man not only conducts his business for what he can get out of it for personal use, but also regulates it so that what thus comes out may accrue not in irregular spurts, but so far as possible in such a stream as will syn chronize with the exigencies of his home life. In a sense we may say, therefore, that it is his home that" runs" his business rather than his business that" runs" his home. § 4 In order to see how the theory of interest which has been explained applies to business loans, let us consider the two chief classes; namely, short loans, or those growing out of periodic variations, and long loans, or those for rela tively permanent investment. The short or periodic loans are those which grow out of the change in the seasons and the ebb and flow of business. These loans are obtained usually but once a year at a specified time. The ultimate cause is the cyclical change in the position of the earth in reference to the sun. This gives rise to the cycle of the seasons, the effects of which are felt not only in agriculture, but in manufacturing, transportation, trade, and banking.

The alternate congestion and thinning of the freight busI ness, the alternate stocking and depletion of raw ma terial in factories, the fluctuations of trade activity, both wholesale and retail, the transfer of bank deposits between New York and the West for "moving crops" or for other uses, all testify to the seasonal rhythm which is constantly felt in the great network of business operations. Without some compensating apparatus such as that for borrowing and lending, these seasonal fluctuations would transmit themselves to the final enjoyable income-streams of indi viduals, and those incomes, instead of constituting an even flow, would accrue by fits and starts, a summer of lavish enjoyment being followed by a winter on short rations. To show how borrowing and lending compensate for these fluctuations, we may consider first what is perhaps SEC. 4] APPLICATION TO ACTUAL CONDITIONS 243 the most primitive type of the short or periodic loan; namely, that contracted by poor farmers in anticipation of crops. In the South among the negroes this takes the form of what is called a "crop lien," the cultivator borrow ing money enough to enabl~o live until crop time and pledging repayment from the crop_ Here, evidently, the purpose of the loan is to eke out the meager income of actual enjoyments. The loan, in other words, is for sub sistence. This case, therefore, is covered by the theory of interest which has been given.

We proceed now to show that this same theory of interest applies also to loans contracted in the commercial world at large. A short-time commercial loan is contracted for the purpose of buying goods, with the expectation of repayment after their sale. A common form is what is called "com mercial paper." A ready-made clothing house may buy overcoats in summer in order to sell them in the fall. If these operations were conducted on a strictly cash basis, the tendency would be for the income of the clothier to suffer great fluctuations. He could realize but little during the summer, on account of the enormous expense of stock ing-in for fall trade, whereas in the fall he could obtain large returns and live on a more elaborate scale. This would mean the alternation of famine and feast in his family. One way to avoid such a result would be to keep on hanc\ a large supply of cash as a buffer between the money-income and personal expenditure. In this case the fluctuations would not reach the stage of personal enjoyment, but would spend their force in fluctuations of the volume of.

cash. A more effective and less wasteful method for the merchant, of taking the kinks out of his income, is by negotiating commercial paper. The clothier, 'instead of suffering the large cash expense of stocking-in in summer, will make out a note to the manufacturer of overcoats. Mter the fall trade, this note is extinguished, having fulfilled its function of leveling the income-stream of the clothier.

244 THE RATE OF INTEREST [CHAP. XIII Sometimes merchants contract short-time or periodic loans, not for some specific transaction such as the purchnse of stock in trade, but-for general business purposes, as, for instance, improvement or enlargement. In this case, the extraordinary expense involved may be met by a species of loan called "accommodation paper." Evidently its function is precisely the same; namely, to rectify the -time shape of the income-stream. In Wall Street and other speculative centers a type of loan known as the "call loan" is common, subject to redemption at the pleasure of the lender, and used by the speculator for the purchase of se curities. The speculator borrows when he wishes to buy, and repays when he has sold; and by adroitly arranging his loans prevents the sudden draining or flushing of his income-stream which these purchases and sales would otherwise involve.

In all the cases which have been described, the loan grows out of a purchase or group of purchases; and since the tendency of every purchase is to decrease one's income, and of every sale to increase it, it is clear that loans contracted for a purchase and extinguished by a sale have as their \ function the ob!teration of these dec~a~__ i~~~~~_~~ of the income-stream. It IS clear, therefore, that these commercial1oans fit Into the theory of interest which has been propounded. § 5 The second class of business loans is that of long-time loans or "permanent" investments. In this class are placed mortgages, whether on farms or on urban real estate. As shownby Mr.GeorgeK.Holmesof the UnitedStates Census, more than two thirds of farm mortgages are contracted for the purchase of the property, and the remainder principally for improving it, or for the purchase of farm implements and other durable wealth or property. These purchases or improvements, involving as they do large expenditures, would be difficult or impossible without loans. If the attempt SlDC. 6] APPLICATION TO ACTUAL CONDITIONS 245 were made to enter into them without recourse to a loan mar ket, they would cause temporary depressions in the income streamsof the farmers. Thefarmerwho attempted to buy his farmwithouta loanwould have to cut down his current expenses to a minimum and suffer a corresponding reduct'ion in his enjoyable income-stream, unless he avoided this result by some other of the methods which have been explained, such as "the method of buying and selling." For instance, he may sell some other capital in order to buy his farm.

Mortgages on city lots are usually for the purpose of im proving the property by erecting buildings upon it. Here, again, the expense involved would, if taken out of income, reducethe incomeof the ownertemporarilyto verysmallpro.. portions. He naturally prefers to compensate for such extra ordinary inroads by a mortgage which defers this expense to the future, when his receipts will be more adequate to meet it. We come next to the loans of business corporations and firms,such, for instance, as railroad bonds and debentures, the securities of street railroa"ds,telegraph, and telephone com panies, and other" industrials." These loans are usually issued for construction purposes, as in cases in which a rail road wishes to extend its lines, replace iron rails with steel ones, or a curved route by a straighter one. The borrowers in this case are the stockholders. They· may be said to contract th r not to have the expenses , of the i ovement taken out of theirdivi en s. ometimes, where the dividends are large and thestockho ers few, divi dends are applied, in part or wholly, to the making of im provements. But ordinarily the reduction in the stockholder's income-stream is avoided by the device of inviting the bond holders to cancel the outgoes connected with the improve ment, in consideration of receiving a part of the increased income which will later follow from these improvements.

§6 We see, therefore, that business loans, or loans growing out of a purchase and sale, are as truly for the purpose of 246 THE RATE OF INTEREST [CHAP. XIII reshaping the income-streams as are private and public loans. The reasons that business loans are usually re garded by economists as on a different footing from private and public loans appear to be three: 1. The proceeds of business loans are usually spent, not for the borrower's bread and butter, but for durable capital; consequently the loan seems not to be connected with income, but rather with capital. A spendthrift who borrows $1000 in order to pay for wines is certainly to be distinguished from a merchant who borrows the same sum in order to pay for new stock in trade. Yet in either case the loan adds $1000 to immediate income beyond what the income would have been 'Without the loan but with the expense for the wines or the stock in trade. > To make the comparison as simple as possible, let us sup pose that the two men were each enjoying an income of $10,000 a year. This represents the value of their nourish ment, clothing, shelter, etc., which constitute true income.

In the year (say 1901) of the proposed loan, each man has two courses open to him: (1) he may meet the expenditure for wines or stock in trade by sacrificing one-tenth of his $10,000 worth of nourishment, clothing, shelter, etc., or (2) he may meet it by borrowing. If the spendthrift follows the first course and meets the expenditure by skimping out of his $10,000 income, he will not suffer any change in the value of his income, but will obtain $1000 worth of wine drinking, at a sacrifice of $1000 worth of other pleasures. His income for the year 1901 will still be $10,000. Nor will there be any necessary change in the income of subsequent years. He merely changes the composition of this year's enjoyable income partly into wine-drinking, but his income remains $10,000 a year. The merchant, however, who skimps out of his $10,000 income in 1901 in order to pay for stock in trade, will actually reduce his enjoyed income of 1901 by $1000; for this stock in trade, unlike wine, will not give any immediate satisfaction. It serves only as a means of securing future satisfactions, so that, let us say, S:mc.6) APPLICATION TO ACTUAL CONDITIONS 247 81100 may be enjoyed in 1902. The income of the mer chant will thus be, not $10,000 each year, as was that of the spendthrift, but $9000 in 1901 and $11,100 in 1902.

Having seen what· effect the expenditures would have in the two cases without recourse to borrowing, we next ask what will be the effect in the two cases of borrowing $1000 in 1901 and repaying, let us say, $1050 in 1902. The spend~ thrift who borrows to get his $1000 worth of wine will have, in 1901, that much more of enjoyed income, making a total enjoyed income in that year of $11,000, and in 1902, when called upon to pay his debt of $1050, he will have to sacrifice just so much out of his income of $10,000 for 1902. His resulting enjoyed income will therefore be in 1902 only $8950. As to the merchant, he will be able to buy his stock in trade in 1901 without the necessity of any sacrifice out of his $10,000 for that year, so that his income in 1901 will be $10,000. In the following year he will pay the $1050 for his loan out of the $11,100 for 1902. (Of the $11,100,$10,000 was the original income, and $1100 what we have assumed to be the returns from his stock in trade.) He will .thus have $10,050 left as his real income for that year.

Comparisons are shown in the following tables:INCOME OF SPENDTHRIFT WHO BUYS $1000 WORTH OF WINE 1901 1901 Without loan With loan • • • . $10,000 11,000 $10,000 8,950 INCOME OF MERCHANT WHO BUYS $1000 WORTH OF STOC~ IN TRADE 1901 1902 Without loan With loan $ 9,000 10,000 $11,100 10,050 .

248 THE RATE OF INTEREST [CHAP. XIII It is clear that in each case the effect of the loan is to add $1000 to the income of 1901 and subtract $1050 from that of 1902. There is absolutely no difference between the two men in this respect. The difference between them is chiefly that the spendthrift is making a foolish and the merchant a wise addition to his income of 1901 at the expense of that of the year following, and this difference is only one of degree, due to the fact that the final satis factions by means of the wine come earlier than the satisfactions obtained by means of the stock in trade. 2. But the example given of the "consumption" -loan is not the only one possible, and no doubt it will still seem to some readers that there must be another difference between production-and consumption-loans. Suppose the case of a victim of misfortune, such as illness. To tide him over his emergencies he is compelled to borrow, using the proceeds of his loan merely to meet his grocer's and butcher's bills.

Here is indeed a case of a "consumption" -loan which is not foolish, and yet is surely different from the loan of the mer chant to buy stock in trade. The effect of business loans is to enable a merchant to embark on an enterprise, while personal loans merely relieve needs. Let us examine this difference. It is not a dif ference which invalidates the principle that both loans are additions to present income at the expense of future income. The unfortunate, with his misfortune, but without his loan, would have, let us say, an income of $9,000 in 1901 and $11,100 in 1902, which are the same figures we assumed for the merchant with his investment but without his loan. With the loan, therefore, the unfortunate and the merchant would be in the same situation. Both would have $10,000 in 1901 and $10,050 in 1902. The effect of the loan in the two cases is thus identical so far as their income-streams are concerned. The difference is that the unfortunate, if deprived of his loan, could not escape from his income stream of $9,000 in 1901 and $11,100 in 1902, whereas the merchant, if deprived of his loan, could, if he chose, give SlDc.·6] APPLICATION TO ACTUAL CONDITIONS 249 up the investment in new stock altogether. If the merchant did not have this option, the two cases would be so similar that not even a stickler for the distinction between con sumption-loan and productive-loan would assert any es sential difference. For, suppose the merchant has already been committed, sometime previously, to buy the goods for his stock in trade, not, perhaps, realizing that he would be unable to pay for them without borrowing or skimping.

When the time arrives that he must of necessity buy the goodsand pay for them, he finds that a loan is badly needed to avoid pinching himself in income. He will now think of the loan, not as enabling him to buy stock in trade, for that must be done anyway, but as enabling him to buy his bread and butter. In short, his loan, like the unfortunate's, isa necessity-loan. It is because ordinarily the merchant is not thus constrained· to buy the goods that the loan is connected, in his mind, with their purchase rather than with his private necessities. It still serves to relieve that income, but he has another method of relief, - not to buy the goods at all. The contrast, then, between him and the unfortunate is simply that he has a third possible course which the latter does not have. This is shown in the following tabl~s:INCOME OF MERCHANT 1901 1909 A Without loan and without investment • B Without loan but with investment C With loan and with investment . . .

$10,000 9,000 10,000 $10,000 11,100 10,050 INCOME OF UNFORTUNATE 1901 1902 B Without loan C With loan $ 9,000 10,000 $11,100 10,050 250 THE RATE OF INTEREST [CHAP.XIII We see here that the unfortunate has two options, Band C, and the merchant three possible options, A, B, and C. It is the existence of this third option A which makes the chief real difference between the merchant borrower and the borrower in misfortune. So far as the other two options are concerned, the two men are similarly situated. That this fact is overlooked is due to the unconscious substitution, in considering the case of the merchant, of the third option, A, for the second, B. That is to say, when the effect of a merchant's loan is considered, this effect is measured with reference to his situation without the loan and without the purchase of the goods, instead of with reference to his situation without the loan but with the purchase.

The latter method measures the effect of the loan in the sense that it shows the difference produced by its pres en~e or absence, other things being equal. It treats the merchant's loan in the same way that the unfortunate's loan is treated, and thus puts the two on the same basis. The true sequence of thought then is: Of the two options A and B, the merchant selects B (buying the goods) because it has the greater present value (or, what amounts to the same thing, because the rate, 10 per cent., of the return of $1100 on the sacrifice of $1000 is greater than the rate of interest, 5 per cent.); then he selects C (borrowing money), which has the same present value as B, but a more desirable time-shape. This description takes account of the whole series of operations, and cor responds to the principles propounded in Chapter VIII. 3. It is the third option A which gives rise to the con tention that the loan produces a profit not possible or·easy without it, and that it is, therefore, "productive." We have just seen that the loan phenomena are resolved into two separate steps, the rejection of A in favor of B, and the rejection of B in favor of C. Yet since it may often happen, as shown in Chapter VIII, that the first step (choice of options) would not be taken unless the second step (loan) were already in contemplation, it is true that, in a sense, SEC. 7] APPLICATION TO ACTUAL CONDITIONS 251 the choice of the loan includes the choice between the -optiQDS A···',and·B. Looked at in this way, the effect of the loan is measurable by comparing a with A, such com parison including both the steps stated. In this sense, and in this sense alone, is the loan II productive." It is productive in that it enables the merchant to buy the goods. He thus chooses an option (B) which has an advantage (over A) in present value, or yields a rate of return on sacrifice (10 per cent.) greater than the rate of interest. The reason that the loan is regarded as "productive," then, is that it gives the merchant the op portunity to make 10 per cent. instead of 5 per cent. But obviously it is not the loan (choice of C rather than B) which yields the 10 per cent., but the choice of options with out the loan (B rather than A). The pro£.t·is the advantage of B over A; but the loan merely substitutes C as a more desirable equivalent of B. It does not add to the profit, though it changes the form in which it appears. After the loan, the profit appears in the accounts for 1902 in the form of $50 more income for C than for A.

If, after all has been said and understood, anyone still prefers to call such a loan H productive," no objection is offered, pr<Widoo always that it is made wholly clear what is meant by the term "productive." The essential point is that our theory of interest is not restricted in its application to personal and public loans, but includes the loans of business. These business loans come into the same theory as the other loans, and differ only in the existence of a wider range of choice in income streams. § 7 We have seen that the theory of interest which has been propounded is adequate to explain the motives which lead to borrowing and lending in the actual business world. The purpose of loans in all casesmay be said to be to modify the shape of income-streams so as to suit the particular 252 THE RATE OF INTEREST [CHAP. XIII requirements of the case, - to increase present income at the sacrifice of future, and to eke out present scarcity in anticipation-.Qf future abundance. As Jevons stated, capital is required to enable one to support himself while engaged in undertakings which require time.

The foregoing classification is made from the standpoint of the borrower. From the standpoint of the lender, loans do not need to be so minutely classified. The lender is usually either one who wishes to invest permanently, or one who wishes to invest temporarily. The former may lend on mortgage, or he may buy the securities of companies, governments, or municipalities, or he may be a depositor in a savings bank. In all cases the lender is evidently sacrificing what he might enjoy in present income, in order that he may have a still larger income in the future. In other words, he is modifying the time-shape of his income curve in a manner opposite to that which the borrower pursues. When he invests for short times, this course is generally due to a periodic fluctuation in his income-stream, the large present flow being precedent to a shortage in the not far distant future. Business men and institutions are in this way constantly investing for short periods funds which otherwise would exist in the form of idle cash. The government or individual which we supposed to have borrowed at the time of deficit in anticipation of surplus may, instead, fol low the reverse policy of investing the surplus at interest, in order to provide better for the payment of expenses at the time of anticipated deficit.

§ 8 The same person may be alternately borrower and lender, according to the exigencies of his income-stream. When the same person is simultaneously borrower and lender, he be comes a broker for managing credit operations for other persons. This is usually the function of institutions such as banks of discount and deposit, savings banks, trust com panies, exchangebrokeragefirms,and mortgagecompanies.

SEC. 8] APPLICATION TO ACTUAL CONDITIONS 253 It ,is through such firms that borrowers and lenders usually reach each other, rather than directly; but whether directly or by means of such intermediaries, the borrowers· and lenders are constantly playing into each other's hands. This is particularly evident in the case of periodic fluctua tions; for it usually happens that the same cycle of opera tions which makes one man's income alternately large and small will make another man's alternately small and large. Thus, when the clothing manufacturer sells to the retailer of ready-made clothing, not. only does this operation tend to make inroads in the income-stream of the latter, but it also tends to bring to the -former an accession of income inconvenientlY.concentrated. For this reason the manu facturer.may decide to keep the commercial note which the clothier makes to him, rather than to discount it at a bank.

The manner in which fluctuations in income-streams mutually compensate among borrowers and lenders fs well seen in the South, where cotton planters have long been accustomed to borrow of the banks in springtime, to repay in the fall after the cotton is sold. Until recently the banks which supplied these loans found difficulty in leveling the consequent irregularities produced in their own income streams. They were forced to do so largely by keeping an idle stock of cash, or investing it at low.rates in Northern banks. But r,tt.centlycoJ.ton mUla have set.t.led jn the SQuth, with a. cycle 0 • ctl the reverse of that of the plan ers. . They buy their crops in the fall, manufacture through the winter, and sell in the spring. The conse quence is that they come to the banks for loans in the fall, which is just the time when the ~anks are receiving their pay from the planters, and liquidate these loans in the spring, at just the time when the banks are in need of funds to lend to the planters. In this way the irregularities in the income-streams of both planters and manufacturers are leveled, virtuallyby mutual cancellation,but actually through the intermediation of the banks.

254 THE RATE OF INTEREST § 9 [CHAP. XIII Hitherto we have considered loans only with reference to the time of issue and repayment. But it frequently happens that loans are transferred at points intermediate between these two dates. In that case they pass by sale like other property, and affect the income-streams of those whobuy and sell in precisely the same way as if they lent and borrowed. The buyer of a security is in the same position as a lender, - he parts with present income for the sake of future. The seller of a loan security is in the same position as a borrower, - he is securing present income and foregoing the future interest he would otherwise receive. The price at which such loan securities are sold will determine the rate of interest realized and borne by the buyer and seller respectively. The effects caused by the transfer of loans may be negatived by later transactions. The seller of a bond may not really use the proceeds to swell a large income, but may reinvest in some other security, and the buyer may not hold the security until maturity, but may sell again at the next turn of the market.

What has been said of loan securities applies also to every form of property which may be regarded in the same light. The buyer of railway stock is not very different from the buyer of railway bonds, or the lender. He also is sacri ficing present income for future, so far as this particular purchase is concerned, even though, as .just shown, the effect may be negatived by some other transaction. Likewise the seller of railroad stock is similar to the seller of bonds, or the borrower. The only distinction is that in the case of buying and selling stock the rate of interest is implicit rather than explicit. § 10 Explicit and implicit interest really differ, however, in degree rather than in kind. An income bond, while SEC. 10] APPLICATION TO ACTUAL CONDITIONS 255 nominally yielding explicit interest, may actually, if the income is inadequate, yield quite a different interest, and the price of sale takes into account the latter contingency quite as much as the former. Preferred stock, likewise, while nominally involving the risk of non-payment, often represents a case more nearly like that of explicit interest.

It is quite as possible, on the basis of the purchase price and the practical certainty of adefinite fixed income, to calculate the rate of interest to be realized to the investor, as in the case of the bond buyer. In the case of ordinary stock, however, in order to calculate the interest to be realized, it becomes necessary to make a forecast of the probable dividends. It is where the element of chance thus enters that implicit interest really differs from· explicit. Where the ownership of an article of wealth is total instead of partial, the element of chance is always present. In fact, bonds, so far as they escape from the universal reign of chance, do so only by carving out of the fluctuating income arising from amass of capital-wealth a certain definite part, small enough not to absorb the whole even at its lowest ebb. But while the rate of interest is somewhat difficult to calculate in advance in the case of other property than loan securities, it may be approximately estimated, and from the rate which has been actually realized in the past it may sometimes even be exactly calculated. In the case of land, it is not uncommon to reckon the value of so many years' purchase of the crop returns, on the assumption that the same value of the crop returns will continue indefinitely.

The element of risk, which is so dominant in actual businessrelations, has also been considered in the theory of this book. The buying and selling of property serve to modify not only the time-shape of the income-stream, but also the degree of certainty. The investor who wishes to take chances may invest in stock, and he who does not, in bonds. Risk constitutes the real difference between them, and the reason for the existence of the two types of securities. Both are investors, and both sacrificepresent 256 THE RATE OF INTEREST [CHAP. XIII income for future; but one assumes a future income with risk and the other receives one without risk, or at any rate, with no large degree of risk. That stockholders and bondholders are both investors is not inconsistent with the fact already emphasized that the stockholder is a borrower .of the bondholder as a lender. In dealing with each other they are on opposite sides of the market, the bondholder being a buyer or investor and the stockholder a seller or borrower. But in dealing with" the company," they are on the same side of the market ; both are buyers of securities, or~investors.

Thus by borrowing and lending, or by buying and selling, an individual regulates the character of his income-stream to suit his individual needs and idiosyncrasies. This ad justment involves comparisons of risk and of futurity, and in the latter case involves a rate of interest, implicit or explicit. This rate is utilized by individuals to enable them to increase or decrease the flow of their income at different periods of time, and it is through their efforts to do so, by bargaining with each other, that the rate of interest is itself determined. The theory of its determina tion applies to the actual loans of business, loans of neces sity, improvidence,or purchase,loans of persons,corpora tions, and loan brokers, and applies also to cases in which there are no contract loans at all, but only the buying, selling, and valuing of property, in which transactions the rate of interest is always implicitly contained.