§11. Income Rather Than Capital in the Leading Rôle

The essential fact, however, is that for any given individual at any given time, his impatience depends in a definite manner upon the size, time shape, and probability of his income stream.

This view, that the degree of impatience and, consequently, the rate of interest depend upon income, needs to be contrasted with the common view, which makes the rate of interest depend merely on the scarcity or abundance of capital. It is commonly believed that where capital is scarce, interest is high, and where capital is plentiful, interest is low. In a general way, there is undoubtedly some truth in this belief; and yet it contains a misinterpretation of borrowing and lending.

In the first place, we must distinguish between capital wealth and capital value. It is capital value of which most people think when they say capital. But capital value is merely capitalized income. Behind, or rather beyond, a capital of $100,000 is the stream of income which that capital represents, or rather the choice of any one among many possible streams. To fix attention on the $100,000 capital instead of on the income which is capitalized is to use the capital as a cloak to cover up the real factor in the case.

Moreover, capital value is itself dependent on a pre-existing rate of interest. As we know, the capital value of a farm will be doubled if the rate of interest is halved. In such a case there would seem to be more capital in farms than before; for the farms in a community would rise, say, from $100,000,000 to $200,000,000. But it is not Edition: current; Page: [92] the rise in capital value which produces this fall in interest. On the contrary, it is the fall in the interest rate which produces the rise in the capital. If we attempt to make the rate of interest depend on capital value, then, since capital value depends on two factors—the prospective income and the rate of interest—we thereby make the interest rate depend partly on income and partly on itself. The dependence on itself is of course nugatory, and we are brought back to its dependence on income as the only fact of real significance. It is present and future income that are traded against each other.

But, even as thus amended and explained, (that capital stands for income) the proposition that the rate of interest depends on the amount of capital is not satisfactory. For the mere amount of capital does not tell us enough about the income for which the capital stands. To know that one man has a capital worth $10,000,000 and another has a capital worth $20,000,000 shows, to be sure, that the latter man can have an income of double the value of the former; but it tells us absolutely nothing as to the time shapes of the two incomes actually selected; and the time shape of income has, as we have seen, a most profound influence on the time preference of its possessor, and time preference is a prime determiner of interest.

To illustrate this important fact, let us suppose that two communities differ in the amount of capital and the character of the income which that capital represents but, as far as possible, are similar in all other respects. One of these two communities we shall suppose has a capital of $100,000,000, invested, as in Nevada, in mines and quarries nearly exhausted, while in the other community there is $200,000,000 of capital invested in young orchards and forests, as in Florida. According to the theory Edition: current; Page: [93] that abundance of capital makes interest low, we should expect the Nevada community to have a high rate of interest compared with the Florida community. This would ordinarily be true if the two communities had income streams differing only in size with the same time shapes and probabilities. But, under our assumptions, it is evident that, unless other circumstances should interfere, the opposite would be the case; for Nevada, due to the progressive exhaustion of her mines, is faced by a decreasing future income, and in order to offset the depreciation of capital which follows from this condition,47 she would be seeking to lend or invest part of the income of the present or immediate future, in the hope of offsetting the decreased product of the mines in the more remote future. The Florida planters, on the contrary, would be inclined to borrow against their future crops. If the two communities are supposed to be commercially connected, it would be Nevada which would lend to Florida notwithstanding the fact that the lending community was the poorer in capital of the two. From this illustration it is clear that the mere amount of capital value is not only a misleading but a very inadequate criterion of the rate of interest.48

Apologists for the common idea that abundance or scarcity of capital lowers or raises interest might be inclined to argue that it is not the total capital, but only the loanable capital which should be included, and that the Nevada community had more loanable capital than the Florida community. But the phrase loanable capital is merely another cloak to cover the fact that it is not the Edition: current; Page: [94] amount of capital, but the decision to lend or borrow it, (or the income stream which the capital stands for) which is important.

We end, therefore, by emphasizing again the importance of fixing our eyes on income and not on capital. It is only as we look through capital value at the income beyond that we reach the effective causes which operate upon the rate of interest. It has, perhaps, been the absence of a definite theory and conception of income which has so long prevented economists from seeing these relations. Borrowing and lending are in form a transfer of capital, but they are in fact a transfer of income of which that capital is merely the present value. In our theory of interest, therefore, we have to consider not primarily the amount of capital of a community, but the future expected income for which that capital stands.