§5. Productivity as a Determinant of Interest Rates

When the true nature of the income concept is grasped, it will be found that it includes within itself many special cases which have been advanced by various writers in explanation of the rate of interest. The relation of both impatience and opportunity to the rate of interest, in my opinion, can be comprehended accurately only by analyzing rigorously these concepts and determining the effect of each upon the income stream. By this procedure, we arrive at a fundamental explanation of the nature of impatience and of return on income invested and see how, by changes in the income stream, these rates are brought into conformity with the rate of interest.

I have always felt that John Rae came closer than any of the earlier writers to grasping all the elements of the interest problem. According to Rae, all instruments may be arranged in an order depending on the rate of return over cost. This amounts to saying that the formation of any instrument both adds to and subtracts from the preexisting income stream of the producer, its cost being the subtracted item and the return, the added one. The statement of Rae that for a certain cost of production an instrument will yield a certain return, is merely a form Edition: current; Page: [471] of my statement that a certain decrease of present income will be accompanied by a certain increase in future income. The relation between the immediate decrease and future increase will vary within a wide range, wherein the choice will fall at the point corresponding to the ruling rate of interest.

The same relationship was conceived by Adolphe Landry in his Intérêt du Capital. He states that one of the conditions determining the rate of interest is the "productivity of capital", in the peculiar sense which he gives to this phrase,98 which is, in effect, the rate of return over cost.

It has seemed to me that much of the criticism, both favorable and unfavorable, of my book, The Rate of Interest, has been based on the erroneous assumption that the so-called productivity element found no place in my theory. Much of the misunderstanding of my theory may have been fostered by the lack, in my first book, of a good term with which to express this productivity factor in interest.

As a consequence, one critic, Professor Seager, writes that I refuse to admit that what Böhm-Bawerk calls the "technical superiority of present over future goods", and what other writers have characterized more briefly as "the productivity of capital" has any influence on the comparison between present gratifications and future gratifications in which, as he believes, the complete and final explanation of interest is to be sought.

"The most striking fact about this method of presenting his factors", this criticism continues, "is that he dissociates his discussion completely from any account of the production of wealth. From a perusal of his Rate of Edition: current; Page: [472] Interest and all but the very last chapters of his Elementary Principles (chapters which come after his discussion of the interest problem), the reader might easily get the impression that becoming rich is a purely psychological process. It seems to be assumed that income streams, like mountain brooks, gush spontaneously from nature's hillsides and that the determination of the rate of interest depends entirely upon the mental reactions of those who are so fortunate as to receive them.... The whole productive process, without which men would have no income streams to manipulate, is ignored, or, as the author would probably say, taken for granted."99

My views are quite contrary to those here set forth. As I wrote in 1913:100

"What Professor Seager calls the 'productivity' or 'technique' element, so far from being lacking in my theory, is one of its cardinal features and the one the treatment of which I flattered myself was most original! The fact is that my chief reason in writing the Rate of Interest at all arose from the belief that Böhm-Bawerk and others had failed to discover the true way in which the 'technique of production' enters into the determination of the rate of interest. Believing the 'technical' link in previous explanations unsound, and realizing as keenly as Professor Seager does the absolute necessity of such a link, I set myself the task of finding it. In the desirability of this I emphatically agree with Böhm-Bawerk."

I do not assume, except temporarily in the first approximation, that "income streams, like mountain brooks, gush spontaneously from nature's hillsides", and this is temporarily assumed, precisely as physicists temporarily assume a vacuum in studying falling bodies, or, to take a Edition: current; Page: [473] better but still imperfect analogy, precisely as, in treating supply and demand, we first assume a fixed supply before introducing the supply schedule or supply curve. This assumption gives place in the second approximation and the third approximation to the more complicated conditions of the actual world. My method of exposition is here, as usual, to take one step at a time, which means to introduce one set of variables at a time. All other things, for the time being, are assumed to remain equal. I realize that this is not the only method and that it may not be the best one, but it is at least a legitimate method.

On the other hand, it does not seem to me that the theory of interest is called upon to launch itself upon a lengthy discussion of the productive process, division of labor, utilization of land, capital, and scientific management. The problem is confined to discover how production is related to the rate of interest.

It should not, however, be assumed from what has been said that I regard all productivity theories as sound. Mention was made in Chapter III of the "naïve" productivity theories which hold that interest exists simply because nature, land and capital are productive.