2. Böhm-Bawerk’s Theory of Interest and the Earlier Theories

How does interest arise, and in particular, how can consumable goods bear interest; that is to say, at least in appearance yield useful services, without thereby diminishing in value?

I should like to let Böhm-Bawerk speak on this question. No one can have read his two volumes Kapital und Kapitalzins carefully without having gained therefrom a real enrichment of his theoretical knowledge. If we cannot agree with all his conclusions, yet we must gratefully acknowledge that scarcely any other author has penetrated so deeply as he into the real nature of the matter. At any rate, no one has been able to combine profundity and clarity to the extent that he has done.

His one fault, it seems to me, is that he sometimes wants to be too profound. He loves to pile up theoretical difficulties, in order, of course, to remove them later on—for the most part satisfactorily, but in a way which is somewhat confusing to the ordinary reader.

The simple formula in which Böhm-Bawerk wishes to comprehend all phenomena in the realm of capital interest, and by which all earlier theories of interest are to be replaced, runs, as is well known, as follows: Interest is an agio which comes into being when present and future goods are exchanged. It rests solely on the relationship between present and future in human economy and simply expresses the fact that present goods (at least according to the contemporary valuation) are as a rule more valuable than future goods of the same kind and number.

There can be no doubt that this formula governs the problem of interest in its whole extent¹—and it is no mere tautology, which simply expresses that A = A, interest is—interest! The clarifying element, newly added, lies in the word exchange: the problem of interest can now be treated as a true problem of exchange. In particular, the consideration of marginal utility will play the same part in the theory of interest as in the theory of ordinary exchange. And this applies to ‘natural interest’ as well as to interest on loans. He who parts with present goods, in order in some way or other to obtain future goods of the same kind, really makes an exchange between two uses of the same commodity. He thus performs the very action which we, at the beginning of our remarks concerning exchange, put forward as its simplest form; and the degree in which he does this is regulated, as there, by the proportion of two marginal utilities (that of the present goods and that of the future goods, according to the contemporary valuation).

Also, the interest on the loan, just like the exchange value in the case of ordinary exchange, will depend on two proportions of marginal utility; that is to say, it will depend first on the proportion between the marginal utility of present and that of future goods for the creditor, and secondly on the proportion between the analogous marginal utilities for the debtor. Usually in this case the marginal utility of present goods for both will prove to be higher than the marginal utility of future goods of the same kind and number; so that the interest almost always turns out to be positive—that is to say, it will be paid by the debtor. The proportion of marginal utility can finally become identical on both sides, but not the proportion of the total utility. This, on the contrary, must always be different, if a loan is to take place at all, and in such a way that the debtor as opposed to the creditor always values present goods relatively higher. The interest which must really be paid will then fall somewhere or other between these two different valuations.¹

The passages in which he discusses how and why present goods, according to the existing valuation, almost always possess a higher utility or marginal utility respectively than future goods, belong to the best-known and most important parts of Böhm-Bawerk’s book. These we shall now examine briefly.

The first main ground is stated to be the difference in the circumstances of want and provision at different periods of time.

Whether this can rightly be conceived as a main ground of the phenomenon of interest, is open to question. In a stationary economy (which in my opinion must always be considered first as the simplest case), needs and their satisfaction are to be understood as, on an average, constant magnitudes. In such an economy also, it is true, several persons, or whole age-groups, could expect a more abundant satisfaction in the future than now. But besides these there are other individuals for whom the opposite is true; so that it seems as if, under this assumption, supply of, and demand for, present goods against future goods must equal each other also at par.

Böhm-Bawerk remarks, however, that even where provision for the future will presumably be less plentiful, the present goods must at least be equal in value to the future goods, since they can, if necessary, easily be preserved for use in the future. This is certainly a great exaggeration. Böhm-Bawerk mentions, to be sure, ‘an exception’ to this rule—in respect, that is, of ‘perishable goods, such as ice, fruit, and so forth.’ But this applies in a greater or less degree to all food-stuffs without exception. Why, there are perhaps no goods apart from precious metals or stones, for instance, whose preservation for the future does not require special care and effort, with the additional risk that they may yet be lost in a fire or by some such misfortune.¹

In countries with a great future before them, like certain colonial countries, more plentiful provision for the future can admittedly be regarded as a common fact, and undoubtedly contributes to the level of the rate of interest customary there. In countries with a long-established culture, and in the case of a practically stationary economy, the higher valuation of present as against future goods will, on the other hand—if the possibility of a productive application of these is disregarded—occur to a much more limited extent than Böhm-Bawerk seems to think.

However, this would have been the place to discuss a circumstance which Böhm-Bawerk only mentions later in another connexion and only in passing—namely, that the use of present goods for the future, under otherwise similar circumstances, must in itself call forth for the possessor in question a more plentiful provision for the future as distinct from the present, and therefore, in its turn, lead to the higher valuation of present goods.

It is just this circumstance which, in combination with the second main ground, soon to be mentioned, sets bounds to the sacrifice of present pleasures in the interests of the future; that is to say, the formation of capital.

Böhm-Bawerk’s second main ground—the subjective and often incorrect underestimation of future wants resulting from defects of imagination or will—is without doubt of the utmost importance. Not only does it constitute, in combination with the uncertainty of all legal and economic affairs, the chief cause of the feeble formation of capital and the excessively high rate of interest in all primitive economies, but scarcely a day goes by without its effects being traced by each one of us to some extent.

But when Böhm-Bawerk mentions in this connexion the ‘consideration of the shortness and uncertainty of our life,’ and asserts: ‘Payments which become due in 100, 50 or even only 20 years lose value for all . . . receivers in view of the uncertainty of their expectation of life,’ it seems to me open to question whether one can speak here only of subjective underestimation. Our children, grandchildren and great-grandchildren will in general have at their disposal the same means of satisfying their needs as we. Whether we, by denying ourselves now, can give them a corresponding advantage, therefore remains doubtful, especially with regard to the more distant generations of our posterity, whose well-being will depend only to a very limited extent on us. We will not allow ourselves to be held up by this, however, but proceed now to the third and last of the main grounds put forward by Böhm-Bawerk.

This, as the author himself admits, is practically identical with what in former times one used to understand by the phrase ‘productivity of capital.’ Since, however, as is well known, he cannot recognize the ‘productivity theory’ as relevant, he now endeavours to explain independently why present goods are, ‘as a rule, on technical grounds, preferable instruments for the satisfaction of our needs and assure us, therefore, of a higher marginal utility’ than future goods.

According to him the explanation lies in the fact ‘that time-consuming, round-about methods of production are more productive. That is to say, given the same quantity of means of production, the lengthier the productive method employed, the greater the quantity of products that can be obtained.’ The role of capital in production is therefore, as was already emphasized by Jevons, simply this, that it can introduce a shorter or longer interval of time between the beginning and the completion of production, whereas primitive production, carried on without capital, must always live ‘from hand to mouth.’

With a certain sum of primary productive forces—for instance, with one working month which is to-day at our disposal—we shall be able to produce more goods if it is used as the starting-point of a period of production of one year, than if we were to use it for the immediate production of goods of the same kind; and consequently more goods also than could be obtained if one of next year’s working months were used to produce goods straight away. If even lengthier methods of production are adopted, so that, for instance, the goods in question are intended to be ready in two years’ time, the superiority of to-day’s working month over next year’s working month holds good also; for the former could then be employed as the starting-point of a two-year production process, whilst the latter could at best be employed as the starting-point of a one-year production process, and so on. In so far as the above-mentioned fact can be supposed to be generally applicable, the technical superiority of present productive forces (labour or natural forces) over future ones is proved.

This theory is, however, somewhat more amply constructed than the older productivity theory (Thünen’s), which simply refers to the fact that by sacrificing, for instance, a hundred present units of goods, the future production can be increased by more than a hundred units of goods of the same kind.¹ Fundamentally, however, both theories are identical, and the agreement even becomes complete when Böhm-Bawerk arrives at the question: Why have present consumption goods, too, an advantage over future consumption goods ?

Here, too, Böhm-Bawerk tries to formulate his explanation slightly differently. He says (Positive Theorie, p. 287): ‘Command over a sum of present consumption goods provides us with the means of subsistence during the current economic period. This leaves the means of production which we have at our disposal for just this period (labour, uses of land, capital-goods) free for the technically more productive service of the future, and gives us the more · abundant product attainable by them in longer methods of production. On the other hand, of course, command over a sum of future consumption goods leaves the present unprovided for, and consequently leaves us under the necessity of directing the means of production that are at our command now, wholly or partially to the service of the present. But this involves curtailment of the production process and a correspondingly diminished product. The difference in the two products is the advantage associated with the possession of present consumption goods.’

But this is immediately clear only when it is a question of the production of consumption goods of precisely the same kind as the ones at our disposal. Otherwise it will always be open to doubt whether, just because of the more abundant future production of the goods (A) in question, their value, as compared with the value of the consumption goods (B) available before, will not be so greatly diminished that finally it will be of no consequence whether this sum of (B) is available now or in future. This difficulty vanishes when it is merely a question of the production of consumption goods of the same kind—but here we find ourselves in the very midst of Thünen’s productivity theory.

Böhm-Bawerk himself, however, did not, or could not, remove the objection which he directed against this theory in the first volume of his book—namely, that it explains at best the physical, but not the value production of capital. For the demand which he there makes of the productivity theorists was, after all, not to explain why present goods are higher in value than future goods of the same number and kind according to the present valuation—this (in so far as the above-mentioned fact is generally true) Thünen’s theory certainly explains as well as his own theory, though in a somewhat more concise manner—but why the product of capital, when it becomes due, should be more valuable than the sacrificed capital commodity itself. But Böhm-Bawerk has not explained this either; and it can after all only be explained if one sets out from the assumption of a nearly stationary position of economy.

Nor has Böhm-Bawerk answered, by his explanation set forth above, his further main objection to the productivity theory: Are the surplus values or surplus products obtained by the use of capital really added to the capital itself, or do they perhaps fall to the share of the other contributing factors of production, labour, landed property, etc.? It may be true that more future products can be produced with a present working month than with a next year’s working month. But will this surplus benefit the possessor of to-day’s working month without more ado? That is not clear in itself (for nothing can be produced at all with working-time alone and without the use of the forces of nature). It is also not generally true, because the share which belongs to the different factors of production depends entirely on the position of the market. This no one has shown more clearly and finely than Böhm-Bawerk himself in the later parts of his work.

But in the discussion of this problem one is always obliged to assume an approximately stationary economy as the simplest and fundamental case, and as soon as this assumption is made, his objections to Thünen’s theory answer themselves.

Another question which requires to be answered is why this stationary condition, or what comes to about the same thing here, a society in which there is only a slow progression, can be assumed as a rule in theory as well as in practice, and why the incomes of capitalists, landowners and workers are on the whole consumed instead of being hoarded and added to the stock of capital. And although this question is closely connected with the problem of interest, it remains nevertheless a question in itself. In my opinion, Böhm-Bawerk must be blamed for having mixed up the two questions of the origin of interest and the origin of interest-bearing capital itself—in his criticism of the older theories of interest as well as in his own positive presentation—instead of separating them in a truly scientific manner.

And finally a word ought to be said about the Use theory. As is well known, this theory sets out from interest on durable goods, conceiving interest as the price for the use of the commodity during a given time. If the commodity is subject to wear and tear, interest is conceived as the price of its net use; since trouble and labour, necessary for the replacement of the wear and tear which has taken place, are subtracted from the utility of the simple use of the commodity. Whether the value of the commodity remains unchanged in this case and whether the commodity really possesses a capital-value which could be compared with the value of the useful services themselves, remains unsettled.¹ It is merely assumed that the commodity keeps its substance, so that it can yield identical useful services in the future also. Once we have adopted this terminology, it is, in my opinion, no fiction, but a scientific generalization, if these concepts of use and net use respectively are extended to cover consumable goods as well. In the case of durable goods, too, it is, after all, of no consequence whether the wear and tear amounts to more or less, provided only they are replaced by continuous repairs. But then the wear and tear can, as in the case of consumable goods, finally extend to the whole commodity, provided its use includes the repair or reproduction of the commodity itself or of an identical commodity. If now this use consists precisely in the acquisition of goods of the same kind as the capital commodity concerned, then obviously a rate of interest is hereby already determined (an element in the determination of the average rate of interest), which can lead retrospectively to a higher estimate of the capital-value of durable goods.

This view can be regarded as more or less satisfactory and scientifically fruitful. To explain it as depending merely on delusion seems to me unjustified. And when Böhm-Bawerk¹ finds it ridiculous that the Use theory should presuppose the possibility of ‘transferring to someone a little more than the whole of something, that is to say, transferring along with the possession of the loaned object, the right to each and every use which is to be got from the object until it is completely used up, plus a separate fragment of use for which interest can be separately demanded,’ then the answer is simply, that interest is not demanded or given for some ‘separate fragment of use’ but in fact ‘for every scrap of use which is to be got from the article’—use, that is to say, which is only compatible with the repair of the article itself or its replacement by an identical one.²

The mode of explanation of the Use theory (and of the productivity theory) is only excluded in the case of the pure consumption loan. This case is to be understood, rather, from the point of view of an exchange between a present and a future commodity.¹

Böhm-Bawerk’s formula is thus undoubtedly the most general of all. It brings out better than the earlier explanations the true essence of the matter, namely the economic significance of time, and it adapts itself quite as well as any other mode of explanation to the different phenomena of interest. This formula consequently represents, in my opinion, an important scientific advance—more, however, in the sense that it supplies what was missing in the older explanations than in the sense that it substitutes for possibly false or meaningless ideas a completely new and altogether true interpretation, as, to be sure, Böhm-Bawerk himself on more than one occasion states.