A theory of interest

Preface

The purpose of this book is not to give a history of the problem of interest or to discuss in detail all the supposed solutions of it, but to try to solve it correctly.

The importance of a correct solution can hardly be overestimated. Millions of men now call themselves party Socialists in countries where that party is committed to the Marxian doctrine of interest, according to which interest is due to the exploitation of wage-earners by capitalists. Millions of men, in other words, on account of the theory of interest they have accepted, regard themselves as robbed by capitalists. By many party Socialists in the United States and elsewhere, indeed, the view is held that the capitalists themselves fully understand how the system robs the wage-earners, and sustain universities, whose professors defend it, not, as they pretend, primarily for the advancement of learning, but primarily for the perpetuation of organized injustice. Such is the attitude, I say, of millions of persons at one end of the scale of political opinion. At the other end of the scale are the business men — the ''bourgeoisie," in the Marxian terminology — who in fact do not see any injustice in the receipt of interest, and who therefore in turn view the party Socialists as men who would rob them of their just accumulations. Neither group respects or understands the other. And the root of the whole misunderstanding, which breaks out into bitter struggles and dynamite plots today

vii

Vlll PREFACE

and which may break out into civil war before long, is a difference in accounting for the surplus called interest. Marx's theory, which is accepted by acclamation by many wage-earners, seems wholly untrue to the few capitalists and the many professional economists who inquire into it. The theories of the professors and the capitalists, on the other hand, are hard to understand, and hopelessly at odds with each other. To the few leaders among the wage-earners who inquire into them, therefore, they are quite unconvincing. So the misunderstanding and the recriminations go on, and the political sky is full of warnings.

All that is needed is light and moral courage. The light must come from those who study the problem of interest deeply and honestly. The courage must be furnished by the leaders of those political groups, in all lands, whose conceptions of interest must be modified in accordance with the light.

Though inclined by my natural sympathies, on undertaking the study of interest, to take sides with the poor rather than with the rich if I could do so with intellectual sincerity, I was concerned, above all things, to discover the truth. And my conclusion is that, provided only a person's capital itself is equitably his own, his title to the interest accruing from it is as good as his title to the earnings of his hands.

Here, of course, the Marxians and the Anarchists among my readers will be inclined to throw the book aside because its conclusion conflicts with their own. To such readers, therefore, I want to address two paragraphs.

You who believe that interest is robbery, who, indeed,

PREFACE

IX as you would say, know that it is robbery, you who are sure that perpetual motion is as impossible in finance as it is in mechanics, do you dare to read this book and then to act honestly according to your convictions ? If interest does not involve perpetual motion in finance, and if it is involved in the very make-up of the world, nothing is to be gained by faihng to understand the truth about it and to modify your political and economic programs accordingly.

Wage-earners and capitalists can understand each other and work together for the common good, as they cannot do now, just as soon as they agree on the interest problem ; and they will agree on that problem, obviously, as soon as they both see the truth. The capitalists are approaching the truth, under the guidance of the professional economists, who in the main are quite honest men. It is to be hoped that the wage-earners will approach the same truth from their side, under the guidance of their leaders, of whom, perhaps, you are one. To understand the interest problem will call for time and thought, but surely they are well bestowed for so great an object. To defend the truth among those who now oppose it will call for moral courage.

Of the professional economists I must ask indulgence for using a terminology containing more new words and meanings than will at first seem to them necessary. My defence is that my whole theory is cast in a fresh mould, and I could not bring myself to be satisfied with expressing it in terms shaped by their associations with theories that will not fit my mind. I venture to hope that I have thrown enough fight on the problem to be partly excused for my innovations.

X PREFACE

The keystone of economic theory is the conception of value. Without a correct theory of value it was impossible to work out a correct theory of interest, and without a correct theory of interest it was impossible to work out correct theories of price and of distribution. This book makes in the theory of value some modifications that seem to me important.

If my theory is to be called by a brief name, it should be called t/ie nominal value theory^ for the keystone of it is my conception of nominal value.

The author to whom I owe most is Professor von Bohm-Bawerk, whose Capital and Interest and Positive Theory of Capital were very helpful to me. The following gentlemen have extended to me various courtesies, and it gives me pleasure to record my obligation to them : Professors Patten and McCrea of the University of Pennsylvania ; Clark, Seager, and Mussey of Columbia ; Taussig and Carver of Harvard ; Barrett and Wilson of Haverford College ; Mr. J. A. Hobson of England; Mr. Cyril A. Ward of Lausanne, Switzerland; Mr. Arthur H. Thomas of Haverford, Pa.; and Mr. Charles L. Serrill and Dr. C. W. Macfarlane of Philadelphia. Mr. Ward was very kind in helping me in regard to the algebraic formulae. Most of all I am indebted to my wife. Without her encouragement and cooperation I could not have written the book at all.

CLARENCE GILBERT HOAG.

Haverford, Pa., April 15, 1913.

Contents

I. The Problem

II. Some Definitions and Fundamental Conceptions

III. Theory of Normal Prices

CHAPTER I The Problem

§ I . The facts of interest have presented a theoretical and a moral problem from time immemorial. Lending at interest was condemned by the Mosaic law ^ as between Israelites ; it was declared by Aristotle ^ to be unnatural, was forbidden by the Roman Church until modern times, and is denounced by most Socialists today ; yet it persists age after age, and its justification seems to most business men too obvious for discussion. If we turn from moralists and business men to professed economists, we find that although most of them justify interest, they are well-nigh hopelessly disagreed as to the theory of its justification. The most no table, recent books on the subject, indeed, such as those of Cassel,^

^ E.g. Deut. xxiii. 19, 20: "Thou shalt not lend upon usury to thy brother . . . unto a stranger thou mayest lend upon usury. ..."

2 Jowett's translation, as quoted in Macfarlane's Value and Distribution, p. 140: "The most hated sort [of money-making], and with the greatest reason, is usury, which makes a gain of money itself, and not from the natural use of it. For money was intended to be used in exchange, but not to increase at interest. And this term usury, which means the birth of money from money, is applied to the breeding of money because the offspring resembles the parent. Wherefore of all modes of making money, this is the most unnatural."

^ G. Cassel : The Nature and Necessity of Interest, Macmillan & Co., London, 1903.

B I

Bohm-Bawerk/ Landry,^ and Fisher,^ offer theories so different that a faint-hearted inquirer would be tempted to give up the problem in despair.

Confronted by such a variety of opinions, we should be justified in assuming, notwithstanding the views of business men to the contrary, that the facts of interest do present a problem, and that one of the utmost difficulty. Instead of making this assumption forthwith, however, let us analyze the facts briefly in connection with some of the most commonly accepted explanations of them, to convince ourselves at first hand of the difficulty of the problem and to get some idea of its nature.

§ 2. The facts themselves are obvious enough. If you have $ioo to spare under any normal circumstances, you can get at least $3 in addition to the original hundred by lending it for a year under conditions that eliminate virtually all risk. Furthermore, if you do not lend the $100, but invest it in machinery, you can normally increase the value of your product for the year enough to cancel the cost of repairing the machinery so that it is as good as new, of insuring against its destruction or its depreciation in value, and of making and overseeing the investment, and to leave you at the end of the year a net surplus of at least $3.

The apparent surplus of $3 that you get in the first case we shall call, with everybody else, loan interest.

^ E. V. Bohm-Bawerk : Recent Literature on Interest, Macmillan Co., N.Y., 1903.

3 Irving Fisher : The Nature of Capital and Income, Macmillan Co., N.Y., 1906; The Rate of Interest, Macmillan Co., N.Y., 1907.

THE PROBLEM 3

The apparent surplus of the same amount that you get in the second case we shall call, for reasons that will appear later, natural interest}

§ 3. It is against loan interest that the attacks of moralists have been mainly directed. The reason is evident : in the case of loan interest the fact that the lender gets something of value that costs him no labor is perfectly obvious ; whereas in the case of natural interest the apparent surplus — that is, the something of value which costs the recipient no labor — is noticed only when the several items that go to make up the cost, excluding any allowance for interest on the capital employed, but including outgo for repairs, insurance, and oversight, are carefully added up and compared with the receipts from the sale of the finished product. Recently, however, natural interest has been attacked as vigorously as ever loan interest has been, notably by Karl Marx in his work Das Kapital, in which it is called "the average rate of profit."

§ 4. That the bulk of the great sums constantly borrowed by business men nowadays are borrowed solely to secure natural interest, so that loan interest and natural interest are most closely connected and rise and fall together, is now realized by nearly everybody who thinks of the subject at all. Intelhgent men of affairs, such as bankers and manufacturers, look upon loan interest as simply the price of what we are calling natural interest. A loan yields interest, they say, because it gives the borrower the opportunity to use, for the time covered by the loan, machinery or other things

^ This definition is modified in § 2>2>'

useful in production to the value of the sum lent. Of course, they add, some borrowers may not take advantage of this opportunity; but that should make no difference in its price : you must pay as much for a loaf of bread you throw away as for one you eat. Loan interest, they conclude, is the price of the opportunity to use labor-saving instruments to the value and for the time covered by the loan ; and it is just as fair that that opportunity should be paid for at its market price as that any concrete commodity should be.

Now this is true enough so far as it goes ; indeed, it does not differ, practically, from the conclusion I shall sustain ; but to suppose, as many men of affairs do, that it leaves no problem of interest unsolved, seems amusingly naive either to a Marxian Socialist or to an academic economist. The Marxian Socialist asks how it is possible, unless we are to believe in perpetual motion in finance, for natural interest to accrue to the owners of tools of production, admittedly without labor on their part, unless it is produced by somebody else's labor. He challenges such an owner to produce so much as a single pin with no worker to guide the machine. He scorns the notion of perpetual motion in finance, and he knows that ''surplus value," as he calls it, is produced by poor devils, down at the bottom somewhere, working. The economist, on the other hand, asks how we are to account for the fact that opportunities to get natural interest remain open age after age; and why natural interest, which seems to be a surplus of value added to the value of the product without extra labor but solely by the ^'productivity" of additional labor-saving in-

THE PROBLEM 5

struments, is not reflected back upon the price of those instruments when they are bought? If those instruments can produce such surplus value, why do they not have it? Why can they be bought, generation after generation, for prices below the sum of the values of their future services ?

§ 5. These questions go deep. Whoever fails to see their significance has yet to understand what the interest problem really is. But they do not exhaust the difficulties which the explanation of the man of affairs fails to meet. What is to be said of the income that accrues to the owner of a ^'durable consumption good," such as a dwelling-house or a pleasure carriage, net above all cost of repairs and oversight, from renting it to others ? If that apparent surplus is not also interest, what is it ? And if it is interest, is it a mere reflection of the natural interest arising in connection with labor-saving instruments, or does it arise independently ?

A little thought will reveal that it is interest and that it would arise even if there were no such things as tools in the world. Whether there were tools or not a stone dwelling would not sell for a price equal to the sum of all its future rents, reckoned net above the cost of repairs and so forth, to the end of time. And if discounting is applied to the values of the future services of the dwelling precisely as to those of the future services of tools, interest must accrue to the owner of the dwelling, as its future services come in, just as to the owner of the tool.

§ 6. What, after all, is the cause of interest in any case but the discounting of future services to begin with ? If a man buys the future net rents of a dwelling or of a pleasure carriage for a price equal to all those future net rents discounted at 5 %, what is the cause of the 5 % interest on that price which he will receive as the years go by but merely the discounting to begin with ? Or if he buys a factory building and machines for a price equal to the values of all their future services discounted at 6 %, what is the cause of the 6 % interest on that price which he will receive on selling the finished product as the years go by but merely the discounting to begin with ?

§ 7. All these questions are very perplexing to persons who suppose, as most of us not Marxians do suppose until we give special study to the problem, that interest is due to some imagined power on the part of labor-saving instruments to "produce" surplus value. They even suggest, indeed, that so far from interest's being produced by any such power on the part of labor-saving instruments, this supposed power is rather itself caused by interest, so to speak; for they suggest that this supposed power is a mere illusion due to the discounting of the price of the instruments at the beginning : and what is discount but interest itself in another aspect?

At this point another question presents itself. Can it be that the supply of labor-saving instruments and the progress of invention have nothing to do with the rate of interest ? That we cannot believe : we are sure, whether we can incorporate it in a consistent theory or not, that there is some causal connection between invention and the rate of interest and between the supply of labor-saving instruments and that rate. We must admit that neither labor-saving instruments nor their undoubted

THE PROBLEM 7

usefulness can ''produce" surplus value, but we cannot give up the conviction that somehow interest is causally bound up with invention and the supply of such instruments.

§ 8. Finally — and this might serve as a challenge to all theories of interest hitherto propounded — no one has quite solved the interest problem who has not fully explained just what it is that men discount when, as we say carelessly, they discount "future goods" or ''future services." No one has quite solved the problem, in other words, who has not fully explained the nature of what we call the principal. What is the principal? Two lots of goods or services, one of an earlier time and the other of a later — so much is obvious. It is obvious also that the two lots are conceived to be in some sense equal. But in what sense? Whole books are written without giving an answer to this apparently simple, and certainly fundamental, question. Some of the leading economists refer to the two lots as merely "present goods" and "future goods" or as "earlier goods" and "later goods," as if nothing less hopelessly vague were required. We must insist, however, on knowing, and knowing precisely, in what sense the two lots are equal.

Are they, perhaps, equal in "kind and number," as Bohm-Bawerk ^ implies in some passages ? No ; for

^Positive Theory of Capital, Macmillan & Co., London, 1891, p. 237: "Present goods are, as a rule, worth more than future goods of like kind and number. This proposition is the kernel and centre of the interesttheory which I have to present." P. 248 : . . . "present goods, as a rule, have a higher exchange value and price than future goods of like kind and number." These passages are in Book V. In Book VI if I borrowed a ton of ice of you in July, agreeing to repay you with interest at 6 % per annum in six months, you would be far from satisfied if I repaid you in January with one and three-hundredths tons of ice of the same kind. Such an example, you may say, involves peculiar conditions. Pecuhar in degree, perhaps, but certainly not in kind. The only reason why you would not be satisfied with the one and three-hundredths tons of ice in January is that a given amount of ice has — in temperate climates, of course, and under usual circumstances

— less value in January than in July ; and it is equally true, though in less striking degree, of innumerable other things, that the value ^ of any amount changes with the passing of time.

Are the two lots of goods or services that are to be considered the principal equal in the amount of pleasure

— or reduction of pain — that they afford any particular person or group of persons? To adopt this view involves the behef that when you or I or anybody else spends, instead of saving and investing at interest till some future time, the dollar he barely fails to save — ■ the marginal dollar spent, as we might call it — • he thereby necessarily sacrifices not a mere surplus of goods or services, but a surplus of pleasure. Can you beheve that ? I cannot. I have analyzed my motives critically, and

Bohm-Bawerk writes: "In the previous book I tried to show, and account for, the natural difference that exists between the value of present and the value of future goods. I have now to show that this difference of value is the source and origin of all Interest on Capital." 1 The word " value" I define in § 14 below. Here I use it in its most widely accepted significance, the significance that I give in § 14 to "nominal value."

THE PROBLEM g

I do not find that I am usually disposed to sacrifice a greater future pleasure for a less present pleasure ; and I find among my acquaintances others who believe themselves equally free from improvidence. We all discount ^'future goods" in some sense, of course; for example, we all frequently give up $1.02 next year in favor of Si this year ; but that is not to be identified with discounting future pleasure and pain unless it be shown that $1.02 of next year means more pleasure or more relief from pain than $1 of this year. Note that I do not say that nobody discounts future pleasures and pains constantly or that the most provident of us discount them never : I say only that many people do not discount them usually, and that therefore it is hard to believe that the true conception of the principal is two lots of goods or services on which are dependent equal amounts of pleasure or relief from pain on the part of any particular person or group of persons.

Finally, then, are the two lots constituting the principal to be conceived as equal in value ? After our examination of the other two conceptions, this one seems more like the truth. Yet it is not without its difficulties. It is, indeed, contrary to a principle generally accepted as fundamental for all economic thinking and expressed as a definition of value by many writers, including J. S. Mill,^ Walker,^ Carver,^ and

1 T. N. Carver: The Distribution of Wealth, Macmillan & Co., N.Y., 1904, p. 2: "In Walker's brief but excellent phrase, 'Value is power in exchange'; and as Mill defines it, the value of a thing is 'its general power of exchanging; the command which its possession gives over purchasable commodities in general.' Either definition expresses the whole meaning of the word value." The quotation from Walker lO A THEORY OF INTEREST

Davenport.^ I mean the principle that "value is power in exchange." The lot of today and the lot of ten years hence that would constitute the principal of a loan for that time are obviously very unequal in "power in exchange/' for the latter cannot be exchanged for the former unless a good deal of what we call interest is thrown in to boot. We must therefore give up either the idea that the two lots of goods or services constituting the principal are equal in value or the principle that value is always power in exchange; for the two are flatly inconsistent.

§ 9. This short analysis suffices, perhaps, to show that interest does present a difficult problem and that the problem involves a fundamental aspect of the conception of value itself, the heart of all economic theory. Of this problem I shall offer now what seems to me an essentially correct, though doubtless very imperfectly developed, solution.

is from his Political Ecoiiomy, Part I, § 8 ; that from Mill, from his Principles of Political Economy, Book III, Ch. i, § 2.

1 H. J. Davenport : Value and Distribution, Univ. of Chicago Press, 1908, p. 569. Davenport there defines value as "a ratio of exchange between two goods, quantitatively specified."

CHAPTER II Some Definitions and Fundamental Conceptions

§ lo. The object of all economic acts is increase of pleasure or decrease of pain. Its opposite is decrease of pleasure or increase of pain. The first group of alternatives I shall call in this book simply pleasure, the second group simply pain.

Pleasure is dependent primarily on nature, but it is dependent also — and this is what concerns men practically, and therefore what concerns economics — on human eforts and on an interval of time ^ between these efforts and the enjoyment of the pleasure dependent upon them.

Up to a certain point efforts may be pleasant in themselves. This point is soon reached, however, and beyond it efforts are painful. To work in my orchard half an hour a day in good weather and when my interests do not call me elsewhere may be distinctly pleasant ; but to work in it nine hours a day every working day of the year, or even every day when it urgently needs attention, is certainly somewhat painful. By the words pain and painful here I mean to cover not only the positive pain which must begin and increase as efforts

^ This point about an ''interval of time" anticipates part of my theory which I cannot conveniently develop in the present chapter. The point will be duly supported in Chapter IV, § 37.

are continued beyond a certain point, but also the negative pain, as we might call it, involved in the cutting down, by such continuance of efforts, of the time ^ available for positive enjoyments.

Efforts painful in themselves may be the cause of pleasure later. The ninth hour of the day in my orchard is painful in itself, yet it may be the cause of increasing or improving my crop of apples ; and the extra size or number or quality of the apples may give me pleasure when I come to eat them or to consume what they bring me in exchange at the market.

At what point, then, will men naturally discontinue their efforts? In so far as men are rational they will discontinue their efforts where their total pleasure dependent on continuing ceases to be greater than their total pain on which continuing is dependent.

§11. Efforts painful in themselves on which pleasure depends we call labor. I say ''efforts painful in themselves" because we must exclude efforts exerted in sport or play : we must not make the definition too broad. But, on the other hand, we must not make it too narrow : we must not exclude efforts which, though pleasant in

1 This bearing of time for enjoyment on pain was pointed out by H. H. Gossen in his Entwickelung der Gesetze des Menschlichen Verkehrs und der daraus fliessenden Regeln fiir menschliches Handeln, Brunswick, 1854. It is covered by this theorem of his : "Given the option of several pleasures, and a time so limited as not to suffice for enjoying them all to the point of extinction, we obtain a hedonic maximum by enjoying each pleasure in such measure that its intensity at the moment when the period of fruition expires is equal to that of every other pleasure." This note is based on p. 28 and p. 32 of M. Pantaleoni's Pure Economics, translated by T. B. Bruce, Macmillan & Co., London, 1898.

themselves in some cases, are not forthcoming in sufficient quantity to meet the demand unless they are paid for. Examples of efforts of this sort are those of the first hours of the day in the case of many a professional man who enjoys his work. Extending our definition to include such efforts as these, we may put it thus : efforts on which pleasure depends that are painful in themselves or command a market price are called labor.

§ 12. In some cases the pleasure dependent on efforts or on the interval of time mentioned in § 10 results directly, that is, without the intervention of any intermediate product. The results in these cases are called services. In other cases the pleasure results indirectly, the direct or immediate result being a good or commodity which in turn furnishes the pleasure itself. As an example of the services of a person take those of a violinist as he plays before an audience. An example of a good or commodity is the violin itself, which stands between the efforts of its maker and the pleasure that comes to the audience. Besides the services of persons we have also, of course, the services of goods : what the violin does towards making the music is its services.

§ 13. We often think of goods or services as being such, that is, as being capable of affording pleasure, by virtue solely of an attribute — due to properties physical, chemical, and the like — inherent in themselves. And this attribute we call their utility. Further analysis, however, reveals the fact that pleasure depends quite as much on the person pleased — on whether he exists, for example, and can avail himself of the good or service, and if he can, on his capacity for enjoying — as on the objective nature of the good or service itself. Utility, indeed, loses all its meaning if the capacity of the person in question for being pleased under the particular circumstances in question is left out of the case. Yet the moment we give this capacity a precise meaning, in respect to the person as well as to the good or service, we can drop the word utility altogether in favor of others ^ that have not been associated so long with a vague, nay, an erroneous, notion. I propose, therefore, to drop the word utility altogether from general use in this book.

The conditions of a pleasure that are satisfied by what is inherent in a good or service, in short by the good or service itself, strictly speaking, may be called the objective factor of pleasure ; those satisfied by the pleasure receiver, the person pleased, may be called the subjective factor of pleasure. There is no pleasure within the scope of economic inquiry that does not result from the cooperation of both these factors.