Appendix to Chapter 14
APPENDIX ON THE RATE OF INTEREST IN MARSHALL'S
PRINCIPLES OF ECONOMICS, RICARDO'S PRINCIPLES
OF POLITICAL ECONOMY, AND ELSEWHERE
I
There is no consecutive discussion of the rate of interest in
the works of Marshall, Edgeworth or Professor Pigou,セnothing more than a few obiter dicta.
Apart from the passage already quoted above (p. 139) the only
important clues to Marshall's position on the rate of interest
are to be found in his Principles of Economics (6th edn.),
Book VI. p. 534 and p. 593, the gist of which is given
by the following quotations:
'Interest, being the price paid for the use of capital in any
market, tends towards an equilibrium level such that the
aggregate demand for capital in that market, at that rate of
interest, is equal to the aggregate stock
forthcoming there at that rate. If the market, which we are
considering, is a small oneセsay a
single town, or a single trade in a progressive countryセan increased demand for capital in it will
be promptly met by an increased supply drawn from surrounding
districts or trades. But if we are considering the whole world,
or even the whole of a large country, as one market for capital,
we cannot regard the aggregate supply of it as altered quickly
and to a considerable extent by a change in the rate of interest.
For the general fund of capital is the product of labour and
waiting; and the extra work, and the extra waiting, to which a rise in the rate of interest
would act as an incentive, would not quickly amount to much, as
compared with the work and waiting, of which the total existing
stock of capital is the result. An extensive increase in the
demand for capital in general will therefore be met for a time
not so much by an increase of supply, as by a rise in the rate of
interest; which will cause capital to withdraw itself partially from those
uses in which its marginal utility is lowest. It is only slowly
and gradually that the rise in the rate of interest will increase
the total stock of capital' (p.534).
'It cannot be repeated too often that the phrase "the
rate of interest" is applicable to old investments of
capital only in a very limited sense.
For instance, we may perhaps estimate that a trade capital of
some seven thousand millions is invested in the different trades
of this country at about 3 per cent net interest. But such a
method of speaking, though convenient and justifiable for many
purposes, is not accurate. What ought to be said is that, taking the rate of net interest on the
investments of new capital in each of those trades [i.e. on
marginal investments] to be about 3 per cent; then the aggregate
net income rendered by the whole of the trade-capital invested in
the various trades is such that, if capitalised at 33 years'
purchase (that is, on the basis of interest at 3 per cent), it
would amount to some seven thousand million pounds. For the value
of the capital already invested in improving land or erecting a
building, in making a railway or a machine, is the aggregate
discounted value of its estimated future net incomes [or
quasi-rents]; and if its prospective income-yielding power should
diminish, its value would fall accordingly and would be the
capitalised value of that smaller income after allowing for
depreciation' (p.593).
In his Economics of Welfare (3rd edn.), p. 163,
Professor Pigou writes: 'The nature of the service of
"waiting" has been much misunderstood. Sometimes it has
been supposed to consist in the provision of money, sometimes in
the provision of time, and, on both suppositions, it has been
argued that no contribution whatever is made by it to the
dividend. Neither supposition is correct. "Waiting"
simply means postponing consumption which a person has power to
enjoy immediately, thus allowing resources, which might have been
destroyed, to assume the form of production
instruments.
The unit of "waiting" is, therefore, the use of a given
quantity of resources セfor example, labour or machineryセfor a given time. . . In more
general terms we may say that the unit of waiting is a
year-value-unit, or, in the simpler, if less accurate, language
of Dr Cassel, a year-pound. . . A caution may be added
against the common view that the amount of capital accumulated in
any year is necessarily equal to the amount of
"savings" made in it. This is not so, even when savings
are interpreted to mean net savings, thus eliminating the savings
of one man that are lent to increase the consumption of another,
and when temporary accumulations of unused claims upon
services in the form of bank-money are ignored; for many savings
which are meant to become capital in fact fail of their purpose through misdirection into
wasteful uses.'
Professor Pigou's only significant reference to what
determines the rate of interest is, I think, to be found in his Industrial
Fluctuations (1st edn.), pp. 251-3,
where he controverts the view that the rate of interest, being
determined by the general conditions of demand and supply of real
capital, lies outside the central or any other bank's control.
Against this view he argues that: 'When bankers create more
credit for business men, they make, in their interest, subject to
the explanations given in chapter xiii. of part i.,
a forced levy of real things from the public, thus increasing the
stream of real capital available for them, and causing a fall in
the real rate of interest on long and short loans alike. It is
true, in short, that the bankers' rate for money is bound by a
mechanical tie to the real rate of interest on long loans; but it
is not true that this real rate is determined by conditions
wholly outside bankers' control.'
My running comments on the above have been made in the
footnotes. The perplexity which I find in Marshall's account of
the matter is fundamentally due, I think, to the incursion of the
concept 'interest', which belongs to a monetary economy, into a
treatise which takes no account of money. 'Interest' has really
no business to turn up at all in Marshall's Principles of
Economics,セit belongs to another
branch of the subject.
Professor Pigou, conformably with his other tacit assumptions,
leads us (in his Economics of Welfare) to infer that the
unit of waiting is the same as the unit of current investment and
that the reward of waiting is quasi-rent, and practically never
mentions interest, which is as it should be. Nevertheless these
writers are not dealing with a non-monetary economy (if there is
such a thing). They quite clearly presume that money is used and
that there is a banking system. Moreover, the rate of interest
scarcely plays a larger part in Professor Pigou's Industrial
Fluctuations (which is mainly a study of fluctuations in the
marginal efficiency of capital) or in his Theory of
Unemployment (which is mainly a study of what determines
changes in the volume of employment, assuming that there is no
involuntary unemployment) than in his Economics of Welfare.
II
The following from his Principles of Political Economy (p.
511) puts the substance of Ricardo's theory of the rate of
interest:
'The interest of money is not regulated by the rate at which
the Bank will lend, whether it be 5, 3 or 2 per cent., but by the
rate of profit which can be made by the employment of capital,
and which is totally independent of the quantity or of the value
of money. Whether the Bank lent one million, ten millions, or a
hundred millions, they would not permanently alter the market
rate of interest; they would alter only the value of the money
which they thus issued. In one case, ten or twenty times more
money might be required to carry on the same business than what
might be required in the other. The applications to the Bank for
money, then, depend on the comparison between the rate of profits
that may be made by the employment of it, and the rate at which
they are willing to lend it. If they charge less than the market
rate of interest, there is no amount of money which they might
not lend;セif they charge more than
that rate, none but spendthrifts and prodigals would be found to
borrow of them.'
This is so clear-cut that it affords a better starting-point
for a discussion than the phrases of later writers who, without
really departing from the essence of the Ricardian doctrine, are
nevertheless sufficiently uncomfortable about it to seek refuge
in haziness. The above is, of course, as always with Ricardo, to
be interpreted as a long-period doctrine, with the emphasis on
the word 'permanently' half-way through the passage; and it is
interesting to consider the assumptions required to validate it.
Once again the assumption required is the usual classical
assumption, that there is always full employment; so that,
assuming no change in the supply curve of labour in terms of
product, there is only one possible level of employment in
long-period equilibrium. On this assumption with the usual ceteris
paribus, i.e. no change in psychological propensities and
expectations other than those arising out of a change in the
quantity of money, the Ricardian theory is valid, in the sense
that on these suppositions there is only one rate of interest
which will be compatible with full employment in the long period.
Ricardo and his successors overlook the fact that even in the
long period the volume of employment is not necessarily full but
is capable of varying, and that to every banking policy there
corresponds a different long-period level of employment; so that
there are a number of positions of long-period equilibrium
corresponding to different conceivable interest policies on the
part of the monetary authority.
If Ricardo had been content to present his argument solely as
applying to any given quantity of money created by the monetary
authority, it would still have been correct on the assumption of
flexible money-wages. If, that is to say, Ricardo had argued that
it would make no permanent alteration to the rate of interest
whether the quantity of money was fixed by the monetary authority
at ten millions or at a hundred millions, his conclusion would
hold. But if by the policy of the monetary authority we mean the
terms on which it will increase or decrease the quantity of
money, i.e. the rate of interest at which it will, either by a
change in the volume of discounts or by open-market operations,
increase or decrease its assetsセwhich
is what Ricardo expressly does mean in the above quotationセthen it is not the case either that the
policy of the monetary authority is nugatory or that only one
policy is compatible with long-period equilibrium; though in the
extreme case where money-wages are assumed to fall without limit
in face of involuntary unemployment through a futile competition
for employment between the unemployed labourers, there will, it
is true, be only two possible long-period positionsセfull employment and the level of
employment corresponding to the rate of interest at which
liquidity-preference becomes absolute (in the event of this being
less than full employment). Assuming flexible money-wages, the
quantity of money as such is, indeed, nugatory in the long
period; but the terms on which the monetary authority will change
the quantity of money enters as a real determinant into the
economic scheme.
It is worth adding that the concluding sentences of the
quotation suggest that Ricardo was overlooking the possible
changes in the marginal efficiency of capital according to the
amount invested. But this again can be interpreted as another
example of his greater internal consistency compared with his
successors. For if the quantity of employment and the
psychological propensities of the community are taken as given,
there is in fact only one possible rate of accumulation of
capital and, consequently, only one possible value for the
marginal efficiency of capital. Ricardo offers us the supreme
intellectual achievement, unattainable by weaker spirits, of
adopting a hypothetical world remote from experience as though it
were the world of experience and then living in it consistently.
With most of his successors common sense cannot help breaking inセwith injury to their logical consistency.
III
A peculiar theory of the rate of interest has been propounded
by Professor von Mises and adopted from him by Professor Hayek
and also, I think, by Professor Robbins; namely, that changes in
the rate of interest can be identified with changes in the
relative price levels of consumption-goods and
capital-goods
It is not clear how this conclusion is reached. But the argument
seems to run as follows. By a somewhat drastic simplification the
marginal efficiency of capital is taken as measured by the ratio
of the supply price of new consumers' goods to the supply price
of new producers' goods.
This is then identified with the rate of interest. The fact is
called to notice that a fall in the rate of interest is
favourable to investment. Ergo, a fall in the ratio of the
price of consumers' goods to the price of producer's goods is
favourable to investment.
By this means a link is established between tncreased saving
by an individual and increased aggregate investment. For it is
common gound that increased individual saving will cause a fall
in the price of consumers' goods, and, quite possibly, a greater fall than in the price of producers' goods; hence,
according to the above reasoning, it means a reduction in the
rate of interest which will stimulate investment. But, of course,
a lowering of the marginal efficiency of particular capital
assets, and hence a lowering of the schedule of the marginal
efficiency of capital in general, has exactly the opposite effect
to what the above argument assumes. For investment is stimulated
either by a raising of the schedule of the marginal
efficiency or by a lowering of the rate of interest. As a
result of confusing the marginal efficiency of capital with the
rate of interest, Professor von Mises and his disciples have got
their conclusions exactly the wrong way round. A good example of
a confusion along these lines is given by the following passage
by Professor Alvin Hansen:
'It has been suggested by some economists that the net effect of
reduced spending will be a lower price level of consumers' goods
than would otherwise have been the case, and that, in
consequence, the stimulus to investment in fixed capital would
thereby tend to be minimised. This view is, however, incorrect
and is based on a confusion of the effect on capital formation of
(i) higher or lower prices of consumers' goods, and (2) a change
in the rate of interest. It is true that in consequence of the
decreased spending and increased saving, consumers' prices would
be low relative to the prices of producers' goods. But this, in
effect, means a lower rate of interest, and a lower rate of
interest stimulates an expansion of capital investment in fields
which at higher rates would be unprofitable.'