Interest of capital

Book 6, Chapter 6

§1. Marshall begins with a caveat often omitted these days:

The aid which economic science has given towards understanding the part played by capital in our industrial system is solid and substantial; but it has made no startling discoveries. Everything of importance which is now known to economists has long been acted upon by able business men, though they may not have been able to express their knowledge clearly, or even accurately. (p 482)

Then he lists a number of uses for capital, all of which are reconciled via interest rates: Everyone is aware that the accumulation of wealth is held in check, and the rate of interest so far sustained, by the preference which the great mass of humanity have for present over deferred gratifications, or, in other words, by their unwillingness to “wait” (p 483). I teach students that discount rates (which vary by individual) are related to interest rates in the following way: People with low discount rates are patient relative to those with high discount rates, and they “trade” money — as lenders and borrowers, respectively — at an interest rate that lies between their discount rates.

§2. Ancient prejudice against lending money for interest (usury) makes no sense if it is ok to charge interest when lending things (a house or horse). In both cases, the lender forgoes the use of the money or thing; in both cases, the borrower pays to make use of the money or thing.

§3. Claims by Marx and others that surpluses should be attributed to labor but not capital are based on the same confusion over money and things. If one sees capital as contributing to production and understands that capital accumulation depends on “patience”, then it is hard to deny that productive surpluses should be jointly attributed to capital and labor.

Indeed it is hard to find examples of labor-only production that is equally efficient to production that combines labor and capital. Yes, I can dig a hole with my hands, but it’s much easier to use a shovel, which is why I am happy to pay the shovel-owning capitalist for its use.

§4. With Marx dismissed (one page!), Marshall differentiates between net and gross interest — or what we now call “risk-free” and “market” rates respectively. Gross interest is the rate a lender charges while net interest is what the lender receives after deducting losses from deadbeat borrowers and other elements of a “troublesome business.”

§5. Lenders face risks from borrowers who are unable to put borrowed money to good use (adverse selection) or who are lazy or dishonest (moral hazard). Borrowers face risks from lenders who might refuse to renew their loans, leaving them to face a “cash crunch” that no other lender — on hearing of that refusal — will relieve.

§6. A large share of “investments” merely replace capital that has been lost in use (depreciation). Only a small share of investment adds to capital stocks.

§7. Interest rates must take inflation into account. If buying power is falling, then rates must be higher to return the lender to status quo ante –– and vice versa.

This post is part of a series in the Marshall 2020 Project, i.e., an excuse for me to read Alfred Marshall’s Principles of Economics (1890 first edition/1920 eighth edition), which dominated economic thinking until Van Neumann and Morgenstern’s Theory of Games and Economic Behaviour (1944) and Samuelson’s Foundations of Economic Analysis (1946) pivoted economics from institutional induction to mathematical deduction.

Author: David Zetland

I'm a political-economist from California who now lives in Amsterdam.

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