Interest and the Productivity of Capital

Interest and the Productivity of Capital

Concern for the economic aspects of interest dates from the latter part of the 17th century when a pamphlet debate engaged in by Sir Josiah Child brought forth the theory that the wealth of a country was a cause and not an effect of a low interest rate. Locke proposed that the interest rate could be determined by the ratio of ready money to the "whole trade of the kingdom," by which he probably meant business transactions. John Law also took the position that if the quantity of available money increased the interest rate would fall. Sir William Petty in opposing at­tempts to restrict the rate of interest protested that such a course was impossible since interest rates were set by the quantity of money, which was beyond Parliament's control.

David Hume writing in 1752 subscribed to the quantity of money theory in the sense of a temporary cause of interest. Using Spain as an illustration, he showed how the influx of gold and silver from the New World caused prices and interest to rise tem­porarily, only to subside again to normal levels. This theory, he believed, was not the true cause of variation in interest rates. Very realistically he claimed that the interest rate was set by supply and demand. If society was composed mainly of poor per­sons who were always wanting to borrow, interest rates would be high; should society have an abundance of wealthy men seeking profitable places to lend money, the competition among them would tend to drive down interest rates. He added a significant factor, that interest rates were also influenced by the profit to be secured from commerce. High profits meant less money to lend, therefore high interest rates, and vice versa.

Cantillon, in a book published in 1755, although written much earlier, objected along with Hume to the quantity of money theory of interest. Though an increase of money might raise prices it would not necessarily raise interest rates. He believed that a change in the class status of borrowers and lenders also influenced the rate. For example, in the Middle Ages when bor­rowing was by persons in dire need, interest hinged upon the degree of necessity of the borrower and the unscrupulous nature of the lender. In the time during which Cantillon was writing, borrowing was for business enterprise, and the interest rate rose in direct relation to the number of such enterprises. He claimed that the prodigality of nobles and war also caused a rise in in­terest rates by increasing the activity of business enterprises. In addition to this he made a unique contribution to interest theory by describing the importance of a person's social class upon the rate of interest.

Upon the simple foundations laid by Hume and Cantillon, Turgot built a more elaborate concept of interest. He accepted the supply and demand theory. To this he added the new idea that increasing supplies of "movable riches" were constantly being provided out of savings from previous incomes and profits. He believed that a greater amount of saving would lower the interest rate if the number of borrowers remained constant. Tur­got also claimed that interest was the price of an advance of money. Although this last observation seemed obvious, it began a never ending series of speculations on the question of why in­terest was paid at all.

The more formal statement of the theories expounded by Hume and Turgot came from Jean Baptiste Say. His reduc­tion of all prices to a matter of supply and demand was directly

applied to interest. By dividing capital into disposable capital and production capital he made a notable advance in the under­standing of interest. Only the former influenced interest rates, he claimed, for since the latter was already incorporated into enter­prise there was no way in which it could affect the supply of disposable capital. Say also introduced the idea that not one but many factors may influence interest rates including risk and liquidity, i.e. the ease with which the loan can be converted into cash.
Another class of interest theories has been called the indirect productivity theories. The basis of these theories is the fact that the addition of capital enables a workman to produce in greater quantities.

Therefore the one who supplies the capital is entitled to a share of the increase. Lauderdale was one of the first support­ers of this theory. He believed in the independent productivity of capital. Although he did not distinguish between interest and profit, his argument showed that both would naturally come from the earnings of capital. Von Thunen in Der Isolierte Staat applied his theory of diminishing returns to the general produc­tivity idea and proposed that the interest rate would be de­termined by the productivity of the marginal unit of capital, that is, by the unit whose cost just equaled the amount it could pro­duce. Von Thunen went on to explain that the interest rate could not hope to be the total increase in production derived from the use of the capital, since competition tended to reduce the price of capital to the amounts paid by those who could profit by the capital least.

One of Ricardo's ideas on interest might possibly be classified here although it differs slightly in being simpler. He said that the interest on money is determined by the rate of profit which can be made by the employment of capital. Add the idea of diminish­ing returns, and the theory is not materially different from von Thiinen's.