Capital and Interest: A Critical History of Economical Theory

The Physiocrats were the first to bring in a real system. For a long time, however, even they passed over our problem without consideration. Quesnay, the founder of the school, so little comprehends the nature of natural interest that he sees in it replacement costs—a kind of reserve fund, out of which the loss, in wearing out of capital and by unforeseen accidents, is to be defrayed—rather than a net income of the capitalist.
*1

Mercier de la Rivière,
*2 more correctly, recognises that capital produces a net profit; but he only points out that there must be this profit on the capital that is employed in agriculture, if agriculture is not to be abandoned for other pursuits. He does not go on to ask why capital in general should yield interest. As little does Mirabeau, who, as we saw, has written a great deal on the subject of interest, and has written very badly.
*3

It was Turgot, then, the greatest of the physiocrats, who was also first among them to seek for a fuller explanation of the fact of natural interest. Even his way of treating the problem is modest and naïve enough: it is easy to see that it was not the fiery zeal in a great social problem that forced him to take up the pen, but only the need for clear consistency in his ideas—a need that would, if necessary, be content with an explanation of very moderate depth, provided only it found a plausible formula.

In the
Mémoire sur les Prêts d’Argent, already known to us, Turgot simply deals with the question of loan interest. His more comprehensive interest theory is developed in his chief work,
Réflexions sur la Formation et la Distribution des Richesses.*4 To be correct, it is not so much developed as contained in it; for Turgot does not put the question as to the origin of interest formally, nor is the consideration he devotes to it a very connected one. What we find is a number of separate paragraphs (§§ 57, 58, 59, 61, 63, 68, and 71), containing a series of observations, out of which we have to put together his theory on the origin of interest for ourselves.
*5

Seeing that this theory bases the entire interest of capital on the possibility always open to the owner of capital to find for it an ulterior fructification though the purchase of rent-bearing land, I propose to call it shortly the Fructification theory.

The argument is as follows. The possession of land guarantees the obtaining of a permanent income without labour, in the shape of land-rent. But since movable goods, independently of land, also permit of being used, and on that account obtain an independent value, we may compare the value of both classes of goods; we may price land in movable goods, and exchange it for them. The exchange price, as in the case of all goods, depends on the relation of supply and demand (§ 85). At any time it forms a multiple of the yearly income that may be drawn from the land, and it very often gets its designation from this circumstance. A piece of land, we say, is sold for twenty or thirty or forty years’ Purchase, if the price amounts to twenty or thirty or forty times the annual rent of the land. The amount of the multiple, again, depends on the relation of supply and demand; that is, whether more or fewer people wish to buy or sell land (§ 88).

In virtue of these circumstances every sum of money, and, generally speaking, every capital, is the equivalent of a piece of land yielding an income equal to a certain percentage on capital (§ 59).

Since in this way the owner of a capital, by buying land, is able to obtain from it a permanent yearly income, he will not be inclined to put his capital in an industrial (§ 61), agricultural (§ 63), or commercial (§ 68) undertaking, if he cannot—leaving out of account compensation for all ordinary kinds of costs and trouble—expect just as large a profit from his capital thus employed as he could obtain through the purchase of land. On that account capital, in all these branches of employment, must yield a profit.

Thus, then, is the economical necessity of natural interest on capital first explained. Loan interest is deduced from it simply in this way: the undertaker without capital finds himself willing, and economically too may find himself willing, to give up to him who trusts him with a capital a part of the profit which the capital brings in (§ 71). So in the end all forms of interest are explained as the necessary result of the circumstance, that any one who has a capital may exchange it for a piece of land bearing a rent.

It will be noticed that in this line of thought Turgot takes for his foundation a circumstance which had been appealed to for some centuries by the defenders of loan interest, from Calvin downward. But Turgot makes an essentially different and much more thorough-going use of this circumstance. His predecessors availed themselves of it occasionally, and by way of illustration. Turgot makes it the centre of his system. They did not see in it the sole ground of loan interest, but co-ordinated with it the possibility of making a profit from capital engaged in commerce, industry, etc. Turgot puts it by itself at the head of everything. Finally, they had only used it to explain loan interest. Turgot explains the entire phenomenon of interest by it. Thus was built up a new doctrine, although out of old materials,—the first general theory of interest.

As regards the scientific value of this theory, the fate which has befallen it is very significant. I cannot recollect ever reading a formal refutation of it: people have tacitly declared it unsatisfactory, and passed on to seek for other explanations. It seems too plausible to be refuted; too slight to base anything on. We leave it with the feeling that it has not got down to the last root of interest, even if we cannot give any very accurate account of why and where it fails.

To supply such an account seems to me at the present time by no means a work of superfluity. In doing so I shall not be merely fulfilling a formal duty which I imposed on myself when I undertook to write a
critical history of theory. In pointing out where and how Turgot failed I hope to make perfectly clear what the heart of the problem is, and what it is that every earnest attempt at solution must reckon with, and thus to prepare the way for the profitable pursuit of our future task. The example of a very lively writer of our own day shows that we are not yet so far past Turgot’s line of thought as we might perhaps think.
*6

Turgot’s explanation of interest is unsatisfactory, because it is an explanation in a circle. The circle is only concealed by the fact that Turgot breaks off his explanation at that very point where the next step would inevitably have brought him back to the point from which he stated.

The case stands thus. Turgot says: A definite capital must yield a definite interest, because it may buy a piece of land bearing a definite rent. To take a concrete example. A capital of £10,000 must yield £500 interest, because with £10,000 a man can buy a piece of land bearing a rent of £500.
*7

But the possibility of such a purchase is not in itself an ultimate fact, nor is it a fact that carries its explanation on its face. Thus we are forced to inquire further: Why can a person with a capital of £10,000 buy a rent-bearing piece of land in general and a piece of land bearing £500 rent in particular? Even Turgot feels that this question may be put, and must be put, for he attempts to give an answer to it. He appeals to the relation of demand and supply, as at any moment furnishing the ground for a definite relation of price between capital and land.
*8

But is this a full and satisfactory answer to our question? Certainly not. The man who, when asked what determines a certain price, answers, “Demand and supply,” offers a husk for a kernel. The answer may be allowable in a hundred cases, where it can be assumed that the one who asks the question knows sufficiently well what the kernel is, and can himself supply it. But it is not sufficient when what is wanted is an explanation of a problem of which we do not yet know the nature. If it were sufficient, we might be quite content to settle the whole problem of interest simply by the formula; demand and supply regulate the prices of all goods in such a way that a profit always remains over to the capitalist. For the interest problem throughout relates to phenomena of price;
e.g. to the fact that the borrower pays a price for the “use of capital”; or to the fact that the price of the finished product is higher than the price of its costs, in virtue of which a profit remains over to the undertaker. But certainly no one would find this a satisfactory explanation.

We must therefore ask further, What deeper causes lie behind demand and supply, and govern their movements in such a way that a capital of £10,000 can regularly be exchanged for a rent-bearing piece of land in general, and a piece of land bearing £500 rent in particular? To this question Turgot gives no answer, unless we care to look on the somewhat vague words at the beginning of § 57 as such; and if so the answer cannot in any way be thought satisfactory: “Those who had much movable wealth could employ it not only in the cultivation of land, but also in the different departments of industry. The facility of accumulating this movable wealth, and of making a use of it quite independent of land, had the effect that one could value the pieces of land, and compare their value with that of movable wealth.”

But if we take up the explanation at the point where Turgot broke off, and carry it a little farther, we shall discover that this interest, which Turgot thought to explain as the
result of the exchange relation between land and capital, is in reality the
cause of this exchange relation. That is to say, whether it is twenty or thirty or forty times the annual rent that is asked or offered for a piece of land, depends chiefly on the percentage which the capital that buys it would obtain if otherwise employed. That piece of land which yields £500 rent will be worth £10,000 if and because the rate of interest on capital amounts to 5 per cent. It will be worth £5000 if and because the interest rate is 10 per cent. It will be worth £20,000 if and because capital bears only 2½ per cent interest. This, instead of the existence and height of interest being explained by the exchange relation between land and capital, this exchange relation itself must be explained by the existence and height of interest. Nothing has been done, therefore, to explain interest, and the whole argument moves in a circle.

I should have confidence in finishing my criticism of Turgot’s doctrine at this point, if I did not feel myself bound to be more than usually careful in all cases where the nature of reciprocal action between economic phenomena is concerned. For I know that, in the complexity of economical phenomena, it is exceedingly difficult: to determine with certainty the starting-point of a chain of reciprocal causes and effects, and I am aware that, in deciding on such points, we are particularly exposed to the danger of being misled by dialectic. I should not like, therefore, to force on the reader the opinion that Turgot here made a mistake, without having removed every suspicion on the point by going over the proof again; particularly as this will give us a good opportunity of putting the character of our problem in a clearer light.

Accidents apart, a piece of land will yield its rent for a practically infinite series of years. The possession of it assures the owner and his heirs the amount of the yearly use, not for twenty or forty times only, but for many hundred times—almost for an infinite number of times. But as a matter of common experience this infinite series of uses, which, added together, represent a colossal sum of income, is regularly sold for a fraction of this sum—for twenty up to forty times the year’s use—and this is the fact we wish explained.

In explanation it cannot be enough to point in a superficial way to the state of demand and supply. For if demand and supply are at all times in such a position that this remarkable result takes place, the regular recurrence must rest on deeper grounds, and these deeper grounds demand investigation.

In passing I may dismiss the hypothesis, which may have occurred to the reader, that the reason of the low purchase price is that the owner only takes into consideration those uses which he himself may hope to obtain from the land, and neglects all that lie outside and beyond these. If this hypothesis were correct, then, seeing that the average life of man, and therefore of landowners, has not varied very much in historical times, the proportion of the value of land to the rent of land must have remained tolerably constant. But this is by no means the case. Indeed we see that proportion varying from ten to fifty fold, in visible sympathy with the rate of interest at the time.

There must, therefore, be another reason for this striking phenomenon.

I think we should all agree in pointing to the following as the true reason;—in valuing a piece of land, we make a discounting calculation. Thus we value the many hundred years’ use of a piece of land at only twenty times the annual use when the rate of interest is 5 per cent, and at only twenty-five times the annual use when the rate is 4 per cent, because we discount the value of the future uses; that is, we estimate them in to-day’s value at a smaller amount,
pro rata temporis et usurarum, exactly on the same principle as we estimate the present capital value of a limited or perpetual claim on rent.

If this is so, and I do not think it will be doubted, then the capital valuation of land to which Turgot appealed in explanation of the phenomenon of interest, is itself nothing more than one of the many forms in which that phenomenon meets us in economic life. For that phenomenon is protean. It meets us sometimes as the explicit payment of a loan interest; sometimes as payment of a hire which leaves a “net use” to the owner after deduction of a quota for wear and tear; sometimes as the difference in price between product and costs, which falls to the undertaker as profit; sometimes as the prior deduction by the creditor from the amount of the loan granted to the debtor; sometimes as the raising of the purchase money in cases of postponed payment; sometimes as the limitation of the purchase money for claims, prerogatives, and privileges not yet due; sometimes, finally—to mention an instance closely related, indeed essentially the same—as the lowering of the purchase money paid for uses inseparable from a piece of land, but only available at a later date.

To trace the profit that capital obtains in commerce and industry to the possibility of acquiring land in exchange for definite sums of capital, is, therefore, nothing else than to refer from one phenomenal form of interest to another which is as much in need of explanation as the first. Why do we obtain interest on capital? why do we discount the value of future rates of payment or rates of use? These are evidently only two different forms of the question which puts the same riddle. And the solution of it gains nothing from a kind of explanation that begins with the former question, only to come to a stand before the latter one.