UP TO THIS POINT WE HAVE1 been treating the structure of production as amalgamated into one stage. One or several firms have all been vertically integrating all the stages of production of a product (with all factors specific), until finally the product is sold to the consumer. This is certainly an unrealistic assumption. We shall now consider the production situation in the real world, where (a) factors are nonspecific as well as specific, and (b) production is divided into numerous stages, as the factors continue to work and advance from the higher to the lower stages of the production process.2 Instead of assuming that one firm—one set of capitalists—purchases factors and retains ownership of the product up through the sale to consumers, let us suppose that there are different firms and different sets of capitalists at definite intervals, and at each interval the product, in the stage it has reached up to that point, is sold for money to another capitalist or group of capitalists. It is not necessary to make any restrictive assumptions about how many separate stages occur or what the time intervals between individual stages might be. For purposes of convenience, let us return to our example and the diagram in Figure 40. We shall assume that exchanges of product and service take place at each line marked on the diagram. We shall further assume, for convenience only, that each stage takes the same length of time.

Now, instead of collecting interest income for services in one lump sum at the final stage, the capitalist or capitalists acquire interest income at each stage.3 If each stage takes one year, then the entire production process for the good takes six years. When the stages are all lumped together, or vertically integrated, then one capitalist (or set of capitalists) advances the owners of original factors their money six years ahead of time and then waits for this period to acquire his revenue. (Strictly, since the work and pay of labor and land would be continual as the product advanced to its final form, the earliest hired labor and land would be paid, say, in year one, and the latest toward the end of year six.) With separate stages, however, each capitalist advances the money for only one year.

Let us see the picture on a diagram (Figure 41). We must modify the previous diagram somewhat. A lower bar of 100 ounces is added, and the interest income that accrues to the capitalist at this lowest stage is indicated by an arrow going off to the left side. The upward arrow then represents the amount going to owners of original factors, land and labor, at this stage, and the shaded area the amount going to owners of capital-goods factors of a higher rank, i.e., intermediate products. The diagram in Figure 40 did not depict interest income, but simply presented all income as going to the owners of original factors; the time element had not yet been introduced into our discussion.

The structure of production and payment depicted in this basic diagram is as follows: Consumers spend 100 ounces on the good in question. Of the 100 ounces, five ounces go as interest income to the sellers of the consumers’ good, and 95 are paid out to the owners of factors. In our example, 15 ounces go for the use of land and labor (original) factors, and 80 go into the purchase of factor services of capital goods of a higher order. At the second stage, capitalists receive 80 ounces in revenue from the sale of their product.

Of the 80 ounces, 16 go into the purchase of land and labor factors, and four accrue as interest income to the second-level capitalists. The remaining 60 are used for the purchase of higher-order capital goods. The same process is repeated until, on the highest stage, the highest-order capitalists receive 20 ounces of revenue, retain one for themselves, and pay out 19 to land and labor factors. The sum total of income to land and labor factors is 83 ounces; total interest income is 17 ounces.

In the foregoing section on interest we showed that money is always nonspecific, and the result is that in the ERE the interest return on monetary investment (the pure rate of interest) is the same everywhere in the economy, regardless of the type of product or the specific conditions of its production. Here we see an amplification of this principle. Not only must the interest rate be uniform for each good; it must be uniform for every stage of every good. In our diagram, the interest-rate return received by product-owners, i.e., by capitalists, is equal at each stage. At the lowest stage, producers have invested 95 ounces in factors (both capital goods and original factors) and receive 100 ounces from consumers—a net income of five ounces. This represents a return on the investment of 5/95, or approximately 5.2 percent. In the ERE, which we are considering, there are no profits or losses due to uncertainty, so that this return represents the rate of pure interest.4 The capitalist at the next higher stage invests 60 plus 16 or 76 ounces in factors and receives a net return of four ounces, again approximately 5.2 percent. And so on for each stage of investment, where, except for the vagaries of the arithmetic in our example, the interest rate is uniform for each stage. At the highest stage, the capitalist has invested 19 ounces in land and labor, and receives a net return of one, again about 5.2 percent.

The interest rate must be equal for each stage of the production process. For suppose that the interest rate were higher in the higher stages than in the lower stages. Then capitalists would abandon producing in the lower stage, and shift to the higher stage, where the interest return is greater. What is the effect of such a shift? We can answer by stressing the implications of differences in the interest rate. A higher interest rate in stage A than in stage B means that the price spread between the sum of factors entering into stage A and the selling price of its product, is greater, in percentage terms, than the price spread in stage B. Thus, if we compare stage four and stage one in the diagram in Figure 41, we find a price spread of 43 to 45 in the former case, and 95 to 100 in the latter, for a net interest return of approximately 5.2 percent in each. Let us suppose, however, that the sum of the factor prices for stage four is 35 instead of 43, while the sum of factor prices in stage one is 98. (The sum of factor prices here excludes interest income, of course.) Capitalists investing in stage four would earn a net return of 8, or 23 percent, while investors in stage one earned about 2 percent. Capitalists would begin to stop investing in stage one and shift to stage four. As a consequence of this shifting, the aggregate demand in stage one for its factors diminishes, and the prices of the factors used in stage one therefore decline. In the meanwhile, greater investment in stage four raises factor prices there, so that the cumulative price rises from 35. Products of stage four increase, and the increased supply lowers the selling price, which falls from 43. These arbitrage actions continue until the percentage spread in each of the two stages is equal.

It is important to realize that the interest rate is equal to the rate of price spread in the various stages. To o many writers consider the rate of interest as only the price of loans on the loan market. In reality, as we shall see further below, the rate of interest pervades all time markets, and the productive loan market is a strictly subsidiary time market of only derivative importance.5

Not only will the rate of interest be equal in each stage of any given product, but the same rate of interest will prevail in all stages of all products in the ERE. In the real world of uncertainty, the tendency of entrepreneurial actions is always in the direction of establishing a uniform rate of interest throughout all time markets in the economy. The reason for the uniformity is clear. If stage three of good X earns 8 percent and stage one of good Y earns 2 percent, capitalists will tend to cease investing in the latter and shift to greater investments in the former. The price spreads change accordingly, in response to the changing demands and supplies, and the interest rates become uniform.

We may now remove our restrictive assumption about the equality of duration of the various stages. Any stage of any product may be as long or as short as the techniques of production, and the organizational structure of industry require. Thus, a technique of production might require a year’s harvest for any particular stage. On the other hand, a firm might “vertically integrate” two stages and advance the money to owners of factors for the period covering both stages before selling the product for money. The net return on the investment in any stage will adjust itself in accordance with the length of the stage. Thus, suppose that the uniform interest rate in the economy is 5 percent. This is 5 percent for a certain unit period of time, say a year. A production process or investment covering a period of two years will, in equilibrium, then earn 10 percent, the equivalent of 5 percent per year. The same will obtain for a stage of production of any length of time. Thus, irregularity or integration of stages does not hamper the equilibrating process in the slightest.

It is already clear that the old classical trinity of “land, labor, and capital” earning “wages, rents, and interest” must be drastically modified. It is not true that capital is an independent productive factor or that it earns interest for its owner, in the same way that land and labor earn income for their owners. As we have seen above and will discuss further below, capital is not an independently productive factor. Capital goods are vital and of crucial importance in production, but their production is, in the long run, imputable to land, labor, and time factors. Furthermore, land and labor are not homogeneous factors within themselves, but simply categories of types of uniquely varying factors. Each land and each labor factor, then, has its own physical features, its own power to serve in production; each, therefore, receives its own income from production, as will be detailed below. Capital goods too have infinite variety; but, in the ERE, they earn no incomes. What does earn an income is the conversion of future goods into present goods; because of the universal fact of time preference, future satisfactions are always at a discount compared to present satisfactions. The owning and holding of capital goods from date one, when factor services are purchased, until the product is sold at date two is what capitalist investors accomplish. This is equivalent to the purchase of future goods (the factor services producing capital goods) with money, followed by the sale at a later date of the present goods for money. The latter occurs when consumers’ goods are being sold, for consumers’ goods are present goods. When intermediate, lower-order capital goods are sold for money, then it is not present goods, but less distantly future goods, that are sold. In other words, capital goods have been advanced from an earlier, more distantly future stage toward the consumption stage, to a later or less distantly future stage. The time for this transformation will be covered by a rate of time preference. Thus, if the market time preference rate, i.e., interest rate, is 5 percent per year, then a present good worth 100 ounces on the market will be worth about 95 ounces for a claim on it one year from now. The present value for a claim on 100 ounces one year from now will be 95 ounces. On this basis, the estimated worth of the good could be worked out for various points in time; thus, the claim for one-half year in the future will be worth roughly 97.5 ounces. The result will be a uniformity of rates over a period of time.

Thus, capitalists advance present goods to owners of factors in return for future goods; then, later, they sell the goods which have matured to become present or less distantly future goods in exchange for present goods (money). They have advanced present goods to owners of factors and, in return, wait while these factors, which are future goods, are transformed into goods that are more nearly present than before. The capitalists’ function is thus a time function, and their income is precisely an income representing the agio of present as compared to future goods. This interest income, then, is not derived from the concrete, heterogeneous capital goods, but from the generalized investment of time.6 It comes from a willingness to sacrifice present goods for the purchase of future goods (the factor services). As a result of the purchases, the owners of factors obtain their money in the present for a product that matures only in the future.

Thus, capitalists restrict their present consumption and use these savings of money to supply money (present goods) to factor owners who are producing only future goods. This is the service—an advance of time—that the capitalists supply to the owners of factors, and for which the latter voluntarily pay in the form of the interest rate.

• 1[PUBLISHER’S NOTE: Page numbers cited in parentheses within the text refer to the present edition.] The discussion in this chapter deals with the pure rate of interest, as determined by time preference. On the role of the purchasing-power component in the market rate of interest, cf. chapter 11 on money.
• 2On production theory and stages of production, see the important works of F.A. Hayek, particularly Prices and Production (2nd ed.; London: Routledge and Kegan Paul, 1935); and Profits, Interest, and Investment (London: Routledge and Kegan Paul, 1939).
• 3Cf. Böhm-Bawerk, Positive Theory of Capital, pp. 304–05, 320.
• 4In the ERE of our example, the pure rate of interest is the rate of interest, since, as we shall see, deviations from the pure rate are due solely to uncertainty.
• 5In the reams of commentary on J.M. Keynes’ General Theory, no one has noticed the very revealing passage in which Keynes criticizes Mises’ discussion of this point. Keynes asserted that Mises’ “peculiar” new theory of interest “confused” the “marginal efficiency of capital” (the net rate of return on an investment) with the rate of interest. The point is that the “marginal efficiency of capital” is indeed the rate of interest! It is a price on the time market. It was precisely this “natural” rate, rather than the loan rate, that had been a central problem of interest theory for many years. The essentials of this doctrine were set forth by Böhm-Bawerk in Capital and Interest and should therefore not have been surprising to Keynes. See John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace & Co., 1936), pp. 192–93. It is precisely this preoccupation with the relatively unimportant problems of the loan market that constitutes one of the greatest defects of the Keynesian theory of interest.
• 6As Böhm-Bawerk declared:
  Interest ... may be obtained from any capital, no matter what be the kind of goods of which the capital consists: from goods that are barren as well as from those that are naturally fruitful; from perishable as well as from durable goods; from goods that can be replaced and from goods that cannot be replaced; from money as well as from commodities. (Böhm-Bawerk, Capital and Interest, p. 1)

It is clear that the rate of interest plays a crucial role in the system of production in the complex, monetary economy.7 How is the rate of interest determined? The pure rate of interest, with which we are now concerned, we have seen will tend to be equal throughout all stages of all production processes in the economy and thus will be uniform in the ERE.

The level of the pure rate of interest is determined by the market for the exchange of present goods against future goods, a market which we shall see permeates many parts of the economic system. The establishment of money as a general medium of exchange has greatly simplified the present-future market as compared to the laborious conditions under barter, where there were separate present-future markets for every commodity. In the monetary economy, the present-future market, or what we may call the “time market,” is expressed completely in terms of money. Money is clearly the present good par excellence. For, aside from the consumption value of the monetary metal itself, the money commodity is the one completely marketable good in the entire society. It is the open sesame to exchange for consumption goods at any time that its owner desires. It is therefore a present good. Since consumers’ goods, once sold, do not ordinarily re-enter the exchange nexus, money is the dominant present good in the market. Furthermore, since money is the medium for all exchanges, it is also the medium for exchanges on the time market.

What are the future goods that exchange for money? Future goods are goods that are now expected to become present goods at some future date. They therefore have a present value. Because of the universal fact of time preference, a particular good is worth more at present than is the present prospect of its becoming available as a present good at some time in the future. In other words, a good at present is worth more now than its present value as a future good. Because money is the general medium of exchange, for the time market as well as for other markets, money is the present good, and the future goods are present expectations of the future acquisition of money. It follows from the law of time preference that present money is worth more than present expectations of the same amount of future money. In other words, future money (as we may call present expectations of money in the future) will always exchange at a discount compared to present money.

This discount on future goods as compared with present goods (or, conversely, the premium commanded by present goods over future goods) is the rate of interest. Thus, if, on the time market, 100 ounces of gold exchange for the prospect of obtaining 105 ounces of gold one year from now, then the rate of interest is approximately 5 percent per annum. This is the time-discount rate of future to present money.

What do we mean specifically by “prospects for obtaining money in the future”? These prospects must be carefully analyzed in order to explain all the causal factors in the determination of the rate of interest. In the first place, in the real world, these prospects, like any prospects over a period of time, are always more or less uncertain. In the real world this ever present uncertainty necessarily causes interest and profit-and-loss elements to be intertwined and creates complexities that will be analyzed further below. In order to separate the time market from the entrepreneurial elements, we must consider the certain world of the evenly rotating economy, where anticipations are all fulfilled and the pure rate of interest is equal throughout the economy. The pure rate of interest will then be the going rate of time discount, the ratio of the price of present goods to that of future goods.

What, then, are the specific types of future goods that enter the time market? There are two such types. One is a written claim to a certain amount of money at a future date. The exchange on the time market in this case is as follows: A gives money to B in exchange for a claim to future money. The term generally used to refer to A, the purchaser of the future money, is “lender,” or “creditor,” while B, the seller of the future money, is termed the “borrower” or “debtor.” The reason is that this credit transaction, as contrasted to a cash transaction, remains unfinished in the present. When a man buys a suit for cash, he transfers money in exchange for the suit. The transaction is finished. In a credit transaction he receives simply a written I.O.U., or note, entitling him to claim a certain amount of money at a future date. The transaction remains to be completed in the future, when B, the borrower, “repays the loan” by transferring the agreed money to the creditor.

Although the loan market is a very conspicuous type of time transaction, it is by no means the only or even the dominant one. There is a much more subtle, but more important, type of transaction which permeates the entire production system, but which is not often recognized as a time transaction. This is the purchase of producers’ goods and services, which are transformed over a period of time, finally to emerge as consumers’ goods. When capitalists purchase the services of factors of production (or, as we shall later see, the factors themselves), they are purchasing a certain amount and value of net produce, discounted to the present value of that produce. For the land, labor, and capital services purchased are future goods, to be transformed into final form as present goods.

Suppose, for example, that a capitalist-entrepreneur hires labor services, and suppose that it can be determined that this amount of labor service will result in a net revenue of 20 gold ounces to the product-owner. We shall see below that the service will tend to be paid the net value of its product; but it will earn its product discounted by the time interval until sale. For if the labor service will reap 20 ounces five years from now, it is obvious that the owner of the labor cannot expect to receive from the capitalist the full 20 ounces now, in advance. He will receive his net earnings discounted by the going agio, the rate of interest. And the interest income will be earned by the capitalist who has assumed the task of advancing present money. The capitalist then waits for five years until the product matures before recouping his money.

The pure capitalist, therefore, in performing a capital-advancing function in the productive system, plays a sort of intermediary role. He sells money (a present good) to factor-owners in exchange for the services of their factors (prospective future goods). He holds these goods and continues to hire work on them until they have been transformed into consumers’ goods (present goods), which are then sold to the public for money (a present good). The premium that he earns from the sale of present goods, compared to what he paid for future goods, is the rate of interest earned on the exchange.

The time market is therefore not restricted to the loan market. It permeates the entire production structure of the complex economy. All productive factors are future goods: they provide for their owner the expectation of being advanced toward the final goal of consumption, a goal which provides the raison d’être for the whole productive enterprise. It is a time market where the future goods sold do not constitute a credit transaction, as in the case of the loan market. The transaction is complete in itself and needs no further payment by either party. In this case, the buyer of the future goods—the capitalist—earns his income through transforming these goods into present goods, rather than through the presentation of an I.O.U. claim on the original seller of a future good.

The time market, the market where present goods exchange for future goods, is, then, an aggregate with several component parts. In one part of the market, capitalists exchange their money savings (present goods) for the services of numerous factors (future goods). This is one part, and the most important part, of the time market. Another is the consumers’ loan market, where savers lend their money in a credit transaction, in exchange for an I.O.U. of future money. The savers are the suppliers of present money, the borrowers the suppliers of future money, in the form of I.O.U.’s. Here we are dealing only with those who borrow to spend on consumption goods, and not with producers who borrow savings in order to invest in production. For the borrowers of savings for production loans are not independent forces on the time market, but rather are completely dependent on the interest agio between present and future goods as determined in the production system, equaling the ratio between the prices of consumers’ and producers’ goods, and between the various stages of producers’ goods. This dependence will be seen below.

• 7Cf. Mises, Human Action, pp. 521–42.

Before considering the component parts of the time market further, let us go to the very root of the matter: the value scale of the individual. As we have seen in the problem of pricing and demand, the individual’s value scale provides the key to the determination of all events on the market. This is no less true in regard to the interest rate. Here the key is the schedule of time-preference valuations of the individual.

Let us consider a hypothetical individual, abstracting from any particular role that he may play in the economic system. This individual has, of necessity, a diminishing marginal utility of money, so that each additional unit of money acquired ranks lower on his value scale. This is necessarily true. Conversely, and this also follows from the diminishing marginal utility of money, each successive unit of money given up will rank higher on his value scale. The same law of utility applies to future money, i.e., to prospects of future money. To both present money and future money there applies the general rule that more of a good will have greater utility than less of it. We may illustrate these general laws by means of the following hypothetical value scale of an individual:

We see in this value scale an example of the fact that all possible alternatives for choice are ranged in one scale, and the truths of the law of utility are exemplified. The “1st unit of 10 oz.” refers to the rank accorded to the first unit of 10 ounces (the unit arbitrarily chosen here) to be given up. The “2nd unit of 10 ounces” of money to be given up is accorded higher rank, etc. The “1st added unit of 10 oz.” refers to the rank accorded to the next unit of 10 ounces which the man is considering acquiring, with parentheses to indicate that he does not now have the good in his possession. Above we have a schedule of John Smith’s value scale with respect to time, i.e., his scale of time preferences. Suppose that the market rate of interest, then, is 3 percent; i.e., he can obtain 13 ounces of future money (considered here as 10 years from now), by selling 10 ounces of present money. To see what he will do, we are privileged to be able to consult his time-preference scale. We find that 13 ounces of future money is preferred to his first unit of 10 ounces and also to the second unit of 10 ounces, but that the third unit of 10 ounces stands higher in his valuation. Therefore, with a market rate of 3 percent per year, the individual will save 20 ounces of gold and sell them for future money on the time market. He is a supplier of present goods on the time market to the extent of 20 ounces.8

If the market rate of interest is 2 percent, so that 12 future ounces would be the price of 10 present ounces, then John Smith would be a supplier of 10 ounces of present money. He is never a supplier of future money because, in his particular case, there are no quantities of future money above 10 ounces that are ranked below “1st added unit of 10 oz.”

Suppose, for example, that James Robinson has the following time-value scale:

If the market rate of interest is 3 percent, then Robinson’s valuations are such that no savings will be supplied to the time market. On the contrary, 13 ounces future is lower than “1st added unit of 10 oz.,” which means that Robinson would be willing to exchange 13 ounces of future money for 10 ounces of present money. Thereby he becomes, in contrast to Smith, a supplier of future money. If the rate of interest were 1 percent, then he would supply 22 ounces of future money in exchange for 20 ounces of present money, thus increasing his demand for present money at the lower price.

It will be noticed that there is no listing for less than 10 ounces of future goods, to be compared with 10 ounces of present goods. The reason is that every man’s time preference is positive, i.e., one ounce of present money will always be preferred to one ounce or less of future money. Therefore, there will never be any question of a zero or negative pure interest rate. Many economists have made the great mistake of believing that the interest rate determines the time-preference schedule and rate of savings, rather than vice versa. This is completely invalid. The interest rates discussed here are simply hypothetical schedules, and they indicate and reveal the time-preference schedules of each individual. In the aggregate, as we shall see presently, the interaction of the time preferences and hence the supply-demand schedules of individuals on the time market determine the pure rate of interest on the market. They do so in the same way that individual valuations determine aggregate supply and demand schedules for goods, which in turn determine market prices. And once again, it is utilities and utilities alone, here in the form of time preferences, that determine the market result; the explanation does not lie in some sort of “mutually determining process” of preferences and market consequences.

Continuing with our analysis, let us tabulate the schedules of John Smith and James Robinson, from their time-value scales above, in relation to their position on the time market. John Smith’s schedule is given in Table 11. James Robinson’s schedule is given in Table 12.

The Robinson time schedule is of particular interest. Referring to his time-value scale, we find that at an interest rate of 9 percent, 19 ounces of future money is above the second unit of 10 ounces of present money and therefore also above the first unit. At this interest rate, his supply of present money on the time market, i.e., his savings, equals 20 ounces. Because his valuation of the first unit (of 10 ounces—an arbitrary size of unit that we have picked for this discussion) is between 16 and 17 ounces of future money, when the market interest rate is 6 percent, his return of 16 ounces is less valuable to him than his first unit. Therefore, he will not be a saver and supplier of present money at this rate. On the other hand, he will not be a supplier of future goods (i.e., a demander of present goods on the time market) either. In order to be a supplier of future goods, his valuation of the future money that he would have to give up at the ruling rate of interest has to be lower than the present money that he would get. In other words, what he gives up in prospective future money will have to be worth less to him than the utility of the “1st additional unit of 10 oz.” on his scale. While the market rate is in the 4-percent to 6-percent range, this will not be true, for the 14 to 16 ounces of future money that he would have to supply would be worth more to him than the additional 10 ounces of present money that he would gain from the exchange. In Robinson’s case, the critical point takes place when the hypothetical interest rate drops to 3 percent, for 13 future ounces are worth less than an additional 10 ounces of present money, and he will supply the future ounces on the market. If the interest rate were 1 percent, he would supply 20 ounces of future goods.9

It should be evident that an individual, at any one time, will either be a net saver (i.e., a net demander of future goods), a net supplier of future goods, or not be on the time market at all. The three categories are mutually exclusive.

The diagram in Figure 42 sketches the schedules of Smith and Robinson in graphic form. Interest rate is on the vertical axis, and money on the horizontal. The supplies of present goods are also demands for future goods, and the demand for present goods is also the supply of future goods.

We cannot compare utilities or values between persons, but we certainly may say that Robinson’s time-preference schedule is higher than Smith’s. In other words, it cannot make sense to compare the rankings or utilities that the two men accord to any particular unit of a good, but we can (if we know them) compare their schedules based purely on their demonstrated time preferences. Robinson’s time-preference schedule is higher than Smith’s, i.e., at each hypothetical rate of interest Robinson’s values are such that he will part with less of his present goods in exchange for future goods.10

Let us explore the typical individual time-preference schedule, or time-supply-and-demand schedule, more closely. In the first place, there is no necessity for the unit chosen to be 10 ounces. Since money is perhaps the most divisible of goods, it is possible to break down the units into far smaller sizes. Furthermore, because of the arbitrage of the market, the rate of interest return on investments of present in future goods will be equal for all the various sizes of units. We may therefore visualize a comparatively smooth curve, even for each individual.

One inevitable characteristic of an individual’s time-preference schedule is that eventually, after a certain amount of present money has been supplied on the market, no conceivable interest rate could persuade him to purchase more future goods. The reason is that as present money dwindles and future money increases in a man’s possession, the marginal utility of the former increases on the man’s value scale, and the marginal utility of the latter decreases. In particular, every man must consume in the present, and this drastically limits his savings regardless of the interest rate. As a result, after a certain point, a man’s time preference for the present becomes infinite, and the line representing his supply of present goods becomes vertical upward. At the other end of the scale, the fact of time preference will imply that at some minimum rate of interest the man will not save at all. At what point the supply curve hits the vertical axis depends on the valuations of the individual; but it must do so, as a result of the operation of the law of time preference. A man could not prefer 10 ounces or even less of future money to 10 ounces of present money.11

What happens after the individual supply curve hits the vertical axis depends entirely on the time preferences of the individual. In some cases, as in that of John Smith above, the person’s marginal utility of money falls too fast, as compared with that of future money, for him to participate as a net demander of present goods at low rates of interest. In other words, Smith’s time-preference ratio is too low in this area for him to become a demander of present goods and a supplier of future goods. On the other hand, Robinson’s higher schedule of time preferences is such that, at low rates of interest, he becomes a supplier of future goods for present goods. (See Figure 42.)

We may of course, diagram a typical individual’s supply and demand curve conventionally, as we have done in Figure 42. On the other hand, we may also modify this diagram, so as to make one continuous curve of the individual’s activity on the time market. We may call this curve the “individual’s time-market curve.” At higher interest rates, down to where it hits the vertical axis, this curve is simply the individual’s supply curve of present goods. But below this, we are reversing his demand curve and continuing it on to the left on the horizontal axis. (See Figure 43.)

Every individual on the market has a similar type of time-market schedule, reflecting his particular value scale. The schedule of each will be such that at higher rates of interest there will be a greater tendency toward net saving, and at lower rates of interest, less saving, until the individual becomes a net demander. At each hypothetical rate of interest there is a possible net saving, net demanding, or abstaining from the market, for each individual. For some changes in the rate of interest, there will be no change (vertical curve), but there will never be a situation where the supply will be greater, or demand less, with lower rates of interest.

The time-market schedules of all individuals are aggregated on the market to form market-supply and market-demand schedules for present goods in terms of future goods. The supply schedule will increase with an increase in the rate of interest, and the demand schedule will fall with the higher rates of interest.

A typical aggregate market diagram may be seen in Figure 44. Aggregating the supply and demand schedules on the time market for all individuals in the market, we obtain curves such as SS and DD.

DD is the demand curve for present goods in terms of the supply of future goods; it slopes rightward as the rate of interest falls. SS is the supply curve of present goods in terms of the demand for future goods; it slopes rightward as the rate of interest increases. The intersection of the two curves determines the equilibrium rate of interest—the rate of interest as it would tend to be in the evenly rotating economy. This pure rate of interest, then, is determined solely by the time preferences of the individuals in the society, and by no other factor.

The intersection of the two curves determines an equilibrium rate of interest, BA, and an equilibrium amount saved, 0B. 0B is the total amount of money that will be saved and invested in future money. At a higher interest rate than BA, present goods supplied would exceed future goods supplied in exchange, and the excess savings would compete with one another until the price of present goods in terms of future goods would decline toward equilibrium. If the rate of interest were below BA, the demand for present goods by suppliers of future goods would exceed the supply of savings, and the competition of this demand would push interest rates up toward equilibrium.

Perhaps more fallacies have been committed in discussions concerning the interest rate than in the treatment of any other aspect of economics. It took a long while for the crucial importance of time preference in the determination of the pure rate of interest to be realized in economics; it took even longer for economists to realize that time preference is the only determining factor. Reluctance to accept a monistic causal interpretation has plagued economics to this day.12

• 8This is a highly simplified portrayal of the value scale. For purposes of exposition, we have omitted the fact that the second unit of 13 added future ounces will be worth less than the first, the third unit of 13 less than the second, etc. Thus, in actuality, the demand schedule of future goods will be lower than portrayed here. However, the essentials of the analysis are unaffected, since we can assume a demand schedule of any size that we wish. The only significant conclusion is that the demand curve is shaped so that an individual demands more future goods as the market rate of interest rises, and this conclusion holds for the actual as well as for our simplified version.
• 9The reader may drop the parentheses around the future moneys at the lower end of the value scale, for Robinson is considering supplying them as well as demanding them.
• 10In the same way, though we cannot compare utilities, we can compare (if we know them) individual demand schedules for goods.
• 11It is not valid to object that some might prefer to use the money in the future rather than in the present. That is not the issue here, which is one of availability for use. If a man wants to “save” money for some future use, he may “hoard” it rather than spend it on a future good, and thus have it always available. We have abstracted from hoarding, which will be dealt with in the chapter on money; it would have no place, anyway, in the evenly rotating world of certainty.
• 12The importance of time preference was first seen by Böhm-Bawerk in his Capital and Interest. The sole importance of time preference has been grasped by extremely few economists, notably by Frank A. Fetter and Ludwig von Mises. See Fetter, Economic Principles, pp. 235–316; idem, “Interest Theories, Old and New,” American Economic Review, March, 1914, pp. 68–92; and Mises, Human Action, pp. 476–534.

The time market, like other markets, consists of component individuals whose schedules are aggregated to form the market supply and demand schedules. The intricacy of the time market (and of the money market as well) consists in the fact that it is also divided and subdivided into various distinguishable sub-markets. These are aggregable into a total market, but the subsidiary components are interesting and highly significant in their own right and deserve further analysis. They themselves, of course, are composed of individual supply and demand schedules.

As we have indicated above, we may divide the present-future market into two main subdivisions: the production structure and the consumer loan market. Let us turn first to the production structure. This may be done most clearly by considering once again a typical production-structure diagram. This diagram is the one in Figure 41, with one critical difference. Previously the diagram represented a typical production structure for any particular consumers’ good. Now the same diagram represents the aggretagate production structure for all goods. Money moves from consumers’ goods back through the various stages of production, while goods flow from the higher through the lower stages of production, finally to be sold as consumers’ goods. The pattern of production is not changed by the fact that both specific and nonspecific factors exist. Since the production structure is aggregated, the degree of specificity for a particular product is irrelevant in a discussion of the time market.

There is no problem in the fact that different production processes for different goods take unequal lengths of time. This is not a difficulty because the flow from one stage to another can be aggregated for any number of processes.

There are, however, two more serious problems that seem to be involved in aggregating the production structure for the entire economy. One is the fact that in various processes there will not necessarily be an exchange of capital goods for money at each stage. One firm may “vertically integrate” within itself one or more stages and thereby advance present goods for a greater period of time. We shall see below, however, that this presents no difficulty at all, just as it presented no difficulty in the case of particular processes.

A second difficulty is the purchase and use of durable capital goods. We have been assuming, and are continuing to assume, that no capital goods or land are bought—that they are only hired, i.e., “rented” from their owners. The purchase of durable goods presents complications, but again, as we shall see, this will lead to no essential change whatever in our analysis.

The production-structure diagram in Figure 45 omits the numbers that indicated the size of payments between the various sectors and substitutes instead D’s and S’s to indicate the points where present-future transactions (“time transactions”) take place and what groups are engaging in these various transactions.

D’s indicate demanders of present goods, and S’s are suppliers of present goods, for future goods.

Let us begin at the bottom—the expenditure of consumers on consumers’ goods. The movement of money is indicated by arrows, and money moves from consumers to the sellers of consumers’ goods. This is not a time transaction, because it is an exchange of present goods (money) for present goods (consumers’ goods).13

These producers of consumers’ goods are necessarily capitalists who have invested in the services of factors to produce these goods and who then sell their products. Their investment in factors consisted of purchases of the services of land factors and labor factors (the original factors) and first-order capital goods (the produced factors). In both these two large categories of transactions (exchanges that are made a stage earlier than the final sale of consumers’ goods), present goods are exchanging for future goods. In both cases, the capitalists are supplying present money in exchange for factor services whose yield will materialize in the future, and which therefore are future goods.

So the capitalists who are producing consumers’ goods, whom we might call “first-stage capitalists,” engage in time transactions in making their investments. The components of this particular subdivision of the time market, then, are:

Supply of Present Goods: Capitalists1
Supply of Future Goods: Landowners, Laborers, Capitalists2 (Demand for Present Goods)

Capitalists1 are the first-stage capitalists who produce consumers’ goods. They purchase capital goods from the producer-owners — the second-stage capitalists, or Capitalists2. The appropriate S’s and D’s indicate these transactions, and the arrows pointing upward indicate the direction of money payment.

At the next stage, the Capitalists2 have to purchase services of factors of production. They supply present goods and purchase future goods, goods which are even more distantly in the future than the product that they will produce.14 These future goods are supplied by landowners, laborers, and Capitalists3. To sum up, at the second stage:

Supply of Present Goods: Capitalists2
Supply of Future Goods: Landowners, Laborers, Capitalists3

These transactions are marked with the appropriate S’s and D’s, and the arrows pointing upward indicate the direction of money payment in these transactions.

This pattern is continued until the very last stage. At this final stage, which is here the sixth, the sixth-stage capitalists supply future goods to the fifth-stage capitalists, but also supply present goods to laborers and landowners in exchange for the extremely distant future services of the latter. The transactions for the two highest stages are, then, as follows (with the last stage designated as N instead of six):

Fifth Stage:

Supply of Present Goods: Capitalists5
Supply of Future Goods: Landowners, Laborers, CapitalistsN

Nth Stage:

Supply of Present Goods: CapitalistsN
Supply of Future Goods: Landowners, Laborers

We may now sum up our time market for any production structure of N stages:

To illustrate clearly the workings of the production structure, let us hark back to the numerical example given in Figure 41 and summarize the quantities of present goods supplied and received by the various components of the time market. We may use the same figures here to apply to the aggregate production structure, although the reader may wish to consider the units as multiples of gold ounces in this case. The fact that different durations of production processes and different degrees of vertical integration make no difficulties for aggregation permits us to use the diagram almost interchangeably for a single production process and for the economy as a whole. Furthermore, the fact that the ERE interest rate will be the same for all stages and all goods in the economy especially permits us to aggregate the comparable stages of all goods. For if the rate is 5 percent, then we may say that for a certain stage of one good, payments by capitalists to owners of factors are 50 ounces, and receipts from sales of products are 52.5 ounces, while we can also assume that the aggregate payments for the whole economy in the same period are 5,000 ounces, and receipts 5,250 ounces.

The same interest rate connotes the same rate of return on investments, whether considered separately or for all goods lumped together.

The following, then, are the supplies and demands for present goods from Figure 41, the diagram now being treated as an aggregate for the whole economy:

The horizontal arrows at each stage of this table depict the movement of money as supplied from the savers to the recipient demanders at that stage.

From this tabulation it is easy to derive the net money income of the various participants: their gross money income minus their money payments, if we include the entire period of time for all of their transactions on the time market. The case of the owners of land and labor is simple: they receive their money in exchange for the future goods to be yielded by their factors; this money is their gross and their net money income from the productive system. The total of net money income to the owners of land and labor is 83 ounces. This is the sum of the money incomes to the various owners of land and labor at each stage of production.

The case of the capitalists is far more complicated. They pay out present goods in exchange for future goods and then sell the maturing less distantly future products for money to lower-stage capitalists. Their net money income is derived by subtracting their money outgo from their gross income over the period of the production stage. In our example, the various net incomes of the capitalists are as follows:

The total net income of the capitalists producing capital goods (orders 2 through N) is 12 ounces. What, then, of Capitalists1, who apparently have not only no net income, but a deficit of 95 ounces? They are recouped, as we see from the diagram (in Figure 41), not from the savings of capitalists, but from the expenditure of consumers, which totals 100 ounces, yielding a net income to Capitalists1 of five ounces.

It should be emphasized at this point that the general pattern of the structure of production and of the time market will be the same in the real world of uncertainty as in the ERE. The difference will be in the amounts that go to each sector and in the relations among the various prices. We shall see later what the discrepancies will be; for example, the rate of return by the capitalists in each sector will not be uniform in the real market. But the pattern of payments, the composition of suppliers and demanders, will be the same.

In analyzing the income-expenditure balance sheets of the production structure, writers on economic problems have seen that we may consolidate the various incomes and consider only the net incomes. The temptation has been simply to write off the various intercapitalist transactions as “duplications.” If that is done here, then the total net income in the market is: capitalists, 17 ounces (12 ounces for capital-good capitalists and five ounces for consumers’-good capitalists); land and labor factors, 83 ounces. The grand total net income is then 100 ounces. This is exactly equal to the total of consumer spending for the period.

Total net income is 100 ounces, and consumption is 100 ounces. There is, therefore, no new net saving. We shall deal with savings and their change in detail below. Here the point is that, in the endless round of the ERE, zero net savings, as thus defined, would mean that there is just enough gross saving to keep the structure of productive capital intact, to keep the production processes rolling, and to keep a constant amount of consumers’ goods produced per given period.

It is certainly legitimate and often useful to consider net incomes and net savings, but it is not always illuminating, and its use has been extremely misleading in present-day economics.15 Use of the net “national” income figures (it is better to deal with “social income” extending throughout the market community using the money rather than to limit the scope to national boundaries) leads one to believe that the really important element maintaining the production structure is consumers’ spending. In our ERE example, the various factors and capitalists receive their net income and plow it back into consumption, thus maintaining the productive structure and future standards of living, i.e., the output of consumers’ goods. The inference from such concepts is clear: capitalists’ savings are necessary to increase and deepen the capital structure, but even without any savings, consumption expenditure is alone sufficient to maintain the productive capital structure intact.

This conclusion seems deceptively clear-cut: after all, is not consumer spending the bulwark and end product of activity? This thesis, however, is tragically erroneous. There is no simple automatism in capitalists’ spending, especially when we leave the certain world of the ERE, and it is in this real world that the conceptual error plays havoc. For with production divided into stages, it is not true that consumption spending is sufficient to provide for the maintenance of the capital structure. When we consider the maintenance of the capital structure, we must consider all the decisions to supply present goods on the present-future market. These decisions are aggregated; they do not cancel one another out. Total savings in the economy, then, are not zero, but the aggregation of all the present goods supplied to owners of future goods during the production process. This is the sum of the supplies of Capitalists1 through CapitalistsN, which totals 318 ounces. This is the total gross savings—the supply of present goods for future goods in production—and also equals total gross investment. Investment is the amount of money spent on future-good factors and necessarily equals savings. Total expenditures on production are: 100 (Consumption) plus 318 (Investment = Savings), equals 418 ounces. Total gross income from production equals the gross income of Capitalists1 (100 ounces) plus the gross income of other capitalists (235 ounces) plus the gross income of owners of land and labor (83 ounces), which also equals 418 ounces.

The system depicted in our diagram of the production structure, then, is of an economy in which 418 gold ounces are earned in gross income, and 100 ounces are spent on consumption, while 318 ounces are saved and invested in a certain order in the production structure. In this evenly rotating economy, 418 ounces are earned and then spent, with no net “hoarding” or “dishoarding,” i.e., no net additions or subtractions from the cash balance over the period as a whole.16

Thus, instead of no savings being needed to maintain capital and the production structure intact, we see that a very heavy proportion of savings and investment—in our example three times the amount spent on consumption—is necessary simply to keep the production structure intact. The contrast is clear when we consider who obtains income and who is empowered to decide whether to consume or to invest. The net-income theorists implicitly assume that the only important decisions in regard to consuming vs. saving-investing are made by the factor-owners out of their net income. Since the net income of capitalists is admittedly relatively small, this approach attributes little importance to their role in maintaining capital. We see, however, that what maintains capital is gross expenditures and gross investment and not net investment. The capitalists at each stage of production, therefore, have a vital role in maintaining capital through their savings and investment, through heavy savings from gross income.

Concretely, let us take the case of the Capitalists1. According to the net-income theorists, their role is relatively small, since their net income is only five ounces. But actually their gross income is 100 ounces, and it is their decision on how much of this to save and how much to consume that is decisive. In the ERE, of course, we simply state that they save and invest 95 ounces. But when we leave the province of the ERE, we must realize that there is nothing automatic about this investment. There is no natural law that they must reinvest this amount. Suppose, for example, that the Capitalists1 decide to break up the smooth flow of the ERE by spending all of the 100 ounces for their own consumption rather than investing the 95 ounces. It is evident that the entire market-born production structure would be destroyed. No income at all would accrue to the owners of all the higher-order capital goods, and all the higher-order capital processes, all the production processes longer than the very shortest, would have to be abandoned. We have seen above, and shall see in more detail below, that civilization advances by virtue of additional capital, which lengthens production processes. Greater quantities of goods are made possible only through the employment of more capital in longer processes. Should capitalists shift from saving-investment to consumption, all these processes would be necessarily abandoned, and the economy would revert to barbarism, with the employment of only the shortest and most primitive production processes. The standard of living, the quantity and variety of goods produced, would fall catastrophically to the primitive level.17

What could be the reason for such a precipitate withdrawal of savings and investment in favor of consumption? The only reason—on the free market—would be a sudden and massive increase in the time-preference schedules of the capitalists, so that present satisfactions become worth very much more in terms of future satisfactions. Their higher time preferences mean that the existing rate of interest is not enough to induce them to save and invest in their previous proportions. They therefore consume a greater proportion of their gross income and invest less.

Each individual, on the basis of his time-preference schedule, decides between the amount of his money income to be devoted to saving and the amount to be devoted to consumption. The aggregate time-market schedules (determined by time preferences) determine the aggregate social proportions between (gross) savings and consumption. It is clear that the higher the time-preference schedules are, the greater will be the proportion of consumption to savings, while lower time-preference schedules will lower this proportion. At the same time, as we have seen, higher time-preference schedules in the economy lead to higher rates of interest, and lower schedules lead to lower rates of interest.

From this it becomes clear that the time preferences of the individuals on the market determine simultaneously and by themselves both the market equilibrium interest rate and the proportions between consumption and savings (individual and aggregate).18 Both of the latter are the obverse side of the same coin. In our example, the increase in time-preference schedules has caused a decline in savings, absolute and proportionate, and a rise in the interest rate.

The fallacies of the net product figures have led economists to include some “grossness” in their product and income figures. At present the favorite concept is that of the “gross national product” and its counterpart, gross national expenditures. These concepts were adopted because of the obvious errors encountered with the net income concepts.19 Current “gross” figures, however, are the height of illogicality, because they are not gross at all, but only partly gross. They include only gross purchases by capitalists of durable capital goods and the consumption of their self-owned durable capital, approximated by depreciation allowances set by the owners. We shall consider the problems of durable capital more fully below, but suffice it to say that there is no great difference between durable and less durable capital. Both are consumed in the course of the production process, and both must be paid for out of the gross income and gross savings of lower-order capitalists. In evaluating the payment pattern of the production structure, then, it is inadmissible to leave the consumption of nondurable capital goods out of the investment picture. It is completely illogical to single out durable goods, which are themselves only discounted embodiments of their nondurable services and therefore no different from nondurable goods.

The idea that the capital structure is maintained intact without savings, as it were automatically, is fostered by the use of the “net” approach. If even zero savings will suffice to maintain capital, then it seems as if the aggregate value of capital is a permanent entity that cannot be reduced. This notion of the permanence of capital has permeated economic theory, particularly through the writings of J.B. Clark and Frank H. Knight, and through the influence of the latter has molded current “neoclassical” economic theory in America. To maintain this doctrine it is necessary to deny the stage analysis of production and, indeed, to deny the very influence of time in production.20 The all-pervading influence of time is stressed in the period-of-production concept and in the determination of the interest rate and of the investment-consumption ratio by individual time-preference schedules. The Knight doctrine denies any role to time in production, asserting that production “now” (in a modern, complex economy) is timeless and that time preference has no influence on the interest rate. This doctrine has been aptly called a “mythology of capital.” Among other errors, it leads to the belief that there is no economic problem connected with the replacement and maintenance of capital.21 ,22

A common fallacy, fostered directly by the net-income approach, holds that the important category of expenditures in the production system is consumers’ spending. Many writers have gone so far as to relate business prosperity directly to consumers’ spending, and depressions of business to declines in consumers’ spending. “Business cycle” considerations will be deferred to later chapters, but it is clear that there is little or no relationship between prosperity and consumers’ spending; indeed almost the reverse is true. For business prosperity, the important consideration is the price spreads between the various stages—i.e., the rate of interest return earned. It is this rate of interest that induces capitalists to save and invest present goods in productive factors. The rate of interest, as we have been demonstrating, is set by the configurations of the time preferences of individuals in the society. It is not the total quantity of money spent on consumption that is relevant to capitalists’ returns, but the margins, the spreads, between the product prices and the sum of factor prices at the various stages—spreads which tend to be proportionately equal throughout the economy.

There is, in fact, never any need to worry about the maintenance of consumer spending. There must always be consumption; as we have seen, after a certain amount of monetary saving, there is always an irreducible minimum of his monetary assets that every man will spend on current consumption. The fact of human action insures such an irreducible minimum. And as long as there is a monetary economy and money is in use, it will be spent on the purchase of consumers’ goods. The proportion spent on capital in its various stages and in toto gives a clue to the important consideration—the real output of consumers’ goods in the economy. The total amount of money spent, however, gives no clue at all. Money and its value will be systematically studied in a later chapter. It is obvious, however, that the number of units spent could vary enormously, depending on the quantity of the money commodity in circulation. One hundred or 1,000 or 10,000 or 100,000 ounces of gold might be spent on consumption, without signifying anything except that the quantity of money units available was less or greater. The total amount of money spent on consumption gives no clue to the quantity of goods the economy may purchase.

The important consideration, therefore, is time preferences and the resultant proportion between expenditure on consumers’ and producers’ goods (investment). The lower the proportion of the former, the heavier will be the investment in capital structure, and, after a while, the more abundant the supply of consumers’ goods and the more productive the economy. The obverse of the coin is the determining effect of time preferences on the price spreads that set the rate of interest, and the income of the capitalist savers-investors in the economy. We have already seen the effect of a lowering of investment on the first rank, and below we shall analyze fully the effect on production and interest of a lowering of time preferences and the effects of various changes in the quantity of money on time preferences and the production structure.

Before continuing with an analysis of time preference and the production structure, however, let us complete our examination of the components of the time market.23

The pure demanders of present goods on the time market are the various groups of laborers and landowners—the sellers of the services of original productive factors. Their price on the market, as will be seen below, will be set equal to the marginal value product of their units, discounted by the prevailing rate of interest. The greater the rate of interest, the less will the price of their service be, or rather, the greater will be the discount from their marginal value product considered as the matured present good. Thus, if the marginal value product of a certain labor or land factor is 10 ounces per unit period, and the rate of interest is 10 percent, its earning price will be approximately nine ounces per year if the final product is one year away. A higher rate of interest would lead to a lower price, and a lower rate to a higher price, although the maximum price is one slightly below the full MVP (marginal value product), since the interest rate can never disappear.

It seems likely that the demand schedule for present goods by the original productive factors will be highly inelastic in response to changes in the interest rate. With the large base amount, the discounting by various rates of interest will very likely make little difference to the factor-owner.24 Large changes in the interest rate, which would make an enormous difference to capitalists and determine huge differences in interest income and the profitableness of various lengthy productive processes, would have a negligible effect on the earnings of the owners of the original productive factors.

On the time market, we are considering all factors in the aggregate; the interest rate of the time market permeates all particular aspects of the present-future market, including all purchases of land and labor services. Therefore, when we are considering the supply of a certain factor on the market, we are considering it in general, and not its supply schedule for a specific use. A group of homogeneous pieces of land may have three alternative uses: say, for growing wheat, raising sheep, or serving as the site of a steel factory. Its supply schedule for each of the three uses will be elastic (relatively flat curve) and will be determined by the amount it can obtain in the next best use—i.e., the use in which its discounted MVP is next highest. In the present analysis, we are not considering the factor’s supply curve for a particular industry or use; we are considering its supply curve for all users in the aggregate, i.e., its supply curve on the time market in exchange for present goods. We are therefore considering the behavior of all owners of a homogeneous factor of land (or of one owner if the land factor is unique, as it often is). Land is very likely to have no reservation price, i.e., it will have little subjective-use-value to the owner. A few landlords may place a valuation on the possibility of contemplating the virgin beauty of the unused land; in practice, however, the importance of such reservation-demand for land is likely to be negligible. It will, of course, be greater where the owner can use the land to grow food for himself.

Labor services are also likely to be inelastic with respect to the interest discount, but probably less so than land, since labor has a reservation demand, a subjective use-value, even in the aggregate labor market. This special reservation demand stems from the value of leisure as a consumers’ good. Higher prices for labor services will induce more units of labor to enter the market, while lower prices will increase the relative advantages of leisure. Here again, however, the difference that will be made by relatively large changes in the interest rate will not be at all great, so that the aggregate supply-of-labor curve (or rather curves, one for each homogeneous labor factor) will tend to be inelastic with regard to the interest rate.

The two categories of independent demanders of present goods for future goods, then, are the landowners and the laborers. The suppliers of present goods on the time market are clearly the capitalists, who save from their possible consumption and invest their savings in future goods. But the question may be raised: Do not the capitalists also demand present goods as well as supply them?

It is true that capitalists, after investing in a stage of production, demand present goods in exchange for their product. This particular demand is inelastic in relation to interest changes since these capital goods also can have no subjective use-value for their producers. This demand, however, is strictly derivative and dependent. In the first place, the product for which the owner demands present goods is, of course, a future good, but it is also one stage less distantly future than the goods that the owner purchased in order to produce it. In other words, Capitalists3 will sell their future goods to Capitalists2, but they had bought future goods from Capitalists4, as well as from landowners and laborers. Every capitalist at every stage, then, demands goods that are more distantly future than the product that he supplies, and he supplies present goods for the duration of the production stage until this product is formed. He is therefore a net supplier of present goods, and a net demander of future goods. Hence, his activities are guided by his role as a supplier. The higher the rate of interest that he will be able to earn, i.e., the higher the price spread, the more he will tend to invest in production. If he were not essentially a supplier of present goods, this would not be true.

The relation between his role as a supplier and as a demander of present goods may be illustrated by the diagram in Figure 46.

This diagram is another way of conveniently representing the structure of production. On the horizontal axis are represented the various stages of production, the dots furthest to the left being the highest stages, and those further to the right being the lower stages. From left to right, then, the stages of production are lower and eventually reach the consumers’-good stage.

The vertical axis represents prices, and it could interchangeably be either the production structure of one particular good or of all the goods in general. The prices that are represented at each stage are the cumulative prices of the factors at each stage, excluding the interest return of the capitalists. At each stage rightward, then, the level of the dots is higher, the difference representing the interest return to the capitalists at that stage. In this diagram, the interest return to capitalists at two adjacent stages is indicated, and the constant slope indicates that this return is equal.

Let us now reproduce the above diagram in Figure 47.25 The original production structure diagram is marked at points A, B, and C. Capitalists X purchase factors at price A and sell their product at point B, while capitalists Y buy at B and sell their product at C. Let us first consider the highest stage here portrayed—that of capitalists X. They purchase the factors at point A. Here they supply present goods to owners of factors. Capitalists X, of course, would prefer that the prices of the factors be lower; thus, they would prefer paying A′ rather than A. Their interest spread cannot be determined until their selling prices are determined. Their activities as suppliers of present goods in exchange for interest return, therefore, are not really completed with their purchase of factors. Obviously, they could not be. The capitalists must transform the factors into products and sell their products for money before they obtain their interest return from their supply of present goods. The suppliers of future goods (landowners and laborers) complete their transactions immediately, as soon as they obtain present money. But the capitalists’ transactions are incomplete until they obtain present money once again. Their demand for present goods is therefore strictly dependent on their previous supply.

Capitalists X, as we have stated, sell their products at B to the next lower rank of capitalists. Naturally, they would prefer a higher selling price for their product, and the point B′ would be preferred to B. If we looked only at this sale, we might be tempted to state that, as demanders of present goods, capitalists X prefer a higher price, and therefore a lower discount for their product, i.e., a lower interest rate. This, however, would be a superficial point of view, for we must look at both of their exchanges, which are necessarily considered together if we consider their complete transaction. They prefer a lower buying point and a higher selling point, i.e., a more steeply sloped line, or a higher rate of discount. In other words, the capitalists prefer a higher rate of interest and therefore always act as suppliers of present goods. Of course, the result of this particular change (to a price spread of A′B′) is that the next lower rung of capitalists, capitalists Y, suffer a narrowing of their price spread, along the line B′C. It is, of course, perfectly agreeable to capitalists X if capitalists Y suffer a lowering of their interest return, so long as the return of the former improves. Each capitalist is interested in improving his own interest return and not necessarily the rate of interest in general. However, as we have seen, there cannot for long be any differences in interest return between one stage and another or between one production process and another. If the A′B′C situation were established, capitalists would pour out of the Y stage and into the X stage, the increased demand would bid up the price above A′, the sales at B′ would be increased and the demand lowered, and the supply at C lowered, until finally the interest returns were equalized. There is always a tendency for such equalization, and this equalization is actually completed in the ERE.

• 13The fact that consumers may physically consume all or part of these goods at a later date does not affect this conclusion, because any further consumption takes place outside the money nexus, and it is the latter that we are analyzing.
• 14No important complication arises from the greater degree of futurity of the higher-order factors. As we have indicated above, a more distantly future good will simply be discounted by the market by a greater amount, though at the same rate per annum. The interest rate, i.e., the discount rate of future goods per unit of time, remains the same regardless of the degree of futurity of the good. This fact serves to resolve one problem mentioned above—vertical integration by firms over one or more stages. If the equilibrium rate of interest is 5 percent per year, then a one-stage producer will earn 5 percent on his investment, while a producer who advances present goods over three stages—for three years—will earn 15 percent, i.e., 5 percent per annum.
• 15Very recently, greater realism has been introduced into social accounting by considering intercapitalist “money flows.”
• 16Problems of hoarding and dishoarding from the cash balance will be treated in chapter 11 on money and are prescinded from the present analysis.
• 17Cf. Knut Wicksell, Lectures on Political Economy (London: Routledge and Kegan Paul, 1934), I, 189–91.
• 18For more on the relations between the interest rate, i.e., the price spreads or margins, and the proportions invested and consumed, see below.
• 19On gross and net product, see Milton Gilbert and George Jaszi, “National Product and Income Statistics as an Aid in Economic Problems” in W. Fellner and B.F. Haley, eds., Readings in the Theory of Income Distribution (Philadelphia: Blakiston, 1946), pp. 44–57; and Simon Kuznets, National Income, A Summary of Findings (New York: National Bureau of Economic Research, 1946), pp. 111–21, and especially p. 120.
• 20If permanence is attributed to the mythical entity, the aggregate value of capital, it becomes an independent factor of production, along with labor, and earns interest.
• 21The fallacy of the “net” approach to capital is at least as old as Adam Smith and continues down to the present. See Hayek, Prices and Production, pp. 37–49. This book is an excellent contribution to the analysis of the production structure, gross savings and consumption, and in application to the business cycle, based on the production and business cycle theories of Böhm-Bawerk and Mises respectively. Also see Hayek, “The Mythology of Capital” in W. Fellner and B.F. Haley, eds., Readings in the Theory of Income Distribution (Philadelphia: Blakiston, 1946), pp. 355–83; idem, Profits, Interest, and Investment, passim.
• 22For a critique of the analogous views of J.B. Clark, see Frank A. Fetter, “Recent Discussions of the Capital Concept,” Quarterly Journal of Economics, November, 1900, pp. 1–14. Fetter succinctly criticizes Clark’s failure to explain interest on consumption goods, his assumption of a permanent capital fund, and his assumption of “synchronization” in production.
• 23Cf. Böhm-Bawerk, Positive Theory of Capital, pp. 299–322, 329–38.
• 24The rate of interest, however, will make a great deal of difference in so far as he is an owner and seller of a durable good. Land is, of course, durable almost by definition—in fact, generally permanent. So far, we have been dealing only with the sale of factor services, i.e., the “hire” or rent” of the factor, and abstracting from the sale or valuation of durable factors, which embody future services. Durable land, as we shall see, is “capitalized,” i.e., the value of the factor as a whole is the discounted sum of its future MVP’s, and there the interest rate will make a significant difference. The price of durable land, however, is irrelevant to the supply schedule of land services in demand for present money.
• 25Strictly, of course, the slope would not be constant, since the return is in equal percentages, not in equal absolute amounts. Slopes are treated as constant here, however, for the sake of simplicity in presenting the analysis.

When we state that the time-preference schedules of all individuals in the society determine the interest rate and the proportion of savings to consumption, we mean all individuals, and not some sort of separate class called “capitalists.” There is a temptation, since the production structure is analyzed in terms of different classes—landowners, laborers, and capitalists—to conclude that there are three definite stratified groups of people in society corresponding to these classifications. Actually, in economic analysis of the market we are concerned with functions rather than whole persons per se. In reality, there is no special class of capitalists set off from laborers and landowners. This is not simply due to the trite fact that even capitalists must also be consumers. It is also due to the more important fact that all consumers can be capitalists if they wish. They will be capitalists if their time-preference schedules so dictate. Time-market diagrams such as shown above apply to every man, and not simply to some select group known as capitalists. The interchange of the various aggregate supply and demand diagrams throughout the entire time market sets the equilibrium rate of interest on the market. At this rate of interest, some individuals will be suppliers of present goods, some will be demanders, the curves representing the supply and demand schedules of others will be coinciding with their line of origin and they will not be in the time market at all. Those whose time-preference schedules at this rate permit them to be suppliers will be the savers—i.e., they will be the capitalists.

The role of the capitalists will be clarified if we ask the question: Where did they get the money that they save and invest? First, they may have obtained it in what we might call “current” production; i.e., they could have received the money in their current capacities as laborers, landowners, and capitalists. After they receive the money, they must then decide how to allocate it among various lines of goods, and between consumption and investment. Secondly, the source of funds could have been money earned in past rounds of production and previously “hoarded,” now being “dishoarded.” We are, however, leaving out hoarding and dishoarding at this stage in the analysis. The only other source, the third source, is new money, and this too will be discussed later.

For the moment, therefore, we shall consider that the money from which savings derive could only have come from recent earnings from production. Some earnings were obtained as capitalists, and some as owners of original factors.

The reader might here have detected an apparent paradox: How can a laborer or a landowner be a demander of present goods, and then turn around and be a supplier of present goods for investment? This seems to be particularly puzzling since we have stated above that one cannot be a demander and a supplier of present goods at the same time, that one’s time-preference schedule may put one in one camp or the other, but not in both. The solution to this puzzle is that the two acts are not performed at the same time, even though both are performed to the same extent in their turn in the endless round of the evenly rotating economy.

Let us reproduce the typical individual time-preference schedule (Figure 48). At a market interest rate of 0A, the individual would supply savings of AB; at a market interest rate of 0C, he would demand money of amount CE. Here, however, we are analyzing more carefully the horizontal axis. The point 0 is the point of origin. It is the point at which the person deliberates on his course of action, i.e., the position he is in when he is consulting, so to speak, his time-preference scales.

Specifically, this is his position with respect to the size of his money stock at the time of origin. At point O, he has a certain money stock, and he is considering how much of his stock he is willing to give up in exchange for future goods or how much new stock he would like to acquire while giving up future goods. Suppose that he is a saver. As the curve moves to the right, he is giving up more and more of his present money stock in exchange for future goods; therefore, his minimum interest return becomes greater. The further the curve goes to the right, then, the lower will his final money stock be. On the other hand, consider the same individual when he is a demander of present goods. As the curve proceeds to the left, he increases his stock of present goods and gives up future goods. Considering both sides of the point of origin, then, we see that the further right the curve goes, the less stock he has; the further left, the greater his stock.

Given his time-preference schedule, therefore, he is bound to be in a greater supply position the more money he has, and in more of a demand position the less money he has. Before the laborer or landowner sells his services, he has a certain money stock—a cash balance that he apparently does not reduce below a certain minimum. After he sells his services, he acquires his money income from production, thereby adding to his money stock. He then allocates this income between consumption and savings-investment, and we are assuming no hoarding or dishoarding. At this point, then, when he is allocating, he is in a far different position and at a different point in time. For now he has had a considerable addition to his money stock.

Let us consider (Figure 49) the individual’s time-market graph with two different points of origin, i.e., two different sizes of money stock, one before he earns his income (I), and one immediately after (II).

Here we see how a laborer or a landowner can be a demander at one time, in one position of his money stock, and a supplier at another time. With very little money stock, as represented in the first diagram, he is a demander. Then, he acquires money in the productive arena, greatly increases his money stock, and therefore the point of origin of his decision to allocate his money income shifts to the left, so that he might well become a supplier out of his income. Of course, in many cases, he is still a demander or is not on the time market at all. To coin a phrase to distinguish these two positions, we may call his original condition a “pre-income position” (before he has sold his services for money), and the latter a “post-income position”—his situation when he is allocating his money income. Both points of origin are relevant to his real actions.

We have seen above that a landowner’s pre-income demand for money is likely to be practically inelastic, or vertical, while a laborer’s will probably be more elastic. Some individuals in a post-income position will be suppliers at the market rate of interest; some will be demanders; some will be neutral. The four diagrams in Figure 50 depict various pre-income and post-income time-preference situations, establishing individual time-market curves, with the same market rate of interest applied to each one.

The line AB, across the page, is our assumed market rate of interest, equilibrated as a result of the individual time-preference scales. At this rate of interest, the landowner and the laborer (I and II) are shown with demands for present money (pre-income), and diagrams III and IV depict a demander at this rate and a neutral at this rate, one who is moved neither to supply nor to demand money in the time market. Both the latter are in post-income situations.

We conclude that any man can be a capitalist if only he wants to be. He can derive his funds solely from the fruits of previous capitalist investment or from past “hoarded” cash balances or solely from his income as a laborer or a landowner. He can, of course, derive his funds from several of these sources. The only thing that stops a man from being a capitalist is his own high time-preference scale, in other words, his stronger desire to consume goods in the present. Marxists and others who postulate a rigid stratification—a virtual caste structure in society—are in grave error. The same person can be at once a laborer, a landowner, and a capitalist, in the same period of time.26

It might be argued that only the “rich” can afford to be capitalists, i.e., those who have a greater amount of money stock. This argument has superficial plausibility, since from our diagrams above we saw that, for any given individual and a given time-preference schedule, a greater money stock will lead to a greater supply of savings, and a lesser money stock to a lesser supply of savings. Ceteris paribus, the same applies to changes in money income, which constitute additions to stock. We cannot, however, assume that a man with (post-income) assets of 10,000 ounces of gold will necessarily save more than a man with 100 ounces of gold. We cannot compare time preferences interpersonally, any more than we can formulate interpersonal laws for any other type of utilities. What we can assert as an economic law for one person we cannot assert in comparing two or more persons. Each person has his own time-preference schedule, apart from the specific size of his monetary stock. Each person’s time-preference schedule, as with any other element in his value scale, is entirely of his own making. All of us have heard of the proverbially thrifty French peasant, compared with the rich playboy who is always running into debt. The common-sense observation that it is generally the rich who save more may be an interesting historical judgment, but it furnishes us with no scientific economic law whatever, and the purpose of economic science is to furnish us with such laws. As long as a person has any money at all, and he must have some money if he participates in the market society to any extent, he can be a capitalist.

• 26This Marxian error stemmed from a very similar error introduced into economics by Adam Smith. Cf. Ronald L. Meek, “Adam Smith and the Classical Concept of Profit,” Scottish Journal of Political Economy, June, 1954, pp. 138–53.

Up to this point we have analyzed the time-market demand for present goods by landowners and laborers, as well as the derived demand by capitalists. This aggregate demand we may call the producers’ demand for present goods on the time market. This is the demand by those who are selling their services or the services of their owned property in the advancing of production. This demand is all pre-income demand as we have defined it; i.e., it takes place prior to the acquisition of money income from the productive system. It is all in the form of selling factor services (future goods) in exchange for present money. But there is another component of net demand for present goods on the time market. This is the post-income component; it is a demand that takes place even after productive income is acquired. Clearly, this demand cannot be a productive demand, since owners of future goods used in production exercise that demand prior to their sale. It is, on the contrary, a consumers’ demand.

This subdivision of the time market operates as follows: Jones sells 100 ounces of future money (say, one year from now) to Smith in exchange for 95 ounces of present money. This future money is not in the form of an expectation created by a factor of production; instead, it is an I.O.U. by Jones promising to pay 100 ounces of money at a point one year in the future. He exchanges this claim on future money for present money—95 ounces. The discount on future money as compared with present money is precisely equivalent to that in the other parts of the time market that we have studied heretofore, except that the present case is more obvious. The rate of interest finally set on the market is determined by the aggregate net supply and net demand schedules throughout the entire time market, and these, as we have seen, are determined by the time preferences of all the individuals on the market. Thus, in the case of Figure 50 above, in diagram III we have a case of a net (post-income) demander at the market rate of interest The form that his demand takes is the sale of an I.O.U. of future money—usually termed the “borrowing” of present money. On the other hand, the person whose time-market curve is shown in diagram IV has such a time-preference configuration that he is neither a net supplier nor a net demander at the going rate of interest—he is not on the time market at all—in his post-income position.

The net borrowers, then, are people who have relatively higher time-preference rates than others at the going rate of interest, in fact so high that they will borrow certain amounts at this rate. It must be emphasized here that we are dealing only with consumption borrowing—borrowing to add to the present use of Jones’ money stock for consumption. Jones’ sale of future money differs from the sales of the landowners and laborers in another respect; their transactions are completed, while Jones has not yet completed his. His I.O.U. establishes a claim to future money on the part of the buyer (or “lender”) Smith, and Smith, to complete his transaction and earn his interest payment, must present his note at the later date and claim the money due.

In sum, the time market’s components are as follows:

These demands are aggregated without regard to whether they are post- or pre-income; they both occur within a relatively brief time period, and they recur continually in the ERE.

Although the consumption and the productive demands are aggregated to set the market rate of interest, a point of great importance for the productive system is revealed if we separate these demands analytically. The diagram in Figure 51 depicts the establishment of the rate of interest on the time market.

The vertical axis is the rate of interest; the horizontal axis is gold ounces. The SS curve is the supply-of-savings schedule, determined by individual time preferences. The CC curve is the schedule of consumers’ loan demands for present goods, consisting of the aggregate net demand (post-income) at the various hypothetical rates of interest. The DD curve is the total demand for present goods by suppliers of future goods, and it consists of the CC curve plus a curve that is not shown—the demand for present goods by the owners of original productive factors, i.e., land and labor. Both the CC and the DD curves are determined by individual time preferences. The equilibrium rate of interest will be set by the market at the point of intersection of the SS and DD curves—point E.

The point of intersection at E determines two important resultants: the rate of interest, which is established at 0A, and the total supply of savings AE. A vital matter for the productive system, however, is the position of the CC curve: the larger CC is at any given rate of interest, the larger the amount of total savings that will be competed for and drawn away from production into consumers’ loans. In our diagram, the total savings going into investment in production is BE.

The relative strength of productive and consumption demand for present goods in the society depends on the configurations of the time-preference schedules of the various individuals on the market. We have seen that the productive demand for present goods tends to be inelastic with respect to interest rates; on the other hand, the consumers’ loan curve will probably display greater elasticity. It follows that, on the demand side, changes in time preferences will display themselves mostly in the consumption demand schedule. On the supply side, of course, a rise in time preferences will lead to a shift of the SS curve to the left, with less being saved and invested at each rate of interest. The effects of time-preference changes on the rate of interest and the structure of production will be discussed further below.

It is clear that the gross savings that maintain the production structure are the “productive” savings, i.e., those that go into productive investment, and that these exclude the “consumption” savings that go into consumer lending. From the point of view of the production system, we may regard borrowing by a consumer as dissaving, for this is the amount by which a person’s consumption expenditures exceed his income, as contrasted to savings, the amount by which a person’s income exceeds his consumption. In that case, the savings loaned are canceled out, so to speak, by the dissavings of the consumption borrowers.

The consumers’ and producers’ subdivisions of the time market are a good illustration of how the rate of interest is equalized over the market. The connection between the returns on investment and money loans to consumers is not an obvious one. But it is clear from our discussion that both are parts of one time market. It should also be clear that there can be no long-run deviation of the rate of interest on the consumption loan market from the rate of interest return on productive investment. Both are aspects of one time market. If the rate of interest on consumers’ loans, for example, were higher than the rate of interest return from investment, savings would shift from buying future goods in the form of factors to the more remunerative purchase of I.O.U.’s. This shift would cause the price of future factors to fall, i.e., the interest rate in investment to rise; and the rate of interest on consumers’ loans to fall, as a result of the competition of more savings in the consumer loan arena. The everyday arbitrage of the market, then, will tend to equalize the rate of interest in both parts of the market. Thus, the rate of interest will tend to be equalized for all areas of the economy, as it were in three dimensions—”horizontally” in every process of production, “vertically” at every stage of production, and “in depth,” in the consumer loan market as well as in the production structure.

We have completed our analysis of the determination of the pure rate of interest as it would be in the evenly rotating economy—a rate that the market tends to approach in the real world. We have shown how it is determined by time preferences on the time market and have seen the various components of that time market. This statement will undoubtedly be extremely puzzling to many readers. Where is the producers’ loan market? This market is always the one that is stressed by writers, often to the exclusion of anything else. In fact, “rate of interest” generally refers to money loans, including loans to consumers and producers, but particularly stressing the latter, which is usually quantitatively greater and more significant for production. The rate of interest of money loans to the would-be producer is supposed to be the significant rate of interest. In fact, the fashionable neoclassical doctrine holds that the producers’ loan market determines the rate of interest and that this determination takes place as in Figure 52, where SS is the supply of savings entering the loan market, and DD is the demand for these loans by producers or entrepreneurs. Their intersection allegedly determines the rate of interest.

It will be noticed that this sort of approach completely overlooks the gross savings of the producers and, even more, the demand for present goods by owners of the original factors. Instead of being fundamentally suppliers of present goods, capitalists are portrayed as demanders of present goods. What determines the SS and DD schedules, according to this neoclassical doctrine? The SS curve is admittedly determined by time preferences; the DD curve, on the other hand, is supposed to be determined by the “marginal efficiency of capital,” i.e., by the expected rate of return on the investment.

This approach misses the point very badly because it looks at the economy with the superficial eye of an average businessman. The businessman borrows on a producers’ loan market from individual savers, and he judges how much to borrow on the basis of his expected rate of “profit,” or rate of return. The writers assume that he has available a shelf of investment projects, some of which would pay him, say 8 percent, some 7 percent, some 3 percent, etc., and that at each hypothetical interest rate he will borrow in order to invest in those projects where his return will be as high or higher. In other words, if the interest rate is 8 percent, he will borrow to invest in those projects that will yield him over 8 percent; if the rate is 4 percent, he will invest in many more projects—those that will yield him over 4 percent, etc. In that way, the demand curve for savings, for each individual, and still more for the aggregate on the market, will slope rightward as demand curves usually do, as the rate of interest falls. The intersection sets the market rate of interest.

Superficially, this approach might seem plausible. It usually happens that a businessman foresees such varying rates of return on different investments, that he borrows on the market from different individual savers, and that he is popularly considered the “capitalist” or entrepreneur, while the lenders are simply savers. This lends plausibility to terming the DD curve in Figure 52, the demand by capitalists or entrepreneurs for money (present goods). And it seems to avoid mysterious complexities and to focus neatly and simply on the rate of interest for producers’ loans—the loans from savers to businessmen—in which they and most writers on economics are interested. It is this rate of interest that is generally discussed at great length by economists.

Although popular, this approach is wrong through and through, as will be revealed in the course of this analysis. In the first place, let us consider the construction of this DD curve a little more closely. What is the basis for the alleged shelf of available projects, each with different rates of return? Why does a particular investment yield any net monetary return at all? The usual answer is that each dose of new investment has a “marginal value productivity,” such as 10 percent, 9 percent, 4 percent, etc., that naturally the most productive investments will be made first and that therefore, as savings increase, further investments will be less and less value-productive. This provides the basis for the alleged “businessman’s demand curve,” which slopes to the right as savings increase and the interest rate falls. The cardinal error here is an old one in economics—the attribution of value-productivity to monetary investment. There is no question that investment increases the physical productivity of the productive process, as well as the productivity per man hour. Indeed, that is precisely why investment and the consequent lengthening of the periods of production take place at all. But what has this to do with value-productivity or with the monetary return on investment, especially in the long run of the ERE?

Suppose, for example, that a certain quantity of physical factors (and we shall set aside the question of how this quantity can be measured) produces 10 units of a certain product per period at a selling price of two gold ounces per unit. Now let us postulate that investment is made in higher-order capital goods to such an extent that productivity multiplies fivefold and that the same original factors can now produce 50 units per period. The selling price of the larger supply of product will be less; let us assume that it will be cut in half to one ounce per unit. The gross revenue per period is increased from 20 to 50 ounces. Does this mean that value-productivity has increased two and a half times, just as physical productivity increased fivefold? Certainly not! For, as we have seen, producers benefit, not from the gross revenue received, but from the price spread between their selling price and their aggregate factor prices. The increase in physical productivity will certainly increase revenue in the short run, but this refers to the profit-and-loss situations of the real world of uncertainty. The long-run tendency will be nothing of the sort. The long-run tendency, eventuating in the ERE, is toward an equalization of price spreads. How can there be any permanent benefit when the cumulative factor prices paid by this producer increase from, say, 18 ounces to 47 ounces? This is precisely what will happen on the market, as competitors vie to invest in these profitable situations. The price spread, i.e., the interest rate, will again be 5 percent.

Thus the productivity of production processes has no basic relation to the rate of return on business investment. This rate of return depends on the price spreads between stages, and these price spreads will tend to be equal. The size of the price spread, i.e., the size of the interest rate, is determined, as we have seen at length, by the time-preference schedules of all the individuals in the economy.

In sum, the neoclassical doctrine maintains that the interest rate, by which is largely meant the producers’ loan market, is co-determined by time preference (which determines the supply of individual savings) and by marginal (value) productivity of investment (which determines the demand for savings by businessmen), which in turn is determined by the rates of return that can be achieved in investments. But we have seen that these very rates of return are, in fact, the rate of interest and that their size is determined by time preferences. The neoclassicists are partly right in only one respect—that the rate of interest in the producers’ loan market is dependent on the rates of return on investment. They hardly realize the extent of this dependence, however. It is clear that these rates of return, which will be equalized into one uniform rate, constitute the significant rate of interest in the production structure.27 ,28

Discarding the neoclassical analysis, we may ask: What, then, is the role of the productive loan market and of the rate of interest set therein? This role is one of complete and utter dependence on the rate of interest as determined above, and manifesting itself, as we have seen, in the rate of investment return, on the one hand, and in the consumers’ loan market, on the other. These latter two markets are the independent and important subdivisions of the general time market, with the former being the important market for the production system.

In this picture, the producers’ loan market has a purely subsidiary and dependent role. In fact, from the point of view of fundamental analysis, there need not be any producers’ loan market at all. To examine this conclusion, let us consider a state of business affairs without a producers’ loan market. What is needed to bring this about? Individuals save, consuming less than their income. They then directly invest these savings in the production structure, the incentive for investment being the rate of interest return—the price spread—on the investment. This rate is determined, along with the rate on the consumers’ loan market, by the various components of the time market that we have portrayed above. There is, in that case, no producers’ loan market. There are no loans from a saving group to another group of investors. And it is clear that the rate of interest in the production structure still exists; it is determined by factors that have nothing to do with the usual discussion by economists of the producers’ loan market.

• 27For brilliant dissections of various forms of the “productivity” theory of interest (the neoclassical view that investment earns an interest return because capital goods are value-productive), see the following articles by Frank A. Fetter: “The Roundabout Process of the Interest Theory,” Quarterly Journal of Economics, 1902, pp. 163–80, where Böhm-Bawerk’s highly unfortunate lapse into a productivity theory of interest is refuted; “Interest Theories Old and New,” pp. 68–92, which presents an extensive development of time-preference theory, coupled with a critique of Irving Fisher’s concessions to the productivity doctrine; also see “Capitalization Versus Productivity, Rejoinder,” American Economic Review, 1914, pp. 856–59, and “Davenport’s Competitive Economics,” Journal of Political Economy, 1914, pp. 555–62. Fetter’s only mistake in interest theory was to deny Fisher’s assertion that time preference (or, as Fisher called it, “impatience”) is a universal and necessary fact of human action. For a demonstration of this important truth, see Mises, Human Action, pp. 480 ff.
• 28On Keynes’ failure to perceive this point, see p. 371 of this chapter, note 5 above.

It is clear that, far from being the centrally important element, the producers’ loan market is of minor importance, and it is easy to postulate a going productive system with no such market at all. But, some may reply, this may be all very well for a primitive economy where every firm is owned by just one capitalist-investor, who invests his own savings. What happens in our modern complex economy, where savings and investment are separated, are processes engaged in by different groups of people—the former by scattered individuals, the latter by relatively few directors of firms? Let us, therefore, now consider a second possible situation. Up to this point we have not treated in detail the question whether each factor or business was owned by one person or jointly by many persons. Now let us consider an economy in which factors are jointly owned by many people, as largely happens in the modern world, and we shall see what difference this makes in our analyses.

Before studying the effect of such jointly owned companies on the producers’ loan market, we must digress to analyze the nature of these companies themselves. In a jointly owned firm, instead of each individual capitalist’s making his own investments and making all his own investment and production decisions, various individuals pool their money capital in one organization, or business firm, and jointly make decisions on the investment of their joint savings. The firm then purchases the land, labor, and capital-goods factors, and later sells the product to consumers or to lower-order capitalists. Thus, the firm is the joint owner of the factor services and particularly of the product as it is produced and becomes ready for sale. The firm is the product-owner until the product is sold for money. The individuals who contributed their saved capital to the firm are the joint owners, successively, of: (a) the initial money capital—the pooled savings, (b) the services of the factors, (c) the product of the factors, and (d) the money obtained from the sale of the product. In the evenly rotating economy, their ownership of assets follows this same step-by-step pattern, period after period, without change. In a jointly owned firm, in actual practice, the variety of productive assets owned by the firm is large. Any one firm is usually engaged in various production processes, each one involving a different period of time, and is likely to be engaged in different stages of each process at any one particular time. A firm is likely to be producing so that its output is continuous and so that it makes sales of new units of the product every day.

It is obvious, then, that if the firm keeps continually in business, its operations at any one time will be a mixture of investment and sale of product. Its assets at any one time will be a mixture of cash about to be invested, factors just bought, hardly begun products, and money just received from the sale of products. The result is that, to the superficial, it looks as if the firm is an automatically continuing thing and as if the production is somehow timeless and instantaneous, ensuing immediately after the factor input.

Actually, of course, this idea is completely unfounded. There is no automatic continuity of investment and production. Production is continued because the owners are continually making decisions to proceed; if they did not think it profitable to do so, they could and do at any point alter, curtail, or totally cease operations and investments. And production takes time from initial investment to final product.

In the light of our discussion, we may classify the types of assets owned by any firm (whether jointly or individually owned) as follows:

On this entire package of assets, a monetary evaluation is placed by the market. How this is done will be examined in detail later.

At this point, let us revert to the simple case of a one-shot investment, an investment in factors on one date, and the sale of the resulting product a year later. This is the assumption involved in our original analysis of the production structure; and it will be seen below that the same analysis can be applied to the more complex case of a melange of assets at different stages of production and even to cases where one firm engages in several different production processes and produces different goods. Let us consider a group of individuals pooling their saved money capital to the extent of 100 ounces, purchasing factors with the 100 gold ounces, obtaining a product, and selling the product for 105 ounces a year later. The rate of interest in this society is 5 percent per annum, and the rate of interest return on this investment conforms with this condition. The question now arises: On what principle do the individual owners mutually apportion their shares of the assets? It will almost always be the case that every individual is vitally interested in knowing his share of the joint assets, and consequently firms are established in such a way that the principle of apportionment is known to all the owners.

At first one might be inclined to say that this is simply a case of bargaining, as in the case of the product jointly owned by all the owners of the factors. But the former situation does not apply here. For in the case discussed above, there was no principle whereby any man’s share of ownership could be distinguished from that of anyone else. A whole group of people worked, contributed their land, etc., to the production process, and there was no way except simple bargaining by which the income from the sale of the product could be apportioned among them. Here, each individual is contributing a certain amount of money capital to begin with. Therefore, the proportions are naturally established from the outset. Let us say that the 100 ounces of capital are contributed by five men as follows:

A .......... 40 oz.
B .......... 20 oz.
C .......... 20 oz.
D .......... 15 oz.
E ............ 5 oz.

In other words, A contributes 40 percent of the capital, B 20 percent, C 20 percent, D 15 percent, E 5 percent. Each individual owner of the firm then owns the same percentage of all the assets that he contributed in the beginning. This holds true at each step of the way, and finally for the money obtained from the sale of the product. The 105 ounces earned from the sale will be either reinvested in or “disinvested” from the process. At any rate, the ownership of these 105 ounces will be distributed in the same percentages as the capital invested.

This natural structure of a firm is essentially the structure of a joint-stock company. In the joint-stock company, each investor-owner receives a share—a certification of ownership in proportion to the amount he has invested in the total capital of the company. Thus, if A, B, ... E above form a company, they may issue 100 shares, each share representing a value, or an asset, of one ounce. A will receive 40 shares; B, 20 shares; C, 20 shares, etc. After the sale of the product, each share will be worth 5 percent more than its original, or par, value.

Suppose that after the sale, or indeed at any time before the sale, another person, F, wishes to invest in this company. Suppose that he wishes to invest 30 ounces of gold. In that case, the investment of money savings in the company increases from 100 (if before the sale) or 105 (if after the sale) by 30 ounces. Thirty new shares will be issued and turned over to F, and the capital value of the firm increases by 30 ounces. In the vast majority of cases where reinvestment of monetary revenue is going on continuously, at any point in time the capital value of a firm’s assets will be the appraised value of all the productive assets, including cash, land, capital goods, and finished products. The capital value of the firm is increased at any given time by new investment and is maintained by the reinvestments of the owners after the finished product is sold.

The shares of capital are generally known as stock; the total par value of capital stock is the amount originally paid in on the formation of the company. From that point on, the total capital value of assets changes as income is earned, or, in the world of uncertainty, as losses are suffered, and as capital is reinvested or withdrawn from the company. The total value of capital stock changes accordingly, and the value of each share will differ from the original value accordingly.

How will the group of owners decide on the affairs of the company? Those decisions that must be made jointly will be made by some sort of voting arrangement. The natural voting arrangement, which one would expect to be used, is to have one vote per share of voting stock, with a majority of the votes deciding. This is precisely the arrangement used in the joint-stock company and its modern form, the corporation.

Of course, some joint-stock company arrangements differ from this, according to the desires of the owners. Partnerships can be worked out between two or more people on various principles. Usually, however, if one partner receives more than his proportionate share of invested capital, it is because he is contributing more of his labor or his land to the enterprise and gets paid accordingly. As we shall see, the rate paid to the labor of the “working partner” will be approximately equal to what he could earn in labor elsewhere, and the same is true for payment to the land or any other originally owned factor contributed by a partner. Since partnerships are almost always limited to a few, the relationships are more or less informal and need not have the formal patterns of the joint-stock company. However, partnerships will tend to work quite similarly. They provide more room for idiosyncratic arrangements. Thus, one partner may receive more than his share of capital because he is loved and revered by the others; this is really in the nature of a gift to him from the rest of the partners. Joint-stock companies hew more closely to a formal principle.

The great advantage of the joint-stock company is that it provides a more ready channel for new investments of saved capital. We have seen how easy it is for new capital to be attracted through the issuance of new shares. It is also easier for any owner to withdraw his capital from the firm. This greater ease of withdrawal vastly increases the temptation to invest in the company. Later on we shall explore the pricing of stock shares in the real world of uncertainty. In this real world, there is room for great differences of opinion concerning the appraised value of a firm’s assets, and therefore concerning the monetary appraised value of each share of the firm’s stock. In the evenly rotating economy, however, all appraisals of monetary value will agree—the principles of such appraisal will be examined below—and therefore the appraised value of the shares of stock will be agreed upon by all and will remain constant.

While the share market of joint-stock companies provides a ready channel for accumulating savings, the share market is strictly dependent on the price spreads. The savings or dissavings of capitalists are determined by time preferences, and the latter establish the price spread in the economy. The value of capital invested in the enterprise, i.e., its productive assets, will be the sum of future earnings from the capital discounted by the rate of interest. If the price spreads are 5 percent, the rate of interest return yielded on the share market (the ratio of earnings per share to the market price of the share) will tend to equal the rate of interest as determined elsewhere on the time market—in this case, 5 percent.

We still have a situation in which capitalists supply their own saved capital, which is used to purchase factors in expectation of a net monetary return. The only complications that develop from joint-stock companies or corporations are that many capitalists contribute and own the firm’s assets jointly and that the price of a certain quantum of ownership will be regulated by the market so that the rate of interest yield will be the same for each individual share of stock as it is for the enterprise as a whole. If the whole firm buys factors for a total price of 100 and sells the product a year later for 105, for a 5-percent return, then, say, 1/5 of the shares of ownership of this firm will sell for an aggregate price of 20 and earn an annual net return of one ounce. Thus, the rates of interest for the partial shares of capital will all tend to be equal to the rate of interest earned on the entire capital.29

Majority rule in the joint-stock companies, with respect to total shares owned, does not mean that the minority rights of owners are overridden. In the first place, the entire pooling of resources and the basis on which it is worked out are voluntary for all parties concerned. Secondly, all the stockholders, or owners, have one single interest in common—an increase in their monetary return and assets, although they may, of course, differ concerning the means to achieve this goal. Thirdly, the members of the minority may sell their stock and withdraw from the company if they so desire.

Actually, the partners may arrange their voting rights and ownership rights in any way they please, and there have been many variations of such arrangements. One such form of group ownership, in which each owner has one vote regardless of the number of shares he owns, has absurdly but effectively arrogated to itself the name of “co-operative.” It is obvious that partnerships, joint-stock companies, and corporations are all eminently co-operative institutions.30

Many people believe that economic analysis, while applicable to individually owned firms, does not hold true for the modern economy of joint-stock companies. Nothing could be further from the truth. The introduction of corporations has not fundamentally changed our analysis of the interest rate or the savings-investment process. What of the separation of “management” from ownership in a corporation? It is certainly true that, in a joint-stock firm, the owners hire managerial labor to supervise their workers, whereas individual owners generally perform their own managerial labor. A manager is just as much a hired laborer as any other worker. The president of a company, just like the ditch digger, is hired by the owners; and, like the ditch digger, he expends labor in the production process. The price of managerial labor is determined in the same way as that of other labor, as will be seen below. On the market, the income to an independent owner will also include the going wage for that type of managerial labor, which joint-stock owners, of course, will not receive. Thus, we see that, far from rendering economic analysis obsolete, the modern world of the corporation aids analysis by separating and simplifying functions in production—specifically, the managerial function.

In addition to the capital-supplying function, the corporate capitalists also assume the entrepreneurial function: the crucial directing element in guiding the processes of production toward meeting the desires of the consumers. In the real world of uncertainty, it takes sound judgment to decide how the market is operating, so that present investment will lead to future profits, and not future losses. We shall deal further with the nature of profit and loss, but suffice it to say here that the active entrepreneurial element in the real world is due to the presence of uncertainty. We have been discussing the determination of the pure rate of interest, the rate of interest as it always tends to be and as it will be in the certain world of the ERE. In the ERE, where all techniques, market demands and supplies, etc., for the future are known, the investment function becomes purely passive and waiting. There might still be a supervisory or managerial labor function, but this can be analyzed under prices of labor factors. But there will no longer be an entrepreneurial function because future events are known.

Some have maintained, finally, that joint-stock companies make for a separation of savings and investment. Stockholders save, and the managers do the investing. This is completely fallacious. The managers are hired agents of the stockholders and subject to the latters’ dictation. Any individual stockholder not satisfied with the decisions of the majority of owners can dispose of his ownership share. As a result, it is effectively the stockholders who save and the stockholders who invest the funds.31

Some people maintain that since most stockholders are not “interested” in the affairs of their company, they do not effectively control the firm, but permit control to pass into the hands of the hired managers. Yet surely a stockholder’s interest is a matter of his own preference and is under his own control. Preferring his lack of interest, he permits the managers to continue their present course; the fundamental control, however, is still his, and he has absolute control over his agents.21 A typical view asserts:

The maximizing of dividend income for stockholders as a group is not an objective that is necessarily unique or paramount. Instead, management officials will seek to improve the long-run earnings and competitive position of the firm and their own prestige as managers.33

But to “improve the long-run earnings” is identical with maximizing stockholders’ income, and what else can develop the “prestige” of managers? Other theorists lapse into the sheer mysticism of considering the “corporation”—a conceptual name which we give to an institution owned by real individuals—as “really” existing and acting by itself.34

• 29The shares of stock, or the units of property rights,
  have the characteristic of fungibility; one unit is exactly the same as another. ... We have a mathematical division of the one set of rights. This fungible quality makes possible organized commodity and security markets or exchanges. ... With these fungible units of ... property rights we have a possible acceleration of changes of ownership and in membership of the groups. ... If a course of market dealings arises, the unit of property has a swift cash conversion value. Its owner may readily resume the cash power to command the uses of wealth. (Hastings Lyon, Corporations and their Financing , p. 11)Thus, shares of property as well as total property have become readily marketable.
• 30The literature on the so-called “co-operative movement” is of remarkably poor quality. The best source is Co-operatives in the Petroleum Industry, K.E. Ettinger, ed. (New York: Petroleum Industry Research Foundation, 1947), especially pt. I, Ludwig von Mises, “Observations on the Co-operative Movement.”
• 31See Mises, Human Action, pp. 301–05, 703–05.
• 21The proxy fights of recent years simply give dramatic evidence of this control.
• 33Edgar M. Hoover, “Some Institutional Factors in Business Decisions,” American Economic Review, Papers and Proceedings, May, 1954, p. 203.
• 34For example, see Gerhard Colm, “The Corporation and the Corporation Income Tax in the American Economy,” American Economic Review, Papers and Proceedings, May, 1954, p. 488.

We are now ready to embark on an analysis of the effect of joint-stock companies on the producers’ loan market.

Let us take the aforementioned firm with a total capital stock and capital value of 130 ounces and owned by six stockholders. The firm earns a net income of 5 percent per year for its owners, and this is the interest rate earned by all the firms in the economy.

We have already seen how the firm expanded its capital by 30 ounces through the sale of new capital stock to F. Let us see what happens when a productive loan is made. Suppose that the firm borrows 20 ounces from the producers’ loan market for a five-year period. What has happened? The firm has exchanged a future good—a promise to pay money in the future—for present money. The present money has been supplied by a saver, G. It is clear that G has done the saving and is the capitalist in this transaction, while the joint stockholders A–F are here supplying future goods; and further, it is the stockholders who invest the new capital in the production system. On the surface, this seems to be a positive case of the separation of savings and investment.

However, let us look at the transaction further. G has supplied new capital, worth 20 ounces, to the firm, for a five-year period. The owners A–F take this new capital and invest it in future goods, i.e., factors of production. In other words, to the extent of 20 ounces, A–F are intermediary investors of the savings of the creditors. What will the rate of interest on this loan be? It is obvious that this rate of interest in the ERE, will be equal to 5 percent, i.e., it will be purely dependent on the rate of interest return that prevails in the price spreads of the production structure. The reason for this should be clear. We have already seen how the interest rate is determined in the production structure; we have assumed it to be 5 percent everywhere. Now, suppose that the firm offers to pay G 3 percent on the loan. Clearly, G will not lend the firm 20 ounces for a 3-percent return when he could get 5 percent as a stockholder either in the same firm or in any other firm. On the other hand, the firm is in no position to pay G any more than 5 percent, since its net return on the investment will be only 5 percent. If the maximum that the firm can pay in interest is 5 percent, and the minimum that the creditor can accept is 5 percent, it is obvious that the transaction will take place at 5 percent.

It is clear that, in essence, G, the creditor on the prospective loan market, is no different from F, the man who has invested in stock. Both have saved money instead of spending it on consumption, and both wish to sell their saved capital in exchange for future goods and to earn interest. The time-preference schedules of both F and G, as well as of everyone else, are aggregated on the time market to arrive at the rate of interest; both F and G are net savers at the market rate. The interest rate, then, is determined by the various time-preference schedules, and the final rate is set by the saving schedules, on the one hand, and by the demand-for-present-goods schedules, on the other. The demand schedules consist (and consist only) of the productive demand by laborers and landowners and the consumption demand by borrowing consumers. F and G are both net savers, interested in investing their capital for the highest return. There is no essential difference between F’s method of investing his capital and G’s method of investing his; the difference between investing in stock and lending money to firms is mainly a technical one. The separation between saving and investment that occurs in the latter case is completely unimportant. The interest return on investment, as set by total savings and total demands by owners of factors, completely determines the rate of interest on the producers’ loan market as well as the rate of earning on stock. The producers’ loan market is totally unimportant from the point of view of fundamental analysis; it is even useless to try to construct demand and supply schedules for this market, since its price is determined elsewhere.35 Whether saved capital is channeled into investments via stocks or via loans is unimportant. The only difference is in the legal technicalities. Indeed, even the legal difference between the creditor and the owner is a negligible one. G’s loan has increased the capital value of the assets in the firm from 130 to 150. The invested 150 pays 5 percent, or 7.5 ounces per year. Let us examine the situation and see who the actual owners of this capital are (see Figure 53).

In this diagram, the left-hand rectangle represents assets at any one point in time. We see in the right-hand rectangle that 130 ounces of these assets is represented by owners’ capital, and 20 by liabilities—i.e., by I.O.U.’s due to creditors. But what does this “representation” mean?

It means that if, for example, the firm were to liquidate and go out of business, 20 ounces of its assets would be used to pay off the creditors, and 130 would go to the legal owners. It means, further, that of the seven and a half ounces paid out as net earnings per year, six and a half ounces go to the legal owners and one ounce to the creditors, each being 5 percent of their saving. In fact, each group gets 5 percent on its investment, for are not the creditors just as much investors as the stockholders? In fact, are not the creditors the owners of 20 ounces’ worth of the firm’s assets, and do they not own the pro rata earnings of those 20 ounces? What functions of ownership do the creditors not have as compared to the stockholders? Even from the legal point of view, the creditors get first claim on the assets of a corporation, and they get paid before the stockholders. They are therefore definitely owners of these assets. It might be stated that since they are not shareholders, they do not vote on the decisions of the corporation, but there are many situations in which joint-stock companies issue nonvoting shares, the holders of which do not vote on company affairs, even though they receive their prorata value of the earnings.

We must conclude that economically and even in basic law, there is no difference between shareholders and productive creditors; both are equally suppliers of capital, both receive interest return as determined on the general time market, both own their proportionate share of the company’s assets. The differences between the two are only technical and semantic. It is true that our discussion has so far applied only to the evenly rotating economy, but we shall see that the real world of uncertainty and entrepreneurship, while complicating matters, does not change the essentials of our analysis.36

In recent writings there has been a growing acknowledgment of the essential identity between shareholders and creditors, in contrast to the old tradition that postulated a sharp cleavage between them. But it is curious that the new literature interprets the identity in precisely the wrong way: instead of treating the creditors like shareholder-owners, it treats the shareholders like creditors. In other words, the correct approach is to consider creditors as actually part owners of the firm; but the new literature treats stockholders as merely creditors of the firm, in keeping with the new tradition of picturing the hired managers as its real controllers and owners. Managers are depicted as somehow owning the firm and paying out interest to creditors, as well as dividends to stockholders, just as any factor payment is made—as a grudging cost of production. In reality, the managers are only the hired agents of the stockholders, and it is the latter who decide how much of their earnings to reinvest in the firm and how much to “take out of the firm” in the form of “dividends.”

The commonly made distinction between “dividends” and “retained earnings” is not a useful one for the purposes of economic analysis. Retained earnings are not necessarily reinvested; they may be held out of investment in a cash balance and later paid out as dividends. Dividends, on the other hand, are not necessarily spent on consumption; they may be invested in some other firm. Therefore, this distinction is a misleading one. Earnings are either reinvested or they are not; and all corporate earnings constitute earnings of the individual owners.

Savings may be channeled through intermediaries before entering the actual producers’ loan (or the consumers’ loan) market. Finding a productive investment is one of the tasks of entrepreneurs, and it is often far more convenient for all concerned when the individual, instead of making up his mind himself on the proper channels of investment, lends or invests his money in other institutions specially set up to be experts in investment. These institutions may serve as channels, gathering in the small savings of isolated individuals, whose investments by themselves are too small to be worth the cost of finding a market for them. The institutions then invest the funds knowledgeably in larger lump sums. A typical example is the investment trust, which sells its own stock to individuals and then uses this capital to buy stock of other companies. In the ERE, the interest that will be earned from individuals’ savings via intermediaries will equal the interest earned from direct investments minus the cost of the intermediary’s service, this price to be determined on the market just like other prices. Thus, if the interest rate throughout the market is 5 percent, and the cost of intermediary service is 1 percent, then, in the ERE, those who channel their savings via the convenient intermediary method will receive a 4-percent interest return on the investment of their savings.

We have thus seen the unimportance of the producers’ loan market as an independent determining factor in the establishment of the market rate of interest or in the productive system.

In many cases it is convenient to designate by different terms the rate of interest on contractual loan markets and the rate of interest in the form of earnings on investments as a result of price spreads. The former we may call the contractual rate of interest (where the interest is fixed at the time of making the contract), and the latter the natural rate of interest (i.e., the interest comes “naturally” via investments in production processes, rather than being officially included in an exchange contract). The two interest rates will, of course, coincide in the ERE.

Throughout our analysis we have been making one underlying assumption that might be modified: that individuals will always try to obtain the highest interest return. It is on this basis that we have traced the arbitrage actions and eventual uniformities of the ERE. We have assumed that each investor will try to earn as much as he can from his investment. This might not always be true, and critics of economics have never tired of reproaching economists for neglecting other than monetary ends. Economics does not neglect such ends, however. In fact, praxeological analysis explicitly includes them. As we have repeatedly pointed out, each individual attempts to maximize his psychic income, and this will translate itself into maximizing his monetary income only if other psychic ends are neutral. The ease with which economics can accommodate nonmonetary ends may readily be seen. Suppose that the interest rate in the society is 5 percent. Suppose, however, that there is a line of production that is distasteful to a large number of people, including investors. In a society, for example, where the making of arms is held in disfavor, simple arbitrage would not work to equate returns in the armament industry with those in other industries. We are not here referring to the displeasure of consumers of arms, which would, of course, reflect itself in a lowered demand for the product. We are referring to the particular displeasure of producers, specifically investors. Because of this psychic dislike, investors will require a higher return in the armament industry than in other industries. It is possible, for example, that they might require an interest return of 10 percent in the armament industry, even though the general rate of interest is 5 percent. What factors, then, will have to pay for this increased discount? We are not overly anticipating the results of our subsequent analysis if we state that the owners of nonspecific factors, i.e., those factors which can be employed elsewhere (or, strictly, the services of which can thus be employed) will certainly not accept a lower monetary return in the armament industry than in the other industries. In the ERE, their prices as determined in this industry will, then, be the same as in the other industries. In fact, they might be even higher, if the owners share the investors’ specific antipathy toward engaging in the armament industry. The burden of the lower prices at each stage of production, then, falls on the purely specific factors in the industry, those which must be devoted to this industry if they are to be in the production system at all. In the long run of the ERE, these will not be capital goods, since capital goods always need to be reproduced, and the equivalent resources can gradually or rapidly leave the industry, depending in each case on the durability of the capital good and the length of the process of its production. The specific factor may be labor, but this is not empirically likely, since labor is almost always a nonspecific factor that may shift to several occupations. It is therefore likely to be specific land factors that bear the brunt of the lower return.

The opposite will occur in the case of an industry that most investors specifically are very eager to engage in for one reason or another. In that case, they will accept a lower interest return in this production process than in others. The force of competition on the market will, once again, keep nonspecific factors at the same price from industry to industry, although the price might be lower if the factor-owners were also particularly eager to work in this industry. The higher prices at the various stages are therefore reaped by the owners of specific factors, generally land factors.

The rate of interest, then, always tends toward equality throughout its various submarkets and in its various forms. In the ERE, the rates will be uniformly equal throughout. This conclusion must be modified, however, to state that the rates of interest will differ in accordance with a “psychic” component, either positive or negative, depending on whether there is an acute dislike or liking among investors for a particular production process.37 We may say that, in the case of a particular liking, the investors are “consuming” the enjoyment of investing in the particular process and paying the price of a lower return; in the case of a particular dislike, they are charging more for a particular disutility. It must be emphasized, however, that these differences in return do not occur if merely one person particularly likes or dislikes a certain field, but only if there is a significant aggregate of strong preferences in one direction or another. This type of consumption, positive or negative, is intertwined in the production process and occurs directly with production, and thus differs from ordinary consumption, which occurs at the end of the production process.

• 35As Frank Fetter brilliantly stated:
  Contract [interest] is based on and tends to conform to economic interest [i.e., the “natural interest” price differential between stages]. ... It is economic interest that we seek to explain logically through the economic nature of the goods. Contract interest is a secondary problem—a business and legal problem—as to who shall have the benefit of the income arising with the possession of the goods. It is closely connected with the question of ownership. (Fetter, “Recent Discussions of the Capital Concept,” pp. 24–25)
• 36“The creditor is always a virtual partner of the debtor or a virtual owner of the pledged and mortgaged property.” Mises, Human Action, p. 536. Also see Fetter, “Recent Discussions of the Capital Concept,” p. 432.
• 37Similar psychic components may occur in the consumers’ loan market—for example, if there is general strong liking or dislike for a certain borrower.

Praxeology can never furnish an ultimate explanation for a man’s time preferences. These are psychologically determined by each person and must therefore be taken, in the final analysis, as data by economists. However, praxeological analysis can supply some truths about time preferences, using ceteris paribus assumptions. Thus, as we have seen above, each person has a time-preference schedule relating to his money stock. A lower money stock will cause a higher time-preference rate for any unit of money remaining in his possession, until finally his time-preference rate will rise to infinity when the money stock—or rather, the money for consumption—is low enough. Here, one element, a man’s money stock, is varied and his value scale is otherwise assumed to remain constant. Hence, we can in this way gauge the effects of a change in one determinant, the money stock.

Actually, it is not his money stock that is relevant to his time preferences, but the real value of his money stock. In the ERE, of course, where the purchasing power of the money unit remains unchanged, the two are identical. Ceteris paribus, an increase in his real income—real additions to his money stock—will lower the time-preference rate on his schedule. Of course, historically, there is no reason why his time-preference schedule should remain unchanged. It is important to know, however, that, given an unchanged schedule, his relevant time-preference rate will fall.

There are other elements that enter into the determination of the time-preference schedules. Suppose, for example, that people were certain that the world would end on a definite date in the near future. What would happen to time preferences and to the rate of interest? Men would then stop providing for future needs and stop investing in all processes of production longer than the shortest. Future goods would become almost valueless compared to present goods, time preferences for present goods would zoom, and the pure interest rate would rise almost to infinity. On the other hand, if people all became immortal and healthy as a result of the discovery of some new drug, time preferences would tend to be very much lower, there would be a great increase in investment, and the pure rate of interest would fall sharply.

It is clear that the natural interest rates are highly flexible; they tend toward uniformity and are easily changed as entrepreneurial expectations change. In the real world the prices of the various factors and intermediate products, as well as of the final products, are subject to continual fluctuation, as are the prices of stock and the interest return on them. It is also clear that the interest rate on short-term loans is easily changed with changed conditions. As the natural interest rate changes, the new loans for short periods can easily conform to the change.

A difficulty seems to arise, however, in the case of long-term producers’ loans. Here is an apparently clear-cut rigid element in the system, and one which can conform to the natural rate of interest in investments only after a great lag. After all, a 20-year loan is contracted at an original interest rate that remains fixed for the duration; is this not a fixed element that cannot conform to changing conditions and valuations? This superficial view is incorrect. Long-term I.O.U.’s can also be bought and sold in a market. Most of these long-term debts are called bonds, and they are traded in a flourishing and flexible bond market. The fixed rate of interest at the beginning is unimportant. Thus, a 100-ounce long-term loan is contracted at 5-percent fixed interest, or five ounces per year. If the general interest rate rises, people will tend to sell their bonds, which have been yielding them only 5 percent, and invest their money elsewhere—either in whole firms, stocks of firms, or short-term loans. This increased willingness to sell bonds—an increased supply schedule—depresses the price of the bond until the interest yield to the buyer is the same as the general interest rate elsewhere. Thus, if the general interest rate goes up from 5 percent to 10 percent, the price of the bond will fall from 100 to 50, so that the fixed annual return of 5 will provide an interest yield of 10 percent. The important element in bond investment is not the original interest rate (the fixed return on the so-called “par value” of the bond), but the interest yield on the market price of the bond. A general lowering of the interest rate will, on the other hand, raise the bond prices above par and push yield below 5 percent. As the day of redemption of the bond draws near, the market price of the bond will, of course, rapidly approach the par value, until it finally sells at par, since the amount redeemed will be the original par value, or principal, of the loan.

It is clear that, in the ERE, the interest rates for all periods of time will be equal. The tendency toward such equality at any one time, however, has been disputed in the case of expected future changes in the interest rate. Although surprisingly little attention has been devoted to this subject, the prevailing theory is that, on the loan market, there will not be a tendency toward equalization if a change in interest rates is expected in the near future.38 Suppose that the interest rate is now 5 percent, and it is expected to remain there. Then the interest rate on loans of all maturities will be the same, 5 percent. Suppose, however, that the interest rate is expected to increase steadily in the near future, say to increase each year by 1 percent until it will be 9 percent four years from now. In that case, since the short-run rate (say the rate of interest on loans lasting one year or less) is expected to increase over the next four-year period, then the present long-run rate for that period—e.g., the present rate for five-year loans—will be an average of the expected future short-run rates during this period. Thus, the present rate on five-year loans will be 5 percent plus 6 percent plus 7 percent plus 8 percent plus 9 percent divided by 5, equaling 7 percent. The long-run rate will be the average of short-run rates over the relevant period. Consequently, the long-run rates will be proportionately higher than short-run rates when the latter are expected to increase, and lower when the latter are expected to be lower. (See Figure 54.)

This, however, is a completely question-begging theory. Suppose that a rise in interest rates is expected; why should this be simply confined to a rise in the short-term rates? Why should not the expectation be equally applicable to long-term rates so that they rise as well?39

The theory rests on the quite untenable assumption that it sets out to prove, namely, that there is no tendency for short-term and long-term rates to be equal. The assumption that a change in the interest rate will take place only over the short term is completely unproved and goes against our demonstration that the short-run and long-run rates tend to move together. Further, the theory rests on the implicit assumption that individuals will be content to remain lenders in “shorts” at 5 percent while their fellow investors reap 7 percent on the long market, simply because they expect that eventually, if they stay in the short market, they will earn an average of 7 percent. What is there to prevent a present lender in shorts from selling his currently earning 5-percent loan, purchasing a 7-percent long, waiting for the presumed rise in shorts above 7 percent after two years, and then re-entering the short market, earning 8 percent or 9 percent? If he does this, he will not simply earn 7 percent as the foregoing diagram postulates (either directly in longs or in an average of 5 percent–9 percent in shorts); he will earn 7 percent plus 7 percent plus 7 percent plus 8 percent plus 9 percent, or an annual average of 7.6 percent. By striving to do so, he will set up an irresistible arbitrage movement from shorts to longs, with the rate of interest in the former thereby rising from the sales of loans on the market, and the rate of interest in longs falling, until the rate of interest is uniform throughout the time structure.

The same thing occurs in the case of an expectation of a future fall. Longs cannot remain in equilibrium below shorts for any length of time, since there will be a present movement from longs to shorts on the market, until the rates of interest for all time structures are equal and the arbitrage movement ceases.

The interest rate, then, always tends to be uniform throughout its time structure. What happens if the interest rate is expected to change in the near future? In that case, there will be a similar process as in the case of speculation in commodities. Speculators will bid up the interest rate in the expectation of an imminent rise or bid down the rate in expectation of a fall. Clearly, the earlier a rise or fall is expected to take place, the greater proportionately will be the effect on the speculators, and the greater impact it will have on current movement in the rate. In the case of a commodity, stocks would be withheld in expectation of a rise in demand and price, and then released, thereby effecting a more rapid transition to the price eventually established by underlying supply-and-demand forces. Similarly, in this case money will tend to be withheld from investments and held in cash balances until the rate reaches its expected higher level, or dislodged from cash balances and added to investment if the rate of interest is expected to be lower. This action will speed up the transition to the rate determined by the new alignment of basic time preferences. Just as speculative errors in regard to commodity prices cause losses and impel further change to the “real” underlying price, so speculative errors will be self-correcting here too and lead the rate of interest to the height determined by underlying time preferences.

The time-structure diagram of interest, then, will rather tend to be as depicted in Figure 55.

The absurdity of separating the long-run and the short-run interest rates becomes evident when we realize that the basic interest rate is the natural rate of interest on investments, not interest on the producers’ loan market. We have already seen the essential identity of the rate of earnings on the loan market with that on the stock market. If we consider the stock market, it becomes obvious that there is no distinction in rates between short-run and long-run investments. Different firms engage in stages of production of varying lengths; yet the stock market equates the rate of interest on all investments, obliterating the differences in time structure so thoroughly that it becomes difficult for many writers to grasp the very concept of period of production. But since the operations of the stock market and the loan market are essentially the same, it is obvious that there is no difference in causal explanation between short-run and long-run interest rates. Those writers who postulate an essential difference between the nature of long-run and short-run rates have been misled by a common penchant for considering the time market as confined exclusively to the loan market, when in fact the loan market is only a dependent one.40

In actual practice, it may well happen that either the short-run loan market or the long-run market may change first, with the other market following. Which market characteristically changes first is the outcome of the concrete conditions.41

• 38See Mises, Human Action, p. 541.
• 39Since the writing of this text, Professor Luckett has published a critique of Lutz similar in part. See Dudley G. Luckett, “Professor Lutz and the Structure of Interest Rates,” Quarterly Journal of Economics, February, 1959, pp. 131–44. Also see J.M. Culbertson, “The Term Structure of Interest Rates,” ibid., November, 1957, pp. 485–517.
• 40Since the writing of this text, Professor Luckett has published a critique of Lutz similar in part. See Dudley G. Luckett, “Professor Lutz and the Structure of Interest Rates,” Quarterly Journal of Economics, February, 1959, pp. 131–44. Also see J.M. Culbertson, “The Term Structure of Interest Rates,” ibid., November, 1957, pp. 485–517.
• 41See Mises, Human Action, p. 541.

The late Professor Joseph Schumpeter pioneered a theory of interest which holds that the rate of interest will be zero in the evenly rotating economy. It should be clear from the above discussion why the rate of interest (the pure rate of interest in the ERE) could never be zero. It is determined by individual time preferences, which are all positive. To maintain his position, Schumpeter was forced to assert, as does Frank Knight, that capital maintains itself permanently in the ERE. If there is no problem of maintenance, then there appears to be no necessity for the payment of interest in order to maintain the capital structure. This view, treated above, is apparently derived from the static state of J.B. Clark and seems to follow purely by definition, since the value of capital is maintained by definition in the ERE. But this, of course, is no answer whatever; the important question is: How is this constancy maintained? And the only answer can be that it is maintained by the decisions of capitalists induced by a rate of interest return. If the rate of interest paid were zero, complete capital consumption would ensue.42

The conclusive Mises-Robbins critique of Schumpeter’s theory of the zero rate of interest, which we have tried to present above, has been attacked by two of Schumpeter’s disciples.43 First, they deny that constancy of capital is assumed by definition in Schumpeter’s ERE; instead it is “deduced from the conditions of the system.” What are these conditions? There is, first, the absence of uncertainty concerning the future. This, indeed, would seem to be the condition for any ERE. But Clemence and Doody add: “Neither is there time preference unless we introduce it as a special assumption, in which case it may be either positive or negative as we prefer, and there is nothing further to discuss.” With such a view of time preference, there is indeed nothing to discuss. The whole basis for pure interest, requiring interest payments, is time preference, and if we casually assume that time preference is either nonexistent or has no discernible influence, then it follows very easily that the pure rate of interest is zero. The authors’ “proof” simply consists of ignoring the powerful, universal fact of time preference.44

• 42See Mises, Human Action, pp. 527–29. Also see Lionel Robbins, “On a Certain Ambiguity in the Conception of Stationary Equilibrium” in Richard V. Clemence, ed., Readings in Economic Analysis (Cambridge: Addison-Wesley Press, 1950), I, 176 ff.
• 43Richard V. Clemence and Francis S. Doody, The Schumpeterian System (Cambridge: Addison Wesley Press, 1950), pp. 28–30.
• 44As has been the case with all theorists who have attempted to deny time preference, Clemence and Doody hastily brush consumers’ loans aside. As Frank A. Fetter pointed out years ago, only time preference can integrate interest on consumers’ as well as on producers’ loans into a single unified explanation. Consumers’ loans are clearly unrelated to “productivity” explanations of interest and are obviously due to time preference. Cf. Clemence and Doody, The Schumpeterian System, p. 29 n.