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Chapter 6—Production: The Rate of Interest and Its Determination (continued)

9. Joint-Stock Companies and the Producers’ Loan Market

     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.

10. Forces Affecting Time Preferences

     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.

11. The Time Structure of Interest Rates

     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]


     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]

[35]As 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.

[37]Similar psychic components may occur in the consumers’ loan market—for example, if there is general strong liking or dislike for a certain borrower.

[38]Thus, cf. Friedrich A. Lutz, “The Structure of Interest Rates” in Readings in the Theory of Income Distribution, pp. 499–532.

[39]Since 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.

[40]It is remarkable that in his empirical study of the time structure of interest rates, Charls Walker found an irresistible tendency of interest rates to equalize, but was forced to multiply his assumptions in order to try to demonstrate that this was a proof of the theory that interest rates do not necessarily equalize. Charls E. Walker, “Federal Reserve Policy and the Structure of Interest Rates on Government Securities,” Quarterly Journal of Economics, February, 1954, pp. 19–42. Walker’s article has considerable merit in demonstrating the impossibilities of governmental maintenance of a differential interest pattern in the face of the market’s drive to equality. Cf. Luckett, “Professor Lutz and the Structure of Interest Rates,” p. 143 n.

[41]See Mises, Human Action, p. 541.

[42]See 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, 176ff.

[43]Richard V. Clemence and Francis S. Doody, The Schumpeterian System (Cambridge: Addison Wesley Press, 1950), pp. 28–30.

[44]As 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.

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