Appendix: Schumpeter and the Zero Rate of Interest

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 prefer-ence.⁴⁴

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[PUBLISHER'S NOTE: Page numbers cited in parentheses within the text refer to the present edition.]

¹The 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

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)

⁷Cf. Mises, Human Action, pp. 521–42.

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.

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.

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.

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.

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 [Boston: D.C. Heath, 1938], 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.

³²The 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.

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.

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

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.

⁴⁰It 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.

⁴¹See Mises, Human Action, p. 541.

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.