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Failure of New Economics

Failure of New Economics

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This brings us to the third type of interest theory, which
seeks to combine productivity and time-preference factors.
This third type of theory is sometimes disparagingly
called "eclectic." But the adjective is not justified if it is
meant to imply that those who hold it select a little from
the productivity theories and a little from the time-discount
theories and fail to give any consistent explanation of in-
terest. On the contrary, this third type of theory is really a
combined theory. It seeks to unify what is true in the pro-
ductivity theories with what is true in the time-discount
theories. In the same way as the price of a commodity is
explained as the point of intersection of the supply curve
and the demand curve, so one form of the combined theory
explains the interest rate as the point of intersection of the
curve of supply of savings with the curve of investment

The combined theory of the interest rate reached its
highest and most elaborate expression in Irving Fisher's
great work The Theory of Interest (1930). Schumpeter
called this "a wonderful performance, the peak achieve-
ment, so far as perfection within its own frame is concerned,
of the literature of interest." 9

It is not hard to understand
his enthusiasm. Few persons, after reading Fisher, can fail
to find Keynes's discussion of interest superficial, haphazard,
and even amateurish.

9 Joseph A. Schumpeter, Econometrica, Vol. 16, No. 3, July, 1948.



Fisher marshals the interplay of innumerable factors
governing the rate of interest around two pillars of explana-
tion: "Impatience" (time discount) and "Investment Op-
portunity" ("the rate of return over cost").
F. A. Hayek has followed the Fisher theory in its general
outlines, and explains the relation of the productivity
factor to time-preference as follows:
The most widely held view is probably that, as in Mar-
shall's two blades of the scissors, the two factors [productivity
and time-preference] are so inseparately bound up with each
other, that it is impossible to say which has the greater and
which the lesser influence.
Our problem here is indeed no more than a special case of
the problem to which Marshall applied that famous simile,
the problem of the relative influence of utility and cost on
value. The time valuation in our case corresponds of course
to his utility, while the technical rate of transformation is an
expression of the relative costs of the commodities (or quanti-
ties of income at two moments of time).10

A complete positive theory of interest would have to take
into account more factors than can be adequately discussed
in a single chapter. If the market interest rate, for example,
were in "complete" equilibrium, here are some of the things
that would have to be equated:
1. The supply of, with the demand for, capital (i.e., the
supply of savings with the demand for investment).
2. The price of capital instruments with their cost of


3. The income from capital goods with their price and
their cost of production.
4. The "marginal yield of capital" with the rate of time-
discount (time-preference).
5. The supply of loanable (monetary) funds with the de-
mand for loanable funds.
If we wished to illustrate these complex relationships
graphically, we would produce an unintelligible maze of

10 The Pure Theory of Capital (London: Macmillan, 1941), pp. 420-421.


lines unless we were willing to use a set of diagrams rather
than any single diagram. But the graph on the next page
will illustrate one set of major relationships. The vertical
line OY represents the interest rate; the horizontal line OX
represents the annual volume o£ savings or investment de-
mand measured, say, in billions o£ dollars. The curve ID
represents investment demand. The lower the interest rate
the greater the volume o£ investment demand; the higher
the interest rate the less the volume o£ investment demand.
The curve SS represents the supply o£ savings. As drawn,
it assumes some savings even at a zero interest rate. The
tendency o£ higher interest rates will be, within limits, to
encourage a greater volume of savings.
But the slope and shape o£ the savings curve is more de-
batable than that o£ the investment demand curve. Some
economists would maintain that within a wide range o£
interest rates the savings curve should be vertical—in other
words, that the volume o£ savings is not greatly influenced
by interest rates. Other economists would say that higher
interest rates, within a certain range, might encourage more
savings, but that above a certain rate the line should actu-
ally curve backwards toward the line OY—in other words,
that very high interest rates may actually discourage saving
because a high income from interest could be obtained
from comparatively little saving.
Though the rate of interest and the supply of savings will
of course influence each other, we must remember that the
supply of savings may be to a large extent independent of
the interest rate, just as the interest rate may be to some
extent independent of the supply of savings. There would
be some savings (as a reserve against contingencies) at a zero
interest rate. Perhaps the most important line on this chart
so far as the rate of interest is concerned is not, in the long
run, either ID or SS, but td, the line of time-discount. For
it is this, in the long run, that may determine, rather than
be determined by, both the supply of savings and the in-
vestment demand.



In the diagram as drawn, the market rate o£ interest is in
equilibrium with the time-discount rate at 3¾ per cent. The
supply of savings and investment demand are also in equi-
librium at that point. In any short-run period we may think
of these quantities as all interdependent, rather than as
determined primarily by the time-discount rate.




ë e \





uí td



1 ss





I 2 3 4 5 6 7 8 9 10 II 12 13 ×


Some readers may think that in the graph the investment-
demand curve and the savings-supply curve are together
sufficient to determine the interest rate at their point of
intersection, and that there is no need or legitimate place
for a third line, whether it is called time-discount or any-
thing else. From the standpoint of the orthodox supply
and demand curves they are right. (A II diagrams of this sort
are mere aids to thought, efforts to visualize hypothetical
relations, never to be taken too literally.) But a supply-and-
demand analysis of the interest rate, or of any competitive
price whatever, while correct, is superficial, a mere first
step. The next step is always to inquire what the particular
supply and demand forces are and what causes them to be
what they are.

Let us, as an illustration, take securities on the stock
market. A stock, let us call it American Steel, is selling at
50 on the market. Why is it selling at that particular price?


One answer, of course, is because "supply" and "demand"
are at equilibrium at that price. But this only pushes the
problem back a stage; it only poses it in another form. Why
are supply and demand at equilibrium at that particular
The answer is that the composite valuations put
upon the stock by both buyers and sellers center for the
moment at that point. Another way of putting this is that
the valuations put on the stock by the marginal buyer and
the marginal seller cross at that point. The last buyer must
have valued the stock at more than $50, the last seller must
have valued it at less than $50.
Now let us say that American Steel closes at 50 on Mon-
day, but that after the close of the market the board of direc-
tors unexpectedly fails to declare the regular quarterly
dividend. On Tuesday morning the stock opens 5 points
down, at 45. It can be said, of course, that American Steel
has fallen because the "supply" of the stock has increased
and the "demand" has diminished. But obviously this is
not the cause of the stock's fall in value, but the conse-
Physically, there are no more shares of American
Steel outstanding on Tuesday than there were on Monday.
Physically, the number of snares bought and the number
of shares sold exactly equal each other on Tuesday as they
did on Monday. There were no transactions in the stock
between the closing price of 50 on Monday and the sud-
denly lower opening price of 45 on Tuesday. The value of
the stock has not fallen because of a change in the amount
offered and the amount demanded. It is "supply" and "de-
mand" that have changed because the value of the stock
has fallen!

Putting the matter in another way, the individual valua-
tions set upon the stock by both sellers and buyers have
fallen because of the (generally) unexpected passing of the
previous regular dividend.
The matter could, of course, be diagrammatically repre-
sented by the usual supply and demand curves crossing each
other on Monday, with the demand curve moving to the



left and the supply curve moving to the right on Tuesday.

(Actually, the supply curve in this case is merely the de-
mand curve of the present holders of the stock. The situa-
tion could be represented by placing the valuations of both
holders and potential holders on a single demand curve on
Monday and lowering the whole curve on Tuesday. How-
ever, as the price would be the point at which the valua-
tions of the marginal seller and the marginal buyer crossed
each other, it is graphically better to have a "supply" curve
as well as a "demand" curve.) These curves indicate rela-
tionships, but not necessarily causation. It is the lowered
valuation of the stock in the minds of both buyers and
sellers that causes the change in the "supply" and "de-
mand," rather than the change in amount supplied and
amount demanded that causes the lowered valuation.
In the same way, it is the composite time-preference or
time-discount schedule in the minds of both borrowers and
lenders that determines the rate of interest, the position of
the investment demand curve and the position of the sup-
ply-of-savings curve, rather than the supply and demand
curves which determine the composite time-preference

It may help some readers (even though the parallel is mis-
placed) to think of "normal" time-discount as the main
factor governing the long-run "normal" rate of interest
(rather than the ever changing constellation of day-to-day
market rates of interest) much in the same way as cost-of-
production "determines" the relative "normal" prices of
commodities rather than their short-run market prices. In
modern theory, of course, its cost of production does not
"determine" the "normal" price of a commodity, but rela-
tive costs of production are part of the interdependent re-
lationships among relative prices. As Wicks teed has put it:
"One thing is not worth twice as much as another because
it has twice as much labor' in it, but producers have been
willing to put twice as much labor' into it because they
know [expect] that when produced it will be worth twice


as much, because it will be twice as 'useful' or twice as
much desired." 11
The same sort of cause-and-effect amendment that Wick-
steed makes in the classical theory of the relation of cost of
production to price must be made also in Böhm-Bawerk's
concept of the lengthening of the period of production.
The fact that certain capital goods take longer to produce
than others does not necessarily increase their value or
productivity; but the expectation that certain capital goods
will be more valuable or productive makes producers will-
ing to undertake a longer period of production, if neces-
sary, to secure them.
Each saver's and entrepreneur's time-preference or time-
discount (including his estimate of the composite time-
preference or time-discount of the community as a whole)
will help to determine the current rate of savings or the
current investment demand; but at any given moment the
points of intersection of these supply and demand curves
will "determine" market rates of interest.

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