Essentials of Economic Theory / As Applied to Modern Problems of Industry and Public Policy

by John Bates Clark

Conscious Forecasts not necessary for Insuring the Adjustment of Loan Interest to Changing Prices.—It is possible that, where this subject has been considered, the impression may prevail that this reduction in the nominal rate of interest is the result of foresight on the part of borrower and lender. According to that view, both parties look forward to the time when the loan will be paid. The borrower sees that, although by means of his business he may have at the end of a year five per cent more of commodity in his possession, prices will probably have fallen so as to enable him to realize in money only four per cent. On the other hand, the creditor will see that with four per cent more in money he can, if he will, buy with his principal and interest five per cent more than he virtually loaned in commodity. He is satisfied with this increase; and, moreover, he is forced to adopt it, since the natural increase of real capital will not enable a borrower to pay more. The entrepreneur will stop borrowing if more is demanded. The whole adjustment is supposed to rest on a forecast made by the contracting parties and a speculative calculation as to the trend of prices. Now, while men do indeed consider the future, the adjustment that is actually made does not call for foresight. No conscious forward glance is necessarily involved therein. It is made by a process that works more unerringly than any joint calculation about the coming conditions could possibly do.

The interest on a loan that is to run through a period in the near future is based on the rate that capital is now producing. The evidence as to what that rate is must be furnished by the experience of the immediate past. It takes much experience, of course, accurately to determine how much the marginal unit of capital for the year 1895 has been worth to the men who have used it. This, however, has to be ascertained as best it can. It takes strategy on the part of both borrowers and lenders to make the loan rate correspond to the marginal earnings. Here there is a chance for economic friction and for variations from the theoretical standard, and the loan rate will sometimes exceed it; but in the long run the deviations will offset each other. In any case, the experience of 1906 fixes, with or without variations, the loan rate for 1907.

The earnings revealed by the experience of 1906 may be theoretically computed either in money or in commodity. Let us say they have been five per cent in real wealth, but by reason of the fall in prices they have been only four per cent in money. That, then, is the rate for a loan that is to run through 1907. If prices continue to fall at the rate now prevailing, the loan rate in money will correspond to the marginal earnings of capital for the latter year as accurately as it does for the former year. Bargain-making strategy, the "higgling of the market," may yield an imperfect result, and the lender of real or commodity capital may or may not get the exact real earnings of marginal capital of the same kind. In translating the earnings of real capital for the earlier or test year into terms of money, the appreciation of the coins has unerringly entered as an element. If the same rate of appreciation is continued through the following year, no deviation of the loan rate from the earnings of capital can result from this cause. Whatever deviation there is results from the other causes just noted.

In commercial terms a man borrows "money," and, by using it in his business, produces "money." He does this, however, by converting the currency into merchandise, and then reconverting this into currency. He gives to the lender approximately what the "marginal" part of the loan produces. If this adjustment is inexact, the lender will get less or more than the actual earnings of such capital. With money gaining in its purchasing power at a uniform rate, the adjustment is as exact as it would have been with money of stable value. The appreciation works unerringly in translating earnings measured in goods into smaller earnings measured in money. The loan rate approximates the earnings.

Effects of Changes in the Rate of Appreciation.—What happens if the rate of appreciation changes? What if gold gains two per cent in value, instead of one, during the second of the periods? The capitalist will then clearly be a gainer, and the entrepreneur will be a loser. Getting five per cent in commodity as before, the business man, by reason of falling prices, will realize only about three per cent in money. His contract, based on the experience of an earlier year, makes him pay four per cent, and he loses one. Every acceleration of the rate of increase in the purchasing power of money plays into the hands of lenders. Every retarding of that rate plays into the hands of borrowers. If in 1907 the entrepreneur gets a three per cent rate on what he borrows, as based on the experience of 1906, and if the fall in prices is reduced during that later year to one per cent, the borrower will make a clear gain of one per cent; and this will recoup him for his loss in the earlier period. Moreover, after a long period of steady prices, the beginnings of a downward trend do not instantly affect the loan rate of interest. A period must elapse sufficient to establish the fact of this downward trend, and to enable the struggles of lenders and borrowers to overcome habit in fixing a new rate that will correspond to the new earning power of monetary capital. These facts explain what at times looks like a failure of the loan market fully to take account of the fall of prices during a given interval. What that market really does is to base the interest paid in one interval on the business experience of another.

Opposite Reasons for Favoring Gold as a Basis of Currency.—What, then, is our practical conclusion? Gold has surprised the world by its increase and by the rise in prices by which this change has been attended. The interest on loans has risen as the conditions required that it should do; but the rise in interest has lagged somewhat behind the rise in prices. The enlarged output of the precious metal has been comparatively sudden, and it has been this fact which has played into the hands of entrepreneurs and, for a brief interval, entailed some loss on lenders. When the adjustment of loan interest to the rising prices shall be fully made, neither of these parties will gain at the other's expense so long as the rise shall continue at the prevalent rate; but if the rise should cease as quickly as it began, it would be entrepreneurs who would lose and lenders who would gain. Loans running at rates fixed when prices were rising would be paid by an amount of money which would buy more commodity than the business would afford. With a reduction of the output of gold there will come a demand for some measure of inflation in order that rising prices may forever continue. Adding silver to the currency would, as we have seen, accomplish this purpose only temporarily. In the long run this metal is bound to appreciate like gold. Using paper money would have a temporary effect and would be a more dangerous measure. Waiting for a short time for a new adjustment of loan interest to the trend of prices would be the only rational course. Will the further fall of prices rob the entrepreneurs? They must pay only the rate of interest that capital earns. If that is five per cent, five they must pay, so long as prices are stable. With prices falling by one per cent a year, they will have to pay only four. Will the fall check business and make men afraid to buy stocks of goods? They can carry stocks as cheaply with a four per cent rate of interest and declining prices as they can with a five per cent rate and stable prices. Will it blight enterprise by making men afraid to build mills, railroads, etc.? Here again the loan rate of interest comes to the rescue of the projectors. If they can float their bonds and notes at a lower rate, they can build with impunity.

Steadiness is the vital quality in currency. Let its purchasing power be either unchanging or steadily changing in either direction, and justice will be done and business will thrive. If a metal fluctuates greatly in its rate of increase in value, it is a poor coinage metal, even though the average rate of gain be slow; if it gains slowly and steadily, it is almost an ideally good one.

What would be the effect of any practical measure of inflation? If we use as money available for all debts the present stock of silver in the world, we make one large addition to the volume of money now available. We start an inflation that cannot continue by the use of silver alone. In the hope of perpetuating the rise in prices we may follow the silver with paper. By the action of the principle that we have stated we shall thus make the interest on loans higher, and every man who buys a farm or a house while the inflation continues will pay a high rate of interest on an enlarged purchase price. When we are forced to stop the paper issues, as in the end we must be, the price of the land, etc., will fall, and the rate of interest on new loans will fall also. The price of all produce will go down, and the purchasers of property will struggle again, as in the years following the Civil War men had to struggle, with a fixed debt, a fixed rate of interest, and falling prices. The early post bellum days will be reproduced. Entering on a policy of inflation would therefore be inviting men again to suffer what those suffered whose hard experience is so frequently depicted in Populistic literature. Conceding all that is claimed as to the evil that comes from buying or mortgaging real property while the volume of money is increasing and paying the debt so incurred while that volume is relatively contracting, one must see that a policy of inflation would end by inflicting exactly that evil on new victims, unless a method can be invented by which the inflation can continue forever. Far better will it be to endure the transient evil which a slow change in the supply of gold will bring. Retaining gold through all its minor variations will mean all the prosperity and all the justice that any monetary system can insure. If we shall ever abandon this metal, experience will make us wise enough to return to it; but we shall have paid a high price for the wisdom.

FOOTNOTES

[1] There is a slight compounding here to be taken into account. If commodity has gained five per cent, while prices have lost one per cent, the capital as measured in money has increased by three and ninety-five one-hundredths per cent instead of exactly four.