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Monday, June 17, 2013

The theory of capital, entrepreneurship, savings and interest

In the roster of A.R.J. Turgot's outstanding contributions to economic theory, the most remarkable was his theory of capital and interest which, in contrast with such fields as utility, sprang up virtually full-blown without reference to preceding contributions. Not only that: Turgot worked out almost completely the Austrian theory of capital and interest a century before it was set forth in definitive form by Eugen von Böhm-Bawerk.

Turgot's theory of capital proper was echoed in the British classical economists as well as the Austrians. Thus in his great ‘Reflections’, Turgot pointed out that wealth is accumulated by means of unconsumed and saved annual produce. Savings are accumulated in the form of money, and then invested in various kinds of capital goods. Furthermore, as Turgot pointed out, the ‘capitalist–entrepreneur’ must first accumulate saved capital in order to ‘advance’ his payment to labourers while the product is being worked on. In agriculture, the capitalist–entrepreneur must save funds to pay workers, buy cattle, pay for buildings and equipment, etc., until the harvest is reaped and sold and he can recoup his advances. And so it is in every field of production.

Some of this was picked up by Adam Smith and the later British classicists. But they failed to absorb two vital points. One was that Turgot's capitalist was also a capitalist–entrepreneur. He not only advanced savings to workers and other factors of production; he also, as Cantillon had first pointed out, bore the risks of uncertainty on the market. Cantillon's theory of the entrepreneur as a pervasive risk-bearer facing uncertainty, thereby equilibrating market conditions, had lacked one key element: an analysis of capital and the realization that the major driving force of the market economy is not just any entrepreneur but the capitalist–entrepreneur, the man who combines both functions. Yet Turgot's memorable achievement in developing the theory of the capitalist–entrepreneur has, as Professor Hoselitz pointed out, ‘been completely ignored’ until the twentieth century.

If the British classicists totally neglected the entrepreneur, they also failed to absorb Turgot's proto-Austrian emphasis on the crucial role of time in production, and the fact that industries may require many stages of production with lengthy periods of advance payment before production and sale. Turgot perceptively pointed out that it is the owner of capital

who will wait for the sale of the leather to return him not only all his advances, but also a profit sufficient to compensate him for what his money would have been worth to him, had he turned it to the acquisition of an estate, and moreover, the wages due to his labour and care, to his risk, and even to his skill.

In this passage, Turgot anticipated the Austrian concept of opportunity cost, and pointed out that the capitalist will tend to earn his imputed wages and the opportunity that the capitalist sacrificed by not investing his money elsewhere. In short, the capitalist's accounting profits will tend to a long-run equilibrium plus the imputed wages of his own labour and skill. In agriculture, manufacturing, or any other field of production, there are two basic classes of producers in society: the entrepreneurs, owners of capital, ‘which they invest profitably as advances for setting men at work’; and the workers or ‘simple Artisans, who have no other property than their arms, who advance only their daily labour, and receive no profit but their wages’.

At this point, Turgot incorporated a germ of valuable insight from the physiocratic Tableau – that invested capital must continue to return a steady profit through continued circulation of expenditures, else dislocations in production and payments will occur. Integrating his analyses of money and capital, Turgot then pointed out that before the development of gold or silver as money, the scope for entrepreneurship, manufacturing or commerce had been very limited. For to develop the division of labour and stages of production, it is necessary to accumulate large sums of capital, and undertake extensive exchanges, none of which is possible without money.

Seeing that ‘advances’ of savings to factors of production are a key to investment, and that this process is only developed in a money economy, Turgot then proceeded to a crucial ‘Austrian’ point: since money and capital advances are indispensable to all enterprises, labourers are therefore willing to pay capitalists a discount out of production for the service of having money paid them in advance of future revenue. In short: the interest return on investment (what the Swedish ‘Austrian’ Knut Wicksell would over a century later call the ‘natural rate of interest’) is the payment by labourers to the capitalists for the function of advancing them present money so that they do not have to wait for years for their income. As Turgot put it in his ‘Reflections’:

Since capitals are the indispensable foundation of all lucrative enterprises,... those who, with their industry and love of labour, have no capitals, or who do not have sufficient for the enterprise they wish to embark on, have no difficulty in deciding to give up to the owners of such capital or money who are willing to trust it to them, a portion of the profits they expect to receive over and above the return of their advances.

The following year, in his scintillating comments on the paper by Saint-Péravy, Turgot expanded his analysis of savings and capital to set forth an excellent anticipation of Say's law. Turgot rebutted pre-Keynesian fears of the physiocrats that money not spent on consumption would ‘leak’ out of the circular flow and thereby wreck the economy. As a result, the physiocrats tended to oppose savings per se. Turgot, however, pointed out that advances of capital are vital in all enterprises, and where might the advances come from, if not out of savings? He also noted that it made no difference if such savings were supplied by landed proprietors or by entrepreneurs. For entrepreneurial savings to be large enough to accumulate capital and expand production, profits have to be higher than the amount required to reproduce current entrepreneurial spending (i.e. replace inventory, capital goods, etc. as they are drawn down or wear out).

Turgot goes on to point out that the physiocrats assume without proof that savings simply leak out of circulation, and lower prices. Instead, money will return to circulation, savings will immediately be used either to buy land; to be invested as advances to workers and other factors; or to be loaned out at interest. All these uses of savings return money to the circular flow. Advances of capital, for example, return to circulation in paying for equipment, buildings, raw material or wages. The purchase of land transfers money to the seller of land, who in turn will either buy something with the money, pay his debts, or relend the amount; in any case, the money returns promptly to circulation.

Turgot then engaged in a similar analysis of spending flows if savings are loaned at interest. If consumers borrow the money, they borrow in order to spend, and so the money expended returns to circulation. If they borrow to pay debts or buy land, the same thing occurs. And if entrepreneurs borrow the money, it will be poured into advances and investment, and the money will once again return to circulation.

Money saved, therefore, is not lost; it returns to circulation. Furthermore, the value of savings invested in capital is far greater than piled up in hoards, so that money will tend to return to circulation quickly. Furthermore, Turgot pointed out, even if increased savings actually withdrew a small amount of money from circulation for a considerable time, the lower price of the produce will be more than offset for the entrepreneur by the increased advances and the consequent greater output and lowering of the cost of production. Here, Turgot had the germ of the much later von Mises–von Hayek analysis of how savings narrows but lengthens the structure of production.

The acme of Turgot's contribution to economic theory was his sophisticated analysis of interest. We have already seen Turgot's remarkable insight in seeing interest return on investment as a price paid by labourers to capitalist–entrepreneurs for advances of savings in the form of present money. Turgot also demonstrated – far ahead of his time – the relationship between this natural rate of interest and the interest on money loans. He showed, for example, that the two must tend to be equal on the market, since the owners of capital will continually balance their expected returns in different channels of use, whether they be money loans or direct investment in production. The lender sells the use of his money now, and the borrower buys that use, and the ‘price’ of those loans, i.e. the loan rate of interest, will be determined, as in the case of any commodity, by the variations in supply and demand on the market. Increased demand for loans (‘many borrowers’) will raise interest rates; increased supply of loans (‘many lenders’) will lower them. People borrow for many reasons, as we have seen: to try to make an entrepreneurial profit, to purchase land, pay debts or consume; while lenders are concerned with just two matters: interest return and the safety of their capital.

While there will be a market tendency to equate loan rates of interest and interest returns on investment, loans tend to be a less risky form of channelling savings. Thus investment in risky enterprises will only be made if entrepreneurs expect that their profit will be greater than the loan rate of interest. Turgot also pointed out that government bonds will tend to be the least risky investment, so that they will earn the lowest interest return. He went on to declare that the ‘true evil’ of government debt is that it presents advantages to the public creditors but channels their savings into ‘sterile’ and unproductive uses and maintains a high interest rate in competition with productive uses (or, as we would say nowadays, public debt ‘crowds out’ productive private uses of savings).

Pressing on to an analysis of the nature and use of lending at interest, Turgot engaged in an incisive and hard-hitting critique of usury laws, which the physiocrats were still trying to defend.

A loan, Turgot pointed out, ‘is a reciprocal contract, free between the two parties, which they make only because it is advantageous to them’. But a contracted loan is then ipso facto advantageous to both the lender and the borrower. Turgot moved in for the clincher: ‘Now on what principle can a crime be discovered in a contract advantageous to two parties, with which both parties are satisfied, and which certainly does no injury to anyone else?’ There is no exploitation in charging interest just as there is none in the sale of any commodity. To attack a lender for ‘taking advantage’ of the borrower's need for money by demanding interest ‘is as absurd an argument as saying that a baker who demands money for the bread he sells, takes advantage of the buyer's need for bread’.

And, if the money spent on bread might be considered its equivalent, then in the same way ‘the money which the borrower receives today is equally an equivalent of the capital and interest he promises to return at the end of a certain time’. In short: a loan contract establishes the present value of a future payment of capital and interest. The borrower gets use of the money during the term of the loan; the lender is deprived of such use; the price of this advantage, or disadvantage, is ‘interest’.

It is true, Turgot says to the anti-usury wing of the scholastics, that money as a ‘mass of metal’ is barren and produces nothing; but money employed successfully in enterprises yields a profit, or invested in land yields revenue. The lender gives up, during the term of the loan, not only possession of the metal, but also the profit he could have obtained by investment: the ‘profit or revenue he would have been able to procure by it, and the interest which indemnified him for this loss cannot be looked on as unjust’. Thus Turgot integrates his analysis and justification for interest with a generalized view of opportunity cost, of income foregone from lending money. And then, above all, Turgot declares, there is the property right of the lender, a crucial point that must not be overlooked. A lender has the right to require an interest for his loan simply because the money is his property. Since it is property he is free to keep it...; if then he does lend, he may attach such conditions to the loan as he sees fit. In this, he does no injury to the borrower, since the latter agrees to the conditions, and has no right of any kind over the sum lent.

As for the Biblical passage in Luke that had for centuries been used to denounce interest, the passage that urged lending without gain, Turgot pointed out that this advice was simply a precept of charity, a ‘laudable action inspired by generosity’, and not a requirement of justice. The opponents of usury, Turgot explained, never press on to a consistent position of trying to force everyone to lend his savings at zero interest.

In one of his last contributions, the highly influential ‘Paper on Lending at Interest’ (1770), A.R.J. Turgot elaborated on his critique of usury laws, at the same time amplifying his noteworthy theory of interest.7 He pointed out that usury laws are not rigorously enforced, leading to widespread black markets in loans. But the stigma of usury remains, along with pervasive dishonesty and disrespect for law. Yet, every once in a while, the usury laws are sporadically and unpredictably enforced, with severe penalties.

Most importantly, Turgot, in the ‘Paper on Lending at Interest’, focused on the crucial problem of interest: why are borrowers willing to pay the interest premium for the use of money? The opponents of usury, he noted, hold that the lender, in requiring more than the principal to be returned, is receiving a value in excess of the value of the loan, and that this excess is somehow deeply immoral. But then Turgot came to the critical point: ‘It is true that in repaying the principal, the borrower returns exactly the same weight of the metal which the lender had given him’. But why, he adds, should the weight of the money metal be the crucial consideration, and not the ‘value and usefulness it has for the lender and the borrower?’ Specifically, arriving at the vital Böhm-Bawerkian–Austrian concept of time-preference, Turgot urges us to compare ‘the difference in usefulness which exists at the date of borrowing between a sum currently owned and an equal sum which is to be received at a distant date’. The key is time-preference – the discounting of the future and the concomitant placing of a premium upon the present. Turgot points to the well known motto, ‘a bird in the hand is worth two in the bush’. Since a sum of money actually owned now ‘is preferable to the assurance of receiving a similar sum in one or several years’ time’, the same sum of money paid and returned is scarcely an equivalent value, for the lender ‘gives the money and receives only an assurance’. But cannot this loss in value ‘be compensated by the assurance of an increase in the sum proportioned to the delay?’ Turgot concluded that ‘this compensation is precisely the rate of interest’. He added that what has to be compared in a loan transaction is not the value of money loaned with the sum of money repaid, but the ‘value of the promise of a sum of money compared to the value of money available now’. For a loan is precisely the transfer of a sum of money in exchange for the current promise of a sum of money in the future. Hence a maximum rate of interest imposed by law would deprive virtually all risky enterprises of credit.
In addition to developing the Austrian theory of time preference, Turgot was the first person, in his Reflections, to point to the corresponding concept of capitalization, that is, the present capital value of land or other capital good on the market tends to equal the sum of its expected annual future rents, or returns, discounted by the market rate of time-preference, or rate of interest.

As if this were not enough to contribute to economics, Turgot also pioneered a sophisticated analysis of the interrelation between the interest rate and the ‘quantity theory’ of money. There is little connection, he pointed out, between the value of currency in terms of prices, and the interest rate. The supply of money may be plentiful, and hence the value of money low in terms of commodities, but interest may at the same time be very high. Perhaps following David Hume's similar model, Turgot asks what would happen if the quantity of silver money in a country suddenly doubled, and that increase were magically distributed in equal proportions to every person. Specifically, Turgot asks us to assume that there are one million ounces of silver money in existence in a country, and ‘that there is brought into the State, in some manner or other, a second million ounces of silver, and that this increase is distributed to every purse in the same proportion as the first million, so that he who had two ounces before, now has four’. Turgot then explains that prices will rise, perhaps doubling, and that therefore the value of silver in terms of commodities will fall. But, he adds, it by no means follows that the interest rate will fall, if people's expenditure proportions remain the same, ‘if all this money is carried to the market and employed in the current expenses of those who possess it...’. The new money will not be loaned out, since only saved money is loaned and invested.

Indeed, Turgot points out that, depending on how the spending–savings proportions are affected, a rise in the quantity of money could raise interest rates. Suppose, he says, that all wealthy people decide to spend their incomes and annual profits on consumption and spend their capital on foolish expenditures. The greater consumption spending will raise the prices of consumer goods, and there being far less money to lend or to spend on investments, interest rates will rise along with prices. In short, spending will accelerate and prices rise, while, at the same time, time-preference rates rise, people spend more and save less, and interest rates will increase. Thus Turgot is over a century ahead of his time in working out the sophisticated Austrian relationship between what von Mises would call the ‘money-relation’ – the relation between the supply and demand for money, which determines prices or the price level – and the rates of time-preference, which determine the spending–saving proportion and the rate of interest. Here, too, was the beginning of the rudiments of the Austrian theory of the business cycle, of the relationship between expansion of the money supply and the rate of interest.

As for the movements in the rate of time-preference or interest, an increase in the spirit of thrift will lower interest rates and increase the amount of savings and the accumulation of capital; a rise in the spirit of luxury will do the opposite. The spirit of thrift, Turgot notes, has been steadily rising in Europe over several centuries, and hence interest rates have tended to fall. The various interest rates and rates of return on loans, investments, land, etc. will tend to equilibrate throughout the market and tend towards a single rate of return. Capital, Turgot notes, will move out of lower profit industries and regions and into higher profit industries.

Austrian Perspective on the History of Economic Thought (2 volume set)

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