Interest, Time, and Capital

by Fred Foldvary

The way Henry George defined “interest” in Progress and Poverty, Book III, Chapter 3, and in other works, is quite different from how the term has been used in economics and by most people in the 20th and 21st centuries. George stated, “it includes all returns for the use of capital, and not merely those that pass from borrower to lender.” Since George’s definition is still being used by some of his followers, this warrants an examination into these concepts.

The inputs of production, called “factors,” are land, labor, and capital goods. Economics has standard terms for the returns or income from land and labor, namely rent and wages. But the return of capital goods has not had such a standard term. In the 19th century, it was often called “interest,” but it is more clearly called a “yield of capital goods,” or “capital yield.” The term “capital” has several meanings in economics:

  1. “Capital goods” as a factor of production means “goods that have been produced but not yet consumed.” Capital goods are sometimes defined as “goods that are used to produce other goods,” which is fine as long as this meaning applied broadly to include goods such as buildings and inventory. Although George held that there was, there is no real economic difference between capital goods and household goods. For example, a house that one rents out to another person provides the same housing service as one that is owner occupied.
  2. “Financial capital” consists of funds and bonds.
  3. “Human capital” is the skills, education, and training that make labor more productive. Human capital is part of the labor factor.
  4. “Natural capital” means land.

Since “capital” has these different meanings, it is clearest when the term “capital goods” is used for the factor or production.

The term “interest” as used in economics and by the public means a premium paid to borrow funds. In the market for loanable funds, the supply comes from savings, and the demand comes from borrowers. The interest rate tends to equalize the quantities of loanable funds supplied and demanded. If the interest rate were zero, in normal times, the quantity of loanable funds demanded would be greater than the quantity supplied. The reason for this is “time preference,” the general tendency of most people most of the time to prefer to have goods sooner rather than later. There are two reasons for time preference: the limited human life span, and the uncertainty of the future.

Suppose somebody wants to have a car, and has no savings. He could save money for several years, and then buy the car. Or, he could borrow funds to have the car now. Goods are worth more to us now than in the future, and the rate at which goods get discounted as the purchase is put off further in the future becomes the natural rate of interest.

Henry George thought that interest arises from “The active power of nature; the principle of growth, of reproduction, which everywhere characterizes all the forms of that mysterious thing or condition which we call life. And it seems to me that it is this which is the cause of interest, or the increase of capital over and above that due to labor” (III, 3, paragraph 17). The Austrian economist Böhm-Bawerk refuted that doctrine, explaining, for example, that if a bottle of wine will be worth $500 in ten years, rather than setting a rate of interest from the growth of its value, the already existing rate of interest will determine the value today of a bottle of wine, such that its value will then grow at the market rate of interest to that $500 in ten years.

The natural rate of interest or pure interest is the rate based on time preference. When banks and other financial firms pay “interest” on savings accounts, this is not pure interest. When there is an inflation of prices and money, some of the payment compensates for rising prices – the real interest rate is the nominal rate minus the inflation rate. Also, the interest paid by a borrower includes not just pure interest and an inflation premium, but also a payment for the overhead costs of the lending institution, and an additional premium for risk.

Interest can be a return to any factor of production. If a worker borrows funds to pay for education that increases his productivity, and then pays the interest on the loan from his higher wage, the interest is part of his wage that is being paid to the lender.

If someone borrows funds to buy land, and pays the interest from the rent of that land, the interest payment comes from land rent. If someone borrows to buy or build capital goods, and then pays the interest from the profit from the use of the capital goods, that interest payment is a return on the capital goods. Thus “interest” is not a return on capital goods unless the funds are specifically borrowed to buy capital goods.

When Georgists say that labor gets wages, land gets rent, and capital gets interest, they are using the term “capital” for “capital goods” and “interest” for the yield of capital goods, but this can be confused with interest paid on financial capital, in which case “interest” is being used in the time-preference meaning rather than as a yield of capital goods.

Most people have their savings in funds in financial accounts, and the interest paid on these accounts combines returns on labor, land, and capital goods, depending which factors were bought with the borrowed funds. It is clearer to use the term “interest” to mean the payment for borrowing or payment received for saving, and to use the terms “capital goods” and “yield of capital goods” when referring to that factor.

If one is physically lending out a capital good, then only part of the loan is interest. Suppose you loan out for one year a tool kit that has a purchase price of $100. Suppose also that the real interest rate is five percent, and there is no inflation. Suppose also that the borrower returns the tool kit a year later plus $20 for the loan. Of that $20, only $5 is interest, since the interest rate is five percent. Of the remaining $15, $5 could be for the labor involved in the lending, $5 as land rent for the space the lender uses, and $5 for the depreciation of the tools, as they lose value every year by getting worn out or becoming more obsolete. Payments for borrowing capital goods include depreciation as well as interest. So it is incorrect to call the payment for using capital goods “interest,” as this ignores the depreciation as well as the payment for the wages and rent of the lender.

Therefore, if one wishes to clearly understand and communicate economics:

  1. Use the term “interest” to mean a payment to shift the purchase of goods from the future to the present day, and the receipt of that income by savers and lenders.
  2. Use the term “capital goods” for the factor of production of produced goods.
  3. Use the term “capital yield” for the income due to the ownership of capital goods.
  4. Avoid using the term “capital” by itself unless you have previously used “capital goods” or “financial capital” and are using the term “capital” in the same context. To maximize your clarity in both thinking and communicating, it is best to avoid “capital” and use “capital goods” for the factor and “funds” for money in a financial account.

One thought on “Interest, Time, and Capital

  1. I agree with Fred Foldvary that the use of the term “interest” to describe that portion of wealth produced by the use of capital goods has only served to confuse. His alternatives do solve that particular problem.
    Fred goes on to suggest that Henry George’s distinction between capital goods and household goods is unwarranted. While his example of housing units utilized as an income-producing property versus those occupied by owners has merit, this does not address George’s main distinction. George argued that once goods were in the possession of the final consumption, they were no longer to be COUNTED as capital goods because no new wealth was being produced by the consumer’s ownership of the good. Economics certainly took a step backwards in the pursuit of objective analysis by converting any and all asset or human capability into a form of capital.
    A reason why those who have financial reserves generally charge a fee for the temporary transfer of purchasing power is more complex than straightforward time preference. This is more likely to be true of an individual extending credit to another individual. A lending institution raises financial reserves for the specific objective of enabling others to exercise their time preference through the use of credit. Thus, the bank’s fee is determined by all of the factors Fred identifies except time preference.
    For those of us who have in past years used the books written by Henry George to teach political economy, I suspect we would agree with Fred conceptually about the use of “capital yield” over “interest” as the term used to describe a return to capital goods. These days, I do not rely on George’s books as a text. Adult students today seem much less willing to read and to prepare for classroom discussion by doing homework. So, substituting “capital yield” for “interest” is easy enough to do in my teaching.
    However, as I have tried to convey here, I am less than impressed with what mainstream economics has offered up as the standard measure of economic growth – Gross Domestic Product.

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