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( Originally Published Early 1900's )

1. Reward of capital.—Capital is a product of labor used in the production of other goods. It consists of so-called production goods, its end and purpose being the production of more wealth.

A carpenter's tools are part of his capital. The house he builds for you to live in is regarded as a consumable good, not as capital. Farm implements are capital; they have value solely because of their use for the cultivation of the soil. Potatoes and buck-wheat cakes on the farmer's breakfast table, however, are consumable goods.

Since the labor of a man when he has the aid of capital is more productive than when he works without it, a certain share of the product of the labor is allotted to capital and is called interest.

2. Compensation for past labor and sacrifice.—A capital good does not satisfy directly any human want; it merely renders easier the production of goods that do satisfy wants.

The earliest forms of capital were the various rough implements devised by primitive man for hunting and fishing purposes. The savage who made the first bow and arrow, or who built the first dugout canoe, or who sharpened the first crude fishhook, undoubtedly de-voted much time and labor to his task. He did the work, not because he enjoyed it, nor because he expected to get any pleasure shooting arrows at a target or into the sky, or cruising about in his canoe, but because he believed the bow and arrow, the canoe and the fishhook were going to make it easier for him to get food for himself and family. If it so happened that they did not render this service to him, he would have felt that all his labor was wasted.

So with all forms of capital. The real reward of the labor which produces them lies in the future and is derived from their productive power.

3. Money and capital.—In business capital is always thought of and spoken of in terms of money, and interest is thought of as the amount of money which the borrower pays to the lender for the use of some portion of the latter's money.

But we must not confuse the two terms, capital and money, for they are two entirely different things. Money, since it is a medium of exchange which facilitates production, may be regarded as capital when used in business, but not when spent for a pleasure purpose. The amount of capital in a country does not depend upon the amount of money in it. The capital consists of factories, railroads, raw materials, machinery, etc. The prices of these articles depend upon the amount of money, or upon the value of the money metal if its free coinage is 'permitted. The fact that the supply of money in a country is increasing is no evidence of an increase of its capital or production goods. An increase in the money supply merely tends to cause an advance of prices.

4. Money and the interest rate.—In modern times virtually all lending of capital is done thru the medium of money and credit, and interest is paid at a rate determined by forces which we shall consider later. Here it is sufficient to call attention to the fact that money itself produces nothing. The borrower wants it solely because he can easily convert it into the things he can utilize in his business or industry. By borrowing money and credit a merchant is able to carry a larger stock of goods on his shelves, and to him those goods are capital, altho to his customers they may be consumable goods. With borrowed money the manufacturer is able to enlarge his plant, buy more raw materials and increase his output.

The merchant gives added value to the goods he handles by having them in a place that suits the consumer's convenience, while the manufacturer accomplishes the same end by changing the form of goods, In these processes money plays no part except as a medium of exchange. The interest which the lender receives is in the form of money, but it was earned not by the money he loaned, but by the capital goods for which that money was exchanged by the borrowers.

5. Prejudice against interest.—Because of the popular misunderstanding of the nature of capital, there exists in various quarters a strong feeling that the capitalist is not entitled to the interest he exacts from borrowers, since money can produce nothing. By what right, it is asked, does the man who lends it demand compensation? So strong was this prejudice only a few centuries ago that the money lender was usually despised, and all interest paid for the use of money was regarded as usury, that is, as being undeserved. At the present time the term usury is applied only to an interest rate which is regarded as exorbitant, such, for example, as the so-called loan sharks in cities exact from people compelled by misfortune or necessity to borrow on the pledge of personal property. Any rate of interest that exceeds the productive power of capital is usury.

The popular prejudice against capital will not disappear until its nature is more generally understood. If the canoe that our savage built proved a great assistance to him in his fishing excursions, some of his fellow-tribesmen would doubtless beg for the privilege of using it, and every man will admit that he would have a right to make them pay for the privilege. No-body objects to the fact that a man charges you for the use of his boat, for the use of his horse and wagon, or for the use of his shop and tools. In the popular mind these are all cases of rent, yet essentially they are all cases of interest. Suppose I need a motor truck in my business and have not enough money to buy one. I might hire a truck and pay a rental for it, or I might borrow money and buy a truck, paying interest on the borrowed money. The truck is the capital. I should expect it to help me earn the rental in the one case, or the interest in the other. If I hire the truck, I should of course have to pay as rental a larger sum than I would pay for the borrowed money in form of interest, for the rental would properly include, in addition to a fair price for the use of the truck, a certain sum to cover the loss in value due to depreciation or wear and tear. If a truck lasted only five years, and then became worthless, its owner would naturally plan to get back its full value in the course of five years, as well as a fair rental for its use. On the other hand, if I borrow money from the bank, I should expect the truck to increase my profits by at least the amount of the interest and the debt I incurred in its purchase, for otherwise I should be out of pocket.

Whether I hire the truck, or borrow the money to buy one, my hope of gain or profit lies altogether in the earning power of the truck. The lender of the money is entitled to his compensation quite as much as would be the owner of a truck if I hire one. Economically I get the same service in either case.

6. Various kinds of capital.—Capital is commonly divided into three classes of goods, industrial plants with their machinery, raw materials and food-stuffs. These divisions are, of course, capable of many sub-divisions, but it is sufficient here to note the fact that the productive power of the various classes of capital goods is not the same, and that the productive power of any one form of capital varies with circumstances.

For example, certain occupations are not in good repute and men will not invest their capital in them unless the rewards are above the ordinary. A saloon is a good illustration of this kind of business. Other occupations are uncertain in their yield, being dependent upon the seasons or upon the popular whim, and a man will not risk his capital in them unless he sees the possibility of a large return. On the other hand, certain kinds of business are so easily established and managed and require so little preliminary training, that many men go into them and invest in the aggregate a large amount of capital, but the return on this capital on account of the excessive competition is comparatively small. The small grocery stores and cigar shops found in every city represent capital investments of this sort.

The greatest returns on capital are earned by capital when it is employed by men who have a genius for business, men of ideas, of initiative, of inventive ability. Such men are quick to apprehend changes in the popular tastes and in the demand for various kinds of goods. Sensing a growing demand for an article, they invest more capital in its manufacture and make their capital yield more than ordinary return. During the first two decades of the twentieth century large fortunes were made by men who foresaw the usefulness and increasing popularity of the automobile. They made their capital unusually productive by in-vesting it in the materials which entered into the manufacture of automobiles.

7. Foodstuffs as capital.—Let us consider wheat as a typical foodstuff. When it is harvested by the farmer it is not ready for consumption, and is not a consumable good. To the miller it is a capital good, and he converts it into flour which, as a capital good is sold to the baker, who converts it into loaves of bread. These loaves of bread are part of the baker's capital, and they do not cease to be capital until they become so-called consumers' goods on the tables of his customers.

It is possible to regard a loaf of bread as being a capital good even when it is on the consumer's table. If the consumer is a worker and eats the bread in order to retain his health and strength for his day's work, the bread is consumed with a productive end in view, and may fairly be classed as capital. If, how-ever, the consumer is an idler, not engaged in business and performing for society no useful service whatever, the bread he eats cannot be classed with capital goods. In the one case the consumption of bread leads to an increase in production, in the other case it does not.

8. Diminishing returns.—It is well for the reader at this point to refer back to section 9 of Chapter V, in which is stated the general law of diminishing re-turns upon land, Iabor and capital. Since this law has a direct bearing upon the rate of interest, the reader must be certain that he understands its application to the case of capital.

The penny-in-the-slot machines found in railroad stations are a good illustration of virtually automatic capital, for the operation of these machines requires very little assistance from labor. The number of such machines that can be placed to advantage in any city is evidently limited. Ten machines in the best possible locations might earn 100 per cent on the capital invested, but if a second ten were added, the rate of income might fall to 50 per cent. Let us suppose that the machines cost one hundred dollars apiece, that one hundred machines are placed in different lo-cations of the city, and that the return per machine has fallen to 10 per cent. If the owner is borrowing capital at six per cent and must set aside each year a sum equal to five per cent of his investment to cover the depreciation of his machines, he is manifestly making no gain. He has invested too much capital in the business and is the victim of the law of diminishing returns. If he has no competition, he will reduce the number of machines in that locality until he believes that he has found a number the operation of which yields him the highest net return after all deductions have been made for expenses and depreciation, and will seek to invest his surplus capital in some other business, or in some other locality.

That part of capital which yields a return barely sufficient to compensate its owner is called by economists the marginal unit of capital. It is the least productive part of a country's capital.

The owners of capital are always seeking to invest it in the most productive forms of enterprise. As returns from this or that industry or business decline toward the marginal point on account of the increasing investment of capital, or because the products of the enterprises fall in price because of lessening demand, capital shifts to other enterprises, the returns from which are greater. As a result, in any country where competition is lively, the marginal supply of capital shifts from industry to industry, and the net returns from enterprises of all sorts tend toward a common rate.

9. Demand for capital.—In any country the strength of the demand for capital depends upon three important circumstances:

First, the opportunities offered by the country for the profitable employment of capital.

Second, the existence of an adequate supply of labor properly trained and willing to work at reason-able wages.

Third, the presence of men eager to engage in business and industry, willing to assume all the risks and able to give wise direction to the employment of labor and capital. Economists call these men enterprisers or entrepreneurs; in common speech they are known as good business men.

It is from this third class of men that the demand for capital directly comes. Their reward is called profit, which is governed by circumstances that we shall discuss in a later chapter. The plans and enter-prises of these men usually call for the use of more capital than they themselves own. Then they enter the money market or loan market and borrow. Evidently the rate of interest which a business man is willing to pay cannot exceed that which he can make it earn. If lenders demand more, 'they will do no business. We see at once, therefore, that the rate of interest is somehow related to and dependent upon the productivity or earning power of capital.

Some economists go so far as to maintain that the rate of interest is determined altogether by the productivity of capital, but they qualify this statement by the admission that the rate of interest depends, not on the earning power of capital in general, but upon the earning power or productivity of what they call marginal capital.

To illustrate: If so much capital has already been invested in the businesses and industries of a country that additional supplies cannot be made to yield a return of more than seven or eight per cent, then lenders must be content with a rate of interest some-what below those figures, for otherwise business men will be under no incentive to borrow. This conclusion is perfectly sound. We must admit that the productivity of capital is a most important factor in deter-mining the rate of interest.

10. Loanable supply of capital.—Men do not borrow capital goods. They borrow capital in the form of money and credit, and the available supply of it in this form is often spoken of as its capital fund. The amount of it in any country depends upon the productive power of the people and upon their thrift and willingness to save. As was pointed out in Chapter III, the savings of a man, no matter whether he produces and sells goods or sells merely his services, finally take the form of money or credit and are usually invested in some enterprise or deposited in a bank.

The necessary result is that the loanable capital fund in a country corresponds with and represents the savings of those people who wish to let other people make use of their capital.

What is the force that impels people to save? This is an, important question, for the supply of capital depends upon saving. The motives for saving are various, yet all have a common feature, namely, a regard for future needs and wants. A man may be thrifty and saving because he wishes to provide for the proverbial rainy day, or he may wish to have a competence in his old age, or he may desire to have his children well provided for, or he may have a keen desire to be very rich by the time he is fifty in order that he may live in luxury and ease, or indulge in the pleasures of travel and music and art.. Whatever the motive, the man who saves, who does not spend all of his income in the satisfaction of present wants, is looking into the future and is in some measure under the domination of future wants.

Many men doubtless would lay aside part of their income in order to protect themselves against the contingencies of the future even tho their savings yielded them no rate of interest. Nevertheless the interest paid upon capital is a great stimulus to saving. A return of four per cent would satisfy certain thrifty people and make them save to the limit, while on people of another kind it would have no effect whatever.

An offer of 10 per cent if apparently genuine will induce saving on the part of men who will not be influenced at all by an offer of five per cent.

Differences of this kind exist among men, and for that matter among nations, for instance, the thrifty French and Dutch and the rather improvident Americans and Irish. To the very thrifty man who is induced to save by a promise of three per cent, the thought of possessing one hundred" and three dollars a year hence gives greater satisfaction than he can get by spending at once the one hundred dollars in his hands. Other men are indifferent about the future unless four per cent is promised, and still others do not awake to the thrift motive until a much higher return is promised.

As a general proposition, it is safe to assume that saving in any country tends to increase as the rate of interest rises, and, conversely, to decrease as the rate of interest declines. Hence a rising rate of interest tends to enlarge the supply of loanable capital.

Since the marginal productivity of capital depends upon the supply, tending to decline as the supply in-creases, it is not remarkable that some economists hold to the view that the rate of interest is determined, not by the productivity of capital, but by the forces and circumstances which regulate the supply of a country's capital, especially by the relative values to its people of present and future goods. The advocates of this theory hold that the rate of interest represents a discounting of the future. If a bird in the hand is worth two in the bush, a man must be promised more than two birds in the future if he is to let go of the one bird he has in his hand.

11. Demand and supply in the loan market.--We need not attempt to decide which of these two theories is nearer the truth or the more satisfactory. It is enough if the reader understands that those borrowers in whose hands additional capital will be least productive—called marginal borrowers by economists—are most eager for a low rate of interest. What they can earn with new capital fixes the maximum above which the rate cannot rise if all the available capital is to be loaned. Among the lenders, on the other hand, we find men barely persuaded to save and lend, and ready to withdraw their capital from the market if the rate goes below a certain minimum. Theoretically, the rate of interest must be such as to satisfy both these classes of men.

Let us suppose that in a given market there are ten million dollars in the hands of lenders, all desiring the best possible investment Among these lenders there are certain men who would withdraw some of their funds from the market unless they can get at least five per cent. Among the borrowers we shall find many different classes of men, some in businesses earning high profits and able if necessary to pay a high rate of interest, say 10 per cent. But their demand, we will suppose, would absorb only half a million dollars. Another set of men might use three million dollars profitably and pay eight per cent; another set might use five million dollars at seven per cent and still make a gain. We have now found potential borrowers of eight and a half millions, but it must not be supposed that these borrowers, altho able to pay high rates of interest, are offering any such rates in the market. They are going to borrow as cheaply as possible, and the market rate will depend on the demand for the remaining million and a half dollars. If the market rate were six per cent, we will suppose that half a million might be loaned at that rate. This would leave a million dollars still seeking borrowers, and the rate must be lowered until it satisfies those borrowers who are least able and least willing to pay a high rate.

In other words, the law of supply and demand operates in the market for capital, commonly known as the money market, just as it does in the markets for commodities, where values are determined and prices fixed, and the rate of interest tends in the long run toward such a figure as will establish an equation between the supply of capital and the demand for capital.

In old communities the forces governing the demand for and supply of capital vary but little from day to day, and the rate of interest is therefore comparatively stable. In other communities, especially those where new opportunities for the use of capital are constantly turning up, the rate of interest is subject to greater variations.


1. What is the economic interpretation of capital? What are the three main divisions of capital?

2. Is interest, strictly speaking, a payment for the use of money?

3. What are the sources of loanable capital?

4. What three circumstances regulate the demand for capital?

5. What factors tend to establish interest rates?

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