Archive for March, 2014

A Note on Interest

March 17, 2014

Accumulating capital involves retention of an opportunity to consume in exchange for which surplus labour – labour whose subsistence needs are already funded – can be deployed as finance. Without finance being provided, any return on investment would not be realised, and this therefore confronts us with the following questions: how much of this gain is owed to holders of capital as interest, and what governs this?

In essence, a saver holding capital can provide finance by pledging a relatively liquid asset (typically money) in exchange for a relatively illiquid one (such as a receivable or equity). The shift from liquidity to illiquidity implies a cost measured by the delay (or the risk of economic loss on liquidation) that must be endured by the financier before being able to consume goods and services. This is offset by the gross gains made by the saver’s transaction counterparty, the investor, realised as greater future output.

Investing surplus labour means that consumption (principally workers’ subsistence) has been funded in advance of completion of the works. However, the full wages of labour still need to be paid (the consumption component owing to the provider of finance, which is thus repaid “at par”). Rent must also be discharged in full. The only basis for any excess remaining as a net investment return would be to cover interest charged by the provider of finance in satisfaction of the saver’s “time preference” for immediacy (liquidity).

In certain circumstances, the pure opportunity cost of deferred consumption may be zero, and if this could somehow sustain zero interest rates there would be no return on capital – allowing wages (including for intellectual property) and rent to absorb all the gains. (As intellectual property is diffused, rents take the lion’s share of gains; the biggest beneficiaries of antitrust laws are landlords.)

But savers do not just face a delay on consumption; in parallel, they face an opportunity cost measured as wages foregone by not investing in their own productivity. Zero interest rates would therefore imply an expectation of zero income gains to be made from investing (or else a monopoly on the expertise needed to achieve such gains).

Whereas for non-savers, surplus labour would need to be expended in raising productivity, savers already have the resources (surplus labour) with which to purchase equipment and thereafter enjoy higher wages (at least than would otherwise be the case). Accordingly, if the saver is instead to finance investment undertaken by someone else, in addition to receiving back par he should expect compensation for the loss of wages over the same period. This is a component of time preference and therefore interest.

Provided its fruits are not hoarded as goods – which would dampen aggregate consumption in proportion – but instead exchanged for the opportunity to consume (ie for capital in the form of debt, equity, rental receivables or money), surplus labour can be used to finance investment. Interest plays an essential role in this exchange, without which investment would be curtailed to the detriment of all.

Interest does not impinge upon the funds drawn on to pay wages. This is because wages (for generalised labour ie not “protected” by patented intellectual property) are constantly squeezed down towards the margin of cultivation, the socially-determined minimum return needed – after payment of rent – before labour will be supplied. The return on capital must, therefore, come out of what would otherwise have been drawn as rent. This exerts a stabilising influence on rents: in times of euphoria, higher interest offsets higher output; and vice versa.


A Note on Capital

March 9, 2014

Capital describes an opportunity for someone to consume a measure of goods now or in the future without having to expend labour. Assuming the goods to be consumed do not currently exist, labour will of course be expended to allow the opportunity to be taken. But this labour will be expended by others, to whom the capital under consideration will be distributed in order to elicit the goods.

So capital, in abstract terms, represents labour-time, namely the amount that must be expended to satisfy the opportunity to consume. Labour is the source of the only constraint on capital formation – it exerts the only fundamental cost on production – because, uniquely, human toil creates an additional subsistence need. Wages cannot fall below this margin of subsistence or else the labourer would not be able even to live.

The margin of subsistence must be capable of being met out of output or else the work is essentially non-productive. But workers may demand well in excess of this margin so as to save enough in anticipation of old age, when they will become decreasingly productive and eventually unable to work. Saving is precisely what motivates capital formation in the first place, and allows workers to create capital.

Whereas labour expended must consume part of its fruits, rent imposes no such constraint on capital formation: using the resources on which rent accrues does not imply additional consumption because land already exists, freely and in spite of human activity. It is this fact that actually defines rent, which is a key channel by which capital created is subsequently distributed.

It might appear that when high enough rent will constrain capital formation by leaving insufficient reward for the producer, thus removing the incentive to work. However this is a reversal of causality: rent does not constrain productivity but rather it is productivity that constrains rent. Far from being its nemesis, rent is a sign of productive opportunity: where land accrues no rent, this is because, at best, it scarcely yields enough to cover wages, and most likely is below the margin of cultivation dividing land that is in use from land that is idle.

By the same token, labour working on superior land does not automatically command higher wages, because rent absorbs any surplus over the margin of cultivation. This, Ricardo’s Law of Rent, is the consequence of competition over scarce resources (in this case location). As well as the significance of rent as a channel for distributing capital, this law is among the most important – and least prioritised – observations for economists. Socialising rights to rent, by taxing and remitting rent to all, is the only tool to combat poverty – and to democratise the use of capital.