Interest and the Marginal Product of Capital: Bhm-Bawerk versus Samuelson

Robert P. Murphy Hillsdale College August 2004

Abstract It is quite common to associate the equilibrium rate of interest with the marginal product of capital. However, not all economists have endorsed this practice, and indeed many have challenged the explanation of interest according to marginal principles. In this paper I oer a resolution to this dispute by rst agreeing with the critics of mainstream models, but then demonstrating that the "justication" of interest is quite straightforward, once we have remembered the (elementary) distinction between rents and interest. To underscore my belief that the historical controversy was ultimately due, not to marginal principles, but to more modern techniques that are valid only under special circumstances, I have framed the paper as a pseudo-debate between (nineteenth century theorist) Eugen von Bhm-Bawerk and Paul Samuelson. Keywords: Interest theory, capital theory, capital controversy, Bhm-Bawerk, growth theory JEL Classication: .

Department of Economics, Hillsdale College, 33 E. College St., Hillsdale, MI 49242. E-mail: Robert.Murphy@hillsdale.edu. I would like to thank Paul Dower and Ryuichi Tanaka for helpful comments.

Introduction

The association of the equilibrium real rate of interest with the marginal product of capital is a staple of modern mainstream economics. Indeed, when graduate students are asked to nd a typical models equilibrium values of the real wage and interest rate, there is apparently nothing more natural than calculating the derivative of the production function with respect to labor and capital, respectively. This seems to make perfect economic sense, because

under competitive conditions, the laborer gets paid the marginal product of his labor, while the capitalist gets paid the marginal product of his capital. Despite its popularity, not all economists have always endorsed this practice. Indeed, during the celebrated capital controversy of the 1950s and 60s, many prominent critics questioned the validity of the marginal productivity explanation of interest payments.1 These writers suggested that the orthodox theory proceeded in a vicious circle, because (unlike labor) there was really no such thing as units of abstract "capital"; the only way to amalgamate heterogeneous units of physical machinery, factories, and goods in process into a single number, was to sum their present market values, a calculation which itself relied on an antecedent rate of interest. Consequently, the moral legitimacy of interest income was cast into doubt, since (apparently) such payments were not really a return to any productive factor, after all. The present article seeks to resolve the dispute by acknowledging the partial merits of both sides. First, the critics of orthodox neoclassical theory are correct; in general it really isnt coherent to view interest as a return to the marginal product of capital. Second,

the neoclassical apologists for capitalism are also correct; the distribution of income in a competitive market economy proceeds according to marginal principles, and the income earned by the owners of capital goods is just as legitimate (in this respect) as that earned by laborers or landlords. These two apparently contradictory positions will be reconciled
1

Some of the standard works on this front are Robinson (1953-1954), Sraa (1960), and Pasinetti (1966).

(and hopefully rendered obvious) after a review of some basic economic truisms. Although certainly appropriate to historians of economic thought, the present article is intended for the general economist. Consequently, I have avoided extensive surveys of the literature, and instead have couched my arguments in terms of a "debate" between Eugen von Bhm-Bawerk (a nineteenth century giant in capital and interest theory) and Paul Samuelson (an obvious representative of the modern mainstream approach to capital and interest). As I hope to convince my reader, the mainstream neoclassicals left themselves open to their Cambridge critics not because of any fundamental aw with marginalist theory, but rather because their fascination with mathematical models led them to forget the insights of earlier thinkers. To illustrate this subtle aspect of my thesis, the choices of Bhm-Bawerk and

Samuelson are quite tting.

Bhm-Bawerks Critique of the "Naive" Productivity Theory

In the late nineteenth century, Bhm-Bawerk (1959 [1881]) oered a critique of (what he called) the "naive productivity theory" of interest, a theory which explained (and justied) the capitalists income as a return to the "productivity of capital." Bhm-Bawerk famously argued that this theory was inadequate, since it only explained why capital goods possessed market value; by itself, the physical productivity of a capital good could not explain why its present purchase price was lower than the future revenues it was expected to yield. Referring to a tribal sherman who initially lives hand-to-mouth before using a more capitalistic technique (an example familiar to economists of the time), Bhm-Bawerk argued: Now let us turn to the second interpretation of which the naive productivity theory is capable. Here the productive power ascribed to capital is, in the rst instance, to be understood as physical productivity only, that is to say, a capacity 3

on the part of capital to furnish assistance which results in the production of more goods or of better goods than could be obtained without its help. But it is assumed as self-evident that the increased product, besides replacing the costs of capital expended, must include a surplus of value. Just how convincing is this interpretation? I grant without ado that capital actually possesses the physical productivity ascribed to it, that is to say, that more goods can actually be produced with its help than without. I will also grant. . . that the greater amount of goods produced with the help of capital has higher value than the smaller amount of goods produced without it. But there is not one single feature in the whole set of circumstances to indicate that this greater amount of goods must be worth more than the capital consumed in its production. And that is the feature of the phenomenon of excess value which has to be explained. To put it in terms of Roschers familiar illustration, I readily admit and understand that with the assistance of a boat and net one catches 30 sh a day, while without this capital one would have caught only 3. I readily admit and understand, furthermore, that the 30 sh are of higher value than the 3 were. But that the 30 sh must be worth more than the pro rata portion of boat and net which is worn out in catching them is an assumption which the conditions of the problem do not prepare us for, or even cause to appear tenable, to say nothing of making it obvious. If we did not know from experience that the value of the return to capital is regularly greater than the value of the substance of capital consumed, the naive productivity theory would not furnish a single reason for regarding such a result as necessary. It might very well be quite otherwise. Why should not capital goods that yield a great return be highly valued on that very account and indeed, so highly that their capital value would be equal to the value of the abundance of goods which they yield? Why, for instance, should not a boat

and net which, during the time that they last, help to procure an extra return of 2,700 sh be considered exactly equal in value to those 2,700 sh? But in that event, in spite of the physical productivity, there would be no excess value. (I, pp. 93-94, italics original) Bhm-Bawerks fundamental insight was that the rate of interest was not, in the rst instance, a matter of product, but instead a ratio of the value of product relative to the value of the capital asset yielding it. An engineer can tell us that a certain machine will yield $1000 in output for each of ve years, after which the machine will be useless. But these technical facts alone do not determine the rate of return to a capitalist who purchases such a machine; if the initial price is (roughly) $4,329.48, the rate of return will be 5 percent per year, but if the initial price is $5,000, then the rate of return on the investment will be 0 percent.2 The physical productivity of the machine explains the magnitude of its periodic rental payments, but it is the relation between the initial capitalized value of the machine and these future cash ows that determines the internal rate of return. Of course, no modern economist would deny these truisms. When a mathematical

economist sets the equilibrium rate of interest equal to the "marginal product of capital" in a formal model, this is not to commit the fallacy involved in the so-called naive productivity theory. However, even though it is free from internal contradiction in its formal exposition, the modern approach certainly invites the very misconceptions that Bhm-Bawerk took pains to refute. More serious, by drawing general conclusions from these quite limited models, the mainstream apologist for capitalism leaves him or herself open to critics of a Sraan persuasion. In the following sections, I will take two examples where Samuelson entirely

misses the signicance of Bhm-Bawerks insight, by assuming away the very problems that
For a rate of return of 0 percent, the calculations are straightforward. For a rate of return of 5 percent, consider that the machine at the beginning of its fth year has a spot price of $952.38 (since it will yield $1000 in marginal product at the end of the year). Working backwards, we nd that the rst and second year prices are $4329.48 and $3545.95. Consequently, a capitalist who buys a brand new machine must pay $4329.48. After one year, he will have $1000 in marginal product, plus a machine that can now be sold for $3545.95, for a net return on his investment of ($1000+$3545.95)$4329.48 5%. $4329.48
2

so worried Bhm-Bawerk (and later the Cambridge critics).

Example One: Samuelson Assumes Steady State

In this section, our point of departure will be Samuelsons discussion of von Thnen, whom Bhm-Bawerk had criticized for failing to see that interest involved more than simply the "productivity of capital." As we shall demonstrate, Samuelsons modern exposition of von Thnen involves an expression for the rate of interest that is valid only in the steady state, and thus misses the point of Bhm-Bawerks critique.

3.1

Samuelsons Discussion of von Thnen

In his article celebrating the work of von Thnen, Samuelson writes:

Thnen is indicted and convicted by Bhm as holding a "productivity theory of interest": in allegedly merely assuming that capital projects exist that do yield a saving of labor greater than the labor needed to produce the capital goods themselves, Thnen is accused by Bhm of the logical fallacy of petitio principii he is begging the question that needs to be faced and resolved. However, as

Bhms admirer Knut Wicksell had to point out, the scientist has no choice but to beg every such question in the sense that ultimately a Newton must accept how it is that apples do fall; and that it is not in the power of an Einstein to deduce why Mercury must lag in the way that telescopes conrm it does and that the truth of general relativity theory would entail. (1983, p. 1469, i.o.)

Before proceeding to the technical details, let us pause to note that Samuelson has apparently misunderstood Bhm-Bawerks critique. As a re-reading of the passage quoted in this paper demonstrates, Bhm-Bawerk did not expect productivity theorists to explain particular facts of nature (i.e. the net technical productivity of capitalistic processes). What 6

worried Bhm-Bawerk was that too many writers thought that these brute technical facts alone explained the existence of a positive interest rate. What Bhm-Bawerk sought was a satisfactory explanation of how such technical facts could give rise to a premium on present versus future consumption. Now perhaps von Thnen did give such an explanation, or perhaps he didnt; this is a matter best left to history of thought journals. Either way, we must be clear on what BhmBawerks objection was.3 Because Samuelson has apparently misunderstood it, his formal defense of von Thnen is unsatisfying. In an appendix entitled "Vindicating Thnens Logic on Capital," Samuelson writes: [NOTE TO EDITOR AND REFEREES: For simplicity during the various revisions of the present paper, I have simply attached the relevant page 1485 from Samuelson in its entirety at the end.]

3.2

A General Derivation

We will now derive the general expression4 for the equilibrium interest rate in the discreteperiod model (i.e. the model in Samuelsons footnote 13). First, consider an individual in period t who has b1 units of labor. He must be indierent between selling his labor to

the machine industry or to the grain industry, and so the wages in each industry must be identical. Consequently (because we assume zero prots) the marginal product of his labor in either industry must be of equal exchange value (whether reckoned in period t or in period t + 1). The individuals b1 units of labor can be used (in period t) to produce either 1

machine, or b1 F2 [K(t), LQ (t)] units of grain, in period t + 1. Thus, we have established that in period t + 1, the (spot) grain-price of 1 machine must be b1 F2 [K(t), LQ (t)]. By

similar reasoning, we know that in period t + 2, the (spot) grain-price of a machine must be
Bhm-Bawerks specic remarks on von Thnen (I, pp. 111-116) do not dier importantly (for our purposes) from his arguments presented at the beginning of this paper. 4 It goes without saying (literally, in the case of Samuelson) that we are concerned only with an interior solution, i.e. we are characterizing the equilibrium interest rate and real wages if labor is being used (in every period) in the production of both machines and grain.
3

b1 F2 [K(t + 1), LQ (t + 1)]. Now consider an investor in period t + 1 who wishes to purchase one machine. From above, we know that he must spend b1 F2 [K(t), LQ (t)] units of real consumption on it. He can then use it (in combination with hired laborers) to yield F1 [K(t + 1), LQ (t + 1)] units of grain (which will not be available until period t + 2) that are directly attributable to the productivity of this machine. Because of (physical) depreciation, the investor will also have 1 units of machinery remaining. (Recall that the grain-price of a new machine in investment, and the total market value (in grain) of the resulting assets in the following period, we can express the investors implicit net real rate of interest in period t + 1 by the following:

t + 2 is b1 F2 [K(t + 1), LQ (t + 1)].) Since we know the market value (in grain) of his initial

i(t + 1) =

market value of investment in period t + 2 1 market value of investment in period t + 1 (1 )b1 F2 [K(t + 1), LQ (t + 1)] + F1 [K(t + 1), LQ (t + 1)] 1. b1 F2 [K(t), LQ (t)]

In the special case where the number of machines per worker in the grain industry (i.e.
K(t) ) LQ (t)

is constant, we can write

i(t + 1) =

F1 [K(t + 1), LQ (t + 1)] b1 F2 [K(t), LQ (t)] F1 [K(t)/LQ (t), 1] , F2 [K(t)/LQ (t), 1]b1 Thus,

which is of course identical to Samuelsons expression for (what he labels) z.

Samuelsons expression for the rate of interest is valid only in the steady state. The only mention Samuelson makes of this assumption is when he remarks that his equation (A10) 8

is "valid both in steady states and in general." It is apparently then left to the reader to realize that any other equations are valid only in steady states. Let me emphasize that the issue here is not simply that Samuelson failed to enumerate all of his assumptions. Remember that Bhm-Bawerk had accused von Thnen of begging the question by assuming (in his treatment of capitals productivity and the rate of interest) what he was trying to prove. Samuelson then feels he has adequately defended von Thnen by formally modeling steady state growth. But notice that in such a steady state, where capital per worker in the grain industry is constant, the spot grain-price of machines is also constant.5 In other words, Samuelson has imposed from the outset that the rate of return cannot be inuenced by uctuations in the (market) value of the capital goods from period to period. Thus, Samuelson has merely formalized von Thnens argument without really demonstrating that it should be acquitted of Bhm-Bawerks charges. Samuelson feels he has vindicated von Thnen, because his (Samuelsons) system of equations is free of any vicious circularity. But as we have demonstrated above, this is only true because Samuelsons system of equations is only valid in the steady statei.e. when we have already assumed the conclusion under dispute! Yes, if Samuelsons equations were true in general, then Bhm-Bawerks criticism would indeed be captious. But since the

more general expression for the equilibrium interest rate allows for precisely the type of value uctuations that worried Bhm-Bawerk, Samuelsons techniques in no way allow us to award von Thnen "highest marks for getting all this right."6 Bhm-Bawerk was trying to explain the phenomenon of interest in general, and not merely in steady states. The

modern exponents of the marginal productivity explanation of interest should take little comfort from the fact that their explanation is perfectly sound in the steady state.
K(t) That is, constant LQ (t) implies constant b1 F2 [K(t 1), LQ (t 1)], which is the spot grain-price of a machine in period t. 6 Again, I am not here concerned with whether von Thnens model is ultimately sound or not. After all, someone can "beg the question" and still be right. 5

Example Two: Samuelson Assumes One Good

In the previous section, we saw that Samuelson dismissed Bhm-Bawerks concerns with the productivity approach by a focus on the steady state, without (apparently) realizing that this tactic assumed away the problem. In this section, we will see Samuelson follow a similar strategy in his criticism of Schumpeters famous zero-interest doctrine. Rather than merely imposing a steady state, Samuelson here will postulate an economy consisting of only one good. This too will (obviously) eliminate the possibility of changes in the market value

of capital goods, and hence the one-good model is particularly irrelevant in arguments over capital valuation.7

4.1

Samuelsons Discussion of Schumpeter

One of Joseph Schumpeters most (in)famous theories was that, absent innovation, the rate of interest in an economy in long-run equilibrium would necessarily be zero. In a train of thought reminscent of Bhm-Bawerks critique8 of the naive productivity theory, Schumpeter argued that (absent innovation) there would be no net return in any line of production, because however great the productivity of capitalistic processes, the value of the nal product would be imputed back to the land and labor factors that went into the capital goods. (Schumpeter 1912) Against this reasoning Samuelson replies: ...Schumpeter does not reconcile his doctrine that all value is decomposable into land rent and labour wages with a possible technological case: 100 rice ripen into 110 rice in one years time without need for any labour or scarce land...
Cohen (1989) reaches a similar conclusion. The reader who refers to Samuelsons article may be puzzled, since Samuelson often claims to be taking Bhm-Bawerks side (versus Schumpeters). However, in the context of the present paper, Samuelsons reliance on the single-good model to refute Schumpeter shows that Samuelson does not fully appreciate the logic of Bhm-Bawerks critique of the naive productivity theory.
8 7

10

Schumpeters answer might start out in terms of these words (which I put into his mouth): With more rice next year, the price of each grain falls. Thus, 110 then sell for the total of marks 100 now will sell for. So 100 marks today still get you 100 marks tomorrow. The rate of interest is zero sans innovations. Q.E.D. Around p. 170, Schumpeter (1912) repeatedly makes the point that (when the interest rate is truly zero) the greater magnitude of the forest is already imputed back in value to the saplings: so these foreseen changes in time only conserve the already calculated value of the process. Without labour and land, zero Kuznet product is being produced and it is correctly decomposable into zero real rent and zero real wages. But this is pure self-deception. Real rice is being produced net. Kuznets can measure it. You can eat 10 rice every year and still not impair your circularow income. With land redundant and labour not needed, Kuznets measures national income of zero in terms of primary-factors income. To this he adds

permanent real interest income of 10 rice per year. No hocus-pocus of backward imputationof forest to sapling, or rice grain to rice grainevades the naive fact of productive interest. Empirically, Schumpeter may deny...that there always exists positive technical productivity of capital at the margin. But logically he must throw

in the towel: when 100 rice as input yields 110 rice output at the end of the year, no steady-state (real!, own !) rate of interest can obtain other than 10% per year. A zero equilibrium rate becomes a contradiction (and settling down of the system to a steady state may no longer occur). (Samuelson 1981, pp. 22-23) As with Samuelsons discussion of von Thnen, he has here sought to establish the "naive fact of productive interest" by analyzing the steady state,9 and in particular an
Also as with the discussion of von Thnen, I am not taking sides with Samuelson or Schumpeter in regard to the particular dispute. Schumpeter himself was discussing a long-run steady state, and hence Samuelsons analysis may be quite suitable for his purpose.
9

11

economy with only one good (which serves as both capital and consumption).

Although

internally consistent, the analysis of such a model can be very misleading when it comes to the possible relation between interest and the productivity of capital goods, because all of the complexities are assumed away. For example, the mere fact that one consumption good possesses an own-rate of interest of 10 percent does not, in general, imply a positive rate of return to capitalists who invest in such a good.10 I will demonstrate this claim in the

following subsection, and then I will oer a more general model to illustrate the irrelevance of one-good models in this debate.

4.2

Two-Good Counterexample

The simplest counterexample to Samuelsons contention is a case where there are not one but two goods, each of which can be either consumed in the present period, or used for (re)production in the next period. (There are no other inputs and no other production

technologies.) Following Samuelson, assume that the rst good is rice, and that it contains a net technical productivity of ten percent: 100 units of rice this period will physically transform into 110 units of (equally useful) units of rice next year. Now, following Irving Fisher (1977 [1930] pp. 191-192), imagine that the second consumption good consists of a stock of gs, and that 100 units of uneaten gs this period will physically transform (due to rotting) into 50 units of gs next year. Thus the own-rate of interest on rice is 10 percent, while the own-rate of interest on gs is negative 50 percent. In such an economy, what will be the real rate of return to capitalists? Before answering this question, we must rst specify the relevant "basket" of commodities, the total price of which will serve as our consumer price index. Let us assume that the basket consists of 1 unit of rice and 1 unit of gs. Further suppose that the representaXT tive consumer has utility function U = ln Rt + ln Ft , where Rt and Ft represent the
t=
10

amounts of rice and gs consumed in period t. Finally, suppose that the initial stocks of
For a verbal critique of Samuelsons argument against Schumpeter, see Kirzner (1996) p. 142.

12

rice and gs are such that the representative consumer optimally chooses R0 = F0 in the initial period 0. In this (extremely particular) example, 100 units of rice in period 0 trade for 100 units of gs in period 0. Because of their net technical productivities, 100 units of rice in period 0 trade for 110 units of rice in period 1, while 100 units of gs in period 0 trade for 50 units of gs in period 1. In period 1, the relative price of rice versus gs has changed, due to the growth in rice consumption and decline in g consumption: 100 units of rice in period 1 now trade for approximately 45.45 units of gs. Therefore, a capitalist who had the purchasing power of 100 baskets (i.e. 100 rice and 100 gs) in period 0 and invested in either good (or any combination) would have only 68.75 baskets of purchasing power in period 1, for a real rate of interest of negative 31.25 percent.11 As this extreme example shows, the mere presence of a consumption good with a positive technical net productivity does not guarantee a positive interest rate, because relative prices of consumption goods can change over time.12 In the next subsection, I generalize the

argument and show more formally how the assumption of a single-good economy completely masks the conceptual problems with the marginal productivity explanation of interest.
It may clarify to use some hypothetical dollar prices. Suppose that the spot price of both rice and gs is $1 per unit in period 0, while the period 1 spot price of rice is $0.4545... and the spot price of gs remains at $1. A capitalist in period 0 can then invest $200 in purchasing 100 of the commodity baskets (i.e. 100 units of rice and 100 units of gs). If the capitalist refrains from consuming any of his purchases, in the next year his investment will become 110 units of rice and 50 gs. At the stipulated spot prices, the capitalist can sell these products for a total of $100. The nominal money rate of return is hence negative 50 percent. However, this nominal gure understates his return, because prices in general have fallen; it is now cheaper to buy a basket of commodities. Indeed, because the spot price of rice has fallen to $0.4545..., the $100 in period 1 can purchase 68.75 units of rice and 68.75 units of gs, i.e. 68.75 baskets. 12 In fairness to Samuelson, he explicitly acknowledges (in a dierent paper) the importance of constant spot prices for his critique of Schumpeter: "[I]t is denitely in contradiction to the usual notion of equilibrium to state that the price of corn is constant over time, and yet one hundred units of corn are today worth as much as one hundred and ten bushels are worth tomorrow. But this is what is implied in the Schumpeterian assertion that there will be reected in todays corn the full value of tomorrows output stemming from it....Equilibrium coexistent with a zero money rate of interest would be possible only if prices violated the constancy postulated of the stationary state. If capital in general had a continuing, real, net, own productivity, the money rate of interest could be zero only if prices were falling at a percentage rate equal to that of the productivity." (Samuelson 1943, p. 65)
11

13

4.3

The More General Case: Distinct Capital and Consumption Good

In this subsection, I hope to render quite explicit the drawbacks to the single-good model for resolving any disputes over capital productivity and interest. In both Bhm-Bawerks critique of the "naive" productivity theory, and in the more general attacks on the marginalist approach coming from the Cambridge critics, the central issue was the valuation of capital goods. Yet this is precisely the feature that is obliterated by working with a one-good model. As we shall see, there is a qualitative leap in moving from an economy with two goods (one capital and one consumption) to an economy with only one good.13 The modern practice of focusing either on the steady state or explicitly on a one-good model (as Samuelson has done in his own work in this area) blinds the modern neoclassical to the subtleties of the problem, and severely weakens his or her ideological defense of the capitalists income. 4.3.1 The Model

Suppose there are an innite number of time periods, from t = 0 to t = . At any time t there exists a xed labor supply L and a variable stock of machinery Kt . In any period, labor and machinery can be combined to yield, in the next period, units of (extremely perishable) consumption or units of new machinery. There is no depreciation of machinery in either line of production. Finally, I explicitly model a bank,14 which provides a loan of consumption goods to the machine owners and laborers in period t = 0 (since the machines and labor will not yield consumption goods until t = 1). The bankers earn a perpetual ow of interest

payments on this principal. We thus have the following relations:

Note that the issue is not one versus a multiplicity of various consumption goods, but rather the distinctness of the capital and consumption good. 14 Some third party is necessary in order to complete the model, since (at positive interest rates) the machine owners and laborers earn their discounted product. (This is what leads many writers to deplore interest as "exploitation.") In this section, I will refer to "bankers" and "machine owners," since the more common term "capitalists" is often used to mean both groups.
13

14

Ct+1 = f (Kc,t , Lc,t ) = Cl,t+1 + Cm,t+1 + Cb,t+1 ,

Kt+1 = Kt + g(Km,t , Lm,t ),

Kt = Kc,t + Km,t , and

Lt L = Lc,t + Lm,t , where Cl,t+1 denotes the consumption of laborers in period t+1, Cm,t+1 the consumption of machine owners, and Cb,t+1 the consumption of the bankers. Lc,t and Kc,t are the amounts of labor and machinery devoted in period t to production of the consumption good (which of course will not be available until the next period), while Lm,t and Km,t are the amounts of labor and machinery devoted in period t to the production of machinery. Assuming competitive markets and that f (, ) and g(, ) are dierentiable and yield an interior solution, we know that in equilibrium the following relations must hold: (t+1 )g2 (Km,t , Lm,t ) f2 (Kc,t , Lc,t ) wt = = t+1 and 1 + it 1 + it rt = ( t+1 )g1 (Km,t , Lm,t ) f1 (Kc,t , Lc,t ) = t+1 , 1 + it 1 + it

(1)

(2)

so on. The spot price of consumption has been normalized to one, while a indicates the b price of a machine in period a, when the machine will be delivered in period b. (Thus t+1 t+1 is simply the spot price of a machine in period t + 1.) Take careful note that rt is not the rate of interest but rather the rental (or hire) price of a machine; a machine owner rents out one unit of machinery in period t to immediately receive rt , and then he receives his machine

where f2 (, ) denotes the partial derivative of f with respect to its second argument and

15

back (in perfect condition, since we assume no physical depreciation) at the start of the next period. The net real rate of interest is indicated by it , and is dened as the relative premium on present consumption versus future consumption.15 Relations (1) and (2) require that

labor and machines earn their (discounted) marginal products, and that their returns must be equal whether they are used to produce consumption or machinery. Finally, we have the following relations between the prices of capital goods (machinery) in dierent periods: t+1 t+1 . 1 + it

t = rt + t = rt + t t+1

(3)

The equations in (3) require that the period t spot price of a machine equals its immediate yield, rt , plus the current price for a machine available in period t + 1, i.e. t . (In t+1 equilibrium t = t+1
t+1 t+1 1+it

because of arbitrage.)

Using the rst equation in (2), we can substitute for rt in (3) to obtain t = t Rearranging yields f1 (Kc,t , Lc,t ) ( t t+1 ) t+1 t . t t t+1 f1 (Kc,t , Lc,t ) + t+1 . 1 + it 1 + it

it =

(4)

Equation (4) is completely intuitive. It expresses the fact that the net (real) rate of interest is equal to the net (real) yield of capital divided by the market price of the capital good. 4.3.2 Discussion

As equation (4) demonstrates, the mere fact that capital goods are physically productive by itself does not guarantee a positive rate of interest, because the periodic rental payments
15

That is, if we dene px as the period x price of a unit of consumption good delivered in period y, then y
pt t pt t+1

it

1.

16

(for the "services of capital") may be partially or (in principle) even completely oset by a fall in the market value of the machinery.16 But this possibility is completely masked by

assuming an economy with only one good: In this case, a unit of capital always trades onefor-one against units of consumption, because (obviously) they are units of the same thing. Thus a = 1 trivially in any one-good model, and equation (4) reduces to the standard a it = f1 (Kc,t , Lc,t ). It is for this reason that neoclassicals wishing to consider the objections of the Cambridge critics (as well as the writings of Bhm-Bawerk and Schumpeter) should not adopt a one-good model as the baseline case, as it involves more than a mere harmless simplication. The above model sheds some light even in the case of a steady state, where the price of the capital good is constant over time. Suppose that a = 2; that is, suppose that the spot a price of a machine is always two units of consumption. Further suppose that in some period t, f1 (Kc,t , Lc,t ) = 0.1; that is, suppose that the marginal unit of machinery will yield an extra 0.1 units of consumption good in the following period. Since we are in the steady state,

one might carelessly conclude that the real rate of interest in this economy is 10 percent at period t, because a given unit of machinery will yield itself plus 0.1 units of additional output in the following period. But as equation (4) tells us, this is incorrect: The correct rate of interest in period t is only
0.1(22) 2

= 5 percent.

The Distribution of Income

The discussion thus far in this paper has pointed out shortcomings in the standard mainstream view of interest, using the work of Paul Samuelson for concrete examples. However, my analysis does not lead to the typical conclusions (e.g. Garegnani 1970) of those who side with the critics of the Cambridge debate. Nothing I have written above in any way

bolsters the claim that the existence of interest or the capitalist class somehow "exploits"
Thus the eect is not one of mere physical depreciation, as Bhm-Bawerks critique of the naive productivity theory may appear to suggest. Even without physical depreciation, the perfectly intact capital stock can still become less valuable in terms of consumption goods over time.
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laborers. To demonstrate this, I do not need to resort to any more models. Ironically, it is precisely the analysis of mathematical models that led to trouble in the rst place! In order to understand (and hence properly justify) the distribution of income in a market economy, we would do well to reect on the insights of two pioneers of neoclassical interest theory, namely Eugen von Bhm-Bawerk and Irving Fisher. In a competitive market, every productive factor receives its marginal product, and this exhausts all output; there is no separate type of income called "interest" that is economically distinct from payments to the owners of labor, natural resources, and capital goods. Indeed, to view interest as a type of payment reserved exclusively for "the capitalists" is to revert to classical fallacies. As Fisher explains: The hire of human beings is wages; the hire of land is rent. What, then, is the hire of (other) capitalhouses, pianos, typewriters, and so forth? Is it interest? Certainly not. Their hire is obviously house rent, piano rent, typewriter rent, and so forth...Rent is the ratio of the payment to the physical objectland, houses, pianos, typewriters, and so forthso many dollars per piano, per acre, per room. Interest, on the other hand, is the ratio of payment to the money value of these thingsso many dollars per hundred dollars (or per cent). It is, in each case,

the ratio of the net rent to the capitalized value of that rent. It applies to all the categoriesto land quite as truly as to houses, pianos, typewriters. The

income from land is thus both rent and interest just as truly as the income from a typewriter or a bond. We can and do capitalize land rent just as truly as we do house rent. For example, land worth "20 years purchase" yields 5 per cent interest. (Fisher 1977 [1930], pp. 32-33) As these elementary observations from Fisher remind us,17 there is really nothing unique about capital goods and interest; the owner of an automobile factory receives the same rate
Fisher himself acnowledges his debt to Frank Fetter, the author of the "capitalization theory" of interest. See (Fetter 1977).
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of return (adjusted for risk) on his investment as the owner of farmland receives on hers. The dividends of the shareholder in a corporation are interest, but they also reect the marginal productivity of the various assets of the corporation. And if we consider that workers can choose to invest in their own education, in a suitably dened model the wages a worker receives would (a) equal his marginal product and (b) yield the market rate of return on his "human capital." Viewed from this perspective, there is obviously no question of interest harming workers, because wages too are ultimately interest dividends. Surely the reader has abandoned me at this point; it is inconceivable that the resolution of the controversy could be so simple. After all, isnt there an obvious sense in which workers are hurt by interest? Indeed, equation (1) from above tells us that wt =
f2 (Kc,t ,Lc,t ) . 1+it

Here

we see that the workers real wage is inversely related to the (real) gross rate of interest. Nonetheless, I still maintain that this in no sense reects exploitation. Remember that the worker is not yielding any product in period t; his or her labor will only yield f2 (Kc,t , Lc,t ) units of additional consumption good in period t + 1. But the worker desires to be paid immediately, without waiting for his or her contribution to "ripen." It is thus the banker (in the terminology of my model above) who pays the worker upfront in period t. This

payment must of course be adjusted to allow for the fact that payment is taking place in a dierent period from when the work will actually yield tangible results, and (by denition) the market exchange rate of present for future goods is given by the real rate of interest. In this sense, the banker is no more exploiting the worker by paying the discounted marginal product, than he would be exploiting someone who desires to be paid in US dollars rather than yen, and has the appropriate exchange rate applied. The bankers earn interest, therefore, not because of capitals productivity, but because they sell present goods in exchange for future goods.18 Recall that the machine owners too are only paid the discounted marginal product of their machines. What gives the bankers
Of course, to understand why the market places a premium on present consumption, the fact of technical productivity is quite signicantbut this is of course exactly in agreement with Bhm-Bawerks own positive theory of capital and interest. (II, pp. 259-289)
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a perpetual ow of real consumption is thus not capital goods per se, but the fact that the bankers had a stockpile of consumption goods in the initial period 0 that they were willing to advance to the workers and machine owners.19 If there is still any question of exploitation, note that the worker can become a "banker" himself by lending his wages at the prevailing rate of interest.20 Indeed most workers in modern economies take advantage of positive

interest rates when saving for retirement.

Conclusion

The neoclassical habit of equating the real rate of interest with the marginal product of capital deserves skepticism. In the rst place, the practice is only justiable in special (In contrast, By

circumstances, in which the market value of machinery remains constant.

the wage rate equals the marginal product of labor in any competitive equilibrium.)

focusing on such special cases, the modern economist (not to mention graduate student) is likely to draw false generalizations regarding what interest is. By analogy, consider this: In a suitably designed modelperhaps involving reproducible robots, or even human slavesone could nd that the equilibrium interest rate always equals the "marginal product of labor." More generally, the modern focus on capital productivity tends to resurrect classical fallaciessuch as the confusion between the rental price of a capital good versus the rate of return to its ownerthat were exploded in the 19th century. (The typical one-good model of modern macro and growth theory is particularly conducive to such ambiguities.) Such
In the real world, what normally happens is that the "bankers" would sell their consumption goods in period 0 in exchange for the goods in process (i.e. circulating capital) that were immediately produced by the combination of labor and machines. In the following period, this circulating capital would then ripen into more total consumption goods than were paid to the workers and machine owners in the previous period. However, we can equivalently view the situation as a pure consumption loan: As before, the bankers advance some of their stockpiles of consumption goods in period 0, but now the workers and machine owners retain full ownership of their circulating capital. They sell the full product in period 1, but before they can consume they must pay an interest installment on their loan. Interest payments have nothing inherently to do with capitalistic production, save for the eect on the premium placed on present consumption goods. 20 This argument was one of many Bhm-Bawerk advanced against the "exploitation theory" of interest (I, pp. 250-280).
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confusion is deplorable not only for its own sake, but also because it lends ammunition to the critics of the market economy. In this paper I have attempted to illustrate the weakness of the standard approach by citing two examples where Paul Samuelson failed to acknowledge the severe limitations on his analysis. Were my examples gleaned from a discussion of, say, international trade theory, they could be dismissed as harmless. Yet they were occasions on which Samuelson was

arguing over capital and interest theory itself, and consequently his evasions of the central issue are alarming indeed. In closing, I urge mainstream economists to carefully reconsider their description of interest as "the price of capital services" and phrases such as "factor-price frontier." It is far more accurate to say that interest is, rst and foremost, a reection of the premium on present versus future consumption. (After all, there can be interest even in a pure

exchange economy.) Simple one-good models can still be protably used for certain purposes, but when it comes to capital and interest theory, only a model with distinct capital and consumption goods is acceptable.

References
[1] Bhm-Bawerk, Eugen von. (1959 [1881]) Capital and Interest, (3 vols. in 1), South Holland: Libertarian Press. [2] Cohen, Avi J. (1989) "Prices, capital, and the one-commodity model in neoclassical and classical theories," History of Political Economy, 21:2, pp. 231-251. [3] Fetter, Frank A. (1977) Capital, Interest, and Rent: Essays in the Theory of Distribution, ed. with Introduction by Murray N. Rothbard, Kansas City: Sheed, Andrews, and McMeel. [4] Fisher, Irving. (1977 [1930]) The Theory of Interest, Philadelphia: Porcupine Press.

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[5] Garegnani, P. (1970) "Heterogeneous Capital, the Production Function and the Theory of Distribution," The Review of Economic Studies, Vol. 37, No. 3 (July), pp. 407-436. [6] Kirzner, Israel. (1996) Essays on Capital and Interest, Brookeld, VT: Edward Elger Publishing, Ltd. [7] Pasinetti, L. L. (1966) "Changes in the rate of prot and switches of techniques," Quarterly Journal of Economics, 80, pp. 503-17. [8] Robinson, Joan. (1953-1954) "The Production Function and the Theory of Capital," The Review of Economic Studies, Vol. 21, No. 2, pp. 81-106. [9] Samuelson, Paul A. (1943) "Dynamics, Statics, and the Stationary State," The Review of Economic Statistics, Vol. 25, No. 1 (February), pp. 58-68. [10] (1981) "Schumpeter as an Economic Theorist," pp. 1-27 in Schumpeterian Economics, ed. Helmut Frisch, New York: Praeger Publishers. [11] (1983) "Thnen at Two Hundred," Journal of Economic Literature, Vol. 21, No. 4 (December), pp. 1468-1488. [12] Sraa, Piero. (1960) The production of commodities by means of commodities, Cambridge.

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