The Paradox of Interest Revisited

Courtesy of Antal E. Fekete @ ProfessorFekete.com

The classical formulation of the paradox of interest is due to Böhm-Bawerk and Schumpeter. Its modern formulation is due to Hausman and Kirzner. I quote Kirzner:

Much – perhaps all – will turn out to depend on the way in which the interest problem is formulated. For present purposes we adopt a modern formulation of the problem, but wish to emphasize that this formulation is very similar in spirit and character to classic formulations… The modern formulation we cite is that of Hausman. Hausman points out that an “individual’s capital . . . enables that individual to earn interest. If the capital is invested in a machine, the sum of the rentals the machine earns over its lifetime is greater than the machine’s cost. Why?” Common observation, that is, tells us that possession of a given stock or capital funds can, by judicious investment (say, in a machine) yield a continuous flow of income (annual rentals net of depreciation) without impairing the ability of the capital funds to serve indefinitely as a source of income. The problem is, how this can occur. Why is not the price of the machine (paid by the capitalist at the time he invests in the machine) bid up (by the competition of others eagerly seeking to capture the net surplus of rentals over cost) – to the point where no such surplus remains? We are seeking, then, an explanation for an observed phenomenon which is, in the absence of a theory of interest, unable to be accounted for. Absent a theory of interest, no interest income ought to be forthcoming, except as a transient phenomenon; competition ought to squeeze it out of existence.

In this note I propose to solve the paradox by suggesting that the exchange of wealth and income should be made the cornerstone of the theory of interest, replacing the exchange of a present and a future good.

To say that the capitalist “invests” his wealth is too simplistic. Investing is bound to confuse the issue. Moreover, possession of wealth does not automatically guarantee access to income. There is an implicit exchange of wealth and income interposed between the capitalist and entrepreneur that needs to be made explicit. Here is what happens.

The capitalist exchanges wealth for income. Income is yielded by the entrepreneur, who converts wealth into capital goods (such as a machine or a fruit tree) and hires a manager to tend them (including the task of setting depreciation quotas in anticipation of having to replace the capital goods at the end of their useful life without further charges to the capitalist). The entrepreneur sets up three accounts for the distribution of the yield after depreciation, namely, one for each of:

(1) a fixed interest income payable to the capitalist,
(2) wages payable to the manager,
(3) the remainder, or entrepreneurial profit, payable to himself. Continue reading