This section is from the "Economics In Two Volumes: Volume I. Economic Principles" book, by Frank A. Fetter. Also available from Amazon: Economic
§ 8. Bountiful income and abstinence. Another question that has proved puzzling is as to the relation between the amount of income a man enjoys and the degree of abstinence. For if, as income increases, abstinence becomes easier, then improved methods of industry should have cumulative effects -not only making possible a larger sum of goods to enjoy now, but multiplying the amount of saving to produce other goods, and constantly lowering the rate of interest.
True, it is easier for a man with habits of life somewhat fixed to save more when his income rises. (See above, Chapter 24.) But it is not safe to say as much of men altogether, where the younger generation has time to adjust its tastes to the larger income. A community does not grow old in the same way that an individual does. (See above, under statics and dynamics, Chapter 32, section 2, on renewal of the generations.) "The children are always new" and each generation starts where its fathers left off. For this reason there appears to be little relation discoverable in history between the bountifulness of incomes in successive generations (through the discovery of richer lands, the use of better tools, machinery and methods) and the rate of time-preference. Such differences in the interest rate as appear can be explained through the changing conditions more or less favoring saving, rather than by the productiveness of industry in a community. Amount of production is only one factor in determining the rate of time-preference from generation to generation, and not the primary factor. And so, while interest was less in the seventeenth century in some European countries than it had been for centuries before, it does not seem to have fallen much, if any, in the chief commercial centers during the last two centuries, while enormous strides have been made in the productiveness of industry. It has been a matter of wonderment to social students that the rate of interest continued so high in the United States (higher than in Europe) in the last half of the nineteenth century, when the general level of incomes was so much higher than in the countries of Europe, or in any other country in the world theretofore. In fact, a very large portion of the American people have not been contributing in any degree to cumulative saving; rather they have been heedlessly consuming fully their own comparatively large incomes made possible by and drawn from the consumption and destruction of the natural resources of the country. (See Chapter 35.) The premium on the present as compared with the future may thus be just as high or higher when many men are living in great bounty as when all are in a meager environment. When they have large incomes they may save a smaller proportion of what they have, and yet possibly continue to accumulate more rapidly than when their incomes were smaller. Moreover, a large part of recent progress has been through the invention of simpler and better methods rather than through mere multiplication of old appliances. Time-preference is a psychological factor, which can not be explained by physical productivity. The attitude of men toward their environment has tremendous economic consequences.
§ 9. The interest rate and waiting. Let us now review some familiar facts to see the interrelations of abstinence, capitalization, and the rate of interest, and the dynamic effect that the choice of technical methods of production eventually has in a community.
Individual rates of time-preference unite into a market rate of time-price expressed primarily, in the case of durative agents, by the capitalization of the series of incomes. The capitalization of a series of incomes treated as perpetual is exactly in the ratio of the years' purchase. The rate of interest that arithmetically corresponds with this is the reciprocal of the years' purchase (e.g., 1/20 = .05). Practically by the law of substitution as applied to investments, interest rates and capitalization rates are brought into correspondence.
With each reduction of the time-price goes an identical arithmetic change in the rate of interest and a reciprocal increase in the capital sum, and a proportional decrease in the fraction of capital investment coming to the owner as income. The greater the degree of abstinence, the smaller the fraction of investment value that owners must take as income, the longer they must wait for an income bearing a given proportion of the capital, or equal to it, to accrue. The number of years' purchase, therefore, might well, in this connection, be called the waiting time, or waiting-period. (See Figure 60.)
Now let the time-price rate be twelve and corresponding with that would be a rate of interest on money loans of twelve, and a capitalization of $8.33 for each $1 of income. If the spirit of abstinence grows and extends in the community from whatever combination of favoring conditions, so that the time-price rate of 10 (or any lower figure) results, the change is registered in a corresponding rate of interest of 10 per cent and the capitalization of each dollar of income at $10. This shows itself first in the capitalization of all existing incomes (capable of capitalization), and would do so if there were no technical, productive process whatever, merely a limited number of incomes. All future durative uses attributable to agents are marked up in present price. There are "takers" for capital now that will yield incomes but 1/10 of its face, or what is the same thing, persons willing to have the same income spread over 12/3 years longer, i.e., 10 years instead of 81/3 years. This must cause some transfers of capital, for not all individuals have reduced their time-preference rate, and some will yield to the temptation to get $10 of present capital, whereas they could have resisted the offer of $8.33. The lower the interest rate the greater the temptation for the less abstinent members of the community to relinquish to the more abstinent the guardianship of future incomes with its task of waiting.