The Nature of Capital and Income

The Nature of Capital and Income: A New Addition to IFA's Library

The Nature of Capital and Income

According to Joseph Schumpeter, the father of “creative destruction,” Professor Irving Fisher of Yale University was the greatest economist the United States ever produced.1 James Tobin, another Yale Professor of Economics and 1981 Nobel laureate called2 Fisher “America’s first mathematical economist.” Fisher also had a profound influence on another Nobel laureate, Milton Friedman, described3 by The Economist as “the most influential economist of the second half of the 20th century...possibly of all of it.”

If Irving Fisher was the Isaac Newton of economics, then The Nature of Capital and Income was his Principia. We at Index Fund Advisors are very pleased to have acquired a signed first edition of this book published in 1906. Starting from the most basic of definitions and axioms, Fisher proceeded to derive a full explanation of interest rates and their relationship to the valuation of assets. Just as James Clerk Maxwell formulated the equations that unified electricity and magnetism, so too did Fisher unify economics with accounting in a completely rigorous manner.  The first few sentences of the preface perfectly describe his intentions:

“This book is an attempt to put on a rational foundation the concepts and fundamental theorems of capital and income. It therefore forms a sort of philosophy of economic accounting, and, it is hoped, may supply a link long missing between the ideas and usages underlying practical business transactions and the theories underlying abstract economics.”

A significant chunk of the book is devoted to clarifying exactly what is meant by capital and income. We thought that these sentences from his general summary (page 328) provide the clearest picture:

“To describe in a few words the nature of capital and income, we may say that those parts of the material universe which at any time are under the dominion of man constitute his capital wealth; its ownership, his capital property; its value, his capital-value; its desirability, his subjective capital. But capital in any of these senses stands for anticipated income, which consists of a stream of services or its value.”

Fisher defined the rate of interest as the bridge or link between income and capital. Fisher’s equations for discounting future cash flows form the foundation of Asset Pricing Theory, and the particular equation that bears his name breaks down the rate of interest into two components—the real rate of interest and the rate of inflation. Fisher also gave us a deeper understanding of interest rates when he characterized them as a measure of our “impatience.” During periods of high interest rates, investors (or lenders) are less willing to postpone consumption, so capital incurs a higher cost.

One part of Fisher’s work that we find particularly interesting is his treatment of risk. He articulated how a discount rate for future cash flows should include a risk component. Also, he may have been the first economist to propose standard deviation as a measure of financial risk. Fisher displayed remarkable insight (page 321) into how business owners tend to underestimate the risks they face and how competitive markets price assets to reflect their risk:

“At any rate, it is not infrequent that when a new enterprise is started, those who have the first knowledge of the possibilities, and the first opportunity to exploit them, expect returns out of proportion to the ordinary rate of interest and compensation for risk. The only reason this is not more generally true is because of the existence of competition, by which the special advantage of individuals through special knowledge, foresight, etc., is offset by the vigilance of their rivals.”

One way that Fisher was ahead of his time was his proposal4 for the government to issue bonds that are indexed to inflation. His revolutionary idea did not come to fruition until 1997, 50 years after his death. In the course of developing a methodology for tracking price data to calculate the rate of inflation, Fisher invented the forerunner of the Rolodex filing system. From this invention, Fisher became a multimillionaire, and his fortune greatly increased in the bull market of the Roaring Twenties. He was regularly solicited for market commentary by reporters.

Despite all of Fisher’s enormous contributions to the fields of finance and economics, he may unfortunately be most remembered for his ill-timed statement on the eve of Black Monday in 1929 when he said, “Stock prices have reached what looks like a permanently high plateau.” Even after the crash, Fisher remained optimistic about stock prices and thereby lost his personal fortune as stock prices continued to plummet in the 1930s. Fisher was so discredited by his market pronouncements that few people took notice that he had developed a theory known as “debt-deflation” which explained economic depressions as the result of credit cycles. Instead, the Roosevelt administration turned to John Maynard Keynes whose massive public spending was seen as providing a way out of the Great Depression. Fisher was also discredited for his views on eugenics (racial cleansing) which he never abandoned.

As of today, Index Fund Advisors probably has one of the best collections of rare and antique finance-related books. As we make interesting new additions such as this one, we will keep you apprised.

1Schumpeter, Joseph (1951). Ten Great Economists from Marx to Keynes. New York: Oxford University Press. p. 223.

2Tobin, James (1987), "Fisher, Irving (1867–1947)", The New Palgrave Dictionary of Economics: 369–376.

3"Milton Friedman, a giant among economists"The Economist. November 23, 2006.

4http://www.bloombergview.com/articles/2012-11-27/irving-fisher-the-first-celebrity-finance-professor