The Types of Risk that Affect the Volume of Investment

The most important confusion on nthe meaning of the marginal efficiency of capital is due to the failure to see that it depends on the prospective yield of capital and not its current yield.

This is best illustrated by pointing out the effect on the marginal efficiency of capital of an expectation of changes in the prospective cost of production, whether these changes are expected to come from changes in labour cost or from inventions and new technique.

The output from today’s new equipment must compete with the output from future, more-efficient, lower-cost equipment.

The entrepreneur’s money-profit from equipment, old or new, will be reduced if all output comes to be produced more cheaply.

Thus, the marginal efficiency of capital produced to-day is appropriately reduced.

Thus, the expectation of changes in the value of money influences the volume of current output.

The expectation of a fall in the value of money stimulates investment hence employment generally because it raises the investment demand-curve. The expectation of a rise in the value of money reduces investment because it lowers the investment demand-curve.

This is what is behind Professor Irving Fisher’s theory of “Appreciation and Interest”

The distinction between the money rate of interest and the real rate of interest where the real rate of interest is equal to the money rate of interest after correction for changes in the value of money. It is difficult to make sense of this theory because it is not clear whether the change in the value of money is or is not assumed to be foreseen. If it is not foreseen, then there will be no effect on current affairs. If it is foreseen, then the prices of existing goods will be forthwith so adjusted. The advantages of holding money and of holding goods will become again equalised. It will then be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent.

Professor Pigou’s solution is to suppose that the prospective change in the value of money is foreseen by one set of people but not foreseen by another.

This does not escape the dilemma.

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital.

The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money.

The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital.

The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output — in so far as the rate of interest rises, the stimulating effect is to that extent offset), but to its raising the marginal efficiency of a given stock of capital.

If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices.

For the stimulus to output depends on the marginal efficiency of a given stock of capital rising relatively to the rate of interest.

Professor Fisher’s theory could be best re-written in terms of a “real rate of interest” defined as being the rate of interest which would have to rule, consequently on a change in the state of expectation as to the future value of money, in order that this change should have no effect on current output.[6]

An expectation of a future fall in the rate of interest will have the effect of lowering the schedule of the marginal efficiency of capital.

Since it means that the output from equipment produced to-day will have to compete during part of its life with the output from equipment which is content with a lower return.

This expectation will have no great depressing effect, since the expectations, which are held concerning the complex of rates of interest for various terms which will rule in the future, will be partially reflected in the complex of rates of interest which rule to-day.

Nevertheless, there may be some depressing effect, since the output from equipment produced to-day, which will emerge towards the end of the life of this equipment, may have to compete with the output of much younger equipment which is content with a lower return because of the lower rate of interest which rules for periods subsequent to the end of the life of equipment produced to-day.

The dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle.

Types of Risk Affecting Investments

1. Entrepreneur’s or borrower’s risk

This arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes.

If a man is venturing his own money, this is the only risk which is relevant.

2. Lender’s risk.

This may be due either to moral hazard, i.e. voluntary default or other means of escape, possibly lawful, from the fulfilment of the obligation, or to the possible insufficiency of the margin of security, i.e. involuntary default due to the disappointment of expectation.

3. A possible adverse change in the value of the monetary standard which renders a money-loan to this extent less secure than a real asset

Though all or most of this should be already reflected, and therefore absorbed, in the price of durable real assets.

Now the first type of risk is, in a sense, a real social cost, though susceptible to diminution by averaging as well as by an increased accuracy of foresight.

The second, however, is a pure addition to the cost of investment which would not exist if the borrower and lender were the same person.

Moreover, it involves in part a duplication of a proportion of the entrepreneur’s risk, which is added twice to the pure rate of interest to give the minimum prospective yield which will induce the investment.

For if a venture is a risky one, the borrower will require a wider margin between his expectation of yield and the rate of interest at which he will think it worth his while to borrow.

The very same reason will lead the lender to require a wider margin between what he charges and the pure rate of interest in order to induce him to lend (except where the borrower is so strong and wealthy that he is in a position to offer an exceptional margin of security).

The hope of a very favourable outcome, which may balance the risk in the mind of the borrower, is not available to solace the lender.

This duplication of allowance for a portion of the risk has not hitherto been emphasised, so far as I am aware; but it may be important in certain circumstances. During a boom the popular estimation of the magnitude of both these risks, both borrower’s risk and lender’s risk, is apt to become unusually and imprudently low.

The marginal efficiency of capital curve is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present.

The mistake of regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between to-day and to-morrow.

Even the rate of interest is, virtually,[7] a current phenomenon.

If we reduce the marginal efficiency of capital to the same status, we cut ourselves off from taking any direct account of the influence of the future in our analysis of the existing equilibrium.

The fact that the assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality.

But the introduction of the concepts of user cost and of the marginal efficiency of capital, as defined above, will have the effect, I think, of bringing it back to reality, whilst reducing to a minimum the necessary degree of adaptation.

Economic future is linked to the present because of the durability of equipment.

It is, therefore agreeable to our broad principles that the expectation of the future should affect the present through the demand price for durable equipment.