An Examination of the Nature of Capital
and the Causes of Interest

Charles F. Leonard

[A paper presented at the Henry George International Conference,
New York City, 30 August to 5 September 1964]

This paper is intended mainly as a re-examination and restatement of Henry George's analysis of Interest. As such, only the organization of the paper and the examples are my own; the ideas are those set forth in George's work, Progress and Poverty (75th Anniversary Edition, Robert Schalkenback Foundation; New York, 1958). The main sections drawn upon were chapter 5 of Book I, and charters 3, 4 and 5 of Book III. At the suggestion of Professor Howard Sherman of the Division of the Humanities of the California Institute of Technology, I have also consulted Eric Roll's A History of Economic Thought (2nd Edition, Prentice Hall; New York, 194E). This work was used to gain familiarity with-the terminology and viewpoints of Karl Marx, Eugen von Bohm-Bawerk, John Bates Clark, Alfred Marshall, Thorstein Veblen, and John Maynard Keynes. [Charles F. Leonard]


The purpose of this paper will be to exam in e two economic concepts: Capital and Interest, It will seek to answer two general questions. First, what is Capital arid what is its role in a modern economy? Second, what is Interest, and how and why does it arise?

Before we begin we will describe our plan and method. In the first part of the examination we will confine our inquiry to those economic processes that involve only tangible, physical objects and real human beings engaged in production. In the second part we'll extend the inquiry to those questions about Capital and Interest that involve money, credit, stocks, ownership of assets, and similar topics. Throughout the examination we will define (and, for emphasis, capitalize) each economic term that we introduce, very clearly and concisely. We ask that the reader here think of these terms only as they will here be defined, and not in any way in which he is otherwise accustomed to thinking of them for other purposes.


In this first part of the examination we will want to see what capital essentially is and what its primary functions are, and what interest essentially is and how it originally arises. For these purposes we may limit our field of inquiry to what we may refer to hypothetically as a-pre-monetary economy. We may consider this hypothetical pre-monetary economy to consist of four economic factors: Land, Labor, Wealth and Capital.

Land is defined as the earth apart from man. Land includes all farm lands, all mineral and virgin timber lands, all business and home sites, all oceans, rivers, mountains and deserts, all wild or free-growing plants and animals, arid all other objects that were neither manufactured nor grown by man.

Labor is defined as the species man. Labor includes all classes of human activity, whether mental or physical, that are engaged in for the purpose of satisfying human desires through the exchange of goods and services.

Wealth is defined as any material object produced from Land by Labor, For any object to be considered an article of Wealth it must possess two properties. It must first be a real, tangible object, made of the earth's substance; it cannot be merely an idea or a legal relationship evidenced on paper. It must in addition embody human Labor; it cannot be merely virgin land or raw material as nature provided it.

' Capital is defined as any article of Wealth not in the hands of its final consumer. Capital thus includes both those articles of Wealth that are still being grown, manufactured or exchanged, and also those articles of Wealth that are being used as aids in the production of other Wealth or services. It is important to notice, that the term Capital does not refer to a set of object distinct from the objects referred to by the term Wealth. Rather, Capital is only a sub-category of Wealth. Later on it will be very important to realize that no object can be considered to be an article of Capital if it is not at least an article of Wealth.

We may bring these definitions into sharper focus by means of a few examples that will compare and .contrast them. Comparing Land and Capital, we see that a farm field belongs in the category Land, while the crop of wheat growing on the field belongs in the category Capital; similarly, a natural river is a part of Land, while a man-made irrigation canal is Capital. Comparing Wealth and Capital, we see that to a jeweler diamonds constitute Capital, while for a rich woman diamonds are simply Wealth; similarly, a machinist's lathe and a nurseryman's cuttings are to them Capital, while a hobbyist's workbench and a home-gardener's plants are to these men merely Wealth. Finally we may compare Labor and Capital. Here, in contrast to the metaphorical phrase that refers to such people as scientists, doctors, lawyers and writers, as "social capital," we see that by our definition all human skills can belong only in the economic category Labor. This is so whether the skills are natural talents or whether they were acquired by education and training. This distinction between Labor and Capital is based not only on a definition, however, but also on a philosophical point of view.

Capital refers in general to something passive, something that is used by man as a means to his ends. We choose never to regard man as a passive tool, but rather always to regard him as the active agent of his own will. Hence, regardless of whether a man is highly skilled or only meagerly trained, and regardless of whether he is self-employed or is but one of many thousands of employees of a corporation, we will always regard him here as the initiator of his own actions, and as an end in himself, and as using Capital to achieve his ends. We will never regard him as a means, either to some other individual's ends, or to the ends of society.

In line with the above discussion, we may consider the purpose of such a hypothetical economy to be the satisfaction of human desires through human exertion. This purpose can be achieved in two ways. On the one hand, individuals may exchange their Labor with one another directly (that is, they may render services to one another), without the interposition of any article of Wealth. Barbers and doctors, lecturers and performing musicians earn their living by serving others directly, without producing a product. Individuals may also work to satisfy their desires by storing up their Labor in the form of articles of Wealth, and exchanging these with other individuals for their services or Wealth. Artisans, manufacturers, merchants and writers of books exchange their Labor for the Labor of others through the medium of articles of Wealth. We see immediately that Capital must be used in all trades that produce a product. The things produced, as long as they are still in the hands of their manufacturer or retailer, are Capital.

On the other hand, we see that Capital may be used, as an aid to Labor, not only in the trades that produce a product, but also in the service trades. For example, an artist's brushes and easels and a butcher's cleaver both aid in the production of articles of Wealth, while a minister's pulpit and an accountant's adding machine both aid in the furnishing of services. Yet, all of these objects are Capital. They all have the common quality that they serve as aids to Labor in the production or furnishing of some product or service, but are not themselves sold or consumed for pleasure.

In the terminology of the businessman, we may call Capital that gives rise to revenue directly, Inventory Capital; Capital that is not itself for sale, but which is used as an aid in the production or furnishing of some other marketable product or service, we may call Plant & Equipment Capital.

It is important to notice that this distinction between Inventory Capital and Plant & Equipment Capital applies at all stages of production, however close or distant the stage is from the final consumer. Thus, a farmer's plow, a baker's oven and a delivery-man's truck are to each of these producers Plant and Equipment Capital, while the wheat, flour and bread that pass in turn through the hands of each are always Inventory Capital to each of them.

Of these two kinds of Capital, Inventory Capital alone produces economic Interest. Plant and Equipment Capital acts in every case by increasing the productivity of Labor, and thereby adds to the Wages, the earnings of Labor. Inventory Capital alone is the source of the special return, Interest. Though Interest does not arise without the expenditure of some Labor, it is yet a distinguishable return, the existence of which cannot be attributed to Labor directly, but only to the use of Labor stored up and used as Inventory Capital.

We should note that Interest is but one of three portions into which all Wealth is divided. Interest is the share earned by Inventory Capital, Wages is the share earned by Labor, acting either alone or with the aid of Plant and Equipment Capital. Rent is the share earned by Land. But since Land is only a passive factor in the production of Wealth, the return to Land, Rent, is determined solely by the premium that any producer will pay for the right to the exclusive use of any piece of Land.

We may also note, that while the amounts of each share are set only at the time of the final exchange of the product for other articles of Wealth, the continual additions to the exchange value of the product are evident at every stage of production. Furthermore, the production of any product will never be initiated, unless a prognosis indicates that it will finally be possible to exchange the finished product for other articles of Wealth.

We must now examine how Inventory Capital produces a special addition to the amount of Wealth produced, apart from any exertion of Labor, and apart from the productivity of any piece of Land. It does so by means of two processes, those of growth and exchange, or the raising of living things, and the selling of all things at times and places where they are most desired. These two processes are the causes of Interest. We may examine them individually.

In agriculture and in animal husbandry, the value of the Inventory Capital constantly increases through growth by the action of nature. Seeds germinate and grow into grain, fruit or timber, and calves and lambs grow into cows and sheep, bearing meat, leather and wool. In-all types of production of Wealth that are based on the increase of living things, we may note two important economic facts.

First, both Inventory Capital and Plant and Equipment Capital can be used in such types of production. The Inventory Capital of agriculture includes such things as seed, grain, fruit trees, calves and breeding stock, while its Plant and Equipment Capital includes such articles as fences, barns, reapers, milking machines and incubators. But of these two kinds of Capital, only the articles of Inventory Capital are essential to the carrying on of the production. All the articles of Plant and Equipment Capital are merely aids to production, aids to the Labor of the farmer or breeder. Though they may greatly increase the efficiency of. Labor, the production of Wealth could go on without them. (Note: A breeder of farm animals obtains his Interest by selling only a portion of his stock; he always keeps another portion of his herd for use only as sires or cows. Nonetheless, both his calves for sale and his breeding stock constitute Inventory Capital; the breeding stock, just because it is not for sale, does not thereby become Equipment Capital. We may see this by noting that a breeder could, without too much trouble, produce calves without barns or fences, but he could not at all produce them, by any amount of Labor, without bulls and cows.)

Second, it is the Inventory Capital alone that increases in value through the process of growth. Barns do not grow, and reapers, efficient though they may be, do not multiply. But the seed and the livestock tend constantly to increase in value. And they do this, not solely at the hand of the farmer, but also, indeed largely, by themselves, through the forces of nature.

The increase of Wealth that results from the growth of living things used as Inventory Capital, is one primary cause and source of Interest.

On the other hand, in all trade based on the carrying of goods through time and from place to place, there occurs a completely different cause and source of Interest. This type of production by trade or exchange leads to an increase in the value of the commodity by its being transported from a place where it is of low value to a place where it is of high value, or by its being held for sale from a time when it is in little demand to a time when it is in great demand. The increase in value of commodities by the process of exchange cannot be attributed to any exertion of human Labor. It can rather be attributed solely to the uneven distribution of the earth's resources and population, and to the changing conditions of life from day to day or season to season.

If every service and every article of Wealth could be produced equally easily everywhere on earth, and if one day or month was exactly the same as any other day or month, then no gain could be derived from the transporting of articles from place to place for sale, or from the holding of goods idle for long periods in anticipation of future sale. But in the world as it is, some regions are better suited for growing bananas, some for producing steel and automobiles, some for producing seals and furs. Similarly, by the chance development of human societies, the inhabitants of some areas of the world are more skilled in making watches, those of others are more skilled in making leather goods, and those of others in making clothes, shoes and perfume.. Again, some seasons of the year are best adapted to the production of fruits, others to the production of grains. But both of these articles are in demand all through the year. On the other hand, beach cottages that bring high rents in summer are in very low demand the other eight or nine months of the year. But they cannot for this reason be alternately built and torn down; they must be left as inventory all the year round.

In all the types of production of Wealth that involve the transportation or holding of goods from places or; times where they will bring little in exchange, to places or times where they will bring much in exchange, the increase in exchange value can occur only by the use of Inventory Capital, Examples of this kind of increase in Wealth through exchange include the carrying of knives to Eskimos and the obtaining of skins in exchange, or the carrying of chemical fertilizers from America to Africa in exchange for native gems or ores. In all such cases, both parties to the exchange rightly consider themselves the gainers, even after the costs of transportation have been paid. The general principle operating in all such exchanges is that both articles being exchanged are more valuable at their respective points of destination than at their points of origin. The principle is the same whether the article is in a crude state, such as raw oil, furs or ore, or in a highly manufactured state, such as tools or processed chemicals. The increase of Wealth is a real one at both ends of the exchange, just as real as is the increase of Wealth that occurs between the planting of seed in May and the harvesting of grain in September.

Furthermore, the increase in value of the articles exchanged is, like the increase in value of grain and livestock, independent of the kind or amount of Plant and Equipment Capital used in the transportation or later merchandising of these articles. The items of Plant and Equipment Capital used in the transportation and retailing of articles of Wealth -- things such as ships, trucks, warehouses and department stores -- do not cause the increase in value of the things being exchanged, but only affect the efficiency and ease with which they may be exchanged.

The increase in value that results from the exchange of articles -- of Inventory Capital, is the other primary cause and source of Interest.

. We have now examined, in purely physical, non-monetary terms the nature and functions of Capital, and the causes and sources of Interest, Before we turn to the monetary aspects of our subjects, it will be well to fix firmly and finally in our minds a few further points about the purely physical economic concepts of production, Capital and Interest.

First, we must see clearly that traders or retailers of goods for sale, "middlemen, "are as truly "producers" of these goods are the people who grew or manufactured them. For in all cases, "the production of Wealth" means the delivery of a finished article of Wealth into the hands of its final consumer, in a condition and at a time and place at which he desires it. Hence, all persons who contribute to this process are producers, whatever the stage at which they participate in the process.

Second, we must see, that the production of Wealth by manufacture is not, in itself, a primary source or cause of Interest. Rather, all the value that is added to an article in the course of manufacture (aside from its being transported about in this process), is value added by Labor. All the drill presses, foundries, lathes, factories and chemical plants that constitute so much of the Plant and Equipment Capital of our industrial economy really are just so many aids to human Labor, just as the first stone ax, wheel, or fire used by primitive man were merely aids that extended the range and effectiveness of man's use of his own mind and muscle. Just how it is that these "sterile" articles come to command Interest in the marketplace, we have yet to see. But before we see that, we must see clearly the very real distinction between Plant and Equipment Capital, which produces nothing by itself but merely allows Labor to produce all things more easily, and Inventory Capital, which is inherently a source of increase in Wealth through growth or exchange.


In this second part of the examination we must answer two questions. First, if Inventory Capital is the only kind of Capital that produces economic Interest directly, why do articles of Plant and Equipment Capital still command Interest if loaned in the marketplace? Second, how does money resemble Capital; and why does money command Interest if loaned in the marketplace? These two central questions may be more concisely stated in the following way: First, why are all capital goods interchangeable? Second, why is money interchangeable with Capital?

After we have answered these two remaining central questions about economic and monetary Interest, we will finally be able to examine and to understand the whole range of peripheral topics that are, after all, the practical and important questions about Interest to the worker, homeowner, businessman, investor or government economist. These will be, specifically, the topics of personal credit financing and mortgages, stocks and bonds, risk, monopoly and profits.

As we begin this part of the examination we must give a definition of a monetary economy. This is one in which Land, Labor, Wealth and Capital all exist and operate as in a pre-monetary economy, but in which in addition money bank credit, tariffs, franchises, patents, land titles, and corporations also exist and require consideration. That is, a pre-monetary economy contained only tangible objects and autonomous human beings, whereas a monetary economy contains also many intangible objects and many impersonal, legal institutions.

One consequence of the admixture of tangible with intangible economic factors in a monetary economy, is that we must now define a new common denominator or scale by which all types of economic objects may be measured and compared. This common denominator is value. Once we are able to measure the value of any economic object, we will be able to analyze all the complex legal relations referred to above very easily.

We may both define and measure the economic or exchange value of any object very simply: it is what you can get for the object. Thus, if wheat is the standard of value in any time and place, we may compare the value of any two other unrelated objects, such as a horse and a desk, in terms of the amount of wheat needed to purchase each object. If Labor is taken as the standard of value, then any individual may compare the exchange value of any two other objects in terms of the amount of Labor that he must expend in order to obtain either object, or the amount of other people's Labor he may command in exchange for either object.

If we now restate the first question, why are all articles of Capital interchangeable at their value, the answer comes easily. From the above definition of value, it is obvious first of all that all values are interchangeable at their value. Next, it follows that all material things of equal value, such as two different types of Capital goods of equal purchase price, are interchangeable, Finally, it follows from this, that in order to cause Labor to be expended in the production of any kind of capital good, that capital good must bring a return equal to the highest return open to any Capital. The man who thus wants to borrow, a machine worth one hundred dollars, must pay a premium equal to the Interest that any one hundred dollars worth of Capital could earn in its most productive use, namely as seed or livestock or as merchandise for trade. Restated in terms of marginal utility, an article of Plant and Equipment Capital will be built, bought or hired only if the saving of Labor it procures, or the increased revenue it produces as an aid to Labor, is at least as great as the Interest that so much worth of Inventory Capital could produce; or in more practical terms, only if the saving or the increase in revenue it produces is at least as great as the cost of hiring the article.

In summary of this important point, the man who stores up his Labor as Inventory Capital receives Interest on that Capital. He will continue so to store his Labor and receive Interest only as long as there is an effective market demand for the thing he grows or sells. On the other hand, the man who stores up his Labor as Plant and Equipment Capital, must pay Interest on that Capital. He will continue so to store his Labor and pay Interest only as long as the increased efficiency given to his Labor by the new tool or new building is at least great enough to offset the interest he must pay.

The second question, why is money interchangeable with Capital, may now also be answered easily in terms of value. We have seen that all tangible articles are interchangeable at their value. But in very few societies are goods exchanged directly, rather all human societies adopt some article as a medium of exchange. In pre-monetary societies various commodities are used as the medium of exchange -- for example wheat, salt, shells, or skins. By custom or habit, the article used as the medium of exchange in any society comes to be the article in terms of which the value of all other articles is measured. The medium of exchange, in any society, becomes the standard of value of that society; and further, the medium of exchange comes to be a symbol of value, a store of value.

In our society, printed money is the medium of exchange. Hence, to all persons, businesses and banks alike, money represents value, it represents stored up Labor or Labor to be had in exchange. Hence, to borrow money for any purpose is equivalent to borrowing money for the purpose of purchasing Interest-producing Capital. Hence, it requires the payment of a premium equivalent in amount to the Interest that so much Capital could produce.

We have now completed the main part of our examination, and have given sound theoretical bases to the economic concepts Capital and Interest, both in terms of purely physical factors, and in terms of money and value. We may therefore turn now to the various practical questions associated with these subjects.

If one wants to borrow money for the purchase of an article of Wealth to be used solely for pleasure, one must still pay a premium for the borrowed money. To purchase a house by taking out a mortgage, to ''fly now and pay later, "or to borrow money to purchase an automobile, all legitimately require the payment of a premium.

The payments received by a bank or finance company for the use of their money for such purposes, take the form of Interest. But it must be understood, that these payments, like the charges made for the use of Plant and Equipment Capital in production, are only secondary effects. The demand for such payments is an evidence of the fact that the same amount of money, if spent for Inventory Capital, could actually produce an independent increase in value. The point is, that Interest is not properly considered as a payment made for the use of Capital, but rather as a gain resulting from the actual increase of Capital, in the ways that we examined in part I.

Similarly, when a business borrows money from a bank or from its bondholders, it must repay the bank or the bondholders a net premium over the principal, and this premium also takes the form of Interest. But again, neither the money borrowed nor the notes or bonds produce Interest. Only the physical articles of Capital purchased with the money are the source of Interest. Since Interest is a share of the Wealth that results from production, not until there has been production in the physical sense (either growth, manufacture or exchange of Wealth), can there be Interest in the economic sense.

Common stocks, unlike bonds, are not 1egally considered to be loans subject to repayment with Interest. They are rather considered as shares of ownership in the company, and hence carry with them the possibility both of greater rewards and of greater loss. This element of risk, which is so large a factor in the value of common stocks, will be considered further below. We only need observe here, that in the economic sense, the purchase of a-share of common stock is identical to any other loan or investment of Capital, and that the dividends that the stock pays are likewise equivalent to Interest as we have been considering it. As in many other cases, the law recognizes, distinctions that economic theory takes no notice of. Later on we will see some important economic distinctions which, conversely, ,are overlooked in the law.

The factor of risk enters into the subjects Capital and Interest only in a peripheral way. We hare always tacitly assumed above that every planted seed germinates into grain, that every ship bearing cargo for sale reaches its destined port across the sea, and that all the produce or merchandise is sold, and at its expected price. These assumptions are not always borne out in practice. Many businesses simply fail, many crops get destroyed by drought, fire or flood, and many articles of merchandise must be sold below cost or not at all. Ships even still sink at sea. All these possible sources of loss as well as gain in business ventures enter into the factor of risk. Some types of business are inherently more risky than others. The effect of greater risk in a business is to increase the average rate of Interest paid for Capital invested in that business, so that, including both the successful and the unsuccessful ventures, the average return obtained is the same as the return in all other businesses. If stocks in general pay higher nominal rates of dividends than bonds do Interest, it is because stocks frequently pay no dividends while bonds go on paying their smaller but more steady returns. It is instructive to observe that the same premium for risk or danger applies to Labor as well as to Capital. For Labor it takes the form of the bonus pay received by front-line soldiers over the base pay received by non-combatants, and in the higher salaries received by acrobats, loggers and riveters on skyscrapers, as compared to those received by dancers, carpenters and riveters in airplane factories.

The factor of monopoly must also be explained as it enters into the economics of Capital and Interest. The common effect of all kinds of monopolies is to restrict or prevent the free flow of Capital into certain fields, and to create differences in the apparent rates of Interest on Capital invested in these fields. Examples of legal institutions that create monopolies include tariffs, high license fees, patent rights, exclusive franchises, and land titles. In all these cases the incomes received from money invested in these fields are not economic Interest, but simply legalized redistributions of Wealth. In some of these cases it is deemed advisable public policy to grant such monopoly privileges, and so to create artificial incomes for certain investors -- for example, so as to provide an added incentive to invention, or in effect to subsidize a particular industry, or to limit the number of certain businesses, such as bars, in a community. Whether these legally created monopolies are in fact wise or unwise public policies, it is not our purpose here to determine; our purpose here is only to point out the way in which these monopolies affect the economics of Capital and Interest,

We have now to consider one more topic, the relation of profits to Interest. Before we turn to this, however, we should take notice of an important distinction between two economic terms that we used frequently. These terms are Wealth and Value.

Wealth, it will be recalled, consists of all real objects which are produced by Labor, and which have the power of satisfying some human desire. We may reasonably assume that all such articles will have some desirability to many individuals, and hence will have an exchange value in the marketplace. We may say that articles of Wealth both require Labor to be produced and can bring Labor in exchange. Value, on the other hand, means only the quality of being able to command Labor in exchange. Value may arise from physical production, and may reside in some article of Wealth, or it may arise from mere legal obligation, and reside in no physical object. Many articles of Value are thus not articles of Wealth at all; that is, they allow their owner to receive Labor without rendering Labor in exchange. Articles such as franchises, tariff privileges, war bonds and land titles, fit this description. Such articles are not the creations of Labor, but of legislatures. They require no Labor but only a law, to be produced; yet, they will command much Labor in exchange. For our purpose, it is important here to realize that money invested in a franchise does not earn Interest, but a royalty; that money invested in commercial tariff privileges or in government war bonds does not receive Interest from production, but the proceeds of taxes on production; that money invested in a company that buys mortgages on Land does not earn Interest, but economic Rent. These are distinctions that are unknown to the law but which are essential to an understanding of economic processes.

At this point just a few words are needed about the relation of profits to Interest The term profit is not an economic term, but a business term. Profits are the gains of a business, the difference between its incomes and its expenses. It should be clear by now that a business may obtain its profits from many sources -- from the Labor of its owner if it is a small proprietorship, from the Labor of its managers if it is a corporation, from Interest on its Inventory Capital, from unpredictable gains through high risk deals, from an efficient production with its Plant and Equipment Capital, from monopoly privileges of-various kinds, or from the ownership of Land titles and other non-Capital assets. Returns from all of these sources contribute to profits. Profits in general are neither moral nor immoral. Profits are essential to the heal thy and continuous functioning of an economy; without them no businesses could attract the money of investors, and industry would collapse. If one would judge the legitimacy or illegitimacy, or the good or evil social effects, of profits, one must judge individually each of the various individual sources that contribute to profits in general.


We have now answered every question we set out to answer. We have seen what Capital essentially is, and have examined the various functions that Capital performs in an economy. We have discovered the primary cause of Interest, and have found that it lies in the increase of Wealth that results from the use of Inventory Capital in production. And we have seen how this primary cause of Interest necessitates the payment of a premium, that takes the form of Interest, for the use of Plant and Equipment Capital.

We have seen why all articles of Capital are interchangeable, and why money is interchangeable with Capital. We have seen why credit purchases require the payment of a premium. We have seen how stock and bond ownership, risk, and various legal monopolies enter into the relations of Capital and Interest. We have noted the fundamental distinction between the economic concepts of Wealth and Value. And finally we have examined and clarified the relation of business profits to economic Interest.