In the roster of Turgot’s outstanding contributions to economic theory, the most remarkable was his theory of capital and interest, which, in contrast to such fields as utility, sprang up virtually full-blown unrelated to preceding contributions. Not only that, but Turgot worked out almost completely the Austrian theory of capital and interest a century before it was set forth in definitive form by Eugen von Böhm-Bawerk.

Turgot’s theory of capital proper was echoed in the British classical economists as well as the Austrians. In his great “Reflections,” Turgot pointed out that wealth is accumulated by means of consumed and saved annual produce. Savings are accumulated in the form of money, and then invested in various kinds of capital goods. Furthermore, as Turgot pointed out, the “capitalist-entrepreneur” must first accumulate saved capital in order to “advance” their payment to laborers while the product is being worked on. In agriculture, the capitalist-entrepreneur must save funds to pay workers, buy cattle, pay for buildings and equipment, etc., until the harvest is reaped and sold and he can recoup his advances. And so it is in every field of production.

Some of this was picked up by Adam Smith and the later British classicists, but they failed to absorb two vital points. One was that Turgot’s capitalist was a capitalist-entrepreneur. He not only advanced savings to workers and other factors of production, he also, as Cantillon had first pointed out, bore the risks of uncertainty of the market. Cantillon’s theory of the entrepreneur as a pervasive risk-bearer facing uncertainty, thereby equilibrating market conditions, had lacked one key element: an analysis of capital and the realization that the major driving force of the market economy is not just any entrepreneur but the capitalist-entrepreneur, the man who combines both functions. Yet Turgot’s memorable achievement in developing the theory of the capitalist-entrepreneur, has, as Professor Hoselitz pointed out, “been completely ignored” until the twentieth century.

If the British classicists totally neglected the entrepreneur, they also failed to absorb Turgot’s proto-Austrian emphasis on the crucial role of time in production, and the fact that industries may require many stages of production and sale. Turgot anticipated the Austrian concept of opportunity cost, and pointed out that the capitalist will tend to earn his imputed wages and the opportunity that the capitalist sacrificed by not investing his money elsewhere. In short, the capitalist’s accounting profits will tend to a long-run equilibrium plus the imputed wages of his own labor and skill. In agriculture, manufacturing, or any other field of production, there are two basic classes of producers in society: (a) the entrepreneurs/owners of capital, and (b) the workers.

At this point, Turgot incorporated a germ of valuable insight from the physiocrats–invested capital must continue to return a steady profit through continued circulation of expenditures, or dislocations in production and payments will occur. Integrating his analyses of money and capital, Turgot then pointed out that before the development of gold or silver as money, the scope for entrepreneurship had been very limited. For, to develop the division of labor and stages of production, it is necessary to accumulate large sums of capital, and to undertake extensive exchanges, none of which is possible without money.

Seeing that advances of savings to factors of production are a key to investment, and that this process is only developed in a money economy, Turgot then proceeded to a crucial Austrian point: since money and capital advances are indispensable to all enterprises, laborers are therefore willing to pay capitalists a discount out of production for the service of having money paid them in advance of future revenue. In short, that the interest return on investment is the payment by laborers to the capitalists for the function of advancing them present money so that they do not have to wait for years for their home.

The following year, in his scintillating comments on the paper by Saint-Peravy, Turgot expanded his analysis of savings and capital to set forth an excellent anticipation of Says Law. Turgot rebutted pre-Keynesian fears of the physiocrats that money not spent on consumption would “leak” out of the circular flow and thereby wreck the economy. As a result, the physiocrats tended to oppose savings per se. Turgot, however, pointed out that advances of capital are vital in all enterprises, and where might the advances come from, if not out of savings? He also noted that it made no difference if such savings were supplied by landed proprietors or by entrepreneurs. For entrepreneurial savings to be large enough to accumulate capital and expand production, profits have to be higher than the amount required to merely maintain the current capital stock.

Turgot goes on to point out that the physiocrats assume without proof that savings simply leak out of circulation. Instead, he says, money will return to circulation immediately; savings will be used either (a) to buy land, (b) to be invested as advances to workers and other factors, or (c) to be loaned out at interest. All of these uses of savings return money to the circular flow. Advances of capital, for example, return to circulation in paying for equipment, buildings, raw materials, or wages. The purchase of land transfers money to the seller of land, who in turn will either buy something with the money, pay his debts, or re-lend the amount. In any case, the money returns promptly to circulation.

Turgot then engaged in a similar analysis of spending flows if savings are loaned at interest. If consumers borrow the money, they borrow in order to spend, and so the money expended returns to circulation. If they borrow to pay debts or buy land, the same thing occurs. And if entrepreneurs borrow the money, it will be poured into advances and investments, and the money will once again return to circulation. Money saved, therefore, is not lost; it returns to circulation. Furthermore, the value of savings invested in capital is far greater than that piled up in hoards, so that money will tend to return to circulation quickly. Furthermore, Turgot pointed out, even if increased savings actually withdrew a small amount of money from circulation for a considerable time, the lower price of the produce will be more than offset for the entrepreneur by the increased advances and the consequent greater output and lowering of the cost of production. Here, Turgot had the germ of the much later Mises-Hayek analysis of how savings narrows but lengthens the structure of production.

The acme of Turgot’s contribution to economic theory was his sophisticated analysis of interest. We have already seen Turgot’s remarkable insight in seeing interest return on investment as a price paid by laborers to capitalist-entrepreneurs for advances of savings in the form of present money. Turgot also demonstrated–far ahead of his time–the relationship between this natural rate of interest and the interest on money loans. He showed, for example, that the two must tend to be equal on the market, since the owners of capital will continually balance their expected returns in different channels of use, whether they be money loans or direct investment in production. The lender sells the use of his money now, and the borrower buys the use, and the “price” of those loans, i.e., the loan rate of interest, will be determined, as in the case of any commodity, by the higgling and haggling of supply and demand on the market. Increased demand for loans will raise interest rates; increased supply of loans will lower them. People borrow for many reasons–to try to make an entrepreneurial profit, to purchase land, pay debts, or consume–while lenders are concerned with just two matters–interest return and the safety of their capital.

While there will be a market tendency to equate loan rates of interest and interest returns on investment, loans tend to be a less risky form of channeling savings. So that investment in risky enterprises will only be made if entrepreneurs expect that their profit will be greater than the loan rate of interest. He also pointed out that government bonds will tend to be the least risky investment, so that they will earn the lowest interest return. Turgot went on to declare that the “true evil” of government debt is that it presents advantages to the public creditors but channels their savings into “sterile” and unproductive uses, and maintains a high interest rate in competition with productive uses.

Pressing on to an analysis of the nature and use of lending at interest, Turgot engaged in an incisive and hard-hitting critique of usury laws, which the physiocrats were still trying to defend. A loan, Turgot pointed out, “is a reciprocal contract, free between the two parties, which they make only because it is advantageous to them.” Turgot moved in for the clincher: “Now on what principle can a crime be discovered in a contract advantageous to two parties, with which both parties are satisfied, and which certainly does no injury to anyone else?” There is no exploitation in charging interest just as there is none in the sale of any commodity. To attack a lender for “taking advantage” of the borrowers need for money by demanding interest “is as absurd as an argument as saying that a baker who demands money for bread he sells, takes advantage of the buyers need for bread.”

It is true, Turgot says to the anti-usury wing of the Scholastics, that money employed successfully in enterprises yields a profit, or invested in land yields revenue. The lender gives up, during the term of the loan, not only possession of the metal but also the profit he could have obtained by investment. The “profit or revenue he would have been able to procure by it, and the interest which indemnified him for this loss cannot be looked on as unjust.” Thus, Turgot integrates his analysis and justification for interest with a generalized view of opportunity cost, that is, of income foregone from lending money. And then, above all, Turgot declares, there is the property right of the lender, a crucial point that must not be overlooked.

Turgot, in the highly influential “Paper on Lending at Interest” (1770), focused on the crucial problem of interest: why are borrowers willing to pay the interest premium for the use of money? The opponents of usury, he noted, hold that the lender, in requiring more than the principal to be returned, is receiving a value in excess of the value of the loan, and that this excess is somehow deeply immoral. But then Turgot came to the critical point: “It is true that in repaying the principle, the borrower returns exactly the same weight of the metal which the lender had given him.” But why, he adds, should the weight of the money metal be the crucial consideration, and not the “value and usefulness it has for the lender and the borrower?” Specifically, arriving at the vital Böhm-Bawerkian–Austrian concept of time preference, Turgot urges us to compare “the difference in usefulness which exists at the date of borrowing between a sum currently owned and an unequal sum which is to be received at a distant date.” The key is time preference–the discounting of the future and the concomitant placing of a premium upon the present. Turgot points to the well known motto, “a bird in the hand is better than two in the bush.” Since a sum of money actually owned now “is preferable to the assurance of receiving a similar sum in one or several years time,” the same sum of money paid and returned is scarcely an equivalent value, for the lender “gives the money and receives only an assurance.” But cannot this loss in value “be compensated by the assurance of an increase in the sum proportioned to the delay?” Turgot concluded that “this compensation is precisely the rate of interest.” He added that what has to be compared in a loan transaction is not the value of the money loaned with the sum of money repaid, but the “value of the promise of a sum of money compared to the value of money available now.” For a loan is precisely the transfer of a sum of money in the future. Hence, a maximum rate of interest imposed by law would deprive virtually all risky enterprises of credit.

In addition to developing the Austrian theory of time preference, Turgot was the first person, in his “Reflections,” to point to the corollary concept of capitalization, that is, the present capital value of land or other capital good on the market tends to equal the sum of its expected annual future rents, or returns, discounted by the market rate of time preference, or rate of interest.

As if this were not enough to contribute to economics, Turgot also pioneered a sophisticated analysis of the relation between the interest rate and the quantity of money. There is little connection, he pointed out, between the value of currency in terms of prices and the interest rate. The supply of money may be plentiful, and hence the value of money low in terms of commodities, but interest may at the same time be very high. Perhaps following David Hume‘s similar model, Turgot asks what would happen if the quantity of silver money in a country suddenly doubled, and that increase were magically distributed in equal proportions to every person. Turgot then points out that prices will rise, perhaps doubling, and that therefore the value of silver in terms of commodities will fall. But, he adds, it by no means follows that the interest rate will fall if people’s expenditure proportions remain the same.

Indeed, Turgot points out that, depending on how the spending-saving proportions are affected, a rise in the quantity of money could raise interest rates. Suppose, he says, that all wealthy people decide to spend their incomes and annual profits on consumption and spend their capital on foolish expenditures. The increased consumption spending will raise the prices of consumer goods, and there being far less money to lend or to spend on investments, interest rates will rise along with prices. In short, spending will accelerate and prices rise, while, at the same time, time-preference rates rise, people spend more and save less, and interest rates will increase. Thus, Turgot is over a century ahead of his time in working out the sophisticated Austrian relationship between what Mises would call the “money-relation”–the relation between the supply and demand for money, which determines prices or the price level–and the rates of time preference, which determine the spending-saving proportion and the rate of interest. Here, too, was the beginning of the rudiments of the Austrian theory of the business cycle, of the relationship between expansion of the money supply and the rate of interest.

As for the movements in the rate of time preference or interest, an increase in the spirit of thrift will lower interest rates and increase the amount of savings and the accumulation of capital; a rise in the spirit of luxury will do the opposite. The spirit of thrift, Turgot notes, has been steadily rising in Europe over several centuries, and hence interest rates have tended to fall. The various interest rates and rates of return on loans, investments, and land will tend to equilibrate throughout the market and tend toward a single rate of return. Capital, Turgot notes, will move out of lower-profit industries and regions and into higher-profit industries and regions.

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