Anne Robert Jacques Turgot
Chronique de François Meunier
Turgot had said almost everything as early as 1766, ten years before Adam Smith, about the formation of the interest rate and its relationship with the return on capital and the price of fixed-income financial securities. This is in his major economic work: “Reflections on the Formation and Distribution of Wealth .”
In particular, three concepts that are not simple to understand or to make understood.
1. That the rate of return or cost of capital (depending on whether we take the point of view of the investor or the company) depends on the associated risk. The interest rate (which ensures a fixed income, independent of the profitability of the investment except in the event of default) must then be lower. (Underlining and brackets are from the author)
I have counted five different ways to use capital or to invest it in a profitable way. The first is to buy land that yields a certain income. The second is to invest one’s money in agricultural enterprises by leasing land whose fruits must yield, in addition to the price of the rent, the interest on the advances and the price of the labor of the person who devotes his wealth and his effort to cultivating them. The third is to invest one’s capital in industrial and manufacturing enterprises. The fourth is to invest it in commercial enterprises. And the fifth, to lend it to those who need it, for an interest. […]
It is obvious that the annual products that can be withdrawn from the capital invested in these different jobs are limited by each other, and all relative to the current rate of interest on money.
• LXXXIV. — Money invested in land must yield less. Anyone who invests their money by buying land leased to a well-paying farmer obtains an income that gives them very little trouble to receive, and that they can spend in the most pleasant way by giving a career to all their tastes. It also has the advantage that land is the most secure possession against all kinds of accidents
.• LXXXV. — Money lent must yield a little more than the income of land acquired with equal capital. He who lends his money at interest enjoys even more peacefully and more freely than the landowner; but the insolvency of his debtor can cause him to lose his capital. He will therefore not be satisfied with an interest equal to the income of the land he would buy with the same capital. The interest of the money lent must therefore be stronger than the income of land purchased for the same capital, because if the lender were to buy land of equal income, he would prefer this use.
• LXXXVI. — Money invested in agricultural, manufacturing, and commercial enterprises must yield more than the interest on money lent. For a similar reason, money employed in industry or commerce must yield a more considerable profit than the income of the same capital employed in land or the interest of the same money lent; for these employments require, in addition to the capital advanced, a great deal of care and work, and if they were not lucrative, it would be much better to obtain an equal income that could be enjoyed without doing anything. […]
2. That the costs of capital are interrelated, in a proportion that depends on the risk. An increase in the cost of capital causes an increase in the interest rate, through an arbitrage relationship. In modern terms, this resembles the CAPM.
• LXXXVII. — However, the products of these different uses are limited by each other and are maintained despite their inequality in a kind of equilibrium. The different uses of capital therefore yield very unequal products; but this inequality does not prevent them from reciprocally influencing each other, and from establishing a kind of balance between them. […] I suppose that suddenly a very large number of landowners want to sell their land: it is obvious that the price of land will fall, and that with a smaller sum one will acquire a greater income. This cannot happen without the interest of money becoming higher; for the owners of money will prefer to buy land than to lend it at an interest that would not be stronger than the income of the land they would buy. So if borrowers want to have money, they will be forced to pay a higher rent. If the interest of money becomes higher, it will be better to lend it than to assert it, in a more painful and risky way, in the enterprises of culture, industry and commerce, and we will only do business with those who will bring, in addition to the wages of labor, a much greater profit than the rate of money lent.
In short, as soon as the profits resulting from any employment increase or decrease, capital is poured into it by withdrawing from other employments, or is withdrawn from it by pouring into other employments; which necessarily changes the ratio of capital to annual product in each of these employments. […] The product of money used in any way whatsoever cannot increase or decrease without all other uses experiencing a proportionate increase or decrease.
3. Finally, the price of annuities or fixed-income bonds is inversely related to the interest rate.
LXXXVIII. — The current interest rate of money is the thermometer of the abundance or scarcity of capital; it measures the extent that a nation can give to its cultural, manufacturing and commercial enterprises. […] It is obvious that the lower the interest on money, the more valuable the land. A man who has fifty thousand pounds of annuities, if the land is only sold at twenty [i.e., with a P/E of 20X or a rate of return of 5%], has only a wealth of one million; he has two million if the land is sold at forty [a P/E of 40X]. If the interest is at 5%, any land to be cleared, […] any factory, any trade that does not yield 5%, in addition to the wages of the labor and the risks of the entrepreneur, will not exist.
[…] We can look at the price of interest as a kind of level below which all work, all culture, all industry, all commerce cease. It is like a sea spread over a vast land: the mountain peaks rise above the waters, forming fertile and cultivated islands. If this sea flows, as it descends, the sloping land, then the plains and the valleys, appear and are covered with productions of all kinds. It is enough for the water to rise or fall by one foot to flood or to return to the cultivation of immense beaches. – It is the abundance of capital that drives all businesses, and the low interest of money is both the effect and the index of the abundance of capital.
Article by François Meunier in VOXFI