Value and interest

in Galianis Della Moneta

Nicola Giocoli
University of Pisa
nicola.giocoli@unipi.it
http://pisa.academia.edu/NicolaGiocoli

Two open analytical issues from DM

Value theory: one theory or two?
The puzzle of labor (= fatica)
Is it objective labor or subjective pain?
Schumpeter: FG also foreran classical labor theory of
value (= a theory stating that the quantity of labor
contained in a good is the foundation of the exchange
value of that good);
Hutcheson: FG had only asubjective theory of value

Interest theory:
What kind of theory is FGs?
Abstinence, liquidity preference, loanable funds, or what?

My solutions
Value theory:
FG had an entirely subjectivist theory of value, based upon the
opportunity cost of alternative pleasures, the notions of will &
control, and a stock/flow classification of goods that depends on
whether Nature plays a direct role in determining their supply.
Labor is indeed objective, but it is a voluntary and controlled flow of
a specific input extracted from a predetermined stock. The general
principles of value theory also apply to the value of labor

Interest theory:
FG had no actual theory of interest; he just identified interest with
risk premium, itself the consequence of an a priori assumption upon
an agents subjective attitude to risk (= risk aversion).
However this theory of interest hides another gem: one of the
earliest forays by an economist into decision theory.

Only a sketch of these solutions here. Full details see:

History of Economic Ideas, vol. IX, n.3, 95-135, 2001.

Why studying value in a monetary tract?

In Ch.1, Bk.I of DM the value of money the core
topic of FGs work is said to regulated almost
entirely by the value of the precious metals in their
non-monetary uses, or, alternatively, by the value of
the goods we may purchase with it.
In either case, the value of the metals or the goods is
determined by the general principles of value theory.
Hence FG undertakes the analysis of value in Ch.2.
Two crucial questions for any theory of value
(Schumpeter 1954):
Why does a good have exchange value?
What factors determine the value of a good?

Galianis answer
FGs answer is that value is a ratio which is, in
turn, composed of two other ratios expressed by
the names utility and scarcity.
Value is a ratio between two ratios.
This intuition allows him to accommodate in his
explanation of value the basic mechanism of
demand and supply.
But demand and supply cannot be the causes of
value: each market force is the manifestation of a
different factor placed at the foundation of value.
Demand is determined by utility, supply by scarcity:
V = V (U,R)
with VU, VR > 0; V = 0 if U = 0 or R = 0

Utility

Defined as the ability a thing has to provide us with

happiness.
But why also utility enters as a ratio in commodity value?
The reason is that FG always compares the benefit and
the cost of a certain use of a good, where the cost is in
terms of forsaken alternatives (= opportunity cost notion).

Consumption depends on utility, i.e., on opportunity

cost calculus: c = c (U)
Consumption can take two forms: destruction c d
and appropriation ca.
Appropriation means a good is utilized but not destroyed
(its stock is unaltered: say, metallic money).

Scarcity
FG wrongly defines the scarcity ratio as: the proportion
between the quantity of a thing and the use which is made of it
The inverse is correct: scarcity R is the ratio between a flow, the
use (or consumption) c, and a stock, the quantity Q:
R = R (c, Q) = c / Q, with Rc > 0, RQ < 0
First remark: having consumption as the numerator of scarcity,
FGs value theory reduces to the analysis of the scarcity ratio
alone: the numerator of R depends upon use, i.e., demand; the
denominator of R depends upon quantity, i.e., supply:
V = V (R) = V (R(c, Q)), with Vc > 0, VQ < 0
You may explain value by understanding R alone!
R depends upon a subjective component, consumption (a flow),
and a seemingly objective one, quantity (a stock).
But: quantity in FG is not total quantity Qtot, but rather available quantity
Qdisp. This, together with the stock/flow relation, is crucial to FGs
explanation of value.

Two classes, two activities

Two classes may be distinguished. For some things, quantity depends upon
the different degrees of abundance with which nature provides them. For
others, it depends on the different amounts of labor employed upon them.
The distinction is not the Classical one between reproducible and nonreproducible goods. It is based on the difference between goods that exist in
nature without the need to apply (significant) labor to use them and goods for
which labor need be applied to make them available for use.
The former, first class goods, include agricultural goods; so they are not
irrelevant or special goods, like Classical non-reproducibles, but are crucial
components of any economic system.
The latter, second class goods, are in turn divided into goods that are merely
extracted/gathered (precious metals) and goods that need be produced
(works of art, manufactured goods).
Production flow qp depends on labor (F) & natural agents (N): qp = q (F, N)
Extraction flow qe depends on F & Qtot, but Qtot depends on N, so again qe = q
(F, N). Extraction leaves stock unaltered, but increases available quantity.
The final formula for R (and so for value) becomes:
R = R (c, Qdisp) = R ((cd+ca), F, N)
In words: scarcity depends positively upon use (both destructive &
appropriative), negatively upon labor, while natural agents have an uncertain
role (again the latter feature is crucial).

First class goods

FG says the flow of the goods belonging to the first
class (animals & fruits of the earth) doesnt depend
(or depends very little) upon labor. It depends on
nature N, which in turn is uncertain & unstable in its
results (say, harvests may fluctuate due to weather).
For this class of goods the scarcity ratio is only a
function of cd and N: R1 = R (cd, N).
Human will may affect R1, and so value, only by
varying destructive consumption. For the rest, value is
unstable, driven by Natures caprice (cf. Dialogues
about the instability of agricultural values).

Second class goods

These include the goods for which labor [...] alone gives things value. This is the
sentence that has raised so much debate among historians of economics.
Remark #2: FG exemplifies the goods in the second class with minerals, stones,
and marbles, but these are just examples! He is not at all arguing that minerals,
etc. exhaust the second class of goods.
He is just pointing at an important sub-class of these goods, those whose stock
Q0 is fixed by Providence (= a more stable, friendly Nature). These goods can be
neither produced nor can be consumed by destruction. This sub-class is
particularly relevant in DM because precious metals belong to it.
What actually varies here is the available quantity Qdisp, which is a function of the
extraction flow and of consumption by appropriation: Qdisp= Q (qe, ca).
The extraction flow is fully controlled by human will (so the quantity of these
things always corresponds to this labor), precisely because the total stock is
given and stable. Nature played its part long ago.
But objective conditions (= total stock) act as a constraint on this scarcity, by
making it more or less laborious to extract a given flow: qe = q (F, Q0).
So scarcity for this sub-class of second order goods is: R2met = R (ca, F, Q0)
Remark #3: The fact that the precious metals scarcity, i.e., their value, is not
under full human domain, nor under the whimsical play of Nature, is one of the
reasons for choosing them to become money.

When labor is alone

Remember that, in general, R = R (c, Q disp) = c /Qdisp = R ((cd+ca), F, N)

When FG says labor is alone in giving value to some second class goods, he means alone
with respect to the possible pair of factors (F, N) that may affect the denominator of R , i.e., Qdisp.
He means that, opposite to first class goods, N plays no direct role in their value.
The examples chosen here by Galiani (minerals & wild fruits) are again those goods whose total
stock is constant and must only be gathered or extracted (i.e., made available) through the
supply of labor. For them, Nature affects R 2met only indirectly, by determining the stock to which
labor is then applied.
But for both second class goods not exemplified & first class goods, total stock Qtot directly
affects the scarcity ratio: their stock is variable, so, if Q tot grows, scarcity decreases. Hence,
labor is not alone in giving value to them: Nature plays a major role through Q tot.
What about the works of art? Are they an exception? Not all: they confirm my reading.
What drives FGs theory is whether Nature plays a direct role in determining the stock/flow.
In the case of metals, N only plays an indirect role, by establishing once and for all the stock Q 0.
In the case of works of art, though their stock is variable, their flow is totally determined by
human will, i.e., labor. Indeed, they are the only goods for which the denominator of R depends
entirely upon labor, with N playing no role at all: R 2art= R(ca, F). Hence, they too belong to the
second class.
In short:

all goods in the second class share the property that their flow, either production or extraction, is directly
regulated by labor,
in the metals case the flow depends upon labor extracting/gathering them, given a predetermined
stock,
in the works of arts case the flow depends upon labor producing them,
for other goods in that class, labor directly contributes (together with N) to regulate their scarcity.

What about manufactured goods?

These also belong to the second class. Like the works of art, their total
stock is variable. However, differing from the works of art, human action
is not alone in determining scarcity: a significant contribution of the
natural agents exists in the form of primary inputs.
But why FG never mentions the manufactured goods?
Because his goal in Ch.2 is to explain, by appropriate examples, the
basic determinants of value : scarcity, labor, Nature.
The manufactured goods are of no special significance. They are goods
for which we have: Qtot = Qdisp, c = ca + cd, qp = q (F, N), i.e., goods that
are perfectly normal with respect to the general formula of scarcity
R2man = R ((cd+ca), F, N).
In short, they have no explanatory or exemplary appeal. They fall within
FGs general notion that value depends on scarcity and use.
Remark #4: in the case of manufacturing, by controlling Qtot, we may
control both terms of the scarcity ratio. Hence, for these goods the forces
of demand and supply are under the full domain of human will and are
subjected to neither the caprices of Nature nor the will of Providences
(cf. Dialogues, VIth dialogue).

Summing up Galianis value theory

The foundations of value are twofold:
human will, i.e., a subjective choice driven by the opportunity cost
principle about the allocation of labor upon alternative uses,
Nature, which affects in varying degrees the stock of the goods.

Labor and Nature together determine scarcity and value

Labor can be used to augment the stock of a good
(production) or to make more of an existing stock available for
consumption (extraction).
Labor is objective labor (say, working hours), but its contribution to the
value of goods is itself subject to the general rules of value theory.
Hence labor is applied by looking at opportunity costs and its value
depends on utility and scarcity.

Natures role is crucial in FGs theory & explains his

complicated classification of goods. It may have different
effects upon scarcity: sometimes Nature is the only decisive
factor, sometimes it is just a constraint, some others it
combines its effects with labor.
Only for works of art it plays no role at all.

Precious metals are employed for money because in their case

Nature acts as an insuperable, yet stable, constraint.

An abstinence theory of interest?

DM, Bk.V, Ch.1: interest is not an illegitimate surplus
gained by the lender, but a necessary condition to
warrant equivalence in lending (= commutative
justice criterion).
Lending causes the loss of a stock of wealth for the
lender. This creates an utility gap that is filled in
by the utility generated by the flow of additional
payments warranted by the interest.
Devising interest as something connecting a stock
and a flow of utility is the basis of abstinence theory
la Bohm-Bawerk & Fisher.
Surely FG had no theory of interest as productivity of
capital. But was it an abstinence theory?

Abstinence or heartbeat?

Following FGs value theory, none can obtain pleasure from a good
without depriving someone else of the possibility to do otherwise. A price
has to be paid, which must coincide with such a privation of pleasure.
According to FG, what is referred to as the fruits of money is nothing but
the price of heartbeats, i.e., of the anxiety suffered by the lender
whenever the loan repayment is unsure.
If no interest existed, justice would be violated: the lender who is repaid
with a sum exactly equal to what she lent would obtain a lower pleasure
than the one she would have obtained by keeping the sum, as the former
is diminished by the disutility induced by the heartbeat.
Absent the interest, the exchange between the lender and the borrower
would be unjust: the latter would enjoy the borrowed sum without paying
the former the price for her heartbeat; he would not repay the equivalent
in terms of utility, thereby violating commutative justice.
Hence the interest is not a profit for the lender, but the filling of a
deficiency, i.e., what must be added to the borrowed sum to ensure the
equivalence prescribed by the contract of lending without granting
illegitimate gains to any of the parts.

Just a risk premium

What causes the lenders heartbeat?
FG points at two factors that justify both the exchange and
the interest rate: the reduction in convenience, or comfort,
and the increase in risk or, separation in space and time.
The interest rate equalizes the utility of present and future
money, while the exchange rate equalizes the utility of
present and distant money.
Yet, these seem both to refer to a situation of risk aversion.
FGs interest thus looks like a simple risk premium.
But if this is so, then DM contains no a theory of interest, but
only a series of deductions from a specific assumption on the
lenders preferences.
Scholastic writers already knew: i) that pure interest should not be
confused with the risk premium or the reward for transporting money,
and ii) that justifications for pure interest had to be found in something
external to the lending contract, e.g., in the availability of alternative
profit opportunities for the lender.

Remark #5: FG denies interest is a necessary element of a

lending contract if the loan is riskless (e.g. Holland, Venice).

The hidden gem(s)

DMs theory of interest hides a gem: a theoretical
explanation of choice under uncertainty as the maximization
of expected value.
FG makes explicit reference to the idea that, thanks to
probability calculus, agents may price uncertain events and
act accordingly. He also realizes the rule is very general,
valid for a vast array of economic situations.
Unfortunately, despite having all the elements available, he
does not make the full transition from expected value to the
expected utility rule la Daniel Bernoulli (1738).
IMHO, FGs pioneering contribution to decision theory is at
the same level of other two DMs outstanding, though often
neglected, contributions: the dynamic analysis of market
processes (the wine supply example) and the metaphor of
the Supreme Hand (a.k.a., invisible hand) guaranteeing
optimality in an economy populated by self-interested agents
More on both in my 2001 paper!