The Causes Which Determine the Rate of Interest
( Originally Published Early 1900's )
THE question of usury has been one of the stumbling-blocks of mankind in all ages. Except in the most intelligent society, and in recent times, the taker of "usury" has been generally looked upon as one who unjustly made a profit without rendering any service in return. The view of the natural man may be illustrated as follows : I loan a man $1000. During the year it remains in his hands I, the owner of the money, have nothing to do with it and have no agency in its operations, yet at the end of the year I demand and receive back from him not only the $1000, but $50 or perhaps $100 or more in the way of compensation. Compensation for what? Apparently not for anything I have done or been doing. Not for my labor in gaining the $1000, because I was compensated for that when I got the money; not for anything I did afterwards, because I did nothing afterwards. Thus it looks as if I got my interest without rendering any service whatever. The case seems strengthened when traced to its everyday consequences. If, by my own earnings or by inheritance, I am fortunate enough to be the owner of $100,000 or more, I can spend my life without performing any labor whatever, and live in comfort, and perhaps in affluence, on what society pays me as interest without expending any of my original fortune.
Yet if we look at concrete cases we shall see that this difficulty must be surmountable. If the usurer were a person who forcibly compelled people to take his money and pay him interest for it, then the preceding general conclusion would be evidently correct. But, as a matter of fact, he never loans money unless some one conies to him for it, and is willing to pay the interest demanded. Now, evidently no one will do this unless he expects, by means of the money, to receive not only the benefit of the money itself, but of the interest which he expects to pay. Of course it is here presumed that the borrower knows what he wants and what he is likely to do, and that he is not systematically the victim of a delusion which prompts him to seek that which is going to do him an injury. As a matter of fact, if we look into the case, we shall find that as a rule the borrower of money does gain by the bargain. Take for example the owner of a fertile pasture-field in California. The field is of no use to him unless he can stock it with sheep. Unless he can find somebody to supply him with sheep, he may have to sell half his field in order to get sheep for the other half. Instead of doing this he goes to a capitalist, borrows money, perhaps at twelve per cent interest, and buys the necessary sheep. At the end of the year he sells his wool and receives for it more than lie has expended for pasturage and services, and still has his sheep. He pays the capitalist his interest, and is still richer than he was when he started. He could sell the sheep, and with the proceeds pay off the principal and have a profit left.
What has gained this profit? Only his own labor and exertions, says the objector. But this is clearly an error, for it is certain that if nothing but his own labor and exertions were necessary he would not have gone to the capitalist at all. His labor would have been worthless without the sheep, and he could not get the sheep without money. But granting this, the objector asks, What right had the capitalist to charge him interest? The answer is that in the course of the year the man, has been enabled to make twice as much profit with the capitalist's money that he could have made without. Nothing, therefore, can be more equitable and just than that the capitalist should have his share of what his money helped to produce. Between rational people there can be no lending and borrowing unless it is expected that the money is going to enable the borrower to gain more than its interest, through the advantage it gives him. Without this it would be unwise for him to borrow.
Indeed without this it will be unwise for the capitalist to lend, because he may not get his money back again unless the borrower has been so successful in the use of it as to be able to repay it with interest. Thus the difficulty which we have cited is simply a wrong way of looking at things, and arises from neglecting or overlooking the principle that every agency necessary to production is to be counted as a factor in production. The mistake is of the same nature as when we look upon a brick house as simply a product of the labor of brickmakers, bricklayers, and carpenters, and leave out of ac-count the knowledge and skill which were necessary to organize and direct their work.
Since there are people always ready to borrow money and others ready to supply it, it follows that we may speak of supply and demand in borrowing and lending money as we do in exchange. Moreover, we can easily see that the rate of interest is determined, at least for the time being, by the relation between demand and supply, just as the price of goods is so determined. Every increase in the rate of interest tends to discourage borrowers and thus to diminish demand, for the same reason that a rise in prices diminishes the demand for goods. It also increases the supply by offering stronger inducements to owners of money to save and lend it instead of spending it themselves. Thus in each state of the market there will be a certain rate of interest at which the supply and demand for money to lend and borrow will be equal. When the demand exceeds the supply the rate of interest will rise, thus checking the demand and stimulating the supply. When demand falls off, the rate of interest falls also, thus discouraging the supply and encouraging the demand.
Fluctuations of this sort are seen from week to week and month to month in the great money-centres of the world. The Bank of England fixes its rate of discount from time to time according to the state of the market, to which it therefore serves as an index. Ordinarily the rate is three or four per cent per annum. But occasionally satisfactory borrowers cannot be found without going even below three per cent. Occasionally the rate rises to six, eight, or ten per cent, In America the prevalence of usury laws nominally prevents these fluctuations ; but the result of this is that when the demand for money is so great that the rate of interest necessary to equalize demand and supply is above the legal rate, the banks select the customers to whom they will lend. The principles upon which this is done will be discussed later; all we have at present to understand is that in each state of the market there is a certain definite rate of interest which will equalize demand and supply.
All this does not, however, tell us why in the long-run money should have a definite rate of interest. Why is it, for example, that in a certain state of the market the borrowers and lenders should be in such proportion that four per cent per annum would equalize the two rather than one per cent or fifty per cent?
To answer this question we have to examine the causes upon which the demand and the supply respectively depend, and see by what conditions they are equalized. In order that any person may be willing to borrow money at a definite rate of interest, he must consider that he has at least an average chance of gaining more than that rate by means of the money. At this point a source of confusion is to be noted and avoided. What the borrower really pays interest for is capital, not money. The borrower can gain nothing by keeping the money; all he borrows it for is to purchase some kind of capital. True, it is morally and physically possible that he might expend the money in his own support. But a man who would do this would never be able to borrow at all. As a matter of fact, it is always necessary that the lender should have full assurance that the borrower will be able to pay, and he therefore requires that the borrower shall place a full equivalent of capital, with a margin to guard against loss, in possession of the lender or of some trustee. Suckalegal conveyance of the ownership of capital to guard a lender against loss is a mortgage.
We see then that what is called the rate of interest on money is not a property of the money itself, but depends upon the advantage which capital give's its owner in production. We havé then to see in what this advantage consists. In the first place, it has been pointed out that capital is a labor-saving agent (II. 29). Its fundamental property is that, with `the aid of labor, it returns its user at some future time a value greater than that of the capital and labor combined. For example, if by `expending $100 in any kind of capital today, the manufacturer finds that be can add $10 per year to the net value of his product, after paying for the additional labor, and deducting all the cost of keeping up his capital to its original value of $100, then that capital yields him. a profit of ten per cent per annum. If the increase of production does flat exceed the cost of keeping up the capital, then he would make no greater profit with `the capital than without it, and so there would be no use in his acquiring capital at all.
It has already been shown that nature may be said to keep a number of standing offers of interest upon capital open to the world (II. 29). These offers take the form of opportunities for digging canals, building railways and tunnelling mountains; and, in general, of developing the resources of the country. The rate of profit offered depends upon how far the country is already developed. In an absolutely new country, such as America was three centuries ago, we can hardly set any limit to the rate of interest offered by nature. This is the same thing as saying that capital was very much needed, or that there was great room for improvement in the facilities for production. ' At the present time it is not always possible to know with certainty in advance what rate of interest nature does offer for building a particular railway or factory. But men engaged in the management of capital make the best estimate they can of the profit to be gained in each case, and select their field of investment accordingly.
Next consider the case of circulating capital. A manufacturer finds that with the machinery he already possesses and the laborers he already employs lie can make more goods than lie does. But to do this he must increase his stock of raw materials. If he has not the means of doing this, he must borrow money in order to purchase the necessary materials. In order that he may 'gain a profit exceeding the interest which lie pays, he must be able to sell his increased product at an advance over the increased cost of material and labor. Were the state of things such that neither he nor any other manufacturer could do this, there would be no profit in' increasing the quantity of goods' manufactured, and the work would remain stationary. Hence, although circulating capital is not a labor-saving agent, it is yet a requisite of production whose accumulation requires abstinence from its immediate enjoyment on the part of the owner.
Next let us see in what way this demand acts upon the supply. The first question is, Why is the supply of money to lend limited at all ? The reason is that the amount of every man's income which he is able and willing to save from current expenditures is limited, and this is all he can have to. lend. A large fraction, probably a large majority, of the population do not expect permanently to save anything for use as capital. It is to the few whose incomes are so large or whose personal wants are so few that they are willing to save that borrowers must look for capital. Now, unless some interest is to be gained as the result of saving, there is no strong motive for anybody to save more than is necessary for the support of himself and his family, and for insurance against want in his old age.
To see this by an example, suppose that you have gained one hundred dollars. You have your choice to expend it in something for present enjoyment, or to postpone the expenditure to some future time, say the end of the year. Perhaps you intend to buy a cyclopedia, and the question is whether you shall buy it now or at the end of the year. Other conditions being equal, the advantage is in favor of buying it now, because then you will have the enjoyment of it during the year, while if you postpone the purchase, you not only lose this enjoyment, but you may die in the mean time and thus lose all opportunity of any enjoyment of your money. If then a manufacturer comes to you and wants to borrow the money, it is evident that you and be cannot both have the benefit of what the money may purchase during the year coming. You will therefore refuse him unless he pays you what you consider a sufficient compensation for going one year without the use of the cyclopedia.
Viewing the same case from a different standpoint, let us suppose that you do not under any circumstances want the cyclopedia until the end of the year,—perhaps indeed it is not to be published until after that interval; and that you have not yet earned the money to buy it. The question then takes the form, Shall you earn the money necessary to purchase it now, or shall you wait until you want it? Unless you are so fortunate that you can earn a hundred dollars without any disagreeable labor, your wisest course is to wait. It will at worst cost you no more to earn the money a year hence than it will now, and, since the future is always uncertain, it is best not to expend labor for what after all may fail to yield fruition. And so for this reason also you have no sound motive for earning the money in advance, unless you are to make a future profit by doing so. Thus, as a general rule, there will be no money to loan unless interest is to be gained.
The minimum below which the rate of interest can never fall is that which just suffices to induce the savers of income to earn an income in advance of their enjoyment of it. What rate this is is a fact of human nature which can be learned, not by reasoning, but only by observation. Human nature differs so widely with different men that not even the law of averages can be satisfactorily applied, except in a single place and at a given time. Some men are in receipt of great incomes without any more exertion than is really necessary to their enjoyment of life. To such men it is all the same whether they earn money now or next year, and they might be willing to part with it without receiving any interest at all. In the case of other men a certain instinct of what is right leads them to live frugally and thus to expend less than their income. Such men will be willing to loan at a very low rate of inter-est. These cases are, however, exceptional, and the rule is that men save only in consequence of the interest they are to gain.
The numerical value of the minimum rate of interest is a result of certain qualities of human nature which we cannot measure with certainty. It is, however, a curious fact that up to the present stage of human history the rate of interest has rarely fallen below that which would yield a young man, in the course of his average life, a profit equal to the principal invested. The expectation of life for a man at twenty may be put at forty years. If he has gained a certain capital it will, without any investment, last him his average life, if he consumes two and a half per cent of it per annum. Hence, so far as he is individually concerned, he has no motive for saving unless he can gain this rate of interest. Now this is about the minimum rate yet known. Of course no perfectly exact numerical statement can be made in such a case, because the rate is always fluctuating; but this is a sufficient approximation for our purpose. Since, then, as human nature is constituted, the supply of capital tends to diminish as the rate of interest falls, it follows that all persons who want capital must pay interest. Nature is competing with them, and they must at least pay her price. But the rate they have to pay may be very small. As a country increases in wealth, the rate of interest tends to fall, both from diminished demand and increased supply. Nature continually offers less and less, as the resources of a country are developed, and the accumulation of raw material and the development of factories constantly approach the limit at which no further profit can be made by the further increase of capital. Again, as wealth increases men are more and. more able to save, and thus the supply increases.
Risk as affecting the Rate of Interest. In the preceding discussion we have taken no account of the risk which a lender incurs of wholly or partially losing the money he has loaned, in consequence of inability on the part of the borrower to repay him. For this risk he must be compensated ; and of course the amount of the compensation will be greater the greater the risk. Since he is "himself the sole judge of the risk and the compensation, no sure, mathematical law can be laid down to govern the case. The mathematical theory of probabilities, however, embodies a principle which is applicable to a certain class of cases, if the lender reaches his conclusions in the most reasonable manner. This principle is that the compensation for a risk is equal to the amount in jeopardy multiplied by the probability of loss. Suppose, for example, that from the best judgment which a lender. can, form there is one chance out of twenty that the borrower with whom he is dealing will fail within a year. We then say that the probability of failure within the year is one twentieth, and the proper compensation for the risk would be five per cent per annum. If the minimum rate of interest were also five per cent, then the lender should receive ten per cent per annum for his money.
We ought perhaps to say that this is the minimum which he as a prudent man ought to accept. If his situation is such that the loss of the money would reduce him to distress, he ought to demand a higher compensation on account of the risk. The wealthier he is the nearer this reasonable compensation will approach the mathematical limit. It can never fall below that limit.
The Nature of Capital and Cause of Interest. The reader who has carefully mastered the subject of capital and interest will see that they depend fundamentally upon the fact that time, and perhaps a long time, must elapse between the performance of labor and the enjoyment of its products if we would get the maximum of ultimate enjoyment from our labor. For example :
If I sow a crop, I must wait a year for its final enjoyment.
If I raise a horse, he will not be of any use for three or four years, and I may not get all the use of him for ten or fifteen years.
If I build a railway, I may not be fully compensated for my labor until after the lapse of twenty or thirty years.
Now, as I am situated in civilized society, I have my choice either to enjoy all my' labor shortly after the time of performing it, or to postpone my enjoyment for one or many years.
The longer I am willing to postpone my enjoyment the more thorough and effective I can make the agencies. by which my future wealth is to be produced, and hence the greater the amount of ultimate enjoyment which I or my posterity can command from my labor.
But my wants are immediate. I cannot live now on next year's crop, nor haul my crop to 'market with a new-born colt. I must be fed, 'clad, and housed while working for my future self.
He who loans me money is one who enables me to devote my labor to my future good by feeding, clothing, and housing me now, and hence enables me to produce more wealth in the long-run. If he does not require repayment of the money until I have begun to gain the increased means of enjoyment, it is just that I share the increase with him when I do pay it. Interest is the excess which I pay him on account of his permitting me to anticipate the future results of my labor by enjoying now what otherwise I would only have enjoyed in the future, or perhaps would never have enjoyed.
When I devote myself to labor intended to yield sustenance only in the distant future, I" do not engage in the direct product of the sustenance, but in the production Of some intermediate form of wealth intended to increase the productiveness of my future labor. This intermediate form of wealth we call capital.