Chapter Nine: The Interest of Money and its Causes

Chapter Nine

Interest on Money and its Causes

Abstract: Interest is established in the market by lenders and borrowers and the interest rate on a particular loan is determined by the risk of default. A loan is repaid from the income generated from capital investments and the interest paid is equivalent to the profits of fully capitalized enterprises. Small entrepreneurs pay high rates whether they borrow cash or purchase goods to be paid at a later date, based on risk and their propensity to spend beyond their means. Thereby, interest rates on loans are connected with an individual’s time preference.

JUST AS THE PRICES OF GOODS are set by the bargaining process in the market and by the quantity of goods offered for sale relative to the quantity of money offered for them, or in other words, by the relative number of sellers and buyers, so in the same way the interest on loans in a state is settled by the relative number of lenders and borrowers.

Although money serves as a medium of exchange, it does not multiply itself or earn interest simply by being in circulation. It is the needs of mankind that seem to have introduced the usage of interest. A man who lends money backed by good securities or a mortgage only runs the risk of the ill will of the borrower, or of expenses, lawsuits, and losses. However, when he lends without collateral, he runs the risk of losing everything. For this reason, needy men must have begun by tempting lenders with profit as bait and this profit must have been proportionate to the needs of the borrowers and the fear and avarice of the lenders. This seems to be the origin of interest although its continued use in states seems to be based upon the profits that entrepreneurs can make from it.

Land aided by human labor, naturally produces 4, 10, 20, 50, 100, 150 times the amount of wheat sown, depending on the fertility of the soil and the industry of the inhabitants. It also produces fruits and cattle. The farmer who runs the operation generally keeps two-thirds of the production, with one third paying his expenses and upkeep and the other being the profit for his enterprise.

If the farmer has enough capital for this enterprise, such as the necessary tools, horses for plowing, cattle to increase the value of the land,⁹⁸ etc., he will keep for himself, after paying all expenses, one-third of the farm’s production. But if a competent laborer, who lives on his wages from day to day and who has no land, can find someone willing to lease land or the money to buy some, he will be able to give the lender all of the third rent, or one-third of the production of the farm over which he will become the farmer or entrepreneur. However, he will see his condition improved because he will obtain his upkeep in the second rent, and will become master instead of employee. If he can save and do without some necessities, he can gradually accumulate some capital and have less to borrow every year. Eventually, he will manage to keep all of the third rent.

If this new entrepreneur can buy wheat or cattle on credit that will be paid back long term when he sells his farm products for money, he will gladly pay more than the cash market price. This is the same thing as if he borrowed cash to buy wheat, with the interest paid being the difference between the cash price and the price payable at a future date. However, whether he borrows cash or goods, there must be enough left over for his upkeep, or he will become bankrupt. This risk is the reason why he will be required to pay 20 or 30 percent profit or interest on the amount of money or value of the goods he borrows.

In a similar manner, a master hat maker who has capital to carry on his manufacture of hats; to rent a house, buy beaver skins,⁹⁹ wool, dye, etc., and to pay for the subsistence of his workmen every week, should obtain his own upkeep from this enterprise and a profit similar to that of the farmer who keeps one-third of his farm’s output as profit. This upkeep and the profit should come from the sale of the hats, the price of which ought to cover not only the materials, but also the upkeep of the hatter and his workmen, and also the profit in question.

A capable journeyman hatter with no capital may undertake the same business by borrowing money and materials and giving the profit to anybody who is willing to lend him the money or entrust him with the beaver, wool, etc., for which he will pay sometime later when he has sold his hats. If, when his bills are due, the lender requires his capital back, or if the wool merchant and other lenders will not grant him further credit, he must give up his business, in which case he may prefer to go bankrupt. But if he is prudent and industrious, he may be able to show his creditors that he has, in cash or in hats, about the same value that he has borrowed, and they will probably choose to continue to give him credit and be satisfied, for the time being, with their interest or profit. In this way, he will carry on and will perhaps gradually save some capital by cutting back upon his necessities. In this manner, he will have less to borrow every year, and when he has collected enough capital to conduct his business (which will always be proportional to his sales) he will keep his entire profit and grow rich if he does not increase his expenditures.

It is useful to observe that the upkeep of such a manufacturer is small compared to the sums he borrows for his business or to the value of materials entrusted to him. Therefore, the lenders run no great risk of losing their capital if the borrower is respectable and hard working. However, as he may not be, the lenders will always require a profit or interest of 20 to 30 percent of the value of their loan. Even then, only those who have a good opinion of him will trust him. The same inductions may be made with regard to all the masters, artisans, manufacturers and other entrepreneurs in the state, who carry on enterprises in which the capital considerably exceeds the value of their annual upkeep.

However, if a water carrier in Paris sets himself up as the entrepreneur of his own work, all the capital he needs is the price of two buckets, which he can buy for one ounce of silver, after which all his gains are profit. If he earns 50 ounces of silver a year by his labor, the amount of his capital or borrowing relative to his profit is 1 to 50. That is, he will earn 5,000 percent, while the hatter will earn only 50 percent and will also have to pay 20 or 30 percent to the lender.

Nevertheless, a moneylender will prefer to lend 1,000 ounces of silver to a hat maker at 20 percent interest, rather than lend 1,000 ounces to 1,000 water carriers at 500 percent interest. The water carriers will quickly spend on their maintenance, not only the money they gain by their daily labor, but all that is lent to them. These amounts of capital are small compared with what they need for their maintenance; however much or little they work, they can easily spend all that they earn. Therefore, it is difficult to determine the profitability of small entrepreneurs. It may well be that a water carrier earns 5,000 percent of the value of the buckets that are the capital of his company. He could even earn 10,000 percent, if by hard work he earns 100 ounces of silver a year. However, because he could easily spend 100 ounces on himself just as easily as 50, it is only by knowing what he devotes to his upkeep that we can determine how much clear profit has been made.

It is always necessary to deduct the subsistence and maintenance of the entrepreneur before determining their profit. We have done this in the example of the farmer and of the hat maker. However, we have shown that this is difficult to determine in the case of the smallest entrepreneurs, the majority of whom will eventually go bankrupt.

Ordinarily, brewers in London will lend a few kegs of beer to pub owners, and when they pay for the first kegs they continue to lend them more. If these pubs do a brisk business, the brewers can make an annual profit of 500 percent; and I have heard that the big brewers grow rich when no more than half the pubs go bankrupt on them in the course of the year.

All the merchants in a state are in the habit of lending merchandise or products to retailers. They proportion the amount of their profit or interest to that of their risk. The risk is always considerable when the proportion of the borrower’s maintenance is high relative to the amount of the loan. If the borrower or retailer does not have a prompt flow of sales in his small business, he will quickly be ruined and will spend all he has borrowed on his own subsistence and will consequently be forced into bankruptcy.

The fish merchant, who buys fish at Billingsgate¹⁰⁰ in London to sell again in other areas of the city, generally pays, under a contract made by a professional writer, one shilling per guinea or per twenty-one shillings of interest per week, which amounts to 260 percent per year.¹⁰¹ The market women in Paris, whose business is smaller, pay five sols¹⁰² for the week’s interest on an ecu¹⁰³ of three livres, which exceeds 430 percent per year.¹⁰⁴ And yet, there are few lenders who make a fortune from such high interest.

These high rates of interest are not only tolerated but are in a way useful and necessary in a state. Those who buy fish in the streets pay for these high interest rates with an increase in the price they charge. They provide a convenience for their customers who do not consider it a loss. In the same manner, an artisan who drinks a beer and pays a price that gives the brewer his 500 percent profit, is satisfied with this convenience and does not feel the loss of this small detail.

The Casuists, who hardly seem suitable to judge the nature of interest and matters of trade, have created a concept (damnum emergens) through which they will tolerate these high interest rates. Rather than disrupt its use and suitability to business, they have agreed to allow those who lend at great risk to charge a proportionally high rate of interest. And there is no limit, for they would be at a loss to find any definite limit because in reality, this business depends on the fears of the lenders and the needs of the borrowers.¹⁰⁵

Maritime merchants are praised when they can generate a profit from their enterprise’s capital, even though it is as high as 10,000 percent; and whatever profit wholesale merchants make or demand for selling products or merchandise to smaller retail merchants on long credit, I have not heard the Casuists declare it a crime. They are, or seem to be, a little more scrupulous about loans of money even though it is essentially the same thing. They even tolerate these loans by a distinction (lucrum cessans) that they invented. I understand this means that a man who usually makes a 500 percent profit in his business may demand this rate when he lends money to another. Nothing is more entertaining than the multitude of laws and rules made in every century on the subject of the interest of money—always unnecessarily—by wiseacres who hardly understand the facts of commerce.

From these examples and inductions, it seems that there are many classes and pathways of interest or profit in a state. In the lowest classes, interest is always highest in proportion to the greater risk, and it diminishes, from class to class, up to the highest which is that of rich merchants who are known to be creditworthy. The interest stipulated for this class is called the current rate of interest in the state and it differs little from the interest rate charged on land mortgages. A bill of exchange from a solvent and solid merchant is as well regarded, at least in the short run, as a mortgage on land, because the possibility of a lawsuit or a dispute involving the mortgage is equivalent to the possibility of the merchant’s bankruptcy.

If entrepreneurs in a state could not make a profit on the money or goods that they borrow, the use of interest would probably be less frequent than it is. Only extravagant people and spendthrifts would contract for loans. But accustomed as everyone is to depend on entrepreneurs, there is a constant source for loans and consequently for interest. Entrepreneurs are the ones who cultivate the land and supply bread, meat, clothes, etc., to all the inhabitants of a city. Those who work on wages for these entrepreneurs, also seek to set themselves up as entrepreneurs, in emulation of each other. The multitude of entrepreneurs is much greater among the Chinese as they have a lively spirit, a genius for enterprise, and a determination to achieve their goals. There are among them many entrepreneurs whose work here is done by people on fixed wages. They even supply meals for laborers in the fields. It is perhaps this large number of small entrepreneurs and others, from the various classes, who earn a living from consumption without injuring the consumer, that keeps the rate of interest for the highest classes at 30 percent, while it hardly exceeds 5 percent in Europe. At Athens, in Solon’s time,¹⁰⁶ interest was at 18 percent. In the Roman Republic, it was most commonly 12 percent, but has also been known to be 48, 20, 8, 6, and its lowest was 4 percent. It was never so low in the free market as toward the end of the Republic and under Augustus after the conquest of Egypt.¹⁰⁷ The Emperor Antoninus¹⁰⁸ and Alexander Severus¹⁰⁹ only reduced interest to 4 percent by lending public money on the mortgage of land.

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⁹⁸ In the era before chemical fertilizer, cattle manure was often crucial as a fertilizer for maintaining the productivity of agricultural land.

⁹⁹ Beaver skin hats were fashionable in Europe from the mid-sixteenth to mid-nineteenth century. Beavers were a stimulate to colonization in North America where they were nearly made extinct.

¹⁰⁰ Billingsgate was the location of a fish market that developed during the sixteenth and seventeenth centuries in the southeastern part of London, on the docks located on the north bank of the Thames River.

¹⁰¹ One shilling interest per twenty shillings borrowed equals () or 4.76% per week or 248% simple interest per year.

¹⁰² One sol was worth of a livre.

¹⁰³ A French silver coin originally worth three livres.

¹⁰⁴ Five sols interest per sixty sols borrowed (3 livres * 20 sols per livre) equals 8.3% interest per week or 433% simple interest per year.

¹⁰⁵ The Casuists were scholastic theologians who wrote on the topic of usury. Starting from the position of “just price” where any interest was illegitimate and unjust, the scholastics gradually moved towards accepting the concept of interest, the charging of high rates of interest, and eventually to the position that any rate determined in the market and agreed to by both parties was a just price for a loan. Cantillon mentioned two concepts the Casuists developed, lucrum cessans and damnum emergens, which supported the payment of interest against charges of usury. Lucrum cessans provided an exception whereby a lender could legitimately receive interest from a borrower equal to the same return he could have made from an alternative use of his money had he not lent it to the borrower. Similarly, damnum emergens provided an exception whereby a lender could be compensated for any damages suffered because of the absence of the money lent. Both concepts justified the charging of interest and recognized the existence of the opportunity cost of money.

¹⁰⁶ Solon (638 B.C.–558 B.C.), a foreign trader, wrote the first Constitution of Athens in which he established a civic democracy based on wealth rather than social position or family ties. He also abolished slavery and serfdom and instituted trial by jury. He also eliminated all debts, which may have had an impact on interest rates.

¹⁰⁷ Egypt became part of the Roman Empire 31 B.C. Augustus reigned from 27 B.C. to 14 A.D. and instituted a relatively free market economy.

¹⁰⁸ Antoninus was Roman emperor from 138 A.D. to 161 A.D.

¹⁰⁹ Alexander Severus, also known as Marcus Aurelius was a Roman emperor (222 A.D. to 235 A.D.)