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Interest and Usury
by Fred E. Foldvary, Senior Editor
One of the most contentious topics in economics has been the concept of interest and interest rates. In ancient Israel, the payment of interest was outlawed for fellow Israelites, most likely because most loans were for consumption, and borrowers desperate for the funds could be exploited.
This view was also held by some of the ancient Greeks. Aristotle thought that interest was unnatural because it required an increase in money, which interfered with the purpose of money as a medium of exchange.
The term “usury” derives from the Latin for “use” and originally meant the practice of lending money at interest, and later came to mean lending at an excessive or illegal rate of interest. If any payment of interest is morally wrong, then all interest is usury.
Roman law had allowed interest, but during the Middle Ages, St. Thomas Aquinas condemned all interest as usury. The Catholic Church opposed the payment of interest on the basis of Scripture. Islamic law as currently interpreted still forbids the payment of interest; banks instead become partners in enterprises. But in Europe, towards the end of the Middle Ages, it became recognized that parting with one’s money constitutes a loss of opportunity, and that present-day money has a higher value than future money.
A turning point came when John Calvin in the 1500s allowed the payment of interest in principle. The philosopher John Locke wrote about economics along with ethical and political philosophy, and said that regulating the interest rate is futile — people will evade the law, and the supply of loanable funds will be reduced.
Economists during the 1800s did not have a good understanding of what causes the rate of interest. Some thought it had to do with the amount of money. Some had a “fructification” idea that interest rates were related to the natural growth of crops and value added such as when wine ages and becomes more desirable.
Interest was regarded as a return to capital, or the profit made by providing capital. Some thought interest was a reward for abstinence or waiting, for going without goods for a while. Marxists considered interest as inherently exploitative of labor.
In 1884, the Austrian economist Eugen Böhm-Bawerk wrote a book entitled Capital and Interest. He refuted all the past doctrines of interest, proposing instead that interest came from “time preference.” Most folks prefer to have goods at the present time rather than in the future, because life is short and uncertain. Entrepreneurs also typically want to borrow to start enterprises in the present, using other people’s savings.
The Swedish economist Knut Wicksell combined Austrian and classical ideas and developed the concept of the “natural” rate of interest, the rate in a pure free market. The actual “market” rate of interest can be lower than the natural rate in the short run if the amount of money grows rapidly, but not in the long run as prices go up.
The Austrian economist Friedrich Hayek then theorized that when the market rate is below the natural rate, investment gets distorted, and some projects will not be profitable and fail. The American economist Irving Fisher then put it all together in 1930 in a book entitled Theory of Interest. Fisher recognized that interest is not just a return to capital goods. The rate of interest measures the price of using goods now rather than later.
So it was not until 1930 that economists really understood interest rates. However, older ideas about interest rates still circulate, as some folks still think that interest is a bad thing and has to do with banking and money monopolies and the return to capital.
Economists distinguish between the “nominal” or money rate of interest, the figures quoted by banks, and the “real” interest rate, which is the nominal rate minus the inflation rate. What matters in economics is the real rate. Interest rates today are distorted not only from inflation, but from taxes, since interest income is taxed while often interest payments can be deducted from taxable income. Taxes and excessive regulations distort prices and profits in general, further skewing interest rates. Easy bankruptcy increases the interest rates of loans to folks without much collateral. The government monopoly of fiat money and its control over the banking system further distorts interest rates.
The pure natural rate of interest is the interest that would exist in a pure market economy, with no inflation, no taxes, no central banking monopolies, no restrictions on exchange rates, and apart from any premiums paid for the riskiness of loans. In a pure market, public revenue comes from user fees and land rents, which do not affect interest rates. Interest could be lower than it is today, since one would not have to borrow to pay for land, as the public collection of the rent would drive the price of land down to near zero, and there would be no tax premium. But interest rates would not fall to zero, since even in a prosperous society, young adults would borrow to buy a house and car, and entrepreneurs would want start-up funds to finance a business or some project.
Since the natural rate of interest is based on the time preferences of people, when folks want to save a lot of their income, interest rates would be lower, and when they would rather save less, interest rates would be higher. Interest rates rise in a growing economy and fall during a depression.
In a pure market, interest rates would be set by the supply and demand for loanable funds based on time preferences. If interest rates are set by the pure market, then neither high nor low interest rates are an economic problem. Only when government intervenes with taxes, restrictions, and money monopolies do interest rates become exploitative usury. Pure free-market interest rates are as natural as time itself.
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Copyright 1998 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieveal system, without giving full credit to Fred Foldvary and The Progress Report.