Chap. IV: Of the Principles which regulate the Rate of Interest

We must now recal to mind the principles of demand and competition, so fully deduced in the second book, in order to answer the following question, viz.

What is the principle which regulates, at all times, the just and adequate rate of interest for money, in any particular state?

I answer, That at all times, there is in every state a certain number of persons who have occasion to borrow money, and a certain number of persons who desire to lend: there is also a certain sum of money demanded by the borrowers, and a certain sum offered to be lent. The borrowers desire to fix the interest as low as they can; the lenders seek, from a like principle of self-interest, to carry the rate of it as high as they can.

From this combination of interests arises a double competition, which fluctuates between the two parties. If more be demanded to be borrowed, than there is found to be lent, the competition will take place among the borrowers. Such among them as have the most pressing occasion for money, will offer the highest interest, and will be preferred. If, on the contrary, the money to be lent exceed the demand of the borrowers, the competition will be upon the other side. Such of the lenders, as have the most pressing occasion to draw an interest for their money, will offer it at the lowest interest, and this offer will be accepted.

I need not launch out into a repetition of what has been said concerning the influence of double competition, in fixing the price of commodities; as I suppose these principles to be now well understood, and well retained, by those who read this chapter; I shall therefore confine myself here to what is peculiar to the demand for money.

The price of commodities is extremely fluctuating: they are every one calculated for particular uses; money serves every purpose. Commodities, though of the same kind, differ in goodness: money is all, or ought to be all of the same value, relatively to its denominations. Hence the price of money (which is what we express by the term interest) is susceptible of a far greater stability and uniformity, than the price of any other thing.

We have shewn in the 28th chapter of the second book, in examining the principles which regulate the price of subsistence, that the only thing which can fix a standard for it, is frequent and familiar alienation. The same holds true of money. Were we to suppose a state, where borrowing and lending are not common, and where the laws fix no determinate interest for money, it would hardly be possible to ascertain the rate of it at any time. This was the case of old.

Before the reign of Henry VIII of England, in 1545, there was no statute regulating the rate of interest, in that kingdom. The reason is very plain. In those days there was little circulation, and the borrowing of money upon interest was considered as a mortal sin. The consequence of this was, that usurers, having nothing but conscience to restrain them, carried the price of their money to a level with the pressing occasion of spendthrifts, while others, from friendship, lent for no interest at all. Henry fixed the rate of interest at 10 per cent and his contemporary, Francis I of France, in 1522, (who was the first who borrowed money in a regular manner upon the townhouse of Paris) fixed the interest at the 12th penny, that is, at 8 1/3 per cent.

In those days, it was impossible for a statesman to determine any just rate for interest; and accordingly we find history filled with the extortion of usurers, on one hand, and the violence and injustice of princes and ministers towards those who had lent them money, on the other: was it then any wonder, that lending at interest was universally cried out against? It really produced very little good, and was the cause of manifold calamities to a state. When the Prince borrowed, it was in the most urgent distress: those who had money, foresaw the danger of being plundered if they refused to lend it to him, and of being defrauded as soon as the public distress was over: for this reason they exacted the most exorbitant interest: the consequence was, that the people were loaded with the most grievous taxes, and the tax-gatherers were the Prince's creditors, to whom such taxes were assigned.

In our days, trade, industry, and a call for money, enable the borrower to enrich himself, to supply the wants of the state, and to pay his interest regularly.

If we compare the two situations, we shall find every disadvantage attending the former, and every advantage connected with the latter.

Without good faith their can be no credit; without credit there can be no borrowing of money, no trade, no industry, no circulation, no bread for the lower classes, no luxury, not even the conveniences of life, for the rich. Under these circumstances, there can be no rule for the rate of interest; because borrowing cannot be frequent and familiar.

In proportion, therefore, as borrowing becomes frequent and familiar, the rule for fixing the rate of a legal interest becomes more practicable to a statesman. Let me make a step farther.

We have said, that it is the fluctuation of the double competition between borrowers and lenders, which occasions the rise and fall of the rate of interest; I must now point out the principles which occasion this fluctuation.

Were the interests of trade and industry so exactly established, as to produce the same profit on every branch of them, the money borrowed for carrying them on, would naturally be taken at the same rate; but this is not the case: some branches afford more, some less profit. In proportion, therefore, to the advantages to be reaped from borrowed money, the borrowers may offer more or less for the use of it.

Besides the class of men who borrow in order to profit by the loan, there is another class, who borrow in order to dissipate. The first class never can offer an interest which exceeds the proportion of their gains: the second class, finding nothing but want of credit to limit their expence, become a prey to usurers. Were it not then upon account of these last, there would be no occasion for a statute to regulate the rate of interest. The profits on trade would strike an average among the industrious classes; and this average would fall and rise, in proportion to the flourishing or decay of commerce.

Let us next examine the principles which prevent the monied men from committing extortions, and which oblige them to lend their money for that rate of interest which is in proportion to the profits upon trade and industry.

In every country there is found a sum of money (that is, of circulating value, no matter whether coin or paper) proportioned to the trade and industry of it. How this sum is determined, and how it is made to augment and diminish in proportion to industry, we have already explained in the 26th chapter of the second book: we are now to examine some of the consequences which result from the accidental stagnation of any part of it to the prejudice of alienation; and we must shew how the loan upon interest is the means of throwing it again into circulation.

There are in every state some who spend more, and some who spend less than their income. What is not spent must stagnate; or must be lent to those who spend more than the produce of their own funds. Were the first class found so to preponderate, as to require more money to borrow than all that is to be lent, the consequence would be, to prevent the borrowing of merchants; to raise interest so high as to extinguish trade; and to destroy industry; and these resources coming to fail, foreign commodities would be brought in, while exportation would be stopped, money would disappear, and all would fall into decay.

This, I believe, is a case which seldom happens; because the rise of interest (as states are now formed) has so much the effect of depreciating the value of every species of solid property, that spendthrifts are quickly stripped of it, by the growing accumulation of that canker worm, interest; their ruin terrifies many from following so hurtful an example, and their property falling into the hands of the other class, who spend less than their income; these new possessors introduce, by their example, a more frugal set of manners. This may be the case in countries where trade and industry have been introduced; and where the operations of credit have been able to draw into circulation a large quantity of solid property, according to the principles deduced in the chapter above referred to. But in nations of idleness, who circulate their coin only, and who are deprived of the resource of credit; high interest prevents them from emerging out of their sloth, and the little trade they have, continues to produce great profits, which are incompatible with foreign commerce: this may, indeed, make the coin they have to circulate for home-consumption, but it can bring no augmentation of wealth from abroad.

On the other hand, when trade and industry flourish, and when a monied interest is formed, in consequence of the melting down of solid property, and still more in consequence of a State's contracting great debts; were the money-lenders to attempt to raise the rate of interest to the standard of the spendthrift, the demands of trade, etc, would soon be cut off: the stagnation would then swell so fast in their hands, that it would in a manner choak them, and in a little time interest would fall to nothing. Whereas by contenting themselves with the standard of trade, the largest supplies (provided for the borrowers) easily find a vent, without raising the rate of interest so high as to be hurtful to any interest within the state.

Add to this, that the advantage of realizing, into lands, so unstable a property as money, must naturally throw the proprietors of the money into a competition for the lands which dissipation brings to market; thus, by rising the value of lands, the monied men, with their own hands, defeat the consequences of the dissipation of spendthrifts, and hurt their own interest, to wit, the rise of the price of money. From a combination of these circumstances, lenders become obliged to part with their money at that rate of interest which is the most consistent with that good of commerce.

We have hitherto preserved our combinations as simple as possible. We have suggested no extrinsic obstacle to borrowing and lending. If money be to be lent, and if people be found who incline to borrow, we have taken it for granted, that circulation will go on; and that the stagnations in the hands of the lenders, will find a ready vent by the dissipation of the other class: we must now make still a step farther.

The spendthrifts must have credit; that is, they must have it in their power to repay with interest what they have borrowed: any impediment to credit, will have the effect either of diminishing the demand for money, and consequently of lowering the rate of interest, or of introducing unlawful usury. If we suppose the rate of interest well determined, and usury prevented by a regular execution of good laws, it is very certain, that a statesman by hurting the credit of extravagant people, will keep the rate of interest within due bounds.

If, therefore, the laws of any country, in our days, appear defective, as to the regulation of securities for money lent upon the mortgage of solid property, while the rate of interest stands higher than is consistent with the good of trade, and with public credit; we should be slow in finding fault with such a defect. The motives of statesmen lie very deep; and it is not always proper to explain them. An example of such defects are entails upon lands, and the want of proper registers for mortgages.

Did the dissipation of landed men tend to promote foreign trade, such clogs would be pernicious: but if the tendency of dissipation be to promote domestic luxury only, and thereby to raise the price of labour and industry, the case is widely different. This observation is merely incidental: our object at present extends no farther than to shew, that the dissipation of landed men, and the credit they have to borrow money, influence, not a little, the rate of interest in every modern state.

These are the general principles which, arising from things themselves, without the interposition of a statesman, tend to regulate the rate of interest in commercial nations.