Section I.: Of Loans at Interest.

The interest of capital lent, improperly called the interest of money, was formerly denominated usury, that is to say, rent for its use and enjoyment; which, indeed, was the correct term; for interest is nothing more than the price, or rent, paid for the enjoyment of an object of value. But the word has acquired an odious meaning, and now presents to the mind the idea of illegal, exorbitant interest only, a milder but less expressive term having been substituted by common usage.

Before the functions and utility of capital were known, it is probable, that the demand of rent for it by lenders was considered an abuse and oppression,—an expedient to favour the rich and prejudice the poor; nay, further, that frugality, the sole means of amassing capital, was regarded as parsimony, and deemed a public mischief by the populace, in whose eyes, the sums not spent by great proprietors were looked upon as lost to themselves. They could not comprehend, that money, laid by to be turned to account in some beneficial employment, must be equally spent; for, if it were buried it could never be turned to account at all; that it is, in fact, spent in a manner a thousand times more profitable to the poor; and that a labouring man is never sure of earning a subsistence, except where there is a capital in reserve for him to work upon. This prejudice against rich individuals, who do not spend their whole income, still exists pretty generally; formerly it was universal; lenders themselves were not altogether free from it, but were so much ashamed of the part they were acting, as to employ the most disreputable agents in the collection of profits perfectly just, and highly advantageous to society.

It is, therefore, not surprising that the ecclesiastical, and at several periods, the civil codes, likewise, should have interdicted loans at interest; and that, during the whole of the middle ages, throughout the larger states of Europe, this traffic should have been reputed infamous, and abandoned to the Jews.—The little manufacturing or commercial industry of those days was kept alive by the scanty capital of the dealers and mechanics themselves: and agricultural industry, which was pursued with somewhat better success, was supported by the advances of the lords and great proprietors, who employed their serfs or retainers on their own account. Loans were contracted for, not with a view of profitably employing the money, but merely to satisfy some urgent want, so that the exactor of interest was profiting by a neighbour's distress; and it may easily be conceived, that a religion, founded on the principle of fraternal love, as the Christian religion is, must disapprove a calculating spirit, that even now is a stranger to generous bosoms, and repugnant to the common maxims of morality.—Montesquieu attributes the decline of commerce to this proscription of loans at interest; which was undoubtedly one cause, although, indeed, it was one amongst many.

The progressive advance of industry has taught us to view the loan of capital in a different light. In ordinary cases, it is no longer a resource in the hour of emergency, but an agent, an instrument, which may be turned to the great benefit, as well of society, as of the individual. Henceforward, it will be reckoned no more avaricious or immoral to take interest, than to receive rent for land, or wages for labour; it is an equitable compensation adjusted by mutual convenience; and the contract, fixing the terms between borrower and lender, is of precisely the same nature, as any other contract whatsoever.

In ordinary cases of exchange, however, the transaction is ended as soon as the exchange is completed; whereas, in the case of a loan, there remains to be calculated the risk the lender incurs of never recovering the whole, or at least a part, of his capital. The risk is practically estimated, and indemnified by some addition of interest, in the nature of a premium of insurance. Whenever there happens to be a question about the interest of advances, a careful distinction should be made between these, its two component parts; otherwise, there is always danger of error; and individuals, or even the agents of public authority, will be apt to involve themselves in useless and disastrous operations.

Thus, the practice of usury has been uniformly revived, whenever it has been attempted to limit the rate of interest, or abolish it altogether. The severer the penalties, and the more rigid their exaction, the higher the interest of money was sure to rise; and this is what might naturally have been expected; for the greater the risk, the greater premium of insurance did it require to tempt the lender. At Rome, while the republican form of government lasted, the interest of money was enormous, as it was natural to suppose, even if it were not a matter of history. The debtors, who are always the plebeians, were continually threatening their patrician creditors. The laws of Mahomet have prohibited loans at interest; and what is the consequence in the Mussulman dominions? Money is lent at interest, but the lender must be indemnified for the use of his capital, and, moreover, for the risk incurred in the contravention of the law. It was the same in Christian countries, so long as loans at interest were illegal: and where the necessity of borrowing enforced the toleration of the practice amongst the Jews, such were the humiliation, oppression, and extortion, to which, on one pretext or another, that nation was exposed on this score, that nothing short of a very heavy rate of interest could indemnify for such repeated loss and mortification. Letters patent of the French king John, bearing date in the year 1360, are now extant, which authorises the Jews to lend on pledges at the rate of four deniers per week for every livre of twenty sous, which is more than eighty-six per cent. per annum; but in the year following, the same monarch, though recorded as one of the most scrupulous performers of his royal word that our annals can boast of, caused the quantity of pure metal contained in the coin to be reduced; so that the lenders no longer received back a value equal to what they had lent.

This explanation will alone suffice to justify the very heavy interest demanded, without at all taking into calculation, that at a period, when loans were negotiated, not to forward industrious enterprises, but to support war, to feed extravagance, and to further the most hazardous projects; at a period when laws were powerless, and lenders unable legally to enforce their claims against their debtors, it required a very ample premium to cover the risk of non-payment. In fact, the premium of insurance absorbed the far greater part of what passed under the name of interest, or usury: and the actual bona fide interest, the rent for the use of capital lent, was reduced to a very trifle; for, though capital was scarce, there is reason to suppose, that productive employment was still more so. Of the 86 per cent. interest paid in the reign of king John, perhaps not more than 3 or 4 per cent. was the equivalent for the productive service of the capital advanced; for all productive labour is better paid now, than it was in those days; and even now-a-days the rent of capital can scarcely be reckoned higher than 5 per cent.; the excess is so much premium of insurance for the lender's indemnity.

Thus, the ratio of the premium of insurance, which frequently forms the greater portion of what is called interest, depends on the degree of security presented to the lender; which security consists chiefly in three circumstances:—1. The safety of the mode of employment; 2. The personal ability and character of the borrower; 3. The good government of the country he happens to reside in. We have just seen, how much the hazardous purposes, to which loans were applied in the middle ages, enhanced the premium of insurance necessarily paid to the lender.

It is the same with all perilous investments of capital, with a difference in degree only. The Athenians of old, made a distinction between marine interest, or interest of capital afloat, and land-interest, or interest on shore; the former was rated at 30 per cent. more or less per voyage, whether to the Euxine, or to any port in the Mediterranean. As two such voyages were accomplished with ease in the year, the annual marine interest may be rated at about 60, while other interest was commonly not more than 12 per cent. Supposing that, of the 12 per cent. one half was assigned to cover the risk of the lender; we shall find, that the mere annual rent or hire of money at Athens, was 6 per cent. only, which I should still think above the mark; yet, supposing it to have been so high, the marine interest allowed 54 per cent. for insurance of the lender's risk. So enormous a premium must be attributed in part to the barbarous habits then prevalent among the nations with whom they traded; for different nations were then much greater strangers to each other, than they are at present, and commercial laws and customs much less respected; and in part to the imperfections of the art of navigation. There was more danger in a voyage from the Piræus to Trapezus, though but three hundred leagues distant, than there is now in one from L'Orient to China, which is a distance of seven thousand. Thus, the improvements of geography and navigation have contributed to lower the rate of interest, and ultimately to reduce the cost price of products. Loans are sometimes contracted not for a productive investment, but for mere barren consumption. Transactions of this kind should always awaken the suspicion of the lender, inasmuch as they engender no means of repayment of either principal or interest. If charged upon a growing revenue, they are, at all events, an anticipation of that revenue; and if charged upon any of the sources of revenue, they afford the means of dissipating the particular source itself. If there be the security neither of revenue nor of its source, they barely place the property of one person at the wanton disposition of another.

Among the circumstances incident to the nature of the employment, which influence the rate of interest, the duration of the loan must not be forgotten; ceteris paribus, interest is lower when the lender can withdraw his funds at pleasure, or at least in a very short period; and that both on account of the positive advantage of having capital readily at command, and because there is less dread of a risk, which may probably be avoided by timely retreat. The facility of immediate negotiation presented by the transferable bills and notes of modern governments, is one principal cause of the low rate of interest, at which many of these governments are enabled to borrow. This interest, in my opinion, hardly covers the risk of the lender; but he always reckons on the certainty of selling his securities before the moment of catastrophe, should any serious alarm be entertained. The public securities that are not negotiable, bear a much higher interest; such, for instance, as the old personal annuities in France, which the government generally sold at the rate of 10 per cent. a high average for young lives. Wherefore the Genevese acted with excellent judgment, in settling their annuities on thirty lives of well-known public characters. By this means, they made their annuities negotiable, and so contrived to get the rate of interest of securities not negotiable, upon securities that were negotiable.

About the vast influence of personal character and ability in the borrower, in determining the amount of the premium of insurance to the lender, there can be no doubt whatever: they are the basis of what is called personal credit; and it is hardly necessary to say, that a person in good credit borrows at a cheaper rate, than another who has none.

Next to approved integrity and probity, what most contributes to the credit of an individual or of a government, is past punctuality in performance of engagements; this is, in fact, the very corner-stone of credit, and one that seldom proves insecure. But why, it may be asked, may not a man who has never yet made default in his payment, fail the very next moment? There is very little probability that he will, especially if his punctuality be of long standing. For, to have been ever punctual in his payments, he must either have always been possessed of value in hand sufficient to meet demands upon him; that is to say, he must have been a man of property over and above his debts, which is the best possible ground of trust; or else he must have managed matters so well, and have speculated with so much judgment and safety, as always to have had his returns arrive before the calls became due; thus evincing a degree of ability and prudence, which afforded an excellent guarantee for his future punctuality. The converse of this is the reason, why a merchant, that has once failed or hesitated in the performance of his engagements, thenceforward loses his credit entirely.

Finally, the good government of the country, where the debtor resides, reduces the risk of the creditor, and consequently, the premium of insurance he is obliged to demand to cover that risk. Hence it is, that the rate of interest rises, whenever the laws and their administration do not insure the performance of engagements. It is yet more aggravated, when they excite to the violation of them; as when they authorise non-payment, or do not acknowledge the validity of bona fide contracts.

The resort to personal restraint against insolvent debtors has been generally considered as injurious to the borrower; but is, on the contrary, much in his favour. Loans are made more willingly, and on better terms, where the rights of the lender are best secured by law. Besides, the encouragement to accumulate capital is thereby enlarged; whenever individuals mistrust the mode of investing their savings, there is a strong inducement to every one to consume the whole of his income, and this consideration will, perhaps, help to explain a curious moral phenomenon; namely, that irresistible avidity for excessive enjoyment, which is a common symptom in times of political turbulence and confusion.

However, while on the subject of the necessity of personal severity towards debtors, I cannot recommend the practice of imprisonment; to confine a debtor is to command him to discharge his debts, and at the same time deprive him of the means of so doing. There seems more reason in the Hindu institution, giving the creditor the option of seizing the person of his insolvent debtor, and confining him at the creditor's own home to compulsory labour, for the creditor's benefit. But, whatever be the means, whereby the public authority enforces the payment of debts, they must always be ineffective, if law be partially or capriciously administered. The moment a debtor is, or hopes to be, out of his creditor's reach, there is a risk to be run by the creditor, which is of value, and must be indemnified.

After having thus detached from the rate of bare interest all that is paid as premium of insurance to the lender against the risk of total or partial loss of his capital, it remains to consider that part, which is purely and simply interest; that is to say, rent paid for the utility and the use of capital.

Now this portion of the gross sum called interest is larger in proportion as the supply of capital available for loans is less; and as the demand of capital for that specific object is greater; and again, that demand is the greater in proportion to the more numerous and more lucrative employments of capital. Consequently, a rise in the rate of interest does not infallibly or universally denote, that capital is growing scarcer; for possibly, it may be a sign, that its uses are multiplied. Smith has remarked this consequence upon the close of the very successful war on the part of England, which terminated with the peace of 1763. The rate of interest then advanced instead of declining; the important acquisitions of England had opened a new field for her commercial enterprise and speculation; capital was not diminished in quantity, but the demand for it was increased; and the rise of interest, which ensued, though in most cases a sign of impoverishment, was, in this, a consequence of the acquisition of new sources of wealth.

France, in 1812, experienced the opposite effect of a cause directly the reverse. A long and destructive war, which had annihilated almost all external communication; exorbitant taxation; the ruinous system of licenses; the commercial enterprises of the government itself; frequent and arbitrary alterations in the duties on import; confiscation, destruction, vexation; in fine, a system of administration uniformly avaricious and hostile to private interest, had rendered all enterprises of industry difficult, hazardous and ruinous in the extreme. The aggregate capital of the nation was probably on the decline; but the beneficial employment of it became still more rare as well as dangerous; so much so, that interest never fell so low in France as at that period; and, what is in general the sign of extreme prosperity, was then the effect of extreme distress.

These exceptions serve but to confirm the general and eternal law, that the more abundant is the disposable capital, in proportion to the multiplicity of its employments, the lower will the interest of borrowed capital fall. With regard to the supply of disposable capital, that must depend on the quantum of previous savings. On this head, I must refer to what I have before said upon the subject of the formation of capital.

If it be desired, that capital in search of employment, and industry in search of capital, should both be satisfied in the fullest manner, entire liberty of dealing must be allowed in all matters touching loans at interest. Disposable capital, being thus left to itself, will seldom remain long unemployed; and there is every reason to believe, that as much industry will be called into activity, as the actual state of society will admit.

But it is essential to pay a strict attention to the meaning of the term, supply of disposable capital; for this alone can have any influence upon the rate of interest; it is only so much capital, as the owners have both the power and the will to dispose of, that can be said to be in circulation. A capital already vested and engaged in production or otherwise, is no longer in the market, and therefore no longer forms a part of the total circulating capital; its owner is no longer a competitor of other owners in the business of lending, unless the employment be one, from which capital may be easily disengaged and transferred to other objects. Thus, capital lent to a trader, and liable to be withdrawn from his hands at a short notice, and, à fortiori, capital employed in the discount of bills of exchange, which is one way of lending among commercial men, is capital, readily disposable and transferable to any other channel of employment, which the owner may judge convenient.

Capital employed by the owner on his own account, in a trade that may be soon wound up, in that of a grocer for instance, stands nearly in the same predicament. The articles he deals in find at all times a ready market, and the capital thus employed may be realized, repaid if lent, re-lent and re-employed in other trades, or applied to any other use. It is always either in actual circulation, or at least on the point of being so. Of all values, the one most immediately disposable is that of money. But capital embarked in the construction of a mill, or other fabric, or even in a movable of small dimensions, is fixed capital, which being no longer available for any other purpose, is withdrawn from the mass of circulating capital, and can no longer yield any other benefit than that of the product wherein it has been vested. Nor should it be lost sight of, that even though the mill or other fabric be sold, its value, as capital, is not by that means restored to circulation; it has merely passed from one proprietor to another. On the other hand, the disposable value, where-with the buyer has made the purchase, is not thrown out of circulation, having merely passed from his into the seller's hands. The sale neither increases nor diminishes the mass of floating capital in the market. Attention to this circumstance is essential to the forming a correct estimate of the causes, that determine the rate, as well of interest on capital, as likewise of profit accruing from capital employed, which we are about to consider presently.

It has been sometimes supposed, that capital is multiplied by the operation of credit. This error, though frequently recurring in works professing to treat of political economy, can only arise from a total ignorance of the nature and functions of capital. Capital consists of positive value vested in material substance, and not of immaterial products, which are utterly incapable of being accumulated. And a material product evidently cannot be in more places than one, or be employed by more persons than one, at the same identical moment. The works, machinery, utensils, provisions, and stock in hand, composing the capital of a manufacturer, may possibly be wholly borrowed; in which case, he will be acting upon a hired capital, and not on one of his own; yet, beyond all question that capital can be made use of by no one else, so long as it remains within his control and management: the lender has parted with the power of otherwise disposing of it for the time. A hundred others might have equal security and credit to offer; but their applications could not multiply the volume of disposable capital, and could have no other effect than to prevent other capital from remaining idle and out of employ.

It is not to be expected, that I should here enter upon a computation of the motives of affection, consanguinity, generosity, or gratitude, which may occasionally give rise to the loan of capital, or influence the amount of interest demanded for it. Every reader must take upon himself to appreciate the influence of moral causes upon the laws of political economy, which alone we profess to expound.

To limit capitalists to the lending at a certain fixed rate only, is to set an arbitrary value on their commodity, to impose a maximum of price upon it, and to exclude, from the mass of floating or circulating capital, all that portion,whose proprietors cannot, or will not, accept of the limited rate of interest. Laws of this description are so mischievous, that it is well they are so little regarded as they almost always are, the wants of borrowers combining with those of lenders, for the purpose of evading them; which is easily managed, by stipulating for benefits to the lender, not indeed bearing the name of interest, although really the same thing in the end. The only consequence of such enactments is, to raise the rate of interest, by adding to the risks, to which the lender is exposed, and against which he must be indemnified. It is somewhat amusing to find that those governments, which have fixed the rate of interest, have almost invariably themselves set the example of breaking their own laws, by borrowing at higher than legal interest in their own case.

That interest should be fixed by law is highly proper and necessary; but it should be fixed only in cases, where there is no previous agreement about it; as in the case of a legal recovery of a sum with interest. And, in such case, I think the interest fixed by law should be estimated at the lowest rate that is usually paid by individuals; because the lowest rate is that paid by the safest investments. Now, it is quite consistent with justice, that the withholder of capital should restore it even with interest; but that is in the supposition, that it has remained all the while in his possession; which it cannot be supposed to have done, without his having invested it in the way the least hazardous, and consequently without his having drawn from it at least the lowest interest it would have afforded.

But this rate should not be denominated the legal interest, because the rate of interest ought no more to be restricted, or determined by law, than the rate of exchange, or the price of wine, linen, or any other commodity. And this is the proper place to expose a very prevalent error.

Capital, at the moment of lending, commonly assumes the form of money; whence it has been inferred, that abundance of money is the same thing as abundance of capital; and, consequently, that abundance of money is what lowers the rate of interest. Hence the erroneous expressions used by men of business, when they tell us, that money is scarce, or that money is plentiful; which, it must be confessed, are equally just and appropriate, as the very incorrect term, interest of money. The fact is, that abundance or scarcity of money, or of its substitute, whatever it may be, no more affects the rate of interest, than abundance or scarcity of cinnamon, of wheat, or of silk. The article lent is not any commodity in particular, or even money, which is itself but a commodity, like all others; but it is a value accumulated and destined to beneficial investment.

A man, who is about to lend, converts into money the aggregate value he means to devote to that particular purpose; and the borrower no sooner has it at command, than he exchanges it for something else; the money that has effected this operation, forthwith served to effect other similar or dissimilar operations; the payment of a tax perhaps, or the subsidy of an army. The value lent has but for a moment assumed the form of money, in the same manner, as we have traced revenue received and expended, passing through the same temporary form; the identical pieces of money serving perhaps a hundred times in the course of a year, to transfer equivalent portions of income. So, likewise, the same sum of money, that has served to transfer a value from the hands of one lender into those of a borrower, may, after infinite intervening transfers, perform the like office between a second borrower and lender, without stripping the former borrower of any part of the value he has received. In reality, then, it is value which has been borrowed, and not any particular sort of metal or of merchandise. All kinds of merchandise may be lent and borrowed, as well as money; nor does the rate of interest at all depend upon the quality of the object lent or borrowed. Nothing is more common in trade, than to lend and borrow other objects than money. When a manufacturer buys the raw material of his business at a certain credit, he, in fact, borrows the wool, or cotton, as the case may be, making use of the value of those materials in his concern; and their quality has no influence on the interest, with which he credits the seller. The glut or scarcity of the commodity lent only affects its relative price to other commodities, and has no influence whatever on the rate of interest upon its advance or loan. Thus, when silver money lost three-fourths of its former relative value, although four times as much of it was necessary to pass a loan of the same extent of capital, the rate of interest remained unaltered. The quantity of specie or money in the market, might increase tenfold, without multiplying the quantity of disposable, or circulating capital.

Wherefore, it is a great abuse of words, to talk of the interest of money; and probably this erroneous expression has led to the false inference, that the abundance or scarcity of money regulates the rate of interest. Law, Montesquieu, nay, even the judicious Locke, in a work expressly treating of the means of lowering the interest of money, have all fallen into this mistake; and it is no wonder that others should have been misled by their authority. The theory of interest was wrapped in utter obscurity, until Hume and Smith dispelled the vapour. Nor will it ever be clearly comprehended, except by such as shall have acquired a correct notion of what has, throughout this work, been denominated capital, and shall proceed in the conviction, that the object lent or borrowed, is not a particular commodity or object of merchandise, but a portion of value,—of the aggregate value of the capital available for that object; and that the per centage paid for the use of this portion of capital, at all times and places, depends on the relative supply and demand of capital to be lent, and is wholly independent of the specific form or quality of the commodity, wherein the loan is made, whether it be money, or any other article whatever.