Book I, Chapter IX, 2

The acquisition of new territory or new branches of trade may sometimes raise the profits of stock, and with them the interest on money, even in a country rapidly growing richer. The country's stock is not sufficient for all the additional business that such acquisitions bring to the various people who hold it, and so it is directed only to the branches offering the greatest profit. Some stock formerly employed in other trades must be withdrawn and turned toward the new and more profitable ones. Competition in all those older trades consequently declines. The market is less fully supplied with many kinds of goods. Their prices necessarily rise to some degree, yielding greater profits to their dealers, who can therefore afford to borrow at a higher rate of interest. For some time after the end of the late war, not only private individuals with the best credit but also some of London's greatest companies commonly borrowed at five per cent., though previously they had not been accustomed to pay more than four, or four and a half per cent. The great increase in both territory and trade from our acquisitions in North America and the West Indies adequately accounts for this without any supposition that the society's capital stock had diminished. So great an increase in new business conducted with the old stock must necessarily have reduced the amount employed in many particular branches, where diminished competition must have enlarged profits. I shall later give the reasons that lead me to believe that Great Britain's capital stock was not diminished even by the enormous expense of the late war.

A reduction in the society's capital stock, or in the funds set aside to maintain industry, however, raises the profits of stock and therefore the interest on money, just as it lowers the wages of labor. With wages reduced, the owners of the stock remaining in society can bring their goods to market at less expense than before; with less stock employed in supplying that market, they can sell those goods for more. They pay less for their goods and receive more for them. Their profits thus increased on both sides, they can readily afford a high rate of interest. The great fortunes acquired so suddenly and so easily in Bengal and the other British settlements in the East Indies may convince us that, as wages are very low, profits of stock are very high in those ruined countries. Interest on money is correspondingly high. In Bengal, money is often lent to farmers at forty, fifty, and sixty per cent., with the next crop mortgaged to repay it. Profits large enough to bear such interest must consume almost the landlord's entire rent; such enormous usury must in turn consume most of those profits. Before the fall of the Roman republic, similar usury seems to have been common in the provinces under their proconsuls' ruinous administration. The virtuous Brutus lent money in Cyprus at eight-and-forty per cent., as we learn from Cicero's letters.

In a country that had attained the full measure of riches allowed by its soil, climate, and position in relation to other countries, and thus could neither advance further nor decline, both wages and profits of stock would probably be very low. If its population were as large as its territory could support or its stock employ, competition for work would necessarily be so intense that wages would fall to the amount barely sufficient to maintain the number of laborers; already at its full population, the country could never increase that number. If its stock were as large as all its business could accommodate, each particular branch would employ as much as the character and extent of the trade permitted. Competition would therefore be at its greatest everywhere, and the ordinary profit, consequently, at its lowest.

Perhaps no country, however, has yet reached this degree of wealth. China seems long to have remained stationary, and probably long ago attained the full measure of riches consistent with its laws and institutions. Yet that measure may be far below what its soil, climate, and position could support under different laws and institutions. A country that neglects or scorns foreign commerce and admits foreign vessels to only one or two of its ports cannot conduct as much business as it could under other laws and institutions. Nor can the stock employed in its various branches of business ever reach the amount their character and extent might accommodate in a country where the rich, or owners of large capitals, enjoy considerable security, while the poor, or owners of small capitals, enjoy almost none and may at any time be robbed and plundered by lesser mandarins under the pretense of justice. In every branch, oppression of the poor must establish a monopoly for the rich; taking the whole trade into their own hands, they can make very large profits. Accordingly, twelve per cent. is said to be the ordinary interest on money in China, and ordinary profits of stock must be large enough to bear so high a rate.

A defect in the law may sometimes lift interest considerably above the rate that a country's wealth or poverty would otherwise warrant. When the law does not enforce contracts, it places nearly every borrower on the same footing as a bankrupt or a person of doubtful credit in a better-governed country. Uncertain of recovering his money, the lender demands the same usurious interest commonly demanded of bankrupts. Among the barbarous nations that overran the Roman empire's western provinces, fulfillment of contracts depended for many ages on the good faith of the parties. Their kings' courts of justice seldom intervened. This may partly explain the high interest rates of those ancient times.

When the law forbids interest altogether, it does not prevent interest from being charged. Many people must borrow, and no one will lend without compensation for the use of his money appropriate both to what it could earn and to the difficulty and danger of evading the law. M. Montesquieu attributes the high interest rate among all Mahometan nations not to their poverty, but partly to this prohibition and partly to the difficulty of recovering the money.

The lowest ordinary rate of profit must always exceed what is needed to cover the occasional losses to which every use of stock is exposed. Only this excess is net, or clear, profit. What is called gross profit often includes not just this excess but the sum retained against such extraordinary losses. The interest a borrower can afford to pay is proportionate only to clear profit. Similarly, the lowest ordinary rate of interest must exceed what is needed to cover the occasional losses incurred even in reasonably prudent lending. Otherwise charity or friendship alone could induce anyone to lend.

In a country possessing its full measure of riches, with the greatest possible stock employed in each particular branch of business, the ordinary rate of clear profit would be very small. The usual market rate of interest payable from that profit would then be so low that only the very wealthiest could live on the interest of their money. People of small or moderate means would have to supervise the employment of their own stock. Almost everyone would have to conduct business or engage in some trade. The province of Holland appears to be approaching this condition. There it is unfashionable not to be in business. Necessity makes business the usual pursuit of almost everyone, and custom everywhere determines fashion. Just as it is ridiculous not to dress like other people, so, to some extent, is it ridiculous not to work like them. A man in a civilian profession looks out of place in a camp or garrison and even risks being despised there; an idle man looks much the same among businesspeople.

The highest ordinary rate of profit may be so great that, in the price of most commodities, it consumes everything that should go to land rent and leaves only enough to pay for the labor of preparing and bringing them to market at the lowest wage paid anywhere: the laborer's bare subsistence. A worker must always have been fed somehow while working, but a landlord need not always have been paid. The profits from the trade carried on in Bengal by servants of the East India Company may perhaps be not far from this rate.

The proportion that the usual market rate of interest ought to bear to the ordinary rate of clear profit necessarily changes as profit rises or falls. In Great Britain, interest doubled is reckoned what merchants call a good, moderate, reasonable profit—terms that, I believe, mean no more than an ordinary and usual profit. Where the ordinary rate of clear profit is eight or ten per cent., it may be reasonable for half to go to interest whenever business is conducted with borrowed money. The borrower bears the risk of the stock, effectively insuring it for the lender; four or five per cent. may be sufficient in most trades both as profit on the risk of this insurance and as payment for the trouble of employing the stock. But interest and clear profit might stand in a different proportion in countries where ordinary profit was much lower or much higher. If much lower, perhaps half could not be paid as interest; if much higher, more could be paid.

In countries advancing rapidly toward riches, low profit may offset high wages in the prices of many commodities, enabling those countries to sell as cheaply as less prosperous neighbors whose laborers earn lower wages.

In fact, high profits tend to raise the price of work far more than high wages. Suppose, for example, that in making linen the wages of every class of worker—the flax dressers, spinners, weavers, etc.—rose by twopence a day. The price of a piece of linen would need to rise only by as many twopences as the number of people employed on it multiplied by the number of days each worked. Throughout the stages of manufacture, the portion of its price attributable to wages would rise only in arithmetical proportion to the wage increase. But if every employer of those workers earned five per cent. more profit, the portion of the commodity's price attributable to profit would rise through those stages in geometrical proportion to that increase. When selling his flax, the flax dressers' employer would demand another five per cent. on the entire value of the materials and wages he had advanced his workers. The spinners' employer would demand another five per cent. on both the higher price of flax and the spinners' wages. The weavers' employer would likewise demand five per cent. more on both the higher price of linen yarn and the weavers' wages. In raising commodity prices, higher wages work like simple interest in accumulating debt; higher profits work like compound interest. Our merchants and master manufacturers complain loudly that high wages raise prices and thereby diminish sales of their goods at home and abroad. They say nothing of the harmful effects of high profits: silent about the destructive effects of their own gains, they complain only about those of other people.

Gaining new territory or new kinds of trade can sometimes raise the profits on stock and the interest paid on loans, even in a country that is rapidly growing richer. The country's stock is not enough to cover all the new business these gains offer its owners. So they put it into the activities that pay best. They have to take some stock out of older trades and move it into newer, more profitable ones. Competition in those older trades then decreases. The market receives fewer goods of many kinds. Their prices rise to some extent, increasing the dealers' profits and allowing them to pay higher interest on loans. For some time after the recent war ended, even private borrowers with the best credit and some of London's largest companies commonly borrowed at five per cent. Before the war, they had usually paid no more than four, or four and a half per cent. The large additions of territory and trade gained in North America and the West Indies explain this without assuming that society's capital stock had fallen. Carrying on so much new business with the old stock must have reduced the amount used in many existing trades. Less competition there meant higher profits. Later I will explain why I believe that even the enormous expense of the recent war did not reduce Great Britain's capital stock.

A fall in society's capital stock, or the funds available to support industry, does, however, lower wages while raising profits on stock and therefore interest rates. Lower wages let the owners of the remaining stock bring goods to market more cheaply. With less stock used to supply the market, they can also sell those goods for more. Their costs fall and their selling prices rise. With profits growing on both sides, they can afford to pay high interest. The large fortunes made so quickly and easily in Bengal and the other British settlements in the East Indies show that wages are very low and profits on stock very high in those ruined countries. Interest is correspondingly high. In Bengal, farmers often borrow at forty, fifty, and sixty per cent. and pledge the next crop to repay the loan. Profits large enough to pay such interest must consume nearly all the landlord's rent. Such enormous interest, in turn, must consume most of those profits. Before the Roman republic fell, similar lending at high interest seems to have been common in its provinces under the destructive rule of their proconsuls. As Cicero's letters tell us, the virtuous Brutus lent money in Cyprus at eight-and-forty per cent.

Suppose a country had become as rich as its soil, climate, and position relative to other countries allowed. It could grow no richer but was not becoming poorer. Both wages and profits on stock would probably be very low. Its population would already be as large as its land could support or its stock could employ. Competition for jobs would then drive wages down to the bare amount needed to maintain the number of workers, and the population could not grow further. The country would also have as much stock as all its business could use. Each activity would employ as much stock as its size and nature allowed. Competition would therefore be as intense as possible everywhere, and normal profits as low as possible.

Perhaps no country has ever reached that degree of wealth. China seems to have stopped growing long ago. It probably reached, long ago, the maximum wealth possible under its laws and institutions. But different laws and institutions might allow its soil, climate, and location to support much more wealth. A country that neglects or looks down on foreign commerce and admits foreign ships to only one or two ports cannot do as much business as it could under different rules. Moreover, in a country where the rich and those with large amounts of capital enjoy considerable security, while poor people and owners of small amounts of capital enjoy almost none, less stock is put to use than the available business could support. Lower-ranking mandarins can rob the poor at any time under the pretense of enforcing justice. In each kind of business, this oppression gives rich people a monopoly. They take over the entire trade and can make very large profits. Accordingly, the usual interest rate in China is said to be twelve per cent. Normal profits on stock must be high enough to pay that rate.

A flaw in the law can sometimes push interest rates far above the level that the country's wealth or poverty would otherwise produce. If the law does not enforce contracts, it makes nearly every borrower as risky as a bankrupt or a borrower with doubtful credit in a country with better laws. Uncertain of getting his money back, a lender demands the same very high interest usually charged to bankrupts. For many centuries among the peoples who overran the western provinces of the Roman empire, keeping a contract depended on the promises of the parties who made it. The kings' courts rarely got involved. This may partly explain the high interest rates of those times.

When the law bans interest entirely, people still charge it. Many people need to borrow, and no one will lend without payment for the use of the money. That payment must cover both what the lender could earn with the money and the trouble and danger of evading the law. M. Montesquieu explains the high interest rates among all Mahometan nations partly by this ban and partly by the difficulty of recovering loans, rather than by poverty.

The lowest normal profit rate must exceed the amount needed to cover the occasional losses faced in every use of stock. Only the excess is net, or clear, profit. What people call gross profit often includes both that excess and money set aside to cover such losses. A borrower can afford to pay interest only out of clear profit. Likewise, the lowest normal interest rate must exceed the amount needed to cover the occasional losses that even reasonably careful lenders face. Otherwise, people would lend only from charity or friendship.

In a country that had reached its maximum wealth, every activity would already use as much stock as it could. Normal clear profit would be very small. The market interest rate that could be paid from it would be so low that only the very wealthiest could live on interest from their money. People with small or middling fortunes would have to manage the use of their own stock themselves. Almost everyone would have to do business or engage in some trade. The province of Holland seems close to this state. There it is unfashionable not to be in business. Necessity makes nearly everyone engage in it, and custom sets fashion everywhere. Not dressing like other people looks ridiculous; to some extent, so does not working like them. A person in a civilian profession looks out of place in a camp or garrison and may even be looked down on there. An idle person looks equally out of place among businesspeople.

The highest normal profit rate might, in the price of most goods, consume everything that ought to go toward land rent. It would leave only enough to pay the workers who prepare the goods and bring them to market, at the lowest possible wage: their bare subsistence. A worker must somehow be fed while doing the work, but the landlord need not always be paid. The profits from the trade carried on in Bengal by servants of the East India Company may be close to this level.

The relationship between the usual market interest rate and the normal rate of clear profit must change as profits rise or fall. In Great Britain, merchants consider profit at twice the interest rate to be good, moderate, and reasonable. I take those words to mean simply ordinary profit. Where normal clear profit is eight or ten per cent., it may be reasonable to pay half of it as interest when business is financed by borrowing. The borrower bears the risk to the stock, effectively insuring it for the lender. In most trades, the remaining four or five per cent. may adequately reward both that risk and the work of putting the stock to use. But the relationship between interest and clear profit might differ where normal profits were much lower or much higher. If they were much lower, perhaps a borrower could not afford to pay half in interest. If they were much higher, a borrower might afford to pay more than half.

In countries growing rich quickly, low profits may offset high wages in the price of many goods. Those countries can then sell as cheaply as less successful neighbors where wages are lower.

In fact, high profits tend to raise the price of manufactured goods much more than high wages do. Take linen making. Suppose the wages of the flax-dressers, spinners, weavers, etc. all rose by twopence a-day. The price of a piece of linen would need to rise only by twopence for each worker involved, multiplied by the number of days each worked. Through every stage of production, the wage portion of the price would grow in arithmetical proportion to the wage increase. But suppose every employer of these workers raised profits by five per cent. Through each stage, the profit portion of the price would grow in geometrical proportion to the profit increase. When selling his flax, the employer of the flax dressers would require another five per cent. on the full cost of materials and wages he had advanced. The spinners' employer would require another five per cent. on both the increased price of the flax and the spinners' wages. The weavers' employer would likewise require five per cent. on both the increased price of the linen-yarn and the weavers' wages. A wage increase affects goods prices as simple interest affects a growing debt. A profit increase acts like compound interest. Our merchants and master manufacturers often complain that high wages raise prices and reduce sales at home and abroad. They say nothing about the harmful effects of high profits. They stay silent about the harm caused by their own gains and complain only about other people's gains.