Book II, Chapter IV, 2

Before the discovery of the Spanish West Indies, ten percent seems to have been the usual rate of interest through most of Europe. Since then it has fallen, in different countries, to six, five, four, and three percent. Suppose that in each country the value of silver has fallen in exactly the same proportion as the rate of interest; suppose, for example, that where interest fell from ten to five percent, the same quantity of silver now buys just half as many goods as it once did. I do not believe this supposition holds true anywhere, but it is the one most favorable to the view we are examining. Even on this supposition, a decline in the value of silver could not possibly have the slightest tendency to lower the rate of interest. If £100 in those countries is worth no more now than £50 was then, £10 now must be worth no more than £5 was then. Whatever causes reduced the value of the capital must necessarily have reduced the value of the interest in exactly the same proportion. The ratio between the value of the capital and that of the interest would have remained the same, even if the rate had never changed. Changing the rate, on the contrary, necessarily changes the ratio between those two values. If £100 now is worth no more than £50 was then, £5 now can be worth no more than £2:10s. was then. By reducing the rate of interest from ten to five percent, therefore, we pay, for the use of a capital supposedly worth half its former value, interest worth only a fourth of the former interest.

An increase in the quantity of silver, while the quantity of commodities it circulates remains the same, could have no effect other than to diminish the metal’s value. The nominal value of all kinds of goods would rise, but their real value would remain precisely what it was. They would exchange for more pieces of silver, but the quantity of labor they could command, and the number of people they could maintain and employ, would be exactly the same. The country’s capital would be the same, though more pieces might be needed to transfer any given portion of it from one hand to another. The deeds of assignment, like a long-winded attorney’s conveyances, would be more cumbersome; but the thing assigned would be precisely what it had been, and could produce only the same effects. Since the funds for maintaining productive labor would remain the same, so would the demand for it. Its price, or wages, though nominally higher, would therefore be the same in real terms. Wages would be paid in more pieces of silver, but would purchase only the same quantity of goods. The profits of stock would remain the same, nominally as well as really. The wages of labor are commonly calculated by the quantity of silver paid to the laborer. When that quantity rises, his wages appear to rise, even though they may sometimes be no greater than before. But the profits of stock are calculated not by the number of silver pieces in which they are paid, but by the ratio those pieces bear to the entire capital employed. Thus, in a particular country, 5s. a week might be called the ordinary wages of labor, and ten percent the ordinary profits of stock. Yet with the country’s total capital unchanged, competition among the individual capitals into which it is divided would also remain unchanged. All would trade with the same advantages and disadvantages. The usual ratio of capital to profit would therefore remain the same, and so, consequently, would the ordinary interest on money: what one can ordinarily pay for the use of money is necessarily governed by what one can ordinarily earn by using it.

An increase in the quantity of commodities circulated annually within the country, while the quantity of money circulating them remained the same, would, by contrast, have many important effects besides raising the value of money. The country’s capital, though nominally perhaps the same, would really have grown. It might still be expressed as the same quantity of money, but it would command more labor. It could maintain and employ more productive labor, and demand for that labor would consequently increase. Its wages would naturally rise with demand, yet might appear to fall. They might be paid in less money, while that smaller sum bought more goods than the larger sum had bought before. The profits of stock would fall, both in reality and in appearance. As the country’s total capital grew, competition among its component capitals would naturally grow as well. Their owners would have to accept a smaller share of the produce of the labor employed by their respective capitals. Interest on money, always moving with the profits of stock, could thus fall substantially even while the value of money—the quantity of goods a particular sum could purchase—rose substantially.

In some countries the law has prohibited interest on money. But because something can be earned by using money everywhere, something ought everywhere to be paid for its use. Experience has shown that this regulation increases, rather than prevents, the evil of usury. The debtor must pay not only for the use of the money, but also for the risk his creditor takes in accepting payment for that use; he must, so to speak, insure his creditor against the penalties for usury.

Where interest is permitted, the law generally sets a maximum rate that may be charged without penalty, in order to prevent usurious extortion. That rate should always stand somewhat above the lowest market rate—the rate ordinarily paid for the use of money by those able to offer the most unquestionable security. If the legal rate is set below that lowest market rate, its effects must be nearly the same as those of a complete ban on interest. A creditor will not lend his money for less than its use is worth, and the debtor must compensate him for the risk he takes in accepting its full value. If the legal rate is set exactly at the lowest market rate, it destroys, among honest people who respect their country’s laws, the credit of everyone unable to offer the very best security, forcing them to turn to exorbitant usurers. In a country such as Great Britain, where money is lent to the government at three percent and to private borrowers on good security at four and four and a half, the present legal rate of five percent is perhaps as suitable as any.

The legal rate, it should be observed, ought to be somewhat above the lowest market rate, but not much above it. If the legal rate of interest in Great Britain, for example, were set as high as eight or ten percent, most money available for lending would be lent to spendthrifts and speculative schemers, the only people willing to pay such high interest. Prudent people, who will pay for the use of money no more than a portion of what they expect to earn from using it, would not enter the competition. Much of the country’s capital would thus be kept out of the hands most likely to use it profitably and advantageously, and put into hands most likely to waste and destroy it. Where the legal rate of interest is set only a little above the lowest market rate, on the other hand, lenders universally prefer prudent borrowers to spendthrifts and schemers. A lender receives almost as much interest from the former as he dares charge the latter, and his money is much safer in one group’s hands than in the other’s. Much of the country’s capital is thus placed in the hands most likely to employ it to advantage.

No law can reduce the usual rate of interest below the lowest ordinary market rate prevailing when the law is made. Despite the edict of 1766, by which the French king tried to reduce the rate of interest from five to four percent, money continued to be lent in France at five percent, the law being evaded in several ways.

The ordinary market price of land, it should be observed, depends everywhere on the ordinary market rate of interest. A person with capital from which he wishes to draw revenue without the trouble of employing it himself considers whether to buy land or lend the capital at interest. The greater security of land, along with other advantages attached almost everywhere to this kind of property, will generally persuade him to accept a smaller revenue from land than he could obtain by lending his money at interest. These advantages can make up for a certain difference in revenue, but only a certain difference. If the rent of land falls further short of interest on money, no one will buy land, and its ordinary price will soon fall. Conversely, if the advantages more than make up for the difference, everyone will buy land, and its ordinary price will soon rise. When interest was ten percent, land commonly sold for ten or twelve years’ purchase. As interest fell to six, five, and four percent, the price of land rose to twenty, five-and-twenty, and thirty years’ purchase. The market rate of interest is higher in France than in England, and the ordinary price of land is lower. In England it commonly sells at thirty years’ purchase; in France, at twenty.

Before the discovery of the Spanish West Indies, the usual interest rate across most of Europe seems to have been ten per cent. Since then, it has fallen to six, five, four, and three per cent. in different countries. Suppose that, in each country, silver lost value at exactly the same rate as interest fell. In countries where interest fell from ten to five per cent., for example, suppose the same amount of silver now buys only half as many goods as before. I do not think this is true anywhere. But it gives the strongest possible case for the view we are examining. Even then, a fall in silver’s value could not possibly cause interest rates to fall. If £100 now has only the value that £50 had then, £10 now must have only the value that £5 had then. Whatever reduced the value of the capital must also have reduced the value of the interest by exactly the same proportion. Their relative values would remain unchanged if the interest rate stayed the same. Changing the rate, by contrast, necessarily changes their relative values. If £100 now is worth no more than £50 was then, £5 now can be worth no more than £2:10s. was then. So by cutting interest from ten to five per cent., we pay for the use of capital worth supposedly half its former value with interest worth only a fourth as much as the former interest.

If the amount of silver increased while the amount of goods it circulated stayed the same, the only effect would be to reduce silver’s value. The money prices of all kinds of goods would rise, but their real value would stay exactly the same. They would trade for more pieces of silver, but they would still command the same amount of labor and support and employ the same number of people. The country’s capital would be the same, though transferring any given share of it might require more pieces of silver. The papers used to transfer ownership would grow longer, like a long-winded attorney’s documents. But what was transferred would remain the same and could have only the same effects. The funds available to support productive labor would be unchanged, so demand for that labor would be unchanged. Its price, or wages, would therefore be higher in money but unchanged in real terms. Workers would get more pieces of silver, but those pieces would buy only the same amount of goods. The profits of stock would remain the same, both in money terms and in real terms. We usually calculate workers’ wages by how much silver they receive. When that amount rises, their wages appear to rise, even though they may be no higher than before. But we calculate the profits of stock not by the number of silver pieces received, but by the ratio of those pieces to the entire capital invested. For example, a country may have usual wages of 5s. a week and usual profits on stock of ten per cent. If the country’s total capital is unchanged, competition among the different individual capitals that make it up will also be unchanged. All will trade with the same advantages and disadvantages as before. So the usual ratio of capital to profit will stay the same, as will the usual interest rate on money. What people normally can pay to use money necessarily depends on what they can normally earn by using it.

Now suppose the amount of goods circulated annually within a country increased while the money circulating them stayed the same. This would do much more than raise the value of money. The country’s capital might look the same in money terms, but its real size would increase. It might still be stated as the same sum of money, but it would command more labor. It could support and employ more productive labor, increasing demand for that labor. Wages would naturally rise with demand, though they might appear to fall. Workers might receive less money, but that smaller sum could buy more goods than the larger sum bought before. The profits of stock would fall both in real terms and in appearance. As the country’s total capital grew, competition among the individual capitals making it up would grow too. Their owners would have to accept a smaller share of what the workers their capitals employed produced. Interest on money always follows the profits of stock. It could therefore fall substantially even while money gained substantial value—that is, even while a given sum could buy many more goods.

Some countries have laws forbidding interest. But money can be used to earn something everywhere, so its use ought to be paid for everywhere. Experience shows that this rule increases the harm of usury instead of preventing it. Borrowers must pay not just for using the money but also for the risk lenders take in accepting payment for its use. In effect, borrowers must insure lenders against the penalties for usury.

Where interest is allowed, the law usually sets the highest rate lenders can charge without a penalty, to prevent excessive interest. This ceiling should always be a little above the lowest market rate: the rate normally paid by borrowers who can offer unquestionable security. If the legal ceiling is set below that lowest market rate, it will have nearly the same effects as banning interest altogether. Lenders will not lend for less than the use of their money is worth. Borrowers must then pay them extra for the risk of accepting its full value. If the ceiling is set exactly at the lowest market rate, law-abiding lenders will refuse credit to anyone unable to provide the very best security. Those borrowers will have to turn to lenders charging excessive rates. In a country like Great Britain, where the government can borrow at three per cent. and private borrowers with good security pay four or four and a-half, the present legal ceiling of five per cent. is perhaps as suitable as any.

The legal ceiling should be somewhat above the lowest market rate, but not far above it. Suppose Great Britain set it as high as eight or ten per cent. Most money available for lending would go to spendthrifts and speculative promoters, the only people willing to pay such high interest. Careful borrowers, who will pay for money only part of what they expect to earn by using it, would not compete. Much of the country’s capital would be diverted from those most likely to use it profitably and well to those most likely to waste and destroy it. But when the legal ceiling is only slightly above the lowest market rate, lenders consistently prefer careful borrowers to spendthrifts and speculators. The lender earns nearly as much from the careful borrowers as he dares to charge the others, and his money is much safer with them. Much of the country’s capital thus reaches the people most likely to use it well.

No law can push the usual interest rate below the lowest ordinary market rate at the time it is passed. In 1766 the French king issued an edict meant to cut interest from five to four per cent. But lenders in France kept charging five per cent. by finding various ways around the law.

The usual market price of land everywhere depends on the usual market interest rate. Someone with capital who wants revenue without the trouble of using that capital himself considers whether to buy land or lend the money at interest. Land is more secure and comes with other advantages nearly everywhere. So he will usually accept less revenue from land than he could get by lending the money. Those advantages can make up for some difference in revenue, but only so much. If land rent fell too far below interest income, nobody would buy land, and its usual price would soon fall. Conversely, if land’s advantages more than made up for the difference, everybody would buy land, and its usual price would soon rise. When interest was ten per cent., land usually sold for ten or twelve years’ purchase—that is, ten or twelve years’ rent. As interest fell to six, five, and four per cent., land prices rose to twenty, five-and-twenty, and thirty years’ purchase. Market interest rates are higher in France than in England, and the usual price of land is lower. Land commonly sells for thirty years’ purchase in England and twenty in France.