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"It is the compensation which the borrower pays to the lender, for the profit which he has an opportunity of making by the use of the money."

   --  Adam Smith

What is interest

Quote 1262

"Interest is wage for capital's work." 

   --  Eugen von Böhm-Bawerk

In order to understand interest, you need to understand its creator "Capital".

Quote 1268

"Capital signifies a complex of produced means of acquisition—that is, a complex of goods that originate in a previous process of production, and are destined, not for immediate consumption, but to serve as means of acquiring further goods." 

   --  Eugen von Böhm-Bawerk

In the Netherlands, interest is called rent. That is exactly what interest is. Someone lends you capital and expects rent on the use of that capital. The longer the period they lend you that capital, the more demand there is for it, or the riskier it is to lend it to you, the higher the rent. The same factors that effect any other property that is lent.

To ban interest, wold be to ban credit, for without the incentive to lend, no-one would. If lending is a necessity, and people will not lend without interest, then it is a necessity to allow it.

Interest is composed of

Transaction costs --> as you would pay in foreign exchange (stock holding, workers time, bookkeeping)
Risk costs           --> as you would pay in an insurance premium (the funds may not be returned)
Market demand    --> As with any other good, high demand pushes up prices and high supply pushes them down.
Time                    --> The time value of money

Those which seek to explain interest by the theory of costs carry a heavy handicap by assuming that value grows out of production.
The apparent difference in value is of receiving $100+ interest in a years time for borrowing $100 now is forgetting that $100 now an $100 in a years time are not of equivalent value.
Wage, will always be less than that of product, and thus allow the employer an interest. This is due to the employee being paid a current wage based on a future product.

Eugen von Böhm-Bawerks 4 categories of where people think interest comes from

Quotes 1321-1324

The Productivity theories

Those which, more or less explicitly, attribute the existence of interest to the productive power of capital—are dismissed as confusing quantity of product with value of product, either in the way of tacitly assuming the identity of the two, or of failing to show any necessary connection between them. The problem of capital is a problem of surplus value, and value does not come from the side of production but from the side of consumption. Capital is productive, but interest is not its product.

The Use theories

Which are more or less scientific expansion of the familiar formula, "Interest is the price paid for the use of capital," are shown to base interest, which is notoriously an income obtained from all kinds of capital, on an analogy drawn from one special kind of capital, viz. durable goods. The idea that the use of capital is something distinct from the using-up of capital, and interest something different from the price of the principal, becomes untenable when the true economic nature of the "good" is understood as the sum of its material uses or services. If consumption is only a single exhaustive use, and use only a prolonged consumption, the payment for "use" of Capital must be included in the price of capital.

In the Abstinence theory

Which makes interest a compensation, made to the owner of capital, for his renunciation of immediate consumption, Böhm-Bawerk sees a confusion of the origin and accumulation of capital with the source and cause of interest. Abstinence will account for the owner having a sum to lend, but it will not account for that sum growing 3% larger in a year's time.

Socialist or Exploitation theory

Which makes interest simply a gain from exploited labour, is shown to be a theory which could only arise on the negative basis of the unsatisfactory accounts hitherto given, and on the positive basis of a mistaken value theory. When an income obtained without work and without risk was claimed as the reward of abstinence, and when all value was ascribed to the action of material labourers, it was inevitable that there should rise a reactionary theory proving that interest was robbery. Thus the board was swept clean for the Positive Theory.

Interest by comparison

The 3 factors of production:
Loaned land               --> Rent
Loaned labour            --> Wages
Loaned capital           --> Interest

What is compound interest?

This is interest where the capital is lent out for more than one period, and the interest is not paid in the first period but collated to be paid at a later period.
This means in the second period, there is the interest to pay on the original capital still lent, but also the interest on the interest also lent out.

Can compound interest be made illegal?

Quote 1022

"Interest is not something that can be abolished or legislated away, because it is part of human nature. "

   --  Dr Eamonn Butler
  • Re-invest your money each year so it doesn't compound. 
    (no-one could get a loan of more than a year then)
  • Increase the term of the loan, so the compound amount would be implicit 
    (this means all the interest is paid in one lump sum rather than instalments- rates would increase to compensate for risk).
  • Move your money overseas.
    (few would get loans at all)
Even if you could outlaw it, savers would take their money out of banks and invest in shares/property/gold with implicit compounding.

  • People would find it harder to get loans and mortgages.
  • It would hurt the elderly and retired who rely on investment income
  • Administrating it would cost a lot, meaning possibly less nurses and doctors.

Objections to Interest

What do people object to?
The context often makes it doubtful whether they object to interest as such, or only to an excess of it; and, in the former case, whether their objection is on the ground of a peculiar blot inherent in interest itself, or only because it usually favours the riches they despise.

It is possible to argue against charging interest, but not thinking this is a role for the state to intervene.


"in an economical point of view, the loan itself can never be considered responsible for previous necessities, which it has not created, and which it relieves to a certain extent."

   --  Frédéric Bastiat

"In some countries the interest of money has been prohibited by law. But as something can everywhere be made by the use of money, something ought everywhere to be paid for the use of it. This regulation, instead of preventing, has been found from experience to increase the evil of usury. The debtor being obliged to pay, not only for the use of the money, but for the risk which his creditor runs by accepting a compensation for that use, he is obliged, if one may say so, to insure his creditor from the penalties of usury." 

   --  Adam Smith

Put simply if you want to borrow someone's property long term like a car, the person/company who owns that car will expect some compensation. They want compensation for not having the use of the car, and the risk of not getting it back. Possibly also for the revenue they could have otherwise generated with the car. That's how car rental companies work, and the more of a risk you are, or the longer you want the car the more it costs. When borrowing money, the same principle applies. Charging interest on money is no worse than charging rent on any other item, especially since money is interchangeable for other items.

The more usurers there are the better; their competition will press down the rate of interest.

Should people and organisations be able to charge interest?

Some people contend that there should be no interest, as the lender has added no value. They claim that all value is added by labour, not capital, therefore interest is a form of theft.
However the quote below puts to be the concept that value comes from labour.

Quote 1263

"But the fact is that, in all this, we have an entire misconception of the origin of value. Value cannot come from production. Neither capital nor labour can produce it. What labour does is to produce a quantity of commodities, and what capital co-operating with labour usually does is to increase that quantity." 

   --  Eugen von Böhm-Bawerk

The privilege of creating value belongs as little to human labour as to any other factor. Labour, like capital, creates goods, and goods only; and these goods wait for and obtain their value only from the economical relations which they are meant to serve.

Idle money does nothing, therefor no charge for it should occur

It is true that money that is lent out does nothing, and no charge occurs for this. Just like an unrented house. But money that is lent out does not do nothing. If it did nothing the borrower would not want to borrow it.

When the lender lends out money, they suffer an injury of a foregone use of that money. The lender therefore should be justly compensated for this sacrifice.

Although money itself has no worth, so does land when it is not worked upon. Money put to good use, like land produces value.

You are swapping money now for more money later, this is not an equal transaction

When you do foreign exchange, there is always a transaction cost. Even if two currencies are pegged. The costs of the transaction means you can never have an equal transaction.
And so it is for interest, transaction fees are implicitly included in interest. The transaction can never be equal.  Loan interest nothing else than the equalisation of the difference there is between the value of present and future sums of money 

Time value

Take 1kg of coal is it worth the same in these circumstances
  • In the pit
  • At the depot
  • At your fire side
You would not swap a bucket of coal at your fireside for one in the pit, they are not the same. This is the same with money, money later is worth less than money now.
Present goods can, as a rule, only be purchased by a larger sum of future goods. And so it is with money.

Interest rate

"The depression of interest is proportioned to the abundance of capitals."

   --  Frédéric Bastiat

"If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent. the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition." 

   --  Adam Smith

Lending is more deserving of interest than hire is of rent. 
Quote 1279

"the case of the hire (locatio) the lender can take back his property at any moment, because he remains the owner of it. In the case of the loan he cannot do so, because his property is destroyed in the consumption. Consequently the lender of money suffers delays, anxieties, and losses, and by reason of these the claim of the loan to payment is even more consistent with fairness than that of the Commodatum." 

   --  Eugen von Böhm-Bawerk

Interest rate caps

The problem with caps, is they don't stifle demand. Banks or lenders will either raise charges, or restrict credit.

Interest laws

Quote 1270

"The canon doctrine of interest had to all appearance reached its zenith sometime during the thirteenth century. Its principles held almost undisputed sway in legislation, temporal as well as spiritual. Pope Clement V, at the Council of Vienna in 1311, could go so far as to threaten with excommunication those secular magistrates who passed laws favourable to interest, or who did not repeal such laws, where already passed, within three months." 

   --  Eugen von Böhm-Bawerk

Lending belongs to that class of legal transactions in which the use of a thing is made over by its owner to another person.

Even when interest was illegal, there have been exceptions

Borrowing of Jews when Christianity forbade it and indirect exceptions :
  • The buying of annuities
  • Taking of land in mortgage for lent money
  • The use of bills of exchange
  • Partnership arrangements, 
English interest laws
  • Henry VIII had by 1545 removed the prohibition of interest, and replaced it by a simple legal rate. 
  • The prohibition was reimposed under Edward VI
  • But in 1571 it was once more taken off by Queen Elizabeth, and this time forever. 

The relationship between profits and interest

No-one will accept of low profits where he can have high interest; and no-one will accept of low interest where he can have high profits."

Justification of interest

Capital(money) is property like any other. The creditor has property rights, he has an "inviolable" right to dispose of the money as he will, and to lay such conditions on its alienation and hire as seem to him good—e.g. the condition of interest being duly paid.
Why should money be any different that any other property one owns, where one may establish payments conditions as desired?

Quote 1290

"If these gentlemen suppose that a sum of 1000 francs and a promise of 1000 francs possess exactly the same value, they put forward a still more absurd supposition; for if these two things were of equal value, why should any one borrow at all?" 

   --  Eugen von Böhm-Bawerk

As something can everywhere be made by the use of money, something ought everywhere to be paid for the use of it.

If investing capital in land provides rent, the all capitals otherwise must provide rent, or everybody would invest in land.