§1. The present seems the most proper place for discussing the circumstances which determine the rate of interest. The interest of loans, being really a question of exchange value, falls naturally into the present division of our subject: and the two topics of Currency and Loans, though in themselves distinct, are so intimately blended in the phenomena of what is called the money market, that it is impossible to understand the one without the other, and in many minds the two subjects are mixed up in the most inextricable confusion.
In the preceding Book1 we defined the relation in which interest stands to profit. We found that the gross profit of capital might be distinguished into three parts, which are respectively the remuneration for risk, for trouble, and for the capital itself, and may be termed insurance, wages of superintendence, and interest. After making compensation for risk, that is, after covering the average losses to which capital is exposed either by the general circumstances of society or by the hazards of the particular employment, there remains a surplus, which partly goes to repay the owner of the capital for his abstinence, and partly the employer of it for his time and trouble. How much goes to the one and how much to the other, is shown by the amount of the remuneration which, when the two functions are separated, the owner of capital can obtain from the employer for its use. This is evidently a question of demand and supply. Nor have demand and supply any different meaning or effect in this case from what they have in all others. The rate of interest will be such as to equalize the demand for loans with the supply of them. It will be such, that exactly as much as some people are desirous to borrow at that rate, others shall be willing to lend. If there is more offered than demanded, interest will fall; if more is demanded than offered, it will rise; and in both cases, to the point at which the equation of supply and demand is re-established.
Both the demand and supply of loans fluctuate more incessantly than any other demand or supply whatsoever. The fluctuations in other things depend on a limited number of influencing circumstances; but the desire to borrow, and the willingness to lend, are more or less influenced by every circumstance which affects the state or prospects of industry or commerce, either generally or in any of their branches. The rate of interest, therefore, on good security, which alone we have here to consider (for interest in which considerations of risk bear a part may swell to any amount) is seldom, in the great centres of money transactions, precisely the same for two days together; as is shown by the never-ceasing variations in the quoted prices of the funds and other negotiable securities. Nevertheless, there must be, as in other cases of value, some rate which (in the language of Adam Smith and Ricardo) may be called the natural rate; some rate about which the market rate oscillates, and to which it always tends to return. This rate partly depends on the amount of accumulation going on in the hands of persons who cannot themselves attend to the employment of their savings, and partly on the comparative taste existing in the community for the active pursuits of industry, or for the leisure, ease, and independence of an annuitant.
§2. To exclude casual fluctuations, we will suppose commerce to be in a quiescent condition, no employment being unusually prosperous, and none particularly distressed. In these circumstances, the more thriving producers and traders have their capital fully employed, and many are able to transact business to a considerably greater extent than they have capital for. These are naturally borrowers: and the amount which they desire to borrow, and can obtain credit for, constitutes the demand for loans on account of productive employment. To these must be added the loans required by Government, and by landowners, or other unproductive consumers who have good security to give. This constitutes the mass of loans for which there is an habitual demand.
Now it is conceivable that there might exist, in the hands of persons disinclined or disqualified for engaging personally in business, a mass of capital equal to, and even exceeding, this demand. In that case there would be an habitual excess of competition on the part of lenders, and the rate of interest would bear a low proportion to the rate of profit. Interest would be forced down to the point which would either tempt borrowers to take a greater amount of loans than they had a reasonable expectation of being able to employ in their business, or would so discourage a portion of the lenders, as to make them either forbear to accumulate, or endeavour to increase their income by engaging in business on their own account, and incurring the risks, if not the labours, of industrial employment.
On the other hand, the capital owned by persons who prefer lending it at interest, or whose avocations prevent them from personally superintending its employment, may be short of the habitual demand for loans. It may be in great part absorbed by the investments afforded by the public debt and by mortgages, and the remainder may not be sufficient to supply the wants of commerce. If so, the rate of interest will be raised so high as in some way to re-establish the equilibrium. When there is only a small difference between interest and profit, many borrowers may no longer be willing to increase their responsibilities and involve their credit for so small a remuneration: or some who would otherwise have engaged in business, may prefer leisure, and become lenders instead of borrowers: or others, under the inducement of high interest and easy investment for their capital, may retire from business earlier, and with smaller fortunes, than they otherwise would have done. Or, lastly, there is another process by which, in England and other commercial countries, a large portion of the requisite supply of loans is obtained. Instead of its being afforded by persons not in business, the affording it may itself become a business. A portion of the capital employed in trade may be supplied by a class of professional money lenders. These money lenders, however, must have more than a mere interest; they must have the ordinary rate of profit on their capital, risk and all other circumstances being allowed for. But it can never answer to any one who borrows for the purposes of his business, to pay a full profit for capital from which he will only derive a full profit: and money-lending, as an employment, for the regular supply of trade, cannot, therefore, be carried on except by persons who, in addition to their own capital, can lend their credit, or, in other words, the capital of other people: that is, bankers, and persons (such as bill-brokers) who are virtually bankers, since they receive money in deposit. A bank which lends its notes, lends capital which it borrows from the community, and for which it pays no interest. A bank of deposit lends capital which it collects from the community in small parcels; sometimes without paying any interest, as is the case with the London private bankers; and if, like the Scotch, the joint stock, and most of the country banks, it does pay interest, it still pays much less than it receives; for the depositors, who in any other way could mostly obtain for such small balances no interest worth taking any trouble for, are glad to receive even a little. Having this subsidiary resource, bankers are enabled to obtain, by lending at interest, the ordinary rate of profit on their own capital. In any other manner, money-lending could not be carried on as a regular mode of business, except upon terms on which none would consent to borrow but persons either counting on extraordinary profits, or in urgent need: unproductive consumers who have exceeded their means, or merchants in fear of bankruptcy. The disposable capital deposited in banks; that represented by bank notes; the capital of bankers themselves, and that which their credit in any way in which they use it, enables them to dispose of; these, together with the funds belonging to those who, either from necessity or preference, live upon the interest of their property, constitute the general loan fund of the country: and the amount of this aggregate fund, when set against the habitual demands of producers and dealers, and those of the Government and of unproductive consumers, determines the permanent or average rate of interest; which must always be such as to adjust these two amounts to one another.2 But while the whole of this mass of lent capital takes effect upon the permanent rate of interest, the fluctuations depend almost entirely upon the portion which is in the hands of bankers; for it is that portion almost exclusively, which, being lent for short times only, is continually in the market seeking an investment. The capital of those who live on the interest of their own fortunes, has generally sought and found some fixed investment, such as the public funds, mortgages, or the bonds of public companies, which investment, except under peculiar temptations or necessities, is not changed.
§3. Fluctuations in the rate of interest arise from variations either in the demand for loans; or in the supply. The supply is liable to variation, though less so than the demand. The willingness to lend is greater than usual at the commencement of a period of speculation, and much less than usual during the revulsion which follows. In speculative times, money-lenders as well as other people are inclined to extend their business by stretching their credit; they lend more than usual (just as other classes of dealers and producers employ more than usual) of capital which does not belong to them. Accordingly, these are the times when the rate of interest is low; though for this too (as we shall hereafter see) there are other causes. During the revulsion, on the contrary, interest always rises inordinately, because, while there is a most pressing need on the part of many persons to borrow, there is a general disinclination to lend. This disinclination, when at its extreme point, is called a panic. It occurs when a succession of unexpected failures has created in the mercantile, and sometimes also in the non-mercantile public, a general distrust in each other’s solvency; disposing every one not only to refuse fresh credit, except on very onerous terms, but to call in, if possible, all credit which he has already given. Deposits are withdrawn from banks; notes are returned on the issuers in exchange for specie; bankers raise their rate of discount, and withhold their customary advances; merchants refuse to renew mercantile bills. At such times the most calamitous consequences were formerly experienced from the attempt of the law to prevent more than a certain limited rate of interest from being given or taken. Persons who could not borrow at five per cent, had to pay, not six or seven, but ten or fifteen per cent, to compensate the lender for risking the penalties of the law: or had to sell securities or goods for ready money at a still greater sacrifice.
In the intervals between commercial crises, there is usually a tendency in the rate of interest to a progressive decline, from the gradual process of accumulation: which process, in the great commercial countries, is sufficiently rapid to account for the almost periodical recurrence of these fits of speculation; since, when a few years have elapsed without a crisis, and no new and tempting channel for investment has been opened in the meantime, there is always found to have occurred in those few years so large an increase of capital seeking investment, as to have lowered considerably the rate of interest, whether indicated by the prices of securities or by the rate of discount on bills; and this diminution of interest tempts the possessor to incur hazards in hopes of a more considerable return.
The rate of interest is, at times, affected more or less permanently by circumstances, though not of frequent, yet of occasional occurrence, which tend to alter the proportion between the class of interest-receiving and that of profit-receiving capitalists. Two causes of this description, operating in contrary ways, have manifested themselves of late years, and are now producing considerable effects in England. One is, the gold discoveries. The masses of the precious metals which are constantly arriving from the gold countries, are, it may safely be said, wholly added to the funds that supply the loan market. So great an additional capital, not divided between the two classes of capitalists, but aggregated bodily to the capital of the interest-receiving class, disturbs the preexisting ratio between the two, and tends to depress interest relatively to profit. Another circumstance of still more recent date, but tending to the contrary effect, is the legalization of joint-stock associations with limited liability. The shareholders in these associations, now so rapidly multiplying, are drawn almost exclusively from the lending class; from those who either left their disposable funds in deposit, to be lent out by bankers, or invested them in public or private securities, and received the interest. To the extent of their shares in any of these companies (with the single exception of banking companies) they have become traders on their own capital; they have ceased to be lenders, and have even, in most cases, passed over to the class of borrowers. Their subscriptions have been abstracted from the funds which feed the loan market, and they themselves have become competitors for a share of the remainder of those funds: of all which, the natural effect is a rise of interest. And it would not be surprising if, for a considerable time to come, the ordinary rate of interest in England should bear a higher proportion to the common rate of mercantile profit, than it has borne at any time since the influx of new gold set in.3
The demand for loans varies much more largely than the supply, and embraces longer cycles of years in its aberrations. A time of war, for example, is a period of unusual drafts on the loan market. The Government, at such times, generally incurs new loans, and as these usually succeed each other rapidly as long as the war lasts, the general rate of interest is kept higher in war than in peace, without reference to the rate of profit, and productive industry is stinted of its usual supplies. During part of the last war with France, the Government could not borrow under six per cent, and of course all other borrowers had to pay at least as much. Nor does the influence of these loans altogether cease when the Government ceases to contract others; for those already contracted continue to afford an investment for a greatly increased amount of the disposable capital of the country, which if the national debt were paid off, would be added to the mass of capital seeking investment, and (independently of temporary disturbance) could not but, to some extent, permanently lower the rate of interest.
The same effect on interest which is produced by Government loans for war expenditure, is produced by the sudden opening of any new and generally attractive mode of permanent investment. The only instance of the kind in recent history on a scale comparable to that of the war loans, is the absorption of capital in the construction of railways. This capital must have been principally drawn from the deposits in banks, or from savings which would have gone into deposit, and which were destined to be ultimately employed in buying securities from persons who would have employed the purchase money in discounts or other loans at interest: in either case, it was a draft on the general loan fund. It is, in fact, evident, that unless savings were made expressly to be employed in railway adventure, the amount thus employed must have been derived either from the actual capital of persons in business, or from capital which would have been lent to persons in business. In the first case, the subtraction, by crippling their means, obliges them to be larger borrowers; in the second, it leaves less for them to borrow; in either case it equally tends to raise the rate of interest.
§4. I have, thus far, considered loans, and the rate of interest, as a matter which concerns capital in general, in direct opposition to the popular notion, according to which it only concerns money. In loans, as in all other money transactions, I have regarded the money which passes, only as the medium, and commodities as the thing really transferred — the real subject of the transaction. And this is, in the main, correct: because the purpose for which, in the ordinary course of affairs, money is borrowed, is to acquire a purchasing power over commodities. In an industrious and commercial country, the ulterior intention commonly is, to employ the commodities as capital: but even in the case of loans for unproductive consumption, as those of spendthrifts, or of the Government, the amount borrowed is taken from a previous accumulation, which would otherwise have been lent to carry on productive industry; it is, therefore, so much subtracted from what may correctly be called the amount of loanable capital.
There is, however, a not unfrequent case, in which the purpose of the borrower is different from what I have here supposed. He may borrow money, neither to employ it as capital nor to spend it unproductively, but to pay a previous debt. In this case, what he wants is not purchasing power, but legal tender, or something which a creditor will accept as equivalent to it. His need is specifically for money, not for commodities or capital. It is the demand arising from this cause, which produces almost all the great and sudden variations of the rate of interest. Such a demand forms one of the earliest features of a commercial crisis. At such a period, many persons in business who have contracted engagements, have been prevented by a change of circumstances from obtaining in time the means on which they calculated for fulfilling them. These means they must obtain at any sacrifice, or submit to bankruptcy; and what they must have is money. Other capital, however much of it they may possess, cannot answer the purpose unless money can first be obtained for it; while, on the contrary, without any increase of the capital of the country, a mere increase of circulating instruments of credit (be they of as little worth for any other purpose as the box of one pound notes discovered in the vaults of the Bank of England during the panic of 1825) will effectually serve their turn if only they are allowed to make use of it. An increased issue of notes, in the form of loans, is all that is required to satisfy the demand, and put an end to the accompanying panic. But although, in this case, it is not capital, or purchasing power, that the borrower needs, but money as money, it is not only money that is transferred to him. The money carries its purchasing power, with it wherever it goes; and money thrown into the loan market really does, through its purchasing power, turn over an increased portion of the capital of the country into the direction of loans. Though money alone was wanted, capital passes; and it may still be said with truth that it is by an addition to loanable capital that the rise of the rate of interest is met and corrected.
Independently of this, however, there is a real relation, which it is indispensable to recognise, between loans and money. Loanable capital is all of it in the form of money. Capital destined directly for production exists in many forms; but capital destined for lending exists normally in that form alone. Owing to this circumstance, we should naturally expect that among the causes which affect more or less the rate of interest, would be found not only causes which act through capital, but some causes which act, directly at least, only through money.
The rate of interest bears no necessary relation to the quantity or value of the money in circulation. The permanent amount of the circulating medium, whether great or small, affects only prices; not the rate of interest. A depreciation of the currency, when it has become an accomplished fact, affects the rate of interest in no manner whatever. It diminishes indeed the power of money to buy commodities, but not the power of money to buy money. If a hundred pounds will buy a perpetual annuity of four pounds a year, a depreciation which makes the hundred pounds worth only half as much as before, has precisely the same effect on the four pounds, and cannot therefore alter the relation between the two. The greater or smaller number of counters which must be used to express a given amount of real wealth, makes no difference in the position or interests of lenders or borrowers, and therefore makes no difference in the demand and supply of loans. There is the same amount of real capital lent and borrowed; and if the capital in the hands of lenders is represented by a greater number of pounds sterling, the same greater number of pounds sterling will, in consequence of the rise of prices, be now required for the purposes to which the borrowers intend to apply them.
But though the greater or less quantity of money makes in itself no difference in the rate of interest, a change from a less quantity to a greater, or from a greater to a less, may and does make a difference in it. Suppose money to be in process of depreciation by means of an inconvertible currency, issued by a government in payment of its expenses. This fact will in no way diminish the demand for real capital on loan; but it will diminish the real capital loanable, because, this existing only in the form of money, the increase of quantity depreciates it. Estimated in capital, the amount offered is less, while the amount required is the same as before. Estimated in currency, the amount offered is only the same as before, while the mount required, owing to the rise of prices, is greater. Either way, the rate of interest must rise. So that in this case increase of currency really affects the rate of interest, but in the contrary way to that which is generally supposed; by raising, not by lowering it.
The reverse will happen as the effect of calling in, or diminishing in quantity, a depreciated currency. The money in the hands of lenders, in common with all other money, will be enhanced in value, that is, there vill be a greater amount of real capital seeking borrowers; while the real capital wanted by borrowers will be only the same as before, and the money mount less: the rate of interest, therefore, will tend to fall.
We thus see that depreciation, merely as such, while in process of taking place, tends to raise the rate of interest: and the expectation of further depreciation adds to this effect; because lenders who expect that their interest will be paid and the principal perhaps redeemed, in a less valuable currency than they lent, of course require a rate of interest sufficient to cover this contingent loss.
But this effect is more than counteracted by a contrary one, when the additional money is thrown into circulation not by purchases but by loans. In England, and in most other commercial countries, the paper currency in common use, being a currency provided by bankers, is all issued in the way of loans, except the part employed in the purchase of gold and silver. The same operation, therefore, which adds to the currency also adds to the loans: the whole increase of currency in the first instance swells the loan market. Considered as an addition to loans it tends to lower interest, more than in its character of depreciation it tends to raise it; for the former effect depends on the ratio which the new money bears to the money lent, while the latter depends on its ratio to all the money in circulation. An increase, therefore, of currency issued by banks, tends, while the process continues, to bring down or to keep down the rate of interest. A similar effect is produced by the increase of money arising from the gold discoveries; almost the whole of which, as already noticed, is, when brought to Europe, added to the deposits in banks, and consequently to the mount of loans; and when drawn out and invested in securities, liberates an equivalent amount of other loanable capital. The newly-arrived gold can only get itself invested, in any given state of business, by lowering the rate of interest; and as long as the influx continues, it cannot fail to keep interest lower than, all other circumstances being supposed the same, would otherwise have been the case.
As the introduction of additional gold and silver, which goes into the loan market, tends to keep down the rate of interest, so any considerable abstraction of them from the country invariably raises it; even when occurring in the course of trade, as in paying for the extra importations caused by a bad harvest, or for the high-priced cotton which, under the influence of the American civil war, was imported from so many parts of the world. The money required for these payments is taken in the first instance from the deposits in the hands of bankers, and to that extent starves the fund that supplies the loan market.
The rate of interest, then, depends essentially and permanently on the comparative amount of real capital offered and demanded in the way of loan; but is subject to temporary disturbances of various sorts, from increase and diminution of the circulating medium; which derangements are somewhat intricate, and sometimes in direct opposition to first appearances. All these distinctions are veiled over and confounded, by the unfortunate misapplication of language which designates the rate of interest by a phrase (“the value of money”) which properly expresses the purchasing power of the circulating medium. The public, even mercantile, habitually fancies that ease in the money market, that is, facility of borrowing at low interest, is proportional to the quantity of money in circulation. Not only, therefore, are bank notes supposed to produce effects as currency, which they only produce as loans, but attention is habitually diverted from effects similar in kind and much greater in degree, when produced by an action on loans which does not happen to be accompanied by any action on the currency.
For example, in considering the effect produced by the proceedings of banks in encouraging the excesses of speculation, an immense effect is usually attributed to their issues of notes, but until of late hardly any attention was paid to the management of their deposits; though nothing is more certain than that their imprudent extensions of credit take place more frequently by means of their deposits than of their issues. “There is no doubt,” says Mr. Tooke,4 “that banks, whether private or joint stock, may, if imprudently conducted, minister to an undue extension of credit for the purpose of speculations, whether in commodities, or in overtrading in exports or imports, or in building or mining operations, and that they have so ministered not unfrequently, and in some cases to an extent ruinous to themselves, and without ultimate benefit to the parties to whose views their resources were made subservient.” But, “supposing all the deposits received by a banker to be in coin, is he not, just as much as the issuing banker, exposed to the importunity of customers, whom it may be impolitic to refuse, for loans or discounts, or to be tempted by a high interest? and may he not be induced to encroach so much upon his deposits as to leave him, under not improbable circumstances, unable to meet the demands of his depositors? In what respect, indeed, would the case of a banker in a perfectly metallic circulation, differ from that of a London banker at the present day? He is not a creator of money, he cannot avail himself of his privilege as an issuer in aid of his other business, and yet there have been lamentable instances of London bankers issuing money in excess.”
In the discussions, too, which have been for so many years carried on respecting the operations of the Bank of England, and the effects produced by those operations on the state of credit, though for nearly half a century there never has been a commercial crisis which the Bank has not been strenuously accused either of producing or of aggravating, it has been almost universally assumed that the influence of its acts was felt only through the amount of its notes in circulation, and that if it could be prevented from exercising any discretion as to that one feature in its position, it would no longer have any power liable to abuse. This at least is an error which, after the experience of the year 1847, we may hope has been committed for the last time. During that year the hands of the bank were absolutely tied, in its character of a bank of issue; but through its operations as a bank of deposit it exercised as great an influence, or apparent influence, on the rate of interest and the state of credit, as at any former period; it was exposed to as vehement accusations of abusing that influence; and a crisis occurred, such as few that preceded it had equalled, and none perhaps surpassed, in intensity.
§5. Before quitting the general subject of this chapter, I will make the obvious remark, that the rate of interest determines the value and price of all those saleable articles which are desired and bought, not for themselves, but for the income which they are capable of yielding. The public funds, shares in joint-stock companies, and all descriptions of securities, are at a high price in proportion as the rate of interest is low. They are sold at the price which will give the market rate of interest on the purchase money, with allowance for all differences in the risk incurred, or in any circumstance of convenience. Exchequer bills, for example, usually sell at a higher price than consols, proportionally to the interest which they yield; because, though the security is the same, yet the former being annually paid off at par unless renewed by the holder, the purchaser (unless obliged to sell in a moment of general emergency), is in no danger of losing anything by the resale, except the premium he may have paid.
The price of land, mines, and all other fixed sources of income, depends in like manner on the rate of interest. Land usually sells at a higher price, in proportion to the income afforded by it, than the public funds, not only because it is thought, even in this country, to be somewhat more secure, but because ideas of power and dirty are associated with its possession. But these differences are constant, or nearly so; and in the variations of price, land follows, caeteris paribus, the permanent (though of course not the daily) variations of the rate of interest. When interest is low, land will naturally be dear; when interest is high, land will be cheap. The last long war presented a striking exception to this rule, since the price of land as well as the rate of interest was then remarkably high. For this, however, there was a special cause. The continuance of a very high average price of corn for many years, had raised the rent of land even more than in proportion to the rise of interest and fall of the selling price of fixed incomes. Had it not been for this accident, chiefly dependent on the seasons, land must have sustained as great a depreciation in value as the public funds: which it probably would do, were a similar war to break out hereafter; to the signal disappointment of those landlords and farmers who, generalizing from the casual circumstances of a remarkable period, so long persuaded themselves that a state of war was peculiarly advantageous, and a state of peace disadvantageous, to what they chose to call the interests of agriculture.
1 Supra, book ii, ch. xv. section 1.
2 I do not include in the general loan fund of the country the capitals, large as they sometimes are, which are habitually employed in speculatively buying and selling the public funds and other securities. It is true that all who buy securities add, for the time, to the general amount of money on loan, and lower pro tanto the rate of interest. But as the persons I speak of buy only to sell again at a higher price, they are alternately in the position of lenders and of borrowers: their operations raise the rate of interest at one time, exactly as much as they lower it at another. Like all persons who buy and sell on speculation, their function is to equalize, not to raise or lower, the value of the commodity. When they speculate prudently, they temper the fluctuations of price; when imprudently, they often aggravate them.
3 To the cause of augmentation in the rate of interest, mentioned in the text, must be added another, forcibly insisted on by the author of an able article in the Edinburgh Review for January, 1865; the increased and increasing willingness to send capital abroad for investment. Owing to the vastly augmented facilities of access to foreign countries, and the abundant information incessantly received from them, foreign investments have ceased to inspire the terror that belongs to the unknown; capital flows, without misgiving, to any place which affords an expectation of high profit; and the loan market of the whole commercial world is rapidly becoming one. The rate of interest, therefore, in the part of the world out of which capital most freely flows, cannot any longer remain so much inferior to the rate elsewhere, as it has hitherto been.
4 Inquiry into the Currency Principle, ch. xiv.
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