<h2>CHAPTER 16</h2>
<h3>INTEREST ON MONEY LOANS</h3>
<h4>§ I. VARIOUS FORMS OF CONTRACT INTEREST</h4>
<div class="sidenote">Distinction between contract interest and time-value</div>
<p>1. <i>Interest, the amount paid according to contract by one person to
another for credit given in terms of money, is but one expression of a
larger problem, that of the difference in present worth of goods at two
periods of time.</i> This larger problem appears under several forms:
first, as a difference in value, due to time, where there is no money
expression (to be considered in the following chapter); second, in
discount on a money loan for a short, definite time; third, in a
long-time money loan at a fixed rate of interest; fourth, in a credit
loan—that is, the sale of the thing on credit in terms of money.</p>
<p>The last three cases involve interest more or less clearly.
Time-discount, as will be more fully explained, is the basis of
interest. The interest may be greater or less than the time-discount in
the goods, owing to miscalculation on the part of the borrower or to an
unforeseen change in the conditions. Men bid for the use of wealth with
the intention of repaying it at some future time, and the interest they
agree to pay is based on their estimate of the discount of future rents,
which they think is involved in the present valuations of the goods.
Time-discount is involved in goods, however, in numberless cases where
there is no contract interest. Even a Robinson Crusoe must recognize in
his consumption goods and in his various indirect agents differences in
value at different periods of time, of which he must take account.</p>
<p><span class="pagenum"><SPAN name="Page_132" id="Page_132">[Pg 132]</SPAN></span></p>
<div class="sidenote">Risk and expenses to the money-lender</div>
<p>2. <i>Gross interest must be distinguished from net interest.</i> The forms
of wealth yielding incomes are so mutable, and are used under such
complicated conditions, that both in theoretical discussion and in
practice much care is needed to distinguish between the yield
attributable to the income-bearer, and that attributable to other wealth
or services used in connection with it. That the sum paid as interest on
a loan contains other elements is recognized constantly in practice. As
in the case of contract-rent allowance must be made for repairs and
depreciation, so in the case of contract-interest allowance must be made
for risk, or the average loss occurring in the industry. Money loaned in
hazardous ventures must yield a higher rate of interest. Likewise
capital used by the owner in a hazardous venture must frequently earn
very high returns (not all logically interest) to offset the losses that
are likely to occur.</p>
<p>The lender must also, in estimating net interest, count the cost of
placing, supervising, and collecting the loan. A pawnbroker lends only
small sums and spends much time and effort to keep at interest a
moderate capital. Five thousand dollars loaned in sums averaging ten
dollars represents five hundred transactions, and yet if placed at five
per cent, it yields but two hundred and fifty dollars a year. While,
therefore, the borrower of a small sum estimates the economic interest
(or anticipated gain in income) even higher than the oppressively high
contract-interest he may be forced to pay, the lender must credit a
large part of the gross interest to the labor he expends in carrying on
the business.</p>
<div class="sidenote">Short-time loans by discounting of commercial paper</div>
<p>3. <i>The most usual form of short-time loan is that made by a bank or
broker to business men on security of commercial paper.</i> By commercial
paper is meant promissory notes given by customers of the merchants,
bills of lading for goods that have been shipped to their customers, and
various other evidences of indebtedness that may be offered the banks
for discount. When goods have been sold on time (as thirty, sixty, or
ninety days) the seller has the<span class="pagenum"><SPAN name="Page_133" id="Page_133">[Pg 133]</SPAN></span> choice between letting the time expire
and collecting the bills direct from the customers, and discounting the
bills for ready money at the bank. According to the conditions and needs
of the particular business, either method may be chosen. In most
industries there is need for larger capital at the seasons when the
product is put upon the market. The merchant or manufacturer plans his
business in the expectation of an average rate of discount at such
times, and if it chances that the discount rates are abnormally high, he
has no choice but to go on borrowing and paying the high interest out of
the expected profits of his business. This risk of a change in the
interest rate is one of many chances he has to run.</p>
<div class="sidenote">Long-time loans by purchase of mortgages, bonds, and stocks</div>
<p>4. <i>Most debts in modern times are outstanding for a term of years and
represent the lender's purchase of a claim on the earnings of some
productive enterprise.</i> The simplest forms of long-time loans are those
made on the security of real estate, which is mortgaged to the lender
for the term of the debt. Usually the debtor is obliged to pay the
interest either annually or semi-annually, and often, but not always, is
permitted to reduce the principal by partial payments. These real-estate
mortgages rest on the security of the particular mortgaged wealth, and,
unlike most short-time loans in bank, are not personal obligations
resting on the general credit of the borrower. Most other long-time
debts share this character of being non-personal; if payment is
defaulted, only the particular wealth can be sold for payment, not the
general wealth of the borrower. Corporation bonds, issued by railroads
and other large stock companies, have increased greatly in number in
recent years. They yield an income fixed in advance, and are secured
usually by mortgage on the entire property of the corporation issuing
them. The income of some special kinds of "preferred stocks" is so
guaranteed as to make them for investors substantially the same as
bonds. Another large class of long-time loans are those made by
national, state, and local<span class="pagenum"><SPAN name="Page_134" id="Page_134">[Pg 134]</SPAN></span> governments. Tens of billions of dollars of
public debts are now outstanding, held by private investors in every
walk of life.</p>
<p>The contract in the case of each kind of these loans provides for a
fixed term after which the borrower must repay or renew, and for a fixed
rate on the nominal or par value of the loan. Nearly all the securities
(bonds, certificates, evidences of indebtedness) are salable at a market
rate. It is therefore the income that is fixed, the selling price (or
capital value) fluctuating above or below the nominal sum except just at
the moment when it is payable. The long-time loan thus is very similar
in its economic character to the old-time rent-charge.</p>
<div class="sidenote">The cost of credit to the improvident buyer</div>
<p>5. <i>The sale of goods on credit is a mode of lending and involves
interest in a disguised form.</i> In some cases merchants will not sell
cheaper for cash than for credit, for fear of offending their main body
of credit customers; but this is exceptional, as there are good reasons
why such a difference should be made. The credit sale usually involves
interest, and often at a very high rate. In many stores there are two
appreciably different prices, one for "slow pay," the other for "spot
cash." If a bill paid at the end of the month is five per cent. more
than the cash price, the difference is equal to sixty per cent. per
annum for the privilege of postponing payment. Such a rate of interest
is paid only by the improvident, but that is a large class ranging from
factory workers to college students. The cash discounts allowed by
merchants clearly express the time difference. On fifty to one hundred
dollars of outstanding bills, many perfectly honest persons are paying
interest at the rate of seventy-five per cent. per annum. The merchant
is forced to make this difference because he must seek not only to earn
interest on the capital thus invested, but to recover the costs of
bookkeeping and collections, and the risk and loss of unpaid bills. The
discounts allowed by manufacturers and wholesale houses measure in the
same way<span class="pagenum"><SPAN name="Page_135" id="Page_135">[Pg 135]</SPAN></span> the difference between cash and credit sales. Not unusual is a
discount of "six per cent, in ten days, five per cent, in thirty, or
sixty net." The buyer allowing his bills to run for two months (six per
cent, for sixty days) pays thirty-six per cent, per annum for the use of
that money. The difference is so great that it is impossible to carry on
in this way a large business against strong competition. Such purchases
on credit frequently are made, however, by dealers in small towns.</p>
<div class="sidenote">Evasion of legal rate of interest</div>
<p>6. <i>Interest is often concealed under other forms which increase the
apparent rate.</i> This fact is well shown in the ways by which usury laws
fixing the legal rate of interest are evaded. A simple method is for the
lender to charge a commission for making the loan, or, if it is a bank,
to charge for a pretended cost of exchange to bring the money from some
other city. Sometimes the borrower is required to keep larger deposits
with the bank than he voluntarily would. Needing $5000, he is compelled
to borrow $10,000 and to pay interest on twice as much as he is
permitted to use. Again the borrower, in periods of unusual demand for
money, is forced to make a long loan instead of a short one. When a one
month's loan at ten per cent, would meet his need, he is forced to
borrow for twelve months at six per cent., during ten months of which
time four or five per cent, is the prevailing rate. In these and other
ways the real rate, or burden of the loan, is made different from that
which is expressed.</p>
<h4>§ II. THE MOTIVE FOR PAYING INTEREST</h4>
<div class="sidenote">Money borrowed to buy consumption goods</div>
<p>1. <i>Interest for loans to obtain consumption goods is paid because they
are felt to have greater importance at the moment than an equal amount
(either of goods or of money) will have in the future.</i> A sudden stress
of misfortune may impart to a thing at the moment far more than its
usual value. One standing face to face with starvation cannot<span class="pagenum"><SPAN name="Page_136" id="Page_136">[Pg 136]</SPAN></span> be worse
off a year hence; often there is good ground to hope that if the present
misfortune can be relieved, the future better fortune will make it
possible to repay a loan with interest. In other cases, the object of a
loan of consumption goods is to increase the future earning-power of the
borrower. When the student borrows money that represents to him food,
clothing, text-books, tuition, and other expenses incidental to a course
in college, the expenditure is intended to increase the effectiveness of
the worker. When he borrows he has little earning-power, but with that
faith in himself which makes the young American so interesting, he
pictures himself four years later, sheepskin in hand, drawing a
munificent salary with which he can easily satisfy the most exacting
Shylock. Such an expenditure is sometimes called "an investment of
capital," but it should be called a consumption loan—nevertheless in
many cases a loan wisely made. To call this an investment of capital is
to confuse man, the end of production, with material means.</p>
<p>Sometimes this higher estimate of the present good is unwise, viewed in
the light of wider experience. Goods that meet momentary desire make an
exaggerated appeal to untrained minds. The child, the spendthrift, the
savage, cannot properly estimate the relative values of present and
future. The improvident sometimes lightly agree to pay an exorbitant
interest for an immediate consumption loan, making a ruinous difference
between present and future gratifications.</p>
<div class="sidenote">Money borrowed to buy indirect agents</div>
<p>2. <i>Interest on indirect agents is paid as a more or less indirect means
of securing gratification.</i> This can be clearly seen when durable agents
are hired that produce gratification directly. A carriage bought with
borrowed capital and used for the pleasure of the borrower is expected
to afford a utility greater than that to be gotten by the amount of the
interest in any other way. A spade bought with borrowed capital and used
to cultivate the owner's garden is expected to add products of greater
value than the interest.</p>
<p><span class="pagenum"><SPAN name="Page_137" id="Page_137">[Pg 137]</SPAN></span></p>
<p>But how is it in case the agent is used to gratify persons other than
the owner? The music-teacher who buys a piano on credit expects to
increase his earnings by a sum greater than the interest he has to pay.
If the addition to his earnings exceeds the interest charge, it is
because he has found a use for the borrowed capital greater than that on
the basis of which it was capitalized in the market. The amount of the
interest is secured through the pleasures and services the piano affords
to the patrons of the teacher. In the most complex cases of the
borrowing and use of indirect agents, there is ultimately this same
basis for the interest: enjoyment afforded by the use of capital in the
particular period. To the borrower, what the capital makes possible is
an addition to his income as great as, or greater than, the prevailing
interest. Most loans in our society are now of this sort. Money is
borrowed to invest in business, to get better machinery or a larger
stock; with this capital is secured a better or larger product, and the
product finally being sold at a profit, the business man is at a point
where he can satisfy his wants without encroaching on his capital.
Logically, therefore, the consumer of the product pays the interest in
the price, and the final consumer's enjoyment must be deemed the logical
source of the money interest. The borrower's motive for paying interest
on these indirect goods evidently is his hope of profit through
realizing a greater money rent than he has contracted to pay for their
use.</p>
<div class="sidenote">The special case of money borrowed to pay debts</div>
<p>3. <i>The money market in which short-time loans are made is peculiar in
that the money frequently is borrowed to pay debts, not for investment.</i>
In beginning the discussion of interest, it always is remarked that it
is not money, but capital, that is borrowed and loaned. This caution
against the superficial errors that so easily beset the popular
discussion of interest is much needed, but it is well to note a peculiar
case which is apparently in contradiction to this statement. The usual
method by which money is loaned in the great<span class="pagenum"><SPAN name="Page_138" id="Page_138">[Pg 138]</SPAN></span> industrial centers is
called discount, which is the exchange of a certain sum of money for a
note or other credit paper of a larger amount, the interest thus being
taken out in advance. Much borrowing in the form of discount is for the
same purpose as other borrowing—to acquire control of more productive
agents, to embark on new enterprises. The peculiarity of the discount
money-market is that an unusual number of loans are made to meet
contracts that have already been made. There is always a great mass of
outstanding obligations, and merchants are compelled to renew these
loans on penalty of bankruptcy. This market for short-time loans is not
connected closely with the general market for loanable capital. When the
need is for ready money, other concrete capital cannot flow in to meet
it. This special money demand, therefore, in time of greater or less
stress, may fluctuate rapidly, and the interest rate be temporarily
higher or lower than the rate on long-time loans. This case is similar
to that where two markets, as a retail and a wholesale one, exist side
by side, but slowly exerting a mutual influence.</p>
<div class="sidenote">Productive borrowers seek a profit on their investments</div>
<p>4. <i>In the long-time money loan the money generally is borrowed first
merely as a medium of exchange to get control of indirect agents.</i> The
borrower of a long-time money loan for productive purposes is always
seeking to gain by investing the money in wealth that will yield an
income larger than the interest he must pay. The borrower, therefore,
invests in view of the rate of interest, of the market price of the
goods in which he plans to invest, and of the probable chances for
earning profits in the business. This case, where certain goods whose
price is known are approximately selected before the money is borrowed
for investment, is the type of loan to be kept most usually in mind in
economic discussion.</p>
<p>Evidently the price of these goods, to control which is the real object
of the loan, is merely the sum of the expected rents they will yield,
capitalized at the prevailing rate of<span class="pagenum"><SPAN name="Page_139" id="Page_139">[Pg 139]</SPAN></span> time-discount. The borrower
expects either to make these particular goods earn rents larger than
those on the basis of which they have been capitalized, or to transfer
them to an economy where goods are capitalized at a higher rate than he
is paying. The income yielded by these goods, if the borrower's
expectation is fulfilled, is but the difference between present and
future rents that has been wrapped up in their capitalization. As time
elapses and the rents emerge in wisely chosen investments, the borrower
has a surplus large enough to pay the contract interest. It appears,
therefore, that the motive of the borrower is to get control of future
rents at prices that already involve, in their capitalization, a rate of
discount somewhat greater than the interest he contracts to pay.</p>
<div class="sidenote">The developed market for money loans</div>
<p>5. <i>The rate of contract interest on money loans is adjusted at each
moment in the money market by the bidding for money loans.</i> This is a
true statement only if it is understood in a somewhat superficial sense.
No error connected with interest is, however, more crude than the view
that the interest rate is in any broad sense due to the quantity of
money. Some loans are made apart from the general market, by private
agreement between borrower and lender; but in nearly every such case the
rate agreed upon is seen to be closely related to that of the general
market to which either borrower or lender can resort if he wishes. The
greater number of borrowers and lenders of money have a range of choice
in their bargaining. The interest rate in modern developed money markets
is that rate which brings to equilibrium the demand for money loans and
the money capital available within the period. If the ready, loanable
money in private hands, in banks, in insurance-company reserves, &c.,
increases, a lower rate must be offered to borrowers; if the supply
decreases, a higher rate will be quoted. In the one case, more men
borrow; in the other, fewer borrow and more seek to lend. Thus a rate
results, but a rate that is closely connected with larger set of
facts—those, indeed,<span class="pagenum"><SPAN name="Page_140" id="Page_140">[Pg 140]</SPAN></span> which determine in the long run the rate of
capitalization in the community.</p>
<div class="sidenote">Every person is a buyer or a seller of present goods</div>
<p>6. <i>The individual must adjust his business dealings to the market rate
of interest.</i> The market rate is fixed by the bidding of individuals,
and every one has something to do with fixing it. In a multitude of
minutely small ways, as present and future goods are compared by men,
the rate of interest is affected positively or negatively. But for
practical purposes the individual, counting for little in the midst of
millions, must look upon the interest rate as beyond his influence.
Therefore, while the rate is determined by each to some degree, all that
any one does is to buy or sell present goods, borrow or lend capital,
use up or save wealth, according as his own estimate of time-value is
less or more than the market rate. In fact, the estimates of individuals
diverge constantly from the market rate, but are brought into harmony by
their actions with reference both to money loans and to the use and
valuation of the various forms of wealth. A Robinson Crusoe working on
his island and valuing future goods relatively to present goods higher
than before, consumes less; or, valuing them lower, consumes more. The
business man who values indirect agents above the market rate borrows,
and if he miscalculates and fails to make them earn the expected rent,
he loses. In this experimental way many other acts are influenced by the
prevailing interest rate and in turn affect it, thus aiding to formulate
society's estimate of the value of present as compared with future
rents.</p>
<hr class="chap" />
<p><span class="pagenum"><SPAN name="Page_141" id="Page_141">[Pg 141]</SPAN></span></p>
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