§ 1. The Rate of Interest depends on the Demand and Supply of Loans.
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 book(285) 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.
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 centers 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 can not
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. Circumstances which Determine the Permanent Demand and Supply of
Loans.
In [ordinary] 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
give security for, constitutes the demand for loans on account of
productive employment. To these must be added the loans required by
Government, and by land-owners, 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, (1) 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 endeavor to increase their income by engaging in business on
their own account, and incurring the risks, if not the labors, of
industrial employment.
The low rates of interest, rather, tempt people to take some
additional risk, and enter into investments which offer a higher
rate of dividends; so that a period of low interest is a time when
speculative enterprises find victims, and then by bad and
worthless investments much of the loanable funds is actually lost;
thereby reducing the total quantity of loans more nearly to that
demand which will give an ordinary rate of interest.
(2.) 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, instead of [capital] 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. [For] 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, can not,
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. A bank which lends its notes lends capital which it borrows from
the community, and for which it pays no interest.
Of late years, however, banks are generally not permitted to issue
notes on their simple credit. That privilege has been so often
abused in this country that now, in the national banking system, a
separate part of the resources are set aside for the security of
the circulating notes (as is also true of the Bank of England
since 1844). It is not generally true, then, that banks now create
the means to make loans by issuing notes by which they borrow
capital from the community without paying interest. They do,
however, depend almost entirely on deposits.
A bank of deposit lends capital which it collects from the community in
small parcels, sometimes without paying any interest, and, if 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. The
disposable capital deposited in banks, 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.(286)
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. Circumstances which Determine the Fluctuations.
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 immediately 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.(287)
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.
The pernicious and hurtful custom exists in various States in this
country of making any interest beyond a certain rate illegal. When
it is remembered that legitimate business is often largely done on
credit—until the proceeds of goods sold on credit are
collected—the rate of interest from day to day is very important
to trade. So, when there is a sudden demand for loans, a rate
higher than the legal one will certainly be paid, and the law
violated, if the getting of a loan is absolutely necessary to save
the borrower from commercial ruin. The effect of a legal rate is
to stop loans at the very time when loans are most essential to
the business public. It would be far better to adopt such a
sliding scale as exists at great European banks, which allows the
rate of interest to rise with the demand. No one, then, with good
security, need want loans if he is willing to pay the high rates;
and those not really in need will defer their demand until the
sudden emergency is past. Already in New York the legal penalty
has been removed for loaning at higher than the legal rates when
charged upon call-loans; and it has mitigated the extreme
fluctuations of the rate in a market when financial necessity is
contending against the law.
Except at such periods, the amount of capital disposable on loan is
subject to little other variation than that which arises from the gradual
process of accumulation; which process, however, 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 mean time, 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 possessors to incur hazards in hopes of
a more considerable return.
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 draughts 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.
The United States during the late war found that it could not
borrow at even six or seven per cent. By receiving depreciated
paper at par for its bonds it really agreed to pay six gold
dollars on each loan of one hundred dollars in paper (worth,
perhaps, at the worst only forty gold dollars), which was
equivalent to fifteen per cent. This high rate was largely due to
the weakened credit of the Government; but still it remains true
that the rate was higher because the United States was in the
market as a competitor for large loans. Now the Government can
refund its bonds at three per cent.
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 rapid payment of the public debt by the United States,
$137,823,253 in 1882-1883, and more than $100,000,000 in
1883-1884, has taken away the former investment for enormous sums
of loanable funds, and to the same extent increased the supply in
the market. Without doubt this aids in making the present rate of
interest a very low one. Whether the rate will remain “permanently
lower,” however, will depend upon whether the field of investment
in the United States is already practically occupied. We believe
it is not.
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.
§ 4. The Rate of Interest not really Connected with the value of Money,
but often confounded with it.
From the preceding considerations it would be seen, even if it were not
otherwise evident, how great an error it is to imagine that the rate of
interest bears any necessary relation to the quantity or value of the
money in circulation. An increase of the currency has in itself no effect,
and is incapable of having any effect, on the rate of interest. A paper
currency issued by Government in the payment of its ordinary expenses, in
however great excess it may be issued, 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 dollars
will buy a perpetual annuity of four dollars a year, a depreciation which
makes the hundred dollars worth only half as much as before has precisely
the same effect on the four dollars, and therefore can not alter the
relation between the two. Unless, indeed, it is known and reckoned upon
that the depreciation will only be temporary; for people certainly might
be willing to lend the depreciated currency on cheaper terms if they
expected to be repaid in money of full value.
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. Says Mr.
Tooke: “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 truth, the most difficult questions of banking center around
the functions of discount and deposit. The separation of the Issue
from the Banking Department by the act of 1844, which renewed the
charter of the Bank of England, makes this perfectly clear. After
entirely removing from their effect on credit all influences due
to issues, England has had the same difficulties to encounter as
before, which shows that the real question is concerned with the
two essential functions of banking—discount and deposit. Since
1844, there have been the commercial disturbances of 1847, 1857,
1866, and 1873. Although no expansion of notes, without a
corresponding deposit of specie, is possible.
§ 5. The Rate of Interest determines the price of land and of Securities.
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 salable 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.
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 [England], to be somewhat more
secure, but because ideas of power and dignity are associated with its
possession. But these differences are constant, or nearly so; and, in the
variations of price, land follows, _cæteris 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.
A lot of land, which fifty years ago gave an annual return of
$100, if ten per cent was then the common rate of interest, would
sell for $1,000. If the return from the land remains the same
($100) to-day, and if the usual rate of interest is now five per
cent, the same piece of land, therefore, would sell for $2,000,
since $100 is five per cent of $2,000.
The price of a bond, it may be said, also varies with the time it
has to run. At the same rate of interest, a bond running for a
long term of years is better for an investment than one for a
short term. The lumberman, who looks at two trees of _equal
diameter_ at the base, estimates the total value of each according
to the _height_ of the tree. Then, again, a bond running for a
short term may be worth less than one for a long term, even though
the first bears a higher rate of interest. That is, to resume the
illustration, one tree, not rising very high, although _larger_ at
the bottom, may not contain so many square feet as another, with
perhaps a _less_ diameter at the bottom, but which stretches much
higher up into the air.