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Interest From Where?

By James H. Nolt

Since the inception of political economy, interest paid on loans has been something of a mystery. Where does the wealth to pay it come from? Is it a payment for productive activity or a mere unproductive transfer of income from debtors to creditors? Several religions took the latter view and therefore banned or restricted it for centuries. Islam still does. Modern textbook economics, however, claims that interest is either “the time value of money” or part of the payment for the productive use of capital.

The earliest loans in recorded history were all loans in kind. Interest was also paid in kind. For example, imagine a farmer who had a bad winter. Rats had eaten most of the seed he had laid aside for next year’s planting. He might beg the local temple priests to lend him some of their stored grain as seed, and they would write a debt contract on a clay tablet, perhaps providing five bags of grain but requiring back eight bags four months later when his harvest was in. There would hopefully be plenty left to feed his family for the coming year. Temples stored contributed grain to feed the priests, provide burnt offerings to the local god, and lend out in this way. If the debtor was virtuous, the god would reward him with a good harvest and he would be grateful to repay the god with more grain than he borrowed. After all, the priests told him that it was thanks to the god that he received such a bountiful crop anyway.

Contemplating agricultural loans in money or kind such as this example, early political economists like the French physiocrats often argued that the wealth to pay interest came from the natural increase of nature’s bounty. Cattle tend to increase by natural reproduction. Seed produces many times more grain at harvest. Physiocrats believed that only nature produced expanding wealth in such a way as to justify payment of interest. All other interest payments they viewed as parasitic on nature’s bounty.

Classical political economy, starting with Adam Smith, rejected the physiocrats' identification of interest payments merely with fertility of nature. Smith believed that increasing the division of labor yields increased output. Therefore, if a “master” (his word for capitalist) borrows money to expand his pin factory and thus increase the specialization of each process involved in the manufacture of pins, output increases at a rate faster than that of the increase of inputs. Later this would be called “economies of scale,” though Smith himself emphasized the specialized organization of the work process rather than mere scale. Later political economists would also emphasize applying new technologies to expand output faster than the increase in inputs, thus providing a wellspring for interest payments.

Whatever the source in each of these cases, all involve an increase in capital (which Smith called “stock”) that might be funded by debt. As long as the future product of this increase exceeds the cost of the capital equipment, it provides a fund to pay interest and, if there is additional surplus, profits to the factory owner.

However, physiocrats and classical political economists both realized that much if not most lending was not productive in this way. Governments borrowed huge amounts to fight the many wars of early modern Europe. A victorious war might result in the gain of a province or plunder, but this was not new production, just a transfer of wealth from one nation to another. Therefore, lending for war must be unproductive. The interest paid on the loan might come from plunder gained by war, but no new wealth is created, so such interest is merely the creditors’ share from a robbery rather than a productive return on capital. Defeat in war was even worse. Defeated debtors typically defaulted on their debts or taxed their subjects more ruthlessly to pay back the loans borrowed to fund their folly.

The obvious example of government loans for war might make it seem like the line between productive and unproductive lending is merely the line between private and sovereign loans. Indeed, modern textbook economics, not to mention conservative ideology, assumes this sort of simple-minded dichotomy.

The truth is that most private lending is just as unproductive as war loans and some sovereign borrowing is in fact productive. Sovereign or governmental borrowing is productive if invested in useful projects that increase output more than proportionate to their inputs, including things like most canals, roads, airports, power stations, government-run factories, and even things less immediately productive, such as public security, public health, and education. Of course, there is no guarantee that either public or private investments will return output greater than their cost, but if they do, then interest payments on the debt incurred have a real source in expanded output.

Most private loans are unproductive not because they are “bad loans” in the sense of being made to support uneconomic projects, though there is some of that. Most private loans are made merely to transfer existing assets from one owner to another. Transfer of ownership in itself is not productive. In theory it could be if the new owner superintends the asset better than the old one, but on average this is not true, and many assets are paper ones that can produce nothing whatsoever.

Real estate is the most common asset. Since ancient times, land has of course been considered the supremely productive asset, but merely transferring ownership of it or increasing its price does not produce anything new. Consider an example: suppose we have an agricultural country with no mortgage market. The first bank opens and begins making loans to landlords using their asset, their land, as collateral for the loan. As the bank extends credit to landlords to purchase land from their neighbors, landlords’ buying power is increased by this new credit. There is no more land than before, but there is more buying power, so naturally land prices start to rise.

This increase in price has no counterpart in increased production. Landlords who borrow can buy their neighbor’s land. Their income increases as their landholdings expand, but now a portion of their income is paid to the bankers as interest. Meanwhile, their neighbors, no longer landlords, have sold their land in exchange for a large pool of liquid funds and might become speculators in agricultural commodities. They produce nothing, but they use their capital to buy agricultural products during the harvest time when these are abundant and prices are low. They store them until the dead of winter, when prices increase and they can sell at a profit. Now they too have an income that owes nothing to any increase in real output.

Until the advent of neoclassical economics, it was clear to both physiocrats and classical political economists that both the speculative profits of the commodity trader and the interest on private loans that facilitated merely the transfer of asset ownership at ever increasing prices (e.g., a real estate bubble), were unproductive uses of capital–therefore interest or profits derived from such activity must be parasitic. In other words, income is transferred from producers to non-producers. Since the neoclassical or marginalist revolution of the 1870s, this important distinction has been increasingly obscured by the more and more abstract treatments of capital and lending. Having lost the distinction between productive and unproductive uses of capital, modern economists are unable to understand the dynamics of our boom and bust economy that were so starkly manifest during the worldwide crisis of 2008.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Wikimedia Commons. The painting shows François Quesnay (1694-1774), one of the first French physiocrats. Painting by Heinz Rieter, date and other details unknown]

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