Smita Roy has an outstanding article detailing the history of how philosophers and economists have thought of the concept of interest, entitled Historical Evolution of Interest and Its Analysis in Economic Literature. This is easily the best paper I have read in the past year (or possibly more), so expect a long post.
This paper focuses on the emergence of the phenomenon of interest in human history and the analysis of the concept in economic literature. The concept of interest is closely associated with the concept of capital in economic theory and theories of capital have deeply influenced theories on interest. While the justification of interest on money loans formed the core of initial theories on interest, focus later on shifted on what made possible this payment of interest on money loans. Again, twentieth century has seen a sharp distinction between monetary and non-monetary theories of interest
The author begins by noting that “credit preceded coinage by over two thousand years,” and the concept of credit emerged even before barter was established (2). Despite this, a real concept of interest is relatively recent. In most economic literature, the idea of interest is a return on capital, with an intense debate during the 17th and 18th century on whether “dead” money earns interest (2). Before this discussion, though, came the idea of “contract interest,” which is the idea of a payment greater than the principal for a commodity or monetary loan (3). This was usually frowned upon for religious or philosophical reasons (4), and for this reason, it wasn’t until the 12th century that we really see any discussion of the topic, and no defenses before the 16th century (4).
Despite this relative lack of discussion, the author notes that we do see the development of financial and capital-based institutions that would in turn engender interest. We see currency standardization early on to solve the problem of exact payment in kind. Many of these currencies were physical goods, such as grains, dates, olives, or animals (5). In lending out these physical commodities, the lender could then expect a return greater than the investment. Lend out a cow for several years and you can demand two cows in return, because the cow can give birth to new calves. Going further down this road, in India, Kautilya’s “Arthashastra” discusses risk premia, and in 1356 Florence, we see an early capital market in the Monte Commune (6).
This all happened in spite of religious decrees against “usury.” The case against interest came down to three ideas in the Catholic church: the idea that money is “barren” (unlike animals or grains, as above); that the lender sells the use of money apart from the money itself; and that the lender sells time, which belongs to the borrower (7-8). These arguments did not apply to lending durable goods, so you could see some level of lending in the form of physical goods.
Naturally, people try to get around these limitations, and so scholars figured out a trick to get around the prohibitions: the concept of “intereo,” which means “to be lost.” Interest, according to scholars, was not a premium for another person’s use of my property, but rather a payment for the loss of my ability to use my property (8). There were other methods developed as well, including annuities, using land as a mortgage, setting up bills of exchange, and even having partnership arrangements (9), all of which served the same goal but in different ways. Like many other things in economics, “interest was a practical reality before theories arrived to support it” (10), so the theories were developed to explain why something is the case, rather than coming up with a great new idea and trying to implement it. This led to a number of competing theories on interest.
Classical economics had several theories on what interest was. Most of these theories required the underpinning of the labor theory of value and that labor was the sole source of “surplus value” (defined as Revenue – Costs) (12). In these classical works, as a result, you often see the concept of interest conflated with the concept of profit, especially in Nassau Senior and David Ricardo (13). At this point, the author delves into a number of the theories, but also introduces Eugen von Böhm-Bawerk’s critiques of these theories. The author considers Böhm-Bawerk the fulcrum point for interest analysis, as you can cleanly split the history of interest thinking into two categories: what happened before his analysis, and what happened after (16).
Classical theories and how Böhm-Bawerk tore them apart (17-21):
|“Productivity” theories: Assume surplus value exists (which implies the labor theory of value). In this case, interest is the return on this value.
||Most classical economists after Adam Smith, especially Jean-Baptiste Say
||The labor theory of value is wrong. Because of this, productivity-based theories of interest are untenable.
|“Use” theories: Interest is the cost of using capital employed during a period of production. The substance of the capital + the use of capital = the value of capital.
||Karl Menger (according to Böhm-Bawerk; this is controversial). J.B. Say, Friedrich Hermann
||The marginal return to capital is due to the disposal of real capital over time, and this disposal is not an economic good. Destruction via use is not valuable, but rather is costly.
|“Abstinence” theories: Interest is a reward for abstaining from consumption.
||No real definition of what “abstinence” really is. Proponents tend to use the term in several different ways.
|“Labor” theories: interest is payment earned by the capital owner’s previous labor. Capital is a stock of previously-used labor.
||Interest is a payment over and above the cost of capital. The cost of capital itself is the value of its stored labor.
|“Exploitation” theories: Interest is expropriated surplus value
||Labor theory of value does not hold. This concept also ignores the time element involved: wages are paid out before the revenue comes in (if it ever comes in).
After laying down the law on all of these theories, Böhm-Bawerk describes his own theory. His idea of interest is that there are two independent components: the subjective time preference of economic agents, and an objective “average period of production” (22). Economists after Böhm-Bawerk tend to adhere to one of the two points, but not both. This has caused a bifurcation between the “psychological” schools (including the Austrian school) and the “Neoclassical” schools.
After Böhm-Bawerk, we can see this split occur over time. Frank Knight and John Bates Clark thought of capital as including land, natural agents, and all other intangible rights to income (23), and interest was the return on all of these. Irving Fisher started out with a similar belief to Böhm-Bawerk, that interest is time preference + “investment opportunity,” but later discourse had him basically abandon the time preference portion of his theory (23). Fisher also thought that he could define time preference as “impatience,” and saw it as a combination of the size, time shape, and probability of a person’s income stream, whereas the investment opportunity idea is the ability to shift from one income stream to another given an agent’s current resources (28). Later Neoclassical economists (such as Frank Knight) dropped the “impatience” part and kept the productivity theory (29).
On the other hand, Frank Fetter and Ludwig von Mises argued that Böhm-Bawerk made a big mistake by adding the objective portion to his theory, and instead, should have stuck with an entirely subjective, time preference-based theory of interest (24). They argued that interest is based on time preferences alone. Time preferences, according to the authors, is the discounting of future goods against present goods. Humans prefer to satisfy their desires now as opposed to later, so any push to get them to satisfy these later requires something in return. The notion of “contract interest,” according to Fetter, is a recent phenomenon compared to time preference interest (33). He considers the interest from time preferences as economic interest, and it is the difference in value between like goods available at different times (33).
Fetter breaks things down even further, arguing that there were three basic stages of interest development (35). In the first stage, we see immediate gratification, which requires a theory of wants and marginal utility. People have to be able to determine how best to satisfy their needs, and begin to think at the margin rather than at the average. After this, we see more durable tools being used, which requires a theory of rents. People need to be able to get a return on their tools and property, so they charge rent for other people to use them. Finally, we see exchange over time between non-synchronous events. This requires a theory of discounting and capitalization, which leads to interest.
Mises, on the other hand, defines capital as “the sum of the money equivalent of all assets less the sum of the money equivalent of all liabilities as devoted at a definite date to the running of the operations of a specific business unit” (36). This differs from the idea of capital goods, which are the produced means of production. From this point, Mises, comes on the idea of originary interest, which is the ratio of value of current versus future want satisfaction (36). This determines the demand for and supply of capital and capital goods (37).
The author ends this discussion with some information on monetary funds theories. The two described are loanable funds and liquidity preference theories. The loanable funds theory says that the supply and demand for “claims” on loanable funds or interest-bearing securities defines the notion of interest (38), and liquidity preference is based on the desire to hold cash, where the interest rate is what equilibrates this market (39).
Again, this was a very interesting paper, but it is quite long and detailed. I try to scratch the surface of these papers, describe some of the findings, and interject my own thoughts, so I recommend reading the paper in full to get much more information on this topic.