Friday, January 2, 2009

Is It Immoral to Charge Interest?

A common misconception about finance and economics is that those who give a loan are abusing (hence the term "usury") the borrower by charging him interest. However, it is easy to see that this notion is both naive and wrong.

Let's say I have $100 in my pocket. I can either keep the money in my pocket or spend it on something. Now, let's say you come to me and ask to borrow $100 for one month and I agree. However, if I give that $100 over to you, then for one month (until you repay), if I see something I want to buy - perhaps on a clearance sale that will be gone in a day - I have to forgo that purchase because you are using my money for the time being. Once the month is up, you repay me my $100 but it has cost me to allow you to use the money. Perhaps I could have saved $20 on a pair of boots that were marked down but sold before you gave me my money back. In that case, I have borne what economists call opportunity cost because I lost an opportunity to save some money, or perhaps earn some money.

In other words, the cost to me of giving you the loan is the forgoing of all the opportunities to purchase things or otherwise put that money to use while you were using it instead for whatever purpose you needed it for. It is only fair that I ask you to recompense me for that cost. Since the cost is real (I'm not just saying it costs me, it really costs me), you won't find anyone else who will give up $100 for a month without asking for something in return to compensate them for their trouble. Even if they didn't plan to use the money for a month or more, they could have just kept it in an account as insurance against loss of their job, or a natural disaster washing away their house, or whatever.

Now, this brings me to the general economic concept underlying the charging of interest and this is what economists call time preference. People prefer desirable things sooner rather than later (and undesirable things later rather than sooner) That is why consumers will pay interest to have a consumer item now, rather than waiting until such time as they have saved sufficient money to purchase the consumer item outright. Or, they will put off paying their bills until the absolute last minute required to avoid fees. Few people pay their bills more than a few days earlier than required and only then for convenience (usually because they're paying other bills due at different times all at once).

People prefer things sooner rather than later for the same reason they prefer more of something to less - consumption now means more total consumption, but deferral of consumption may mean less total consumption. Also, time involves risk - risk of death, risk of loss of senses, property etc. - so that deferral of present consumption may mean loss of the ability to consume at all. If I choose not to eat a banana today, it may become overripe by the next opportunity I have to eat it, for example. Or, if I forgo getting a massage today, I may die tomorrow without having received the massage I had wanted. And so on. For these reasons, I prefer things sooner rather than later.

Some people prefer present consumption much more than future consumption. People who strongly prefer present consumption we call "spenders" and people who strongly prefer to defer present consumption we call "savers." But, overall, there is a certain degree of time preference that emerges between those who are deferring present consumption and those who are presently consuming and this is what Austrian economists call the originary interest rate. This originary interest rate does not apply only to money, but to any good or service. It is the price that must be paid on the market by someone wanting to consume something in the present to persuade someone else to defer their present consumption.

The use of money is no different than the use of any other good. People prefer to have their money in their hand now, rather than later. To get someone to forgo the use of their money (or any other property they own which they might like to use, e.g. renting their house), you will have to pay them. The price which must be paid for the use of money is called interest. The interest rate for money is directly related to the originary interest rate and it reflects the price which must be paid to persuade someone to give up the use of their money so someone else can use it instead.

I wrote this post because it is a recurring misconception on this board and elsewhere that the charging of interest is an immoral and arbitrary abuse of borrowers by lenders. Not only is the charging of interest not immoral, it is a basic building block of the industrialized world. Without the charging of interest, it is impossible to allocate resources over time. And setting the interest rate to zero through price controls (laws prohibiting the charging of interest) simply causes a shortage of capital and excess present consumption. It destroys the division of labor by preventing those who would rather defer present consumption for greater future consumption from transferring their deferred consumption to be used by others who would rather consume more in the present at the cost of giving up more future consumption. In other words, it leads to underinvestment and this is exactly the consequences wherever the charging of interest is prohibited. Infrastructure is not built and capital investments are not made. Why bother? If you have a lot of money, better to spend it on luxuries for oneself than loan it out because no profit can be made from capital loans. Those who need capital to pursue a business idea can't bring their idea to fruition because the money they would have paid to use is being consumed for present luxuries.


Anders said...

I have to respond to this ignorant article. First off, if you loan me 100$, at 5% interest in fiat money, where does the interest come from?

The interest is NEVER created, therefore the foundation of usury is based on fraud.

This is why America gets further and further into debt. A small group of ethnics have a stranglehold on the creation of money and then they charge interest on this money, which eventually leads to the population needing to borrow more and more just to service their loans.

No country needs usury to develop. Look at America before the 1930's and our stable money supply. Look at the Muslim world today and banks that operate interest free.

How could promoting a reckless buy now pay later policy ever be good for society?

Clayton said...

Where's your response? I gave very detailed reasons in my arguments, none of which you have responded to.

Interest earned is simply one kind of revenue, it is not in a special class from other kinds of revenue. Interest does not have to be repaid from "newly created money", it can be repaid from existing money just like any other kind of payment. If I loan money out at interest, there is some chance I may lose the whole principal or I may get the principal repaid along with the interest. Either way, giving a loan is no different than any other sort of business venture involving risk of loss and potential reward.