Front Page Titles (by Subject) [II.iv] CHAPTER IV: Of Stock lent at Interest - Glasgow Edition of the Works and Correspondence Vol. 2a An Inquiry Into the Nature and Causes of the Wealth of Nations, Vol. 1
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[II.iv] CHAPTER IV: Of Stock lent at Interest - Adam Smith, Glasgow Edition of the Works and Correspondence Vol. 2a An Inquiry Into the Nature and Causes of the Wealth of Nations, Vol. 1 
An Inquiry Into the Nature and Causes of the Wealth of Nations, Vol. I ed. R. H. Campbell and A. S. Skinner, vol. II of the Glasgow Edition of the Works and Correspondence of Adam Smith (Indianapolis: Liberty Fund, 1981).
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Of Stock lent at Interest
1The stock which is lent at interest is always considered as a capital by the lender. He expects that in due time it is to be restored to him, and that in the mean time the borrower is to pay him a certain annual rent for the use of it. The borrower may use it either as a capital, or as a stock reserved for immediate consumption. If he uses it as a capital, he employs it in the maintenance of productive labourers, who reproduce the value with a profit. He can, in this case, both restore the capital and pay the interest without alienating or encroaching upon any other source of revenue. If he uses it as a stock reserved for immediate consumption, he acts the part of a prodigal, and dissipates in the maintenance of the idle, what was destined for the support of the industrious. He can, in this case, neither restore the capital nor pay the interest, without either alienating or encroaching upon some other source of revenue, such as the property or the rent of land.
2The stock which is lent at interest is, no doubt, occasionally employed in both these ways, but in the former much more frequently than in the latter. The man who borrows in order to spend will soon be ruined, and he who lends to him will generally have occasion to repent of his folly. To borrow or to lend for such a purpose, therefore, is in all cases, where gross usury is out of the question, contrary to the interest of both parties; and though it no doubt happens sometimes that people do both the one and the other; yet, from the regard that all men have for their own interest, we may be assured, that it cannot happen so very frequently as we are sometimes apt to imagine. Ask any rich man of common prudence, to which of the two sorts of people he has lent the greater part of his stock, to those who, he thinks, will employ it profitably, or to those who will spend it idly, and he will laugh at you for proposing the question. Even among borrowers, therefore, not the people in the world most famous for frugality, the number of the frugal and industrious surpasses considerably that of the prodigal and idle.
3The only people to whom stock is commonly lent, without their being expected to make any very profitable use of it, are country gentlemen who borrow upon mortgage. Even they scarce ever borrow merely to spend. What they borrow, one may say, is commonly spent before they borrow it. They have generally consumed so great a quantity of goods, advanced to them upon credit by shopkeepers and tradesmen, that they find it necessary to borrow at interest in order to pay the debt. The capital borrowed replaces the capitals of those shopkeepers and tradesmen, which the country gentlemen could not have replaced from the rents of their estates. It is not properly borrowed in order to be spent, but in order to replace a capital which had been spent before.
4Almost all loans at interest are made in money, either of paper, or of gold and silver. But what the borrower really wants, and what the lender really supplies him with, is, not the money, but the money’s worth, or the goods which it can purchase.1 If he wants it as a stock for immediate consumption, it is those goods only which he can place in that stock. If he wants it as a capital for employing industry, it is from those goods only that the industrious can be furnished with the tools, materials, and maintenance, necessary for carrying on their work. By means of the loan, the lender, as it were, assigns to the borrower his right to a certain portion of the annual produce of the land and labour of the country, to be employed as the borrower pleases.
5The quantity of stock, therefore, or, as it is commonly expressed, of money which can be lent at interest in any country, is not regulated by the value of the money, whether paper or coin, which serves as the instrument of the different loans made in that country, but by the value of that part of the annual produce which, as soon as it comes either from the ground, or from the hands of the productive labourers, is destined not only for replacing a capital, but such a capital as the owner does not care to be at the trouble of employing himself. As such capitals are commonly lent out and paid back in money, they constitute what is called the monied interest. It is distinct, not only from the landed, but from the trading and manufacturing interests, as in these last the owners themselves employ their own capitals.2 Even in the monied interest, however, the money is, as it were, but the deed of assignment, which conveys from one hand to another those capitals which the owners do not care to employ themselves.3 Those capitals may be greater in almost any proportion, than the amount of the money which serves as the instrument of their conveyance; the same pieces of money successively serving for many different loans, as well as for many different purchases. A, for example, lends to W a thousand pounds, with which W immediately purchases of B a thousand pounds worth of goods. B having no occasion for the money himself, lends the identical pieces to X, with which X immediately purchases of C another thousand pounds worth of goods. C in the same manner, and for the same reason, lends them to Y, who again purchases goods with them of D. In this manner the same pieces, either of coin or of paper, may, in the course of a few days, serve as the instrument of three different loans, and of three different purchases, each of which is, in value, equal to the whole amount of those pieces. What the three monied men A, B, and C, assign to the three borrowers, W, X, Y, is the power of making those purchases. In this power consist both the value and the use of the loans. The stock lent by the three monied men, is equal to the value of the goods which can be purchased with it, and is three times greater than that of the money with which the purchases are made. Those loans, however, may be all perfectly well secured, the goods purchased by the different debtors being so employed, as, in due time, to bring back, with a profit, an equal value either of coin or of paper. And as the same pieces of money can thus serve as the instrument of different loans to three, or, for the same reason, to thirty times their value, so they may likewise successively serve as the instrument of repayment.
6A capital lent at interest may, in this manner, be considered as an assignment from the lender to the borrower of a certain considerable portion of the annual produce; upon condition that the borrower in return shall, during the continuance of the loan, annually assign to the lender a smaller portion, called the interest; and at the end of it a portion equally considerable with that which had originally been assigned to him, called the repayment. Though money, either coin or paper, serves generally as the deed of assignment both to the smaller, and to the more considerable portion, it is itself altogether different from what is assigned by it.
7In proportion as that share of the annual produce which, as soon as it comes either from the ground, or from the hands of the productive labourers, is destined for replacing a capital, increases in any country, what is called the monied interest naturally increases with it. The increase of those particular capitals from which the owners wish to derive a revenue, without being at the trouble of employing them themselves, naturally accompanies the general increase of capitals; or, in other words, as stock increases, the quantity of stock to be lent at interest grows gradually greater and greater.
8As the quantity of stock to be lent at interest increases, the interest, or the price which must be paid for the use of that stock, necessarily diminishes, not only from those general causes which make the market price of things commonly diminish as their quantity increases, but from other causes which are peculiar to this particular case.4 As capitals increase in any country, the profits which can be made by employing them necessarily diminish.5 It becomes gradually more and more difficult to find within the country a profitable method of employing any new capital.6 There arises in consequence a competition between different capitals, the owner of one endeavouring to get possession of that employment which is occupied by another. But upon most occasions he can hope to justle that other out of this employment, by no other means but by dealing upon more reasonable terms. He must not only sell what he deals in somewhat cheaper, but in order to get it to sell, he must sometimes too buy it dearer. The demand for productive labour, by the increase of the funds which are destined for maintaining it, grows every day greater and greater. Labourers easily find employment, but the owners of capitals find it difficult to get labourers to employ. Their competition raises the wages of labour, and sinks the profits of stock.7 But when the profits which can be made by the use of a capital are in this manner diminished, as it were, at both ends, the price which can be paid for the use of it,8 that is, the rate of interest, must necessarily be diminished with them.
9Mr. Locke, Mr. Law, and Mr. Montesquieu,9 as well as many other writers, seem to have imagined that the increase of the quantity of gold and silver, in consequence of the discovery of the Spanish West Indies, was the real cause of the lowering of the rate of interest through the greater part of Europe.10 Those metals, they say, having become of less value themselves, the use of any particular portion of them necessarily became of less value too, and consequently the price which could be paid for it. This notion, which at first sight seems so plausible, has been so fully exposed by Mr. Hume, that it is, perhaps, unnecessary to say any thing more about it.11 The following very short and plain argument, however, may serve to explain more distinctly the fallacy which seems to have misled those gentlemen.
10Before the discovery of the Spanish West Indies, ten per cent. seems to have been the common rate of interest through the greater part of Europe. It has since that time in different countries sunk to six, five, four, and three per cent.12 Let us suppose that in every particular country the value of silver has sunk precisely in the same proportion as the rate of interest; and that in those countries, for example, where interest has been reduced from ten to five per cent., the same quantity of silver can now purchase just half the quantity of goods which it could have purchased before. This supposition will not, I believe, be found any where agreeable to the truth, but it is the most favourable to the opinion which we are going to examine; and even upon this supposition it is utterly impossible that the lowering of the value of silver could have the smallest tendency to lower the rate of interest. If a hundred pounds are in those countries now of no more value than fifty pounds were then, ten pounds must now be of no more value than five pounds were then. Whatever were the causes which lowered the value of the capital, the same must necessarily have lowered that of the interest, and exactly in the same proportion. The proportion between the value of the capital and that of the interest, must have remained the same, though the rate had never been altered. By altering the rate, on the contrary, the proportion between those two values is necessarily altered. If a hundred pounds now are worth no more than fifty were then, five pounds now can be worth no more than two pounds ten shillings were then. By reducing the rate of interest, therefore, from ten to five per cent., we give for the use of a capital, which is supposed to be equal to one–half of its former value, an interest which is equal to one–fourth only of the value of the former interest.
11Any increase in the quantity of silver, while that of the commodities circulated by means of it remained the same, could have no other effect than to diminish the value of that metal. The nominal value of all sorts of goods would be greater, but their real value would be precisely the same as before. They would be exchanged for a greater number of pieces of silver; but the quantity of labour which they could command, the number of people whom they could maintain and employ, would be precisely the same. The capital of the country would be the same, though a greater number of pieces might be requisite for conveying any equal portion of it from one hand to another. The deeds of assignment, like the conveyances of a verbose attorney,13 would be more cumbersome, but the thing assigned would be precisely the same as before, and could produce only the same effects. The funds for maintaining productive labour being the same, the demand for it would be the same. Its price or wages, therefore, though nominally greater, would really be the same. They would be paid in a greater number of pieces of silver; but they would purchase only the same quantity of goods. The profits of stock would be the same both nominally and really. The wages of labour are commonly computed by the quantity of silver which is paid to the labourer. When that is increased, therefore, his wages appear to be increased, though they may sometimes be no greater than before. But the profits of stock are not computed by the number of pieces of silver with which they are paid, but by the proportion which those pieces bear to the whole capital employed. Thus in a particular country five shillings a week are said to be the common wages of labour, and ten per cent. the common profits of stock. But the whole capital of the country being the same as before, the competition between the different capitals of individuals into which it was divided would likewise be the same. They would all trade with the same advantages and disadvantages. The common proportion between capital and profit, therefore, would be the same, and consequently the common interest of money; what can commonly be given for the use of money being necessarily regulated by what can commonly be made by the use of it.
12Any increase in the quantity of commodities annually circulated within the country, while that of the money which circulated them remained the same, would, on the contrary, produce many other important effects, besides that of raising the value of the money. The capital of the country, though it might nominally be the same, would really be augmented. It might continue to be expressed by the same quantity of money, but it would command a greater quantity of labour. The quantity of productive labour which it could maintain and employ would be increased, and consequently the demand for that labour. Its wages would naturally rise with the demand, and yet might appear to sink. They might be paid with a smaller quantity of money, but that smaller quantity might purchase a greater quantity of goods than a greater had done before. The profits of stock would be diminished both really and in appearance. The whole capital of the country being augmented, the competition between the different capitals of which it was composed, would naturally be augmented along with it. The owners of those particular capitals would be obliged to content themselves with a smaller proportion of the produce of that labour which their respective capitals employed. The interest of money, keeping pace always with the profits of stock, might, in this manner, be greatly diminished, though the value of money, or the quantity of goods which any particular sum could purchase, was greatly augmented.
13In some countries the interest of money has been prohibited by law. But as something can every where be made by the use of money, something ought every where to be paid for the use of it.14 This regulation, instead of preventing, has been found from experience to increase the evil of usury; the debtor being obliged to pay, not only for the use of the money, but for the risk which his creditor runs by accepting a compensation for that use. He is obliged, if one may say so, to insure his creditor from the penalties of usury.
14In countries where interest is permitted, the law, in order to prevent the extortion of usury, generally fixes the highest rate which can be taken without incurring a penalty. This rate ought always to be somewhat above the lowest market price, or the price which is commonly paid for the use of money by those who can give the most undoubted security. If this legal rate should be fixed below the lowest market rate, the effects of this fixation must be nearly the same as those of a total prohibition of interest.15 The creditor will not lend his money for less than the use of it is worth, and the debtor must pay him for the risk which he runs by accepting the full value of that use. If it is fixed precisely at the lowest market price, it ruins with honest people, who respect the laws of their country, the credit of all those who cannot give the very best security, and obliges them to have recourse to exorbitant usurers. In a country, such as Great Britain, where money is lent to government at three per cent. and to private people upon good security at four, and four and a half, the present legal rate, five per cent., is, perhaps, as proper as any.
15The legal rate, it is to be observed, though it ought to be somewhat above, ought not to be much above the lowest market rate.16 If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent., the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people,17 who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it. Where the legal rate of interest, on the contrary, is fixed but a very little above the lowest market rate, sober people are universally preferred, as borrowers, to prodigals and projectors.18 The person who lends money gets nearly as much interest from the former as he dares to take from the latter, and his money is much safer in the hands of the one set of people, than in those of the other. A great part of the capital of the country is thus thrown into the hands in which it is most likely to be employed with advantage.19
16No law can reduce the common rate of interest below the lowest ordinary market rate at the time when that law is made.20 Notwithstanding the edict of 1766, by which the French king attempted to reduce the rate of interest from five to four per cent., money continued to be lent in France at five per cent., the law being evaded in several different ways.21
17The ordinary market price of land, it is to be observed, depends every where upon the ordinary market rate of interest.22 The person who has a capital from which he wishes to derive a revenue, without taking the trouble to employ it himself, deliberates whether he should buy land with it, or lend it out at interest. The superior security of land, together with some other advantages which almost every where attend upon this species of property, will generally dispose him to content himself with a smaller revenue from land, than what he might have by lending out his money at interest.23 These advantages are sufficient to compensate a certain difference of revenue; but they will compensate a certain difference only; and if the rent of land should fall short of the interest of money by a greater difference, nobody would buy land, which would soon reduce its ordinary price.24 On the contrary, if the advantages should much more than compensate the difference, every body would buy land, which again would soon raise its ordinary price. When interest was at ten per cent., land was commonly sold for ten and twelve years purchase. As interest sunk to six, five, and four per cent., the price of land rose to twenty, five and twenty, and thirty years purchase. The market rate of interest is higher in France than in England; and the common price of land is lower. In England it commonly sells at thirty; in France at twenty years purchase.
[1 ]The point that loans are in effect loans of goods rather than of money appears in LJ (B) 283, ed. Cannan 220.
[2 ]In his Defence of Usury, Bentham pointed out that a division of interest between borrower and lender reduced the possibility of purely speculative investment: ‘there are, in this case, two wits, set to sift into the merits of the project . . . and of these two there is one, whose prejudices are certainly not most likely to be on the favourable side.’ (Economic Writings, ed. W. Stark (London, 1952), i.181.)
[3 ]See above, I.vi.18 and below, V.iii.35, where it is pointed out that the great merchants are ‘generally the people who advance money to government’. Hume also stresses the importance of the monied class in his essay ‘Of Interest’.
[4 ]The relationship between profit and the rate of interest is considered above, I.ix.
[5 ]In his essay ‘Of Interest’ Hume remarked that ‘when commerce has become extensive, and employs large stocks, there must arise rivalships among the merchants, which diminish the profits of trade’. He added: ‘An extensive commerce, by producing large stocks, diminishes both interest and profits’ and that ‘if we consider the whole connexion of causes and effects, interest is the barometer of the state, and its lowness is a sign almost infallible of the flourishing condition of a people.’ (Essays Moral, Political, and Literary, ed. Green and Grose, i.327.) Cf. above I.ix.4. Cf. Hutcheson, System, ii.72: ‘When many hands and much wealth are employed in trade, as men can be supported by smaller gains in proportion upon their large stocks, the profit made upon any given sum employed is smaller, and the interest the trader can afford must be less.’ Similar arguments appear in the Short Introduction, 219.
[6 ]See above, I.ix.2 and I.x.c.26.
[7 ]The inverse relationship between profit and wages is considered in I.ix.
[8 ]The phrase ‘at both ends’ is used in a similar context at I.ix.13.
[9 ]John Locke, Some Considerations of the Consequences of the Lowering of Interest, and raising the Value of Money (1691), Works, v.47:
[10 ]Cf. LJ (B) 281–2, ed. Cannan 219–20: ‘It is commonly supposed that the premium of interest depends upon the value of gold and silver . . . If we attend to it, however, we shall find that the premium of interest is regulated by the quantity of stock.’
[11 ]David Hume ‘Of Interest’, Essays Moral, Political, and Literary, ed. Green and Grose, i.321: ‘Prices have risen near four times since the discovery of the INDIES; and it is probable gold and silver have multiplied much more: But interest has not fallen much above half. The rate of interest, therefore, is not derived from the quantity of the precious metals.’ And, more positively, ‘High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce: And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver.’ (Ibid., 322.)
[12 ]37 Henry VIII, c.9 (1545) legalized interest in England at a maximum of 10 per cent, reduced to 8 per cent by 21 James I, c.17 (1623), to 6 per cent by 12 Charles II, c.13 (1660), and to 5 per cent by 13 Anne, c.15 (1713). See above, I.ix.5 and below V.iii.27.
[13 ]The verbosity of the attorney is explained in V.i.b.22 as being due to the practice of setting fees in relation to the number of words used in legal documents.
[14 ]See above, I.ix.4.
[15 ]The relationship between the market and legal rate of interest is illustrated at I.ix.5.
[16 ]See also Locke, Some Considerations of the Consequences of lowering the Interest and raising the Value of Money (1691), where the distinction is between the natural and the legal rates of interest. Works, v.9–10. Steuart makes a similar point in discussing the ‘conventional’ and legal rates, Principles, ii.128, ed. Skinner ii.460.
[17 ]By ‘sober people’, Smith means the ‘prudent man’ of the TMS, prudence being that virtue which is concerned with the fortune and rank of the individual. ‘Security . . . is the first and principal object of prudence.’ ‘It is rather cautious than enterprising.’ (TMS VI.i.6.) It is interesting to recall that Bentham objected to Smith’s suggestion for regulation of the rate of interest, partly on the ground that such regulation was a violation of Smith’s own principle of liberty, and partly on the ground that it would discourage those men of enterprize on whom the economic process depends. See especially, Letter XIII of the Defence of Usury, which is addressed to Smith and entitled ‘On the Discouragement imposed by the above restraints to the progress of inventive industry.’ Smith would appear to have had something of a bias against the projector largely because his failures constituted a loss of capital. See for example II.iii.26, but cf. I.x.b.43, where any new manufacture is described as being a speculation, and V.i.e.10, where it is stated that the activities of speculative traders would help to keep down the rate of profit.
[18 ]However, it is pointed out below, IV.i.16, that even sober men may face problems as a result of over–trading.
[19 ]Bentham’s critique of Smith is founded on the argument of this passage. It is reported that Smith described the Defence of Usury as ‘the work of a very superior man, and that tho’ he had given him some hard knocks, it was done in so handsome a way that he could not complain’. The statement appears in Rae, Life, 423–4 on the authority of William Adam; it was suggested that Smith ‘seemed to admit’ that Bentham was right. In an addendum to Letter XIII of the Defence Bentham himself wrote: ‘I have been flattered with the intelligence, that, upon the whole, your sentiments with respect to the points of difference are at present the same as mine’, while stressing however that this information did not come directly from Smith. But the offending passage was not altered in subsequent editions.
[20 ]Cf. Cantillon, Essai, 292, ed. Higgs 221, where it is stated that regulation of the rate of interest must be ‘fixed on the basis of the current market rate in the highest class, or thereabout’.
[21 ]Above, I.ix.9. Cf. M. Marion, Dictionnaire des institutions de la France aux XVII et XVIII siècles (Paris, 1923), 301: ‘En réalité alors comme toujours, le taux de l’intérêt n’a jamais été réglé que par le plus ou moins d’abondance des capitaux et le plus ou moins de confiance qu’inspire l’emprunteur’.
[22 ]A similar argument appears in Hutcheson’s System, ii.73. Cf. Cantillon (Essai, 294, ed Higgs 221): ‘The current rate of Interest in a State seems to serve as a basis and measure for the purchase price of Land. If the current interest is 5 per cent. or one–twentieth part the price of Land should be the same.’ But not so, according to Locke: ‘The legal interest can never regulate the price of land, since it is plain, that the price of land has never changed with it, in the several changes . . . made in the rate of interest by law: nor now that the rate of interest is by law the same through all England, is the price of land every where the same, it being in some parts constantly sold for four or five years’ purchase more than in others . . . this is plain demonstration against those who pretend to advance and regulate the price of land by a law concerning the interest of money.’ (Some Considerations of the Consequences of the Lowering of Interest, and raising the Value of Money, Works, v.38.) Cf. Turgot, Reflections, LXXXV and LXXXIX.
[23 ]See below, IV.vii.c.58, where Smith comments further on the relationship between interest and rent, and V.ii.e.2, where he refers to the rate of interest and building rent.
[24 ]See above, I.x.b.34, and below, III.i.3, where Smith comments on the advantages of investment in land. Cf. Hutcheson, System, ii.72–3: ‘As money grows plentier, and bears less interest in loans, more incline to purchasses of lands than formerly; and this demand raises the rates of lands, so that smaller land rents can be obtained for any sum. Men are therefore contented with smaller interest than formerly when they could have got greater land–rents. They should be satisfied if it surpasses the annual profits of purchases, as much as compensates the greater troubles or hazards attending the loans.’