Adam Smith's Simplified Wealth of Nations, Book 1, Chapter 9b: Interest Rates
Chapter 9b: Interest Rates
The Effect of Laws on Interest Rates
A defect in the law may sometimes raise interest rates above what is needed by the country.
- When contracts are not enforced, all borrowers are treated in the same way bankrupts or people of doubtful credit.
- The uncertainty of recovering his money makes the lender demand the same usurious interest usually required from bankrupts.
- Contracts in barbarous nations was left for many ages to the faith of the contracting parties.
- They were seldom dealt with by the courts.
- This caused high interest rates during ancient times.
17When the law prohibits interest, it does not prevent it.
- Many people must borrow.
- Their only lenders would be those who would want something in return for:
- the use of their money
- the difficulty and danger of evading the law
- Mr. Montesquieu points the cause of the high interest rates in all Muslim nations not from poverty but partly from:
- this law
- the difficulty of recovering the money
18 The lowest ordinary profit rate must always be something more than what is sufficient to compensate the occasional losses of employing stock.
- Only this surplus compensation is neat or clear profit.
- Gross profit includes:
- clear profit or the compensation for occasional losses
- what is retained for compensating extraordinary losses
- The interest paid by the borrower is in proportion only to the clear profit of the lender.
19The lowest ordinary interest rate must be more than sufficient to compensate the occasional losses in lending.
- Were it not more, charity or friendship could be the only motives for lending.
In a country with maximum riches, where all businesses had maximum stock employed, the ordinary clear profit rate would be so small and interest rates so low.
- Only the wealthiest people could to live on the interest of their money.
- Those with less wealth would be obliged to employ their own stocks.
- Almost every man should be in business.
- Holland seems to be approaching this state.
- Business there is a common necessity and entrepreneurship a fad.
- Idle men there will be less tolerated just as a non-military person will be despised in a garrison.
The highest ordinary rate of profit among commodities, eats up the landlord's rent and leaves only the lowest wages.
- The worker must always be fed while employed, but the landlord is not always paid.
- The profits of the East India Company in Bengal is perhaps not far from this rate.
The proportion of the usual market interest rate to the ordinary clear profit rate varies as profit rises or falls.
- In Great Britain, merchants see double interest as the usual profit.
- If the ordinary clear profit rate is 8-10%, it may be reasonable that half of it should go to interest if the business is funded by loans.
- The borrower insures it to the lender at the rate of 4-5%.
- It may be sufficient profit for the risk to the lender and compensation for the trouble of employing the stock.
- But the proportion between interest and clear profit might not be the same in countries where the ordinary profit rate was much lower or much higher.
- If it were much lower, half of it perhaps could not be afforded for interest
- If it were much higher, more might be afforded for interest.
In countries fast advancing to riches, the low profit rate in commodities may compensate high wages.
- It may enable those countries to sell cheaper than their less thriving neighbours who have lower wages.
24In reality, high profits tend much more to raise the price of work than high wages.
- If the wages of flax-dressers, spinners, weavers, etc. in linen production should be raised by 2-pence a day:
- The price of each finished linen would only be raised by 2-pence multiplied by the number of workers employed, multiplied by the number of days they took to produce it.
- The wage part of the price of the linen would only rise arithmetically in proportion to this rise of wages.
- But if the profits of all the raw materials for linen were raised to 5%, the profit part of the price of the linen would rise geometrically in proportion to this rise of profit.
- The employer of the flax-dressers would increase the selling price of his flax by 5%.
- The employer of the spinners would also increase prices by 5%.
- This includes the higher price of the flax and the wages of the spinners.
- The employer of the weavers would also increase prices by 5% for the same reason.
- Raising wages raises the price of commodities in the same way as simple interest raises the price of loans.
- Raising profits raises the price like compound interest.
- Our merchants and manufacturers complain of the bad effects of high wages in raising the price, which lessens the sale of their goods.
- They say nothing about the bad effects of high profits.
- They are silent with regard to the pernicious effects of their own gains and complain only of those of other people.
Next: Chapter 10a: Wages and Profit