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Interest: What Is It and What Happens When We Try to Control It?

Interest: What Is It and What Happens When We Try to Control It?

Interest is a lot more controversial than it should be. Historians, theologians, and philosophers have debated whether it is moral to accept interest on loans. There are Biblical injunctions against usury, Aristotle and other philosophers thought that interest was "unnatural," Karl Marx thought interest was exploitation, and interest is illegal in Islamic banking. Many American jurisdictions have laws governing the interest rates that banks can charge, and a sure way to provoke outrage is to point to the very high interest rates on loans from title pawn and payday loan establishments.

It’s a surprising amount of controversy for something that is simply taken for granted by most people who participate in financial markets, so let’s peek behind the curtain and explore the reasons why we earn and pay interest in financial markets. We’ll do a few things. First, we’ll define it and explain where it comes from. Then we’ll talk about what happens when we try to control it. Finally, we’ll ask whether it is unnatural, exploitative, or earned.

What Is It and Where Does It Come From?

Interest is a price paid for borrowed money. It’s determined like any price in a competitive market: by supply and demand. Demanders pay interest because they want command over resources right now, and suppliers earn interest because they are willing to wait to consume. On the demand side, people might want to borrow money so they can consume now rather than later. Perhaps they wish to smooth their consumption by having a higher standard of living as college students and young adults which they will then pay for later, during their prime earning years.* Maybe they want to take a vacation or buy a new car with money they haven’t earned yet.

People also demand money now because they want to invest in projects that require lots and lots of resources but that could also generate handsome incomes. Maybe gym owner White Goodman wants to build a new gym, but he might not have the millions of dollars he needs just lying around. Fortunately, banks have combined their depositors’ many small sums into the large sums that can finance a large venture like a gym. What he will be willing to pay for access to those resources will be a function of what he thinks he can earn with the new building and equipment.

On the supply side, people save based on their willingness to put off consumption. Consumption-smoothing, which is probably not a very good idea when you’re young, makes sense when you are in your prime working years and thinking about retirement. People save to defray easy-to-anticipate expenses (the "check engine" light is bound to come on eventually), to insure against harder-to-anticipate expenses (a bad diagnosis from the doctor), and so they can have adequate food, clothing, shelter, and entertainment during their retirement years.

What Happens When We Try to Control It?

The amount people are willing to borrow and save will vary based on the costs and benefits of doing so. When interest rates are high, people will borrow less and save more. When interest rates are low, people will borrow more and save less. The equilibrium interest rate will be the rate at which the amount people wish to borrow is equal to the amount people wish to lend. Equilibrium is a moving target because information and preferences are constantly changing, but it has a very important quality: it is impossible to make people better off, on net, by moving away from the equilibrium price of anything, whether it be loanable funds, potatoes, or flashlights after natural disasters.

Let’s suppose (unrealistically) that we decide to pass a minimum interest rate that is above the equilibrium, market-clearing interest rate to prevent borrowers from taking advantage of lenders and to encourage saving. More people would want to save and lend, to be sure, and those who are able to lend would earn more. This might look like a Very Good Thing, but it ignores the other side of the coin. With a minimum interest rate that is above the market-clearing rate, fewer people will want to borrow.

With a minimum interest rate that is above the market-clearing rate, fewer people will want to borrow.

We recently completed a kitchen renovation with the help of a home equity line of credit. If, right before agreeing with the contractor, the government passed a law doubling the interest rate we would have to pay, we probably would've done without the renovation. Gym owner White Goodman might be willing to build a new gym at an interest rate of 5%, but not at 10%. As a society, we would be poorer because some people who would have been willing to borrow and lend at the market-clearing interest rate would be legally prohibited from doing so.

What about usury laws? Don’t they protect borrowers from unscrupulous, predatory lenders?

Sadly, they don’t. While people who are able to borrow at the artificially low interest rate will be better off, ask: what would happen to the amount of lending people are willing to do if we held the interest rate below the market-clearing rate? Fewer people would be willing to lend, which means that some people who would be willing to borrow at the market-clearing rate (and many people who wish to borrow at the artificially-low, anti-usury rate) will not be able to get loans.

Is It Unnatural, Exploitative, or Earned?

Interest is sometimes considered "unearned" income. This is a mistake. Interest might not be a wage or salary you earn for doing your job, but it is still earned in that it requires a combination of sacrifice and prudence. First, you earn interest by abstaining from consumption so you can have something to lend out. When you consume less than you produce, you can lend out the excess so that others can use it. You are doing the work of waiting, of advancing money to people so they can do things that might not pay off for a few years.

Interest might not be a wage or salary you earn for doing your job, but it is still earned in that it requires a combination of sacrifice and prudence.

Second, it takes prudence to find the right projects in which to invest. Banks help solve this problem, but even then selecting the right bank for you and your needs requires judgment and appraisal on your part. The interest payments you receive on your savings represent not just a reward for waiting, but also a reward for being wise in selecting financial institutions.

A lot of things combine to determine interest rates, and like any price interest rates are set by supply and demand. Interfering with interest rates has unintended consequences that work to market participants’ detriment as setting an interest rate floor or ceiling means that people who would otherwise be able to are unable to borrow and lend. Contrary to popular belief, savers do earn interest, first by saving and second by being wise about where and how they save.

*--This is a very unwise strategy, and I counsel my students against it.
Parts of this article are based on classroom discussions in the author’s Principles of Macroeconomics class at Samford University.

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Sandra   |     |   Comment #1
So, are you saying the Federal Reserve (and equivalent agencies in other countries) should stop trying to set interest rates?
alpha (anonymous)   |     |   Comment #5
That's different - Federal Reserve and equivalent agencies set these interest rates as monetary policy - basically using this as a tool to control how much money is in the economy. That basically determines what the market interest rate is. It doesn't have anything at all to do with how "normal" banks operate.
Anonymous   |     |   Comment #2
What are you saying is, if there is no demand for projects, the savers can not demand interest from the bank, in other words we owe the bank money and or favor.
You must be a socialist or democrat, there is no other explanation for this story.
Same like in Europe, negative interest rates if the bank can not land the money out.
Yes, it is true, in Europe you pay 0.1% on all deposit at the bank and you get less principle when you withdraw the money.
Are you preparing us for such scenario or you want to destroy the capital, just like Obama and the democrats like it. If you have savings, you are evil person as per Obama thinking and the democrats salivate and cheer every time he says it.
On the other side, the democrats and Obama borrowed already $7 trillions in the last 5 years and now they say, we can not pay you interest on your loans and can not give you the principal back, just ask China, Japan and the other creditor nations about it and be ready for war.
Anonymous   |     |   Comment #3
Nothing new, I see!  Same old, same old!
alpha (anonymous)   |     |   Comment #4
....I don't think that was what was implied at all? If there is no demand for projects, then people simply wouldn't borrow money - you wouldn't be owed interest, but I don't see how you make the jump to "you should pay the bank for deposits"? (By the way: negative interest rates are an extreme measure to counter deflation. Doesn't mean that you don't have other investment options either.)
Anonymous   |     |   Comment #6
#4, I'm sorry you did not make the connection after the projects, banks are required to use first the savings from the people accounts to fund the projects or re-fi or for purchase money for what ever reason. The savers are the lenders at the banks, if that is not enough, the banks borrows from other banks or issues bonds. The banks are not allowed to use their own money for any projects or demands from the consumers.
#2 is right in his/hers observation. This article is a half baked potato, just to stir interest without conclusion.
#3, you always pop in just to annoy and distract without any substance in your posts. Say what is on your mind and leave the other people to express themselves.