Explain like I'm 5: Interest Rates
Following text heavily indebted to Edward Chancellor's book, "The Price of Time"
It’s pretty much impossible to read about finance these days without people talking about interest rates, but what exactly are they? The answer is seemingly obvious, but interest is an extremely complex subject. Even the metaphors that are used to describe interest are varied: “the wages of abstinence”, “the cost of leverage”, “the capitalization rate”. Most contain a kernel of the truth, if not its entirety.
In the beginning God said “let there be light”.
And then he said, “let there be interest”.
Interest is much older than money, which originated in the 8th century B.C. In fact, it’s now widely believed that the earliest transactions were for credit rather than barter. The people of the fertile crescent charged interest on loans before they discovered how to put wheels on carts.
In any case, the origin of interest is somewhere deep in our past- some even argue that that interest began with the practice of reciprocating gifts among tribal people.
For these prehistoric peoples, the most important interest was on loans of seed for crops, and livestock. The productive and eventually consumptive uses of corn seed are obvious. Livestock, similarly, have consumptive value as beef or pork and also productive value: they are fecund, and increase and multiply.
These properties naturally lend (hah) themselves to interest. The seeds yield a harvest, at which point the seeds can be returned with an interest. For livestock, one could return some part or all of the animals progeny along with the animal. These practices resulted in the ancient words for interest. Sumerian, mas, “a kid lamb”. Greek, tokos, “a calf”. Hebrew, marbit, “to increase”.
Though the linguistic connection between a loan and its natural fecundity became more abstract over time, the word usury clearly derives from the Latin usarius, “one who has the use but not ownership of the thing.” In the 17th century, a loan was still commonly referred to as the “use” of money.
Interest rates over time
Hammurabi capped the annual interest rate at 33.33% for grain and 20% for silver in his famous code. The ancient Egyptians were not as disapproving of high rates of interest. We have records of 12 month loans bearing 100% annual interest from 900 BC and a tablet from 664 BC recording a loan of grain bearing 75%.
These rates decreased by 100 AD, when Egypt was extremely wealthy. Interest rates were capped at a mere 12%, and compound interest was banned. Compound interest is the practice of charging interest not only on principal, or the face value of the loan, but also on an accumulated interest. So, for example, if I loaned you $100,000 at 10% interest a year, the Egyptians would disapprove of me charging you 10% on $110,000 the following year, not just the principal of $100,000.
By 443 BC in Rome, interest rates were capped at 8.33%. This was further reduced to 4.17% by 347 BC, though the Byzantines tolerated 8-12% interest rates over the course of their empire.
This fixation on interest rates is remarkable. It suggests interest rates were significant enough to cause considerable social unrest, even thousands of years ago.
Usury
An early and enduring problem with interest is that compounding debt tends to become unpayable over time. Furthermore, high real interest rates necessarily benefit existing capital holders and harm the poorest in society. It’s easy to see, for example, that when John borrows barley from Seneca at 5% interest a year, he is getting a better deal than when he borrows barley at 30% a year. So why have interest at all?
Because resources have always been scarce and must be rationed somehow, because wealth is unequally distributed between creditors and borrowers, and because those in possession of capital need to be induced to lend, because borrowing is a risky business.
The intellectual assault on interest dates back millennia. In The Politics, Aristotle declared that usury was immoral because “money was intended to be used in exchange, but not to increase at interest”. Usury has always been seen as socially disruptive, an act of “otherhood” rather than brotherhood. This belief is still widespread. You can hardly go a day without hearing a zoomer talk about how unfair it is that landlords charge rent or make a profit, for example.
Though interest is a charge for the use of money over a certain period of time, the medieval scholastics disapproved of “selling time” because “time belongs properly to God”, and he cannot therefore “make a profit from selling someone else’s property”. This view was ultimately challenged by the Italian renaissance. Europeans no longer believed that time belonged to god alone but rather that it was a dimension of human life, one of man’s possessions which he would do well not to waste.
This does not mean, of course, that the distastefulness of usury had washed away in the mind of the public, or that the social unrest that accompanied scarcity and high interest rates went away.
Proudhon
Proudhon, the famous anarchist, argued in 1849 for the old-fashioned view of interest. Though it was an antiquated stance, elements of his beliefs eventually came into vogue both with elements of the communist movement and in America with figures such as Williams Jennings Bryan1, a populist leftist who is virtually unknown today despite being the Buffalo Bills of politicians during his lifespan.
Proudhon argued that interest was “usury and plunder”, and that usury was an unequal exchange, because creditors didn’t deprive themselves of the capital they lent and thus had no right to demand a greater sum in return. Interest was simply a “reward for idleness and the basic cause of inequality and poverty”.
As a solution, Proudhon argued that the Banque de France should be nationalized, the money supply should be expanded, and interest rates should be reduced close to zero. Gold would be replaced by paper money. In addition, Proudhon demanded a tax on capital tantamount to negative interest rates.
This argument was vigorously opposed by Frederic Bastiat, a free-trade advocate. Bastiat believed that if lending was not rewarded, there would be no lending. Additionally, he believed that in affect, to restrict payments on capital was to abolish capital. Savings would disappear.
For the purposes of this essay, it’s insignificant whether Bastiat or Proudhon is right. Unfortunately, like any good debate, they both have some valid points. Allowing existing capital holders to coast along, their status and influence in society guaranteed, is a bad thing in the long term. Any society that allows too high of a natural interest rate, naturally deprives itself of beneficial churn at the highest levels of power and allows wealth to concentrate in the hands of a few. Additionally, high interest rates breed class resentment, because the poor are almost by definition borrowers and the rich are creditors. Conversely, interest rates serve as a way to allocate scarce resources. Without interest, those with capital now may not lend at all. And if interest is too low, it has other, even more perverse results in the world of finance.
The Effect of Low Interest Rates on Speculation
It has been known that low interest rates tend to produce speculative manias for centuries or more. The Scottish economist John Law, who reduced interest rates in France to 2% in the 18th century and oversaw some of the first experiments with paper money, famously justified the high share price of the Mississippi Company in 1720 with reference to the low prevailing rate of interest.
Value, in capital, really exists relatively to the rate of interest.
For example, consider land. In 1621, an anonymous pamphlet claimed that “land and money are ever in balance against one another, and when money is dear, land is cheap, and where land is cheap money is dear.” He was not very far off.
The price of land should obviously be based off of it’s rents. But if rents in future years aren’t worth less than rent in the current year, an acre of land would be equal in value to a thousand of acres of the same land, which is absurd, an infinity of units being equal to an infinity of thousands.
With interest rates, there is no paradox. You simply reduce the value of future rents based on the prevailing rate of interest and the distance of those rents from you in the future and voila, we have a reasonable value for land. Without this anchoring point, long duration assets can trade wildly and enter into speculative manias.
In Conclusion
Interest rates exist because capital is “fecund”
Interest rates partially determine the social structure of society
Low interest rates seem like they’d be good for the poor, but they may lead to no willing creditors and asset bubbles
Value in capital really exists only relative to the rate of interest
There was a brief “populist moment” in the 1890s in the US. Farmers, upset with deflation and high real interest rates, pushed for bimetalism, i.e. expanding the monetary supply by issuing silver money in addition to gold. The movement began in 1892 and ceased to be relevant by 1896, largely because prices stopped falling in the 1890s anyways due to the discovery of new gold supply in Alaska and South Africa, which doubled the world’s stock of gold between 1890 and 1914. Though the populist plan was too radical to be seriously pursued by later generations of reformers, their core plan, that of an audacious redefinition of money as a contract with the future and not the past, mediated by a democratic central bank, is hugely influential to this day.