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Saturday, August 21, 2010

Defending the Wicked Part 12: Usury

Usury is the act of charging excessively high interest rates, it is often characterized by being above the legal rate. The obvious position that most people take towards usury is that it is exploitation and stealing money from other people and so we need laws against interest being too high. I am going to defend usury and argue that the interest rates need to be set by the market rather than by some mandated artificial law. If through the market interest rates become excessively high then so be it, it must be left alone at this rate and not tampered with. Therefore, I will defend usury.

In the process of defending usury I will also defend a group of people who consistently went through difficult times because of usury. And those were the Jews. Throughout history the Jews have been accused of committing usury. When a country fell into economic problems they blamed the Jews for all the mess in the economy by saying that the usury of the Jews brought forth about the economic breakdown. Instead of seeing usury as the effect of a bad economy they saw it as the cause of their problems. Since Jews mostly worked as moneylenders they were usually the first people to get into lots of trouble. This is what lead to a lot of Jews being killed or banned from a country. Thus, not only am I defending usury I will in a way be defending the innocent Jews of past history that were either expelled or murdered by countries where they lived at.

Before we can defend usury we need to understand what interest rates represent. Where do interest rates cometh from? The answer to this question depends on whose point-of-view you are looking at it from. The answer will vary between the point-of-view of the creditor and the debtor. For the debtor, interest is the willingness to have money now than the future. The more desire the debtor has to have money at the moment the higher he would be willing to pay. This is fine except interest is always some percentage. If interest was just the willingness to pay for money now than the future then it can be purchased for a fixed given price, say $100 per loan. Why is it rather that interest is always in a form of a percentage? The answer is based on understanding interest from the point-of-view of the creditor. For him interest rates measure the risk involved in giving loans. Loans are always borrowed under risk. There is always some risk that the loan will not be paid back. If the lender simply gave away money with no interest then in the long run he would be running at a loss. The lender must charge an interest rate to repay off his inevitable losses. Here is an example. Suppose that the lender knows that there is a 20% chance that a borrower will not repay off his loan. How he knows that is not important here, we are just assuming he knows this figure. If it is 20% risk then the lender must charge an interest rate higher than 20%, say 25%. Consider the scenario of 5 borrowers all taking a $100 loan from the lender. Under this model one of the borrowers will not pay off the loans, so the lender losses $100. But at the same time he gains $25+$25+$25+$25=$100 from the other borrowers who paid of his loan, so he did not lose anything. This is the necessity of charging interest in terms of percentages rather than fixed payments. Because the percentages reflect the probability behind a loan at risk. Giving loans is therefore like a gamble. A casino does not operate in a way to never lose money, rather a casino operates in a way to win more money than it loses. It does so by calculating the correct probabilities in various games. Interest rates are likewise a gamble. The creditor does not operate to never lose his loans but operates in a way so that the amounts of money he gets from authentic debtors is sufficient to pay off his loses and furthermore earn him some profit.

Interest rates are therefore determined by the willingness of the borrowers and the risk involved in giving loans. It is important to understand this point. Be sure to understand that interest rates are not arbitrary decided upon by the creditors. This seems to be the whole confusion about the issue of usury. The way people look at the loanshark is some incredibly greedy person who makes his rates purposely so high to cause harm to other people. No. The loanshark is irrelevant here, the amount of value people have to immediate money over eventual money and the risk involved in giving a loan is what is important here. That is to say, there is something inherent to high interest rates, not some artificial decision of the loanshark.

But this alone does not determine the market interest rate. That is determined by supply and demand. The inherent nature of how much people want to have immediate money and the risk of a loan determines the demand and the supply respectively. Now it begins to make sense why interest rates become excessively large. If there is an economic disturbance in some country the people have more demand for having immediate money. But at the same time the risk is very high because lots of people would not be able to repay their loans. So the demand becomes high and the supply is limited because not many people are able to loan high risks. This causes the market interest rate to become very large.

The point of all of this is to emphasis that the loanshark is completely irrelevant. If he decides to charge excessively high interest rates that he artificially decided then his competitors would win over him. This means that loansharks set their interest rates roughly what the nominal interest rate is. Loansharks do not just pull a random high figure out of their anus and decide it to be their interest rates, there are forces of economics at work here that set the correct interest rates based on these factors.

If an airplane crashes it would be silly to blame the law of gravity for that. The laws of physics are entirely unconcerned about what happens with airplanes. In the exact same manner these economic laws are almost like the laws of physics. They are entirely unconcerned about people and what happens in the world, they do not judge, they just act. A loanshark is just a byproduct of the market, he is not relevant to it. He has no control over this issue. Thus, there are certain realities at work that decide upon the market interest rate. And it is foolish to condemn anyone for these laws working out the market rate. If a country is headed for tough times ahead then it is likely to see very high interest rates, those rates, if left untempered with, just correspond to certain economic realities that make them be what they are. No one is to blame here. It is the economic problems of a country that may cause high interest rates, not the high rates causing instability of the country, to confuse this is to confuse the effect for the cause. And therefore, the loanshark is not wicked, he is just providing loans for people at the appropriate market rates.

[Note, the above analysis of interest rates is entirely my own. I may be wrong in how I explain them. I know there is some difficulty in interpreting Adam Smith's Wealth of Nations chapter IX where he says that interests rates rise if there is more profit being made of stock. It seems that higher profits of stock implies that a country is in prosperous economic times. But if this is the case then what I describe is the exact opposite situation. I hope that Smith is wrong here, or perhaps I misunderstood him.]


  1. Are you coming up with the choice of topics on your own, or are they borrowed from Block, or what?

    I don't really know where you're going with your interest rate discussion. I'll say this, though - in economics we separate risk premium, rent, interest, and profit, so the risk premium should not be included in the interest. The interest is what you pay, as you say, for having the money now vs. later. The risk premium is what you pay for the faith placed in you by the creditor. To separate them, we use the thought experiment of the ERE, where there is no profit and no risk, but interest remains.

    So, looking just at the interest rate, what is it? Well, suppose I offer you an apple, and tell you I can give it to you today, or next year. Which do you prefer (for simplicity, it's the same apple both times.) Clearly, you'd rather have it now, and not just because it will rot, and not just because I might reneg, but because you prefer to satisfy your wants now rather than later. Similarly, if I offer you $100 now or in a year, you'll choose now. Now, if I want to induce you to choose a year instead (assume you know I'm good for it, so there's no risk, and I have full knowledge, so there's no profiteering going on in either direction) I have to offer you more money. That's called time preference, and time preference rates vary among individuals. If you have a high time preference, it means you strongly prefer to consume vs. invest.

    Now, suppose you and I have different time preferences. You'd need $200 to induce you to choose a year, and I'd need $120, so you have a higher time preference than I do. Since you consider $100 now to be like $200 in a year, you'd be willing to take $100 now and repay anything less than $200 in a year. I'm willing to loan you the $100 now, and I'll take anything more than $120 in a year. So we agree on, say, $130.

    Now, this isn't a pure example. There's profit in there, too - in this case, on both sides. To get the profit out, you'd need a perfectly competitive market where if I offer too much money, someone else will take the offer faster than you will, and I'll walk away if there's too little. However, you can see in this example how the interest arises.

    The person giving the loan is willing to foregoe present consumption; the person receiving the loan is willing to suffer in the future.

    Now, you ask why it's in a percentage rather than a fixed amount. I can only blankly stare - prices are always proportional, but it's not always so obvious. Interest rates are in percentage for the same reason that house prices depend on the amount of house you get - the "price of money" depends on how much money you get. It's like buying a chocolate bar vs. 10 bars - you pay 10 times as much. If you want, express the percentage as much cents on the dollar.

    It is absolutely crucial that interest rates move freely. Interest rates sort out time preference across the economy, which is the crucial signal to entrepreneurs as to whether or not capacity needs to expand, and what type of products will be desired in the future. They might guess wrong about the specifics, but it tells them if they'll need durable, high cost goods or cheap, throw away goods. When interest rates are pushed down (the most common activity) by, for instance, FOMC actions, the result is an inflationary bubble, followed by a depression or recession.

  2. Your explanation of interest rates is a bit off. Smith's terminology is no longer used. Together, this causes the confusion. I had written out an explanation on interest rates, but your site threw it away and I don't feel like retyping. If you're interested, ask me and I'll do it again. (economics teacher)

  3. "Are you coming up with the choice of topics on your own, or are they borrowed from Block, or what?":

    I am making up these topic myself, not everything I discuss is economics. I do not think Block covered usury in his book. I wanted to cover them so that I can implictly defend the Jews of the past who got into trouble for usury.

    "Your explanation of interest rates is a bit off. Smith's terminology is no longer used. Together, this causes the confusion. I had written out an explanation on interest rates, but your site threw it away and I don't feel like retyping. If you're interested, ask me and I'll do it again.":

    This was the one post I was not very confident in. I was making up explanations as I was writing it out, but I think I got a few important things right about why interest rates need to be set by the market. Instead of writing anything out if you can link me to some sites explaining interest rates then I would be interested (pun!) to read them.

  4. Sure thing. I'll send you an email.

  5. Hmm, I don't know your email address. Here are some links:

    Let me know if any questions.