This section is from the "Economics In Two Volumes: Volume I. Economic Principles" book, by Frank A. Fetter. Also available from Amazon: Economic
§ 8. Special markets for money loans. The choice of timeliness is possible in a market along any one of many series of incomes, but in commercial circles trade in timeliness most commonly takes the form of money-loans. Let us see how this would appear. Let lender A offer some dollars at 10 per cent interest (or more); let borrower B be ready to borrow some dollars at 16 per cent (or any less). Then there is a motive for trade (omitting fractions) for a loan at any rate between 15 and 11, let us say 13 per cent. But this motive exists only with respect to certain marginal units of money, not without limits. A could not give up all his control over income during the year for 13 per cent for that would mean greater present deprivation than he chooses to make; B would not borrow much beyond a certain amount even at less than 13 per cent, for he would have to pay interest either for less urgent personal desires (consumption loans) or to get control of incomes which to him will yield a smaller surplus.4
If there are numerous competing would-be lenders and borrowers there is a true lending market. The various preference rates (each regarding successive dollars, viewed with relation to the marginal valuation) unite into hypothetical bidders' curves (as in the market for commodities, see Chapter 7) and a price results that establishes equilibrium between demand and offer.5 So in a market all the individual bids
4 If B (having good security to offer) should bid a very high rate of interest (say 20 per cent) either through bad judgment or because of a chance to buy under-capitalized goods (or incomes) it might induce A to sell his goods which involve a premium of, let us say, only 10 per cent, to lend the proceeds to B; A meantime could escape any deprivation by renting the goods he had sold, for a little more than half of the interest he is receiving. A is then not using fewer present goods but is temporarily taking advantage of a chance to substitute a more advantageous mode of purchasing both present and future incomes.
5 This may be traced on figure 11, showing how various bids meet in that are satisfied and enter into the making of the market-price are modified by trade; the urgent bidder (or bidders) on either side is included on the marginal principle, the units most easily spared being loaned, the units most urgently desired being borrowed. As in the market for objective commodities, so in the market for loans, the valuations of the various individuals within a certain range are thus brought into conformity with the market-price. The earlier isolated valuations cease to be actual; they are, as we look back at them, merely of historical interest, and as we look forward, are only hypothetical, being the rates at which preference would appear under other conditions than the present. (See Chapter 7, section 7.)
Under these conditions the price of loans (expressed as a rate of interest) has to the superficial view an appearance of independence, as if the market for loans were a thing apart from the existing premium involved in capitalization. But this loan market could not exist apart from an existing status of prices. Money borrowed to keep would indeed be barren of any income; it would even cease to be money.6 The representative character of money makes a loan mean to the borrower the loan of whatever use-yielding, or whatever rent-bearing, agent can be bought with the amount of money borrowed; and makes it mean to the lender parting with the purchasing power to buy goods at their present prices. The loan market is meaningless and motiveless, if it be thought of as cut off from the existing system of prices (capitalization) .
§ 9. Capitalization, the clue to the general interest rate. a common price. The excluded lenders on the line to the right of the price point are those who hold their present dollars (or a part of them) rather than lend further at the market-rate of interest; the excluded buyers are those to whom further loans at the market will cost more than the expected increment in incomes.
6 Of course cases occur where after the loan is made, the money is kept for a while awaiting a better time to buy the incomes which are to yield the increment of price.
In agreeing to pay interest at a certain rate, the borrower is obviously selling to the lender the right to collect a series of future money incomes including the return of the principal, and is in return buying a present sum of money. The principal is the result of capitalizing the incomes, so discounted that they will emerge at the rate of interest specified on the investment of capital. A thousand dollars at 5 per cent will yield an income of $50 a year until the principal is repaid. The loan is in perpetuity unless a date of payment is named. The form of the loan at interest plainly is that of the exchange of a larger (future) sum of money for a smaller (present) one. From ancient times this has seemed on the face of things a moral wrong to the borrower and an economic mystery, therefore an economic absurdity. " Money is barren," said Aristotle, and his thought is often echoed to-day in communistic arguments against the loan of money at interest. " The borrower pays interest and agrees to this unequal bargain because he is made to pay," is declared on the one side; " he pays because he can afford to pay," is answered from the other. Both statements may be right yet their very form indicates that the problem is looked upon as one of morality rather than of economics. The borrower doubtless would not make such an agreement unless he chose to do so; his choice, as every choice, may be thought of as due to economic pressure or to economic advantage, as a choice of evils or a choice of benefits. Why must he (can he be made to) pay interest if he is to get the loan? How can he afford to pay interest?
After the foregoing study of time-preference and capitalization we have not far to go to find the explanation of the contractual rate of interest at which incomes are yielded on money loans. No borrower would or could, for long, pay interest on money and let it lie in a chest. What does he do with it? He buys things. Everything he can buy has a price, is capitalized, and the explanation of the interest rate lies in the relation between the price of goods that present money will buy, and the price of the series of incomes which those goods will afford up to the time of the repayment of the loan.