This section is from the "Economics In Two Volumes: Volume I. Economic Principles" book, by Frank A. Fetter. Also available from Amazon: Economic
§ 1. Interest subsequent to time-price. § 2. Origin and definition of the term interest. § 3. Interest versus income, or gross versus net interest. § 4. Concealed rate of interest. § 5. Commercial paper. § 6. Mercantile cash discounts. § 7. Long-time loans. § 8. Special markets for money loans. § 9. Capitalization, the clue to the general interest rate. § 10. Time-series of incomes, monetary and non-monetary. § 11. Present dollars and what they can buy. § 12. Blending of the investment premiums into a common rate. § 13. Indicative nature of the interest rate.
§ 1. Interest subsequent to time-price. There remains to consider that form of a price for time which is most prominent in the thoughts of men in the business world, which therefore often is the only form that is recognized - namely, interest on a loan of money, or on credit expressed in terms of money. The buying and selling of anything for a price expressed arithmetically was very unusual until some form of money came into use; and this was particularly true of the sale of timeliness in a barter economy. The loaning of money occurred in the commercial cities of ancient times, but for a long period, in the Middle Ages, was very unusual. The practice again became common in commercial cities of Europe about the fifteenth and sixteenth centuries. The deepest thinkers from Aristotle (b.c. 384-322) to Thomas Aquinas (1224-1274 a.d.) could see nothing in a money-loan but its superficial money-aspect, nothing of its underlying economic nature, and they studied the problem only as one of morals. When, despite all the disapproval of philosophic moralists of church and state, the practice of money loans had become common in commercial circles in cities, the earlier economists began to attempt an explanation of the phenomena. A prevailing rate of premium on money-loans appeared only where money was in use, and therefore at first was deemed to be peculiarly connected with the quantity of money in the country. This idea still widely persists, is indeed the naive theory of every mind until it is corrected by some economic thought. Some economists began to see that the rate of interest on money-loans was somehow a reflection of the general state of wealth of the community, and was not in the long run dependent on the quantity of money in the community. Behind the problem of the rate on contractual loans was seen to be a more fundamental economic problem of value. The explanation of the problem was, however, still begun in the market for contractual loans, the so-called money market. We, having studied the nature of time-preference and of capitalization, are in a position from which to view money-loans in a different way, and to see them in their true character as merely forms in which time-preference sometimes appears in an economy where money is in general use and borrowing is common in commercial affairs.
§ 2. Origin and definition of the term interest. The term interest,1 applied in the Middle Ages to a payment for the use of a money loan, was first a substitute for the word usury. It was intended, by indicating that the lender had something involved in the business, to soften the general opposition of the church and of public opinion to such agreements.
The word interest will be here defined in its original meaning, still almost universal in business circles, to wit: Interest is the amount paid and received according to a contract for credit given in terms of money. Credit is the postponement of the right of either party in an exchange to require immediate delivery of the price agreed upon. The creditor puts faith (credence) in the promise of the debtor. The rate of interest is the percentage that the interest (usually for one year) makes of the principal. The principal is the amount loaned expressed in dollars as a capital sum estimated apart from the interest. Interest, in this sense, always is a price, and not simply an individual's estimate. Its amount is always stipulated by a contract between persons (expressed or implied, as either the customary amount or the legal amount specified by statute law). The interest contract may not illogically be looked upon as a special case of the rent contract, the thing rented being a stated amount of money (the standard of deferred payments or things acceptable to the lender as of equal value) and the rent (interest) being a smaller amount of money. Interest is payable at stipulated periods until the money loaned is returned. The expression of the interest as a percentage (rate of interest) is of great practical convenience, permitting as it does payment of parts of the principal and for partial periods of a year without alteration of the contract. Moreover, the expression of interest as a rate per cent of the principal gives to the interest problem an aspect very different from any presented by the rent problem.2
1The economists of the eighteenth, and early part of the nineteenth, century gradually broadened the term to include any income attributable to those goods generally bought and sold in terms of money. Later the term was extended to include, tlio never consistently, a large part of the problem of time-value, the nature of which was beginning to be seen.
§ 3. Interest versus income, or gross versus net income. The sum paid as interest on a loan and the rate specified contain other elements than a pure time-price. This is recognized constantly in practice and must be observed in theory.
2 When the amount of the loan is expressed as more than the borrower receives, the deduction being either in lieu of, or in addition to, an expressed percentage, the deduction, called discount, is interest taken in advance, and therefore is not exactly equivalent in rate to the same payment at the end of year, the time at which the usual rate is calculated; e.g., if a note for $1000 is discounted at 6 per cent the true principal is $940, and the true interest $G0 at the rate of .06383. See ch. 23, sec. 3, note.
Gross interest must be distinguished from net interest. The lender does not, as in most cases of rent, have to make allowance for repairs and for physical depreciation of the objects loaned, for the borrower is bound to return the specific standard of payment; but allowance must be made first for risk, or the chance that the money will not be all returned or paid promptly. Risk and trouble are to interest what depreciation and repairs are to rent. (Chapter 15, section 2.) Money loaned in hazardous ventures must yield a higher contractual rate of interest to offset this, or the true rate realized will, on the average, be less than the market rate. The lender may in the end get either more or less than the usual interest, or even get negative interest through the loss of a whole or a part of his capital. A lender strives in making a number of loans to have the gains cancel the losses, so that the capital may be kept intact, besides yielding a net income (interest). The lender must also count the cost of placing, supervising, and collecting the loan. A pawnbroker lends only small sums and spends much time and effort to keep at interest a moderate capital. The sum of $5000 loaned for a year in sums averaging $10 represents 500 transactions, yet if placed at 5 per cent it yields an income of but $250 a year.3 While, therefore, the borrower of a small sum may think he is paying an oppressively high rate of interest, the lender may find that the loan nets him a very small rate of income on the investment. Risk, labor, and the various costs of carrying on the business of lending money, are thus costs in exchanging things of different time-periods which are analogous to transportation charges in exchanging things at different places, narrowing the margin of advantage and excluding many from the exchange.
3 The Provident Loan Association of New York is a corporation organized as a philanthropy to release the poor borrower from the jaws of the "loan-shark"; but it is conducted on business principles to pay expenses. It finds that the minimum cost of making a loan, even the smallest, is about 49 cents. Yet it makes a large number of loans of amounts less than $10, and for not over a month at the rate of 1 per cent per month (or 10 cents at the maximum). This loss must be made up by the larger loans.