Between the Lines of Adam Smith’s Endorsement of an Interest-Rate Cap

esotericism interest rates usury just sentiments liberty principle

Jonathon Diesel for AdamSmithWorks

Diesel treats one of Smith’s most discussed exceptions to the liberty principle, namely, his endorsement of the status-quo cap on interest rates. Diesel proposes that we read between the lines. Smith’s argumentation for the cap is immediately subverted by his own statement that lenders can distinguish between sober and unsober borrowers.

" a free-market lenders could of their own choosing refrain from lending at high rates, simply to attract some of the sober borrowers to their pool of applicants."

October 25, 2023
Almost all of what Adam Smith says about loans and interest would lead you to believe that he sees it as an integral piece of the free-enterprise system. Just as Smith dispelled confusions about the demand and supply of gold and silver, likening them to the supply and demand of “pots and pans” (WN, 439), Smith sees the demand and supply of loanable funds as like rental markets for other resources. At the start of the chapter “Of Stock Lent at Interest” in the Wealth of Nations, Smith says that interest is “annual rent for the use of it [stock]” (350).
Odd, then, is the endorsement that Smith—the apostle of “allowing every man to pursue his own interest his own way”—gives to the status-quo cap on interest rates. Jeremy Bentham in 1787 famously and incisively upbraided Smith for the flagrant departure from his own teachings.
Smith does not propose caps on other rental rates or indeed any other kind of prices. So why this one?
Also odd is Smith’s argumentation for the cap. Whatever sense we try to make of Smith’s argumentation, it can be subverted by the logic of his own immediately subsequent remarks.
Things become odder still in view of what Smith said elsewhere about caps on interest rates—and in view of what he did not say elsewhere (for example in the public-policy portion of his Lectures on Jurisprudence).
I suggest that Smith’s endorsement was not wholehearted, even that it was dissembling. The present piece is based on a dissertation chapter, subsequently published in Journal of Economic Behavior and Organization, “Adam Smith on Usury: An Esoteric Reading” (link). Here I avoid extensive analysis of Smith’s text, the discourse situation at Smith’s time, and subsequent scholarship, instead making the main points for an esoteric reading.
Peak esotericism
The time in which Smith lived was a time of peak esotericism, as explained by Arthur Melzer in his master work on esoteric writing and its role in history (Melzer 2014, 12–29, 96). Signs of esoteric writing in a text, Melzer notes, include “something [that] jars the reader, such as incongruity or an uncharacteristic misquotation, it can serve as a marker for where an author has hidden his or her true meaning” (p. 296). Melzer quotes Alexander Pope:
Those oft are stratagems which errors seem
Nor is it Homer nods, but we that dream.
Melzer explains that an author may also hide his true message by dispersing it piecemeal throughout his work (p. 317), and that too pertains to our issue here with Smith.
Dugald Stewart (1753–1828) was well acquainted with Smith, personally and intellectually. He led the way on our issue. Stewart insinuated that Smith dissembled on interest-rate caps, in both Account of the Life and Writings of Adam Smith ([1795]) and Lectures on Political Economy ([1856]). Stewart follows Jeremy Bentham in rejecting Smith’s position on interest-rate caps. Stewart plays a deft game of association where he likens Smith’s tepid justification to that of John Locke’s on the same topic. Stewart goes on to point out that most of Locke’s positions were quite liberal in nature, and that his justification for regulating interest rates were likely an appeasement of current conventions and a compromise of principle to mollify readers (Stewart [1795], 349). Stewart is explicit that Locke dissembled and created the association, strongly suggesting that Smith did as well (Diesel 2021, 734).
In Smith’s writings we find abundant instances of slyness or esotericism. Smith himself taught his students about tactful engagement (LRBL 111-5, 146-7). David Hume’s experience taught valuable lessons about being too direct (Diesel 2021, 736). The Frenchman Pierre-Samuel Dupont de Nemours wrote to Smith in 1788, explaining that in his own work he tempers things: “By assaulting their eyes with a bright light, we would reconstitute their blindness” (quoted in Prasch and Warin 2009, 69). Dupont would later use the same blinding-light metaphor in suggesting that Smith himself engaged in the same sort of dissembling (Dupont [1809], 179).
But why be esoteric about interest-rate caps? Here are some broad points that might begin to answer the question:
  • The concept of usury had a long religious and Biblical tradition behind it, a tradition that promulgated interest-rate restrictions throughout much of the world and over centuries. Smith may have been reluctant to deploy free-market economics to attack laws with strong religious overtones. Libertarians today who favor the freedom to sell sex do not necessarily lead with that unseemly point. Likewise, one might have been reluctant to advocate the freedom to charge ‘usurious’ interest rates. Let me add that in researching the intellectual history of usury, I have come to believe that Smith is not unique; many economic writers, including theologians, treated the topic in ways that seem like dissembling.
  • Smith’s goal was to persuade the aristocracy to embrace liberalism. Such a hope might be dashed by too bold a proclamation. Perhaps it is best to take Smith’s advice regarding Solon, and when the ideal is too much to bear seek the compromise that moves things in the right direction (TMS 233; Clark 2021).
  • Perhaps Smith was worried that an outright endorsement of unregulated loans would appear too friendly to the growing merchant class.
  • Smith may have figured that he would leave it to some forward soul like Bentham to point out the flimsiness of his reasoning and to advocate the legalization of usury.
What Smith says
In the discussion of interest-rate controls that lead to his endorsement of the cap, Smith begins by describing the worst-case scenario of outright bans on interest. No one will lend money without interest. Smith understands that black markets and exploitation are the result of prohibition:
In some countries the interest of money has been prohibited by law… This regulation, instead of preventing, has been found from experience to increase the evil of usury; the debtor being obliged to pay, not only for the use of the money, but for the risk which his creditor runs by accepting a compensation for that use. He is obliged, if one may say so, to insure his creditor from the penalties of usury. (WN 356)
Next, he says that if the cap is fixed too low, “the effects of this fixation must be nearly the same as those of a total prohibition of interest.” Smith continues: “If it is fixed precisely at the lowest market price, it ruins with honest people, who respect the laws of their country, the credit of all those who cannot give the very best security, and obliges them to have recourse to exorbitant usurers [in black markets, that is].”
It is then that Smith endorses the status-quo cap: “In a country, such as Great Britain, where money is lent to government at three per cent. and to private people upon good security at four, and four and a half, the present legal rate, five per cent., is perhaps, as proper as any” (WN 356-7; italics added). And he begins the next paragraph by reiterating that endorsement: “The legal rate [that is, the cap], it is to be observed, though it ought to be somewhat above, ought not to be much above the lowest market rate.”
Smith follows immediately with his justification for such a cap, called “the legal rate,” as opposed to a higher cap:
If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent., the greater part of the money which was to be lent, would be lent to prodigals and projectors, who alone would be willing to give this high interest. Sober people, who will give for the use of money no more than a part of what they are likely to make by the use of it, would not venture into the competition. A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it. (WN, 357.15)
Smith does not explain why, in a freer market, lenders would tend to lend to unsober borrowers. One might infer that Smith is implying that lenders are fated to blindness about the soberness of borrowers, and thus, from the lenders’ perspective, the market for borrowers is like the “market for lemons” in a famous but fantastically far-fetched model (Akerlof 1970).
But what directly follows subverts that reading of Smith, for Smith writes:
Where the legal rate of interest, on the contrary, is fixed but a very little above the lowest market rate, sober people are universally preferred, as borrowers, to prodigals and projectors. The person who lends money gets nearly as much interest from the former as he dares to take from the latter, and his money is much safer in the hands of the one set of people, than in those of the other. A great part of the capital of the country is thus thrown into the hands in which it is most likely to be employed with advantage. (357, boldface added)
So Smith believes that lenders can distinguish the sober from the unsober. Indeed, and as Stewart had noted about Smith’s texts, Smith himself said that most lenders are judicious and borrowers circumspect (WN 341, 342, 350).
What’s more, just a few lines after saying that lenders can distinguish between the sober and unsober, Smith speaks of the experience in France when the king attempted to reduce the cap from five to four percent: “money continued to be lent in France at five per cent., the law being evaded in several different ways” (358).
Some commentators have neglected Smith’s statement about the ability of lenders to distinguish sober and unsober and, on that basis, relate Smith’s discussion to models of asymmetric information in a credit-rationing framework (Stiglitz and Weiss 1981; see Hollander 1999, 528, 544-5). But even if you give Smith only that careless reading, it still would not work as justification for the government imposition of a cap, because, in a free-market lenders could of their own choosing refrain from lending at high rates, simply to attract some of the sober borrowers to their pool of applicants.
Bentham’s Defence of Usury (1787) takes Smith to task. The work was very influential in setting the tone on lending headed into the modern era (Houkes 2004, 394; Persky 2007, 234-5; Rockoff 2009, 295; Chesterton 1933, 67). The 13th letter is specifically addressed to Smith, and it does a convincing job of using Smith’s own words against him on the matter—although Bentham failed to use Smith’s own admission that lenders can distinguish the sober from the unsober.
There is anecdotal evidence from a personal engagement about what Smith said to his visitor when asked about Bentham’s critique. The report is consistent with the idea that Smith’s heart was not really in the endorsement he had given to the status-quo cap on interest rates (see Rae 1895, 423-24; Pesciarelli 1989, 532; Viner 1965, 19; Paganelli 2003, 45).

Jonathon Diesel studied economics at George Mason University beginning in 2001 and culminating in a PhD in 2017. His research focuses on Adam Smith and expanding on Smithian concepts such as jural relationships and distinguishing the jural superior as a unique social role. He lives in northern Virginia with his family where he enjoys weekends watching his children grow. He is employed by a government contractor managing programs and providing systems engineering services.

This essay is part of the AdamSmithWorks series Just Sentiments curated by Daniel B. Klein and Erik Matson. New essays will be published on the fourth Wednesday of the month. You can read more about the series in this Speaking of Smith post, "Just Sentiments- Welcome!". Klein and Matson lead the Adam Smith Program in the Department of Economics at George Mason University, in association with the Mercatus Center. In the program, they study big ideas in jurisprudence, politics, ethics, and economics as they were pursued during the original arc of liberalism, especially in the 18th century in Britain.

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