Adam Smith on Interest Rates

interest interest rates macroeconomics money lending

Maryann Keating for AdamSmithWorks

"Smith writes that high-interest rates crowd out productive investments. Does this justify his willingness to damper excessive exuberance coercively?"

July 19, 2023

The following is a response by ChatGPT to the query “Why Is Placing a Ceiling on Interest Rates Inefficient?”:

The concept of interest rates is an essential aspect of modern economies, as it enables individuals and businesses to borrow money and invest in their ventures. Interest rates are the price that borrowers pay lenders for the privilege of using their money. The determination of interest rates is often left to the market forces of supply and demand. However, some governments have attempted to control interest rates by imposing a legal ceiling on them. While the intention may be to protect consumers from exploitation by lenders, placing a legal ceiling on interest rates is inefficient and creates more problems than it solves.

One of the main reasons why placing a legal ceiling on interest rates is inefficient is that it distorts market signals. Interest rates play a crucial role in signaling the demand for and supply of credit. In a free market, interest rates reflect the risk of lending, the cost of borrowing, and the time preference of borrowers and lenders. By imposing a legal ceiling on interest rates, governments interfere with the natural market forces of supply and demand, leading to an artificial shortage of credit. This shortage can lead to rationing, which means that some borrowers may be unable to access credit, even if they are willing to pay higher interest rates.

Another reason why placing a legal ceiling on interest rates is inefficient is that it reduces the incentives for lenders to lend. By capping interest rates, lenders may not be able to cover their costs, including the cost of funds, operating expenses, and default risk. This can lead to a reduction in the supply of credit, which can hurt borrowers who are willing to pay higher interest rates. Additionally, lenders may shift their focus to other activities that offer higher rates of return, leading to a reduction in the availability of credit.

Furthermore, placing a legal ceiling on interest rates can lead to adverse selection. Adverse selection occurs when borrowers who are more likely to default are willing to pay the same interest rate as those who are less likely to default. This means that lenders cannot differentiate between high-risk and low-risk borrowers, leading to an increase in default rates. As a result, lenders may be reluctant to lend, leading to a further reduction in the supply of credit
(ChatOn-AlChat, powered by Chat GPT & Gpt-4, May 15, 2023).

Adam Smith ever so politely would disagree with ChatGPT. Smith realized that a mandated interest rate ceiling is a danger to property rights. However, Smith posed no objection in The Wealth of Nations (WN) to a legal ceiling on interest rates. Jeremy Bentham wrote Smith in the late 1780s suggesting that this was a violation of Smith’s principle of liberty and discouraged entrepreneurship. Yet, Smith refused to revise his conclusion in subsequent editions of The Wealth of Nations. 21st Century economists are more likely to agree with Bentham and ChatGPT than with Smith. However, they might we willing to concede the validity of Smith in assessing the costs to future national productivity versus the benefits of tolerating misbehavior by a few in the loanable funds market.

I. Smith’s Plutological Macroeconomics

Catallactics is defined as the science of exchanges and plutology, as the scientific study of wealth. An Inquiry into the Nature and Causes of the Wealth of Nations positions Smith squarely in the plutology camp analyzing a nation’s policies from a macroeconomic point of view (Liberty Fund Edition, 1981). This is an important distinction that aids in understanding Smith’s position.

The title of Smith’s book is An Inquiry into the Nature and Causes of the Wealth of Nations. Consider that wealth is a stock concept tied to the quantity of machinery, tools, plant, and infrastructure available to a nation and coordinated with labor to produce a given’s year output. Smith writes that high-interest rates crowd out productive investments. Does this justify his willingness to damper excessive exuberance coercively?

Macroeconomic Fundamentals

In “The Accumulation of Capital, or of Productive and Unproductive Labour,” Smith lays out the eternal verities of a nation’s economic growth.

When we compare, therefore, the state of a nation at two different periods, and find, that the annual produce of its land and labour is evidently greater at the latter than at the former, that its lands are better cultivated, its manufactures more numerous and more flourishing, and its trade more extensive, we may be assured that its capital [machinery, plant, tools, infrastructure] must have increased during the interval between those two periods, and that more must have been added to it by the good conduct of some, than had been taken from it by the private misconduct of others, or by the publick extravagance of government.
(WN, Vol. I, Book II, Chapter iii, 32).

Smith, relying on a labor theory of value, writes, “The annual produce of the land and labor of any nation can be increased in its value by no other means, but by increasing either the number of its productive laborers or the productive powers of those laborers who had been employed (32).” Goods produced but not used up in a given period extend the value of labor. Smith writes, “Every increase or diminution of capital, therefore, naturally tends to increase or diminish the real quantity of industry, the number of productive hands, and consequently the exchangeable value of the annual produce of the land and labor of the country, the real wealth and revenue of all its inhabitants (13).” Did Smith’s labor theory of value lead him to assume that there is a finite upward limit to the potential rate of return, knowable to any reasonable person?

Marginal economic theory takes exception to Smith’s labor theory and confirms that value is determined both by preferences and an expanded production function. However, it is not beyond our imagination to realize that any measure of macroeconomic well-being, aside from natural resources, is a function of human effort and capital, embodied with technological know-how.

Smith views labor inputs as mainly homogeneous but emphasizes the role of specialization in economic growth. He uses national comparisons to show that the distribution of labor between industries in one period determines productivity in the next. He suggests that value is best stored in manufactured goods. He is not explicitly concerned with dependency ratios, those in the labor force to the total population. Smith merely states a fact when he writes that both those responsible for creating investment goods and all others are “equally maintained by the annual produce of the land and labor of the country (3).”

In Smith’s time, suppliers of funds tended to be owners not savers in general. He continues, “As the capital [wealth] of an individual can be increased only by what he saves from his annual revue or his capital gains, so the capital of a society, which is the same as that of all the individuals who compose it, can be increased only in the same manner (15). Owners, according to Smith, after replacing depleted capital, may realize a profit. If they do not plan to use this revenue to augment their stock of capital, they may supply this revenue to the loanable funds market in return for interest.

Thus, investors demanding funds are willing to make interest payments, a percentage of the amount borrowed over the years. Smith does not refer explicitly to an equilibrium rate of interest in which the quantity of loanable funds supplied equals the quantity of loanable funds demanded in a given region at a particular time. He does, however, refer to a “market” or “ordinary” rate of interest.

In opulent countries, Smith observed, interest rates were significantly lower than in poorer countries. He explains that revenue from a larger stock of capital exceeded that in poorer countries, but “in proportion to the stock, the profits are generally much less (10).” Today, Smith’s observation holds true in general, although economists suggest that fewer (greater) opportunities for productive investment, as well as a larger (smaller) existing stock of capital, are significant factors in determining lower (higher) rates of interest.

Smith in The Wealth of Nations, focuses on the means available to increase output and provide for a total population. He warns, “Every injudicious and unsuccessful project in agriculture, mines, fisheries, trade, or manufactures, tends in the same manner to diminish the funds destined for the maintenance of productive labour (26).”

What measures exist to freely guarantee prudence and efficiency in the loanable funds market? The primary mechanism is, or should be, the consequence of failure. Smith writes, “Bankruptcy is perhaps the greatest and most humiliating calamity which can befall an innocent man (29).” However, in our times, limited liability for corporations, government deposit insurance, and bankruptcy provisions weaken the consequences of failure.

Consider one example limiting the liability of lenders and borrowers resulting from the failure of First Republic Bank on May 1, 2023. By the estimates provided by the Federal Deposit Insurance Corporation (FDIC), the bankruptcy comes with a taxpayer-funded subsidy of $13 billion guaranteeing First Republic’s depositors (suppliers of funds) plus the absorption of 80% of losses on residential and commercial loans (demanders of funds) previously issued by First Republic Bank.

Smith offers hope: If the uniform, constant, and uninterrupted efforts of every person in attempting to better his or her condition are ”protected by law and allowed by liberty to exert itself”, the profusion of government will not be able to retard the natural progress of a country towards wealth and improvement (30-31).

II. Misbehavior and the Misallocation of Loanable Funds

Smith’s goal in recommending an interest rate ceiling was neither to protect borrowers from exploitation by lenders nor to protect lenders’ loss from unscrupulous borrowers. In “Of Stock Lent at Interest” Smith acknowledges risks associated with the fallible nature of borrows, lenders, and government. The issue is who should bear responsibility for these faillures. Smith could not dismiss the truth that national productivity is “increased by parsimony, and diminished by prodigality and misconduct.” Therefore, he was concerned with the consequences for the wealth of a nation givien a dysfunctional loanable funds market (WN, Volume I, Book II, Chapter iv).

Smith neither minces words condemning individuals who borrow for immediate consumption nor is he willing to acknowledge their role in increasing aggregate demand! He writes that anyone who borrows to spend will soon be ruined and will occasion to repent of their folly. By not confining expenses with income, they will encroach on any wealth or property he or she may own. Remember, Smith is not preaching but writing as an economist prioritizing economic growth. The prodigal’s misconduct “dissipates what was intended to support the industrious,” and “If the prodigality of some was not compensated by the frugality of others, the conduct of every prodigal, by feeding the idle with the bread of the industrious, tends not only to beggar himself, but to impoverish his country (2).”

Smith also has some harsh words for self-serving lenders whose lack of discretion results in the misallocation of loanable funds into the hands of those least likely to employ them to a country’s advantage.

If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten percent, 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 competition. A great part of the capital of the country would 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. Where the legal rate of interest, on the contrary, is fixed but 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. (15).

Does Smith incorrectly assume that lenders are incapable of weeding out unpromising borrowers or figuring out an appropriate risk premium?

When Smith refers to “projectors” he is not referring to some short-term contagion like tulip mania, but rather to speculators making calculated decisions to defraud and gain an advantage in trading on future unknowns. In the private sector, the threat of bankruptcy remains the preferred mechanism for reducing unproductive investments.

However, if economic growth is a priority, Smith identifies the crowding out of loans issued to investors hoping for a realistic return versus career speculators. Smith might smile at the suggestion that large risk premiums are necessary to subsidize radical originality in new technologies. Rather, he might say, an interest rate ceiling, given scarce funds and an uncertain future, would lead to greater diligence in discerning potential.

The consequences of the public sector’s miscalculations or imprudence, unfortunately, lack the immanent threat of bankrkuptcy and must be assumed by private citizens. “Great nations are never impoverished by private, though they sometimes are by publick prodigality and misconduct. The whole, or almost the whole publick revenue, is in most countries employed in maintaining unproductive hands.” Splendid government facilities, established great churches, and great fleets and armies, when unnecessarily multiplied, do not leave a sufficiency for maintaining the productive laborers, who should reproduce it next year. Therefore, Smith writes, “The next year’s output will be less than that of the foregoing, and if the same disorder should continue, that of the third year will be still less than that of the second” (iii, 30). Smith does not propose that the government be charged with the allocation of loanable funds!

Governments, in the U.S. and abroad, undertake destabilizing projects hindering wealth creation. These projects are approved without market tests and leverage local tax revenue. Proponents of such ventures are not actual investors or risk-taking entrepreneurs. Economic development government agencies coordinate with private rent seekers who are paid upfront regardless of a project’s success or failure. These projects are often presented to voters in terms of the number of expected new jobs, seldom justified in terms of present value or any potential stream of community benefits.

Nothing about an interest rate ceiling would preclude governments from issuing bonds. Nevertheless, some states, to guard against official speculation, actually have constitutional provisions prohibiting deficit spending. However, these provisions can be circumvented. For example, if there is no prohibition on municipal or nonprofit borrowing, a state administrating federal disbursements can agree to issue bonds bearing interest for poorly vetted projects. Such cases do not necessarily justify an interest rate ceiling but highlight Smith’s concern about the crowding out of creditworthy loans by “publick prodigality”.

Despite misbehavior in all sectors of the economy, Smith concludes on an optimistic note, “It can seldom happen, indeed, that the circumstances of a great nation can be much affected either by the prodigality or misconduct of individuals; the profusion or improvidence of some being always more than compensated by the frugality and good conduct of others (iii, 27).”

Money and Interest Rates

Smith had no objection to lending money at interest. A lender expects that by forfeiting the use of their funds “he expects in due time it is to be restored to him, and that in the meantime the borrower is to pay him a certain annual rent for the use of it.” If the borrower employs the funds in the maintenance of productive laborers, sufficient value will be created to pay expenses, restore the depreciated capital stock, and pay interest. He fully realized that efforts to outlaw interest have the effect of raising the cost of borrowing in black markets. He argues as well that setting a floor on interest rates increases the potential for illegality. Yet, Smith was convinced that without caps on interest rates prodigals and projectors would outbid “sober people.” (Joseph Persky, “From Usury to Interest,” Journal of Economic Perspectives, Winter 2007, 227-236).

What is it about the interest rate that makes it different from any other price? Like payments made for any other good, Smith notes that interest rates will increase, decrease, and tend towards a “common market” rate. The Wealth of Nations does not employ present value formulations but Smith realized that higher interest rates reduce the present value of long-term credit-worthy investment relative to present consumption.

Like any other good or service, loans at interest are expressed in terms of money. Smith writes that “money is, as it were, but the deed of assignment, which conveys from one hand to another those capitals [investment goods] which the owners do not care to employ themselves…A, for example, lends to W a thousand pounds, with which W immediately purchases of B a thousand pounds worth of goods. B having no occasion for the money himself lends the identical pieces to X, with which S immediately purchases of C another thousand pounds worth of goods. These three loans, purchased with the same pieces of money by three different debtors, are expected to yield in due time sufficient revenue to bring back an amount equal to the principal and interest on the loans (iv, 5). Does Smith intuitively grasp the concept of an unsustainable multiple expansion of loans beyond the understanding of his 18th-century critics?

Because money in circulation was not bank created but tied to a stock of gold or silver, Smith concluded that the price level, not interest rates, reflected the quantity of money in circulation. He says, “It is utterly impossible that the lowering of the value of silver could have the smallest tendency to lower the rate of interest (10).” The revenue stream generated from investment to Smith “is not computed by the number of pieces of silver with which they are paid, but by the proportion which those pieces bear to the whole capital employed (11).” Smith does not explicitly differentiate between a real and nominal rate of interest. However, he recommends that the rate of interest be somewhat in line with the productivity of capital. If a country chooses to fix the highest interest rate taken without penalty, “The legal rate, it is to be observed, though it ought to be somewhat above, ought not to be much above the lowest market rate (15).

In supporting a ceiling interest rate, Smith undoubtedly could not conceive of a Central Bank targeting interest rates as a policy tool for controlling inflation and business cycle fluctuations. However, he might suggest that a known ceiling interest rate rule is less distortionary than Central Bank discretion or “forward guidance” in the loanable funds market. Imposing a general prohibition to reduce the negative externalities associated with an interest rate out of line with productivity, Smith suggests, could be the best alternative.

Smith never used a Marshallian diagram, such as that above, to model a ceiling interest rate. However, doing so clarifies Smith’s macroeconomic position and offers insight into why he was willing to ignore criticism of his interest rate position. Consider that D in the diagram represents the demand for creditworthy loans at varying rates of interest (i) and D’ is the horizontal summation of the demand curve for both creditworthy and unworthy loans. QA represents the total loanable funds available at a given time and place for investment. Suppose interest rates are permitted legally to rise significantly above the market-determined rate, from iE to iL, for example. In this case, the difference between QI and QE represents the loss of funds invested in creditworthy investments; this reduces the capital available to employ labor in the future.

What we learn from Smith is that quantity of loanable funds available at any point in time to support future productivity is finite and could very well be squandered. Certainly, Smith would insist that individuals, either borrowers or lenders, bear personal consequences for their poor judgment, misbehavior, and failure. However, it is the nation as a whole that inevitably assumes the burden of negative externalities generated by dysfunction in the loanable funds market.