In a modern society there is always a good deal of borrowing. This is a natural consequence of the fact that those who have money are not always the same people as those who can see a profitable use for it. Everyone is therefore benefited if the money is lent at an appropriate charge.
The need for the charge arises from the fact that when a person lends money he suffers a detriment in three ways. He cannot use the money himself should he suddenly find he needs it, he takes the risk that he will lose some or all of it and he takes the risk that the value of money will fall during the currency of the loan; he therefore demands a price for the loan. This price is what is usually called interest, though as the next paragraph indicates, it contains elements which the economist would not recognise as interest.
Interest is thus a price paid for the loan of money capital. Sometimes part of what is charged as interest is not strictly interest at all, being a payment for risk rather than a payment for the use of capital. Sometimes borrowers find that they cannot raise funds except at a very high rate of interest. The reason is that lender shave some doubt about whether they will be repaid in full; consequently they will not lend unless they are paid a rate high enough to make this risk worth their while. This extra payment, being an insurance against default, is not strictly interest. Interest is solely that part of the payment which is made for the loan of the funds without counting any insurance against risk.
Interest is usually regarded as a feature of a money-using community. This is not necessarily so, and in fact some kind of calculation of interest rates must be made even by a Robinson Crusoe who wishes to obtain the maximum benefit from the resources at his disposal. Suppose a man cast on a desert island discovers that by fishing from rocks by the sea he can catch an average of five fish in a day. He guesses that if he had a boat he could increase his catch to seven. Making the boat takes him twenty days, during which period he has no time for fishing. The fall in consumption we may regard as saving; the building of the boat is investment and the boat when finished is capital. He is now able to catch seven fish per day using the boat, so that the extra two fish per day may be regarded as the return on his capital interest. The boat will have paid for itself in fifty days or approximately seven times over in a year. The rate of interest on the investment is therefore approximately 700 per cent. per annum.
Boat building is not the only investment our Robinson Crusoe might make. He might for example catch wild goats and breed them, keeping them in a pen which he would have to make. If his investment is to be rationally conducted he will have to make some kind of calculation of the return from each project. He will then undertake those which yield a higher rate of return before those which yield a lower rate.
Some kinds of investment do not yield a measurable return but will nevertheless increase his comfort. An example might be the building of a hut to live in. He would have to decide whether the marginal utility of the hut was greater or less than the marginal utility of the extra fish the boat would yield.
These problems are fundamentally the same as those met in a money-using community. The community has to decide such problems as whether to build power stations, electrify railways or increase chocolate-making capacity. The test must be the return on the investment. A dictator in charge of production would have to estimate the resources available for investment, arrange all the claims for these resources in order of their yield and decide how many could be met. He would then have to set a particular rate of yield as the rate which would have to be satisfied by any line of investment claiming the available resources. Some kinds of investment would have to be evaluated on grounds of social utility instead of measurable return but this does not affect the principle.
In a ‘free’ society these decisions are made not by a dictator but by the operation of market forces. Those planning profitable investment will be able to offer higher interest rates than those planning less profitable investment and so market forces will direct capital into the most remunerative lines of investment.
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