Aristotle’s View of Interest
Aristotle and the Scholastic thinkers believed that charging interest was morally wrong because money itself does not produce anything. According to them, money is “sterile,” and therefore earning income merely by lending it was considered unjust. However, they allowed certain exceptions, such as compensation for risk or effort involved in lending, which they did not consider entirely impermissible.
Development of Interest Theory (1600s–1700s)
During the 17th and 18th centuries, economists began to give more practical explanations of interest. Nicholas Barbon argued that interest is similar to rent, as money is borrowed to purchase goods and assets, and interest becomes a payment for their use. Later, David Hume explained interest in terms of demand and supply of funds. He stated that interest depends on the demand for borrowing, the availability of money, and the profits earned from commerce, emphasizing that higher profits increase borrowing demand and thus influence interest rates.
Fructification Theory (Turgot)
Anne Robert Jacques Turgot introduced the fructification theory to explain why interest rates are generally positive. He used the concept of opportunity cost, arguing that money can be invested in productive assets like land, which generate returns. If interest rates were zero, land prices would rise infinitely, which is not realistic. Therefore, a positive interest rate is necessary to maintain balance in the economy. This theory brought the analysis of interest closer to scientific reasoning.
Classical Theory of Interest
The classical theory, developed by economists such as David Ricardo, John Stuart Mill, and Irving Fisher, explains interest as the result of the interaction between saving and investment. Saving represents the supply of funds, while investment represents the demand. People save to consume more in the future, while borrowers, including entrepreneurs and governments, borrow to invest or meet current needs. The rate of interest is determined at the point where saving equals investment, ensuring equilibrium in the market for loanable funds.
Keynes’s Criticism of Classical Theory
John Maynard Keynes criticized the classical theory for its limitations. He argued that it ignores the role of money and assumes full employment, which is unrealistic. Keynes pointed out that the classical approach involves circular reasoning, as investment depends on interest rates, but interest rates are also said to depend on investment. He emphasized that changes in the money supply can directly affect interest rates, which the classical theory fails to explain properly.
Theories of Exploitation, Productivity, and Abstinence
Different economists attempted to justify interest in various ways. Some, like Ricardo and Marx, viewed interest and profits as a form of exploitation of labor. Others, like McCulloch, explained interest through productivity, suggesting that capital increases output and thus earns a return. Nassau Senior’s abstinence theory described interest as a reward for saving and postponing consumption, though this idea was often criticized for having moral implications.
Wicksell’s Theory
Knut Wicksell introduced a distinction between the natural rate of interest and the market (monetary) rate. The natural rate is determined by real economic factors like savings and investment, while the market rate is influenced by financial systems. Wicksell argued that if the market rate is lower than the natural rate, prices will rise, leading to inflation, and if it is higher, prices will fall. Stability in prices occurs when both rates are equal.
Austrian Theory of Interest
Economists like Eugen von Böhm-Bawerk and Murray Rothbard explained interest through the concept of time preference. They argued that individuals prefer present goods over future goods, and interest is the reward for postponing consumption. According to this view, interest is not limited to loans but exists across all stages of production in the economy.
Pareto’s View
Vilfredo Pareto believed that interest is determined as part of the overall economic equilibrium. He argued that it is not caused by any single factor but is influenced by multiple economic variables simultaneously, making it unnecessary to search for one specific cause.
Keynes’s Theory of Interest
In his famous work The General Theory of Employment, Interest and Money, Keynes developed the liquidity preference theory. He explained that interest is the reward for giving up liquidity, meaning the willingness to hold money. The rate of interest is determined by the demand for money (liquidity preference) and the supply of money, rather than just saving and investment.
Interest-Free Economy
An interest-free economy is one in which pure interest does not exist. Such an economy may still function using money, credit, or loans, but financial institutions earn through administrative costs or service charges instead of interest. Historically, many societies discouraged or prohibited interest due to moral or religious beliefs. However, even in such systems, other components like risk and operational costs may still remain.