In the previous posting on this subject, we noted that the difference between interest per se and usury is that interest is a legitimate sharing of profits on some equitable basis, while usury consists of taking a profit where no profit is due. Complicating understanding of this difference is the confusion between past savings and future savings, and the different types of money derived from each of them.
This is based on the first principle of finance, which is to know the difference between a mortgage and a bill of exchange. The difference is actually very easy to understand once you get out of the “past savings paradigm” and recognize the existence and legitimacy of “future savings.”
A mortgage is a past savings instrument and is only legitimate if the issuer owns the asset on which the mortgage is drawn at the time the mortgage is drawn. Charging interest on a productive project financed with past savings is perfectly legitimate because somewhat has put what he or she owns to work generating a profit and by right of private property is due a share of what is produced.
In contrast — or, perhaps more accurately, in tandem — a bill of exchange is s future savings instrument and is issued on the creditworthiness of the issuer. The issuer does not have to own or even have in his or her possession what he or she promises to deliver on the maturity of the bill at the time the bill is issued. (Mortgages are “drawn,” bills of exchange are “issued,” while bills of credit are “emitted.”)
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| There's a difference between interest and usury |
Charging interest on a bill of exchange or bill of credit is illegitimate because the issuer is not actually borrowing existing money out of past savings but is creating new money out of future savings. Instead of paying a rate of interest, then, a bill is issued for a certain amount and discounted from the face value. On maturity it is redeemed at the face value.
For example, suppose you want to finance a capital project that will cost you $98,000, but is expected to pay off in the amount of $117,000 in ninety days, with a 2% risk that it will not pay off. You go to a commercial bank with your proposal, they check it out, and agree to issue you a promissory note worth $98,000 today in exchange for your $100,000 bill of exchange, due in ninety days.
Your bill has been “accepted” and discounted at 2% to its present value of $98.000. In ninety days if the project pays off as anticipated, you pay the bank $98,000 is created and which the bank now cancels, and a $2,000 service fee or discount, which is the bank’s revenue and out of which it must meet its expenses and make a profit. Your profit is $15,000 ($117,000 - $100,000 - $2,000 = $15,000), or $15.3%
Note that the 2% is a discount rate, not an interest rate, even though many people call it that. It is not a share of the profits you owe the bank, but a service fee for creating new money and taking a risk on your behalf. Morally, it is due whether or not you make a profit because the bank performed a service by creating the money, and the bank — not you — is liable when somebody presents your check for payment. The bank owes the creditor, but you owe the bank.
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| All usury is interest, but not all interest is usury |
So, when using money for a productive project, you owe interest if the loan is made out of past savings, and a service fee or discount if the loan is made out of future savings. None of this comes under the heading of usury or “dishonest profit.”
The case is different if money is lent for consumption. This should only ever be out of past savings, never future savings. Even restricting lending for consumption out of past savings gets a little complicated.
In general, if existing money is lent for consumption, the lender is due back only the value of what is lent. Admittedly, this can get a little complicated and raises some ethical questions that we cannot get into here in any depth.
For example, suppose you lend someone $100 to buy food for his family. When he comes to repay the loan, the value of the dollar has fallen by half, that is, a loaf of bread that cost fifty cents when you loaned the money now costs a full dollar. Are you due back $100 or $200?
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| Either one or the other, not both |
Suppose you lend someone that same $100 for the same purpose, but the value of the dollar remains stable, i.e., a loaf of bread that cost fifty cents when you lent the money still costs fifty cents when the money is repaid. In order to lend the money, however, it cost you an additional $10 to obtain it yourself, e.g., a trip to town to go to the bank, a check cashing fee, etc. Are you due back $100 or $110?
What about opportunity cost? Suppose you were planning on using that $100 yourself in a productive project that you believe would have resulted in a profit of $25. Are you due $125 if you lend the money to someone else for consumption? (Ethically, this one is easy: no. You cannot be compensated for what might have been, only for what is or was. It was your choice to forgo a potential profit for yourself by lending the money to someone else, and you cannot ethically have your cake and eat it, too.)
Suppose, however, that you lent someone that same $100 for a specific productive project that made a profit of $50. Asking around, you discover that people who lend money on productive projects of that sort are entitled to 10% of the profits, with 90% of the profits divided among the people who provided labor, land, and technology. Are you due $105? Most certainly.
What about investment versus speculation? That is what we will look at in the next posting on this subject.
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