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Book 2, Chapter 3
Themes
Key
LitCharts assigns a color and icon to each theme in The Wealth of Nations, which you can use to track the themes throughout the work.
Labor, Markets, and Growth
Capital Accumulation and Investment
Institutions and Good Governance
Mercantilism and Free Trade
Money and Banking
Summary
Analysis
Lenders treat the stock they lend with interest as capital. Borrowers generally use it as capital, but they sometimes use it to cover their immediate consumption needs, which is imprudent and destructive. The amount of money available to lend in a country depends on how much of its revenue is destined to replace capital, and specifically how much of that revenue its owners choose not to invest. As it circulates, a small amount of money can replace a much larger amount of capital. As the amount of national revenue destined to replace capital grows, so does the amount of money available to lend at interest. The more money becomes available to lend at interest, the more interest rates fall.
“Stock lent at Interest” is just Smith’s technical term for a loan. Capital owners who lack the time, wherewithal, or risk tolerance to invest their capital can always loan it out for interest, which offers low but guaranteed returns. (As Smith will point out, they can also buy and rent out land.) Smith also distinguishes between good debt and bad debt: some loans get used for capital, as an investment in the borrower’s business or future, while others are used to replace revenue and cover the borrower’s day-to-day expenses. Taking a loan to cover living expenses is a clear indication of living beyond one’s means—or an economy that can’t provide workers with subsistence-level wages.
Themes
Some have attributed these falling interest rates to the European discovery of the Americas, but this makes little sense, as the availability of more silver doesn’t change the proportion between capital and profit (and thus the interest for lending money). If more goods circulated in a country for the same amount of money, nominal prices would fall but real prices would remain the same. Due to the rise in the country’s real revenue—the amount of goods and services circulating in its economy—profits and thus interest rates would have to fall.
Interest rates reflect the supply of and demand for credit. Falling interest rates show that this supply is increasing relative to demand, but this doesn’t necessarily mean that the money supply has expanded. This is because, as Smith emphasizes once again, money is not capital. An increase in the silver supply raises prices, without significantly enriching the national economy or expanding the amount of credit available to borrowers. But a real increase in economic activity would.
Themes
Some countries outlaw lending money for interest, but this has the opposite effect, creating a black market with even higher interest rates. In contrast, countries that permit lending for interest generally define the highest permissible interest rate. This should be set just above the market interest rate. If it is too low, it will stop responsible people from lending and borrowing as much as they should. But if it is too high, it will encourage lending to irresponsible people for speculative, imprudent ventures. The law can’t possibly reduce the market interest rate, as people will either evade it or stop lending money.
Smith introduces another important principle that has shaped subsequent economic theory—and to which he will return in his analysis of smuggling. Namely, outlawing a category of economic activity doesn’t stop it, but merely drives it underground. The activity becomes riskier, which raises prices and profits for it. Illegal lending might be very profitable, but it’s also very dangerous. This is why organized crime has always earned much of its revenue from illegal loans—and unscrupulous, violent loan sharks are a stock character in movies and literature about crime. Even though rational economic actors would not take loans they cannot repay, setting a maximum interest rate is essential to make sure that people’s overconfidence and folly do not lead them to take out loans they cannot repay. If this happens on a large scale, banks can fail—and take the whole economy with them.
Themes
Lastly, land prices depend on interest rates because people with excess capital who don’t want to manage it themselves have two choices: they can give loans with interest or buy land to rent out. They will choose whatever yields higher returns, but interest rates fall if too many people lend money and rents fall if too many people rent out land, so interest rates and rents tend to stay closely correlated.
People become lenders or landlords for essentially the same reason, so these two options compete with each other like two goods in the market: people will choose the better deal. Indeed, interest rates affect the whole economy in this way, since capital owners know they can always lend out their capital if interest rates are higher than their expected profit rates.
Themes
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