The most significant characteristic of money in our society that is not contained in the common definition is its ability to generate “interest.” Interest is commonly described as a form of rent charged when money is lent to someone else. Economic theory also talks about interest as the “price of money” or the “price of time.” 

If one thinks of money as purchasing power which has accrued to individuals because of their actions or social standing, then the idea that it can be temporarily transferred to someone who must eventually return a larger amount of it may not be obvious. Something fundamental has been added to the concept of money.

There is, of course, a long history of debate about “usury” and whether interest on loans should be forbidden or regulated. [see Usury ] The main thing this tells us is that ideas about money have an ethical, moral or political dimension, but the question here is more analytical. What are the conceptual implications of interest? What is the fundamental addition to the concept of money that makes interest seem so natural and obvious.

There are two ways in which economic theory incorporates interest into the concept of money. One suggestion is that interest derives from the incorporation of time. The other is the characterization of money as “capital.”

One way in which time is incorporated in to the conception of money is by viewing money as part of a dynamic system involving growth. [see Growth] The rate of interest on loans is seen as somehow related to the rate of growth in the productivity of the economy at large.  If an economy grows, however, it is entirely possible that the amount of money circulating in it could grow correspondingly without money being lent at interest. Money is expected to grow because it is considered a form of capital.

When economists speak of interest as the “price of time” or the expression of “time preference,” there are two underlying assumptions: 1) that time is has “value” and 2) that time is an individual’s possession. The common sense notion that something can be a “waste of time” implies that time is valuable in some way since any lifetime involves a limited amount of time during which one can accomplish something “worthwhile.”  Seeking to make good use of one’s time on earth, however, does not mean that “time” is a limited resource to which a numerical “value” can be ascribed in terms of money.  To say that time is an individual’s possession seems to involve an odd reification of something which is not an object or thing. If an individual has time “on his hands” the obvious way he could sell it would be to accept wages for work to which he devoted his time.

The connection between interest and time is most often formulated in terms of an individual’s “time preference.” In its simplest terms it describes how the value of a certain amount of money in the present is greater that the value of the same amount of money some time in the future. Given a choice between $100 now and $100 a year from now, people will choose $100 now. To persuade someone to wait a year instead, it might be necessary to offer them $110 in a year. Irving Fisher developed a theory of interest based on this idea of “time preference.” [see Fisher Theory of Interest] The rate of interest is like an inverse of a discount rate. If I have a bond which will pay $100 on its maturity in one year and I need cash now, I might be willing to sell the bond to someone for $90 now. His purchase of the bond would then be an investment which will yield about 10% in one year. None of this really justifies or explains interest. Fisher just accepted interest as a given and was trying to incorporate it into a conceptual framework where individual income is the most basic economic fact. The only way to know an individual’s time preference is to see what interest rate he is willing to pay or accept under a specific set of circumstances.

The connection in our current system between money and growth is the assumption that accumulated money must be invested to produce growth or the assumption that investment requires savings or foregoing current consumption for the sake of greater options in the future. Investment, however, is possible without interest-bearing loans. It can be private equity investment where individuals contribute cash they have accumulated in exchange for a percentage of any profits generated by the enterprise. Or it can be public expenditures as is the case with so much research and development or infrastructure projects financed by the government. It could even conceivably be credit extended by a bank or other financial institution without interest charges. [ see Investment ]

The most common explanation of interest-bearing loans is money is a “capital asset” which should yield a “return.” Given our current system people expect to be able to “put money to work” so that it yields income, but money should not be viewed as a capital asset. [see Capital] Adam Smith apparently defined capital as “that part of man’s stock which he expects to afford him revenue,” and most people think of capital as any financial asset including cash which can yield revenue. The problem with this view is that it gives rise to the “financial markets” which seem to have such an overwhelming impact on the economy. [see Financialization]

Interest-bearing loans exist in our economic system because there is a market consisting of people who want or need more money and have no other way to get it. The net effect of most interest-bearing loans is a redistribution of wealth in favor of those who already have cash reserves or entities that are in a position to extend credit.

Interest-bearing loans should not be confused with rewarding entrepreneurial innovation and risk with “profit.” [see Profit]

^BackToTop