On the Cause and Effect of Interest Rates
It is a common idea, accepted by all those who have written on commerce, that an increased quantity of money in a state decreases the rate of interest, because when money is abundant it is easier to find some to borrow. This idea is not always true or accurate. For proof, we need only to remember that, in 1720, nearly all the money in England was brought to London. In addition, the number of notes in circulation further accelerated the movement of money to an extraordinary level.1
However, this abundance of money and increased circulation did not decrease the interest rate, which had been running at 5 percent or lower. It only served to raise the rate, which increased up to 50 and 60 percent. It is easy to account for this increased rate of interest. The reason is that everyone had become an entrepreneur in the South Sea scheme and wanted to borrow money to buy shares, expecting to make an immense profit with which it would be easy to pay this high rate of interest.2
If the abundance of money in the state comes from the hands of moneylenders, the increase in the number of lenders will probably lower the rate of interest. However, if the abundance comes from the hands of people who will spend it, this will have just the opposite effect and will raise the rate of interest by increasing the number of entrepreneurs who go into business as a result of this increased spending and will need to supply their businesses by borrowing at all types of interest.
The abundance or scarcity of money in a state always raises or lowers the price of everything in markets, without any necessary connection to the rate of interest, which may very well be high in states where there is plenty of money and low in those where money is scarcer—high where everything is expensive, and low where everything is cheap; high in London, low in Genoa.
The rate of interest rises and falls every day from mere rumors, which might decrease or increase the confidence of lenders without affecting the prices of products in markets.
The most constant source for a high rate of interest in a state is the great expenditures of nobles, property owners, and other rich people. Entrepreneurs and master craftsmen supply the great houses with all the elements of this spending, and entrepreneurs almost always need to borrow money in order to supply them. When the nobles consume beyond their income and borrow money, they doubly contribute to raising the interest rate.
In contrast, when the nobles of the state live frugally and buy firsthand [without middlemen] as often as they can, they will acquire many products from their servants without dealing with entrepreneurs. This diminishes profits and the numbers of entrepreneurs in the state, and it consequently reduces the number of borrowers, as well as the interest rate. Because these entrepreneurs work with their own capital—borrowing as little as they can—and content themselves with small profits, they prevent those who have no capital from starting similar enterprises with borrowed money. Such is the case today in the Republics of Genoa and Holland, where interest is sometimes at 2 percent, or lower for the upper classes.
Meanwhile, in Germany, Poland, France, Spain, England, and other countries, the affluence and expenses of noblemen and property owners has kept the country’s entrepreneurs and master artisans accustomed to large profits, enabling them to pay a high rate of interest, which is higher still when they import
Article from Mises Wire