Readings in Money and Banking / Selected and Adapted

by Chester Arthur Phillips

Interest and Loan Capital

THE PROBLEM OF LENDERS AND BORROWERS OF CAPITAL

The task of ascertaining the effect of the greenback issues upon the situation of lenders and borrowers of capital is in one respect more simple and in another respect more complex than the task of dealing with wage-earners. It is simpler in that there are not different grades of capital to be considered like the different grades of labor. But it is more complex in that the capitalist must be considered not only as the recipient of a money income, as is the laborer, but also as the possessor of certain property that may be affected by changes in the standard money.

The problem is further complicated by the fact that the relative importance of these two items—rate of interest and value of principal—is not the same in all cases. Whether a lender is affected more by the one item or the other depends upon what he intends to do with his property at the expiration of existing contracts. A widow left in 1860 with an estate of say $10,000, who expected to keep this sum constantly at interest and to find new borrowers as soon as the old loans were paid, could neglect everything but the net rate of interest received. On the other hand, if this estate had been left to a youth of twenty who intended to invest his property in some business after a few years, the rate of interest would be of relatively less importance to him than the purchasing power of the principal when the time came to set up for himself.

Of course, the same difference exists in the case of different borrowers. Those borrowers who expected to renew old loans on maturity would have to consider little beyond the interest demanded by lenders, while borrowers who expected to pay off the loans out of the proceeds of their ventures would be interested primarily in the amount of goods that would sell for sufficient money to make up the principal.

Although these two classes of cases are by no means independent of each other, the following discussion will be rendered clearer by observing the broad difference between them. Accordingly, attention will first be directed to the effect of the price fluctuations upon the purchasing power of the principal of loans, and afterward to changes in the rate of interest.

PURCHASING POWER OF THE PRINCIPAL OF LOANS

Most persons who made loans in the earlier part of the Civil War and were repaid in greenbacks must have suffered heavy losses from the smaller purchasing power of the principal when it was returned to them. But while this general fact is clear, it is difficult to make a quantitative statement of the degree of the loss that will be even tolerably satisfactory.

In the case of almost all loans made before the middle of 1864 and repaid prior to 1866, the creditor found that the sum returned to him had a purchasing power much less than the purchasing power that had been transferred to the borrower when the loan was made. This decline varied from 1 to more than 50 per cent. On loans made in the middle of 1864 or later, on the contrary, the creditor gained as a rule. In the case of loans made in January, 1865, and repaid six months later, the increase in purchasing power was over 40 per cent.

THE RATE OF INTEREST

In turning to study the fortunes of men who have no thought of employing their capital for themselves, but expect to seek new borrowers as rapidly as old loans are repaid, one finds it necessary to distinguish between cases where loans have been made for short and for long terms; between the cases, that is, where there is and where there is not an opportunity to make a new contract regarding the rate of interest. The latter cases may be dismissed with a word. The capitalist who lent $10,000 for five years in April, 1862, at 6 per cent. interest, would be in relatively the same position as the workingman who received no advance in money wages; while his money income remained the same, the rise of prices would decrease his real income in 1864 and 1865 by about one-half. Of course, this loss to the creditor is a gain to the debtor; for to the business man using borrowed capital the advance of prices means that he can raise his interest money by selling a smaller proportion of his output.

More interesting is the case of loans maturing and made afresh during the period under examination. The important question is: How far did the lender secure compensation for the diminished purchasing power of the money in which he was paid by contracting for a higher rate of interest?

The advance in the rate of interest was comparatively small—much too small to compensate for the increased cost of living. While prices rose approximately 85 per cent. and money wages somewhat less than 60 per cent. during the years 1860-65, rates of interest on call and time loans increased less than 15 per cent. during the same period.

The conclusion is not only that persons who derived their income from capital lent at interest for short terms were injured by the issues of the greenbacks, but also that their injuries were more serious than those suffered by wage-earners.

To explain this state of affairs is not easy. The first reason that suggests itself to the mind considering the problem is that both lenders and borrowers failed to foresee the changes that would take place in the purchasing power of money between the dates when loans were made and repaid. No doubt there is much force in this explanation. If, for instance, men arranging for loans in April, 1862, to be repaid a year later, had known that in the meantime the purchasing power of money would decline 30 per cent., they would have agreed upon a very high rate of interest. Men able to discern the future course of prices would not have lent money at the ordinary rates, and if the rates prevailing in the New York market throughout all 1862 and 1863 were less than 7 per cent., it must have been because the extraordinary rise of prices was not foreseen by borrowers and lenders.

Nor is it surprising that business men failed to see what was coming; for the course of prices depended chiefly upon the valuation set upon the greenbacks, and this valuation, in turn, depended chiefly upon the state of the finances and the fortunes of war—matters that no one could foresee with certainty. Indeed, there was much of the time a very general disposition to take an unwarrantedly optimistic view of the military situation and the chances of an early peace. Many members of the business community seem to have felt that the premium on gold was artificial and must soon drop, that prices were inflated and must collapse. To the extent that such views prevailed borrowers would be cautious about making engagements to repay money in a future that might well present a lower range of prices, and lenders would expect a gain instead of a loss from the changes in the purchasing power of money.

But the full explanation of the slight advance in interest cannot be found in this inability to foresee the future—at least not without further analysis of what consequences such inability entailed. Workingmen are commonly credited with less foresight than capitalists, and nevertheless they seem, according to the figures, to have succeeded better in making bargains with employers of labour than did lenders with employers of capital. The explanation of this less success seems to be found in the difference between the way in which depreciation affected what the capitalist and the laborer had to offer in return for interest and wages. There is no reason for assuming that an artisan who changed employers during the war would render less efficient service in his new than in his old position, or that a landlord who changed tenants had less advantages to put at the disposal of the incoming lessee. In both these cases the good offered to the active business man remained substantially the same, and it may safely be assumed that, other things being equal, this business man could afford to give quite as much for the labor and the land after as before suspension. From the business man's point of view, therefore, there seems to have been room for a doubling of money wages and rent when the purchasing power of money had fallen one-half. But in the case of the borrower of capital the like was not true. The thousand dollars which Mr. A offered him in 1865 was not, like the labour of John Smith or the farm of Mr. B, as efficient for his purposes as it would have been five years before. For, with the thousand dollars he could not purchase anything like the same amount of machinery, material, or labor. And since the same nominal amount of capital was of less efficiency in the hands of the borrower, he could not without loss to himself increase the interest which he paid for new loans in proportion to the decline in the purchasing power of money, as he could increase the wages of laborers or the rent for land.

It should also be pointed out that on one important class of loans capitalists suffered comparatively little even during the war. Interest on many forms of Government bonds was paid in gold. Capitalists who invested their means in these securities consequently received an income of almost unvarying specie value. If the person who made these investments were an American, he would be able to sell his gold-interest money at a high premium, but he would also have to pay correspondingly high prices for commodities, so that upon the whole his position would not be greatly different from that of the foreign investor. That such opportunities for investment as these securities offered should exist when men were most of the time loaning money for short terms at 7 per cent. or less, is perhaps the most emphatic proof that could be offered of the inability of the public to foresee what the future had in store.