This we apprehend to be the cause why the rate of interest in this country was so high as it is well known to have been during the last war. It is, therefore, by no means to be inferred, as some have done, that the general rate of profits was unusually high during the same period, because interest was so. Supposing the rate of profits to have been precisely the same during the war, as before or after it, the rate of interest would nevertheless have risen, from the causes and in the manner above described.
The practical use of the preceding investigation is, to moderate the confidence with which inferences are frequently drawn with respect to the rate of profit from evidence regarding the rate of interest; and to shew that although the rate of profit is one of the elements which combine to determine the rate of interest, the latter is also acted upon by causes peculiar to itself, and may either rise or fall, both temporarily and permanently, while the general rate of profits remains unchanged.
The introduction of banks, which perform the function of lenders and loan-brokers, with or without that of issuers of paper-money, produces some further anomalies in the rate of interest, which have not, so far as we are aware, been hitherto brought within the pale of exact science.
If bankers were merely a class of middlemen between the lender and the borrower; if they merely received deposits of capital from those who had it lying unemployed in their hands, and lent this, together with their own capital, to the productive classes, receiving interest for it, and paying interest in their turn to those who had placed capital in their hands; the effect of the operations of banking on the rate of interest would be to lower it in some slight degree. The banker receives and collects together sums of money much too small, when taken individually, to render it worth while for the owners to look out for an investment, but which in the aggregate form a considerable amount. This amount may be considered a clear addition to the productive capital of the country; at least, to the capital in activity at any moment. And as this addition to the capital accrues wholly to that part of it which is not employed by the owners, but lent to other producers, the natural effect is a diminution of the rate of interest.
The banker, to the extent of his own private capital, (the expenses of his business being first paid,) is a lender at interest. But, being subject to risk and trouble fully equal to that which belongs to most other employments, he cannot be satisfied with the mere interest even of his whole capital: he must have the ordinary profits of stock, or he will not engage in the business: the state of banking must be such as to hold out to him the prospect of adding, to the interest of what remains of his own capital after paying the expenses of his business, interest upon capital deposited with him, in sufficient amount to make up, after paying the expenses, the ordinary profit which could be derived from his own capital in any productive employment. This will be accomplished in one of two ways.
1. If the circumstances of society are such as to furnish a ready investment of disposable capital; (as for instance in London, where the public funds and other securities, of undoubted stability, and affording great advantages for receiving the interest without trouble and realizing the principal without difficulty when required, tempt all persons who have sums of importance lying idle, to invest them on their own account without the intervention of any middleman;) the deposits with bankers consist chiefly of small sums likely to be wanted in a very short period for current expenses, and the interest on which would seldom be worth the trouble of calculating it. Bankers, therefore, do not allow any interest on their deposits. After paying the expenses of their business, all the rest of the interest they receive is clear gain. But as the circumstances of banking, as of all other modes of employing capital, will on the average be such as to afford to a person entering into the business a prospect of realizing the ordinary, and no more than the ordinary, profits upon his own capital; the gains of each banker by the investment of his deposits, will not on the average exceed what is necessary to make up his gains on his own capital to the ordinary rate. It is, of course, competition, which brings about this limitation. Whether competition operates by lowering the rate of interest, or by dividing the business among a larger number, it is difficult to decide. Probably it operates in both ways; but it is by no means impossible that it may operate in the latter way alone: just as an increase in the number of physicians does not lower the fees, though it diminishes an average competitor's chance of obtaining them.
It is not impossible that the disposition of the lenders might be such, that they would cease to lend rather than acquiesce in any reduction of the rate of interest. If so, the arrival of a new lender, in the person of a banker of deposit, would not lower the rate of interest in any considerable degree. A slight fall would take place, and with that exception things would be as before, except that the capital in the hands of the banker would have put itself into the place of an equal portion of capital belonging to other lenders, who would themselves have engaged in business (e.g., by subscribing to some joint-stock company, or entering into commandite). Bankers' profits would then be limited to the ordinary rate chiefly by the division of the business among many banks, so that each on the average would receive no more interest on his deposits than would suffice to make up the interest on his own capital to the ordinary rate of profit after paying all expenses.
2. But if the circumstances of society render it difficult and inconvenient for persons who wish to live upon the interest of their money, to seek an investment for themselves, the bankers become agents for this specific purpose: large as well as small sums are deposited with them, and they allow interest to their customers. Such is the practice of the Scotch banks, and of most of the country banks in England. Their customers, not living at any of the great seats of money transactions, prefer entrusting their capital to somebody on the spot, whom they know, and in whom they confide. He invests their money on the best terms he can, and pays to them such interest as he can afford to give; retaining a compensation for his own risk and trouble. This compensation is fixed by the competition of the market. The rate of interest is no further lowered by this operation, than inasmuch as it brings together the lender and the borrower in a safe and expeditious manner. The lender incurs less risk, and a larger proportion, therefore, of the holders of capital are willing to be lenders.
When a banker, in addition to his other functions, is also an issuer of paper money, he gains an advantage similar to that which the London bankers derive from their deposits. To the extent to which he can put forth his notes, he has so much the more to lend, without himself having to pay any interest for it.