Literature Study GuidesThe Wealth Of NationsVolume 1 Book 2 Chapter 4 Summary

The Wealth of Nations | Study Guide

Adam Smith

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The Wealth of Nations | Volume 1, Book 2, Chapter 4 : Of Stock Lent at Interest | Summary

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Summary

Smith next takes up the topic of interest. He first explains, in basic terms, how interest works and how lenders choose which borrowers to lend to. He then criticizes the mercantilist view of the relationship between interest and money. The amount of money available for lending, he says, is tied not to the value of actual currency in a country, as the mercantilists believed, but to the country's overall economic productivity as represented in commodities in all forms. He also attempts to refute another mercantilist belief, namely that interest has fallen as a result of the discovery of precious metals in America. The abundance of gold and silver, he asserts, makes those metals cheaper, but is does not affect the overall interest rate.

Finally, Smith remarks on the laws that regulate the interest rate in various countries or forbid the charging of interest altogether. If lending at interest is banned, he says, people will simply lend illegally at an even higher rate than would otherwise prevail. Similarly, if the interest rate is set too low, people will simply set their own rate, with a premium on top for evading the law. Smith does not, however, call for the total abolition of a maximum legal interest rate.

Analysis

Smith's support of a cap on the interest rate may seem surprising, given his emphasis on free trade elsewhere in The Wealth of Nations. In light of the modern scandals surrounding predatory lending and payday loans, one might even be tempted to see Smith as advocating an early form of consumer protection. This, however, would be a misreading. Smith is interested not in protecting borrowers from lenders, but in protecting the economy overall from irresponsible borrowers—"prodigals and projectors," as he calls them. If people could lend legally at up to 10 percent interest, he fears, "sober" borrowers would be crowded out of the market, and only "prodigals" with wild dreams of reaping a huge profit would borrow money, since only they would ever expect to be able to repay such high rates and still make money for themselves. This, for Smith, is one of those rare cases in which free-market practices might lead to capital being drawn out of productive enterprises and into risky, unprofitable schemes. His proposed solution is to set the interest rate just above the lowest market rate, which is what people of good credit are already paying to borrow money.

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