Usury Laws: Harmful When Effective NORMAN N. BOWSHER OST INTEREST iates have risen to historically Bible (Deuteronomy 23:19-20) stated, “Thou shalt not high levels in recent months. This development, in lend upon usury to thy brother, ...Unto a stranger view of present law, has caused serious problems to thou mayest lend upon usury; but unto thy brother develop in the credit markets because in most juris- thou shalt not lend upon usury ....“ In the New dictions usury restrictions on the payment of interest Testament (Luke 6:35) the admonition was broadened have generally remained at previously established lend freely, hoping nothing thereby.” lower levels. The consequence of this has been that In Greece, Aristotle considered money to be sterile, borrowers who are willing to pay the competitive rate and that the breeding of money from money was for funds often find that they are legally unable to unnatural and justly hated. During the period of obtain financing. As a result, they are faced with the the Roman Republic, interest charges were forbidden, choice of either circumventing the law to obtain the desired funds or losing out to other borrowers who but they were permitted during the time of the Ro- may not be svilhng to bid as much, but who are man Empire. legally able to contract because of the nonuniformity During the early Middle Ages religious leaders of usury laws. treated the subject niore thoroughly, and reached the same conclusion — that interest on loans was unjust. Despite the credit market distortions caused by ceil- The exploitation of the poverty-stricken by rich and ings on interest rates, usury laws have been retained powerful creditors who lent money at interest was in most jurisdictions. It is the intent of this article to considered sinful to the Christians of that period, who provide some insight and perspective on the value of stressed humility and charity as among the greatest such restrictions by reviewing briefly the history and virtues and played down the value of earthly goods. justification of such laws, the role of interest rates, Secular legislation responded to the Church’s influence and some of the effects of interest rate restrictions.’ and, in general, interest charges and usury were re- garded as synonymous.~ The increase in economic activity and expansion of personal freedom that came with the Renaissance Usury laws have been traced back to the dawn of forced modifications in the prevailing views concern- recorded history. Both legal and religious restrictions 2 ing interest rates. Recognizing that man was imper- on interest charges were imposed in ancient times. fect, Martin Luther and other 15th century reformers The early Babylonians permitted credit but limited began to concede that creditors could not be pre- the rate of interest. One of the earliest writings of the vented from charging interest. In the 16th century John Calvin rejected the scriptural basis for interest I Previous discussions of interest rate controls were given by prohibition on grounds of conflicting interpretations Clifton B. Luttrell, “Interest Rate Controls — Perspective, Purpose, and Problems,” this Review (Septcunbcr 1968), pp. and changed circumstances, but still advocated some 6-14, and Charlotte F. Ruebling, “The Aduninistration of Regulation Q,” this Review (February 1970), pp. 29-40. 3 2 hugene von Böhnm-Bawerk, Capital and Interest, trans. See Sidney 1-loruer, A Iiistorij of Interest Rates (New George Huneke and Hans Sennholz ( South 1-lolland, Illi- Brunswick, New Jersey: Rutgers University Press, 1963). nois: Libertarian Press, 1959), pp. 13-24. Page 16 FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1974 control. Turgot, an 18th century French economist, rate of interest they are paying. Furthermore, rela- claimed that money was the equivalent of land, tively few make a serious effort to study conditions and hence the owner should not be inclined to loan or to shop around for better terms or better timing. his money unless he could expect a return as great as Finally it is argued that contracts made with such he would obtain through the purchase of land.4 unknowing borrowers at rates above those existing in the market for similar types of loans represent a dis- Legal restrictions on the payment of interest were tortion of competitive forces and provide a windfall generally relaxed in the 18th century, but the belief to lenders. continued that the people who needed to borrow funds should be protected against overly high charges. A similar argument for the regulation of interest Consequently, most nations maintained legal maxi- rates is related to the comparative market power of mum usury rates at “reasonable” levels, borrowers and lenders. Since lenders are usually fewer in number and larger in resources than borrowers, it Usury laws in the United States were inherited, in is contended that they haave market power which can large part, from the British in colonial days. While be used to command artificially high rates. Hence, these laws generally remain in force in the United usury laws provide competitive balance between the States, Great Britain, after intense pressure in the two groups. early 19th century, repealed these and other restric- tions on commerce and trade in 1854.~ Another argument for interest rate regulation is One factor complicating attempts to maintain in- concerned with the impact of lower interest rates on the economy. It has been contended that low interest terest rate ceilings arose from the fact that risks and rates are desirable to encourage more investment and administrative expenses in making very small loans consumption and promote faster economic growth. were often so great that legitimate dealers could not handle such advances with prevailing rate ceilings. This situation fostered illegitimate loan “sharks” with exorbitant interest charges. As a result, it was even- tually recognized that higher rates should be per- Those who oppose interest rate restrictions view mitted on small loans, and the small loan laws emerged. credit markets as relatively efficient when left alone to operate freely. According to this position free com- petitive markets lead to an optimum allocation of resources and maximum individual satisfaction. Con- As noted, ethical and religious arguments have sequently, interferences with noi-mal credit flows, by been relied on to a great extent to justify either the use of imposed ceilings on lending or deposit rates, prohibition or limitation of interest payments. Another can only create inefficiencies in financial markets factor which has been instrnmental in sustaining sup- which hamper production and exert an adverse influ- port for usury laws has been public opinion which ence on the distribution of goods and services, generally viewed the small borrower as an underdog It has been charged that maximum loan rates are at the mercy of large well-financed institutions, As a necessary because credit applicants are gullible and consequence of this public attitude, legislators have would enter into oppressive contracts without such been reluctant to raise or eliminate interest rate protection. But, are not individuals just as likely to ceilings. be gullible in their dealings in other markets? Why Several economic arguments also have been ad- then is the credit market singled out as an area to vanced to justify usury laws, and these considerations promulgate legal restrictions against such oppressive tend to bolster the moral and political reluctance to contracts? More importantly, has this special attention raise rate ceilings. The first of these arguments asserts had its intended effects? That is, can and do these that whereas most lenders are knowledgeable about laws protect the uninfonned from exploitation, and conditions in the particular credit market in which can the benefits of this protection be justified in view they operate, it is readily observable that a sizable of the attendant social costs? Existing imperfections number of borrowers are unsophisticated and naive. in credit markets could probably be reduced to a It is contended that these borrowers are concerned greater extent and with less cost by fostering greater only with obtaining credit and do not even know what competition among lenders. Also, education and coun- seling of borrowers may be a more efficient method ~Ibid, pp. 25-60. to improve their performance than imposing rigid 5 Homer, A History of Interest Rates, p. 187, ceilings. Page 17 FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1974 In most credit markets competiton is very keen. pects it is not desirable to pay the going rate for Major lenders include commercial banks, savings and funds. They are “priced out of the market,” just as loan associations, insurance companies, mutual sav- there are those who find that at current prices it is ings banks, mortgage companies, sales finance com- not expedient to hire a servant, eat steak, or pur- panies, personal finance companies, credit unions, real chase a luxury automobile. Any movement in interest estate investment trusts, fann credit agencies, retail- rates (as with other prices) will cause a reevaluation ers, and individuals. It is relatively easy to establish of projects which require the borrowing of funds. a business for lending funds, except for restrictions imposed by the Government. In most cases where competition is lacking in a given market, it has resulted from legal limitations on entry or activities. In prac- Throughout most of the period since the l920s, tice, competitive forces have kept most market interest usury laws have been ineffective because the interest rates below usury ceilings for most of the past forty ceilings were at levels above prevailing market rates. years. However, with the rise in inflation, and consequently For a brief period, artificially holding interest rates interest rates, since the mid-l960s, usury laws have down probably does stimulate investment and con- had a significant impact on many credit markets.