Savings and Investment

The Old Testament prohibits interest on loans to the poor, because they are a form of charity (Ex 22:24; Lev 25: 35-37). The poor person will have to use the money borrowed for consumption goods so there will be no profit, which can be used to pay interest. This prohibition on interest was erroneously extended by Christians to business loans (Matt 25:27). Interest on commercial loans for use in trade or business is not forbidden.

The legitimacy of interest is an important principle to establish because interest is essential to economic growth. Economic growth can only take place if the economy’s capital (stock of productive plant and equipment) is built up. This can only happen if someone in the economy saves, and interest is essential for saving to occur.

Consider a subsistence fisherman. He has no equipment, but he catches enough fish with his bare hands to survive, by working most of the day. He could improve his fishing by making some nets or a boat, but while he was doing this he would not have time to fish so he would go hungry. If he can save a little bit of fish each day, he can build up a stock of fish. Then he can live on saved fish while he builds a net and boat. With the net and boat (his capital) he can catch enough fish to live on in half a day. This means that he will only need to fish every second day. He can use the other day to make better equipment or other things that will improve his lifestyle. Or he could fish every day, and trade the surplus with other people for other things that he needs. Getting some capital equipment improves the quality of his life. However to obtain the capital equipment, he had to make some saving first. The reward for saving was the stream of extra income he was able to produce with his capital. This is the equivalent of interest.

The same principle applies in any economy. If all money is spent on consumption goods, there will be no money available to buy capital goods. For money to be available to buy capital goods some people have to forgo consumption. They can either buy capital goods themselves and start a business, or they can deposit the money in a bank. The bank can lend the money to a business to buy capital goods. The reward for forgoing consumption is the profit that the business makes, or the interest that will be earned on the savings account.

If it is not possible to pay interest on a loan, there will be no incentive to save. The only people who would save are those who can start business themselves. Most others would just consume all they earn. The resulting shortage of capital would limit the growth that takes place in the economy.

The price of capital goods will adjust so that their supply is equal to the value of savings available for purchasing them. For example if people decide to save more, some of the consumer goods being produced will no longer be required. The price of consumer goods will fall. This will encourage producers to produce capital goods. These can be purchased with loans that will be made available through the additional deposits in savings accounts.

The interest rate should also rise and fall to clear these markets.  When these markets are distorted, problems arise. See savings and investments.