Inflation, of either the single or multiple digit variety, is merely one of the numerous uncertainties of economic life for which the free market—through the price mechanism—will automatically and optimally adjust.
But lest we take too much comfort in the resourcefulness of the unfettered free market, we should remember that, while our minds may dwell in the ethereal realms of free trade, our bodies must exist in our present quasi-fascist environment.
In an attempt to preserve the value of contracts in the face of irresponsible governmental monetary policy, a good deal of attention has been paid to the use of indexed contracts. Under these arrangements either the price to be paid or, in the case of a loan, the amount of the interest or principal is indexed to some nonmonetary value, such as the price of gold or the Consumer Price Index.
But as we saw in earlier discussions of the use of gold clauses [see "Gold Clauses," REASON, Dec. 1974, p. 35], there is a danger that a court will refuse to recognize the right of freedom of contract and strike down these indexed provisions as usurious.
In what may be the first such case since the 1930's, a court has had occasion to rule on an indexed loan. In a case decided October 27th, the Supreme Court of Tennessee held that a loan agreement whose principal amount was indexed to the Consumer Price Index was a usurious contract and not enforceable for the additional amount called for by the index clause. They held that the additional amount of principal called for by the adjustment for inflation constituted interest and, since Tennessee has a 10 percent usury ceiling, the total interest charged under the agreement violated the law and could not be enforced.
The case was brought by Union Planters Bank in an attempt to get around the 105-year old usury provision of the Tennessee constitution. They made a $50,000 one-month loan to a Memphis developer, Aztec Properties, at the 10 percent ceiling rate, subject to a principal adjustment to reflect any change (upward or downward) in the Consumer Price Index. When the loan was repaid there had been a one percent change in the CPI and the Bank sued for the additional $500 inflation adjustment to the principal.
The Tennessee court rejected arguments based on "exchange of money" cases, which involved payment of obligations in different currencies, and stated that it found no case which did not view the intentional increase in the face amount of the principal to be interest. The court took the position that, since interest had traditionally been used to offset inflation, that a device such as this, which had the same intent, could reasonably be considered interest. Since the interest thus calculated exceeded the 10 percent interest ceiling, the court held the index clause to violate the law.
Since at the time this loan was made the largest banks in Tennessee were having to pay 11½ to 12 percent for their money, the effect of this ruling, should interest rates heat up again, should be apparent. Money will be diverted to loans that are exempt from usury ceilings or made only to the most creditworthy (i.e., rich) borrowers. If a bank has a choice of putting its money into loans to poor people at an 8 or 10 percent usury ceiling, or loaning it to General Motors or some other "unprotected" borrower at 11 percent, it requires no abstruse Marxist class analysis to predict the results.
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The usury law is a relic of that long and deplorable epoch of man's history when he was denied the freedom to control his own life and property. We know that formal laws limiting the payment of interest existed at least as early as the Babylonians. Scriptural authority is found in the Bible which states (Deuteronomy 23:19) "Thou shall not lend upon usury to thy brother," and again (Luke 6:35) "…lend freely, hoping nothing thereby." Aristotle considered money to be sterile, and that the breeding of money from money was unnatural. The medieval church was of the same opinion. It is interesting to speculate how much of the poverty and suffering of that period is attributable to this restriction on the movement of capital.
The expansion of personal freedom during the Renaissance was accompanied by changes in the attitude toward the charging of interest. In the 15th century Luther conceded that creditors could take interest and during the 16th century John Calvin rejected the scriptural basis of the prohibition, but still advocated some form of control. In the following centuries pressure continued against the restrictions on the taking of interest until they were finally repealed in England in the mid-19th century. The United States, however, has largely retained these restrictions from colonial days. These restrictions on interest rates are embodied in both state constitutions and legislative acts, and frequently set the maximum rate chargeable at 8 percent, although the laws provide for a wide variety of exemptions.
The principal pressure for interest rate ceilings today comes from two sources. On one hand certain parties, both lenders and borrowers, have a vested interest in the market distortion produced by the usury. The other, more visible source are the consumerists, who hold as an article of faith that it is better for their clients to be denied credit because of a usury law than to obtain credit at the market rate.
Illustrations of this effect are common. A few years ago the consumer protectors in the state of Washington decided that the masses were being oppressed by the 18 percent interest charge of the credit card companies, so they got a law passed limiting the rate to 12 percent. As any fool should know, when you lower a price below the market rate you will have more demand than supply and the seller must ration on some basis other than price. The obvious alternative was to offer credit only to the lower risk borrowers. The people who got the consumerists' bargain credit were the most creditworthy—those with good jobs, property, etc. The losers were not the profit-gouging usurers but the welfare mothers, students, elderly, etc. who didn't qualify for the cheap credit and weren't permitted to bargain for a loan reflecting their creditworthiness. The invisible hand strikes again!
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Lest you think the only villain is the usury law, it should be mentioned that the Tennessee court also declared that the index clause violated the Joint Congressional Resolution of June 5, 1933, by which the New Deal Congress declared unenforceable the gold clauses in private contracts.
Davis Keeler's Money column alternates monthly in REASON with John J. Pierce's Science Fiction column. © 1975 Davis E. Keeler