Brandon Watson has two fascinating posts here (July 2011) and here (July 2009) about the morality of lending money (‘usury’) and scholastic theories thereof. I raised the question of whether modern financial theory can inform us about this subject, without any satisfactory answer – partly because of the problems of thread formatting, partly because of confusion about the meaning of the terms involved.
Some of the concepts used by the scholastics have a direct counterpart in modern financial theory. For example, damnum emergens, an entitlement to a charge for the administrative costs involved, and periculum sortis, entitlement to a charge covering the risk of the loan defaulting. Two others are much more difficult: lucrum cessans – entitlement to compensation for losing profit that the lender would have certainly had if he had not done the lending, and the view that money on its own never carries an intrinsic title to interest – “money does not breed. It carries no intrinsic potential for profit, and it is immoral and unnatural to treat it as if it did -- 'unnatural', indeed, is the word they often used for it”.
In the following series of posts I will try and make sense of these ideas in terms of modern financial theory. The best place to start would be the efficient market hypothesis. This is the hypothesis that financial markets are "informationally efficient", and that an investor cannot consistently achieve returns in excess of the risk free rate on a risk-adjusted basis, given the information available at the time the investment is made.
Like all theories, it has a theoretical and an empirical aspect. The theory is that because excess returns are so desirable, people will soon find out about them (that’s the ‘informationally efficient’ part), and so competition for them will drive the return down (usually by driving up the price of the investment that yields the returns). Thus, though some investors may find excess returns, they cannot consistently do so. The ‘risk-adjusted’ part involves stripping expected losses from risks to the investment. Some investments may apparent yield excess returns. But once the return is adjusted for the expected or probable loss, it will disappear.
The empirical part is driven by statistical analysis. Louis Bachelier was the first person to propose (in 1900) that stock markets follow a random process. Though his theory was rejected at the time, subsequent investigation seemed to confirm that, if market prices are random, it follows at least that the ‘weak’ form of the hypothesis is true*. One cannot earn excess returns by analysis of past investment prices. The theory is not uncontroversial, particularly after the recent ‘credit bubble’ and subsequent collapse.
The efficient market hypothesis has no ethical component, and involves no moral judgment. It simply posits that there is, in fact, no ‘free lunch’. But there is an associated moral judgment. Our natural view – apparently shared by the medievals – is that a genuine free lunch is somehow wrong or immoral. Unearned income is wrong: everything we get, we should earn, etc. What the efficient market hypothesis suggests is that there is a kind of natural justice. There shouldn’t be excess returns, and in fact – as suggested by the theory and the science –there aren’t.
However, the modern theory diverges from the scholastic one on at least three key points. First, the theory defines excess returns as the risk-adjusted returns over the ‘risk free rate’. The risk-free rate underpins all modern financial theory, and acceptance of it is essentially accepting that money has an intrinsic potential for return, which the scholastics did not accept. Second, the idea that one is only entitled to compensation for losing profit if there was a legitimate profit to be had is somewhat alien to modern financial theory. Third, if the theory is true, then we can reject the notion that lending and investment has to be legislated. The best way of promoting fair lending would be to abolish anti-usury laws.
I will examine these problems in the next post.
*For the semi-strong and strong forms, see the Wikipedia article Efficient-market hypothesis.