Friday, July 08, 2011

On usury

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.

Labels:

4 Comments:

Blogger Brandon said...

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.

I don't understand what you mean by this at all. It's clearly not our natural view that genuine free lunches are somehow wrong or immoral. People do have a problem with things like dishonesty, oppression, abuse of power, theft, taking unilateral advantage of someone's need to profit at their expense, and other things that contribute to the unfairness of exchange (all of which play a role in discussions of usury, which are not about the fact that interest is charged but about why it is charged). Justice or fairness in exchange involves a sort of equality, but does not involve a sort that rules out any sort of free lunch as a moral matter. Indeed, I can think of nothing whatsoever that morally rules out the legitimacy of one party getting a free lunch in an exchange as long as the exchange is voluntary and the other party is not harmed. Morally speaking, it's entirely possible to have a morally acceptable scenario in which you can get all the unearned income you want as long as I give it to you freely and you aren't harming me by taking it. It's only in the context of very particular kinds of exchanges that unearned income, or the attempt to get free lunches, or trying to get something for nothing, is a violation of the fairness of the exchange itself.

This is one reason why it's a bad idea to start with interest if you are trying to understand usury itself, as opposed to simply looking at the question of whether standard discussions of usury allow interest-charging at least in principle (and they do, of all different kinds, as long as they are charged for the right reasons or under the right circumstances). Considerations of the morality of usury arise out of the nature of lending as a form of exchange, and the sort of justice that applies to exchanges. The wrongness of usury doesn't follow from the nature of interest (which is why rejecting usury is consistent with accepting some charging of interest). It follows from the nature of commutative justice.

2:08 am  
Blogger Edward Ockham said...

Actually, does the idea of *consistent* excess returns help? I did mention this in one of the posts. The efficient market hypothesis does not rule out accidental risk-free returns. But it rules them out on a consistent basis.

What is our moral view on such consistent returns? Probably that to achieve them must have involved some cheating or other, and thus immoral.

11:34 am  
Blogger Edward Ockham said...

>>whether standard discussions of usury allow interest-charging at least in principle (and they do, of all different kinds, as long as they are charged for the right reasons or under the right circumstances).

As I note in today's post, there are only two types of interest rate. Charging for administration costs, e.g. is not an interest charge. A lender might conceal an administration charge as an interest charge, of course, but that is a different matter. The question is whether the 'standard theory' would count the two types of interest charge (non-risky and risky) as usury or not. From what you say, it sounds as though they might have allowed the second, i.e. risky type, so long as it compensated for the risk of loss and no more, but not the first. I discuss the first in the next post.

12:25 pm  
Blogger Edward Ockham said...

I am also looking at Thomas here.

1:03 pm  

Post a Comment

<< Home