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I essentially asked this question here, but IMO didn't get an answer from anyone who knew what they were talking about.

Normally someone gets paid because they work in a job, i.e. they contribute to society. I get paid by lending money to other people and charging interest. What exactly am I being paid for? It doesn't feel that I'm doing anything to better society.

It enables them to buy things they otherwise couldn't afford... in the near term. But ultimately they have to pay back the debt plus interest, so they can actually afford less in the long term. Is it just that I'm being paid to satisfy people's impatient desires? It doesn't seem that I'm contributing to long-term economic growth, and it seems that I may even be hurting it.

Someone suggested that the loans can be used to finance investment, so I thought about it for a while. I considered an economy consisting of three agents: BANK, person A, and person B.

Suppose person A is destitute and BANK lends £100 to person A in exchange for £110 later. Then person A pays person B the £100 to build a factory. Then person A manufactures goods with the factory and sells them to person B for £150. It seems that BANK has made £10 for nothing, as person A and person B could have come to an arrangement where person B would build the factory + pay person A £50 in exchange for the goods manufactured by person A directly. Maybe it's different with more than three agents. But I still come to the conclusion that the agents could collectively come to an agreement that wouldn't involve the BANK "middleman". Maybe that wouldn't work in practice. But in any case, it doesn't feel that lending money does anything to contribute to society.

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In this simplified hypothetical world, yes, person B could give 100 currency to person A to build the factory directly. But what if person B does not want to take on that risk? How does person B know that person A will be contracted to make 150 worth of goods properly? Person B could just wait to see if someone else finances person A and then buy from A if the factory is successful. A single individual lending, or even small businesses lending out money can be a relatively large amount of money for that entity (so, high risk), whereas banks are able to diversify risks, by making many different loans and spending time evaluating how risky different people are.

Banks take on risk that other people/firms can't afford to or don't want to. Interest rate is very roughly, the price needed to be willing to take on these risks, or more precisely, the rental rate of money.

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  • $\begingroup$ So, if I deposit money in a bank for interest (essentially "lending" money to the bank), am I being paid because I'm taking a risk (of the bank not giving the money back)? What if I invest the money in government bonds (usually regarded as "risk-free" assets)? Why am I being paid then? $\endgroup$ – Peter Aug 22 '17 at 8:17
  • $\begingroup$ When you lend money, you're giving the bank access to money in exchange for you not using it all at once so that the bank is more liquid. People prefer money today more than the same money tomorrow, so are given some sort of compensation. For """risk-free""" bonds, as interest rate rises, the price of bonds falls making the rate of return better, because the bonds have to compete with higher payoff assets. $\endgroup$ – Kitsune Cavalry Aug 22 '17 at 12:42
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There's a bunch of different answers, depending on which of the paragraphs you want to address. In order:

  1. First, you need to be more precise about what "society contribution" means. After all, working as a drug seller may or may not contribute to society! Using a pretty standard definition like Pareto Optimality, by sacrificing consumption for a price and allowing others to consume or invest, someone else is better off and/or more production is available in the future.

  2. Indeed, they can afford less things in the future. But that's like saying you can afford less coconuts because you bought a watermelon. There's a trade-off with expenditures, but in this case the trade-off is against the future. While it looks like hurting society, consider the economic forces put in motion because this individual, with a desire to spend, now has the ability to do so. Just as an example, if everyone had to save their own cash to buy a house, the construction sector would be highly inefficient, volatile and people that want houses, even if they could pay in a few years, would stay homeless.

  3. It has more to do with the social value of banks than of lending, but let's have a stab. Indeed, A and B may come into an agreement. This has a couple of hidden assumptions. Say:

    1. A can appraise (a) the investment risk and (b) person B's inherent risk. In practice, a bank is more likely to know and evaluate those two risks.
    2. A knows and performs risk mitigation strategies like insurance, maybe even building reinforced walls for preventing theft.
    3. A has enough money to finance B's needs. In practice, there are very few individuals with enough money; banks pool money from different lenders.
    4. A knows B. Usually, time and space constraints interfere with this.
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  • $\begingroup$ I think #2 best answers my question. So is it basically the principle of comparative advantage: except instead of the two goods being coconuts and watermelons, the two goods are coconuts now and coconuts in the future. An individual can choose between (say) producing 2 coconuts now, or 3 coconuts in the future by spending the time today producing coconut-producing capital. Then the law of comparative advantage says trade can produce greater quantities of coconuts both now and in the future, by the person with the comparative advantage producing coconuts now lending the other coconuts. $\endgroup$ – Peter Aug 24 '17 at 1:58

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