the plan for the future
7 October 2008 - 20 July 2017
Money has been invented to make trade easier. There are different types of money, but most money nowadays is bank debt. If you borrow money from a bank, the bank performs a magic trick and creates this money from thin air so that you can spend it. In this way your debt has become money. If you pay back the loan, the money disappears. To make the economy grow, more debts are needed. As is often the case with magic tricks, there is much that can go wrong.
For example if depositors want to take out their money, the bank could go bankrupt because the money the bank has created isn't real money. There is not enough cash in the bank to pay out all deposits. Central banks have been invented to support banks in trouble by performing another trick, which is printing cash when banks need it to show depositors that their magic trick really works. This gives people confidence in the financial system based on debt.
All this sorcery may look like some kind of fraud, but without it, the capitalist economy cannot operate, and we would probably be starving. Now bankers and central bankers have run out of tricks because many people, corporations and governments are deeply in debt. They cannot go further into debt without going bankrupt. And the trick has always been to let someone go further into debt to let the economy grow so that investors can make profits.
In the meantime investors have so much capital that they have trouble finding profitable investments while many people and governments cannot borrow more to increase profits on their investments. We need a way to get the economy going without more debts. This requires a new way of thinking. Rich people need to spend more so that others can earn money and pay off their debts. For that we need lower interest rates and a way to reduce debts.
Natural Money is interest-free money with a holding tax. The maximum interest rate on loans is zero. The holding tax is a tax of 0.5% to 1.0% per month on cash. If you lend out your money or put it in a bank account, you don't have to pay the tax. In this way it can be attractive to lend out money at zero or even negative interest rates. The holding tax can stimulate the economy because it makes keeping money costly. It also allows interest rates to go below zero.
Interest is amongst others a reward for taking risk, so a maximum interest rate of zero can curb risky lending and reduce debts. Debtors that have financial problems cannot borrow at an interest rate of zero. This can make banks safer and the financial system more stable. It can benefit people in financial trouble it is often better not to borrow at all than to borrow at usurious interest rates because that only makes their financial situation worse.
Money and Banking
What is money?
Why is there money?
Uses of money
The value of money
Types of money
What do banks do?
Banks turn debt into money
Banking is bookkeeping
How banks create money
What is the role of governments?
How the current financial system came to be
Regulation and central banks
Supply and demand
What determines interest rates?
The price of money
Returns on investments
Capitalist spirit versus time preference
Properties of money
The problem of interest
Compounding interest on money
Interest on capital versus economic growth
Working towards a solution
Debts, interest and economic crises
Managing the economy
Is there too much debt or are interest rates too high?
Natural Money is a theory about money, banking and interest. Don't stop reading now if you fear that this is going to be boring or incomprehensible. You may think that Whatsapp, Facebook, Twitter and Netflix are far more interesting than these dreadful topics, and maybe you’re right, but I made quite an effort to explain it in plain language and to make it entertaining. As you may find out when reading this chapter, these topics are important. And really, the idea of Natural Money isn't very hard to understand.
Natural Money might be the solution for the financial crisis that is coming. And it is remarkably simple. First, charge a tax on money, so that people that have money will spend it and no new debts are needed to keep the economy going. Second, forbid charging interest on loans, so that risky lending will stop because there is no reward for taking such risk, and debts cannot grow out of control because of interest charges. This can make the economy perform better, which will make people happy. It could also attract new investments so that the economy can improve even further.
If it is so simple then why didn't economists think of it? The answer is that a maximum interest rate is a price control. For economists price controls are amongst the worst kind of evil because they distort the market. But if interest rates are already low or negative, the distortion reduces, and if the alternative is worse then a price control could be good idea. In the past interest rates were too high, and a maximum interest rate of zero would have caused mayhem in the markets, but now interest rate are near zero and destined to go lower. And so Natural Money is an idea whose time has come.
I presume that you have little or no knowledge of economics, so I will start with explaining what money is and what it is used for. Then I discuss the use of banks and how they do their magic trick, which is creating money from thin air. Also the role of the government is important because the government decides what is money and what is not. Then I will make a short trip into history and discuss how the current financial system came to be.
After that we arrive at the most important part of this paper that investigates interest and the problems it causes. First I will show what factors determine interest rates. Governments and central banks have found solutions for some of the problems caused by interest, but not for all of them. I will demonstrate that the financial crisis of 2008, and the next one that may be coming, are caused by interest. That doesn't mean that interest is something evil. Interest is a natural phenomenon and it is needed for the capitalist economy to operate. Still, interest causes wealth inequality and financial instability.
Because of this, governments and central banks try to manage the economy. Governments try to manage economic growth with spending and central banks try the same with printing money and setting interest rates. But now governments are deeply in debt and interest rates are near zero so the old tricks may not work any more in the future. Finally, I will introduce Natural Money, an idea that can solve the coming financial crisis. I will only discuss an outline of the solution here. If you want to know more about it, you could read Economic Theory Of Natural Money.
Despite these mind blowing advantages, humans did not need money for a long time because they lived in small bands and villages where everyone depended on each other and everyone helped each other . This meant, for example, that when a fisherman needed a hat, you would give him the hat, in the expectation that if you needed anything, someone else would provide it to you. You did someone a favour so that he or she was obliged to do something back. Villages were largely self-sufficient. Trade with the outside world was very limited so that it could be done with barter instead of money .
The invention of writing and money made it possible to administrate cities and kingdoms. To create more advanced societies, people had to specialise in certain professions and engage in long distance trade in order to make more products and services available. Without writing and money it was very difficult to track whether or not everybody was contributing to society. Trade as well as tax collection required an administrative system as well as a unit of account to represent value.
Money being a medium of exchange as well as a store of value is like your pet being a cat as well as a dog. The result is not really a success. The parts of the pet may often quarrel, for example because the dog part wants to play while cat part wants to sleep. If someone keeps money for a rainy day, and doesn't spend it, others cannot use this money for buying stuff. And this really can be a big problem. A simple example can explain this.
Imagine that everyone suddenly decides to save all his or her money. Nothing would be bought or sold. All businesses would go bankrupt and everybody would be unemployed. Without the businesses all the money that has been saved would buy nothing, simply because there isn't anything to buy. This is a total economic collapse. In reality it doesn't get that bad because people will always spend on basic necessities like mobile phones. When people only spend money on necessities there is an economic depression. Saving can make you poorer when there are too much savings already. Economists call this the “paradox of thrift”.
Money has no value if there isn’t any stuff you can buy or if there aren’t any other people you can trade with. Imagine that you get the offer to be dropped alone on a remote island in the Pacific with 10 million euros. This probably isn't an attractive deal, even if you can keep your mobile phone. So other people and stuff give money its value. But how? The answer is remarkably simple. The value of money is just a belief.
The value of money comes from the fact that people are willing to work for money and sell their stuff for money. And because other people are willing to do this, you are willing to do the same. For example, you may think that euro notes have an appalling design as well as an unpleasant odour, but nevertheless you probably desire to own these euro notes because other people want them too. The value of the euro is based on the belief that other people will accept euros for payment .
Suddenly you may ask yourself in distress whether or not your precious bank notes still have any value. What is the value of the euro without the European Union? Then you may find yourself hurrying to the nearest phone shop in an effort to exchange this pile of bank notes for the latest model mobile phone.
And to prove this point even further, suppose that the phone shop gladly accepts your euros. Suddenly they become desirable again and you may start to have second thoughts about that latest model mobile phone. It may not remain hip for much longer, so you may change your mind and prefer to keep your precious euros because there will be a newer model next month. So, because the shop wants your euros, you wants them too.
Originally, money was often an item that people needed or desired. Grain was one of the earliest forms of money. Everybody needed grain so it was easy to make people believe that others accept grain for payment too. In prison camps during World War II cigarettes became money because they were in high demand. Even non-smokers accepted them for payment because they knew that other people desired them very badly. For that reason cocaine can be money too.
Wares like grain, cigarettes and cocaine have disadvantages. Their quality degrades over time so that they are not a very good store of value. This makes them a great medium of exchange because people will not save them. An example can demonstrate this. Assume that apples are money, and you think about buying a house. Assume further that a house costs 120,000 apples but that your monthly salary is just 2,500 apples, of which you can save 1,000. It takes 10 years of saving to buy a house. Soon you discover that they rot and that you will never be able to buy a house. Then you will spend all your apples right away.
More importantly, gold and silver do not deteriorate in quality like apples, grain or cigarettes. They do not even rust after 1,000 years. This makes gold and silver an excellent store of value. But this should make us suspicious of the consequences. A perfect cat makes a lousy dog so a perfect store of value can fail the test for being a good medium of exchange. People can store gold and silver so that there is less money available for buying and selling stuff. And this can cause an economic depression as we have seen.
In fact, another reason why gold and silver are attractive as money, is that the value of gold and silver does not depend on the authority of a government. This made gold and silver internationally accepted as money. In the 19th century most government currencies could be exchanged for a fixed amount of gold. This is called the gold standard. The gold standard boosted trade because gold was internationally accepted as money.
Fiat currencies lose value over time. There is always some inflation, and sometimes the inflation is high, often because governments print money because they spend more than they receive in taxes. Therefore it is costly to store fiat currency in a safe deposit box. For example, the US Dollar has lost 95% of its value between 1913 and 2013. This means that the same dollar that bought 20 cans of beer in 1913, buys only one can of beer now. And that is a lot of beer wasted. Because government money rots, even though not as much as apples, government money is a lousy store of value, but often a good medium of exchange.
So if the fisherman promises you to pay next week for the hat you just made, you could say to the lawyer that you expect the fisherman to pay in a week, and ask her if you can pay in a week too. The lawyer could then ask the same of the barber and the barber could ask the same of the fisherman. If all those debts cancel out then there is no need for cash.
If the fisherman borrows money to pay for the hat you made, then this money ends up in your account. You can use it to pay the lawyer. And so the fisherman's debt becomes the lawyer's money until she uses it to pay the barber. People that have a deposit lend money to their bank and they trust the bank even though they do not know the people the bank is lending money to.
There was very little debt and there were very few banks until Capitalism came along. Banking and debts helped to increase trade and production to unprecedented levels by creating money that doesn't exist to start businesses that don't yet exist that will make products which will be bought by the people those businesses will hire with this newly created money. Debt is the basis of the capitalist economy.
The basic rule is that the sum of the amounts on the left side, which is called debit, always equal those on the right side named credit. On the left (debit) side is the value of your assets, which are the things you own. On the right (credit) side is the value of your liabilities, which show how your assets are paid for. To make it even easier to understand, your debt is on the credit side of your balance sheet, not the debit side. Okay, that was a joke.
Your balance sheet might look like this:
the value of your house and other stuff + cash and bank deposits = size of mortgage and loans + your net worth (debit = credit)
When you buy a car, you will have more stuff, but also another loan or fewer bank deposits as you have to pay for the car. This is because debit always equals credit. When you drive the car, it goes down in value, as does your net worth, because debit always equals credit. If your salary comes in, your bank deposits as well as your net worth rise because debit always equals credit. If you pay down the loan, the amount in your bank account as well as the amount of your loan goes down because debit always equals credit. If debit does not equal credit then you have made a calculation error.
Also for a bank the sum of the amounts on the left side must always equal those on the right side, so that debit always equals credit. Your debt is on the debit side of the bank's balance sheet. You have borrowed this money from your bank. The bank owns this loan. Your bank deposits are on the credit side of the bank's balance sheet. The loans of the bank are paid for by deposits. Banks also lend money to each other. This may happen when you make a payment to someone who has a bank account at another bank. Your bank may borrow this money from the other bank until a payment comes the other way.
Your bank's balance sheet might look like this:
the value of mortgages and loans + cash and central bank deposits = the size of bank deposits + the bank's net worth (debit = credit)
And now comes the magic trick. Banks create money out of thin air. How do they do that? That will be explained next. Assume that you, the hatter, the lawyer, the barber, and the fisherman all have € 10 in cash. Together you decide to start a bank. You all bring in the € 10 you own so that you all have a deposit of € 10 and the bank has € 40 in cash. The bank also allows everyone to withdraw deposits in cash. This is no problem because the total amount of deposits equals the total amount of cash. So after everyone has put in the deposit, the bank's balance sheet looks as follows.
the bank's balance sheet after everyone has put in a deposit:
How much money is there now? That’s an interesting question. First, there was only € 40 in cash. Now there are also € 40 in bank deposits. And so you might think that the bank has created money. But that isn’t true. The reason is that the depositors can’t spend the cash unless they take out their deposits. In other words, the depositors don’t have more money at their disposal than before. If you look at the total, there is still € 40. And this is bookkeeping, so you have to write down the total twice, because debit must equal credit.
But now things are going to get wild. The fisherman comes to you and he wants a to buy hat. The hat costs € 50 but the fisherman has only € 10 in his account. To make the sale possible, the bank is going to do its magic. The fisherman calls the bank and asks if he can borrow some money. The bank grants him a loan of € 40 and puts the money in his deposit account so that he can spend it. And look!
the bank's balance sheet after the fisherman takes out a loan:
the bank's balance sheet after the hat has been paid for:
A perfectly healthy bank could get into trouble in this way. Clever minds have already figured out a solution. Central banks can print the needed cash. If the European Central Bank would print € 20 on a piece of paper, and would lend this money to the bank, there would be enough cash in the bank to pay out your deposit. Banning the use of cash completely, and only use bank deposits for payments, would be another option.
the bank's balance sheet after the ECB rescues it:
After you have paid the fisherman € 50 in cash, he can use the cash to pay off his loan, and the bank will have enough cash to pay out all deposits again, so that the central bank deposit is not needed any more. And so the bank can repay the central bank deposit, and everything is fine and dandy again.
the bank's balance sheet after the fisherman repays his loan:
The central bank just saved a solvent bank. The bank is solvent because the fisherman is able to repay his loan. But a central bank can easily save an insolvent bank as well. If the fisherman goes bankrupt after taking out the loan, there will never be enough cash to pay out all deposits because the loan will not be repaid. The bank is now insolvent, which means technically bankrupt. Yet, the central bank can take two pieces of paper, print € 20 on both, and deposit them in the bank forever. The bank would still be bankrupt, but it can remain open because there is enough cash to pay out all deposits.
Why should banks create money? Without the ability of banks to create money, fewer transactions would be possible. If the hat is € 50, the legal advice € 60, the hairdo € 30, and the fish € 20, and you, the lawyer, the barber and the fisherman all have only € 10, nothing can be bought or sold. If the bank lends € 40 to the fisherman, he can buy a hat from you, you can buy legal advice from the lawyer, the lawyer can buy a hairdo and the barber can buy fish. This wouldn’t be possible without the bank creating money. Debt is the basis of the capitalist economy. Nearly all money is debt, and without debt, the economy would come to a standstill.
Governments can issue money, for example by printing € 20 on a piece of paper, and demand that this money should be used for payments and taxes. Government money is often called currency or fiat money. Fiat money doesn't mean that you can buy small Itialian cars with this money, but that this money is money by law. Governments make legal tender laws that declare that the money governments can print is the only money you can use for payments. A shop owner doesn't have to accept your credit card but should accept your euro bank notes because euro bank notes are legal tender.
Currencies are created by the government or the central bank. Currencies consist of coins, bank notes and central bank deposits. Banks can deposit their cash at a central bank in exchange for a central bank deposit. The value of a currency such as the euro or the dollar is based on a belief like all other forms of money. Governments create belief in their currencies by forcing people to use their currencies for payments and taxes. Governments do much more to promote belief in their currencies. Most notably, they make laws and enforce them, so that people can safely trade and pay.
These regulations limit the amount of loans banks can make and therefore the amount of money that can exist. But everyone can lend to anyone. And so alternative forms of financing emerged that circumvent the regulations imposed on banks. For example, corporations can issue bonds or use crowd funding. Human imagination is the only limit on the amount of debt that can exist. As long as enough people expect those debts will be repaid, even if it is with new debts, there is trust in these debts. The financial crisis of 2008 has demonstrated that trust in debts can suddenly disappear.
Once upon a time when gold was internationally accepted as money, goldsmiths fabricated gold coins of standardised weight and purity and thus they became a trusted source of these gold coins. The goldsmiths also owned a safe where they stored their own gold. Other people wanted to store their gold there too because those safes were well guarded.
The goldsmiths also had another business, which was lending out their gold at interest. Because depositors rarely came in to collect their gold, the goldsmiths found out that they could also lend out the gold of the depositors at interest. When the depositors found out about this, they demanded interest on their deposits too. At this point modern banking started to take off, and paper money became known as bank notes.
Borrowers also preferred paper money to gold coin, so the goldsmiths, who had now become bankers, found out that they could lend out more money than there was gold in their vaults. Bankers started to create money from thin air. This is called fractional reserve banking because not all deposits were backed by gold reserves . This newly created money was spent on new businesses and those businesses hired new people so that the economy boomed.
But sometimes people started to distrust their bank, and worried depositors came to the bank to exchange their bank notes for gold. When that happened, the bank could run out of gold and close down because the gold wasn't there. The bank's bank notes could become worthless, even when borrowers had no problems repaying their debts. This is called a bank run. When the bank notes became worthless, the money that the bank had created out of thin air suddenly vanished. This is called a financial crisis.
Because a lot of money had suddenly disappeared, people had less money to spend. This could hurt sales so that some businesses would go bankrupt. Those businesses then did not repay their debts at other banks and depositors at other banks might fear that their bank would go bankrupt too. This could cause more bank runs and more money disappearing so that people would have even less to spend, so that things would become even worse. This is called an economic crisis. As you can see, a financial crisis can trigger an economic crisis.
Measures have been taken to forestall financial crises and to deal with them if they occur. Banks needed to have a minimum amount of gold available in order to pay depositors. This is called a reserve requirement. Central banks were instituted to support banks in trouble by supplying additional gold if too many depositors came in to collect their gold. Central banks could still run out of gold but this problem was solved when the gold backing of currencies was ended.
Nowadays it is possible to create additional dollars and euros to cope with any shortfall because money is not backed by gold any more. In fact, this is what central banks do all the time, even though the pace they do it varies. There is always a shortfall because of interest. This is because most money is debt, and interest on this debt needs to be paid. For example, if there is € 1,000 in circulation, and the interest rate is 5%, then € 1,050 needs to be returned at the end of the year. That is a problem because there is only € 1,000.
The only ways to make up for the shortfall are to print new currency or to make people borrow more so that new money is created. When central banks lower interest rates, they print new currency at a faster pace, so that the shortfall decreases, the price of money, which is the interest rate, falls, and people can borrow more. If central banks raise interest rates, they print new currency at a slower pace, so that money becomes more scarce, the interest rate rises so that the shortfall increases, and people can borrow less. Central banks may do that when people are borrowing too much money into existence so that inflation picks up.
If a bank went bankrupt, its banknotes would become worthless, so the financial condition of a bank affected the value of its bank notes. For that reason, only central banks issue bank notes nowadays. Bank notes from the central bank are currency because a central bank is a government institution. If you examine a dollar or a euro note then you can find the signature of the head of the FED or the ECB on it. The great advantage of this arrangement is that all bank notes of 10 euro have the same value so that people do not have to check the condition of the bank issuing the note when they receive a bank note.
Before we go any further, we have to discuss the most basic law of economics, the law of supply and demand. It is a simple law. If many people desire an item but there are only a few of them then the price of such an item is often high. If the coffee harvest in Brazil fails, the price of coffee rises because many people crave for coffee. On the other hand, if few people desire an item, and there are many of them, the price of the item is often low. If the harvest of couch potatos is abundant, people may even want to pay to get rid of them. So, the price of an item depends on how much it is wanted and how many of such items are available.
Probably both phones will be sold for a price above € 120. You and the lawyer probably will end up owning one. Assume now that the fisherman and the barber have outwitted you and the lawyer by going to the bank and borrowing € 50. Now you have € 130, the lawyer has € 140, the fisherman € 160, and the barber €170, so that the mobile phones will be sold for a price above € 140 to the fisherman and the barber. Money is often worth less when there is more of it, so that you need more money to buy an item such as a mobile phone.
The owner of the mobile phone shop sees no customers coming in except you, and because there is a rumour that these mobile phones will not remain hip for much longer, he offers you a huge discount. And so you end up buying both phones for only € 100. In this case it doesn't matter how much money everyone has.
The next question you may ask is what determines the supply and demand for money, and therefore the price of money? Diligent economists have come up with the following list of factors. Interest rates are determined by convenience, risk, returns on investments, and time preference. There something else, and it is often overlooked. It is the type of money used. The theory of Natural Money is a theory about money as well as interest. And what’s a theory about interest without an explanation of interest?
If the inconvenience is not there, the interest rate could be lower. If you deposit money in a bank, you lend it to the bank, but you can still use it any time you want. The bank can do that because if you make payment, for example for legal advice, this money ends up the account of the lawyer, and the bank will be borrowing this money from the lawyer instead, until she uses it to pay someone else. For that reason interest rates on current accounts or checking accounts tend to be low. And because having money in a current account is more convenient than cash, the bank may even charge you.
Lending out money can be a risky adventure. Perhaps you have tried it yourself, and discovered that there are two types of risk. First the borrower may not pay back the loan. That could make you a bit reluctant. So if someone wants to borrow money from you, and you fear that she may not pay back, she could offer you a high enough interest rate on the loan so that you might think, "Well, there is some chance that she will pay back, and the interest rate is very attractive, so I'll do it."
As we have already seen, it is the business of banks to know their customers. For that reason lending money to a bank is less risky than lending out money to an individual or a corporation. And because banks are supposed to be good at managing risk, they can borrow at lower interest rates. And because they know their customers well and lend to many different customers, they can also lend at lower interest rates.
Depositors may fear that their bank may go bankrupt because some loans will not be paid back or because there isn’t enough cash to pay out all deposits. For that reason depositors may desire higher interest rates on deposits to compensate for these risks. As we have seen, central banks can print cash and save banks if needed. When depositors expect central banks to step in in times of trouble, they feel safer, and interest rates can be lower. In 2008, when the financial crisis started, interest rates on deposits first spiked, but went close to zero after the central banks saved the banks.
If you have some money, you could invest it in corporations or real estate. Corporations pay dividends and real estate pays rent. If the rents and dividends are higher than the interest rate you get when lending out money, you may prefer to invest your money. But investing is more risky than lending. If sales are sluggish, dividends may be cut, but lenders will still get their interest. And when a business goes bankrupt, lenders will get back their money fist. Investors only get what's left over. But if the dividends or rents are higher than interest rates on loans, you may prefer to invest despite these risks.
So, if someone wants to borrow money from you, the interest rate must be attractive, otherwise you may prefer investing and receiving dividends and rents. Other people that have money are in a similar position. Borrowers need to offer attractive interest rates in order to be able to borrow any money. Similarly, if dividends and rents are low, people with money may prefer lending to investing, so that borrowers do not have to pay high interest rates. Interest rates on loans therefore also depend on profits that can be made by investing.
Suppose that you are a hatter and just received € 50 for a hat. You could rush to the nearest phone shop and buy that phone cover you saw yesterday. Alternatively, you could save the money so that you could buy a mobile phone later when you have sold more hats. You could even save some money for retirement. Choices are abundant, but the odds are that the money will be gone before the month is, and that you have acquired the phone cover or some other gewgaw. Most people spend their money sooner rather than later, and even borrow some more. Economists now think that you suffer from a condition named “time preference”.
But time preference only works for ordinary people. There are other people too. They are called capitalists. Capitalists think differently. They suffer from a condition economists call “capitalist spirit”. Capitalists think that money spent on a frivolous item is money wasted. That is because if you invest your money, you will end up with more money that you can invest again. Consequently capitalists often have a lot of money when they die. What's the point of that? Capitalists invest in all kinds of businesses that make the items ordinary people enjoy. Ordinary people wouldn’t have invested their money, but spent it instead on frivolous items, so that these items wouldn’t have been produced in the first place.
Because capitalists are such special people, they pile up a lot of money they need to invest. It is unlikely that they will spend it on frivolous items, and even if they do, it doesn't matter much because they have so much money. For example, if your income is 200 million euro, spending 10 million on a luxury yacht means that you have only a little less available for investing. Interest rates are so low nowadays, partly because capitalists have so much money that they need to invest that they are running out of things to invest in, so that they are willing to lend it at lower interest rates. Again, it is the law of supply and demand at work here. If other people can’t borrow any more because they pay too much in interest, interest rates must go down.
The type of money can also affect interest rates. Just imagine that apples are money and you are saving to buy a house. If someone wants to borrow 1,000 apples from you, and promises to repay those 1,000 apples after 10 years when you want to buy your house, you would gladly accept this generous offer. You may even have accepted an offer of 900 apples. In this case you would settle for a negative interest rate. But you would only do so if there are no alternatives.
If you could make 10% per year in the stock market, you could exchange your apples for Apple stock because their gadgets are in great demand and outrageously expensive. In that case, it doesn't matter that the apples rot, and you could demand interest on a loan. But if returns on the stock market are low, and stock prices are fluctuating so wildly that you can't sleep at night, you may prefer the offer of 900 apples.
But if the money had been gold, you wouldn't accept such an offer, even when the stock market is doing terrible. If interest rates are negative, you can always store your gold in a safe deposit box. Similarly, you wouldn't accept negative interest rates on euros or dollars because you can take bank notes and store them in a safe deposit box. If you put money in a safe deposit box other people can’t use it for buying and selling stuff. And as we have seen, this can cause an economic depression.
In order to allow for negative interest rates, money can’t be gold, and cash is a problem too. In Wörgl people had to glue a stamp on the bank notes every month. That is quite cumbersome. One option is to abolish cash altogether. The other option is to make cash a different currency so that there will be an exchange rate between cash euros and euros in your bank account. So, if the holding tax is 10% then one cash euro will be worth 0.90 bank euro after one year.
Assume that Jesus' mother put a small gold coin weighing 3 grammes in Jesus' retirement account at 4% interest in the year 1 AD. Jesus never retired but he promised to return. Suppose that the account was kept for this eventuality. Assume further that the end is near. So, how much gold would there be in the account in 2015? You will be surprised.
But we shouldn't worry too much about these things because bankers cannot create gold. The interest on the deposits is created out of thin air in the same way money is created out of thin air. Jesus has an account with 10 million Earth masses in fictional gold. As long as he doesn't show up, the bank can remain open.
This looks very much like the situation where the cash isn't there when depositors want to take out their deposits in cash. And so the banker may fear the day of reckoning because he has no real talents to back up his bluster. The problem of interest exists when there is a limited amount of gold because compound interest is infinite. As long as bankers can create money out of thin air to pay for the interest, and people accept bank deposits for payment, everything is fine. Problems only arise when people demand real gold for their deposits.
Perhaps Jesus’ retirement account isn’t such a big problem after all. Our money isn’t gold but currencies central banks can print. Assume now, and imagine it was possible, that Jesus’ mother had put one euro in the account instead. One euro at 4% interest makes 21,000,000,000,000,000,000,000,000,000,000,000 euro after 2015 years. That may seem an intimidating figure, but the European Central Bank can take 21 pieces of paper and print 1,000,000,000,000,000,000,000,000,000,000,000 euro on them. And there you are.
As you can see, another important reason to have central banks is to cope with interest on money. The amount of money in bank accounts as well as debts grows unabated because of interest. If depositors suddenly crave for cash central banks can print as much cash as needed. As a matter of fact, central banks always print some to accommodate for interest and economic growth so that banks are never short of cash. If that had solved the problem of interest we wouldn’t have financial crises and I wouldn’t be writing about Natural Money. So what’s the problem then?
To explain it, we have to simplify matters, and assume that there are two types of people: workers who receive wages and spend it all and capitalists who receive interest and invest it all. For a while this works great because the capitalists invest in factories that produce all kinds of fantastic stuff. The capitalists hire employees who can buy all this stuff from their wages. Capital helps to let the economy grow and everybody profits. If that isn't a good deal then what is?
Assume that the economy grows 2% per year and the interest rate on capital is 5%. Assume also that the size of the economy, which is the total value of everything that is produced is € 1,000,000 while the total value of capital is € 2.000,0000. In that case the capitalists receive € 100,000 in interest, so that € 900,000 remains for wages. But what happens over the years?
This is the way how capitalism works, according to its proponents. And it gets even better. After 25 years total income was € 1,640,606, interest income increased to € 338,635, so that € 1,301,971 remains for wages. But something ominous is going on behind the scenes. Perhaps you smell a rat already. Interest income is growing faster than the economy. After 50 years it starts to eat away wages despite the fact that the economic pie is still growing.
After 75 years, total income is € 4,415,835, interest income is € 3,883,269, so that only € 532,567 remains for wages. After 80 years there is nothing left for workers. This is represented in the graph. The outer circle represents total income. The red part is interest. The green part is labour income. What the numbers tell, can also be seen in the graph. Something needs to give. The example is isightful because throughout history, interest on capital, which is another word for business profits, has been higher than the economic growth rate .
When business profits go down there are fewer profitable investments. The capitalists have so much money to invest that they are willing to lend at lower rates. These lower interest rates allow workers to borrow more so that they can spend again. But at some point they cant borrow more and business profits go down again. By then the capitalists have even more money to invest so interest rates go down even further. Finally workers are drowning in debt and capitalists are drowning in money. And so interest rates get stuck near zero and the scheme runs into trouble.
If returns on capital exceed the rate of economic growth, which they normally do, then capitalism can lead to wealth inequality. This can at some point undermine profits and economic growth. But if the capitalists could be induced to spend more of their money on frivolous items, their businesses could make more profits, workers could have higher wages, interest rates could be higher, and workers wouldn’t go so deeply in debt. But alas, that’s not the way things are. It is the capitalist spirit that makes them save and invest. Lower interest rates will do little to change that. But people that suffer from time preference spend more if interest rates are lower, simply because they can borrow more.
And so lower interest rates may seem like a stupid idea. If interest rates were higher, workers can’t borrow as much, and they might even start to save. Think of it like this. An additional hip phone cover might convince you to postpone your purchase of a new mobile phone until next year. A high interest rate can make you start saving and stop borrowing. If you borrow money, you have less money next year. So if you borrow money for a mobile phone this year, you can’t afford the latest model the next time, and you would become an unfashionable nerd, which is more or less like being dead. So, the higher interest rates are, the more attractive saving becomes, and the less attractive borrowing will be.
The problem is that the interest rate is determined by supply and demand in the markets for money and capital. It is the capitalists with their excess supply of money and capital that determine interest rates, not the workers who can’t borrow any more. The capitalists are getting more and more desperate. They have so much money to invest while workers can’t borrow more to make their investments profitable. This is the paradox of thrift. It could lead to an economic depression, and quite possibly a world war. But perhaps this can be avoided with negative interest rates.
If the capitalists are unwilling to spend their money, they should be lured into spending it, or if that doesn’t work, others should be lured into spending the money of the capitalists. Only negative interest can make that happen. If interest rates are negative, capitalists can’t make money by investing. They might spend their instead, so that their businesses remain profitable and keep employing people. And if the capitalists are not willing to spend, they can lend this money to others who will spend this money for them. For example, if the interest rate is -3%, and you can borrow € 100,000, you get € 3,000 for free every year. Even though it may seem crazy, this could be the way to keep the economy going.
If debt is used to finance investments, this doesn't have to be a problem either. For example if a shop owner borrows € 200 to buy two mobile phones he expects to sell for € 300, borrowing € 200 could enable him to make a profit of € 100, at least if everything goes according to plan. But if suddenly a rumour emerges that those mobile phones will not remain hip for much longer, the shop owner may be forced to offer a deep discount and sell both phones for € 100, leaving him with a debt of € 100 he might not be able to repay.
When there is a buying frenzy business owners are optimistic and do a lot of investments, and often they go into debt to make those investments. But if suddenly customers disappear, they may be stuck with unsold inventory and debts they cannot repay. Businesses may then have to fire people. Those people are then left without income, and cannot repay their debts too, so sales will go down further. If their debts are not repaid, banks could get into trouble. In most cases the economy will recover. In the worst case money disappears, the economy collapses, and an economic depression takes off.
Interest can make things even worse. Assume that you have a business and expect to make a return of 8% on your investments. You have € 100,000 yourself and you can borrow € 200,000 at 6%. Because you expect to make 8%, borrowing money at 6% seems a good idea. If you only invest your own € 100,000, you expect to make € 8,000, but if you borrow an additional € 200,000, you expect to make € 12,000 (8% of € 300,000 minus 6% of € 200,000, which is € 24,000 minus € 12,000). The balance sheet of your business might look like this.
Assume now that sales disappoint, and that you only make a return of 2% on the invested capital, which is € 6,000. Because you have to pay € 12,000 in interest charges, your business operates at a loss. You may have to fire workers. Businesses can fail because they have borrowed too much money and have to pay interest, even though they are profitable overall. Many financial schemes like leveraged buy outs work in this way. Venture capitalists borrow a lot of money to buy a company. They may fire workers or split up the company to pay for the interest. If things go right, they can sell the company at a profit.
Some economists argue that central bank management of the economy has caused this problem. Without central banks helping banks, banks would have been more cautious, while any problems would have been corrected in an earlier stage. The problem with this reasoning is that central banks make the financial system more stable. Banks and central banks reduce risk, and this makes taking more risk possible. It is like safe cars making people drive more carelessly.
It doesn't seem a good idea to ban safe cars. It may be better to take away the responsibility of driving away from the driver. New inventions will make this possible in the near future. If we could invent a financial system that drives without a driver, so that markets instead of central bankers and governments could keep the economy on track, we could be better off. But is it possible to a design a financial system that stimulates the economy when needed, keeps debts in check, and discourages reckless lending, so that there can be stable economic growth and low unemployment?
It may seem ridiculous to suggest that interest rates are too high. But if we take a better look, we see that lower interest rates make more investments profitable. If a new factory would generate a return of 4%, then it is not profitable to build when the interest rate is 6%, because investors can get a better yield elsewhere. But if the interest rate is 2%, then it can be profitable to build the factory, so that more products will come on the market, so that people can buy more stuff.
Critics of central bank policies often argue that central banks have artificially lowered interest rates. They propose to raise interest rates and let the economy crash. After some time, things will stabilise, a lot of debt will be gone, and many businesses will have gone bankrupt. Then there will be room for growth again. But what is the point of destroying an economy just in order to rebuild it? Even more so, the Industrial Revolution took off in England, just after England had become the first country to institute a central bank. So the lower interest rates produced by central banking may have made the investments in factories profitable.
But it all depends on the type of money we use. If apples were money, interest rates could go below zero, and people that have a lot of money will then see it losing value. If they see no opportunities to invest their money, they might start to spend it so that the economy could improve. This could trigger new investments and economic growth without new debts. If there is also a maximum interest rate on loans, lending would be curtailed, and debts don't have to grow out of control.
Already in 1916 Silvio Gesell proposed a holding tax on money in his book The Natural Economic Order . Interest-free money is also not a new idea. Many local currencies or community currencies are interest-free. There are already a few economists and central bankers thinking that negative interest rates may be needed to end the next financial crisis. But negative interest rates alone can bring about a lot of reckless lending because investors looking for higher yields will take more risk. You need a maximum interest rate to stop this from happening.
There is so much capital and debt that interest rates can remain low enough to make interest-free money with a holding tax a success. A maximum interest rate of zero can curtail risky lending and economic booms fuelled by new debts so that negative interest rates do not have to incite reckless lending and financial crises. Interest-free money with a holding tax can improve the economy so that returns on investments as well as interest rates can rise.
This could cause a monetary revolution. If you can get a higher interest rate at another bank that is as safe as your current bank, would you stay with your current bank? Probably not. Many people would therefore opt for an interest-free account in a Natural Money currency. And that could cause a capital flight to the interest-free economy so that all countries will adopt Natural Money. This is why Natural Money may be the money of the future.
1. History of Money - Wikipedia (as on 12 October 2013): http://www.naturalmoney.org/historyofmoney.html; current version: http://en.wikipedia.org/wiki/History_of_money
2. A Brief History of Humankind - Part III: The Unification of Humankind, § 8.2, Dr. Yuval Noah Harari, Coursera.org, 2014: https://www.coursera.org/course/humankind; course notes: http://www.naturalmoney.org/briefhistory-03.html#0802
3. A Brief History of Humankind - Part III: The Unification of Humankind, § 8.3, Dr. Yuval Noah Harari, Coursera.org, 2014: https://www.coursera.org/course/humankind; course notes: http://www.naturalmoney.org/briefhistory-03.html#0803
4. Capital in the Twenty-First Century, Thomas Piketty, Harvard University Press, 2014
5. Poor Because of Money: Our theory on interest, Henk van Arkel and Camilo Ramada, Strohalm, 2001: http://www.naturalmoney.org/ poorbecauseofmoney.html
6. The Natural Economic Order, Silvio Gesell, Translated by Philip Pye, Peter Owen Ltd, 1958: http://www.silvio-gesell.de/neo_index1.htm