the plan for the future
16 August 2016 - 25 April 2017
Interest-free money with a demurrage or holding tax may become the money of the future. This idea is wellknown to the social and complementary currencies movement, but mainstream economists do not take it seriously. Interest rates will probably remain low, and may go even lower, so that the superior efficiency of this money can transform the financial system. Silvio Gesell was the first to propose a holding tax on money in his work The Natural Economic Order so this money can be named Natural Money to honour his legacy.
Interest-free means that the maximum nominal interest rate on loans is zero. The demurrage is a tax on holding cash that may range from 0.5% to 1% per month. You don't have to pay the holding tax on money lent and other investments, which can make it attractive to lend out money at interest rates below zero. The holding tax doesn’t apply on bank accounts either. Hence, the business of banks doesn't have to change. There is little difference between borrowing money at 2% to lend it at 4% and borrowing money at -2% to lend it at 0%.
Interest is needed to build the economy but lower interest rates have a number of benefits:
- lower interest rates promote capital formation and prosperity;
- products and services become cheaper because we pay interest costs on everything we buy;
- most people pay more interest than they receive so they benefit from lower interest rates;
- only the wealthiest people receive more interest than they pay, so lower interest rates can reduce income inequality and promote social stability;
- lower interest rates can make it possible to do the investments needed to combat poverty and to make the economy sustainable.
There are a number of issues that Natural Money can deal with:
- Natural Money removes the zero lower bound on interest rates, so that lower rates are possible, and the benefits of these lower interest rates can be attained;
- a maximum interest rate can reduce moral hazard in the financial system as interest is a reward for risk;
- Natural Money can mitigate the business cycle so that the economy can stabilise and operate without the need for fiscal and monetary policies;
- a maximum interest rate can promote the financial discipline that is needed to keep interest rates low.
Not so long ago more than 99% of the world population lived in abject poverty. Most people had barely enough food to survive. In 1651 the philosopher Thomas Hobbes depicted the life of man as poor, nasty, brutish, and short, and it has always been that way. Yet a few centuries later a miracle had happened. Nowadays more people suffer from obesity than from hunger while the life expectancy in the poorest countries exceeds that of the Netherlands in 1750, which was the richest country in the world at the time.
Many people forget about that quite easily when they think of what can go wrong. But it doesn’t have to go wrong. An era of unprecedented prosperity may be upon us. Poverty may soon be gone and the economy may become sustainable. It can happen but such a feat requires a lot of capital. And lower interest rates can facilitate the build-up of this capital. That is because lower interest rates make more projects economical, for instance investments in renewable energy or the infrastructure in high-risk areas like Africa.
Interest rates will probably remain low and may go even lower because the trend towards lower interest rates is sustained by structural developments. Higher interest rates may only be attained by irresponsible actions that scare investors and push up risk premiums, or another great depression or great war that will destroy capital so that it needs to be rebuilt afterwards. Yet, not all is peachy in the land of low interest rates. Low interest rates can promote a quest for yield and the type of irresponsible risk taking that caused the financial crisis of 2008. Interest is a reward for risk so this can be fixed by making money interest-free.
If you are familiar with interest-free money, negative interest rates and a holding tax on money, then you are ahead of most main stream economists. Negative interest rates are entering their mindset for the first time in history, but only as a temporary policy measure for central banks to cope with a crisis. They don’t think that negative interest rates can become the new normal. Economists are not equipped to have such thoughts because negative interest rates require questioning some of the most basic premises of their profession, such as scarcity and time preference, as positive interest rates follow naturally from them.
This paper is an exercise in economic thought on interest-free demurrage currency or Natural Money. The people who use this kind of money nowadays do so only on a limited scale. Their motivation is to empower communities or their objections against interest. They are often not very interested in economic and monetary theories. They may say: “Economists think that this is impossible, but we will demonstrate that it can be done by doing it.” This reflects the attitude that defines the community currency movement. As a consequence, there isn’t much theory and data to work with.
People in the community currencies movement ignored some economic theories, most notably arbitrage. Interest-free money is not feasible on a large scale as long as interest rates are higher elsewhere. If you can borrow money interest-free and lend it at interest, then many people will participate in this trade. People in the community currencies movement also don’t think that the liberalisation of financial markets can benefit their cause. Instead, they often feel that small is beautiful. And so interest-free money never took off in the past. But now interest rates are near zero, and they may go even lower, so economists should take notice.
Natural Money consists of two basic elements. First, there is a holding tax on currency also called demurrage ranging from 0.5% to 1% per month. Cash and central bank deposits are currency and subject to this tax. Regular bank deposits, bonds, stocks, real estate, and other investments are not currency, hence the tax doesn’t apply on them. Second, there is a maximum interest rate of zero on debts. It can be attractive to lend out money at negative interest rates because the holding tax doesn’t apply on money lent.
This paper investigates whether Natural Money can help to improve mature economies. To successfully implement Natural Money, interest rates must be low and remain low in the future. It is assumed that this is going to happen and that the factors that contribute to lower interest rates remain in place. Implementing Natural Money needs to be a gradual process in order not to disrupt financial markets. That is because financial turmoil engenders a risk premium that puts an upward pressure on interest rates.
Natural Money is expected to bring economic improvement in four major ways. First, the removal of the zero lower bound allows interest rates to go negative if market conditions justify such rates. This will probably happen. The new lower bound will be the holding tax rate, which can range from -6% to -13% annually. Lower interest rates make more projects feasible so that more capital and hence more wealth can exist. This can enable the investments needed to combat poverty and to make the economy sustainable.
Second, the maximum nominal interest rate is expected to reduce problematic debts and transfer risk out of the financial system into the hands of investors. A maximum interest rate curbs the risks lenders are willing to take so that there will be fewer problematic debts. Governments and central banks guarantee the integrity of the financial system so this can eliminate moral hazard and private profits at the expense of the public.
Third, Natural Money can mitigate the business cycle. If the economy fares poorly, interest rates can go as low as needed. This will provide a stimulus. If the economy is poised to overheat, interest rates rise. The maximum interest rate then causes equity investments to become more attractive relative to debt because only equity investments can have returns exceeding zero. In this way the available amount of funds for borrowing contracts so that the economy can cool down without a debt overhang.
Fourth, the economy can do well by itself. Government and central bank interventions cause market distortions such as the political business cycle and a mispricing of risk in the expectation of interventions. In the absence of business cycles and problematic debts, the rationale for these interventions disappears. If nominal interest rates are negative, and credit during boom times is curtailed, there may be no need to inject additional currency into the banking system to satisfy reserve requirements.
In this way Natural Money can bring stable growth. The amount of currency and debt are expected to remain stable over time so that prices will deflate at a rate near the rate of economic growth. In this way a maximum interest rate of zero can become a positive real return. The improved economic stability can reduce the risk premium on investments. Investments in Natural Money currencies can therefore be an attractive option compared to interest-bearing currencies hampered by financial instability and moral hazard.
The main proposition being investigated in this paper is that interest-free demurrage money, also called Natural Money, can improve the economy and reduce risk in the financial system, so that the risk reward ratio of investing becomes more attractive, and interest rates can go even lower. Some of the expected benefits of lower interest rates are increased prosperity as lower interest rates allow for more capital to exist, and a reduction of income inequality as interest is an important contributor to income inequality.
There is a lack of data and economic theory as to how an economy under the regime of Natural Money will operate and how economic agents will behave. This paper therefore centres on examining existing economic theories to assess the consequences of implementing Natural Money. The aim of the paper is to predict whether Natural Money is a feasible option for the regular financial system, and under which conditions that may be so. Implementing Natural Money can alter the dynamic of the economy so that the implications can only be estimated in a qualitative way.
The following issues are investigated in this paper:
1. the preconditions for the introduction of Natural Money;
2. the preferred method for implementing Natural Money;
3. feasibility of removing the zero lower bound;
4. feasibility of a maximum interest rate;
5. reducing moral hazard and problematic debts;
6. mitigation of the business cycle;
7. the end of fiscal and monetary policies;
8. efficiency improvements.
Implementing Natural Money on a world wide scale is an economic revolution. It means replacing positive interest rates and a zero lower bound with negative interest rates and a zero upper bound. For that to happen, existing economic thought must be turned upside down. At the basis of economic theory stand scarcity, time preference, and positive interest rates. Scarcity still applies to most ordinary people, but not to wealthiest who own most capital. Yet, the actions of the wealthiest have a growing influence on interest rates, simply because they have the most capital and are faced with dwindling investment options.
Natural Money requires low interest rates and a low inflation rate. Interest rates must be low because a maximum interest rate can cause disruptions in the money and capital markets when a significant portion of lending takes place at higher interest rates. And high inflation rates cause high interest rates to compensate for the loss of purchasing power. Furthermore, there is no need to remove the zero lower bound as long as interest rates are significantly higher. It is expected that interest rates will probably remain low and may go even lower in the future, so that it may become feasible to implement Natural Money.
The factors that contribute to lower interest rates are likely to persist so that interest rates are expected to go lower in the future. These factors, which are mostly in place in developed economies, are the following:
1. rule of law, political stability and economic stability;
2. a lower consumption of capital income related to wealth inequality;
3. fractional reserve banking and central banking;
4. globalisation and efficient financial markets;
5. innovations in the field of risk management such as derivatives;
6. a growing indebtedness related to lower interest rates;
7. retirement savings;
8. reduced population growth.
Negative interest rates require financial discipline, most notably from governments. Government deficits can lead to higher interest rates and this can put the maximum interest rate under pressure. First, government deficits tend to increase the demand for funds. Second, government deficits put a risk premium on the currency. Third, government deficits can cause inflation. With Natural Money the room for primary deficits is limited to the interest governments receive on their debts.
A sudden introduction of Natural Money can cause financial turmoil. The transition preferably is a gradual process that is well communicated in advance. Financial markets can remain in operation in the way they are used to because the trend towards lower interest rates is expected to pave the way for Natural Money. The first step in is the introduction of the holding tax on currencies when interest rates near the zero lower bound. This should be done in small steps so that market participants have ample time to adjust. Introducing a tax on currency is going to affect the demand for currency, so that currency needs to be decommissioned in order to reign in inflation. Central banks can sell assets on their balance sheets in order to retire currency.
After the removal of the zero lower bound, a maximum interest rate can be introduced. The initial maximum interest rate must be sufficiently high in order not to disrupt financial markets. At first, this rate may be between 5% and 10% annually. It is assumed that interest rates will go down further in the future, and that sub-prime credit needs to be phased out, so that the maximum interest rate can be lowered over time.
Implementing a holding tax is complicated because of the existence of cash. Many people still prefer using cash. Cash is currency and therefore subject to the holding tax. The most practical way of implementing the holding tax on cash is via an exchange rate between cash and digital currency. Cash can then depreciate relative to digital currency at a rate of 6% to 13% per year. For example, a person who holds € 150 euro in cash on average will pay € 9 to € 19 per year in holding tax.
A tax on cash and negative interest rates will probably arouse negative sentiments. People are accustomed to a zero interest on cash and positive interest rates on money and debts. The general public may accept Natural Money if the benefits of lower interest rates are well known. The market conditions causing lower interest rates, and the advantages of negative interest rates, as well as a maximum interest rate need to be explained. Yet, many people may oppose the idea unless they are desperate and willing to try anything. It is not a coincidence that the Wörgl currency was introduced during the Great Depression. Only after it became a spectacular success, other communities started to copy the idea.
The zero lower bound is a minimum interest rate. Like a price control it prevents the interest rate from moving freely to the rate where supply and demand for money and capital balance. This can obstruct an economic recovery because market participants prefer holding cash to consumption and investments at the zero lower bound. The holding tax brings down the lower bound to the holding tax rate so that negative interest rates will be possible when market conditions justify them.
Removing the zero lower bound allows interest rates to go lower than otherwise would be possible. Lower interest rates are expected to foster capital formation and prosperity. The lower interest rates go, the more projects become economical, and the more capital and wealth can exist. As capital costs go down, products and services can become cheaper. The additional wealth created by lower interest rates can be used to combat poverty and to make the economy sustainable.
Removing the zero lower bound only affects interest rates when the zero lower bound has already been reached. When interest rates are higher, a holding tax on currency is unlikely to have a major impact on interest rates. The holding tax is not much more than a lower bound, just like zero currently is the lower bound because of the existence of cash. The lower bound only comes into play when interest rates are near it. And if it wasn’t for the existence of cash, removing the zero lower bound wouldn’t be such a big issue.
Removing the zero lower bound doesn’t alter the business of banks. There isn’t much difference between borrowing money at 2% to lend it at 4% and borrowing money at -2% to lend it at 0%. A concern sometimes expressed is that people may shun the currency because of the holding tax. Indeed, few people are willing to lose 6% to 13% per year on money balances, but that isn’t going to happen as most money is in bank accounts and other investments provide better yields. Money is the most liquid asset so people will probably accept slightly negative interest rates on money in bank accounts.
The holding tax will therefore not adversely affect the economy. It can contribute to an improvement when interest rates are near the zero lower bound. There is not much historic evidence to support these claims. Yet money with a holding tax existed in ancient Egypt for more than 1,000 years. This suggests that a currency system with a holding tax can be stable and last a long time. In 1933, when interest rates were at the zero lower bound, a local currency with a holding tax resulted in a remarkable economic recovery in the Austrian town of Wörgl.6 This suggests that removing the zero lower bound can promote an economic recovery.
Central banks can stop printing currency to satisfy the demand caused by the liquidity preference. In other words, central banks can stop buying up assets such as government bonds and end unconventional measures like quantitative easing. Removing the zero lower bound reduces the demand for currency and can make investors look for the assets that central banks have piled up on their balance sheets. In this way quantitative easing can be undone, probably completely, and at a significant profit for the central banks. Removing the zero lower bound may turn out to be the only viable way to undo quantitative easing.
A maximum interest rate is a price control that can distort money and capital markets by hampering lending and borrowing. Insofar the maximum interest rate affects questionable segments of credit like sub-prime lending to consumers, this may be beneficial overall. More troubles can be expected in the arena of business finance as there could be fewer opportunities for businesses to borrow and lend. It is expected that schemes similar to Islamic finance can fill in the gap, but probably only partially.
There is little historic data on the subject of maximum interest rates. In the Middle Ages charging interest was illegal in Western Europe. When economic life became more developed, the ban on interest became difficult to enforce. In the 14th century partnerships emerged where creditors received a share of the profits from a business venture. As long as this share was not fixed, this was not illegal as it was considered a share in business profits rather than interest. Islamic finance is also based on this principle.
In the 17th and 18th century interest bans were often replaced by interest rate ceilings. To circumvent the interest ceiling, creditors and debtors sometimes agreed that less money was handed over to the borrower than stated in the loan contract so that more interest was paid in reality. More recent experiences with Regulation Q in the Unites States indicate that a maximum interest rate is enforceable only if it doesn't affect the bulk of borrowing and lending.
A maximum interest rate seems feasible if it is above the rate at which most borrowing and lending takes place so that the effects on liquidity in the fixed income market are marginal at best. A maximum interest rate creates more room for alternatives like Islamic finance. These alternatives can supplement the fixed income market and mitigate the consequences of the maximum interest rate. A maximum interest rate can be beneficial overall if it mainly affects questionable segments of credit like sub-prime lending while leaving beneficial segments of credit largely untouched.
Interest contributes to moral hazard and financial instability as interest is a reward for taking risk. This idea underpins Islamic finance as Islam forbids gambling and excessive risk taking. Extracting a fixed income out of a variable income source can be seen as a form of gambling. The more uncertain the source of income is, the higher the fixed interest rate needs to be to compensate for the risk of lending, but the higher the fixed interest rate is, the more likely the scheme will fail. This resembles a Catch 22 situation.
All parts of the financial system are intertwined so these risks can enter the financial system. The integrity of the financial system is a key public interest so it is backed by the guarantees of governments and central banks. This arrangement can lead to moral hazard, a mispricing of risk and private profits at the expense of the public. The approach so far has been to use regulations to deal with these issues, but regulations can be cumbersome. An alternative is to finance risky ventures with equity instead of debt.
A maximum interest rate on debt can help to bring about this outcome. If the maximum interest rate offers too little compensation for the risk of lending, lenders will refrain from lending. Maximum interest rates can distort money and capital markets. Most notably, there will be fewer options for businesses to borrow. Schemes similar to Islamic finance can partially fill in the void. An Islamic bank is more like a partner in business than a lender. The bank and its depositors share in the profits as well as the losses of the ventures they participate in, which can have a stabilising effect on the financial system.
People and businesses with problematic debts often pay the highest interest rates and this affects their spending power. These people and businesses might be better off if they can borrow at an interest rate of zero or cannot borrow at all. A maximum interest rate discourages the creation of problematic debts as it caps the risks lenders tolerate. Borrowers then have no other option than to adjust their finances before their debts become problematic. The increased spending power of debtors as well as a reduction of problematic debts can also improve economic conditions.
Regular economics doesn’t provide a satisfactory solution for the business cycle. The main stream view is that central banks should increase interest rates during economic booms to curb investment and spending to prevent the economy from overheating. The rationale is that fewer projects become feasible at higher interest rates. A problem is that a rosy view of the future often prevails during boom times, so that higher interest rates seem justified, and the borrowing continues for some time. When the bust sets in, the picture suddenly alters, so that an overhang of debts at high interest rates can contribute to the woes. It would have been better if these debts hadn’t been made in the first place.
The main stream view also holds that central banks should lower interest rates to stimulate investment and spending when the economy is slowing down. Most notably economists fear deflation and the zero lower bound. Deflation can make people hold on to their cash and postpone their spending. The zero lower bound on interest rates can cause investments to stop when the equilibrium interest rate is below zero because cash at an interest rate of zero is deemed more attractive from a risk/reward perspective. In the aftermath of the financial crisis, central banks have printed a lot of currency to cope with the demand for cash.
Keynesian economists think that governments should curb spending during economic booms in order to slow down the economy and should increase spending during slumps in order to stimulate the economy. It is often difficult to plot the best course of action so that Keynesian interventions are not always well-timed. Political considerations also affect government spending. This can result in a political business cycle, for example if politicians increase spending to stimulate the economy to get re-elected. The alternative view is that governments shouldn’t interfere with the economy but this may worsen slumps and make them last longer.
Natural Money can create a different dynamic. When the economy is improving, equity becomes a more attractive investment compared to debt. That is because of the maximum interest rate. The available funds for lending will then reduce so that the economy is less likely to overheat. This reduces the chances of inflation. Even if the economy overheats, there is less likely to be an overhang of problematic debts afterwards. When the economy slows down, the zero lower bound will no longer be an obstacle so that negative interest rates can provide a stimulus. And in the absence of a debt overhang the economy is poised to recover sooner rather than later. This dynamic should mitigate the business cycle.
The holding tax removes the zero lower bound. This provides a stimulus when needed. The maximum interest rate curbs lending during economic booms. This provides austerity when needed. In this way business cycles can be mitigated. And so there might be fewer problematic debts and financial crises. So what about the darlings of many main stream economists, the fiscal and monetary policies? They are meant to deal with the business cycles and economic crises. Natural Money can make these policies obsolete.
With Natural Money the amount of monetary aggregates such as bank debt and currency are expected to remain fairly stable. Central banks don’t lend money to banks which implies that central banks also don’t set interest rates. Instead, interest rates are expected to float freely between the holding tax rate and zero. Business cycles will be mitigated so deficit spending by governments isn’t needed to prop up the economy. On the contrary, negative interest rates require fiscal discipline.
This could mean the end of fiscal and monetary policies as we know them. Central banks and governments might still need to step in if there is a crisis, but with Natural Money fewer interventions are needed, and possibly none at all, because there will be fewer crises, and none of them probably be very serious. This can bring further economic improvement because government and central bank interventions entail market distortions such as the political business cycle and a mispricing of risk. This can now be avoided.
It is unclear whether or not reserve requirements are required to keep inflation in check. It seems likely that the maximum interest rate will be sufficient. As soon as inflation picks up, lending at zero interest becomes an unattractive proposition, so that the monetary aggregates will not expand, and inflation is reigned in. Some flexibility may be needed to deal with temporary fluctuations in the demand for funds. For that reason central banks may lend money to banks at an interest rate of zero. This is an unattractive proposition for banks as they cannot lend this money at a higher rate, so that they will use this facility as little as possible.
The end of monetary policies can take another problematic issue of the table as it entails a reduction in the policy discretion of central banks. Central banks are technocratic institutions that wield enormous power. The boards of central banks are not democratically elected while they often operate independent of elected governments. This is becoming an increasingly contentious issue that most notably affects the FED as it supports the world financial system because the US Dollar is the primary reserve currency, but it also applies to the ECB because it is a transnational entity. If populists ever succeed in neutralising central banks, people may soon find out to their own detriment why they existed and why they acted in the way they did.
Natural Money can help to improve the economy. That is why Natural Money may become the money of the future. The improvement is expected to come in the following ways:
- the removal of the zero lower bound allows interest rates to go lower if market conditions justify these rates, which can promote capital formation and bring more prosperity;
- removing the zero lower bound also allows the markets for money and capital to clear at the equilibrium rate so that printing additional currency to satisfy the appetite for cash is not needed any more;
- the maximum nominal interest rate is expected to reduce the appetite for risk with lenders, which can reduce problematic debts and transfer risk out of the financial system into the hands of investors, hence reduce moral hazard and the mispricing of risk;
- the business cycle can be mitigated so that there will be more stable economic growth with fewer crises;
- the market distortions caused by fiscal and monetary policies can disappear;
- income inequality may be reduced, which can promote social stability and this could further lower the risk premium on investments.
With Natural Money, negative interest rates are likely to coincide with price deflation. This is easy to see using the quantity theory of money. When the amount of money as well as the turnover of money remain constant as expected, then prices will fall when the economy grows. As a consequence the value of the currency appreciates approximately at the rate of economic growth. Deflation can take hold, and the economy will still do fine.
Suppose now that with Natural Money the average growth rate in mature economies improves from 1.5% to 2.5% per year, which doesn’t seem unreasonable given the expected efficiency improvements, then a nominal interest rate of zero can be 2.5% in real terms. Even deposits with a nominal yield of -2% can have a positive real return that betters the yields on euro and dollar deposits nowadays. From a risk/reward point of view, the improvement could even be greater as the economy will be less prone to instability, so that this yield comes with fewer risks. The improved risk/reward picture may cause a capital flight to economies based on Natural Money. In this way Natural Money can become the money of the future.
Many mature economies are stalling because the zero lower bound hinders the operation of money and capital markets while the financial system is at risk because of the quest for yield and the moral hazard attached to public guarantees for the financial system. The predicament can be summarised as follows:
- structural developments cause interest rates to remain low and quite possibly to go even lower;
- at the zero lower bound the markets for money and capital become dysfunctional because supply and demand cannot clear at the equilibrium rate;
- low interest rates allow for more capital and debt to exist, which puts a constraint on future interest rates;
- business cycles cause debt overhangs because in times of optimism debts are made at high interest rates and raising interest rates by central banks can make matters worse;
- the financial system is a key public interest guaranteed by governments and central banks so that the quest for yield promotes moral hazard leading to private profits and public losses;
- debt fuelled spending to promote economic growth will probably not be an option any more in the future.
Natural Money can deal with this predicament and in this way improve financial stability as well as economic growth in mature economies. The feasibility of Natural Money primarily depends on low interest rates. If irresponsible actions that push up the risk premium remain absent, interest rates will probably remain low and may go even lower, because low interest rates reflect a trust in the financial system and money. Low interest rates require financial discipline, most notably from governments. Governments can still spend more than they receive in taxes, but in the long run only to the extent of the interest they receive on their debts.
We can be more prosperous with lower interest rates. Lower interest rates can reduce income inequality and promote social stability. Lower interest rates can bring down prices. And so most people are expected to benefit from lower interest rates. Natural Money can promote financial discipline, economic stability and social harmony. Natural Money can help to reduce risk in the financial system and curb the moral hazard that comes with government and central bank guarantees for the financial system.
Economists should be inspired by this potential and get busy. Maybe there is a Nobel Prize in it. Natural Money can help to end financial and economic crises. World War II wasn’t possible without the Great Depression so the importance of Natural Money doesn’t need further clarification. If the experiment in Wörgl hadn’t been halted, and communities around the world had been free to copy it, World War II may not have happened. The alternative to new financial and economic crises can be unparalleled prosperity and social stability. This was the vision of Silvio Gesell. Hopefully he was only one century ahead of his time.
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