the plan for the future
7 October 2008 (latest update: 19 November 2019)
Author: Bart klein Ikink
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 creates money from thin air so that you can spend it. In this way your debt becomes money. Banks turn debt into money. If you spend the money, it ends up in the account of someone else. If you pay back the loan, the money disappears.
For every borrower there is a depositor. Depositors want interest on their money so borrowers pay interest. But if fepositors don't spend their money, borrowers don't have the money to pay back their debts or to pay the interest. In that case they can only borrow more or default. To prevent that from happening, central banks can print money or governments can borrow and spend so that people have money to pay back their debts and the interest.
This scheme may not work any more in the future and failing to solve this issue may cause an economic crisis. People and governments are already deeply in debt. We may need to make the economy work without more debt. That might be possible with Natural Money. Natural Money is interest-free money with a holding fee. The maximum interest rate on loans is zero. The holding fee may be 0.5% to 1.0% per month. It applies to central bank money only.
If you lend out your money or put it in a bank account, you don't have to pay the fee. In this way it can be attractive to lend out money at zero or even negative interest rates. Negative interest rates can encourage savers to spend more so that others don't have to go in debt to keep the economy going. The maximum interest rate of zero can reduce excessive debts. Interest is a reward for risk so that it is not attractive to lend to debtors who may not repay.
Natural Money can be introduced when interest rates are low and poised to go negative. To make Natural Money work longer term, interest rates must remain low and negative. This can only happen when there is little or no inflation and governments have their finances in order. Investors may only accept negative interest rates when they trust the currency. To be more precisely, interest can be a sign of distrust.
Money and Banking
What is money?
Why do we have money?
Uses of money
The value of money
Types of money
Most money is debt
What do banks do?
Turning debt into money
Banking is bookkeeping
How banks create money
How much money banks can create
Supply and demand
How interest rates are set
The price of money
Returns on investments
Properties of money
The problem of interest
Compounding interest on money
Interest on capital versus economic growth
Wealth inequality and income inequality
The future of interest rates
Feasibility of Natural Money
Money is the life blood of the economy
The miracle of Wörgl
Too much capital, debt and money?
Allowing markets to operate
Promoting financial responsibility
A stable economy
A better performing economy
This text is about money, banking and interest. Don't stop reading now if you fear 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.
Natural Money might be the solution for the financial crisis that is coming. It is remarkably simple. First, charge a fee on central bank money, so that money can circulate in the economy without new debts. Second, abolish interest on money and loans, so that risky lending may stop because interest is a reward for taking risk, and debts cannot grow out of control because of interest charges. This can make the economy perform better, which will make people happy.
If it is so simple then why didn't economists think of it? The answer is that economists believe that interest is needed and that it is not possible to abolish interest. Only recently interest rates began to turn negative, which suggests that economists can be wrong about that. And that might be great because ending interest might help to end poverty and to make the economy sustainable.
Perhaps you have little knowledge of economics so I 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. Also the role of the government is important because the government decides what is money and what is not. Then I 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 about 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. The financial crisis of 2008, and the next one that is coming, are caused by interest. That doesn't mean that interest is evil. Interest is a natural phenomenon and it is needed for the capitalist economy to operate.
Because of interest, governments and central banks manage the economy with spending, printing money and setting interest rates. Now governments are deeply in debt and interest rates are near zero so the old tricks do not work any more. Finally, Natural Money 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. In ancient times villages were self-sufficient. Trade with the outside world was limited and was done with barter instead of money. 
People living in cities, kingdoms and empires didn’t know each other. It became difficult to track whether or not everyone was contributing. Favours and obligations did not suffice any more and had to be replaced by a formal system for making payments and keeping track of contributions and debts. Writing and money made it possible to specialise in professions and to administrate cities and kingdoms. Commerce as well as tax collection needed an administrative system as well as a unit of account.
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 tomorrow everyone decides to save all his or her money. Nothing would be bought or sold any more. 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 us poorer when there are too many savings already.
Money has no value when there isn’t any stuff to buy or when there aren’t any other people to trade with. Imagine that you get the offer to be dropped alone on a remote island in the Pacific with 10 million euros. Probably you would decline the deal, even if you can keep your mobile phone. It is other people and stuff that give money value. But how? The answer is remarkably simple. The value of money is just a belief.
It comes from the fact that people are willing to work for money and sell their stuff for money. And because others do this, you 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 them because other people want them too. The value of the euro is based on the belief that other people 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 you are about to buy. It may not remain hip for much longer, so you may change your mind again and prefer to keep your precious euros because there may be a newer model next month. So, because the shop wants your euros, you wants them too.
Originally, money was an item that people needed or desired. Grain was one of the earliest forms of money. Everybody needed food so it was easy to make people believe that others accept grain for payment. In prison camps during World War II cigarettes became money because they were in high demand. Even non-smokers accepted them 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. They degrade over time so they aren't a very good store of value. This makes them a great medium of exchange because people won't save them. An example can demonstrate this. Imagine that apples are money and you want to buy a house. A house costs 120,000 apples but 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 will discover that apples 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. 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 was the gold standard. The gold standard boosted trade because gold was internationally accepted as money.
Debts can have value and so debts can be money too. This may seem strange or even outrageous, but money is just a belief. For example, money is the belief that you can exchange a hat for money and then exchange this money for legal advice. Hence, if you believe that the debtor is going to pay, you can accept his or her promise to pay as payment. And if others believe this too, you can use this promise to pay someone else.
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 debts cancel out then there is no need for cash. Most money we currently use is debt. But to make that happen, we needed banks.
If the fisherman borrows money to pay for the hat you made, 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.
Money As Debt argues that debts and banking are a fraud because they are based on belief. But bankers and debts helped to increase trade and production by creating money that doesn’t exist to start businesses that don’t yet exist to make products which will be bought by the people those businesses will hire with this newly created money. Banking and debts are at the basis of the capitalist economy.
On the left is the value of your stuff and money. On the right side is the value of your debts. Your net worth is what remains when you sell all your stuff and pay off your debts. It is on the right side too in order to make it equal to the left side. Your net worth can be a negative value. The left side is named debit and the right side is called credit. Your balance sheet might look like this:
When you buy a car, you own more stuff, but also another loan or fewer bank deposits as you have to pay for the car. This is because debit equals credit. When you drive the car, it goes down in value, as does your net worth, because debit equals credit. If your salary comes in, your bank deposits as well as your net worth rise because debit equals credit. If you pay down a loan, the amount in your bank account as well as the amount of your loan goes down because debit 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 equal those on the right side, so that debit 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 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. The balance sheet of a bank may look like this:
Banks create money. How do they do that? It is easy if you understand balance sheets. Suppose 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 allows everyone to withdraw deposits in cash. This is no problem as long as the total of deposits equal the total amount of cash. After everyone has put in the deposit, the bank's balance sheet looks as follows:
First, there was only € 40 in cash. Now there are € 40 in bank deposits too. You might think that the bank created money. Only, that isn’t true because 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. This is bookkeeping. You have to write down the total twice as debit must equal credit.
But now things are going to get a bit wild. The fisherman comes to you and he wants to buy a 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:
A bank could get into trouble in this way even when debtors repay their debts. That's really stupid. Clever minds figured out a solution. Central banks can print the needed cash. If the European Central Bank (ECB) prints € 20 on a piece of paper and lends this money to the bank, there would be enough cash to pay out your deposit. Banning the use of cash and only use bank deposits for payments would be another option. So, after the ECB deposited € 20 in cash, the bank's balance sheet might look like this:
After you pay the fisherman, he can pay off his loan, and the bank will have enough cash to pay out all deposits. The bank can repay the central bank and everything is fine and dandy again. In this case the bank could not meet the demand for cash but the value of cash and loans wasn't smaller than the deposits (the bank's debt). After the fisherman pays back his loan and the bank pays back the ECB, the bank's balance sheet might look like this:
If banks can’t create money, trade would be difficult. 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. Debt is the basis of the capitalist economy. Nearly all money is debt, and without debt the economy would come to a standstill.
The amount of money a bank can create is limited by the bank’s capital, which is the bank’s net worth. Regulations stipulate that banks should have a minimum amount of capital. This is the capital requirement. If the capital requirement is 10%, and the bank’s capital is € 10,000,000, it can lend € 100,000,000, provided that there are enough deposits. If the bank makes a loan, a new deposit is created. If the deposit leaves the bank, the bank must borrow it back from another bank or cut back its lending.
When a deposit leaves the bank, it ends up at another bank. The other bank lends it back until a payment comes the other way. There may be a reserve requirement, which is a minimum of cash and central bank deposits the bank must hold. If the reserve requirement is 10%, the bank can lend out as much as ten times the amount of cash and central bank deposits it has available.
Once upon a time when gold was internationally accepted as money, goldsmiths fabricated gold coins of standardised weight and purity. They were a trusted source of these gold coins. The goldsmiths owned a safe where they stored their gold. Other people wanted to store their gold there too because those safes were well guarded.
Later this restriction was lifted so that any holder of the voucher could collect the deposit. From then on people started to use these vouchers as money because paper money was more convenient than gold coin. Depositors rarely demanded their gold and it remained with the goldsmiths.
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 out of thin air. This is fractional reserve banking because not all deposits were backed by gold reserves. The new money was spent on new businesses and that hired new people so the economy boomed.
Sometimes people started to have doubts about their bank, and worried depositors came to the bank to exchange their bank notes for gold. This is a bank run. When that happened, the bank could run out of gold and close down because not all the gold was there. The bank's bank notes could become worthless, even when borrowers had no problems repaying their debts. When the bank notes became worthless, the money that the bank had created out of thin air suddenly vanished. This was a financial crisis.
A lot of money had suddenly disappeared so people had less money to spend. This could hurt sales so that some businesses could go bankrupt. Those businesses could not repay their debts at other banks and depositors at those banks might fear that their bank would go bankrupt too. This could cause more bank runs and more money disappearing, so that things would become even worse. This is an economic crisis. This is the way a financial crisis could 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. Central banks were instituted to support banks by supplying additional gold if too many depositors came in to collect their gold. Central banks could still run out of gold but this was solved when the gold backing of currencies was ended. Nowadays a central bank can print new dollars or euros to cope with a shortfall.
Regulations limit the amount of loans banks make and therefore the amount of money that exists. But everyone can lend to anyone. Alternative forms of financing 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 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 demonstrated that trust in debts can suddenly disappear.
To understand how interest rates are set, you should know about the law of supply and demand. This law is simple. As the price of an item rises demand goes down and supply goes up. If coffee is expensive, some people may not be able to buy coffee. Others might decide to take an energy drink instead because that is cheaper. And so demand goes down. On the other hand, some farmers might decide to switch to growing coffee because it can bring them a bigger profit than the crop they are growing currently. And so supply goes up even though it may take a while before the extra coffee becomes available.
When economists discuss the price of money, they mean the interest rate, not the price of dollars and euros. The supply and demand for borrowed money determine the interest rate. When many people want to borrow money or when there isn’t much money available for lending, the interest rate goes up. When only a few people want to borrow money or when there is a lot of money available for lending, the interest rate goes down.
So what determines the supply and demand for money and therefore the price of money? Economists have put a lot of thought into this question. According to them interest rates are determined by convenience, risk, returns on investments, time preference and capitalist spirit. These things will be explained shortly. The type of money we use can also influence interest rates.
When you deposit money at 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 and checking accounts are low. Having money in a current account is more convenient than cash so the bank may even charge you for that. It is convenient to have money at your disposal. Economists call this liquidity preference.
Lending out money can be risky. There are two types of risk. First the borrower may not pay back the loan. That could make you reluctant to lend out your money. So if someone wants to borrow money from you, and you fear that she may not pay back, she could offer you a high interest rate so that you might think, "Well, she is a dubious character, but there is some chance that she will pay back, and the interest rate is very attractive, so I'll do it."
The business of a bank is to know its customers. For that reason lending money to a bank is less risky than lending out money to an individual or a corporation yourself. 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 than you could. In this sense interest is the price paid for distrust. If investors trust the debtors and trust the money to keep its value, interest rates can be lower.
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 still get their interest. And when a business goes bankrupt, lenders get back their money fist. Investors only get what's left over.
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 to lend are in a similar position. Borrowers need to offer attractive interest rates in order to be able to borrow. Similarly, if dividends and rents are low, people with money may prefer lending to investing, so borrowers do not have to pay high interest rates. In this way the returns on other investments affect interest rates.
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. If this applies to you, economists will diagnose you with a condition called time preference.
This is because time preferences differ for different people. Mary may save money if interest rates are above 4% and borrow once interest rates are lower. John may save money as long as interest rates are above 6% and borrow if interest rates are lower. Alex might save if interest rates are above 5% but he may not borrow if interest rates are lower. As interest rates rise, the supply of funds for lending goes up and the demand for funds for borrowing goes down. The interest rate in the market will then be where supply equals demand.
Time preference only works for ordinary people. There are other people too. They are called capitalists. Capitalists think differently. Economists have diagnosed them with a condition called capitalist spirit, which is the opposite of time preference. 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.
Capitalists don't suffer from time preference. They save and invest anyway. Consequently capitalists end up with a lot of money when they die. What's the point of that? Capitalists invest in businesses that make the frivolous 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.
Capitalists have a lot of money they need to invest because of their capitalist spirit. They don't stop saving when interest rates are lower. If they are running out of things to invest in, they are willing to lend their money at lower interest rates. Again, it is the law of supply and demand at work here. If capitalists have a lot of money while other people can’t borrow more because they can't pay the interest, interest rates go down.
The properites of money can 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 plan to buy your house, you would gladly accept this generous offer. You may even have accepted an offer of 900 apples because that is better than letting your apples rot. 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 or when stock prices are fluctuating so wildly that you can't sleep at night, you may prefer the offer of 900 apples.
If the money had been gold, you would never accept such an offer, even when the stock market is doing terrible. You can always keep 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. The problem with this is that if you put money in a safe deposit box other people can’t use it for buying and selling stuff. And this can cause an economic depression.
Suppose that Jesus' mother put a small gold coin weighing 3 grammes in Jesus' retirement account at 4% interest just after he was born in the year 1 AD. Jesus never retired but he promised to return. Suppose now that the account was kept for this eventuality. Assume further that the end is near, and that Jesus is about to return. How much gold would there be in the account in 2017?
It is like the situation where the cash isn't there when depositors want to take out their deposits. The problem is that there is a limited amount of gold and 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 a problem after all. Our money isn’t gold but currencies central banks can print. Suppose now that Jesus’ mother had put one euro in the account instead. One euro at 4% interest makes nearly 23,000,000,000,000,000,000,000,000,000,000,000 euro after 2017 years. That may seem an intimidating figure, but the European Central Bank can take 23 pieces of paper and print 1,000,000,000,000,000,000,000,000,000,000,000 euro on each of them. And there you are. Something like this happened during the financial crisis of 2008.
Central banks can print new dollars and euros to cope with a shortfall. In fact, this is what central banks often do. There is always a shortfall because of interest because most money is debt and interest on this debt needs to be paid. To make up for the shortfall, there are two options. People can borrow more or central banks can print new currency. Both things can happen at the same time. Of course, borrowers can default, but that could cause a financial crisis. Central bank decisions about interest rates are also about dealing with the shortfall caused by interest charges.
When central banks lower interest rates, people can borrow more because interest rates are lower. Central banks lower interest rates when people are borrowing less than is needed to cope with the shortfall. If central banks raise interest rates, people can borrow less because interest rates are higher. Central banks raise interest rates when people are borrowing more than is needed to cope with the shortfall and the extra money makes people buy more stuff than can be made. If people don't borrow, central banks may print more currency to cope with the shortfall.
There is a problem central banks can't fix by printing more currency. Interest is more than just interest on money. Interest is any return on capital. Throughout history returns on investments were mostly higher than the rate of economic growth. Most of these returns have been reinvested so a growing share of total income was for investors. That's the way the rich get richer. This can't go on forever because who is going to buy the stuff corporations make in order to keep their investments profitable? A simple example can illuminate that.
The graph above shows how total income and interest income (in red) develop with an economic growth rate of 2% and an interest rate of 5% when interest income starts out as 10% of total income and all interest income is reinvested. After 25 years the economic pie has grown faster than interest income and wages have risen. At some point interest income starts to rise faster than total income, and wages go down. After 80 years there's nothing left for wages. This graph explains a lot about what is going on in reality.
In the short run it was possible to prop up business profits and interest rates by letting people go further into debt to buy more stuff. In the long run, the growth rate of capital income cannot exceed the rate of economic growth because people must buy the stuff corporations make to make them profitable. Interest rates depend on the returns on capital so this can explain why interest rates went down in recent years. You can use the button below to use a calculation app for the development of total income, interest and wages over the years based on different economic growth rates and interest rates.
Humans are herd animals. They buy stuff and even go into debt to buy stuff when others are going into debt to buy stuff too. Suddenly they may realise that they have bought too much or have gone too deeply into debt, and all at the same time. One day they may be borrowing money, queueing up before the mobile phone shop, and bidding up prices. The next day, they may decide to pay off their debts, leaving the shop owners with unsold inventories they have to get rid of at firesale prices. So prices may go up when people are in a buying frenzy and may go down when sales dry up. That's the law of supply and demand.
Interest can make things worse. Suppose that you have a business and expect to make a return of 8% on your investments. You have € 100,000 yourself and you borrow € 200,000 at 6%. You expect to make 8% so borrowing money at 6% seems a good idea. If you only invest your own € 100,000 you can make € 8,000, but if you borrow an additional € 200,000 you can 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:
If sales disappoint and you only make a return of 2% on the invested capital of € 300,000, which is € 6,000, you make a loss because you pay € 12,000 in interest charges. You may have to fire workers. Businesses can go bankrupt because they have borrowed too much money and have to pay interest, even when they are profitable overall. Sales often disappoint when the economy fares poorly. This means that more businesses face the same difficulties and make losses because of interest payments at the same time. They may fire workers who will lose their income. This can worsen the slump.
When there is more money, prices often go up. A simple example can illustrate this. If two people desperately wanting to buy a house, and only one is for sale, and both have € 50,000, the house may be sold for € 50,000. But if both prospective buyers have € 100,000, the house might be sold for € 100,000. That is unless, a new house can be built for € 70,000. So, if people can get a mortgage, prices of existing homes might go up or more houses may be built or both.
Another situation is that a home is for sale for € 50,000 and two people own € 100,000 but both don't need a new home. In that case the money they have does not produce inflation or new houses. And if the seller is desperately in need for money, he or she might sell the house for € 30,000 if that is what one of those two people is willing to offer. And so more money doesn't always produce inflation.
Costs are also important. If building a house costs € 70,000 no more house will be built as long as prices are below that level. Costs can be the building materials, wages, taxes, but also interest costs. The contractor has to invest in equipment and building materials, but these investments must at least make a return that equals the interest rate, otherwise there is no point in making these investments. If interest rates go down, interest costs go down too.
Inflation is low, economists and central bankers say, but people don't notice it. That may be because of 'quality adjustments' in the statistics. For instance, computers have more computing power than a few decades ago, but their price hasn't risen. So, economists argue that the price of computers has actually gone down. If computers of the 1980s like the Commodore 64 were still built today, they may cost only € 25. But no-one has any use for such a computer.
Similarly, regulations might improve the quality of a product or its harm done to the environment, and as a consequence the price goes up. Economists might argue that you get better quality so that the higher price is not inflation. And as more and better treatments become available, the price of health-care insurance goes up. Most ordinary people experience higher prices and an erosion of their purchasing power despite the low inflation in the statistics.
Negative interest rates tend to bring down prices but you may not notice that because many other issues affect prices too. Massive changes may need to be made to make the economy sustainable so many items may become more expensive so the purchasing power of people may not rise. But with low interest rates, the massive investments needed to make the economy sustainable may be feasible because the cost of capital is low.
Until recently economists and central bankers believed that low and negative interest rates will be temporary even though the graph above tells a different story. It shows interest rates in the United States between 1961 and 2016. The green line is the real interest rate in the market. The real interest rate is the inflation free interest rate. So if the interest rate of your mortgage is 5% and the inflation rate is 2%, the real interest rate on the mortgage is 3%.
The red line is the natural interest rate. This is the ideal interest rate for optimal economic growth. The natural interest rate is estimated by economists using models. Central banks use the natural interest rate to set the interest rate. If the central bank believes the economy is overheating because people are borrowing too much and bidding up prices, it sets the interest rate above the natural rate, so that fewer people borrow because of their time preferences and the economy slows down. If it believes that the economy is in a slump, it sets the interest rate below the natural rate to achieve the opposite.
The trend is clear but most economists and central bankers expect that interest rates will go up again. Only, the developments that drove interest rates down may not go away and interest rates may remain low and may even go lower. This has something to do with capitalist spirit. Interest rates have mostly been higher than the economic growth rate and most interest income has been reinvested because of the capitalist spirit, so that a growing part of total income was for investors.
It is the law of supply and demand at work. The amount of available capital grows faster than the demand for capital so that the price of capital, which is the interest rate, must go down. In a capitalist economy people with lower time preferences than the prevailing interest rate tend to save and invest, while people with a higher time preference tend to consume and borrow. At some point the people with the higher time preferences pay a lot in interest and can't borrow any more, so that they have less money to spend.
The economy then slows down because people can't afford to buy all the stuff corporations make. Interest rates go down because the capitalists can't find good investments and are willing to accept lower interest rates. Then people with a somewhat lower time preference start to consume and borrow. This works for a while until they can't borrow more. This cycle repeats again and again as interest rates go lower. More and more people go into debt because their time preferences exceed the interest rate.
This doesn't suddenly change when interest rates reach zero. If interest rates go lower, capitalist may lose money, but if they suffer from capitalist spirit, small losses may not deter them from saving and investing. And if people can borrow money at negative interest rates from the capitalists, capitalists may be better off because their corporations will be more profitable. Interest rates may go lower until the amount of capital doesn't grow faster the economy and then the situation balances out.
Money is the life blood of the economy. All parts of the body need blood to survive. Likewise all parts of the economy need money to survive. If money stops circulating, the economy dies and people suffer. Money must therefore be used for consumption or investment. If you don't use your money for consumption or investment, it is better that you lend it to someone else who does. In other words, money must be available as supply in the financial markets.
When money is available as supply in the financial markets, but people aren't using it for investment or consumption, there is a lack of demand and the surplus doesn't circulate. According to the law of supply and demand, the interest rate may need to go lower to reduce supply or to increase demand in order to make money circulate again. That is why interest rates may need to go negative. An example from history can demonstrate the way that may work.
During the Great Depression money circulation slowed down. The Austrian town of Wörgl was in trouble and prepared to try anything. Of its population of 4,500, a total of 1,500 people were without a job and 200 families were penniless. The mayor had a long list of projects he wanted to accomplish, but there was hardly any money to carry them out. These projects included paving roads, streetlights, extending water distribution across the whole town, and planting trees along the streets.
Rather than spending the 40,000 Austrian Schilling in the town’s coffers to start these projects off, he deposited them in a local savings bank as a guarantee to back the issue of a currency known as stamp scrip. The Wörgl money required a monthly stamp to be stuck on the circulating notes to keep them valid amounting to 1% of the note’s value.
Nobody wanted to pay for the monthly stamps so everyone receiving the notes would spend them. The 40,000 schilling deposit allowed anyone to exchange scrip for 98 per cent of its value in schillings but this offer was rarely taken up. That was because the scrip could be spent as one schilling after buying a new stamp. The money raised with the stamps was used to run a soup kitchen that fed 220 families.
The council not only carried out all the intended works, but also built new houses, a reservoir, a ski jump and a bridge. The key to its success was the fast circulation of the scrip money within the local economy, 14 times higher than the Schilling. This increased trade and employment. Unemployment in Wörgl dropped while it rose in the rest of Austria. The French Prime Minister made a special visit to see the 'miracle of Wörgl'.
Until now economic growth was generated by allowing people and businesses to go into debt. Interest rates were lowered so that people with lower time preferences stopped saving and went into debt instead. But the capitalists continued saving and investing and ammassed fortunes. And so we have more capital, debt and money than ever before. At some point borrowers can't borrow more. If borrowers stop borrowing and lenders don't start spending, money stops to circulate.
The interest rate may need to go negative to make supply equal demand. If interest rates are low enough then lenders might stop saving and start spending. And if they don't stop saving, they may end up handing out money to borrowers so that they can spend and make money circulate. In Wörgl the money circulated without making new debts. The stamps worked like a negative interest rate so you would lose money if you didn't use your money.
If too many borrowers run into trouble that can blow up the financial system. That can happen when loans are made to people who can't afford them. Interest is a reward for risk, so if you may have trouble paying back your loan, the lender desires a higher interest rate to compensate for that risk. It may therefore be a good idea to have a maximum interest rate so that there is no reward for taking excessive risk that can blow up the financial system.
Natural Money is interest-free money with a holding fee. Interest-free means that the maximum interest rate on money and loans is zero. Negative interest rates are possible. The holding fee may range from 0.5% to 1.0% per month. The fee applies to money that isn't lent. It therefore doesn’t apply to bank deposits, loans and other investments.
It can be attractive to put money in a bank account or to lend money at zero or even negative interest rates. For example, if the holding fee is 12% per year and bank deposits yield -2%, you can save 10% by depositing money at a bank.
The business of banks doesn’t change much with Natural Money. For a bank there is little difference between borrowing money at 2% to lend it at 4% and borrowing money at -2% to lend it at 0%. In both cases the bank can make a profit of 2%.
Cash will be a loan to the government and the interest rate on short-term government loans will apply on cash. That is better than paying the holding fee. As a consequence, cash and digital money become separate currencies, for example digital euro and paper euro. The interest can be implemented by gradually lowering the exchange rate of cash.
The holding fee doesn't apply on bank accounts or cash so no-one will end up paying it. Money will circulate in the economy so the economy will do well, and the interest rate, even though it may be negative, will be better than when the economy is doing poorly.
The interest rate on Natural Money can be better than on interest-bearing money. No more debt may be needed, and most money is debt, so no more money may be needed. More money often leads to higher prices so there may be no inflation with Natural Money.
If the economy is doing well, prices might go down, and a negative interest rate might be a positive real interest rate. For example, if the interest rate is -1% and prices go down by 2%, which is an inflation of -2%, then the real interest rate is 1%. That is better than an interest rate of 2% if inflation is 3%.
Investors may like Natural Money because the returns are better. That is why Natural Money can become a success. A monetary revolution may be at hand. And what would you prefer: Great Depression II, World War II or unprecedented prosperity privided by Natural Money?
Money must remain in the economy. If you keep money for yourself, other people can't use it for buying and selling stuff or making investments. It is better that you spend it, invest it or lend it to someone else who is going to use it to buy stuff or to invest. The holding fee encourages you to chose from these three options that benefit the economy and discourage you from holding on to money.
There is a lot of capital and an abundance of savings so interest rates may remain low and may even go lower in the future to make supply equal to demand. If the interest rate is not allowed to go below zero, prospective borrowers may not be willing to borrow and money piles up in banks. This may cause an economic crisis because this money is not used for buying and selling stuff or making investments.
A maximum interest rate of zero can be a problem too. In that case you may not be willing to lend your money if the risk is too high or when other investment options are more attractive. Natural Money is feasible only when the risks are low and more attractive options are absent so that interest rates remain below zero. If prices go down, lending money at interest rates below zero can be attractive.
Partnerships and equity can replace risky lending when interest rates above zero are forbidden. If lenders become partners then they share in the profits as well as the losses. In that case there are no fixed interest rates but sharing profits and losses. Islamic finance is an example of such a partnership scheme. Depositors of an Islamic bank share in the profits and losses of the ventures they finance.
Germany can borrow at negative interest rates while Argentina can't. Interest rates are negative in Switzerland and high in Turkey. This is a matter of trust and interest is the price paid for distrust. The finances of Germany and Switzerland are in good shape while those of Argentina and Turkey are not. Lenders are willing to lend at negative interest rates to Switzerland and Germany because they trust the governments of these countries.
If there is a maximum interest rate of zero, you can't borrow if lenders don't trust you. It is better that you can't borrow at all when your finances are in poor condition when the alternative is borrowing at usurious interest rates. In this way the maximum interest rate of zero can promote responsible behaviour by preventing irresponsible lending or borrowers getting into trouble because of interest payments.
To promote confidence in their currencies, governments need to have their finances in order. They will reap the benefits in the form of negative interest rates on their debts. For instance, if the government has a debt that equals 70% of the nation's income, and this government can borrow at -3%, then it can spend 2.1% of the income of the nation for free, meaning that governments can do more or that taxes can be lower.
Humans buy stuff and go into debt to buy stuff when others are going into debt to buy stuff too. Suddenly they may realise that they have bought too much or have gone too deeply into debt, and all at the same time. One day they may be borrowing money, queueing up before the shops and bidding up prices. The next day, they may decide to pay off their debts, leaving the shop owners with unsold inventories they have to get rid of at firesale prices. These ups and downs in the economy are called economic cycles.
What if you can't borrow money when the economy is overheating and everybody wants to borrow money? And what if you get some money for free if you borrow at a time the economy is slow and nobody wants to borrow? Natural Money can make that happen. The maximum interest rate is zero. If the economy is doing well there are other attractive investments then lenders are less willing to lend money at such a rate. If the economy is doing poorly, lenders may be willing to lend money at a negative rate, and give you money for free.
People will spend more when the economy is doing poorly and spend less when the economy is booming so the economy will be more stable and economic cycles will disappear. As a consequence governments and central banks don't have to manage the economy with spending and printing money. Governments can have balanced budgets and central banks don't have to print money. This can promote confidence in the currencies that we use and that can keep interest rates in negative territory.
When interest rates are lower, more businesses become economical. That is because a business must at least make the interest rate you can make by putting the investment money in a bank account otherwise there is no point in making the effort. And more business means more products and services, hence more prosperity. Businesses employ people and generate work for other businesses.
An example can illustrate this. Assume you think of starting a business. The required investment capital is € 100,000. You think to make € 5,000 per year after all the expenses are paid for, including the salary you make in your current job. If the interest rate is 2% it makes sense to start the business because you would earn € 3,000 more, but if the interest rate is 7% it makes no sense because you would earn € 2,000 less.
Consumers can also benefit. If you can't borrow at positive interest rates you end up with more money to spend because you don't pay interest. Hence, consumers have more money to spend. Most notably poor people may not be able to borrow. If the alternative is borrowing at usurious interest rates, they may be better off when they can't borrow at all, provided that they get proper assistance when they are in need or want to start a business.
The economy may not grow any more in the future or should not grow because economic growth means a greater use of the limited resources of the planet. In that case, the average interest rate on capital can't exceed zero in the long run, and interest rates on money and debts need to remain negative. This is because the return on business investments must be higher than the interest rates otherwise there is no point in starting a business.
With lower interest rates longer term investments become more attractive. This may contribute to making the economy sustainable. The following example demonstrates how that may work. Suppose that you own a patch of rainforest and that you consider two options. These are:
The most attractive option depends on the interest rate. If the interest rate is 5% then cutting down the rainforest and putting the proceeds in a bank account is more attractive because you can make € 5,000 a year in this way. If the interest rate is 1% it makes more sense to harvest the rainforest in a sustainable way.
If interest rates remain low and negative, the markets for money and capital may work better with Natural Money. The economy doesn't need more debt in order to flourish. Risk will be eliminated from the financial system so that financial crises can become a thing of the past. Financial responsibility will be promoted. The economy can become more stable so that governments and central banks don't have to intervene. It is likely that the economy will improve so that:
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