the plan for the future
7 October 2008 (latest update: 27 April 2023)
Author: Bart klein Ikink
Without money, trade would be cumbersome. There can be different kinds of money but most money today is bank debt. It is the most flexible money. It can easily be created when there is need for it. If you borrow money from a bank, the bank creates money 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. And if you pay back your loan, the money disappears.
For every borrower there is a depositor. Depositors often receive interest on their money so borrowers pay interest. But if depositors don't spend their money, borrowers can't pay back their debts or to pay for the interest. In that case they can only borrow more or default. Defaults can start a financial crisis. To prevent that from happening, central banks can print money or governments can borrow instead and spend that money so borowers pay back their debts and the interest.
This scheme runs into trouble because we are already deeply in debt and borrowing more to pay for the interest might not be a good idea. We may need to make the economy work without more debt. That is the aim of this research project called 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. The holding fee 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 so others don't have to go in debt to keep the economy going. The maximum interest rate of zero can reduce excessive debt burdens. Interest is a reward for risk without interest, it is unattractive to lend to debtors who may not repay.
Money and Banking
What is money?
Why do we have money?
Uses of money
Flows in the economy
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
The miracle of Wörgl
What we need
Joseph in Egypt
Why Natural Money may be the money of the future
Natural Money is about money, banking and interest. You may find WhatsApp,
There is something wrong with interest on money and debts, and people knew it for thousands of years. Muslim still know it because they take their Holy Book from the Middle Ages seriously. But most people don't know. Even most Christians don't know that the Catholic Church forbade interest. The issue can best be illustrated with the example of the introduction page.
There isn't that much gold in the world, but those who borrow from the bank must pay it. And they can only pay for the interest by borrowing more. That is why interest charges can cause stress, poverty, and financial and economic crises. Until recently, interest rates were always in positive territory, so it wasn't possible to have large-scale borrowing and lending without interest. And the modern economy can only operate with large-scale borrowing and lending.
Developments in the economy and innovations in the financial sector may now make it possible to abolish interest on money and debts. In the 2010s, interest rates in Europe turned negative for the first time in history, indicating something has changed. It may now be possible to abolish interest on money and debts and end stress, poverty, and financial and economic crises.
I assume you have little knowledge of economics so I start with explaining what money is and what it is used for. Then I discuss the purpose 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.
What is money?
Why do we have money?
Despite these mind-blowing advantages, humans did not need money for thousands of years because they lived in small bands and villages where everyone depended on each other and helped each other. When a fisherman desired a hat, you would make one for him, expecting that when you needed legal advice, the lawyer would give it to you without charge. You did someone a favour who was obliged to do something back. There was little trade with the outside world. And usually, it required no money. Villages bartered items they could spare for things they needed or desired.
Uses 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. If we keep our money for a rainy day, and don'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.
Money became the system for making payments and keeping track of contributions and debts. Money can be used (1) for buying and selling things, (2) to say how much something is worth and (3) for saving and borrowing. Money therefore is a medium of exchange, a unit of account and a store of value. Money being a medium of exchange as well as a store of value conflict. It is as if your pet is both a cat and a dog and the cat part wants to sleep and be store of value, while the dog part wants to play and be a medium of exchange. To see what can go wrong, we should look at flows in the economy.
Flows in the economyWe can liken the economic process to the human body's circulatory system. The human body depends on the blood circulation. It will perish if the blood circulation stops, and sections like organs will die if the blood doesn't reach them. In the same fashion, the economy depends on the circulation of money. In a money-based economy, households and firms need money to pay for their expenses. Once the money stops flowing in the economy or doesn't reach certain parts, the economy, or parts of it, are in trouble. For instance, firms can't pay wages and households can't buy food.
So what can go wrong? If the blood circulation stops, the body will die, and blood becomes useless. When everyone saves all their income, nothing is bought or sold. Businesses would go bankrupt, and everybody would be unemployed. With the firms gone, the money saved would buy nothing because there isn’t anything to buy. That is a total economic collapse. It never gets that bad because people always spend on necessities and smartphones. In other words, saving can make us poorer when there are too many savings already. It brings us to an important conclusion:
Human blood should contain the right ingredients, otherwise it doesn't perform its function. Even though some people might beg to differ, replacing blood with alcohol doesn't improve the body's health. And for money to perform its role, it must have value. You can't take a bank note from a Monopoly game to a shop and buy groceries with it. But why?
The value of moneyWhat gives money its value? After all, your money is just a piece of paper saying it is ten euros or the computer of your bank saying there is € 112.19 in your bank account. And a bank sometimes mysteriously adds interest to that number too. Can you trust that? Apparently, you can go to a shop and buy groceries with the money in your bank account, including the interest. How so?
There should be a shop or someone you can trade with. Imagine you get the offer to be dropped alone on a remote and uninhabited island in the Pacific with 10 million euros with the promise that no one will come along to bother you for the next twenty years. Probably, you would decline the deal. Other people and the things they can offer you give money its value. They will work for it or sell their stuff for it. How does this work?
People are willing to work and sell their stuff for money. And because others do this, you do the same. You may think euro bank notes have an appalling design and an unpleasant odour. Nevertheless, you want them because others desire them too. The euro's value comes from the belief that people accept euros for payment.1
To prove this point further, suppose now the phone shop accepts your euros. Suddenly your euro notes become desirable again, and you may start having second thoughts about that latest model you are about to buy. It may not remain hip for much longer. And so you may change your mind and prefer to keep your precious euros for a while because there may be a newer model next month. So it appears that because the shop wants your euros, you want them too. That is because you believe you can buy things for them.
Types of moneyOriginally, 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.
Most money is debtDebts 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. Debt is the most flexible money. It can be created when there is need for it and destroyed when there is not purpose for it. To do that, we need banks. A modern capitalist economy can't operate without debt money and banks.
What do banks do?
Turning debt into moneyIn most cases debts cannot be cancelled out so easily. The hat may be € 50, the legal advice € 60, the hairdo € 30, and the fish € 20. You could lend € 10 to the barber and the lawyer could lend € 20 to the fisherman. Perhaps the lawyer doesn't trust the fisherman because he smells fishy. If the lawyer trusts the barber and the barber trusts the fisherman then the lawyer could lend € 20 to the barber and the barber could lend € 20 to the fisherman.
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.
Banking is bookkeepingThe basics of banking aren't complicated at all. Banking is more or less just bookkeeping and balance sheets. Balance sheets can be used to explain the magic trick banks do, which is creating money. Balance sheets are simple. There are no intimidating formulas, only additions and substractions. The important thing to remember with balance sheets is that the sum of the amounts on the left side must always equal those on the right side.
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:
How banks create moneyBanks 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:
The difference is that you are not obliged to accept bank debt for payment if it is not money, but you can still accept it like you can accept bitcoin or gold. Banks are important for the economy, so the government imposes regulations on banks and obliges us to accept bank deposits for payment. That is all there is to it. The fisherman then pays € 50 for the hat. And so it becomes your money:
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.
How much money banks can create
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.
Reserve requirements have become redundant. The reason to hold reserves was that people can withdraw cash from the bank and that the bank should have sufficient cash in its vaults. A thriving bank could get into trouble if it ran out of cash. Nowadays, money is almost always transferred to another account at another bank and the bank borrows that money from that other bank until a payment comes back. This also happens when people withdraw their money from a bank if the don't trust it.
And people don't trust a bank when they think it's not solvent, for instance, when they fear that loans won't be repaid, and the bank may have to write off these loans. Liquidity crises at banks or bank runs come from a lack of confidence in the bank's solvency. So, with reserves you fight the symptom, not the cause, and it doesn't work because solvency is the foundation of trust. Moreover, liquidity crises are easily solved by the central bank as it can provide cash when needed, so reserves are unnecessary.
Banks can go bankrupt. If you don't like that then you can take the money out of your bank account and keep the bank notes, for instance, in a safe deposit box. If the government provides a deposit insurance on smaller deposits then this isn't a serious problem for most people. Many banking reform proposals try to address the risk of banks going bankrupt, for instance by not allowing banks to lend out money in current accounts, and to keep this money as cash in their vaults. Keeping reserves reduces banking risk but capital requirements can achieve the same.
How the current financial system came to be
The goldsmithsOnce 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.1 Depositors rarely demanded their gold and it remained with the goldsmiths.
Modern bankingThe 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.1 The new money was spent on new businesses and that hired new people so the economy boomed.
Bank runsSometimes 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 is a financial crisis.
During a financial crisis a lot of money suddenly disappears so people have less money to spend. This can hurt sales so some businesses might go bankrupt. Those businesses can't repay their debts at other banks and depositors at those banks might fear that their bank would go bankrupt too. This can cause more bank runs and more money disappearing, so that things would become even worse. This is an economic crisis. In this way a financial crisis could trigger an economic crisis.
Regulation and central banksMeasures 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.
Supply and demand
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.
How interest rates are set
The price of money
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.
ConvenienceWhen you have lent your money to someone else, you can’t use it yourself. There may be a new mobile phone that you want to buy, but alas, you have lent out your money. This is not convenient. But then you remember with a smile on your face that you will be able to buy the phone, and a hip phone cover too next year, because you receive a nice interest rate on this loan. So, if people don't receive interest on their money, they may not bother lending it out because they may need it.
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.
RiskLending 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.
Returns on investmentsIf 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.
Time preferenceSuppose 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.
Capitalist spiritTime 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.
Properties of moneyThe 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.
The problem of interest
Compounding interest on moneySuppose 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.
Central banksPerhaps 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.
Interest on capital versus economic growthThere 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.4
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.
Wealth inequality and income inequalityWhen returns on capital go down, interest rates tend to go down, but lower interest rates can make the value of investments rise. That is because if you borrow money to do an investment, your return is the investment income minus the interest you pay. So, if the interest rate goes down, the same investment income becomes worth more. In this way the value of stocks, bonds and real estate can increase, and as a consequence wealth inequality as the wealthy own most investments.
Economic cyclesHumans 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.
InflationWhen there is more money, prices often go up. A simple example can illustrate this. If two people want 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 there is a home 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 in need of cash, he or she might sell the house for € 30,000 if that is what one of the two others 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 houses 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 € 10. But no-one has use for such a computer anymore.
Similarly, regulations might improve a product or reduce its harm done to the environment, but it also makes the price go up. And as more and better treatments become available, the price of health-care insurance goes up. Economists might argue that you get better quality so that the higher price is not inflation. And so many people experience higher prices and an erosion of purchasing power despite the low inflation in the government 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 and the purchasing power of people may even go down. But with low interest rates, the massive investments needed to make the economy sustainable may be feasible because the cost of capital is low.
The future of interest rates
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, capitalists 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. Apart from that we may need a way to make the economy work without more debt.
The miracle of Wörgl
In 1932, in the middle of the Great Depression, 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 Michael Unterguggenberger 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.6 7
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.6 7 A businessman named Silvio Gesell came up with this idea in his book The Natural Economic Order.
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.6 7
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. Six neighbouring villages copied the idea successfully. The French Prime Minister, Édouard Daladier, made a special visit to see the 'miracle of Wörgl'.6 7
In January 1933, the project was copied in the neighbouring city of Kitzbühel. In June 1933 major Unterguggenberger addressed a meeting with representatives from 170 different Austrian towns and villages. Two hundred Austrian townships were interested in the idea. At this point the central bank decided to assert its monopoly rights by banning scrip money.6 7
The miracle of Wörgl is that the economy can do well without more debt if existing money keeps circulating. It suggests that negative interest rates can make existing money circulate so that more debts aren't needed. Stamps on money like in Wörgl make negative interest rates possible as you avoid paying for stamps by lending out money. For instance, lending out money at a negative interest rate of 2% would be more attractive than paying for the stamps.
What we need
We may need negative interest rates to balance the supply and demand for money and capital. If that doesn't happen like in the 1930s, we may have another Great Depression on our hands. When savings exceed the demand for funds then the excess doesn't circulate in the economy. For a smooth operation of the economy, money must circulate. If you don’t need your money for buying stuff then it must be returned to the economy.
In the past the economy could be propped up by allowing people, businesses and government to take on more debt. Now debt is a problem so we may have to make the economy work without more debt. The miracle of Wörgl shows us how that can be done. If interest rates are negative then people who don't spend their money hand it out to people who do. Natural Money has a holding fee like the Wörgl currency so interest rates can be negative.
It may also be a good idea to stop supporting banks. Banks sometimes take too much risk so that governments and central bank need to step in. But interest is also a reward for risk. So, once interest rates are negative, it might be a good idea to abolish positive interest rates. With Natural Money positive interest rates are not allowed. That may make the financial system stable so that government and central banks don't have to support it and taxpayers don't have to pay for it.
Joseph in Egypt
Natural Money may be a permanent solution for the ailments of the financial system. Natural Money already existed in ancient Egypt for more than 1,000 years. There is a story in the Bible that may explain how that happened. Once the Pharaoh had a few bad dreams his advisers could not explain. He dreamt about seven fat cows being eaten by seven lean cows and seven full ears of grain being devoured by seven thin and blasted ears of grain.
Joseph explained those dreams to the Pharaoh. He told the Pharaoh that seven years with good harvests would come followed by seven years with poor harvests. He advised the Egyptians to store food. They followed his advice and built storehouses for grain. In this way Egypt survived the seven years of scarcity.8
The food storage resulted in a financial system. The historian Friedrich Preisigke discovered that the Egyptians used grain receipts for money.9 Farmers bringing in the food received receipts for grain. Bakers who wanted to make bread, brought in the receipts which could be exchanged for grain. According to the Bible, Joseph took all the money from the Egyptians.10 As a consequence the grain receipts may have become money instead.
Farmers bringing in grain did get receipts for the grain. Bakers who wanted to bake bread, returned the receipts for which they received grain. The storage costs were settled when the receipts were exchanged for grain, hence the receipts lost value over time. The effect was similar to buying stamps to keep the money valid as happened in Wörgl. The actions of Joseph may have created this money as he allegedly proposed the grain storage and took all the money from the Egyptians.
During the reign of Ramesses the Great, Egypt became a leading power again. Some historians have suggested that Egypt's wealth during the reign of Ramesses was built upon the grain money. The money remained in circulation until the Romans conquered Egypt. The grain money was stable and survived for more than a thousand years, perhaps because there were no financial crises caused by interest payments.
Natural Money is interest-free money with a holding fee. The maximum interest rate on money and loans is zero and there is a holding fee on central bank currency ranging from 0.5% to 1% per month. The holding fee does not apply on money lent, bank accounts and investments. And so it can be attractive to lend out money or to put money in a bank account, even when the interest rate is negative.
For a bank it doesn't matter. Banks borrow money from depositors at a lower rate to lend it out at a higher rate. There is little difference between borrowing money at 2% to lend it at 4% and borrowing money at -2% to lend it at 0%.
With negative interest rates people may hoard cash if cash has an interest rate of zero, whic can cause an economic depression. To prevent this from happening cash must have a negative interest rate too. Nowadays cash is central bank currency. You can check it out yourself. For instance, euro banknotes have the signature of the President of the European Central Bank on them. On central bank currency the holding fee of 0.5% to 1% per month applies.
That would make cash very unattractive and that is not needed. If there is a market interest rate on cash then would be enough. With Natural Money cash becomes a loan to the government. The negative interest rate on short-term government loans will apply on cash. There will an exchange rate between cash and central bank currency and the price of cash will gradually go down in terms of central bank currency reflecting the negative interest rate on short-term government loans.
People may have trouble accepting negative interest rates, but if cash is to become the currency of choice for most people, they do not experience negative interest rates as cash will have the lowest interest rate as it is risk-free. The interest rates on bank accounts will at least match the interest rate on short term government debts so interest rates on bank accounts may not be negative in terms of cash. Central bank currency will remain the unit of account in the financial system.
It is also possible to have cash accounts at banks. A cash account with Natural Money will be a loan to the government because cash is a loan to the government. The bank isn't allowed to lend out this money. It only administrates the account in the name of the account holder. In the case of a bankruptcy of the bank this money is safe and creditors of the bank have no rights to it. If the government never defaults on its loans, this can be safer than lending money to a bank.
Why Natural Money may be the money of the future
Interest-free money was not feasible until recently because it wasn't attractive to lend out money at negative interest rates. Interest rates in financial markets were higher. If you can receive interest on a bank deposit then it is not attractive to lend out money interest-free. Now interest rates are heading towards negative territory, things are about to change, and interest on money and loans may be abolished.
With Natural Money the economy can do well without more debts so investments may have better returns and interest rates could be be higher. The maximum interest rate is zero. If the value of the money rises this can be a positive return. If there is economic growth without more debts that might happen and a negative interest rates may be more attractive than positive interest rates on currencies that lose value.
To see why, we can look at the real interest rate, which is the actual return. The real interest rate is the nominal interest rate minus the inflation rate. If the interest rate on your bank account is +1%, that is the nominal interest rate. But if the inflation rate is +2%, the real interest rate on the bank account is -1%.
Perhaps economic growth could be +3% with Natural Money so the inflation rate could be -3%. If a bank account yields -2%, the real interest rate could be +1%. That is 2% higher. In this way the real return on interest-free money could be better. And it seems plausible that it works out that way. And that is why investors may prefer Natural Money so that interest can be abolished.
The economy may do better with negative interest rates. The reason is that economic growth as well as the growth of capital is constrained by excess savings. There may be excess borrowing due to the excess of savings because supply and demand for funds must equal at the equilibrium interest rate. Negative interest rates can stimulate savers to spend. Abolishing positive interest rates can curb the excess lending.
A sustainable economy may only be possible with negative interest rates. Investments are only feasible if they at least make the interest rate in the market. The massive investments needed to make the economy sustainable are likely to have low returns. They may only be possible when interest rates are negative.
Negative interest rates may help to combat poverty. Most people pay more in interest than they receive. Only the top 10% richest people receive interest on balance. Interest is everywhere. It is hidden in rents, taxes, and the price of everything we buy. Products on average cost 25% more because of interest. The poorest people often pay the highest interest rates. As interest rates in developed countries go lower, investing in developing countries becomes more attractive.
Negative interest rates may promote financial responsibility. Governments, corporations and people that have their finances in good order can borrow at the lowest interest rates. If the maximum interest rate is zero only credible borrowers can borrow. Governments benefit from promoting trust in their currency as that can allow them to borrow at negative interest rates, which allows them to have deficits without borrowing more.
1. 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 Future Of Money. Bernard Lietaer (2002). Cornerstone / Cornerstone Ras.
7. A Strategy for a Convertible Currency. Bernard A. Lietaer, ICIS Forum, Vol. 20, No.3, 1990. http://folk.ntnu.no/tronda/finans/others/interest-free-money.txt
8. Genesis 41
9. A Strategy for a Convertible Currency. Bernard A. Lietaer, ICIS Forum, Vol. 20, No.3, 1990. http://folk.ntnu.no/tronda/finans/others/interest-free-money.txt
10. Genesis 47:15