Naturalmoney.org
the plan for the future
  
 

Natural Money Theory


7 October 2008 (latest update: 18 February 2023)


Author: Bart klein Ikink


Summary


 
Year 0
Year 10
Year 25
Year 50
Year 75
 


Interest-free money with a holding fee may become the money of the future. Interest rates may go negative and may remain in negative territory. Under these conditions this money may improve the economy and transform the global financial system. There is reason to believe that this can happen and this research aims to explain why and how. Silvio Gesell was the first to propose a holding fee on money in his work The Natural Economic Order. For that reason this money is called Natural Money.

Interest-free means that the maximum nominal interest rate on loans is zero. There is a fee on holding central bank currency that may range from 0.5% to 1% per month. The holding fee doesn't apply on money lent and investments. This can make it attractive to invest or to lend out money at interest rates below zero. Cash will become a separate currency backed by loans to the government so that the holding fee doesn't apply on cash ant cash is not attractive to hoard at the same time.

Why may interest rates remain negative? The graph to the right shows how total income and interest income 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 so that wages have risen. At some point interest income starts to increase faster than total income, and wages go down. After 80 years there's nothing left for wages.

The example is insightful because returns on capital have mostly exceeded economic growth and capitalists tend to save and invest while ordinary people tend to borrow and spend. It shows how wealth and income inequality can increase and why this could harm the economy in the end. Wages have lagged in recent decades and business profits have been propped up by allowing ordinary people to go deeper into debt. But at some point ordinary people can't borrow more so that interest rates may need to go down.

This is not as bad as many people think. In fact this might be beneficial. That is because interest has a number of downsides:
  • We pay interest costs on every product and service we buy. Products and services can be cheaper without interest.
  • On balance, most people pay interest to the wealthiest. Interest contributes to wealth and income inequality.
  • Interest promotes short term thinking with regard to investment decisions as future income needs to be discounted against the prevailing interest rate.
  • Interest is a reward for risk and interest on money and loans can promote risk taking and destabilise the financial system.
  • A stable financial system is a key public interest so interest on money and loans can lead to moral hazard resulting in private profits financed by public losses.

  • There are a number of benefits to Natural Money:
  • The lower interest rates go, the more projects become economical, and the more wealth may exist.
  • The holding fee allows interest rates to go negative which can provide a stimulus during economic slumps.
  • The maximum interest rate restricts credit if the economy does well so the economy may not overheat.
  • There are fewer problematic debts as market participants in poor financial condition can't borrow.
  • The reduction of problematic debts improves financial stability and reduces moral hazard.

  • The business of banks doesn't change much with Natural Money. There is little difference between borrowing money at 2% to lend it at 4% and borrowing money at -2% to lend it at 0%. People may object to negative interest rates until they realise that negative interest rates an improve the economy and products and services can be cheaper and that the benefits are greater than the drawbacks.

    Negative interest rates can improve the economy so that real interest rates can be higher. This means that Natural Money currencies may rise in value at a faster pace than interest accrues on interest bearing accounts so that interest-free money can have better returns than interest bearing money. This can cause a capital flight from the regular economy towards the interest-free economy. Hence, the superior efficiency of Natural Money may transform the global financial system.





    Contents




    Summary

    Contents

    Introduction
    Before you start reading
    Interest: the elephant in the room
    How interest contributes to income inequality
    How interest promotes short term thinking
    How interest contributes to financial and economic crises
    Public guarantees for private profits
    Interest is needed for the economy
    The trend towards lower interest rates
    Natural Economic Order
    Austrian School of Economics
    Recap

    Natural Money
    Concept
    Stabilisers
    Risk
    Employment and labour income
    Balancing trade
    Government regulation and intervention
    Interest versus taxation
    Local currencies
    The financial System
    Banking with Natural Money
    Wholesale banking system
    Governments and central banks
    Reserve requirements

    Natural Money and history
    Introduction
    Joseph in Egypt
    Periodic debt forgiveness
    Solon's economic reforms
    The decline of Rome
    Western Europe in the Middle Ages
    Restrictions on charging interest
    Fiat and scrip currencies
    Recent examples of interest-free money
    The miracle of Wörgl
    The Schwanenkirchen Wara
    The United States
    Lignières-en-Berry

    Can it work?
    Superior efficiency can enforce the change
    Uncovering the prerequisites
    Interest rate ceiling

    Economic Theory
    Common ideas about interest
    The rationale of having interest on loans
    Reasons for interest to exist
    Returns on capital
    Risks associated with lending out money
    Liquidity preference
    Time preference versus marginal utility
    Capitalist spirit
    Effect of a holding fee
    The rationale for lower interest rates
    Economic cycles
    Introduction
    Expectations and money hoarding
    Credit and leverage
    Usury and debt slavery
    Fiscal and monetary policies
    Monetary reform
    Creating money out of thin air
    Full reserve banking
    Less credit and higher interest rates
    Alternative schemes like shadow banks
    Matching the terms of loans and deposits
    The cause of financial instability, inflation and public losses
    Economic schools
    Classical economics
    Keynesian economics
    Monetarism
    Rational expectations
    Community currencies and National Socialism
    Steady state economics and de-growth

    References



    Introduction




    Before you start reading


    If you plan to read this document, you need some knowledge of economics to understand it. If you lack economic knowledge, don't be discouraged. The most important issues are explained in Natural Money For Dummies. The theory is explained in two papers that have been presented at the IV International Conference on Social and Complementary Currencies: Money, Consciousness and Values for Social Change in Barcelona in 2017.

    The first paper named The End of Usury explains why interest rates are likely to go lower and become negative and why this may remain so for the foreseeable future. The second paper named Feasibility Of Interest-Free Demurrage Currency clarifies how Natural Money might be implemented world wide and what the possible consequences will be. This document provides more background and research.

    Wealth inequality and environmental degradation have contributed to collapse of civilisations.1 For that reason it can be important to find ways to reduce income inequality and to preserve the resources of the planet. Natural Money can contribute to solutions even though much more is needed. This document explains how Natural Money can help to reduce these problems and improve the economy.



    Interest: the elephant in the room


    How interest contributes to income inequality

    Most people pay more interest than they receive, directly via loans and rents, and indirectly via the products they buy, so that they would benefit from lower interest rates. German research has shown that the bottom 80% poorest people pay interest to the top 20% of richest people.2 3 4 Interest is therefore sometimes seen as a tax on the poor to the benefit of the rich. The wealthiest people tend to reinvest most of their interest income as they are more likely to be people that see acquiring wealth as an end in itself. Often that is what made them rich in the first place.


    How interest promotes short term thinking

    With positive interest rates, money in the future is worth less than money now. This has a major impact on investment choices. Interest promotes short term thinking. If no interest was charged, long-term investments would be more attractive.5 The following example comes from the Strohalm Foundation6:

    Suppose that a cheap house will last 33 years and costs € 200,000 to build. The yearly cost of the house will be € 6,060 (€ 200,000 divided by 33). A more expensive house costs € 400,000 but will last a hundred years. This house will cost only € 4,000 per year. For two thousand euro per year less, it is possible to build a house that is not only more pleasant to live in, but will also cost less in energy use.

    After going to the bank for a mortgage application the math changes. If the interest rate is 10% then the expensive house will not only cost € 4,000 per year on write-offs, but during the first year there will be an additional interest charge of € 40,000 (10% of € 400,000).

    The long lasting house now costs € 44,000 in the first year. The cheaper house now appears less expensive again. There is the yearly write off of € 6,060 but during the first year there is only € 20,000 in interest charges. Total costs for the first year are only € 26,060. During the following years, interest charges are lower, but they still make the less durable house cheaper.


    The example shows that without interest charges there is a tendency to select long-term solutions, so interest makes long-term solutions less economical. If interest rates are negative, future income would be preferred even more. Interest promotes a short term bias in economic decisions. This must also be true on a larger scale. It may help to explain why natural resources, such as rainforests are squandered for short term profits.

    The problem with this example is that calculations are never that simple. The distant future is more uncertain than the near future and this also affects the time horizon of investors. Furthermore, longer term solutions are not always more sustainable. The building materials of the cheap house might be recycled to build a new house. And technology changes fast. If cars had been built to last 100 years and most old cars were still around this would be a problem. Old cars are more polluting and use more fuel. The example only shows that long term investments become more attractive when interest rates are lower.


    How interest contributes to financial and economic crises

    Financial crises happen when borrowers can't repay their debts. Most of our money is debt and compound interest is infinite. When loans are made they carry interest but the money to pay the interest from doesn't exist. It has to be loaned into existence. Lenders may spend the interest and borrowers may default, but on aggregate the interest has to be loaned. Normally borrowers can repay their loans as economic growth pays for the interest. But if borrowing slows down, the economy can falter, and borrowers can't repay their debts. A simple example can demonstrate why debts may need to grow because of interest.

    Assume that Jesus' mother put a small gold coin weighing 3 grammes in Jesus' retirement account at 4% interest in the year 1 AD. Jesus never retired but he promised to return. Suppose that the account was kept for this eventuality. How much gold would there be in the account in 2018? The answer is an amount of gold weighing 11 million times the mass of the Earth. The yearly interest would be an amount of gold weighing 440,000 times the mass of the Earth. The banking system would collapse if Jesus came back to claim his gold. If instead Jesus’ mother had put one euro in the account, the ECB could print the money out of thin air.

    The basic idea of capitalism is to finance growth by credit and not by increasing the amount of real gold. To pay for the interest on existing debts, growth is needed, and to create growth, more debt is needed. If no one is willing to go further into debt, the system can run into trouble, debts will be defaulted upon, and an economic depression could ensue. For that reason, economists like Keynes advised governments to go further into debt when no one else is willing, while central bankers step in to stabilise the system whenever there is a shortfall of gold or currency.


    Public guarantees for private profits

    Interest contributes to moral hazard and financial instability as interest is a reward for taking risk. This idea underpins Islamic finance as Islam forbids gambling and excessive risk taking.7 Extracting a fixed income out of a variable income source can be seen as a form of gambling. Fixed interest payments on debts can bankrupt a corporation even when it is profitable overall. The more uncertain the source of income is, the higher the fixed interest rate needs to be to compensate for the risk of lending, but the higher the fixed interest rate is, the more likely the scheme will fail. This resembles a Catch 22 situation.

    All parts of the financial system are intertwined so these risks can enter the financial system. The financial system is a key public interest so it is backed by governments and central banks. Banks can take risks and reap the rewards in the form of interest while public guarantees back up the financial system. This arrangement can lead to moral hazard, a mispricing of risk and private profits at the expense of the public. It is the combination of interest on money and debts together with the government and central bank guarantees that cause this problem of moral hazard.


    Interest is needed for the economy

    Some people argue against interest on moral grounds. In the past interest has been restricted or even banned several times. In the Middle Ages charging interest was illegal in Western Europe. When economic life became more developed, the ban on interest became difficult to enforce. In the 14th century partnerships emerged where creditors received a share of the profits from a business venture. As long as this share was not fixed, this was not illegal as it was considered a share in business profits rather than interest.8 Islamic finance is based on similar principles.

    In the 17th and 18th century interest bans were often replaced by interest rate ceilings. To circumvent the interest ceiling, creditors and debtors sometimes agreed that less money was handed over to the borrower than stated in the loan contract so that more interest was paid in reality.9 More recent experiences with Regulation Q in the Unites States, which amounted to maximum interest rates on bank accounts, indicate that a maximum interest rate is enforceable only if it doesn't affect the bulk of borrowing and lending.10



    The trend towards lower interest rates


    Interest rates have gone down in recent decades.11 On the one hand, lower interest rates made more wealth feasible by spurring investments. On the other hand, they induced people and businesses to increase their leverage, which means higher indebtedness. Now interest rates are stuck near zero, there are two important questions to be answered. The first one is how to let the economy recover, and the second one is how to curb debt expansion in the future. What now follows is a sort of situation description that highlights the developments that matter most with regard to the direction of interest rates in the future.

    The accumulation of capital helped to bring down interest rates in the following ways:
    • Throughout history returns on investments have mostly been higher than economic growth.12 This is unsustainable when most capital income is reinvested because this means that at some point capital income will grow at the expense of wages.
    • The growth of interest income can become even more problematic when the ownership of capital is not evenly distributed. Most capital is in the hands of a relatively small group of wealthy people that tend to reinvest their capital income instead of spending it.
    • Neoliberal policies and the deregulation of capital and labour markets accelerated this process, leading to an uneven distribution of wealth. As a result consumers were unable to buy from their labour income all the goods and services that this capital produces, so that interest rates had to go lower.
    • This allowed people to borrow more, which propped up business profits, and most notably financial profits. This accelerated capital and debt buildup meant that interest rates had to go even lower to sustain this scheme that is sometimes called bubble economics.
    In the long run, the rate interest on capital cannot exceed the rate of economic growth, at least when all interest income is reinvested. This is a mathematical certainty, just like compound interest going to infinite. Economic models suggest that wealth will end up in the hands of the most patient consumers.13 The wealthiest people tend to reinvest most of their interest income as they are more likely to be people that see acquiring wealth as an end in itself.14 They own a disproportionate amount of capital so that their attitude may have a disproportionate effect on interest rates.

    Banking, central banking and the deregulation of the financial sector helped to bring down interest rates in the following ways:
    • Banks provide convenience by making it possible to call in loans at short notice. Banks makes loans to many different people and corporations, which lowered the risk premium. Banks increase liquidity and reduce risk, and this can help to lower interest rates.
    • Central banks also increase liquidity and reduce risk. Banks lend out more money than they have in cash so that if depositors demand cash, a bank may run into trouble. Central banks can provide this cash if needed.
    • The deregulation of the financial system further increased liquidity. But deregulation in combination with lower interest rates and better risk management allowed financial institutions to take on more debt and risk.
    Central bank support combined with the deregulation of the financial sector in recent decades probably propped up financial profits, and possibly at the expense of the economy at large. Despite economic growth, real wages in the United States have remained stagnant for decades, while after-tax corporate profits as a percentage of GDP have shot up and reached an all-time high in recent years. Even more so, the US financial sector comprised only 10% of total non-farm business profits in 1947, but grew to 50% by 2010.15 Most if not all of the extra profits from bubble economics ended up, not very surprisingly, in the financial sector.

    There is a rationale to contain the amount of credit and curb risk taking in the financial sector for the following reasons:
    • The safety net of central banks and governments can support the profits of private banks. When things go well, banks can make profits and bankers receive bonuses, but when things go wrong, taxpayers may have to pay for the errors that bankers made.
    • During economic booms there is optimism, new debts are created based upon a rosy picture of the future, and interest rates rise. The greater the optimism, the more debt will be created and the higher interest rates can go, but also the greater the bust can be when those higher interest rates turn out to be unjustified.
    • Lower interest rates allow people and corporations to use more leverage. Leverage can make the financial system unstable.



    Natural Economic Order


    When Silvio Gesell finished writing The Natural Economic Order in 1916, his proposal for a holding fee on money marked the beginning of new school of economic thought. Gesell labelled this money free money because he believed that it promoted the free play of economic forces. The most remarkable success of Gesell's ideas was the emergency currency of Wörgl. Famous economists like Irving Fisher and John Maynard Keynes thought that free money had potential. Still, the idea became close to forgotten after the emergency currency was banned and World War II ended the Great Depression.

    Silvio Gesell is considered a socialist by some and a free-market proponent by others. He favoured free markets without state intervention, which made him a liberal, but he disliked the privileges of money and capital, which puts him in the camp of the socialists. Silvio Gesell was influenced by the Manchester School of Economics that contended that free trade and free capital markets would push interest rates to zero. The Manchester economists based this prediction on the discovery that in interest rates were the lowest England where money and capital markets were the most competitive and well-developed.

    Gesell was also influenced by Proudhon, who thought that the accumulation of more and more capital would push interest rates to zero. Proudhon was a socialist who opposed the general Marxist doctrine that labourers could get the upper hand via class struggle. Instead he suggested that workers should do their jobs and work diligently to produce more and more capital. He thought that building more factories and churning out more products would push down prices while building more houses would push down rents. Proudhon saw that money somehow limited the production of capital. In the words of Gesell 16:

    Proudhon asked: Why are we short of houses, machinery and ships? And he also gave the correct answer: Because money limits the building of them. Or, to use his own words: "Because money is a sentinel posted at the entrance to the markets, with orders to let no one pass. Money, you imagine, is the key that opens the gates of the market (by which term is meant the exchange of products), that is not true-money is the bolt that bars them."


    What Proudhon and Gesell discovered was that interest rates cannot go below a certain minimum level because investments would then stop. Money would go on strike as Gesell put it. The main reason is that low yields make investing and lending out money unattractive because of the risks involved. Money, and most notably gold, does not depreciate like goods so it can be stored without a loss, hence there is no incentive to put money at work if interest rates are low.

    Keynes called this a liquidity trap, which means that when interest rates are low, people tend to prefer cash to investments. Nowadays bank deposits are considered lower risk than cash so the liquidity trap is at an interest rate near zero. Gesell thought that if money depreciated like other goods, the requirements of money would not block the production of more capital, and interest rates could go to zero. When Gesell lived, the gold standard was still in force. He noted that gold does not decay so that the possessors of gold have an advantage over the possessors of other goods. He came up with the following observation 16:

    A and B, separated by space and time, wish to exchange their wares, flour and pig-iron, and for this purpose need the money in C's possession. C can at once effect the exchange with his money, or he can delay, hinder or forbid the exchange; for his money gives him the freedom of choosing the time at which it shall take place. Is it not obvious that C will demand payment for this power, and that A and B must grant it in the form of a tribute on their flour and pig-iron. If they refuse this tribute to money, money withdraws from the market. A and B must then retire without completing the sale and undertake the heavy cost of returning home with their unsold products. They will then suffer equally as producers and consumers; as producers because their wares deteriorate, and as consumers because they must do without the goods to obtain which they brought their products to market.


    Gesell concluded that the owners of money could exploit their advantageous position by charging interest. His observation shows that there is a minimum interest rate that does not depend on the state of the economy. Money will be withdrawn from the economy once this level is reached so that interest rates cannot go lower. This is not because there are fewer savings but because savings are withdrawn from the economy. This causes an economic downturn so that the demand for goods and services drops, which demonstrates that money hoarding could result in an economic recession or even a depression.

    On the other hand, Gesell observed that higher interest rates would make more credit available. This is problematic because higher interest rates and more credit do not create more gold or currency, so that interest and credit produce produce problems in the future. At some point credit may need to be repaid with interest in gold or currency, which is more difficult if there is more credit created or interest rates have been higher.

    The recent economic crisis is not so different. Banks were hoarding money because they did not see investment opportunities at the prevailing low interest rates. Economic theory suggests that the equilibrium interest rate was negative, and that equilibrium could not be reached because there is a minimum interest rate. In plain English this means that there are too many savings and too few investment opportunities and that interest rates must go even lower to discourage saving or to promote investing. Gesell proposed a fee on money to achieve this. He wrote 16:

    Only money that goes out of date like a newspaper, rots like potatoes, rusts like iron, evaporates like ether, is capable of standing the test as an instrument for the exchange of potatoes, newspapers, iron and ether. For such money is not preferred to goods either by the purchaser or the seller. We then part with our goods for money only because we need the money as a means of exchange, not because we expect an advantage from possession of the money.


    And the consequence Gesell envisioned was that 16:

    In whatever way the money is invested, it will immediately create demand. Directly, through purchasing, or indirectly through lending, the possessor of money will be obliged to create a demand for commodities exactly proportionate to the quantity of money in his possession.


    There are some issues with the proposal of Gesell. He foresaw the need of a Currency Office that manages the money supply based on inflation numbers. The Currency Office can become subject to political objectives. Gesell also did not think of a method to reign in credit. The economy may boom, interest rates could go positive, and credit could become abundant. At this point the Currency Office, which is more or less a central bank, might not be in a good position to curb inflation. Reducing the number of currency units could cripple the booming economy and produce an economic depression.



    Austrian School of Economics


    On the opposite side of Silvio Gesell were adherents of the gold standard and what came to be known as the Austrian School of Economics. The Austrian School of Economics contends that too much credit is an important cause of economic crises. Banks issued more credit than there was gold in their vaults and in this way they created money out of thin air. This scheme sometimes collapsed so that sometimes a bank run occurred when people lost their trust in the banker's scheme. Banks also borrow funds from each other so that one bank's trouble can spread to other banks.

    When banks collapsed, credit dried up, and an economic crisis often followed suit. Some branches of the Austrian School oppose fractional reserve banking. Instead they propose a clear distinction between savings and credit. Savings consist of money entrusted to the bank for a specific time and money that cannot be withdrawn on short notice. According to these Austrians, only savings should be used for loans, so that there is always enough gold or money in the vault to pay depositors.17 Other Austrians believe that fractional reserve banking can exist in a free market.

    In the view of the Austrian School, bank credit causes interest rates to be lower than they otherwise would have been, so that malinvestments are made, creating excess capital. As long as the economy is booming, those investments appear to be profitable, but when the bust sets in this excess capital will be destroyed.17 18 Because interest rates cannot go below a certain minimum level, credit will dry up once this level is reached, and this causes recessions. Austrians see recessions as healthy cleansing processes in which businesses have to readjust themselves to become more competitive.

    Central banks meddle with this process. They reduce the risks related to bank failures so that interest rates can go lower. Central banks can also supply credit at a lower interest rate than the mininum interest rate in the market so that the reduction of excess capital during the bust does not have to take place, which makes things worse in the end according to Austrians.17 18 Many Austrians fear a day of reckoning when all this excess credit cannot be repaid so that the economy enters the most serious economic depression there has ever been. This concern is reflected in the following famous words of Ludwig von Mises:

    There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.19


    The Austrian Business Cycle Theory states that excess credit can aggravate economic cycles. On the one hand, low interest rates allow for more debt to exist, which makes the financial system more vulnerable to interest rate changes. On the other hand, excess credit can also be the result of interest rates being too high instead of too low. When the economy is booming, interest rates rise, and credit becomes abundant. During a boom a lot of debt comes into existence at high interest rates based on rosy expectations of the future. When the bust sets in, it turns out that there was too much debt or that interest rates had been too high.



    Recap


    Before introducing the idea of Natural Money, let's sum things up. The following can be concluded from what has been discussed so far:
  • Interest can contribute to wealth inequality, depletion of resources, and financial and economic crises.
  • There is a trend towards lower interest rates caused by wealth inequality and efficient financial markets.
  • Monetary reform aimed at ending fractional reserve banking is not viable.
  • A fee on money as proposed by Silvio Gesell makes it possible to have negative interest rates.
  • If interest rates can be lower, there can be more capital, hence more prosperity.
  • Credit and high interest rates contribute to economic cycles.
  • When interest rates are lower, there can be more debt, which raises the need for a way to reduce leverage.




  • Natural Money



     
     

    Concept


    Natural Money is named after the Natural Economic Order of Silvio Gesell. Natural Money is interest-free money with a holding fee. Interest-free means that the maximum nominal interest rate on loans is zero. The holding fee is a fee of 0.5% to 1.0% per month on currency, which are central bank deposits. The government spends the holding fee so that the amount of currency remains constant. The holding fee does not apply on bank deposits and loans so that it can be attractive to lend out money at zero or even negative interest rates.

    In order to still have cash when interest rates are negative, cash and digital money need to become separate currencies. The monetary unit of the financial system is the central bank currency. Cash will be backed by short-term government loans so there is a negative interest rate on cash. As a consequence cash will steadily depreciate in terms of central bank currency.

    Introducing Natural Money can have the following effects:
  • The holding fee can balance the markets for money and capital when the equilibrium interest rate is below zero so that there is no need for stimulus.
  • Lower interest rates can make more investments profitable and this can help to improve the economy.
  • The interest rate ceiling can prevent the economy from overheating as there will be less credit during economic booms as other investments are more attractive.
  • The interest rate ceiling can help to reduce reckless lending because there is no reward for taking excessive risks.

  • In order for Natural Money to work interest rates need to be near zero or negative to begin with. If interest rates are higher then a maximum interest rate of zero can hamper borrowing and lending and harm the economy. And introducing a holding fee on money has little effect on interest rates if the equilibrium interest rates are significantly above zero. The conditions of low interest rates might however persist so that Natural Money can be introduced successfully.

    The interest rate ceiling makes equity investments attractive relative to debt because the yield of debt is capped at zero. The maximum interest rate can help to reduce leverage and the vulnerability of the financial system to interest rate changes by increasing the amount of equity relative to debt, and by not allowing these interest rate changes to happen by cooling down the economy when it is poised to overheat. Natural Money can stabilise the economy so that sudden changes in interest rates are less likely to occur.

    With Natural Money, banks can lend out money at a maximum rate of zero so deposit accounts can have negative yields that might amount to -2% to -3% annually. Lower yields seem unlikely as these would encourage depositors to spend their balances so that the economy would improve and interest rates rise. The maximum interest rate can prevent credit booms so that there probably is no price inflation. If there is economic growth then the currency can appreciate because economic growth means that more products and services become available while the amount of money remains the same.

    Cash could be an obstacle to implementing the holding fee. Eliminating cash may not be a good idea because some people prefer cash for various reasons. Silvio Gesell proposed a monthly stamp on bank notes 16, but this can be very cumbersome. The holding fee can be implemented via an exchange rate between cash and the electronic currency unit.20 21 22 Keeping cash will then cost 6-13% per year. For small amounts this is not a problem. Alternatively, banks can issue cash that isn't currency but backed by bank loans. This cash can have a lower depreciation rate similar to bank accounts.



    Risk


    Interest contributes to financial crises because interest is a reward for risk. For that reason Islam forbids interest, excessive risk taking and gambling.7 First of all, interest rates reflect the risks involved in lending out money. If the borrower is less likely to repay the loan because of high debt levels or poor and unstable income, he or she has to pay higher interest rates on loans. Borrowing at high interest rates can make those borrowers worse off.

    It works both ways. As interest is a reward for risk, lenders are more willing to take risk if there is a reward in the form of higher interest rates. This risk then enters the financial system, making it more prone to crisis. What is even more troublesome, is the fact that when a borrower is in poor financial shape, paying higher interest rates tends to make his or her predicament even worse. Interest in this way tends to increase the risk of default.

    The trouble in the financial system that led to the crisis of 2008 can in this way be related to interest as lending to subprime borrowers was likely to be interest-induced. The risks were also underestimated because of government policies and guarantees that supported this borrowing. A maximum interest rate could curb the risk lenders are willing to take.



    Stabilisers


    The holding fee makes holding money idle expensive so that the economy can recover quickly from a downturn. When savings exceed investments then real interest rates could go below zero to discourage saving and to promote investing. The maximum downside on interest rates is determined by the holding fee on currency. It is likely that a holding fee of 10% per year will be sufficient to provide quick economic recovery after a crisis.

    The interest rate ceiling on loans can promote responsible behaviour. It will result in a cap on the risk lenders are willing to take. Risky projects may be financed with equity instead of debt. People and businesses in financial trouble may have to adjust their finances and their troubles cannot be compounded by interest charges. It can help to promote fiscal discipline as low interest rates require sound government finances.

    The interest rate ceiling on loans can curb credit expansion when the economy is doing well because people are less inclined to lend money when other investment opportunities provide better returns. It is likely that consumer credit is curtailed during boom times and more readily available if the economy slows down. This will stabilise the economy by mitigating the business cycle. As a consequence the financial system will also become more stable.

    This stability undermines the rationale for governments and central banks to intervene to support the economy. Reductions in debt levels and price deflations probably doesn't do much harm because the holding fee will provide ample stimulus so that the economy can do well without creating new debts. As a consequence fiscal and monetary policies can become obsolete and be replaced by fiscal and monetary discipline.


     
     

    Employment and labour income


    If interest rates are zero then all proceeds of the economy go to people and not to capital. This may not be possible but the thought experiment demonstrates that lower interest rates benefit most people, and that negative interest rates are not to be feared. Negative interest rates can help to reduce unemployment as the holding fee allows for negative interest rates to balance consumption, savings and investments.23

    Profits and interest rates tend to reflect the risk of doing business so that reducing the risk of doing business could increase the overall level of wealth via lower interest rates. If it is sufficiently easy to enter the market, excess profits lead to increased competition or a higher demand for labour, which could lower the price of products or increase the price of labour. Hence, the reward for labour could increase when the risk of doing business is lower.

    The most important precondition for low business risk is political stability and a respect for property rights. Natural money can help to further reduce the risk of doing business if these preconditions are met, and interest rates are low enough, by making the economy more stable. Consequently the reward that capital requires to be employed can be lower so that the portion of national income paid out to labour could rise.



    Balancing trade


    Some countries like China and Japan try to promote exports via currency manipulation. It may be better for those countries to increase aggregate demand. Negative interest rates can help to correct trade imbalances because exporters can makes losses on foreign currency reserves. With negative interest rates exporters will be more inclined to spend their currency balances. The maximum interest rate can help to curtail trade imbalances because it promotes a cap on risk taking.

    Negative interest rates may do a better job than tariffs. There is no magic formula for determining what tariffs on what products are needed or justified, so decisions on tariffs tend to be arbitrary and political. The consequence may be that the advantages of trade between nations diminish, and that people will be paying more for foreign products than needed, and that employment may not improve because higher prices reduce demand for other goods and services.



    Government regulation and intervention


    Government regulations and interventions are aimed at specific goals that most people appreciate but they can produce undesired side-effects. In many cases there are loopholes and opportunities for profit at the expense of the general public. If the economy could realise these intended goals automatically as a result of market forces, this may be more efficient as it could reduce fraud and misuse of public funds.

    Natural Money could provide a number of benefits that reduce the need for government intervention and regulation. The economy can do well by itself so governments and central banks may not need to interfere with the economy. The holding fee eliminates the need for stimulus so that governments may not have to run deficits to stimulate the economy. There could be more employment so that there may be less need for employment benefits and assistance.

    Low interest rates can help to make sustainable investment choices rational economic decisions so that the government may have fewer reasons to encourage them via subsidies. Fewer regulations in the financial system may suffice because a restriction on charging interest on money is likely to reduce risk taking so that many of the abuses caused by financial engineering would become unattractive and disappear.



    Interest versus taxation


    Labour and capital markets have been deregulated while taxes on high incomes and capital were often reduced, most notably in the United States and Great Britain. As a consequence wealth inequality and capital increased while interest rates went down. Thomas Piketty proposed a tax on capital to reduce wealth inequality.12 This measure counters the effects of the compounding of interest. Piketty also proposed to tax high incomes at a high rate because low tax rates give people at the top more motivation to bargain for increases of their income since they can keep more of it.12

    Many studies have found that the inclination to save is considerably higher among wealthier people, so that the savings glut can at least partially be explained as a result of wealth inequality. In this way wealth inequality contributes to lower interest rates. Higher taxes on high incomes and capital can lead to rising interest rates, which then might reduce the amount of capital that will exist as higher interest rates make fewer projects feasible. There might be a choice between redistributing income via low and negative interest rates at a higher capital level versus taxing wealth and accepting a lower capital level.



    Local currencies


    The division of labour and economies of scale are basic economic considerations. Sometimes a reduction in the division of labour can be cost effective when there are diminishing returns on investments in social complexity.24 Local currencies can benefit communities by promoting local economic activities by introducing transaction costs. This works best when the economies of scale are limited or non-existent.

    Global markets are anonymous. If you spend your money on a product you often have no clue where the product is produced and under which circumstances. You have little influence over what your money is used for. Inspired by the success of the local currency in Wörgl, the Community Currencies Movement aims at supporting the local economy by bypassing the global markets where that might be possible.

    Local and regional governments can issue local currencies to support local and regional development. Those currencies can circulate alongside the national currency. People will be inclined to spend their local currency balances first because they can only be used locally. This can promote local trade.25 The potential of local currencies appears to be limited. Reseach has shown that local currencies can not make up more than 20% of the currency in circulation.



    The financial System


    Banking with Natural Money

    With Natural Money banks operate much like they do nowadays. Most regulations that apply now may apply in the future, but there could be two types of banks in the future. Regular banks on the one hand can only lend money at a maximum interest rate of zero. Participative banks can offer higher returns but deposits carry more risk. Depositors at participative banks share in the profits and the losses of their bank. Regular banks are supported by central banks and desposit guarantees from governments so they shouldn't be engaged in risky activities.

    Regular banks should only be able to lend out funds at a maximum nominal interest rate of zero. This puts a cap on the risk they are willing to take. Depositors are expected to accept negative nominal interest rates on their deposits in order for banks to have a profit margin. The central bank can support regular banks by lending money at an interest rate of zero when they cannot borrow elsewhere. Governments may choose to guarantee deposits at regular banks to a certain maximum.

    Only regular banks are allowed to guarantee fixed interest rates with the backing of their capital. Participative banks issue shares and there is a price risk attached to those shares. Participative banks operate more or less like Islamic banks do nowadays. They can invest in businesses and share their profits, offer lease contracts on cars and houses similar to car loans and mortgages. They can also make loans at a maximum nominal interest rate of zero.

    It may be more difficult to provide flexible credit such as overdraft at a maximum interest rate of zero to consumers. It may also not be possible to provide short term credit to corporations under those conditions. Sophisticated borrowers may be able to borrow at negative interest rates in the money market. To address the needs of less sophisticated borrowers, banks could offer loans equalling the credit limit at an interest rate of zero or less for a longer period of time, and invest unused funds in a short-term savings account or a demand deposit, while presenting used funds as an overdraft to the borrower.


    Wholesale banking system

    Fischer Black realised in 1970 that a long term bond could be sold in three separate parts to three different investors. One could supply the money for the bond, one could bear the interest rate risk, and one could bear the risk of default. The last two would not have to put up any capital for the bonds, although they may have to post some sort of collateral.26 This idea became the basis for the development of wholesale banking and derivatives in recent decades. The wholesale banking system is more commonly known as the shadow banking system. It helped to spread risk and thus contributed to the drop in interest rates in recent decades.

    Derivatives are often seen as a dangerous development. The total notational value of outstanding derivatives has grown explosively in recent decades, and this caused concern. Financial innovations such as the credit derivatives tend to improve the risk management of banks. This allowed banks to offer lower corporate loan spreads. The effect of risk management remained unchanged during the crisis period of 2007-2009. Banks with larger gross positions in credit derivatives cut their lending by less than other banks during the crisis and had consistently lower loan charge-offs.27

    Nevertheless, the concerns are justified. In the case of a severe shock, a sudden evaporation of liquidity can occur, so that derivatives can terminate the financial system. This nearly happened during the financial crisis of 2008. This had a number of probable causes:
    1. a lack of liquidity caused by the zero bound liquidity trap. If interest rates could go low enough, liquidity probably would have returned;
    2. immature regulation systems. The financial system was not prepared to meet an event like the financial crisis of 2008;
    3. absence of markets. Many derivatives could not be traded in transparent liquid markets so that their value was difficult to establish;
    4. the regular banking system, and in this way the central banks, backed the wholesale banking system and the derivatives.

    A well-developed wholesale banking system might improve the efficiency of markets. Economic stability and a maximum interest rate of zero could help to reduce risk in the wholesale banking system. Default risk could be reduced with a maximum interest rate of zero. The holding fee on the currency will make it expensive to hold currency so liquidity is less likely to dry up. Combined with adequate regulation that includes solvability and liquidity requirements, as well as transparent liquid markets for derivatives, this could help to develop a mature and stable wholesale banking system.


    Governments and central banks

    On the one hand, Natural Money requires more discipline from governments with regard to their budgets. Government borrowing can crowd out private borrowing and can make it difficult or even impossible to keep nominal interest rates below zero. On the other hand, Natural Money offers more opportunities for governments to enforce budget discipline because there is no need for deficit spending. The holding fee eliminates the need for stimulus so that budget cuts or tax increases may have fewer adverse effects on the economy. Furthemore, if governments can borrow at negative interest rates, this can generate extra revenue for them.

    With Natural Money, the interest rate is set by the market and the upper bound, but not by the central bank. The lower bound is the holding fee rate and the upper bound is zero. The central bank only gives credit to banks at an interest rate of zero. This is unattractive for banks because they cannot lend out this money at a higher interest rate. Banks will therefore not borrow at the central bank unless they have to, for example in case of an emergency. Regular banks can't lend at higher rates than zero because they are backed by public guarantees.


    Reserve requirements

    Reserve requirements are less important today than they were in the past. Banks are backed by public guarantees so reserve requirements may be useful if there is a desire within society to control the amount of bank credit. Banks pay a holding fee on the currency in their vaults so higher reserve requirements translate into lower rates on deposits. It is possible to have reserve requirements based on the moving average of the daily transactions between accounts.

    Fixed reserve requirements do not adapt to the velocity of money. A high velocity of money tends to be price inflationary while a low velocity of money tends to be price deflationary. If the reserve requirement changes with the velocity of money, it could counteract price inflation and deflation. In order not do disadvantage small banks, transactions between accounts within the same bank should be included in the reserve requirement calculation.

    The use of central bank credit with Natural Money is unattractive for banks because they cannot relend this money at a higher interest rate. The central bank thus operates as a lender of last resort in accordance with Bagehot's advice, which states that if there is a credit crunch, central banks should avert panic by lending early and without limit to solvent firms against good collateral at high rates.28

    With Natural Money, central banks do not subsidise the banking system with funds banks can relend at higher rates. This is a source of discipline in the banking system that is backed with public guarantees. Under normal conditions a bank can borrow at better rates from other banks and depositors. Because they cannot make money from central bank credit, banks probably have little appetite for central bank credit, and will curb lending when they are on it.




    Natural Money and history




    Introduction


    Compounding of interest can lead to wealth inequality. Until the Industrial Revolution, economic growth was practically non-existent. Civilisations came and went but the Egyptian civilisation existed for more than 2,000 years. The location of Egypt may have helped to make this extraordinary feat possible. The river Nile was a constant source of wealth while Egypt was shielded from invading armies by the surrounding desert. Furthermore, the ancient Egyptians were unfamiliar with the concept of interest. They operated a financial system based on Natural Money.

    Egypt had a financial system based on grain storage with negative interest rates from around 1,500 BC until the arrival of the Romans around 30 BC. This demonstrates that negative interest rates are feasible and can exist for a long time. Compounding interest might shed a new light on a number of historic issues such as the fall of Rome and the rise of Western Europe in the Middle Ages. A few experiments with a holding fee on money such as the emergency currency of Wörgl and the complementary currency of Lignières-en-Berry showed remarkable results.



    Joseph in Egypt


    The Bible contains a story about the Pharaoh having dreams that he could not explain. The Pharaoh 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 was able to explain those dreams to the pharaoh. He told the Pharaoh that seven good years would come and after that seven bad years would follow. Joseph advised the Egyptians to store food in large storehouses. They followed his advice and built storehouses for food. In this way Egypt survived the seven years of scarcity (Gen. 41:1-45).

    What is less known, because it is not recorded in the Bible, is that the storing of food resulted in a financial system. The historian Friedrich Preisigke discovered that the Egyptians used grain receipts for money and had built a banking system based on this money.29 Farmers bringing food to the storage facilities did get a receipt stating the amount of grain they brought in. Bakers who wanted to make bread, brought in these receipts which could be exchanged back for grain. According to the Bible, Joseph took all the money from the Egyptians (Gen. 47:14-15). This may have prompted them to invent an alternative currency.

    As a consequence the grain receipts may have been accepted as money. The degradation of the grain and storage cost caused the value of the receipts to decrease steadily over time. This probably prompted people to spend the money. There may have been credit and it may have been interest free. The grain receipt system lasted for many centuries. The actions of Joseph may have created this system as he allegedly proposed the grain storage and took all the money from the Egyptians. When Joseph came to Egypt, the country had already passed its zenith and the time of the building of the great pyramids was centuries earlier.

    A few centuries later, during the reign of Ramesses the Great, Egypt became again a leading power.30 Some historians suggested that the wealth of Egypt during the reign of Ramesses the Great was built upon the grain financial system.31 The grain money remained in function in Egypt after the introduction of coined money around 400 BC until it was finally replaced by the Roman currency. The money and banking system were stable and survived for 1,500 years. It seems therefore possible to have a banking system with Natural Money, at least in a stationary and stable economy.

    Grain based money existed before. Sumerian barley money was one of the first forms of money used around 3000 BC. Fixed amounts of barley grains were used as a universal measurement for evaluating and exchanging all other goods and services.18 The Sumerian money was not based on storehouses so it did not have a holding fee nor could the Sumerians build a banking system based on this money like the Egyptians did. The Egyptian example illustrates that money with a holding fee and interest-free banking may prove to work on a large scale over a long timeframe.



    Periodic debt forgiveness


    In the Bible once in seven years a Sabbath Year was introduced in which debts were forgiven (Deut. 15:1-18). Once in the fifty years there was a Jubilee (Lev. 25:8-55). In the Jubilee every man could return to his possession while the land had to be redeemed. The Bible also banned interest.32 The periodic debt forgiveness in the Bible was not unique as Mesopotamian royal edicts cancelled debts, freed debt-servants and restored land to cultivators who had lost it under economic duress.33 These practises helped to free rural populations from debt servitude and the land from appropriation by foreclosures.33



    Solon's economic reforms


    Around 500 BC agricultural output in Greece was not able to keep up with increasing population. Because of interest charges, mostly paid to city people, the debt load for farmers had gotten out of hand so that many of them could no longer pay their debts and were forced into slavery. Farms became the property of rich city folk who didn't understand farm work, while slavery did not contribute to the productivity of agriculture.34

    Harvests declined and the people in the cities were threatened by famine. Solon realised that a healthy countryside is a countryside without debts. Farmers who understand the business of farming must make their own decisions. The farmer's ambition to improve himself is indispensable for a vital countryside. Solon introduced drastic measures eliminating all existing debts. To curb new debts a limit was set to the interest rate and the accumulation of land.34

    Solon's reforms focused on the constitution and the economy. His reforms on debt and interest are just one of them.35 Solon also set a moral example. He identified greed as having negative consequences for society. The modesty and frugality of the rich and powerful men of Athens may have contributed to the city's subsequent golden age. Solon, by being an example and by reforming legislation, may have established a moral precedent.35



    The decline of Rome


    A number of historians and economists investigated the decline of Rome. A number of theories have been brought forward to explain this historic event.36 In the fifth century the Roman historian Vegetius pleaded for a reform of the weakened army. The Roman Empire, and particularly the military, declined largely as a result of an influx of Germanic mercenaries into the ranks of the legions. This led not only to a deterioration of the standard of drill and overall military preparedness within the Empire, but also to a decline of loyalty to the Roman government in favour of loyalty to local commanders.

    There was a slump in agriculture and land was withdrawn from cultivation. High taxation on cultivated land was probably to blame. Another factor may have been the debasement of the currency that led to inflation. Apart from an expansion of the state, the debasement could also have been caused by interest on money as usurers may have amassed most of the gold and silver in the Roman Empire. Price control laws resulted in prices that were significantly below their free-market levels. The artificially low prices led to a scarcity of food. Together with increased taxation and oppressive laws, this led to more poverty.

    In the Decline and Fall of the Roman Empire Edward Gibbon wrote:

    Unable to protect their subjects against the public enemy, unwilling to trust them with arms for their own defence; the intolerable weight of taxes, rendered still more oppressive by the intricate or arbitrary modes of collection; the obscurity of numerous and contradictory laws; the tedious and expensive forms of judicial proceedings; the partial administration of justice; and the universal corruption, which increased the influence of the rich, and aggravated the misfortunes of the poor. A sentiment of patriotic sympathy was at length revived in the breast of the fortunate exile; and he lamented, with a flood of tears, the guilt or weakness of those magistrates who had perverted the wisest and most salutary institutions.


    Taxation was spurred by the expanding military budget, which was the result of the barbarian invasions and the use of mercenaries. A few centuries later the Eastern Roman Empire managed to survive the invasion of Arabs by introducing local militia that were not paid from the treasury but from local revenues.37 Over time the ranks of the militia were filled with local people that had an interest in defending their own land.

    Roman money was based on gold and silver. Contrary to the Egyptian corn receipts, this money could be hoarded and moved abroad. This meant that when the Roman Empire started to decline, money may have disappeared from circulation. This may have reduced trade and impaired the economy. Because of this, as well as the expansion of government and the barbarian invasions, the government was permanently short of funds, causing a debasement of the currency and a rise of taxes that further burdened the Roman economy. In the end the invading barbarians may have been seen as liberators.



    Western Europe in the Middle Ages


    Restrictions on charging interest

    After the Roman Empire collapsed, feudalism became the predominant political and economic system in Western Europe. The power in Western Europe became fragmented, so trade diminished and money became less important. Gold disappeared from circulation. Most transactions were done as barter while taxes were mostly paid in kind. There were metal coins as well as promises.38 From around 1100, money became increasingly important as both trade and cities grew at a steady pace and gold reappeared in Western Europe.

    From the year 300 onwards, the church restricted charging interest. Rates above 1% per month where considered to be usurious and evil. There was no enforcement of the restrictions and charging interest remained common practise in trade.39 In 784 the Council of Aachen forbade charging interest altogether. In Western Europe this rule was more strictly enforced during the subsequent centuries.40 In the Byzantine Empire, restrictions on interest remained less strict, possibly because economic life was more developed, which made it more difficult to enforce a full ban on charging interest.39

    The restrictions on charging interest did not hamper economic development in Western Europe. When the ban on usury was first imposed, Western Europe was backwards compared to the Byzantine Empire and the Arab world, but during the centuries that the ban on charging interest was in force, Western Europe managed to become a dominant power. By the year 1100 when the Crusades started, Western Europe had enough resources to spend on a long war that lasted two centuries. The crusaders maintained long supply lines of thousands of kilometres, while the conquered land was not profitable.

    When economic life in Western Europe became more developed, the ban on charging interest became more difficult to enforce. In the 14th century partnerships emerged where creditors received a share of the profits from a business venture. As long as the share in the profits was not fixed, this was not considered to be usury.41 Over time contracts were devised to evade the restrictions on charging interest. Rents on property were allowed so the definitions of rent and property were extended. During the 15th and 16th century, the restrictions on charging interest became untenable and were gradually lifted.42


    Fiat and scrip currencies

    In the second half of the Middle Ages some lords started to issue fiat and scrip money. The fiat money had value because it could be used to pay taxes. Apart from making money legal tender, taxes can give value to money issued by governments. The scrip money was valid for a limited period of time. After that period the the money had to be returned to the ruler who exchanged it for new money that also was valid for a limited period of time. During the exchange a tax was levied. The actual value of the scrip currency decreased slowly during the period it was valid and was the lowest just before the tax was due.

    A noteworthy example of a fiat currency is the tally stick introduced by King Henry the First around 1100. Henry introduced sticks of polished wood, with notches cut along one edge to signify the denominations. The stick was then split full length so each piece still had a record of the notches. The King kept one half for proof against counterfeiting and spent the other half so it could circulate as money. Only tally sticks were accepted by Henry for payment of taxes so there was a demand for them. This gave people confidence to accept tally sticks as money. The tally sticks remained in use until the early nineteenth century.16

    An example of a scrip currency is the brakteaten. The brakteaten was used in Europe between 1150 and 1350. Brakteaten coins were silver plaques called back by the local authorities from time to time to be reissued with a new image. During reissuing a tax was levied that amounted to a holding fee. At first the currency was only reissued when a new ruler came to power. Later on the silver plaques were called back on a regular basis. Rulers started to misuse the currency and holding fees reached 6% per month. This burden became so heavy that the brakteaten currencies were abandoned.29



    Recent examples of interest-free money


    The miracle of Wörgl

    On 5 July 1932, in the middle of the Great Depression, the Austrian town of Wörgl introduced a complementary currency. Wörgl was in trouble and was 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.43

    Rather than spending the 40,000 Austrian schillings 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 type of complementary currency known as stamp scrip. The Wörgl money required a monthly stamp to be stuck on all the circulating notes for them to remain valid, amounting to 1% of the each note’s value. The money raised was used to run a soup kitchen that fed 220 families.43

    Nobody wanted to pay the monthly stamps so everyone receiving the notes would spend them as fast as possible. 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. Of all the businesses in town, only the railway station and the post office refused to accept the complementary currency. Over the 13-month period the project ran, the council not only carried out all the intended works projects, but also built new houses, a reservoir, a ski jump and a bridge.43

    The key to its success was the fast circulation of the scrip money within the local economy, 14 times higher than the Schilling. This in turn increased trade, creating extra employment. At the time of the project, unemployment in Wörgl dropped while it rose in the rest of Austria. Six neighbouring villages copied the system successfully. The French Prime Minister, Édouard Daladier, made a special visit to see the 'miracle of Wörgl'.43

    In January 1933 the project was replicated in the neighbouring city of Kitzbühel. In June 1933 Unterguggenberger addressed a meeting with representatives from 170 different towns and villages. Two hundred Austrian townships were interested in adopting the idea. At this point the central bank panicked and decided to assert its monopoly rights by banning complementary currencies.43


    The Schwanenkirchen Wara

    In the town of Schwanenkirchen in Bavaria the owner of a small bankrupt coal mine started to pay his workers in coal instead of Reichsmark. He issued a local script which he called the Wara that was redeemable in coal. The bill was only valid if a stamp for the current month was applied to the back of the note. This demurrage charge prevented hoarding and workers paid for their food and local services with the Wara.

    Coal was a necessity and German Marks were in short supply so the currency became widely accepted. The use of this currency was so successful that by 1931 the so-called Freiwirtschaft (free economy) movement had spread through all of Germany. It involved more than 2,000 corporations and a variety of commodities backed the Wara. In November 1931 the German Central bank prohibited the use of the Wara.44


    The United States

    In the United States the leading economist Irving Fisher analysed the miracle of Wörgl. He published various articles about this success. More than 400 cities and thousands of communities all over the US started to issue emergency currencies and many of them were stamp scrip. There was a movement to issue a stamp scrip currency nationwide. Senator Bankhead from Alabama presented a bill to the Senate on 18 February 1933 and Representative Petenhill from Indiana presented a bill to the House of Representatives on 22 February 1933.

    The stamp scrip in the United States often had a high fee rate, sometimes 1 to 2% per week instead of 1% per month like in Wörgl. This undermined the confidence in the stamp scrip currencies. Irving Fisher approached the Undersecretary of the Treasury, Dean Acheson, to obtain support from the Executive branch for issuing stamp scrip. Acheson asked the opinion of one of his Harvard professors, who advised him that the system could work, but that it would imply strongly decentralised decision making. President Roosevelt later prohibited any use of stamp scrip.44


    Lignières-en-Berry

    In 1956 a few people in Lignières-en-Berry started a revolutionary experiment. They issued vouchers of 100 French francs for 95 French francs. After four months the vouchers could be returned for 98 French francs. A notary saw to it that for each voucher 98 French francs were deposited into a bank account. If the vouchers were not returned, a stamp of 1 franc had to be bought to keep the voucher valid.

    The money was attractive because there was three francs of profit to be made by buying vouchers for 95 French francs and returning them for 98 French francs four months later. By spending the vouchers for 100 Francs it was even possible to make a profit of five francs. People tried to spend the vouchers in the shops and the shopkeepers liked the currency because it brought them additional customers. It never cost them more than 2% because the vouchers could be returned for 98 French francs. The shopkeepers also preferred to use the vouchers for their own payments.

    Many people did not return the vouchers but bought the stamps to keep them valid. From the income of the stamps the cost of buying returned vouchers for 98 French francs could be covered. It did not take long before the currency of Lignières-en-Berry had replaced the French francs in the area. The vouchers spread quickly and the French authorities were alarmed. The vouchers were prohibited because they were considered to be a "dangerous monetary virus".45




    Can it work?




    Superior efficiency can enforce the change


    A stable economy operating near the trend growth rate is more likely to achieve the maximum economic potential and full employment. Under those circumstances real interest rates should be near their sustainable maximum. Natural Money can help to realise a stable economy and reduce risk in the financial system and realise this sustainable maximum. It then follows that real interest rates with Natural Money could be higher. Because the maximum nominal interest rate is zero, these higher real rates must be reflected in a strong currency that is rising in value so that an interest rate of zero can be a positive real return.

    A simple calculation can be made to support this view. Economists assume there is a link between the amount of money and money substitutes (M) in circulation and prices in the equation Money Stock (M) * Velocity (V) = Price (P) * Quantity (Q). If ΔP, ΔM and ΔQ are sufficiently small, and velocity is constant, so that ΔV = 0, then it is possible to approximate this equation with %ΔP = %ΔM - %ΔQ, where %ΔP is the percentage change in price level, %ΔM is the percentage change in money stock, %ΔV is the percentage change in money velocity and %ΔQ is the percentage change in the quantity of production.

    The velocity of money (V) for Natural Money may be higher than for interest bearing currency but it is likely to remain constant as the economic picture is more likely to remain stable. Now it is possible to make a calculation of the real interest rate (r), which is the the nominal interest rate (i) minus the inflation rate (%ΔP) so that r = i - %ΔM + %ΔQ.

    Suppose that for interest-bearing money the long-term average economic growth is 2%. For Natural Money it might be 3% because the economy is more often performing at its maximum potential. Assume that the long-term average money supply increase for interest-bearing money is 6% per year. For Natural Money it is 0%. The long-term price inflation rate could then be 4% for interest-bearing money. With Natural Money there could be a price deflation rate of 3% as the economy grows 3% on a stable money supply. Then the following calculation can be made:

     situation  interest on money   Natural Money 
     nominal interest rate (i)+3% -2%
     change in amount of money (ΔM) +6% 0%
     economic growth (ΔQ)+2% +3%
     real interest rate (r = i - ΔM + ΔQ)-1% +1%

    Economic growth is likely to be higher with Natural Money so real interest rates are likely to be higher. Furthermore, because Natural Money has a number of stabilisers that tend to reduce risk in the financial system, the level of risk is likely to be lower in the Natural Financial System. It seems likely that the risk/reward ratios in the Natural Financial System are better than in the current financial system. This suggests that the design of Natural Money is more efficient so that there might be a capital flight from the interest economy to the interest-free economy as soon as Natural Money is implemented somewhere.

    The real interest rate improvement may be higher than the improvement in the economic growth rate as there might a reduction in financial sector profits. Economic and financial stability might imply a reduction in the risks of investing so that investments could be made with less financial sector intermediation. The financial instability and the perceived need for government and central bank interventions in the interest-based financial system may have produced opportunities for politically connected and informed people to enrich themselves at the expense of the general public.



    Uncovering the prerequisites


    The complementary currency of Wörgl was a stunning succes but other experiments with free money did not yield similar results. Was this a fluke or did it highlight a hidden potential? If there is a hidden potential then it may be possible to have stable economic growth with low unemployment or we may come closer to that if we find a way to apply the concept of interest-free demurrage currencies. The ideas of Silvio Gesell have fallen out of grace as they seem impractical as interest rates were too high. In recent years negative interest rates are receiving more attention because interest rates are near zero.

    A major obstacle could be the maximum interest rate of zero. How can the market for money and capital operate if there is ceiling on interest rates in the fixed income market? This depends on the amount of loans that require a higher interest rate. If this amount is relatively small and harmful, for example when most interest rates are already negative and only sub-prime credit fetches higher rates, it may even be beneficial. This may well be the case when the natural interest rate remains in negative territory and central banks start using negative interest rates on a larger scale.

    One critique of Natural Money states that negative interest rates could lead to runaway inflation caused by excess credit. This critique appears to be based on the observation that lower interest rates will produce more credit. It is certainly true that lower interest rates allow for more credit, but once an economic boom sets in, interest rates tend to rise. The driver behind this credit is expectations with regard to the future. The maximum interest rate can channel these expectations into equity investments instead of debt so that a credit boom will be averted.

    Another critique is that Natural Money could lead to runaway deflation. This critique appears to be based on the observation that a lower velocity of money coincides with lower interest rates so that lower interest rates would cause velocity to go down even further. This assumes that low interest rates cause the velocity of money to go down, while it is the economic condition that produces a low velocity of money and low interest rates. In fact, a low velocity be related to the zero bound or the liquidity trap, where people are unwilling to spend and prefer liquidity to investments because they cannot lose money on liquidity.

    It seems important that Natural Money currency is legal tender and the only payment for taxes the goverment accepts. The existence of competing currencies, such as Bitcoin does not seem to be a problem. These alternatives often do not have a holding fee so that the Natural Money currencies will be used for transactions while alternatives like gold and Bitcoin can still be a hedge against a failing financial system. Under normal economic conditions investing in Natural Money deposits is probably more profitable. If Natural Money helps to bring about stable economic growth, alternatives will be unattractive investments.



    Interest rate ceiling


    Setting a legal maximum interest rate can cause evasive behaviour. If market interest rates exceed the interest rate ceiling then investors seek alternative investments there is not enough money available for lending. In Western Europe interest was forbidden during the Middle Ages. When economic life became more developed, the ban on interest became more difficult to enforce. In the 14th century partnerships emerged where creditors received a share of the profits from a business venture. As long as this share was not fixed, this was not considered to be usury.46

    Later on, when usury bans were replaced by interest rate ceilings, creditors and debtors could agree that less money is handed over to the borrower than stated in the actual loan contract so that more interest was paid in practise.47 In the United States there have been maximum interest rates on bank deposits for decades under Regulation Q. The system came under stress because alternatives were offered when interest rates went up. As a consequence, maximum interest rates were phased out in the 1980s. This suggests that a maximum interest rate is feasible only if it doesn't affect the bulk of borrowing and lending.48 49

    In Japan near zero interest rates have existed for decades. Japan could be a harbinger of what is to come for the rest of the world. The excess capital and debt can only be sustained at low or negative real interest rates. The alternatives to zero or negative interest rates could be widespread defaults or high inflation rates caused by money printing and deficit spending. An important prerequisite to Natural Money is that future interest rates will remain low.

    Natural interest rates have been trending lower in recent decades and went into negative territory in recent years 50 so that this assumption seems not far-fetched. It is also supported by the arithmetic indicating that returns on capital cannot exceed the rate of economic growth in the long run if most of these returns are reinvested, which is to be expected as wealth is distributed unevenly. The financial stability produced by central banks reduced the risk premium and made it possible to have interest rates near zero.




    Economic Theory




    Common ideas about interest


    Some economists entertained negative interest rates to kickstart the economy in times of crisis 51 52 but the adverse consequences of interest on money and debts are not an issue in mainstream economics. There is little thought on the idea of interest as a promoter of risk taking and moral hazard within the financial sector. The consequences of interest on money and debts on the stability of the financial system are not given proper attention.

    Proponents of interest-free money do not consider arbitrage. Market participants might borrow interest-free money to lend it at interest if that is possible. An interest-free currency should provide a competitive return in order to be viable.

    Some people think that charging interest is morally wrong. This requires an explanation. It is not wrong to be rewarded for lending out money as there is risk involved and opportunity forgone. It might be a bad idea to charge fixed interest rates as the income streams that have to pay for the interest can vary. This can lead to systemic instability.

    A common misconception is that a restriction on charging interest on loans is a restriction on business profits. Capital needs a reward to be employed and restricting interest on loans does not change that. Others might worry that credit will not be available when charging interest on money is restricted, or they may fear the opposite, that abundant credit will destroy the currency.



    The rationale of having interest on loans


    Reasons for interest to exist

    There are a number of factors that affect interest rates:
  • returns on capital;
  • risks associated with lending out money (default and inflation);
  • liquidity preference;
  • time preference versus marginal utility
  • capitalist spirit;
  • money itself not depreciating in nominal terms putting a floor on interest rates.


  • Returns on capital

    Economists see interest as a payment for deferred consumption. By deferring consumption resources can be used for production to facilitate future consumption. Savings make more future consumption possible because investments are paid out of savings. Investments that add economic value return more than the initial investment. The difference is interest. When interest rates go lower investments with lower economic value become feasible. These investments may turn out to be malinvestments when interest rates rise as they turn out to be loss making if you interest costs into account.

    In a competitive free market interest rates on bank accounts and bonds are related to returns on capital. They tend to go up if returns on capital increase and tend to go down if returns on capital decrease. If they did not, and the expected risk/reward ratio of capital was better or worse, interest rates on bank accounts and bonds would adjust until they do reflect the productivity of capital. For example, if interest rates on money go down and returns on capital go up, then more people would be willing to invest in capital directly, at least if all other things remain equal.


    Risks associated with lending out money

    Interest rates reflect the expected rate of price inflation and the default risk associated with the borrower. It is often assumed that there is a risk free interest rate, for example on government bonds, but even government bonds have risk attached to them, which is the risk of unexpected price inflation. Governments may not default outright but they can create money to pay off their debt, thereby lowering the value of the currency.


    Liquidity preference

    When you lend out your money, you cannot use it yourself. People desire a reward for this inconvenience. Banks provide convenience by lending out money long term and making it available in a shorter timeframe. Banks can make money readily available even when it is backed by loans that cannot be called in. If you make a bank payment, the bank will borrow the money from the person you are sending the money to instead. Because of the convenience banks provide, they help to lower interest rates.


    Time preference versus marginal utility

    Time preference means that people on average prefer to have a good or service sooner rather than later. In this way time preference contributes to positive interest rates. On the other hand, the law of marginal utility also counteracts time preference. If you have enough of everything you need, you prefer to have enough of everything you need in the future to having enough of everything now. If a large number of people have enough of everything, or when there are a few extremely rich people, then the law of marginal utility may overcome the time preference, and interest rates could be negative.

    For example, when there is a choice between 10,000 loaves of bread now or one loaf of bread each day for the next 10,000 days, most people prefer one loaf of bread every day for the next 10,000 days. Most people will even prefer one loaf of bread each day for the next 1,000 days above 10,000 loaves of bread now, which implies a steep negative real interest rate. This is because bread spoils in a short time so no one can use 10,000 loaves of bread. It also applies on durable goods. Most people would prefer to have a new car now and a new car in ten years’ time instead of having two new cars now.


    Capitalist spirit

    Capitalists are special people. They do not suffer from time preference. Instead they believe that money spent on frivolous items is money wasted. If you invest your money, you will end up with more money that you can invest again.13 14 In a sense there is a battle between the spirit of capitalism and time preference. If the spirit of capitalism wins out, interest rates go down. If time preference wins out, interest rates go up. In a capitalist economy people with a lower time preference than the prevailing interest rate tend to save and invest, while people with a higher time preference tend to consume and borrow.


    Effect of a holding fee

    It makes no sense to lend out gold at zero interest because gold does not decay. Below a certain threshold there is no incentive to lend out money under the gold standard because of the risks associated with lending. John Maynard Keynes thought that when interest rates are low, a liquidity trap occurs, which puts a floor under which interest rates cannot fall.53 Similarly, it makes no sense to lend out dollars or euros at negative interest rates if you can put euro bank notes in a safe deposit box. The existence of cash makes it impossible for interest rates to meaningfully drop below zero.

    If money depreciates over time like capital and other goods, for example by applying a holding fee, the picture alters. People may prefer to have money at the time they need it in the same way they desire a loaf of bread when they need it. Under those conditions they may be willing to lend at zero or even negative interest rates. Whether or not that might happen depends on other conditions such as the return on capital and the level of risk associated with lending out money, as well as the value development of the currency over time. Only strong currencies allow for negative interest rates.



    The rationale for lower interest rates


    There a number of reasons why interest rates went down and stay low for the foreseeable future:
  • Excess capital and debt: if there is more capital and debt relative to national income, the interest rate goes down because the marginal utility of investments is lower.
  • Wealth inequality: if more capital is in the hands of a few people, a smaller amount of capital income is consumed and more is invested, so that there is capital abundance and a constraint on consumption, so that profits and interest rates go down.
  • Capital replacing labour: if capital replaces labour, for example with robots, labourers lose their income, which reduces demand and thus returns on investments, so that interest rates go down.
  • Efficient financial markets: efficient financial markets make lower interest rates possible by reducing transaction costs and increasing the number of available options for investing, lending, borrowing, and hedging.
  • Excess savings: there may be a global savings glut, often identified as excess savings in Asian economies.
  • Lower growth rates: mature economies tend to have lower growth rates because there is a lot of capital and a low population growth. More and more economies are entering the mature phase so that interest rates go down.

  • Neoliberal policies have reduced regulations on financial markets. This made financial markets more efficient so that lower interest rates became possible. Neoliberalism reduced government activism with regard to redistributing income so that wealth inequality could increase. Central banks stepped in by providing liquidity whenever the financial system came under stress. Lower interest rates are the reaction of the markets to these developments because the increase in wealth inequality created economic imbalances. These imbalances can be corrected, at least partially, via lower interest rates.



    Economic cycles


    Introduction

    Interest can contribute to economic cycles but it certainly is not the only cause of economic cycles. In general mismatches between supply and demand cause economic cycles. Those mismatches can concern the supply and demand of money, capital, labour, raw materials or consumer products. Interest reflects the market for money and capital. If all markets were perfect, and supply could adapt to demand instantly, there would be no economic cycles.

    Economic cycles occur because mismatches between supply and demand emerge from time to time and are resolved after some time. Fluctuations in demand and supply cause fluctuations in prices, stocks and employment. There are a number of theories and explanations regarding those mismatches, economic cycles and their effects. Money, credit and interest deserve attention as they affect economic cyles.


    Expectations about the future and money hoarding

    Expectations are important. If people feel secure and have a good feeling about their future, they could be more willing to spend. A positive or negative feeling about the economy can become a self-fulfilling prophecy. For example, if people expect a bank to collapse then this could happen because this feeling might cause a bank run. Therefore policy makers tend to give a rosy picture of the economy or the state of the banking system.

    According to Say's law supply creates its own demand because goods and services are produced to acquire an equal value of other goods and services. This applies to a barter economy. If money is used as a medium of exchange, people can hold on to money and postpone their purchases. In this way producers can be left with overproduction, and a reduction in economic activity could be the result.

    Money hoarding can be caused by bleak expectations about the future. Money hoarding can reinforce itself as a decline in economic activity can make people more cautious. They may start to save more and economic activity may decline even more. As a consequence, more people may expect that times get worse and start to save more. This cycle can reinforce itself and become destructive. This happened during the Great Depression in the 1930s.


    Credit and leverage

    During good times businesses and individuals tend to be confident. Credit is often available because future income projections of businesses and individuals are the basis for banks to lend money. Therefore businesses and individuals tend to increase their leverage during good times. When the economy slows down and their incomes reduce, they can get into trouble. People would have more disposable income when they were out of debt and did not have to pay interest. Similarly, businesses can go bankrupt even when they are profitable overall because of interest charges.

    For example, a corporation thinks of starting a project and expects to make 8% per year and it borrows in the market at 6%. If the project then turns out to generate 4%, it will make a loss because of the interest payments, even when the project is profitable overall. In this way viable corporations can get into trouble because of interest payments.

    Leverage contributes to the overall risk in financial markets. Liquid financial markets make it easier to enter and exit positions, making it appear that it is safe to operate with a leverage. If markets were not liquid then leverage appears more dangerous as it is more difficult to exit a position. Liquidity makes it possible to take on more risk so the overall level of risk in the financial system might increase as a consequence of liquidity. This can become apparent during a crisis.


    Usury and debt slavery

    Ancient societies observed the adverse consequences of interest. Interest contributed to the concentration of money in the hands of a few people, while on the other hand many people were in debt or had become serfs of the money lenders. This phenomenon is called debt slavery. For that reason debts were forgiven from time to time.33 The Bible has provisions to forgive debts such as the Sabbath Year and the Jubilee Year.

    An interest rate on debts above the rate of economic growth can contribute to this problem and can henceforth be called usurious. For example, if the economy grows at a rate of 2% then an interest rate of two percent on debts does not contribute to the concentration of money into the hands of a few, but higher interest rates do. In the long run this can harm the economy.



    Fiscal and monetary policies


    Debts are made with the promise to be repaid with interest but the money to pay the interest from doesn't exist. It has to be loaned into existence. Normally this isn't a problem when the economy growing but if there is a lack of borrowing the system may collapse. For that reason central banks and governments may need to step in. Governments can borrow and spend and central banks can alter the interest rate and print currency. It appears that mature economies are now saturated with capital and debt so that these options may not work in the future.

    These actions are called fiscal and monetary policies. When new debts are not made fast enough to pay for the interest, governments can step in by going deeper into debt. They can stimulate the economy by spending more or lowering taxes. Alternatively, central banks can lower interest rates so that it becomes more attractive to borrow money. Both fiscal and monetary policies tend to increase the total amount of debt. These policies appear to be needed because of positive nominal interest rates on debts generating the need for more debt.

    If new debts are made at a faster pace than old debts are repaid with interest, the amount of money in circulation increases, which is monetary inflation. Under those conditions the economy tends to perform well and there could be price inflation. If new debts are made at a slower pace than old debts are repaid with interest, then the amount of money in circulation decreases, which is monetary deflation. Under those conditions the economy tends to perform poorly and there could be price deflation. This is why many economists think that there should be some monetary inflation but not too much.

    Economists assume that there is a natural interest rate at which the economy grows at its trend rate while inflation is stable. The natural interest rate may differ from the actual interest rate under the influence of credit in the financial system. Deviations from this rate can trigger booms and busts. If the interest rate is below the natural rate, for example through expansion of credit during times of optimism, investors receive a false signal to invest projects with a lower yield. During an economic bust, capital may be destroyed that may be rebuilt during the next economic boom. By setting short term interest rates, and in this way influencing long term interest rates, central banks try to influence credit creation.

    The natural interest rate cannot be measured so that policy makers rely on estimates using economic models. Fiscal and monetary policies can become subject to political objectives.54 55 For that reason it was argued that central banks need to be independent. As a consequence central banks became technocratic institutions without democratic oversight so there are benefits to limiting their influence.

    Furthermore, interest rates rise in times of optimism because of rosy projections of future revenues. As a consequence interest rates may be too high during the boom. When the boom is over, it turns out that there had been a lot of borrowing at high interest rates that turned out to be unjustified, leading up to defaults. Yet, lower interest rates may have prolonged the boom, and the end result may have been worse.19

    Keynes argued that there must be multiple natural rates of interest that and that there is no rate of interest that would maintain capitalist stability. Minsky expanded on this idea in his Financial Instability Hypothesis by arguing that capitalist economies exhibit debt inflations and deflations which have the potential to spin out of control because the economic system has a tendency to amplify these movements.56 With Natural Money this might not happen because there is a maximum interest rate so that credit would be reigned in as soon as the economy starts to boom.



    Monetary reform


    Creating money out of thin air

    Banks create money out of thin air and profit from it. We all pay for bank profits and bankers' bonuses via inflation, interest, financial crises and bailouts. Since the end of the gold standard in 1971, credit in the financial system has expanded at an unprecedented pace. According to the documentary 97% Owned, the money supply in Great Britain rose from £ 0.5 billion in 1870 at an annual rate of 2.7% to £ 3.2 billion in 1939 and then at an annual rate of 6.9% to £ 25 billion in 1970 and then at an annual rate of 12.5% to £ 857 billion in 2000 and then at an annual rate of 9.8% to £ 2,185 billion in 2010.

    Most of this newly created credit had speculative purposes, like buying existing houses, rather than productive ones, like starting new businesses. Most notably, the United States and the United Kingdom have financialised their economies, which gave them more economic clout than their industrial bases justify. And that adds a political dimension to monetary reform. A fairer financial system could end the dominance of the United States. And things might not improve when more oppressive regimes like China and Russia take over. And so, monetary reform might require an open, democratic and unified world.

    There are good reasons to reform the financial system, but existing reform proposals come with issues. Cheap business loans may not always be possible as there is less risk attached to mortgages than business loans. Governments could set goals for banks, for instance, a percentage of small-business loans. And financial institutions might participate in businesses as intermediaries for depositors who become investors, a scheme similar to Islamic banking. Many monetary reform proposals are problematic because they involve increasing reserve requirements or full-reserve banking. That is because of the view on savings many monetary reformers share.

    Many monetary reformers think that if banks create money out of thin air, the money in bank accounts isn't savings. But savings are capital, not money. The reformers think in terms of money, but money itself is not capital. It represents capital. When I build a house using materials I barter, I never use any money. But in the end, I own a home. That is capital I have saved. So, if I sell that home to someone who takes out a mortgage to buy it, the money in my account is savings. It gets a bit more questionable if abstract forms of capital like goodwill are involved, but savings back the money in our financial system.

    Full reserve banking

    In the aftermath of the financial crisis of 2008 there is a renewed interest in monetary reform. One of the most well-known monetary reform proposals is full reserve banking, for instance the Chicago Plan. With full reserve banking banks are not permitted to lend out funds deposited in demand accounts or current accounts. Hence, money in these accounts isn't debt but backed by central bank currency or cash. In this way banks can't go bankrupt when depositors demand cash.

    With full reserve banking loans must be made out of longer-term savings, which is money that can't be withdrawn on demand but is entrusted to the bank for a longer period of time. This plan is likely to reduce bank lending and the amount of outstanding bank debt. It would make the banking system less vulnerable to failure and probably there would be less need for bank bail-outs by governments and central banks.

    For these reasons full reserve banking may solve a few issues that have been ailing the banking system since the introduction of fractional reserve banking, most notably excess credit created by banks. It is therefore not surprising that full reserve banking gets attention whenever banks run into trouble. Full reserve banking would reduce the business for banks so it is not suprising that banks and their lobbyists don't support it.

    Many proponents of full reserve banking do not want money creation to be under private control as this might constitute a subsidy to the banking sector. Money created by banks can create inflation as banks can create money for profit and the inflation is paid for by the public. Fractional reserve banking may also contribute to economic cycles and financial crises. And when a bust sets in and debts can't be repaid banks may need to be bailed out with public funds.

    There are downsides to full reserve banking. Often it is argued that banking services will become more expensive as banks can't lend money that is in demand accounts and current accounts so that they have to make up for that with fees. That is a rather insignificant problem and there are more troubling issues. These are:

  • There could be less credit and interest rates could be higher.
  • Alternative schemes like shadow banks might be set up that look like fractional reserve banking.
  • The problem of matching the terms of loans and deposits remains.

  • The choice between full reserve banking and Natural Money may come down to identifying the underlying cause of financial instability, inflation and public losses. Is it the creation of money by privately owned banks or is it interest on money and debts? If it is the creation of money by privately owned banks then full reserve banking might be the solution but if it is interest on money and debts then Natural Money might be the solution.

    Less credit and higher interest rates

    With full reserve banking there could be less credit and interest rates could be higher. Full reserve banking would make lending money to a bank less attractive because money would be locked up for a considerable period of time. To make people save, interest rates on savings accounts may need to be significantly higher. Consequently, there could be fewer funds available for lending. Hence, with full reserve banking interest rates would probably be higher.

    Proponents of full reserve banking might see this as an upside. Higher interest rates allow for less debt to exist as debtors can service less debt. The only problem they may worry about is that it might take an economic depression to get there. If interest rates were to rise to a modest level like 4%, a massive wave of bankruptcies might follow. They may argue that the underlying problem is excess debt fuelled by low interest rates so that debt liquidation is necessary.

    If government and central bank backing for the financial system were to disappear, this would add a risk premium to savings and other forms of credit. This can also contribute to higher interest rates. Savers may feel they need a compensation for the risk of bank failure and systemic failure. The low interest rates we currently see also express a belief in the market that central banks will do whatever it takes to keep the financial system afloat.

    Higher interest rates not only allow for less debt to exist, but also for less capital so that the amount of wealth could go down. In other words, we could all be poorer with full reserve banking. That is because credit is the cornerstone of the capitalist economy. With full reserve banking money remains idle and is not used for economic purposes. In other words, it is not used for investment or consumption, and this may harm the economy.

    Higher interest rates can also affect the competitiveness of businesses. If one country is to introduce full reserve banking, there could be less credit and the cost of borrowing could go up. Businesses would have more difficulty competing with foreign corporations as their access to credit is constrained and interest costs are higher. Businesses in countries that allow for fractional reserve banking would therefore have a competitive advantage.

    Alternative schemes like shadow banks

    Imagine there is full reserve banking and that Eve and Adam only do business with each other. Both have € 100 in their current account that they use for their daily business transactions. This money can be used for payment because it is in the current account. For that reason they don't receive interest. Assume now that the bank offers savings accounts with an interest rate of 4% but money in savings accounts can't be used for payment.

    Then a snake comes along. It advises Eve and Adam to administrate their payments between themselves and to put their money in a savings account. In this way they both can receive interest on their € 100. They give each other credit so that Eve can borrow € 100 from Adam and Adam can borrow € 100 from Eve. In this way they don't need money so they can put their money in a savings account and receive interest.

    At first Eve and Adam had no savings, only money in their current account. The scheme of the snake allows them fabricate savings out of credit. This looks like creating money, only this is not money but credit. Credit can be used for payment like money. Similar schemes can be devised on a larger scale, for instance shadow banks. Shadow banks don't create money, only credit. The difference between fractional reserve money and this type of credit may not be so great.

    When banks create money they do the same. Banks can act as an intermediary between Eve and Adam so that they can lend each other money even when they do not business with each other or do not trust each other. This is also credit but it is called money because the law states that bank credit is legal tender and therefore money. The government backs this scheme. For that reason banks are subject to regulations as a stable financial system is a key public interest.

    The financial crisis of 2008 started in a shadow bank that creates credit and not in a regular bank that creates money. Shadow banks don't have to comply to the regulations that apply to regular banks. Regular banks only ran into trouble because they had given credit to shadow banks. Money creation therefore wasn't the problem in 2008. Replacing regular banks with shadow banks could even destabilise the financial system and leading to more financial crises.

    If a financial crisis is to occur, full reserve banking can ensure that money in current accounts is safe, but that doesn't apply to savings. If the debtors of a bank fail to meet their obligations, the bank may get into trouble and savings entrusted to the bank may be in jeopardy. To ensure financial stability, governments and central banks may end up supporting savings banks and even shadow banks so that the benefits of full reserve banking may end up being void.

    Matching the terms of loans and deposits

    Full reserve banking means that banks have enough cash at all times, even when all account holders come to the bank on the same day to empty their accounts. That hardly happens and it is becoming less likely as cash is used less and less for payment and saving. The security against bank runs that full reserve banking is to provide may therefore be rather limited and the regulations currently placed on banks like capital requirements may provide a better protection.

    With full reserve banking savings are still not safe. The terms of deposits and loans hardly ever match. A thirty year mortgage might be backed by a five year deposit so a bank might run into trouble when the deposit is not renewed and no other deposit is made. So banks may end up holding a reserve on savings to meet such situations like they are now holding a reserve on current accounts and demand deposits to meet possible withdrawals.

    This means that the problem persists in the savings area and still has to be dealt with by holding reserves. Even more so, the distinction between money and savings is arbitrary. A one year deposit can probably be considered savings with full reserve banking but a one day deposit probably cannot. But where do you draw the line? The distinction between money and savings is therefore arbitrary. If one day deposits are savings too this is very close to fractional reserve banking.

    The cause of financial instability, inflation and public losses

    Full reserve banking may not solve much because only money in current accounts and demand deposits would be safe. A financial crisis can still happen and may even be more likely because alternative forms of finance like shadow banks may fill up the void. The public may still end up paying for losses in the financial sector because the alternative could be an economic depression. And full reserve banking may reduce credit and push up interest rates so that the economy may suffer.

    Financial instability, inflation and public losses are not caused by private banks creating money alone, but by all forms of lending together. Lending is more abundant duing economic booms so booms are fuelled by lending and busts can be more severe. There may be too much risky lending because during a boom the prospects of borrowers tend to appear rosier than they turn out to be once the bust sets in.

    If more lending is to take place outside the regulated banking system these problems could become worse so a different approach may be advised. It can be argued that financial instability, inflation and public losses are caused by interest on money and loans. Even though this line of thinking can be debated too, it might lead to better solutions, which may be more important than winning philosophical debates. The argument is as follows:

  • Interest contributes to financial instability because incomes fluctuate while interest payments are fixed.
  • Interest contributes to risky lending because interest is a reward for risk.
  • Financial stability is a key public interest so governments and central banks back the financial system, hence interest can cause public losses.
  • Debts need to be repaid with interest. If savers don't spend their money, which is often the case, more debt is needed to pay for the interest.
  • If debt is money created by a bank, interest can contribute to inflation because money creation contributes to inflation.

  • Financial instability, inflation and public losses might disappear once interest rates are negative and positive interest rates are forbidden, which suggests that interest on money and loans is the cause of these problems.



    Economic schools


    Classical economics

    According to classical economists, the economy tends to be in equilibrium at full employment because the desires of consumers exceed the capacity of the businesses to satisfy them. People produce in order to consume what they have produced or have acquired by exchanging what they have produced for what others have produced. Classical economics suggests that everything will work out fine when markets are competitive and flexible so that prices can adapt fairly quickly. A problem with this reasoning is that all prices are not always flexible and that interest rates can't go below zero.

    Keynesian economics

    Keynes saw that interest rates can't fall below a certain minimum. He called this a liquidity trap in which there are excess savings that are not invested. This can cause an economic downturn. In this situation investors prefer risk-free cash to investments in the hope of better returns on investments in the future.53 Keynes probably realised that the equilibrium interest rate during a crisis was negative, but he may thought that it wouldn't be feasible to have negative interest rates. Keynesian economics therefore prescribes pushing up interest rates via aggregate demand and price inflation in the case of a liquidity trap.

    Monetarism

    The basic tenet of Monetarism is that a change in the money stock will, in the long run and all other things being equal, lead to a proportional increase in price level. Keynesians see a tradeoff between employment and inflation but Monetarists think that this effect only exists in the short run.57 The Monetarists proposed a stable rule for monetary policy so that monetary policy would be predictable. Monetarists think that some monetary inflation is needed to accommodate growth.58 Natural Money may not require monetary policies.

    Rational expectations

    Rational expectations are based on the efficient market hypothesis, which states that markets reflect all available information.59 A possible effect of rational expectations is that it can make government policies ineffective. According to the rational expectations theory, Keynesian theories do not account fully for the changes in people's expectations about the consequences of fiscal and monetary policies because people learn from experience.60 Natural Money doesn't require fiscal and monetary policies so that this issue doesn't apply.

    Community currencies and National Socialism

    The community currencies movement seeks to reassert local control over economic life and money using local interest free currencies. National Socialism tries to do the same on the national level and also sees interest and international finance as the main culprits of economic suffering. If the returns on investments do not meet the prevailing interest rate, the economy suffers. This can lead to unemployment, low wages and wealth inequality. In an effort to address these concerns, the Community Currencies Movement proposes to introduce currencies that circulate at the local or regional level.

    Steady state economics and de-growth

    Steady state economics and de-growth assume that economic growth cannot go on as it did given its consequences such as climate disruption, widespread habitat loss and species extinction, consumption of natural resources, pollution, urban congestion and an intensifying competition for remaining resources, so that lower economic growth might be needed.61 62 The current economic system has a growth imperative because it doesn't allow for negative interest rates so that troubles arise when growth is low. Natural Money allows for negative interest rates so it can deal with low growth or no growth.




    References



    1. Safa Motesharreia, Jorge Rivasb and Eugenia Kalnayc (2014). Human and nature dynamics (HANDY): Modeling inequality and use of resources in the collapse or sustainability of societies. Ecological Economics Volume 101, May 2014, pp 90–102: http://www.sciencedirect.com/science/article/pii/S0921800914000615
    2. Margrit Kennedy (1995). Interest and Inflation Free Money. Seva International: http://userpage.fu-berlin.de/~roehrigw/kennedy/english/Interest-and-inflation-free-money.pdf
    3. Bernard Lietaer (2001). The Future of Money: Creating New Wealth, Work and a Wiser World. Random House: http://www.lietaer.com/writings/books/the-future-of-money/
    4. Poor Because of Money: Our theory on interest, Henk van Arkel and Camilo Ramada, Strohalm, 2001: https://www.naturalmoney.org/ poorbecauseofmoney.html
    5. A Strategy for a Convertible Currency: Impact on the Ecology, Bernard A. Lietaer, ICIS Forum, Vol. 20, No.3, 1990: http://www.itk.ntnu.no/ansatte/...; backup copy: https://www.naturalmoney.org/ convertiblecurrency.html
    6. Poor Because of Money: The consequences of interest, Henk van Arkel and Camilo Ramada, Strohalm, 2001: https://www.naturalmoney.org/ poorbecauseofmoney.html
    7. Muhammad Taqi Usmani (1998). An Introduction to Islamic Finance.
    8. Simon Smith Kuznets, Stephanie Lo, Eric Glen Weyl (2009). The Doctrine of Usury in the Middle Ages, By Simon Smith Kuznets, transcribed by Stephanie Lo, An appendix to Simon Kuznets: Cautious Empiricist of the Eastern European Jewish Diaspora: http://home.uchicago.edu/weyl/Usury_appendi.doc
    9. K. Samuelsson (1955). International Payments and Credit Movements by the Swedish Merchant Houses, 1730-1815. Scandinavian Economic History Review.
    10. R. Alton Gilbert (1986). Requiem for Regulation Q: What It Did and Why It Passed Away. Federal Reserve Bank of St. Louis: https://research.stlouisfed.org/.../Requiem_Feb1986.pdf
    11. Thomas A. Lubik and Christian Matthes (2015). Calculating the Natural Rate of Interest: A Comparison of Two Alternative Approaches. Federal Reserve Bank of Richmond Economic Brief October 2015: https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_brief/2015/pdf/eb_15-10.pdf
    12. Thomas Piketty (2013). Capital in the Twenty-First Century. Belknap Press.
    13. F.P. Ramsey (1928). A Mathematical Theory of Saving. Economic Journal 38 (1929), pp. 543-559.
    14. Heng-Fu Zou (1994). 'The spirit of capitalism' and long-run growth. European Journal of Political Economy 10 (1994), pp. 279-293.
    15. Financial services - Wikipedia (as on 28 October 2013): https://www.naturalmoney.org/financialservices.html; current version: http://en.wikipedia.org/wiki/Financial services
    16. The Natural Economic Order, Silvio Gesell, Translated by Philip Pye, Peter Owen Ltd, 1958: http://www.silvio-gesell.de/neo_index1.htm
    17. Austrian Business Cycle Theory - Mises Wiki (as on 4 March 2015): https://www.naturalmoney.org/abct.html; current version: http://wiki.mises.org/...
    18. Austrian School - Wikipedia (as on 14 September 2013): https://www.naturalmoney.org/austrianschool.html; current version: http://en.wikipedia.org/wiki/Austrian_School
    19. Ludwig von Mises (1949). Human Action: A Treatise on Economics. Yale University Press: https://mises.org/system/tdf/Human%20Action_3.pdf?file=1&type=document
    20. Robert Eisler (1932). Stable Money: The Remedy for the Economic World Crisis: A Programme of Financial Reconstruction for the International Conference 1933. The Search Publishing Co.
    21. Willem H. Buiter (2009). Negative Nominal Interest Rates: Three ways to overcome the zero lower bound. NBER Working Paper No. 15118: http://www.nber.org/papers/w15118.pdf
    22. Ruchir Agarwal and Miles Kimball (2015). Breaking Through the Zero Lower Bound. IMF Working Paper: https://www.imf.org/external/pubs/ft/wp/2015/wp15224.pdf
    23. A Strategy for a Convertible Currency: Impact on Employment, Bernard A. Lietaer, ICIS Forum, Vol. 20, No.3, 1990: http://www.itk.ntnu.no/...; backup copy: https://www.naturalmoney.org/ convertiblecurrency.html
    24. Joseph Tainter - Wikipedia (as on 28 March 2014): https://www.naturalmoney.org/josephtainter.html; current version: http://en.wikipedia.org/wiki/Joseph_Tainter
    25. A Strategy for a Convertible Currency: Decentralised Issuing of Stamp Scrip, Bernard A. Lietaer, ICIS Forum, Vol. 20, No.3, 1990: http://www.itk.ntnu.no/...; backup copy: https://www.naturalmoney.org/ convertiblecurrency.html
    26. Economics of Money and Banking Part Two, Redacted Lecture Notes, Perry G. Mehrling, 2013, chapter 20 paragraph 1, https://www.naturalmoney.org/moneyandbanking-01.html#2001
    27. Lars Norden, Consuelo Silva Buston and Wolf Wagner (2014). Financial innovation and bank behavior: Evidence from credit markets. Tilburg University: https://www.tilburguniversity.edu/upload/c40024bc-fd1f-4718-ad38-84fa8237df5c_lpc.pdf
    28. Walter Bagehot (1873). Lombard Street: A Description of the Money Market. Henry S. King & Co.
    29. A Strategy for a Convertible Currency: Some Historical Precedents, Bernard A. Lietaer, ICIS Forum, Vol. 20, No.3, 1990: http://www.itk.ntnu.no/ansatte/Andresen_Trond/ finans/others/interest-free-money.txt; backup copy: https://www.naturalmoney.org/ convertiblecurrency.html
    30. Ramesses II - Wikipedia (as on 3 September 2013): https://www.naturalmoney.org/ramesses2.html; current version: http://en.wikipedia.org/wiki/Ramesses_II
    31. This was mentioned on Discovery Channel or National Geographic but I was unable to recover the source
    32. Scripture references to usury, interest, The Bible, The Quran: https://www.naturalmoney.org/scriptureusury.html
    33. The lost tradition of Biblical debt cancellations, Michael Hudson, 1993: http://www.scribd.com/ doc/53645620/7/Debt-Crises-in-Classical-Antiquity; backup copy: https://www.naturalmoney.org/debtcancellations.html
    34. Poor Because of Money: Solon, the Greek economist, Henk van Arkel and Camilo Ramada, Strohalm, 2001: https://www.naturalmoney.org/ poorbecauseofmoney.html
    35. Solon - Wikipedia (as on 21 March 2014): https://www.naturalmoney.org/solon.html; current version: http://en.wikipedia.org/wiki/Solon
    36. Decline of the Roman Empire - Wikipedia (as on 21 March 2014): https://www.naturalmoney.org/declineofrome.html
    37. Rome and Romania, 27 BC - 1453 AD: III. Third Empire, Middle Romania - Early Byzantium, Friesian.com: http://www.friesian.com/romania.htm#middle; backup copy: https://www.naturalmoney.org/romania.html
    38. Money in the Middle Ages, Simon Newman, The Finer Times: http://www.thefinertimes.com/Middle-Ages/money-in-the-middle-ages.html; backup copy: https://www.naturalmoney.org/ moneymiddleages.html
    39. The Doctrine of Usury in the Middle Ages: II. The opinion on usury of the Church-fathers in the Roman Empire, Simon Smith Kuznets, Stephanie Lo, Eric Glen Weyl, University of Chicago: http://home.uchicago.edu/weyl/Usury_appendi.doc; backup copy: https://www.naturalmoney.org/doctrineusury.html#02
    40. The Doctrine of Usury in the Middle Ages: III. The doctrine of usury during the dark period, Simon Smith Kuznets, Stephanie Lo, Eric Glen Weyl, University of Chicago: http://home.uchicago.edu/weyl/Usury_appendi.doc; backup copy: https://www.naturalmoney.org/doctrineusury.html#03
    41. The Doctrine of Usury in the Middle Ages: IV. The scholastic doctrine of usury. T. Aquinas, Simon Smith Kuznets, Stephanie Lo, Eric Glen Weyl, University of Chicago: http://home.uchicago.edu/weyl/Usury_appendi.doc; backup copy: https://www.naturalmoney.org/doctrineusury.html#04
    42. The Doctrine of Usury in the Middle Ages: V. The fall of the Doctrine. Second half of the 15th, 16th centuries, Simon Smith Kuznets, University of Chicago: http://home.uchicago.edu/weyl/Usury_appendi.doc; backup copy: https://www.naturalmoney.org/doctrineusury.html#05
    43. Laboratory readings: Wörgl's Stamp Scrip – The Threat of a Good Example?, Martin Oliver, Newciv.org, 2002: http://www.newciv.org/nl/newslog.php/_v105/ __show_article/_a000105-000002.htm; backup copy: https://www.naturalmoney.org/example.html
    44. History of Money, 1930 – 1933, Mindcontagion.org: http://www.mindcontagion.org/money/hm1930.html; backup copy: https://www.naturalmoney.org/mc-historyofmoney-1930.html
    45. Scrip / France, Barataria.org: https://www.naturalmoney.org/stampscrip.html
    46. Simon Smith Kuznets, Stephanie Lo, Eric Glen Weyl (2009). The Doctrine of Usury in the Middle Ages, By Simon Smith Kuznets, transcribed by Stephanie Lo, An appendix to Simon Kuznets: Cautious Empiricist of the Eastern European Jewish Diaspora: http://home.uchicago.edu/weyl/Usury_appendi.doc
    47. K. Samuelsson (1955). International Payments and Credit Movements by the Swedish Merchant Houses, 1730-1815. Scandinavian Economic History Review.
    48. R. Alton Gilbert (1986). Requiem for Regulation Q: What It Did and Why It Passed Away. Federal Reserve Bank of St. Louis: https://research.stlouisfed.org/publications/review/86/02/Requiem_Feb1986.pdf
    49. Regulation Q - Wikipedia (as on 29 March 2014): https://www.naturalmoney.org/regulationq.html; current version: http://en.wikipedia.org/wiki/Regulation_Q
    50. Thomas A. Lubik and Christian Matthes (2015). Calculating the Natural Rate of Interest: A Comparison of Two Alternative Approaches. Federal Reserve Bank of Richmond Economic Brief October 2015: https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_brief/2015/pdf/eb_15-10.pdf
    51. Negative Nominal Interest Rates: Three ways to overcome the zero lower bound. Willem H. Buiter. NBER Working Paper No. 15118. Issued in June 2009: http://www.nber.org/papers/w15118.pdf; backup copy: https://www.naturalmoney.org/w15118.pdf
    52. Buiter, W. H. and Panigirtzoglou, N. (2003), Overcoming the zero bound on nominal interest rates with negative interest on currency: gesell's solution. The Economic Journal, 113: 723–746. doi: 10.1111/1468-0297.t01-1-00162: http://eprints.lse.ac.uk/848/1/liqnew.pdf; backup copy: https://www.naturalmoney.org/liqnew.pdf
    53. Liquidity trap - Wikipedia: http://en.wikipedia.org/wiki/Liquidity_trap
    54. The Political Business Cycle, William D. Nordhaus, The Review of Economic Studies Vol. 42, No. 2, pp. 169-190, 1975: http://www.ekonpol.wne.uw.edu.pl/uploads/Dydaktyka/Ekonomia%20polityczna%20bezrobociaNordhaus.pdf
    55. George T. McCandless Jr. Warren E. Weber (1995). Some Monetary Facts. Federal Reserve Bank of Minneapolis Quarterly Review Vol. 19, No. 3, Summer 1995, pp. 2–11: http://www.bbk.ac.uk/ems/faculty/aksoy/teaching/gradmoney/McCandless%20and%20Weber%20(1995).pdf/view
    56. Hyman P. Minsky (1992). The Financial Instability Hypothesis. The Jerome Levy Economics Institute of Bard College: http://www.levyinstitute.org/pubs/wp74.pdf
    57. Economics Second Edition, David R. Kamerschen, Richard B. McKenzie, Clark Nardinelli, 1989, p. 366-371
    58. Monetarism - Wikipedia: http://en.wikipedia.org/wiki/Monetarism
    59. Economics Second Edition, David R. Kamerschen, Richard B. McKenzie, Clark Nardinelli, 1989, p. 421
    60. Economics Second Edition, David R. Kamerschen, Richard B. McKenzie, Clark Nardinelli, 1989, p. 425
    61. Degrowth - Wikipedia: http://en.wikipedia.org/wiki/Degrowth
    62. Steady state economy - Wikipedia: http://en.wikipedia.org/wiki/Steady_state_economy