Cases against Interest in History
The famous nineteenth century French philosopher Victor Hugo said “there is nothing more powerful than an idea whose time has come.“
Over the millennia interest has been opposed by most great thinkers and civilizations. The reasons for which interest was opposed in the past still exist even though their extreme manifestations have been somewhat mitigated by the laws, practices, and traditions developed for the purpose by numerous societies over the centuries. These historical examples of opposition to interest lend credence to the fact that interest is fundamentally, morally, and socially wrong. By eliminating interest we won’t be possibly doing any harm to the moral, social, or spiritual fabric of our, or any other, society. It should give some comfort to those afraid of radical ideas that the wisdom of ages is also against interest.
This work, however, argues against the idea and the practice of interest as being fundamentally at odds with a prosperous future of the global economy. This work will make arguments of a highly contemporary, practical, and scientific nature. Some of the arguments are old but most are of a very contemporary nature, the kind of arguments that could not have been made even as recently as the twentieth century. This work will argue that the time has finally come for interest to go.
Elimination of interest is not really a new idea; it is an old idea whose time has come. This work will also argue as to why interest continued to exist even in the face of such opposition; and as to why it is time for interest to go, now. Let us start with a few examples of the opposition of interest in the past.
Dr. Alan S. Blinder writes the following in an economics text book:
Attempts to control interest rates (which are the price of borrowing money) go back hundreds of years before the birth of Christ, at least to the code of laws compiled under the Babylonian king Hammurabi in about 1800 B.C.
Aristotle (384-322 BC) is said to have the following view about interest:
Money exists not by nature but by law: The most hated sort (of wealth getting) and with the greatest reason, is usury, which makes a gain out of money itself and not from the natural object of it. For money was intended to be used in exchange but not to increase at interest. And this term interest (tokos), which means the birth of money from money, is applied to the breeding of money because the offspring resembles the parent. Wherefore of all modes of getting wealth, this is the most unnatural.
And he really disliked usurers. – Wikipedia
In ancient biblical Israel, it was against the Law of Moses to charge interest on private loans. As Jewish citizens were ostracized from most professions by local rulers, the church and the guilds, they were pushed into marginal occupations considered socially inferior, such as tax and rent collecting and money lending. Wikipedia
Usury has always been viewed negatively by the Roman Catholic Church. The Christians, on the basis of the Biblical rulings, condemned interest-taking absolutely, and from 1179 those who practiced it were excommunicated. The Bible addresses the charging of interest in the following manner: “Take no usury or interest from him; but fear your God, that your brother may live with you. You shall not lend him your money for usury, nor lend him your food at a profit. ” – Leviticus 25:36-37 – Wikipedia
Interest has often been looked down upon in Islamic civilization as well for the same reason for which usury was forbidden by the Catholic Church, with most scholars agreeing that the Qur’an explicitly forbids charging interest. Wikipedia
Interest became respectable only after the advent of industrial use of fossil fuel because profits from the machines using almost free fossil fuel were initially so high that payment of interest became easy. A typical steam engine with less than 4% efficiency (the percentage of energy that is actually used to do work) generated enough cash to pay interest and make huge profits. Fossil fuels were relatively free but they needed machines to be used or consumed. Demand for machines multiplied and so did demand for loans to buy and produce these machines. Interest-based borrowing became economically attractive only because profits from industrialization were high. Interest made sense then. Interest continued to be supported by the high productive powers of fossil fuel as long as the majority of the world remained undeveloped.
Declining profitability in Developed Countries
However massive industrialization of large developing countries like China and India is rapidly diminishing the profitability from further fossil fuel driven industrialization. Given the high productive powers of fossil fuel driven machines it is obvious that profitability from using these machines will go down after almost everybody starts to use and produce them.
Developing countries are rapidly driving growth based on fossil fuel. As mentioned in the previous chapter, since fossil fuel has supply, environmental and other constraints, growth in developing countries is displacing growth in developed countries. Demand growth in developing countries is also restrained by resource constraints, and as a result does not translate into demand for high value products from developed countries. Potentials in developed countries are therefore suffering not only from the limits of growth in the global economy but also from their declining share of the global economy. The potentials and profitability in developed countries have started to erode rapidly; and are falling below the applicable return thresholds.
This decline in profitability may be the reason behind declining investments of most companies in their own businesses, including those in China. Yves smith and Rob Parenteau in a New York Times article write the following:
Over the past decade and a half, corporations have been saving more and investing less in their own businesses. A 2005 report from JP Morgan Research noted with concern that, since 2002, American corporations on average ran a net financial surplus of 1.7 percent of the gross domestic product – a drastic change from the previous 40 years, when they had maintained an average deficit of 1.2 percent of G.D.P. More recent studies have indicated that companies in Europe, Japan and China are also running unprecedented surpluses.
When companies in general hesitate to invest in their own businesses it certainly points to declining potentials or declining profit margins, particularly when interest rates are low. Most new investments are made with the hope that future investments in the same or related fields will be easy and have better chances of success. In fact most business growth takes place through companies investing in their own businesses. When companies shy away from making investments in their own businesses it is a clear indication of changing business conditions and declining profit potentials.
Declining room for interest
Currently low interest rates don’t address the permanent nature of fall in returns which is driven by resource constraints that are going to increase in severity with time. Temporary reduction in interest rates is not the solution. The economic engine of the future includes wind and solar power which don’t produce the kind of financial returns that can accommodate interest. Interest is not only preventing investments in traditional industries but, more importantly, is also preventing investments in industries of the future e.g. environment related, because their returns are inherently low.
Interest won’t allow developed economies to move forward in any direction, fossil fuel driven or environment driven. Due to the rapidly diminishing profit potentials from fossil fuel based economic activities and also due to inherently low returns of environment friendly industries, interest is again becoming the “evil” it was before the advent of industrial use of fossil fuel.
Interest has to be eliminated mainly because economic activities can no more accommodate interest. In most current economies, particularly developed ones, capital is a big part of all economic activity and of life; unnecessary compensation of capital in the form of interest will severely burden those economies and not allow them to grow enough to prosper and to employ available labor. Additionally, abundance of capital does not allow economic justification of interest based on scarcity.
Interest does not hurt developing countries as much because they have extremely low wages to compensate for interest costs. Additionally, since they have room for further industrialization returns are still high enough to accommodate interest. The decline in potentials and profitability applies far severely to developed countries than it applies to developing ones.
Since the path to economic recovery for developed countries seems to lead through environment related industries, and most environment related industries cannot pay much interest; let us look at the mechanism of interest and explore the possibility of replacing it with a costless or “efficient” method of allocating capital.
If we can eliminate interest we will be able to use the free and abundant sources of energy to achieve unlimited growth for a very long time. The environment would start healing and the finiteness of fossil fuel will no longer restrict economic growth.
Interest is not a reward for saving or for postponing consumption. Interest is a payment for not hoarding money. Interest was supposedly necessary under the gold system because there was only a limited amount of money (gold); and for smooth functioning of the economy it was critical that money remained in circulation. Interest therefore had to be paid fundamentally in order to keep the money in circulation.
In the fiat money system, money can be created at will by the government; so hoarding of money is no longer the concern it was in the gold backed system. If people hoard dollars in their mattresses or their bank accounts, the Federal Reserve will not run out of dollars to provide liquidity to the financial system. Therefore the compelling power of money to demand interest does not exist any more; consequently, interest is now avoidable.
The environment and this economic crisis
Even though global warming is probably being factored in most major investment decisions, it is not necessary to agree with the proposition of global warming to see the role of environment and the limits of the planet in this global crisis. Local pollution chokes life long before the limits of the planet start showing its effects. The 2008 Beijing Olympics provided a good reminder of that fact. China and India have very high density of population; they need more jobs and therefore cannot ship industries overseas. It is also very difficult for them to control pollution because fossil fuel is currently their vehicle out of poverty. Local pollution is currently the first and effective environmental constraint in developing countries.
If the Chinese and Indians could drive more cars and operate more factories without suffocating themselves and if there was no natural resource constraints to the Chinese people consuming the same level of goods and services that people do in the US and Europe; developed countries would have plenty to sell to China and vice versa. There would be no economic crisis. This is the first time that the environment and the resource limits of the planet have caused an economic crisis.
Even though developing countries can for sometime continue with fossil fuel driven growth but their growth in this direction will face resistance from resource constraints and the environment at the local levels and at the planetary level. Due to these resistances their growth, which may take them out of poverty, will not provide the lucrative markets developed countries seek. The focus of growth has therefore to shift from fossil fuel to sustainable industries, which requires elimination of interest.
Interest and resource friendly economy
It is obvious that the world is now in an era when forces of nature like gravity, air, sunlight, waves, tides, and oceans must be harnessed to provide the teeming human population with the energy and resources needed to maintain a modern lifestyle. Another incontrovertible reason for using these sources of energy is that with the current rate of growth in electricity and energy usage the world will soon need energy supply for almost 6 billion people; that will require far more energy than known reserves of oil and gas can support for the expected remaining length of the lives of most people. Oil reserves, its discovery, production, and consumption are discussed in the chapter on energy.
These forces of nature are diffused, gradual, dilute, and slow to form and slow to produce as are other forces that drive or sustain the planet. These forces are no match for the concentrated power delivered by fossil fuel. Compared to fossil fuel returns from clean energy industries like solar and wind power are inherently low because it takes more capital to produce the same amount of energy.
Their rates of return are low also because a significant part of the benefits of clean industries accrue to the environment, to the planet, and to humankind. In other words, a significant part of the benefits of clean industries while beneficial to humankind, do not get translated into financial benefits. Conversely, the loss and harm caused to humankind by use of fossil fuel is not translated into financial costs. In short, the interest based system works against sustainable industries and sectors because of its double failures, i.e. (i) failure to translate environmental and other benefits of clean energy into financial benefits, and (ii) failure to translate environmental and other costs of dirty industries into financial costs. The impacts of both are additive which together make a big difference.
The interest based system is very inhospitable to resource friendly industries. We should therefore no more subject sustainable energy industries to the requirements of the interest based capital allocation process. Capital, as stated earlier, is one resource that is in abundance. To enable replacement of fossil fuel with these diffused forces of nature interest needs to be eliminated or made significantly less burdensome, for the environment related industries.
Interest causes rapid consumption of mineral resources
The possibility of earning interest speeds conversion of minerals resources into cash. Companies that extract minerals want to extract and sell them quickly. The sooner the minerals are converted into cash the earlier they can start earning interest; minerals in the mine don’t earn interest. The forward prices of oil have so far provided little compensation for interest lost. Faster exploitation of mineral resources translates into faster consumption through a series of intermediate steps that are also driven by interest.
At every step along the way, interest drives the flow of goods towards the fastest conversion into cash, which eventually happens to be through consumption. The system is thus forcing us to consume quickly whether we need to or not. No wonder selling and marketing is one of the biggest components in the cost structure of so many companies that operate at or near the final stages of the supply chain. As a consequence, we end up building societies that are designed to consume more and more. This is particularly harmful because these resources are finite and its excessive use is also polluting the planet.
Interest makes us consume resources that we would otherwise not consume. The interest based system is impoverishing the planet. We need an economic system that helps us preserve and protect the resources of the planet, not the one that destroys these resources through unnecessary and excessive consumption.
Exponential growth in debt through interest
Exponential growth in debt through interest makes excessively high level of debt a matter of certainty in an economy with sustained good performance. It is a mathematical certainty that sustained exponential growth in any component of a system will overwhelm the system sooner or later. The geometric growth in debt through interest is the main reason for the overwhelming growth of debt or leverage, particularly during boom times.
Almost all the eleven or so postwar recessions, except for the two caused by oil supply shocks, have followed a similar pattern: an excessive bout of investments, particularly in real estate, financed by debt produced an economic boom or an asset bubble. When these booms or bubbles collapsed a recession was the result. Almost a dozen economic recessions in a space of 60 years indicates the existence of a structural tendency towards growing imbalance and consequent imploding.
The Federal Reserve, the Federal Deposit Insurance Corporation, and other bank regulators are all in place to protect the economy and the society from the dangers of unsustainable levels of debt or leverage. No matter how much regulation is put in place there will always be lending excesses and financial system breakdowns, of one kind or another, as long as there is the pressure of exponential growth in debt.
The governments’ monetary efforts to stimulate the economy through increased lending also add significantly to the growth of debt. Even though the risks of monetary expansion are well known, governments continue to use this method mainly because of the fact that the interest based system offers little else for easing the pain of economic downturns. Monetary expansion is further discussed in the following sections.
Interest causes credit failures
Interest is a continuously accumulating cost for the borrower irrespective of income, activities or circumstances; therefore it significantly increases the chances of bankruptcy of the borrowing businesses and individuals. Interest by itself significantly increases risk for lenders, borrowers and the economy. Interest is a factor that makes credit and credit risk potentially toxic for borrower and lender respectively. Interest based debt increases risk in businesses and also increases the total risk in the economy.
Exponential growth in interest based debt overwhelms the system and in doing so it displaces equity and similar forms of financing. Equity absorbs credit and other risks. Increasing equity reduces the chances of bankruptcy. The interest based system, by reducing the share of equity, diminishes the system’s and its components’ ability to absorb and cushion the risk that accompanies debt.
Additionally, the structure, the practices, the pressures, and the incentives in the interest based system are such that debt often seems to trump equity after a certain minimum level of equity is achieved. Debt displaces equity at all levels of the borrowing chain: borrowers, retail lenders, wholesale lenders, financial institutions etc. Interest based system does not allow much equity to build up in businesses and financial institutions. Interest based system increases risk through debt and its exponential growth and at the same time diminishes the systems’ ability to absorb risk by reducing equity. It is a formula for regular systemic failures.
Frequent credit crises and fractional reserve banking
The crisis creating tendency of the interest based system does not end with the exponential growth in debt and the thinning of equity; fractional reserve banking is another major source of credit crises.
Banks create money. They do so by lending borrowed money (deposits). Lending money entails assuming credit risk. Banks with equity that is usually less than 10% of their asset (loans) size are in fact not assuming 90% of the remaining risk being created. This is the peculiar result of the fractional reserve banking system.
Historically the underlying functional reason for allowing lending without adequate equity cover was the need to make liquidity available to the economy; which was a challenge in the gold system. Banks are still structured to make money flow as if money is inherently scarce, as was the case in the gold system.
In fiat money system, where money can be created at will, banks should be structured to keep credit flowing: that is they should be able to obtain and retain credit (deposits, loans etc.) even under difficult economic conditions; and accordingly be able to lend. In the fiat money system there is no need to sacrifice credit quality, of banks and of other financial institutions, simply in order to get the money to circulate.
Creation of money by the banking system, in itself, was of great value in the gold system; but not so in the fiat money system. Money creation by the banking system will be of great value in the fiat money system only if the credit risk created in the process is also fully or adequately assumed by private sector participants in the financial system.
The money that banks loan out is not really their credit because they don’t assume the risk that accompanies the credit. The thin cover that lenders’ equity provides these loans only works as long as the economy is stable or is booming. As soon as the losses in the economy start approaching 10% the economy starts going into a nose dive. Given the built in tendency of the financial system to increase risk and leverage through exponential growth in debt and other means, it is obvious that fractional reserve banking is a design feature that will drive it towards frequent failures.
Given the financial system’s built in tendency to fail, and its history to do so, it is surprising that people, including governments, continue to assume its perpetual stability. It must be due to lack of alternative that societies continue to work with a financial system that is designed to fail frequently. Under fiat money the 10% (or so) fractional reserve banking is a needlessly dangerous system. Fractional reserve can be made safe by increasing the proportion of equity in lending institution, e.g. the ratio of equity to assets is 50% or higher. Quasi equity, participating or mutual deposits, can be used ot keep equity levels high.
A systemically dangerous consequence of the fractional reserve banking and the consequent thinning cover of equity at all levels of the borrowing chain is the increasing chances of cascading of defaults through-out the financial system. The government rescue of large companies like Citibank, Bank of America, and Merrill Lynch, its issue of guarantees to quell fears in the money market, and other similar steps taken in 2008 and 2009 were done to prevent cascading of failures in the financial markets. The bankruptcy of Lehman Brothers and its consequences demonstrated the threat of cascading in action. Interest based system is structured to fail frequently and to collapse totally if permitted.
Government involvement in credit markets
Under the current fractional reserve system banks extend a hundred dollar debt and have only ten dollars stake in the loan. Depositors, therefore, have to be insured by the government through Federal Deposit Insurance Corporation (FDIC) and through other means.
Currently governments have to explicitly and implicitly assume a huge amount of credit risk of a large number of small and big participants in the financial markets. The Federal Reserve along with its lending and securities purchase programs, the state sponsored enterprises in real estate lending, student loan, and other sectors are all examples of use of sovereign credit to make credit available in the economy.
During difficult economic conditions, the time when credit is most needed; interest based system tends to freeze and compound the pain. Since democratic governments cannot let people suffer for long, they try to ease economic conditions and make credit available by putting the sovereign credit on line. Under the current system the pressure on the government is very high to use the sovereign credit to save the system from falling apart or freezing.
The credit market needs help on both sides of the credit process: retail consumers need the government to subsidize their credit to banks and financial institutions (deposit insurance); financial institutions need the government to subsidize credit to consumers (mortgages, student loans etc.). The government is the super credit provider in the financial system. The lenders to the banks (depositors and others) can count on the government to bail them out if banks default; and the banks, as lenders, can again count on the government to bail them out if their clients (borrowers) default. It is the height of moral hazard, and other perverse incentives; the results of which we see every few years in the form of financial crises and government bailouts.
It is the inherent inability of the interest based system to extend and obtain credit on its own that forces the design of such huge involvement of government in the credit process. If the interest based system was able to extend enough credit on its own there would be no need for the kind of extreme (10%) fractional reserve system that is currently in use. There would be no real need for the government to support the mortgage market if credit extension was providing enough growth to the economy. It is such a rickety and ill constituted system that the government has to be there at every turn to give it support.
It is a failure of any free market system that it depends on the government to operate and to survive. It is not an overzealous government ready to intervene; it is a flawed system that needs propping up almost all the time.
Interest forces socialization of losses
The current financial system lends money without adequately allocating its risk. It just assumes that losses will never exceed ten percent or so. But it does and frequently so. Who pays for the remaining losses? It is the government.
The uncovered risk eventually lands at the government’s door whenever it materializes or threatens to materialize. The government is forced to pay for the uncovered losses of the institutions to save the financial system from collapsing. The recent bailouts of Bear Stearns and other large banks are examples of socialization of losses of the financial sector and its activities. By not adequately allocating the risk it creates, the interest based system destabilizes the economic system and creates challenges for the political system.
By failing to provide adequate credit on its own and by failing frequently, the financial system compels the government to get involved in the credit process thus creating avenues for socialization of losses. Repeated failures of the interest based system over a long period of time have increasingly dragged the government into the business of supporting the financial system. If the government refuses to assume any risk of the financial system the whole financial system would collapse, drastically slow down, shrink in size, or cease to function.
As a result, there are now many implicit and explicit guarantees of the government behind banks and other institutions, which further increase and institutionalize the dependence of the financial system on the government. Socialization of losses is no more the result of an error in the system or due to unforeseen circumstances; but the result of the current structure of the interest based system.
Interest is a bad method for allocation of capital
Interest is not a good tool for regulating or allocating credit. If interest rates are high they increase the chances of bankruptcy and thus further increase the credit premium or credit spread. Increasing interest rates drive effective rates (including credit premium) even higher and increase risks. Higher rates don’t fully benefit the lender because they also increase credit risk; they cost everybody.
Decreasing rates tends to stop or slow lending because the increasing chances of rates going up create additional risk for the lender. When interest rates go up value of fixed rate loans go down causing lenders to lose money. Borrowers mostly take fixed rate loans when interest rates are low. It is obvious that the interest based system of allocating capital is restricting credit under most interest rate scenarios: high and low. No wonder, in spite of its costs and risks, the interest based system needs government help every step of the way. It is a system for allocation of credit that cannot operate on its own and does more harm than good, at least under the current circumstances.
It can be said that any pricing system has this characteristic where too high a price is bad for buyers and too low a price bad for sellers. But most other prices have a set of costs behind them which act as a gravitation point and an economic justification for prices, not so in the case of interest. The point being made here is that capital in a fiat money system does not need to have a pricing mechanism like other commodities with costs. Its pricing mechanism should be purely for efficient and sustainable allocation of capital. Free Capitalism presents such a system.
Creating a cost on holding money in the form of “asset tax on cash” will establish a gravitation point for pricing of capital. This cost will introduce sustainability in the economy; the market will then provide efficiency by pricing capital like other commodities with a cost. Having hoarding money involve a cost will make capital available for lending and will increase willingness to invest even under low profitability conditions.
Interest is no longer a necessary evil
Interest, as we have mentioned before, is a necessity of the gold system. The limited supply of money in the gold system made it necessary to incur huge costs in the form of interest to keep the gold in circulation.
The economic crises and the resulting losses and sufferings that interest causes so frequently was also necessary in the gold system because those losses and sufferings were necessary to squeeze and fit the economy into the rigid money supply. Under the current economic conditions gold system will have to cause deflation or crises on continual basis just to maintain adequate money supply. In other words in a rapidly expanding global economy the gold system will have to regularly destroy value and slow growth just to keep prices stable. Gold money is a relic of the past and should stay in the past, so should interest. Gold money is discussed in detail in the chapter on interest.
Inherent ruthlessness and pro-cyclical nature of the credit system
Interest has a serious and inherent flaw as an institution that serves the purpose of making credit flow: it really has no mechanism for improving availability of credit when the economy is going through tough conditions. In fact it contributes to increasing chances of default and drying up of credit during bad financial times. Interest is very pro-cyclical: it inflates the boom; and accelerates the downfall. During the currently bad financial conditions its inherent flaw is causing untold sufferings. Lenders are the biggest dread that people face in these times, even though the wellbeing of both the lender and the borrower is linked by the debt.
Interest based lending is an inappropriate model for providing credit because it hurts its customer when the customer needs help; it is counter productive when it is most needed. Interest based system is like a trap; it lures customers into taking increasing debt and it crushes them when they fall behind. Human societies and fiat money have made enough progress to finally give up such inherently harsh and punitive systems.
In a fiat money system there is really no need for such a collectively punitive system. In fact, as discussed in the following section, the interest based system is very destructive for fiat money. Fiat money needs stability and delivers stability. Perpetual cycle of recessions or other forms of crises and wealth destruction will be eliminated in a well managed fiat money system, if interest is eliminated. Fiat money can easily maintain its value if the destructive and punitive forces of interest were eliminated.
Interest, therefore, should be replaced with a capital allocation system that allows for adjustments to ease tough economic conditions and conversely to cool fervor during economic booms. Asset tax can be easily and selectively adjusted for economic conditions. Since taxes are government revenues, reducing taxes in tough economic times is a good use of fiscal powers. The government can’t as easily reduce debt servicing expenses for businesses and individuals; and reducing income tax doesn’t help in tough economic conditions. Reducing asset tax burden during tough economic times will help businesses instantly. Asset tax can easily be used as a shock absorber for the economy.
Interest undermines fiat money
In the context of fiat money it is important to understand the difference between the performance risk of the sovereign and its credit risk. The credit risk of a government in relation to its own currency is unquestionable; because the government can always print its own currency and honor its obligation. The real question is the performance risk of the sovereign with respect to its own currency, which is manifested in the maintenance of value of the currency. The difference between the US dollar and the Zimbabwean dollar has to do with the difference in performance risk.
If the sovereign takes too much credit risk and as a result has to pay off too many dollars its performance risk is impaired. Assuming credit risk negatively impacts performance risk. Therefore to safeguard the performance risk it is important that the sovereign take very little credit risk. Since the underlying strength of the fiat money is the performance of the sovereign, we should fortify the sovereign credit as much as we can. Something should have replaced gold when the gold system was replaced; fortification of the sovereign credit is the minimum we should do.
The real challenge in the design of a robust fiat money system is, therefore, to minimize the chances of occurrence of such financial conditions where the sovereign credit is called upon to help or save the system. In other words, for a stable and long lasting fiat money system the losses in the economy should be borne by private sector participants in the economy and should not pierce its way to the sovereign credit. The obvious way to ensure that is to have higher levels of equity in every stage of the financing process. Elimination of interest will increase equity at every stage of the financing process and will allow the government to protect its credit. Elimination of interest will certainly improve the strength and dependability of the fiat money system. If we can adequately protect the sovereign credit we would have a strong currency, a strong economy, and a strong country.
Interest is an illusion in the fiat money system
Fiat money is in fact an unintended step towards eliminating interest. The very feature that made interest necessary, i.e. the physically limited supply of money (gold), is the very object that fiat money tries to do away with. Supply of gold puts a natural limit on money supply and consequently inflation; there are no such restrictions in fiat money. After fiat money became law in 1971 the average US GDP inflation rose to 4.17% for the period 1970 to 2007 whereas it was only 2.08% for the period 1930 to 1969. Inflation offsets the gains from interest.
The Federal Reserve has been pumping money heavily into the financial system since 2008 and intends to continue doing so (early 2011). The underlying technical reason for pumping so much money in the market is falling levels in economic activity, including establishment of new businesses and production of goods and services. The solution being tried through injection of money is to increase lenders’ ability to lend and to bring down interest rates to make it palatable for potential borrowers.
This monetary expansion will in effect also devalue the currency in real terms. The foreign exchange effect is just the visible part of the devaluation. The kind of devaluation in question is: inflation. Inflation will offset the gains from interest. Inflation increases investments in real assets, including real estate, to hedge against the value erosion caused by inflation, which fuels asset price inflation.
Debasement of fiat money will always take place under an interest based system because most modern governments won’t be able to let the system inflict the excessive pain it periodically needs to inflict just to correct the imbalance it creates itself. These imbalances are created through exponential growth in money, consequent concentration of wealth in fewer hands, and most importantly excessive debt in the economy and the financial system. To correct these imbalances the system destroys a huge amount of debt, wealth, and economic potentials. Currently the choice the interest based system offers is stark: either cause extreme pain or inflate the money.
Interest based system is the product of gold based money. It is not designed to respect the fragility of fiat money; it is like a machete on a surgery table. Interest does not harm the gold system; it causes unbearable pain and suffering but the gold system stays in tact. But, as stated above interest causes debasement of fiat money. The range of imbalances and problems that interest creates and the range of solutions applied by Central Banks and their respective governments, all point towards the possibility of debasement of fiat money, sooner or later.
If interest remains an integral part of developed economies; they will continue to face financial, credit, growth, and other economic problems. All the accumulation through interest will turn out to be nothing more than a mirage, because most of it will get eroded by asset bubbles, inflations, higher taxes and credit losses. Under the current economic circumstances interest is really an illusion, particularly given a fiat money system.
Interest and the US dollar
Gold money can no more be used because modern economies need the flexibility that gold cannot provide, we therefore have to use fiat money (this point is elaborated in the chapter on interest). As we have shown above interest undermines fiat money. The US dollar, the main global fiat money, is currently under the kind of economic upheavals typically created by interest. The interest induced factors causing these economic disturbances include exponential growth of debt, lack of non-inflationary methods to prop up the economy, and burdening and fettering of the economy.
The US dollar and dollar denominated assets provide a means for liquidity and wealth storage for the whole world. There is no other currency that comes close in terms of its usage and long term dependability. The US dollar is not only important for the Americans but also for the whole world; it is the life blood of globalization. The absence of any comparable alternative to the US dollar on the global stage has so far helped significantly in maintaining the value of the dollar.
If the US wishes to protect the status of the US dollar as a de-facto global currency it should not subject it to pressures created by interest and its systems. If the US eliminates interest, and fortifies the dollar by significantly increasing equity in businesses and in the financial system, it can potentially make the dollar standard better than the gold standard.
Increasing equity
It seems clear by now that the common reason for the repeated breakdowns of the financial system is the lack of equity in the system and in its institutions. Higher equity in the financial system will enable its institutions to continue functioning without government help even during relatively difficult economic conditions. If there were enough equity in the system credit failures would not find their way to the sovereign, there would be little or no socialization of the losses of the financial institutions, and the fiat money would be protected from debasement.
The proportion of equity in the financial system and in other businesses will increase in the absence of interest firstly because equity will not be displaced by the exponential growth in debt. Secondly, elimination of interest will reduce risk in businesses and therefore in equities, which will make equities attractive; and in turn will also reduce the return threshold for equity investments. Reduction in equity risks and reduction in return thresholds for equity investments will result in higher equity investments. Stock prices will be far more stable (low volatility) than they are now.
Higher equity in the financial system will remove the perverse incentives that cause lending to balloon and consequently go to weaker credits. In other words growing levels of equity would tend to prevent underwriting standards from being compromised and therefore tend to minimize credit failures. Higher equity would work to improve lending standards because more would be at stake.
Making credit risk palatable
Eliminating interest will remove the potential toxicity of credit; which means it will reduce the risk of individual borrowers and the aggregate risk of the economy. Elimination of interest will also make it easier for borrowers to pay for their credit risk or their credit premium. Credit risk without the weight of interest will be easier to asses and price. Credit risk would become easier to assume or to sell at economic prices. It will, consequently, make it easier to get private sector participants to assume most or all of the risk being originated in the market. Reduction in aggregate risk in the economy will further facilitate assumption of a higher proportion of credit risk by the private sector.
Increase in equity investments will enhance the equity cushion for credit thereby making credit risk more palatable. Higher assumption of credit risk by private sector participants will save governments from covering for the credit losses of the system. It will also protect the taxpayers from higher taxes and the fiat money from debasement,
Higher acceptability of credit risk and higher demand for equity will also increase use of hybrid debt and quasi equity instruments to distribute credit risk. Credit risk can be packaged and sold in many forms, including contingent, aggregated, and segmented forms of credit risks. These instruments will further help higher distribution of credit risk. When higher percentage of credit risk, particularly of the financial institutions, is assumed and backed by participants from the private sector the financial system will become stable and strong.
Free Capitalism will not only increase equity in business and financial institutions but will also reduce the riskiness of credit. The risk in the economy will be significantly reduced due to elimination of interest and other risk inducing features of the current system. All the risk in the economy will be assumed by private sector participants. Governments will be saved from the burden of covering for un-assumed credit risk and the financial system prevented from frequent breakdowns. Free Capitalism will make economies and businesses more stable, increase investments and economic growth, and protect the fiat money.
Interest is a hurdle against full employment
As stated earlier the interest based economic system does not automatically attain full employment. Interest rates can’t go below zero therefore as they approach zero they resist falling. Even when interest rates are made to fall their zero bound limits the response of economic and monetary variables, like investment volume and liquidity preference, which in turn limit growth in economic activity and employment. Unemployment or under employment is a condition that is part of the design of the interest based economic system.
As mentioned above, the interest based system was not good at creating employment even when its assumptions about capital scarcity were correct. Scarcity of capital provides opportunities to create employment. Now that there is really no scarcity of capital, interest based system has become counter productive. Due to its hurdle mechanism it is restricting employment of capital and labor. The hurdle mechanism of interest does not work when the world has over-capacity in the production of capital. Under the current conditions most returns are located beyond the vanishing point of the interest based system. Elimination of interest is necessary to cure the myopia of the current fiaincail system and let it see the distant returns that come with increasing employment of labor and capital.
Government expenditure or other fiscal policy measures may not be effective when we are dealing with an employment problem that is influenced by global factors. Global resource constraints and globalization has made it necessary to manage economic growth and employment at the fundamental level of the economy and not through patchwork like subsidies and government expenditures. The recommendations of Keynesian economics for creating employment may not be very effective under the current circumstances.
The resource and environmental challenges we face requires that we employ all the labor and capital available for building a sustainable and prosperous global economy. There are so many people to feed and so much work to do to protect the planet and its resources that we would never face employment problems if we have the right model for building sustainable economies. Eliminating interest, or hurdles in the way of employment of capital in a sustainable manner, is the first step towards building such an economy.
An interest free economy will tend to attain full employment on its own and tend to stay there. Economies mostly run out of productive things to do because of interest. Once interest is eliminated and consequently the myopia, the natural return maximizing tendencies of increasing employment of labor and capital, which is cheap and plentiful, will manifest itself in increasing employment and investments. Since sustainability of resources will be incentivized through the asset tax structure, resource constraint will not remain much of an obstacle to full employment.
Interest makes the US globally uncompetitive
Interest is a big component of the price paid for most goods and services. For example, around 50% of the amount most people end up paying for a car is interest, more so in case of houses. Interest builds up in the price of every item as it, or its components, progress towards completion over time. Even simple products like grains and hamburgers have high interest component because cows and grains take time to grow and also carry interest cost during storage.
Interest starts accumulating even before the seeds are planted. Machinery prices can accumulate a huge interest component through the money tied up in inventories, of material and components, during the manufacturing and distribution process. The mantra of “just in time inventory” is a way of saving interest costs. Interest builds up in the cost of everything and burdens all economic activity. Every time money is paid, even if it is a tax, part of it goes towards interest. Interest is spreading and consuming every organ of our economy, like a parasite.
Let me overstate a little to make the point that interest is crippling the US economy. Let us consider a dramatized version of the US economy and imagine the crippling impact of $5 trillion in debt servicing in an economy of $15 trillion (GDP). Considering that the current level (2009) of total credit market debt in the US is $53 trillion, a $5 trillion of annual debt servicing is within expectations. This level of debt servicing costs will cause economic crises, credit losses, business failures, inflation, and poverty. Such little income would be left for entrepreneurs and labor that few industries would be able to survive, particularly given tough global competition. Consumers would have to drastically cut down on spending. It will shrink the real economy and make Americans poor. It is a hypothetical example but may be actually happening.
That huge cost of almost a third of the economy if eliminated will really free the US economy, create new industries and new jobs, and will make US businesses globally competitive. It will give the US financial room to keep wages and living standards high, which is currently under pressure from low wage international competition. Enhanced competitiveness of the US will keep protectionist sentiments at bay and therefore keep global markets free.
Interest is a huge drag on any economy. The economic growth benefits of eliminating interest will be greater than eliminating all federal taxes. It will be the mother of all tax cuts.
Interest undermining economic recovery
Until recently the high profitability from industrialization allowed interest to be part of the cost structure of all economic units. However the massive industrialization of developing countries has brought down the overall profit potentials of traditional industries in developed countries, making normal level of interest burdensome for a majority of those industries. A New York Times article published on November 17, 2010 quotes a Chinese Commerce Ministry spokesman as follows:
Yao Jian, a commerce ministry spokesman, said at a press conference on Tuesday that the government would tighten scrutiny of foreign investment so as to prevent too much money from pouring into China as foreign investors seek higher returns than are currently available in the West.
Profits from environment related and other futuristic industries are inherently low; therefore interest has become an unsustainable burden on developed economies. Purposefully reducing or slashing wages in the US is not a strategy that will bear lasting results. Some wage adjustment is necessary and will take place in the course of economic adjustments that normally take place over time. Using wage reduction as a strategy for growth will ultimately get the US into a wage war with developing countries, a war the US cannot and should not want to win.
Temporary low interest rates will not help establishment of new environment friendly industries because their returns are permanently low. Investors won’t invest in an industry that has low yields even when interest rates are favorable because interest rates are likely to go up later. As long as there are good chances of interest rates going above the normal yield of the industry that industry will not attract investment.
Since interest rates have for centuries hovered around 5% we can assume that the current financial system will not allow investments to be made in any new industry that normally yields less than 5% financial rate of return. That rules out most clean energy and other planet related industries. Due to global competition investment in conventional industries will not pick up unless there is a significant and permanent reduction in the US cost structure. Elimination of interest will significantly reduce production costs.
Interest is the biggest hurdle in the way of potential investments, both in environment related industries and in traditional industries. Interest is hindering the US economic recovery.
Interest is inhibiting creation of real assets, and blowing asset bubbles
The Federal Reserve creates money and the banking system through the multiplier multiplies that money almost tenfold (depending upon the reserve ratio); consequently a huge amount of money is introduced in the system that originally has no counterpart in produced goods and services. That money if employed in productive activities can produce value or goods to translate monetary expansion into real assets expansion. But if enough productive opportunities are not available they would just bid up prices of available assets and cause asset bubbles. Since these expansions are through loans they tend to bid up asset prices first. In other words if the US does not create massive amounts of new assets, increasing monetary wealth would not correspondingly translate into increasing real wealth. It would create asset bubbles.
Elimination of interest will allow the US to create massive amounts of additional assets that in turn will hold the increasing savings and increasing wealth of individuals and business from all around the world. It would translate monetary expansion into income and wealth expansion. It would also translate foreign dollar savings, into wealth, income and economic growth in the US.
If these assets are not created; current wealth and future savings will be lost in inflation and credit crises because there won’t be enough productive assets to hold the increasing wealth. Investment returns would mainly come from inflation and speculation (asset bubbles). Eliminating interest (and replacing it with asset tax) would allow monetary expansions and foreign savings to create real assets in the US economy and thus create real economic growth; not asset bubbles.
Creation of wealth reserves
Eliminating interest would also allow countries to store huge amounts of monetary wealth in government bonds without any cost. Interest free government bonds are a good and non inflationary way to increase monetary wealth. If there are not enough real investment opportunities or the economy is overheating, a situation similar to the one in which the Federal Reserve sells bonds, interest free government bonds can prevent asset bubbles from forming. Interest free government bonds will act as a wealth reserve for the economy.
Instead of making efforts to increase lending by putting the sovereign credit at risk, governments can just allow favorable liquidation of these bonds during difficult economic times. It will be a macro economic savings account. These stored moneys will not cause asset price inflation or any other inflation but still would improve the balance sheet of individuals and businesses thus improving the ability of market participants to assume risk and to borrow. It will make economies more resilient and more enterprising. It will increase economic stability and economic potentials. Wealth reserves will protect the sovereign credit.
Interest based government bonds currently perform similar function but due to the interest cost burden the government and consequently increase taxes. They compete with private sector and may reduce investments. Interest free government bonds would only take in the money that was not going to earn any return because government bonds won’t give any return. Government borrowing with interest under the current system and that without interest under free capitalism will be very different things and would have different effects. Current government borrowing is thought to have crowding out effect on private investments; no such effect would be attributed to government borrowing under free capitalism. Interest free borrowing would be for the purpose of channeling over flow and creating reservoirs. Since investors hold a certain portion of their assets in bonds there will be limits on the amount the government can borrow.
Restructuring of the global economy for sustainability
Over population, global warming, environmental degradation, resource depletion, and other constraints of the planet require us, humans, to build and structure almost all spheres of our economic and physical existence. As mentioned above wind, wave, solar power and other environment friendly sources of energy are very capital intensive. Environment friendly living for a growing and urbanizing population will require investments of capital intensive nature in industries and in infra structures.
The financial rate of return from these investments is likely to be small, or in other words these investments will have long pay back periods. The reasons for their low returns are basically similar to the reasons for low returns from sustainable energy industries. The current economic system does not allow us to look beyond a 30 year horizon. After 30 years, discounted cash-flow from most investments become negligible. We cannot expect to build a new environment friendly physical and economic infra structure through an economic system that has such short time horizon.
It is obvious that investment opportunities will increase if we are able to look farther in time. We would be able to see much more if our vanishing point is extended much farther into the future. Interest is not allowing us to see the economic and financial benefits of sustainable industries, infra structures, and enterprises. Elimination of interest is therefore necessary for restructuring of the global economy for sustainability.
Interest and global resources
The industrializing population of the world also needs additional resources, particularly in the energy sector, to attain modern living standards. Interest, in fact, shrinks the global resource pie by speeding up the consumption of resources. Sustainably accommodating growing human population on shrinking planetary resources will require building up new resource adding industries and structures. We, humans, have to increase the size of the resource pie to avoid fighting over it.
Elimination of interest will allow new industries and structures to be added and new areas opened for investments, and resource creation. Resource creation will eventually be undertaken in all countries, but some countries need to take the lead. To maintain their economic lead developed countries have to develop new industries and discover new areas for economic activities that will grow in relevance with time. The basic difference between developed and developing countries is the lead developed countries have over developing ones. Developing countries can just copy but developed countries have to invent and lead.
Interest, globalization, and global peace
Following the collapse of the Soviet Union and the opening up of global markets; billions of people joined the global work force. To peacefully employ these people we need to multiply the amount of productive work that is done in the global economy. The current economic system, because of its short time horizon, and other deficiencies, will not allow investments in environment, space, oceans, wholesome and organic products and life styles, and other planet and life augmenting industries; which have the potentials to create a huge amount of peaceful jobs all around the world.
Interest will not allow us to increase the global jobs pie. It will prevent most people from getting a better quality of life because interest won’t allow maximum employment. Presently the increasing employment in developing countries is causing increasing unemployment in developed countries. Globalization cannot continue if the gain of one country is at the cost of the other. Globalization is not only about expanding the jobs pool in developing countries but also about maintaining the jobs pool in developed countries.
Interest won’t allow maximum employment, it won’t allow creation of additional resources, it won’t allow maximum production, and it won’t allow restructuring of the global economy for sustainability; it will consequently push the world towards economic depression, war, conflict and destruction. Interest is the biggest threat to the environment, global peace and to globalization.
If we look at the great depression and numerous other episodes of economic breakdowns and resulting devastations we can see that the problem lies with the economic system. How could so many willing workers be out of work when there are plenty of resources and plenty of ways to employ them? It is only possible if there is a system that is standing in the way of something natural and straight forward from taking place. If we had the right economic system we would never face a situation like the great depression. For example, if interest rates could go below zero there would be no great depression or the great recession.
Interest based system is structured to cause extreme pain and suffering to fix the problems it creates. Human lives and fortunes are ruined and capital and wealth is destroyed, consequently capital becomes scarce again and interest economically justified. It is a system that corrects itself through human suffering and destitution. It is cruel and heartless system that requires human sacrifice to keep working. It may seem a stretch, but the stories of desperation and destitution that are associated with the Weimar Republic, the Second World War, and the great depression have a lot that was caused by the interest based system. There is absolutely no place for this system in a prosperous and peaceful 21st century.
Interest and Profits
Comparison of interest with profits is inappropriate because profits grow and shrink with the economy but interest based pools keep growing, sometimes at a faster rate, during downturns. Profits are necessary to keep the economy working; interest is not. Profit is a reward for producing; interest is not. Interest is an unnecessary burden.
Interest and time value of money
Elimination of interest will also eliminate “time value of money” as we know it. “A dollar today is worth more than a dollar tomorrow” no longer holds true any more than does the opposite, “A dollar tomorrow is worth more than a dollar today.” In a fiat money monetary system there is really no need for “time value of money.” Elimination of time value of money will allow economies to increase investments by extending their time horizon and investing in assets with long payback periods. Time value of money is further discussed in the chapters on speculative bubbles, on interest, and also in the chapter on space. Time value of money is a fiction given life by interest.
Elimination of interest is in the interest of present day creditors
Given the current volume of debt in Europe and America and considering the difficulties being faced by both due to the excessive levels of debt it may not be possible to continue with the current system without destroying a major portion of the current debt outstanding. Creditors face a choice of either continuing with the interest based system and risk loosing a significant part of the principle in credit failures, taxes, economic crises and inflation or accept an interest free system and hope to save their principle. It may be in current creditors’ best interest to do away with interest.
The risk of loss to their portfolio will be significantly reduced because of stable economic conditions and robust financial structures of businesses and that of the economy. Since more people will be employed and more assets created in an interest free system there will be more assets available to hold higher level of savings and wealth. When assets are not created higher wealth is just reflected on paper; it is not real. The best way to protect savings from inflationary and other erosions is to ensure that real wealth is created in the economy. Elimination of interest will create new wealth and protect existing ones.
The present interest based system faces imminent collapse, at least for the foreseeable future. It may reemerge only after it has gone through the cycle of correction that it needs to go through, which will entail huge destitution and devastation, on the economic and political scene. It is therefore in the best interest of present day creditors to accept Free Capitalism as a financial system. If an interest free system is implemented in America, creditors are likely to accept it because they won’t find enough credible borrowers to replace the American government and other American borrowers. Time has come for elimination of interest.
Working people who think they will benefit from interest in their retirement and similar savings are wrong. Under the current economic conditions their savings will not retain even their current value. Under Free Capitalism their earnings would be much higher because of elimination of income tax and interest, and their expenses much lower because of lower prices of almost everything (rents, cars, houses, college tuition, food, clothes, etc.). Therefore their savings and assets will be much higher at retirement. Since inflation would remain under control there will be little or no erosion in the value of their savings (inflation control is discussed in the following chapter). It is in the best interest of all creditors to accept Free Capitalism.
Gold money was the main reasons for the existence of interest and fossil fuel was the main reason for the subsequent respectability of interest. A system as parasitic and inefficient as interest could not have survived for so long if it was not for the economic powers of gold. The days of gold money are over and the days of fossil fuel are receding, so interest should also be on its way out. The following is a bullet point summary of the case for elimination of interest:
Hurdle against new businesses
Hurdle against full employment
Increases costs and prices
Increases risks
Weakens credit quality
Undermines economic stability
Forces government involvement
Debases Fiat money and sovereign credit
Increases resource waste
Destroys savings and asset quality
Threat to globalization and free markets
Interest a phantom
Wasteful way of allocating capital
Eliminating interest will improve US competitiveness
The compelling points for discontinuation of interest are as follows:
– Interest will not let the US recover economically
– Interest is a threat to globalization and to free markets
– Interest is a threat to the environment, the planet, and to global peace
– Interest will destroy the sovereign credit, and the fiat money: the US dollar
It can be concluded from the above that interest has become economically unsustainable and therefore needs to be replaced with an efficient method for allocation of capital. If that method also allowed resource preservation and environmental protection priorities to be made an integral part of the economic system it would help address the existential challenge of our time. Asset tax is costless method for allocation of capital, and it will also help with resource and environmental priorities. Asset tax is discussed in the following chapter.
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