The End Of Usury

Abstract

Interest rates have gone down in recent decades. Most economists think that they will go up again. But what if the opposite happens? What if negative real interest rates become the new normal? That seems unthinkable. Yet, negative interest rates are inevitable unless something bad happens. And that something bad can be an error from the part of our political and economic leaders.

Several factors contribute to the dynamic that drives down interest rates. These factors do not go away when interest rates reach zero. The most significant factor is the room for capital to grow. Interest rates on capital were higher than the economic growth rate and most interest income was reinvested for most of history. This is unsustainable.

It would be wise to allow interest rates to go lower if that is where market forces push them. Lower interest rates make more projects economical so that there can be more capital and wealth. If interest rates are negative, the future is discounted at a higher value than the present so that it becomes possible to make the economy sustainable. Lower interest rates can reduce income inequality as the wealthy mostly receive interest income.

Interest was needed for the economy to operate. Lending and borrowing wouldn’t be possible without interest. If you lend out money, you can't use it yourself. People want a compensation for this inconvenience. And the borrower may not repay. People want a compensation for this risk. Finally, if you can make a profit by investing, why lend out money without interest? This is the traditional justification for interest.

In the meantime a few things have changed. You can lend out your money to a bank but still use it any time. This is convenient. Banks check the financial condition of borrowers and lend to many different people. This reduces risk. Central banks and governments can help out banks if needed so bank deposits are now considered safer than cash.

But what about the returns on investments? Throughout history these returns were mostly higher than the rate of economic growth. Most of these returns have been reinvested so a growing share of total income was for investors. This cannot go on forever because who is going to buy the stuff corporations make? A simple example can illuminate that.

Figure 1 shows how total income and interest income (in red) develop with an economic growth rate of 2% and an interest rate of 5% when interest income starts out as 10% of total income and all interest income is reinvested. After 25 years the economic pie has grown faster than interest income and wages have risen. At some point interest income starts to rise faster than total income, and wages go down. After 80 years there's nothing left for wages. Despite its simplicity, this model explains a lot about what is going on in reality.

And this can be called usury for good reason. It also explains why interest rates went down in recent years. In the short run it was possible to prop up business profits by letting people go further into debt to buy more stuff. In the long run the growth rate of capital cannot exceed the rate of economic growth. In the past economic crises and wars destroyed capital and this created new room for growth.

Most of us agree that economic crises and wars are not great methods for solving problems. The alternative is allowing interest rates to go negative. This is why the era of low and negative interest rates may be upon us. The end of usury could be near and that would be a good thing. People should become aware of this and there is a lot of research that needs to be done.

Introduction

Not so long ago more than 99% of the world population lived in abject poverty. In 1651 Thomas Hobbes depicted the life of man as poor, nasty, brutish, and short. It had always been that way. Yet, a few centuries later a miracle had happened. Nowadays more people suffer from obesity than from hunger while the life expectancy in the poorest countries exceeds that of the Netherlands in 1750, which was the richest country in the world at the time. How could this happen?

This miracle is about the epic battle of 'The Spirit Of Capitalism' versus 'Time Preference'. When time preference prevails, interest rates are high and people are poor, but if the spirit of capitalism gets the upper hand, interest rates are low and people are wealthy. As interest rates went lower, more investments became profitable, and so an unprecedented amount of wealth could be created over the centuries.

Negative interest rates may scare you but there is nothing wrong with them. On the contrary, lower interest rates mean prosperity. But can interest rates go lower? Sure, they can! In the wake of the financial crisis interest rates have hit the zero lower bound. Investors prefer liquidity because returns on other investments are deemed less attractive. In other words, many people, businesses and banks pile up cash, and don’t invest or spend.

Central banks have created a lot of currency to meet the demand for liquidity but they are running out of options. Ending next recession will require negative interest rates. Only negative interest rates can clear the supply and demand for money and capital at the equilibrium level. Most economists think that negative interest rates are just a temporary phenomenon and that interest rates will go up again. But that is probably not going to happen, unless our political and financial leaders make a serious mistake.

Theory

Low and negative real interest rates will become the new normal, unless something bad happens. Figure 1 demonstrates that capitalism can increase overall wealth via investments. It also shows that capitalism can contribute to wealth inequality as long as interest rates exceed the rate of economic growth. This can happen when most capital is in the hands of relatively few people that reinvest most of their capital income. As a consequence, wealth induced income inequality will start to hamper economic growth and the creation of wealth.

Silvio Gesell realised that the economy was hindered by the zero lower bound. If interest rates fall below a certain threshold money would go on strike, he observed. In other words, money would be withdrawn from the economy and this would cause a slump. Many economists fear the zero lower bound as a threat to economic stability. In the wake of the financial crisis of 2008 efforts were made to prop up the economy and promote inflation using fiscal and monetary policies in an attempt to push up interest rates.

Fiscal and monetary policies have downsides such as the political business cycle where politicians try to make the economy perform well just before the elections. Monetary policies can cause distortions in the financial markets by not pricing in risk correctly. The mispricing of risk contributed to the financial crisis of 2008. Moreover, there are powerful forces at work that push interest rates even lower. So where are interest rates heading?

Nearly ten years after the financial crisis the world economy has recovered, but interest rates are still near zero. Deeply negative real interest rates seem unavoidable as soon as a new recession takes hold. And interest rates may remain negative after this recession has ended. Figure 2 from the Federal Reserve shows that interest rates went down in recent decades. The red line is the natural interest rate, which is assumed to be the ideal interest rate for optimal economic growth. The trend towards lower interest rates is clear.

Research Questions And Methodology

Low and negative real interest rates can may become a permanent situation. Central bankers already admit that low interest rates will persist for a long period of time. The aim of this study is to come up with a narrative that explains the trend towards lower interest rates in recent decades, to make a prediction with regard to the direction of future interest rates, and to explore the preconditions for the prediction to come true.

The research starts out with a short trip into history to illustrate relation between interest rates, inflation and financial capital stock, in order to see the importance of the room for capital to grow. Then it examines existing economic theories to discover which factors contribute to lower interest rates, and whether or not these factors are in place. If these factors are still in place then it can be inferred that low and negative interest rates will become the new normal, unless something bad happens.

The following factors contribute to the trend towards lower interest rates:
• rule of law, political stability and economic stability;
• time preference versus spirit of capitalism;
• fractional reserve banking and central banking;
• globalisation, liberalisation and derivatives;
• retirement savings and population growth.

A Short Trip Into History

In 1910 the amount of capital relative to national income in Europe and the United States was close to where it was in 2010. The world had just been divided between the European imperialist powers and this put a constraint on capital growth. Interest rates may have gone to zero in the 1910s if it wasn't for World War I. The war destroyed a lot of capital in Europe. The economy recovered in the 1920s but in the 1930s the Great Depression started.

Deflation took hold and interest rates became stuck near zero. The success of the local currency in the Austrian town of Wörgl suggests that negative interest rates could have ended the depression. Sadly it was World War II and not negative interest rates that brought the Great Depression to an end. The enlistment of soldiers and the production of war goods brought the economy in the United States back to full employment.

Inflation in the United States picked up. Prices doubled between 1939 and 1948. Owners of financial capital incurred serious losses. In those years the S&P 500 stock index rose less than 20%, which wasn’t enough to keep up with inflation. Bond holders fared even worse. Yet, inflation pushed interest rates away from zero, and the loss of financial capital cleared some space for positive real interest rates in the years ahead.

After the war Europe had to be rebuilt. This created new room for growth and positive real interest rates. When capital ran out of room to grow again in the 1960s and 1970s inflation picked up, and this destroyed a lot of financial capital. Prices in the United States more than doubled between 1972 and 1982 and owners of financial capital incurred losses similar to those of World War II. This created new room for positive real interest rates in the years ahead.

There were other places where investors could make good returns on their capital. In the 1970s and 1980s growth in Japan and the Asian Tigers was high. In the 1990s and the 2000s Eastern Europe and China built their economy while consumers in the United States and Western Europe went into debt. Lower interest rates combined with globalisation, efficient financial markets and innovations in risk management, allowed for more debt to exist. This propped up growth for a while but debt fuelled spending is not a sustainable path to growth. The financial crisis of 2008 was a warning sign.

Rule Of Law, Political Stability And Economic Stability

Trust in the future is the basis of the capitalist economy. This trust means that investors imagine that the future will be better so that their investments will turn out to be profitable or at least not loss making. Credit, or alternatively financial capital, is essential to make that happen. Credit is given because of this trust in an imagined future. Most of our money is credit so the value of our money depends on imagination. In order to have trust in the future, investors must believe that their investments are safe.

The rule of law, political stability, absence of graft, and economic stability are such elementary factors for the economy to function, that we often take them for granted. Political stability affects policy uncertainty, which is the risk that a government annuls earlier commitments. Policy uncertainty tends to impede economic growth. Government actions like confiscating or taxing assets can harm businesses and add to policy uncertainty. Inflation is a way of confiscating assets so government deficits are a cause of policy uncertainty.

Interest rates are the lowest in stable countries with low inflation rates as stability and trust influence the risk premium on investments. The greater the perceived risk, the more the future is discounted, and the higher interest rates are likely to be, and the lower the living standard is likely to be. It is not a coincidence that negative interest rates happen in Switzerland and Sweden, and not in Venezuela or Zimbabwe.

Time Preference Versus Spirit Of Capitalism

For most of history, returns on capital were higher than the economic growth rate. This cannot continue indefinitely unless a sufficiently large portion of the proceeds of capital is consumed. As the distribution of wealth in developed economies has become increasingly skewed in recent decades, this is not happening. Wealthy people invest a larger part of their income than people on average. In recent decades people in Asia started to save more and this added to the savings glut. Consequently, interest rates went down.

Capitalists are special people. 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. Hence, capitalists often end up owning a lot of money when they die. What's the point of that? They invest in the businesses that make the items ordinary people enjoy. Ordinary people wouldn’t have invested their money, but spent it instead on frivolous items so that these items wouldn’t have been produced in the first place. That is because they suffer from time preference, a condition that makes them spend their income sooner rather than later.

There is a kind of 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 save and invest, while people with a higher time preference consume and borrow. At some point the people with the higher time preferences pay a lot in interest and can't borrow more so that they have less to spend.

And so the economy slows down because of a lack of demand and interest rates go down. Then people with a somewhat lower time preference start to consume and borrow until they can't borrow more. This cycle repeats as interest rates go lower. But as capitalists get wealthier, their time preferences go down even further and can become negative because they can't spend all their money. As more and more people become indebted and can't borrow more, interest rates are driven down so that in the end interest rates are determined by the lowest time preferences.

Fractional Reserve Banking And Central Banking

Liquidity preference results in a demand for money because it is the most liquid asset. It can be exchanged for any other good or service the most easily so that money commands a position of power. People are unwilling to lend money unless they can call it in at short notice. Fractional reserve banking enabled banks to lend out money that can be withdrawn on demand. This freed up resources that were unavailable until then, which helped to lower interest rates.

Fractional reserve banks can run into trouble when too many depositors withdraw their funds at the same time. The quality of the fractional reserve money greatly depends on the possibility to exchange it for currency at any time. If debt can receive a status similar to currency and gold, this would undermine the bargaining position of the owners of currency or gold.

Central banks help out fractional reserve banks that ran into trouble. This reduced the risk of owning bank deposits so that interest rates could go even lower. It is not a coincidence that the Industrial Revolution started in England, just after the introduction of fractional reserve banking and the institution of the Bank of England, the first central bank in the world. Abundant credit at low interest rates facilitated the largest build-up of capital history ever witnessed.

Central banks have another role, which is adding currency to the banking system in order to cope with the accumulation of interest. The money to pay for the interest doesn’t always exist and may need to be created out of thin air, either by creating new debts or by printing currency. Often there needs to be a ratio between debt and currency in the banking system so that the accumulation of interest prompts central banks to print additional currency.

Globalisation, Liberalisation And Derivatives

The globalisation of financial markets was made possible by advances in information technology and financial innovations. Financial markets were liberalised and capital controls were removed. This reduced the cost of capital. The globalisation and liberalisation expanded the borrowing and lending possibilities throughout the world and reduced the cost of financial intermediation.

Financial markets became more liquid. It became cheaper and easier to exchange financial instruments such as bonds and stocks, but also goods and services for cash. It became easier for people and businesses to rationalise their assets and income flows using financial instruments. This further undermined the position of money as the most liquid asset and hence the commanding position of the owners of money to demand interest.

The globalisation and the liberalisation of financial markets wasn’t without troubles. It enabled money and capital to move more freely so that changing expectations could more easily cause financial instability. A number of financial crises in the 1980s, 1990s and 2000s were neutralised by central bank interventions. Some countries used capital controls to counter the financial instability.

Better risk management allows banks to increase their lending so that interest rates can be lower. Financial innovations such as credit derivatives improved the risk management of banks, which allowed banks to lend more money. This remains true after the crisis of 2008, despite the fact that a poor use of derivatives contributed to the financial crisis.

Retirement Savings And Population Growth

People who have enough money for their present consumption may become concerned about retirement. In this way the law of diminishing marginal utility, which states that the utility of every extra unit of consumption diminishes, counteracts time preference, which states that people desire to consume a good or service sooner rather than later. Affluence promotes retirement savings so that interest rates can go lower.

Population growth contributes to economic growth. More economic growth often leads to higher interest rates. Low population growth in Europe and Japan coincided with low interest rates in these areas. Population growth worldwide is expected to decline in the future. This would lead to lower interest rates.

Conclusion

Low and negative interest rates can become the new normal because the factors contributing to lower interest rates will probably remain in place. Our civilisation and wealth rest upon the trust that is reflected in low interest rates like never before. Most people don’t realise that. Higher interest rates mean a destruction of trust reflected in financial capital. This can lead to depression or war.

Deficit spending and money printing promote inflation and can push interest rates higher. As soon as the inflation genie is out of the bottle, it may be hard to put it back in. Higher interest rates hurt the economy, either by reducing aggregate demand or by undermining confidence in debts. Investors may then seek an additional risk premium when economic instability makes it more difficult to foresee future policy actions. Rising interest rates will probably coincide with poor economic performance, inflation and financial instability.

So why don't economists see this great potential of negative interest rates? They are caught up in the concept of scarcity. It is the main pillar of economic thought. Yet, economists should raise some fundamental questions at a time when more people are dangerously overweight than underfed. At least scarcity doesn’t apply to the wealthy people who own most capital and have the largest influence on interest rates. They are running out of things to invest in. The economic world is turning upside down, and so are interest rates.

This paper has been presented at the IV International Conference on Social and Complementary Currencies in Barcelona. It is to be published in the International Journal Of Community Currency Research. The full version of this paper and other materials can be found on www.naturalmoney.org.