Feasibility Of Interest-Free Money With A Holding Tax

May 31, 2017

Abstract

Natural Money is interest-free money with a holding tax. The maximum interest rate on money and loans is zero and there is a tax on currency. The tax may range from 0.5% to 1% per month. You don't have to pay the holding tax on money lent. This includes bank accounts so it can be attractive to lend money at slightly negative interest rates. Silvio Gesell was the first to propose a holding tax on money in his book The Natural Economic Order. That is why this money is named Natural Money.

Natural Money is to become the money of the future. Natural Money can improve the economy so that its superior efficiency can transform the global financial system. To implement Natural Money interest rates need to be low or negative to begin with. And interest rates will probably remain low, and are likely to go even lower.

Natural Money can improve the economy in the following ways:

  • Removing the zero lower bound allows interest rates to go below zero. In this way the markets for money and capital can balance at the equilibrium rate.
  • The maximum interest rate curbs the risks lenders are willing to take. This promotes financial discipline. It also reduces moral hazard because the integrity of the financial system is guaranteed by governments and central banks.
  • The business cycle can be mitigated. The holding tax provides a stimulus while the maximum interest rate provides austerity.
  • The economy can do well by itself so that government and central bank interventions are not needed. This can bring improvement because interventions can cause market distortions such as political business cycles and the mispricing of risk.

The economy can do better with Natural Money, so returns on investments can increase and real interest rates can rise. The maximum interest rate on money and loans is zero so the currency will rise in value as prices go down. Investments in economies using Natural Money can provide better risk/reward ratios. This can cause a capital flight so that Natural Money can become the money of the future.

Introduction

Let's praise low interest rates. They are wonderful because:

• We can all be wealthier with lower interest rates because more capital will be profitable. Wealthy countries like Switzerland have negative interest rates while poor countries like Venezuela have high interest rates.
• We can make the economy sustainable with lower interest rates. That is because future income is discounted at the prevailing interest rate. With positive interest rates the future has a lower value than the present. With negative interest rates, the future has a higher value of the present.
• Lower interest rates can reduce income inequality. Wealthy people make their money with capital. If interest rates go lower, their share of total income will probably drop.
• Low interest rates require and promote financial discipline because it is attractive to borrow at negative interest rates. For example, Germany can borrow at negative interest rates because creditors trust Germany.

Other monetary reform proposals such as curtailing fractional reserve banking and backing currency with gold cause inefficiencies and lead to higher interest rates. That means that we will all end up poorer. This paper is too short to discuss the issues with these proposals in detail.

Theory

Natural Money consists of two basic elements. First, there is a holding tax on currency ranging from 0.5% to 1% per month. The government spends the tax back into circulation. Cash and central bank deposits are currency and subject to the tax. Second, there is a maximum interest rate of zero on money and debts. It can be attractive to lend out money at negative interest rates because the holding tax doesn’t apply on money lent, and that includes bank accounts.

To implement Natural Money, interest rates must be low or negative already, and remain low or negative in the future. It is assumed that this is going to happen because the factors that contribute to lower interest rates will probably remain in place. The introduction of Natural Money must be a gradual process in order not to disrupt financial markets.

Natural Money is expected to bring efficiency improvements in the following major ways:

• The removal of the zero lower bound allows interest rates to go negative if market conditions justify such rates. This means that the operation of money and capital markets is not hindered by the liquidity preference.
• The maximum interest rate curbs the risks lenders are willing to take. This promotes financial discipline. It also reduces moral hazard because the integrity of the financial system is a public interest that is guaranteed by governments and central banks.
• Natural Money mitigates the business cycle. The holding tax can provide a stimulus because interest rates can go as low as needed while the maximum interest rate can provide austerity as the amount of credit at a maximum interest rate of zero reduces when the economy improves.
• The economy can do well by itself so that government and central bank interventions are not needed. This can bring improvement because these interventions cause market distortions such as political business cycles and the mispricing of risk.

In this way Natural Money can enhance economic growth so that real interest rates rise. The amount of currency and debt are expected to remain stable over time so that prices will deflate. The maximum interest rate of zero can become a positive real return close to the economic growth rate. The improved economic stability can reduce the risk premium so that investments in Natural Money currencies can be attractive. This improved efficiency will cause a worldwide introduction of Natural Money.

Research

The thesis being investigated in this paper is that interest-free demurrage money, also called Natural Money, can improve the economy and reduce risk in the financial system, so that Natural Money should be able to defeat other forms of money in competition. This efficiency argument stands at the core of the thesis.

There is a lack of data and theory as to how an economy with Natural Money will operate. This paper centres on examining the consequences of implementing Natural Money in order to predict whether Natural Money is a feasible option for the regular financial system, and under which conditions that may be so. This paper is laying out a vision for economists to research upon.

The following issues are investigated in this paper:
• implementing Natural Money;
• removing the zero lower bound;
• the maximum interest rate;
• moral hazard and problematic debts;
• business cycles;
• fiscal and monetary policies;
• efficiency improvements.

Implementing Natural Money

To implement Natural Money, interest rates must be low to begin with. This requires financial discipline, most notably from governments. Governments can receive interest on their debts so this isn't austerity. Interest rates will probably remain low and may go even lower in the future, so that it becomes feasible to implement Natural Money.

The transition preferably is a gradual process that is well communicated in advance. The trend towards lower interest rates is expected to pave the way. The first step is introducing the holding tax in small steps so that market participants have time to adjust. Introducing a tax on currency is going to affect the liquidity preference, so that currency needs to be decommissioned in order to rein in inflation.

Cash is currency and subject to the holding tax. This can be implemented via an exchange rate. Cash can then depreciate relative to digital currency at the holding tax rate. A tax on cash and negative interest rates may arouse negative sentiments. The general public may accept Natural Money if the benefits of lower interest rates are well known. The market conditions causing lower interest rates, and the advantages of negative interest rates and a maximum interest rate need to be explained.

After the removal of the zero lower bound, a maximum interest rate can be introduced. The initial maximum interest rate must be sufficiently high in order not to disrupt financial markets. At first, the maximum interest rate may be set between 5% and 10% annually. It is assumed that interest rates will go down further in the future, and that sub-prime credit needs to be phased out, so that the maximum interest rate can be lowered over time.

Removing The Zero Lower Bound

The zero lower bound prevents interest rates from moving freely to where supply and demand for money and capital balance. This can obstruct an economic recovery because of the liquidity preference where market participants prefer holding cash to consumption and investments. The holding tax brings down the lower bound to the holding tax rate so that negative interest rates become possible.

Negative interest rates don’t alter the business of banks. There isn’t much difference between borrowing money at 2% to lend it at 4% and borrowing money at -2% to lend it at 0%. A concern sometimes expressed is that people may shun the currency because of the holding tax. Most money is in bank accounts and other investments that provide better yields. Money is the most liquid asset so people may accept slightly negative interest rates on money in bank accounts.

There is not much historic evidence to support these claims. Money with a holding tax existed in ancient Egypt for more than 1,000 years. This indicates that money with a holding tax can be stable and last a long time. In 1933, when interest rates were at the zero lower bound, a local currency with a holding tax resulted in a remarkable economic recovery in the Austrian town of Wörgl. This suggests that removing the zero lower bound can promote an economic recovery.

After the removal of the zero lower bound central banks can stop printing currency to satisfy the demand caused by the liquidity preference. Removing the zero lower bound reduces the demand for currency and can make investors look for the assets that central banks have piled up on their balance sheets. In this way quantitative easing can be undone, probably completely, and at a significant profit for the central banks.

Maximum Interest Rate

A maximum interest rate can hamper lending and borrowing. It caps the risk lenders are willing to take and causes a deleveraging of balance sheets. Insofar the maximum interest rate affects questionable segments of credit like sub-prime lending, this may be beneficial overall. More troubles can be expected in the arena of business finance. Private equity and partnership schemes like Islamic finance can fill the gap, but maybe this is not enough. Hence, the most contentious questions will probably arise in this area.

The maximum interest rate of zero needs some explanation. Interest is a major cause of financial instability. Central banks have to print additional currency to cope with compounding interest. If the financial system is to operate without intervention, the maximum interest rate should be zero.

There is little historic data on maximum interest rates. 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. More recent experiences with Regulation Q in the Unites States indicate that a maximum interest rate shouldn't affect the bulk of borrowing and lending. A maximum interest rate seems feasible if it is above the rate at which most borrowing and lending takes place.

Moral Hazard And Problematic Debts

Interest contributes to financial instability as interest is a reward for risk. 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, but the higher the fixed interest rate is the more likely the scheme will fail.

Figure 2: Wall Street Redux by John Darkow, Columbia Daily Tribune

All parts of the financial system are intertwined so these risks 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.

A maximum interest rate can deal with this issue. If it offers too little compensation for the risk of lending, lenders will refrain from lending and prefer equity investments. There will be fewer options for businesses to borrow. Schemes similar to Islamic finance can partially fill in the void. An Islamic bank is more like a partner in business than a lender. The bank and its depositors share in the profits as well as the losses of the ventures they participate in. This can have a stabilising effect.

A maximum interest rate discourages the creation of problematic debts. People and businesses with problematic debts often pay the highest interest rates and this affects their spending power. They might be better off if they can borrow at an interest rate of zero or cannot borrow at all. Borrowers then have to adjust their finances before their situation becomes problematic.

Business Cycles

Natural Money can deal with business cycles. When the economy improves, equity becomes a more attractive investment compared to debt because of the maximum interest rate. The funds available for lending will reduce so that the economy is less likely to overheat. If the economy slows down, negative interest rates can provide a stimulus. And in the absence of a debt overhang the economy is poised to recover soon.

There probably will be no inflation because the maximum interest rate of zero doesn't provide a compensation for the loss of purchasing power. This means that the funds available for lending will dry up as soon as inflation picks up so that there will be no expansion of monetary aggregates. Deflation will not be suppressed. Interest rates will be negative and can go as low as needed so that deflation will be accompanied by stable economic growth.

Fiscal And Monetary Policies

The holding tax removes the zero lower bound. This provides a stimulus when needed. The maximum interest rate curbs lending during economic booms. This provides austerity when needed. In this way business cycles can be mitigated. And so there might be fewer debt overhangs and financial crises. The economy will probably do well by itself and doesn't need interventions. Hence, fiscal and monetary policies may become obsolete.

The amount of monetary aggregates are expected to remain fairly stable. Central banks don’t lend money to banks so that central banks don’t set interest rates. This is possible because central banks don't add reserves to the banking system to cope with the compounding of interest. The holding tax provides a stimulus so deficit spending by governments isn’t needed either. On the contrary, negative interest rates require fiscal discipline.

This could mean the end of fiscal and monetary policies as we know them. Central banks and governments still need to step in if there is a crisis, because this is important for the trust within the financial system, but fewer interventions are needed, and possibly none at all. This can bring improvement because government and central bank interventions entail market distortions such as the political business cycle and a mispricing of risk.

As soon as inflation picks up, lending at zero interest becomes less attractive so monetary aggregates will not expand and inflation is reined in. Some flexibility may be needed to deal with temporary fluctuations in the demand for funds. For that reason central banks may lend money to banks at an interest rate of zero. This is an unattractive proposition for banks as they cannot lend this money at a higher rate, so they will use this facility as little as possible.

Superior Efficiency

Natural Money can improve the economy in the following ways:
• Without the zero lower bound the markets for money and capital can clear at the equilibrium rate so markets can function better.
• Interest rates can go lower if market conditions justify these rates, which can promote capital formation and bring more prosperity.
• The maximum interest rate can reduce the appetite for risk with lenders so that there will be fewer problematic debts and risk is transferred out of the financial system into the hands of investors, which curtails moral hazard.
• Business cycles are mitigated so there will be stable economic growth with fewer crises.
• The market distortions caused by fiscal and monetary policies can disappear.
• Income inequality can be reduced because the wealthiest people mostly receive income from their capital, which can promote social stability and lower the risks for investors.

Negative interest rates will probably coincide with price deflation. This is easy to see using the quantity theory of money. When the amount of money as well as the turnover of money remain constant, prices will fall as the economy grows. The value of the currency will appreciate approximately at the rate of economic growth. Deflation will take hold, and the economy will do fine. This can cause a monetary revolution as the following argument demonstrates.

Suppose that the economic growth rate is 2.5% per year, then a nominal interest rate of zero can be 2.5% in real terms. Even deposits with a nominal yield of -2% can have a positive real return that betters the yields on euro and dollar deposits nowadays. From a risk/reward point of view, the improvement could even be greater as the economy will be less prone to instability. The improved risk/reward picture can cause a capital flight to economies based on Natural Money. In this way Natural Money can become the money of the future.

Conclusion

The current predicament can be summarised as follows:

• Structural developments in money and capital markets cause interest rates to remain low and possibly to go even lower.
• At the zero lower bound the markets for money and capital become dysfunctional because supply and demand cannot clear at the equilibrium rate.
• Low interest rates allow for more capital and debt to exist, which means that debtors have less room to pay interest while creditors are faced with an excess of capital, and this puts a constraint on future interest rates.
• Business cycles cause debt overhangs because in times of optimism interest rates are above their natural level so that debts are made at high interest rates.
• The financial system is a key public interest guaranteed by governments and central banks so that the quest for yield promotes moral hazard.
• Debt fuelled spending to promote economic growth will not be an option in the future.

Natural Money can improve financial stability as well as economic growth. The feasibility of
Natural Money primarily depends on low interest rates. If irresponsible actions that push up the risk premium remain absent, interest rates will probably remain low and may go even lower. Low interest rates reflect a trust in the financial system and money. This requires financial discipline, most notably from governments. Governments can still spend more than they receive in taxes because they receive interest on their debts.

We can be more prosperous with lower interest rates. Lower interest rates make it possible to make the economy sustainable. Lower interest rates can reduce income inequality and promote social stability. Lower interest rates can bring down prices. Natural Money can promote financial discipline, economic stability and social harmony. Natural Money can help to reduce risk in the financial system and curb the moral hazard that comes with public guarantees for the financial system.

Economists should be inspired by this potential. Natural Money can help to end financial and economic crises. World War II wasn’t possible without the Great Depression so the importance of Natural Money doesn’t need further clarification. The alternative to new financial and economic crises can be unparalleled prosperity and social stability. This was the vision of Silvio Gesell. Hopefully he was only one century ahead of his time.

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.

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