Author: nivtric

Graffiti near the Renfe station of Vitoria-Gasteiz

The monster called financial system

nivtric4 Comments

Is the financial sector overtaking the real economy?

Less than 1% of foreign exchange transactions are made for trading goods and services. More than 80% are made for exchange rate speculation. Every three days an entire year’s worth of the European Union’s GDP of € 13 trillion is traded in the foreign exchange markets.1 So is the financial sector overtaking the real economy?

Financial industry share of total nonfarm business profits. Evan Soltas (2013)
Financial industry share of total non-farm business profits. Evan Soltas (2013). Economics and Thought.

In the United States financial sector profits grew from 10% of total non-farm business profits in 1947 to 50% in 2010.2 This figure excludes bonuses. It is explosive stuff and the original research has been removed from the Internet. The findings could give us the impression that the financial sector is a big fat parasite that feeds on us. And who would have guessed that?

What a scary monster the financial system has become. This terrible creature could easily wipe out human civilisation as we know it. That nearly happened in 2008. And it can still happen. We are hostage of this monster. It is too big to fail. But what created it? It wasn’t Frankenstein for sure. The answer is already out there for thousands of years. It is interest on money and loans. In the past this was called usury and often forbidden.

The core problem is that incomes fluctuate while interest payments are fixed. This causes instability in the financial system. And if the investment is more risky, lenders demand a higher interest rate, which contributes to the risk. Limiting interest would reduce leverage and make financial system more stable and less prone to crisis.

It’s the usury, stupid!

Fraud in the financial sector contributed to the financial crisis of 2008. To what extent the fraud or the size of the financial sector are to blame is less clear. Financial crises are not a recent phenomenon. They have caused economic crises in the past. For instance, the stock market crash of 1929 and the subsequent bank failures caused the Great Depression of the 1930s. Back then the financial sector was not as large as it is today and there was no large-scale mortgage fraud. Hence, there must be another cause.

Charging fixed interest rates on debts causes problems as incomes fluctuate. So if some person’s income or some corporation’s profit suddenly drops, interest payments may not be met. When the economy slows down that happens to a lot of people and corporations simultaneously, which makes the financial system prone to crisis. And interest is a reward for risk. Creditors may be willing to lend money to people and corporations that are already deeply in debt, but only if they receive a higher interest rate. So if interest was forbidden, that might not happen, and there could be fewer financial crises.

Banning interest has been tried in the past and it failed time after time. That is because without interest lending and borrowing wouldn’t be possible and the economy would come to a standstill. Until now there was a shortage of money and capital so interest rates needed to be positive, but that may be about to change. The increased availability of money and capital pushed interest rates lower. Money and capital may soon be so abundant that interest rates can go negative. That could be the end of usury.

The scary monsters in the financial system

Apart from exchange rate speculation there are frightening creatures like quantitative easing, shadow banks and derivatives. These things will be explained later in this post. Some experts believe that the financial sector is out of control. That may not be the case. Usury created this monster so Natural Money, which is negative interest rates and a maximum interest rate of zero, could make many of these seemingly hard-to-solve issues disappear, and perhaps shrink financial sector profits too.

Leverage, shadow banking and derivatives make the financial sector so profitable for its operators because of interest and risk. Interest is a reward for risk but interest also increases risk because interest charges are fixed while incomes aren’t. But more risk means more profit for the usurers because all that risk needs to be ‘managed’. That provides opportunities to profit for those who make the deals. Usury is the main cause of financial crises and generates most financial sector profits.

Quantitative easing

Quantitative easing means that central banks print money to buy debt with this newly created money. Trillions of dollars and euros have been printed so central banks now own trillions in debt. In this way the financial crisis of 2008 was stemmed. Investors and banks wanted to get rid of debts and preferred cash because there was a risk that some of these debts would not be repaid in full. This caused the crisis.

But what if there was a tax of 10% per year on cash and central bank deposits? Losing a few percent on bad debts suddenly doesn’t seem such a bad deal any more. Investors may have kept these debts and the crisis would not have occurred. The losses on bad mortgages turned out to be a lot less than 10% per year. That was also because the crisis was halted with central bank actions like quantitative easing.

If there had been a tax on cash and central bank deposits there would always have been liquidity. The crisis may never have happened in the first place and quantitative easing may not have been needed. And if this tax is going to be implemented in the future, investors may gladly gobble up the debt on the balance sheets of central banks, so that quantitative easing can be undone, and most likely at a profit for the taxpayer.

Shadow banks

In order to protect depositors, banks are subject to regulations. Regulations are bad for profits because they limit the risks banks can take. Bankers who were looking for bigger bonuses came up with a scheme that is now called shadow banks. Shadow banks don’t offer deposit accounts to ordinary people so regulations don’t apply. And so shadow banks can take more risk and generate more profits.

A shadow bank borrows money from investors and invests it in products like mortgage-backed securities. A mortgage-backed security is a derivative that looks like a bunch of mortgages. The owner of the security doesn’t own the mortgages themselves, but is entitled to the interest from the mortgages but also the losses when home owners fall behind on their payments. Not owning the mortgages themselves makes trading a lot easier because mortgages involve a lot of paperwork.

Shadow banks can be dangerous because bank regulations don’t apply. Ordinary banks are required to have a certain amount of capital to cushion losses so that depositors can be paid out in full when some loans aren’t repaid. The balance sheet of an ordinary bank might look like the one below:

debit
credit
mortgages and loans
€ 70,000,000
deposits
€ 60,000,000
loans to other banks
€ 10,000,000
deposits from other banks
€ 20,000,000
cash, central bank deposits
€ 10,000,000
the bank’s net worth
€ 10,000,000
total
€ 90,000,000
total
€ 90,000,000

But shadow banks don’t need to comply to these regulations because they don’t have depositors. And so the balance sheet of a shadow bank might look like this:

debit
credit
mortgage-backed securities
€ 500,000,000
short-term lending in money markets
€ 490,000,000
insurance and credit lines
the shadow bank’s net worth € 10,000,000
total
€ 500,000,000
 total € 500,000,000

What is so great about shadow banking, at least for bankers? If banks borrow at 2% and lend at 4%, the ordinary bank can make € 1,400,000. The bank’s net worth is € 10,000,000 so the return on investment is 14%. But the shadow bank can make € 10,000,000 and the return on investment is 100%. And you can imagine how great this is for bonuses. Only, if something goes wrong, there is little capital to cushion losses. That’s not a problem for the bankers because by then they have already cashed their bonuses. But it could become our problem as shadow banks can blow up the financial system.

If the loans drop 10% in value because some home owners fall back on their mortgage payments, the capital of the ordinary bank can cushion the loss of € 8,000,000, while the shadow bank goes down in flames leaving an unpaid debt of € 40,000,000. And now we get to the point where financial system blew up. It is the insurance and credit lines part on the balance sheet of the shadow bank. There is no value attached because credit lines so insurances don’t show up on balance sheets or only for a very low amount.

Ordinary banks guaranteed credit to shadow banks just in the case investors like money market funds didn’t want to invest in shadow banks any more. The great thing of credit lines for bankers is that they get a fee for these credit lines while they don’t appear on the balance sheet so that banks don’t have to cut back their lending. When homeowners fell behind on their payments, investors didn’t want to invest in shadow banks any more, and these credit lines had to be used. This means that ordinary banks had to step in and suddenly their capital wasn’t sufficient to cover the losses. Also going down in flames, were the insurers of mortgage-backed securities.

The United States had a government policy of stimulating home ownership. Under the guise of this policy mortgages were given to people who couldn’t afford them. Behind the scenes usury was to blame. If there was doubt whether the borrower could afford the mortgage, a banker could charge a higher interest rate to compensate for the risk. This made the mortgage even less affordable to the borrower. The solution for that problem was giving ‘teaser rates’, meaning that the interest rate was low during the first year so that the home owner could afford the mortgage payments at first. Meanwhile the mortgage was packaged in a mortgage-backed security so the banker was already off the hook when the home owner fell behind on his or her payments.

And there is more. Shadow banks offer higher interest rates to their investors. Shadow banks don’t have a lot of capital so investing in them is a more risky than putting money in a bank account of a regular bank. Investors in shadow banks need a compensation for that risk. That’s no problem because the enterprise is very profitable. It is therefore possible for shadow banks to pay higher interest rates. This might not be possible if interest was forbidden, unless shadow banks had a lot more capital to cover their losses, but that would solve the problem of them being too risky. It is usury that allows for risky schemes like shadow banks to exist.

The multi-trillion-dollar derivatives monster

In 2016 the notational value of all outstanding derivatives is estimated to be $650 trillion. This is the so-called multi-trillion derivatives monster. This figure is more than eight times the total income of everyone in the world.3 Some people are spooked by the sheer size of that number. And indeed, derivatives can be dangerous. In 2003 the famous investor Warren Buffet called derivatives ‘financial weapons of mass destruction’.

Five years later derivatives played a major role in the financial crisis. An improper use of derivatives nearly brought down the world financial system. But derivatives can be useful. Most banks use derivatives to hedge their risks. Banks that managed their risks well using derivatives fared relatively well during the financial crisis compared to banks that didn’t.4 Therefore, derivatives are probably here to stay.

But what about the multi trillion monster? The number is a notational value, not a real value. Derivatives are insurance contracts, often against default of a corporation, a change in interest rates, or home owners falling behind on mortgage payments. You may have a fire insurance on your house to the amount of € 200,000. This is the notational value of the contract. You may pay the insurer € 200 per year. That is the real value of the contract, until something happens, that is.

If your house burns down, the contract suddenly is worth € 200,000. Insurers often re-insure their risks, which is a prudent practice. But re-insurance makes the notational value of the outstanding derivatives increase. So if your insurer re-insures half of your fire insurance to reduce its risk exposure, another contract with notational value of € 100,000 is added to the pile of existing insurance contracts.

So what went wrong? If suddenly half the houses in a nation catch fire because there is a war, insurers go bankrupt. The cause of the financial crisis was many home owners falling behind on their payments at the same time so that insurers of derivative contracts like mortgage-backed securities went bankrupt. The American International Group (AIG) was the largest insurer of these contracts and it was bailed out with $ 188 billion. The US government made a profit of $ 22 billion on this bailout, but only because the financial system wasn’t allowed to collapse.

In a financial crisis a lot of things go wrong at the same time. The financial system can’t deal with a major crisis. If it happens, it may cause the greatest economic depression ever seen, and in retrospect it may herald the collapse of civilisation.

The usury issue

Money circulation in the economy is like blood circulating in the body. It makes no sense for a kidney or a lung to keep some blood just in case the blood stops circulation. The precautionary act makes the dreaded event happen. It is a self-fulfilling prophecy. A financial crisis is like all parts of the body scrambling for blood at the same time. When the blood circulation stops, a person dies. An if the money circulation stops, the economy dies. Hoarding is to blame for that.

Perhaps big banks are too big to fail. Breaking them up may not help because the banking system is closely integrated. Banks lend money to each other. If a few banks fail then others get into trouble too. And in a crisis all the trouble happens at the same time. So perhaps it is better to address the cause of failure itself, which is interest on money and debts. And it may be possible because interest rates are poised to go negative.

A tax on cash makes negative interest rates possible. It can also keep investors from hoarding money. If money keeps on circulating, there may never be a crisis. The crisis happened because investors scrambled for cash when they feared they might lose money on bad debts. But if they expect to lose more on cash, they might keep their debts. And there may have been fewer bad debts in the first place if there had been no interest on debts as interest is a reward for risk.

Featured image: Graffiti near the Renfe station of Vitoria-Gasteiz. Wikimedia Commons. Public Domain.

1. The rise of money trading has made our economy all mud and no brick. Alex Andreou (2013). The Guardian. [link]
2. The Rise of Finance. Evan Soltas (2013). Economics and Thought. [no link because the information has been removed]
3. Here’s What Makes the Derivatives “Monster” So Dangerous (for You). Michael E. Lewitt (2016). Money Morning. [link]
4. Financial innovation and bank behavior: Evidence from credit markets. Lars Norden, Consuelo Silva Buston and Wolf Wagner (2014). Tilburg University. [link]

Arab farmer taking straw to his farm. Public domain.

Clutching at a straw

nivtric2 Comments

I read The Limits of Growth in my late teens. Perhaps, I was twenty already. I was young and hoped to live for another sixty years or so. And suddenly, a computer told me that I would live to see the end. The evidence and the logic were convincing. For a long time, I had hardly thought about the impending doom. As a child, I sometimes feared the future when hearing the disturbing song Vluchten Kan Niet Meer or Fleeing Is No Longer Possible on the radio. It unnerved me profoundly as it painted a dismal time ahead where nature would be gone. But that faded once I went to secondary school. After finishing my studies, I became an environmentalist and joined a local Friends of the Earth group in Groningen in 1993.

Friends of the Earth is an international environmental organisation known in the Netherlands as Mileudefensie. They had local groups of activists, most notably in student towns like Groningen. The organisation researches environmental issues and tries to convince people they should change their lifestyles. Friends of the Earth also lobbies with politicians and pressures corporations. Our group was a hodgepodge of students, people with a job, unemployed, activists and ordinary people led by a woman in her thirties, who acted as an Akela at the boy scouts. A 22-year-old student was her boyfriend.

We were not militant like Greenpeace, but sometimes we protested. One day we blocked the entrance of Groningen Airport to protest against the government subsidies for the airport. The police came and told us to leave, which we did. I then concluded that activism would not help. We will not give up our comfortable lifestyles and vote out politicians if they are serious about solutions. And businesses will go bankrupt if they do more to save the environment than others. Their products would be more expensive, and we wouldn’t buy them. And so there were underlying economic and political issues to address. We organised ourselves around themes, for instance, vegetarianism, air pollution, and economic issues. And these caught my interest.

We were short of money, but that changed when I became the treasurer. I took measures to make expenses match income, but I also had some luck. Every year, we obtained a small grant of 2,500 guilders from both the Groningen province and the Groningen municipality. But when I became treasurer, the provincial administration had just denied the allowance we had received the previous years. And so I wrote an appeal to the Appeals Commission. I then went to the Provincial House to discuss the issue with the official responsible for the grant. He explained that it was because we had been late filing our request, and the money jar was already empty. And so, I asked him whether there was any point to the appeal. He said no. It was a done deal. Then I received an invitation for a hearing at the Appeals Commission. I decided not to waste my time by going there, so a commissioner called me that evening, asking me why I hadn’t shown up. And I told him. That probably touched a nerve, as I gave him the impression that no one took the Appeals Commission seriously. And so, our appeal was granted, and we received the subsidy. As I had made a budget that did not anticipate this money and had implemented budgetary discipline, we ended up with income exceeding expenses.

Once over a cliff, a cartoon character can only clutch at a straw. And only in animation pictures the straw holds. The Dutch saying clutching to a straw means grasping to your last hope. On economic issues, our local group worked together with Strohalm, or more precisely, Rinke. He lived in Groningen and was actively engaged in Strohalm and their ideology. As I remember, he was on social benefits, and working for Strohalm and Friends of the Earth was his job. He was serious about it and worked hard. The meaning of the Dutch word strohalm is straw. According to Strohalm, the economy must grow because of interest, and that’s destroying our planet. It is ‘grow-or-die’ because interest rates need to be positive. Interest charges also cause escalating debts, poverty and financial instability. And in the end, the scheme will collapse because the interest adds to the principal until infinity. Any solution begins with ending that, they believed. And as you may have inferred already, I was into sound accounting, so this made me think. Strohalm aimed to ban interest and charge a fee on money, as Silvio Gesell had proposed. You didn’t have to pay the fee on money lent. In this way, it could be attractive to lend money without interest.

In those days, Strohalm started a LETS (Local Exchange Trading System) in Groningen. We exchanged goods and services using fictitious currency. We had a camp to train our persuading skills as environmentalists. Rinke was one of the organisers. He praised me several times and called me an example for others. That was not because of my social skills but because I knew what other people thought and how they would react. My parents and some friends frowned upon me joining the environmentalist movement.

I soon realised that there were serious issues. If you can receive interest elsewhere then why would you lend out money without interest? And if you can borrow money at an interest rate of zero, you would borrow as much as you can and put it in a bank account at interest. Therefore, interest-free money with a holding tax would not work. Only, that wasn’t particularly satisfactory. If you accept doom then you might as well commit suicide. If interest is the root of many social and environmental problems, and can destroy human civilisation, you should make it work. And perhaps it could work. During the Great Depression, it had been tried in a small Austrian village and it was a stunning success.

I am concerned about the planet. For years, I used public transport. And I still do it for work. But at some point, I realised it was pointless. More and more people started driving SUVs. They didn’t care about the planet. So if I saved petrol by taking a train, there was only more for those people. It didn’t matter what I did. A car makes your life comfortable, and I didn’t aspire to higher moral standards than others. So, I bought a car in 2003.

In 1998, I became a freelance IT specialist. I worked for a small bureau named Betamax, led by Martien, a retired manager. I made lots of money, so I had some capital to invest. My first investments were small and unprofitable, as I believed that profits matter. At the time, loss-making internet startups did very well in the stock market, while profitable corporations did poorly. But I had trouble understanding it. And so I thought I had to stay informed about the financial markets. In 2000, I joined the investment message board Iex.nl. At the time, I still said occasionally, ‘With SuperBart,’ when taking up the phone. That was fun and it sometimes caused hilarious moments, for instance, once I expected a call from Ingrid, but it turned out to be Martien. And so, I chose this name as my avatar.

Later I changed my avatar into niphtrique after someone noted that SuperBart sounded arrogant. And since then, I never took up the phone anymore saying, ‘With SuperBart.’ I didn’t need that to feel better anymore. A strange thing about avatars is that you somehow become this person, SuperBart, on the Internet because people do not know you. And so, I introduced a few other avatars to be someone else and have some fun. Most avatars didn’t last long, except dikkevettebeer, or plumpy fat bear, who believed the stock market would crash to zero and the gold price would rise to infinity.

A colourful investment fund manager, Michael Kraland, ran the message board. He also wrote commentaries about his investments. At the time, he rode the hype of the internet and telecom bubbles. His strategy was risky and not sound advice to inexperienced investors. And because he was a bit of a boaster, he received nasty negative comments on the message board, including unproven accusations of wrongdoing. And perhaps also because he was a Jew, which might not be accidental, as he worked in finance. And even though, as far as I know, he never did anything illegal, I nevertheless found him a dubious character.

After some time, a day trader named Cees joined the message board and began sharing conspiracy theories with us. He found them on US message boards and websites. If the markets were about to collapse, a secret group called Plunge Protection Team would come to the rescue. A stock market crash could undermine confidence in the financial system run by Wall Street, so they didn’t allow that to happen. Many readers first ridiculed Cees. But after the internet bubble had popped, and even more so after 9/11, markets often miraculously recovered when they were about to crash. And so, his credibility gradually rose. And the gold price regularly cratered because of sudden selling at peculiar times when most markets were closed. Cees believed central banks were behind this to promote confidence in their currencies. He wrote that if the gold price were to rise, the public would lose trust in our money. When there is little trade, you can sell a bit of gold to make the price drop. The trick was to break a trend. Trend traders, called technical traders, would then join the bandwagon by selling more gold, bringing down the price even further.

That was new to me, and perhaps it wasn’t all true, but there was ample reason to be suspicious. I had already bought some gold for other reasons. I didn’t trust financial markets and those operating them. Those people make a living from your money, so these stories intrigued me. They might be pulling out all the tricks to keep the Ponzi scheme of interest-bearing debt going. After all, debts continued to grow, as did interest payments, so there could soon be a day of reckoning. And I had read The Limits of Growth, so I feared collapse was inevitable. And if the sky has come down on you once, you worry it might happen a second time. Hence, I was constantly on edge concerning my investments, which was not helpful for profits. And I was not good at picking stocks. And so, I bought gold as a long-term investment. I also hoped that gold ownership could help me weather a financial collapse.

I bought my first gold in 1999 before I joined Iex.nl when I learned on the news that the gold price had reached historic lows. And so, I went to my bank to open a gold account. They sent an investment advisor to talk me out of it. He said, ‘No one does that anymore. I know a man who has a silver account with us for two decades. And silver has gone nowhere all that time. Gold mines are making losses because the price of gold is only going down. You should invest in the stock market instead.’ I smelled apathy concerning the precious metals and concluded it could be the beginning of a long-term trend of rising gold and silver prices that might run for decades, which indeed has happened. And so, I pressed on and opened a gold account. Perhaps, they had a good laugh that day at my bank office.

In 2001, after the Internet bubble had popped, I pitched the idea of interest-free money on the message board of Iex.nl. My lack of knowledge of the financial system didn’t deter me. Everyone can participate in a debate on a message board, and you can exchange thoughts with people you would never meet otherwise. Others rebutted me time after time, but I didn’t give up. Lengthy discussions followed, and they took several years. As these discussions proceeded, my knowledge of the financial system increased. And with the benefit of hindsight, debates on the Internet can be more fruitful than academic debates, which often occur in closed circles, because you get more perspectives.

In theory, interest-free money is a sound idea because fixed-interest payments destabilise the financial system. But practical issues stood in the way. The supporters of interest-free currencies didn’t address them. And economists never took interest-free money seriously because if you can receive interest elsewhere, you will not accept interest-free money. Via gold websites, I became familiar with the Austrian School of Economics and their adherents. They question money creation by banks and the need for central banks and point at the inflation caused by money creation. Some hoped to limit money creation or to return to a gold standard. Usually, they were libertarians who saw the government as the root of all evil. And unlike St. Paul, they saw sound money and free markets as the root of all blessings. They were a most peculiar and fanatic bunch, and even though they were on the opposite side of the political spectrum, a comparison with communists is most apt.

Both ideologies are like religions. Like the communists have their prophets, such as Marx, Lenin and Engels, libertarians have them, like Mises, Hayek, and Rand. And both religions have holy books. Communists have Marx’ Das Kapital or the Communist Manifesto, and libertarians have Rand’s Atlas Unshrugged or Ludwig von Mises’s book The Theory of Money and Credit. If their ideology fails, communists blame the capitalists, while libertarians blame the government. They appear to see money as a goal, not a tool. If you held alternative views like me, they might accuse you f being Keynesian, which seemed worse than being Satan himself. To me, these people seemed misers obsessed with money. Perhaps it is not a coincidence that their hero, after which they named their website, is Ludwig von Mises. So Mises for misers, if you didn’t get it already. And even though Wall Street is much eviler than they are, they represent the worship of Mammon in its purest form. They believed they were always right, so they tried hard to convince me I was wrong with my ideas about interest. And so, I learned as much from the Austrians as I learned from Strohalm. And if you come to think of it, perhaps it is also not a coincidence that the miracle of Wörgl happened in Austria.

Two opposing fringe ideas, interest-free money with a holding tax and the Austrian School view of hard money, challenged each other in my mind. It is how Hegelian Dialectic is supposed to work. It was not so that I was constantly brooding on this issue, but I also couldn’t let it go. In 2008 this resulted in a synthesis, Natural Money. In a gold standard, you need positive interest rates to get the economy going. As a result, you end up with unsustainable debt levels that you can never repay in gold, so you must leave the gold standard. But when you do that, the sky is the limit, and debts can escalate to infinity. But limiting the interest rate to zero can curb money creation too, and stop irresponsible lending. If the money supply is stable and the economy grows, prices drop, including the gold price. And so, a well-managed currency with a holding fee could be stronger than gold. As the economy can do better without interest, interest-free money can give better returns. That was the beginning. In the following decade, I produced a more comprehensive theory with the help of modern monetary economics.

Latest revision: 30 January 2023

Featured image: Roadrunner and Wile E. Coyote. Warner Bros. [copyright info]

Master of my own destiny?

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It’s a miracle

In early 1993, I started to look for a job. My first application was for an IT traineeship at Cap Gemini. They had sixteen vacancies. Some 1,600 people applied, of which they selected 200 for a series of tests. I was one of them. Before these tests began, other applicants told stories about assessments and job interviews they had gone through. The economy fared poorly, so there weren’t a lot of jobs. Many graduates were already searching for a long time. It was discouraging, so I expected to remain unemployed for quite a while.

That was not meant to be. The tests went well, and they invited me for an interview and some more psychological tests. On my way to the appointment, a guy I knew from dormitory Witbreuksweg 389-2 came sitting on the opposite seat on the train. He asked me why I was wearing a suit. I told him about the interview. Then he started to laugh loudly. ‘Your tie is a mess,’ he said, ‘Let me fix it for you.’ He then arranged the tie correctly.

If this event, which appeared accidental at the time, hadn’t happened, they may not have hired me. The interview and the tests went well. My misfortune because of not fitting in during my student years made me investigate cultures and cultural differences. It wasn’t hard for me to translate the expectations of Cap Gemini concerning its employees into test answers. And so, the test results made it appear as if I fitted perfectly into the corporate culture of Cap Gemini. Cap Gemini stressed I was the master of my own destiny. It was one of their company slogans.

They hired me and sent me to a junior programming class to prepare for my first assignment. My self-confidence was low as I had manipulated the test. Perhaps, I didn’t fit in. And it was shortly after the encounter with Suzanne. I was afraid to turn up because I felt unfit for the job. These feelings receded once the class had started. We learned about programming. I was often joking about a programme I was planning to write. I nicknamed it DoEverything as it was supposed to do everything, which is noteworthy because we may be part of such a programme.

My classmates often discussed what car they would choose once they were on the job. I was the only one planning to use public transport. Not surprisingly, I was not a model employee. One classmate, a cheerful guy from the Eindhoven area named Ad, expressed his amazement about the fact that I passed all the tests. ‘There were 1,600 applicants. And they picked you? It’s a miracle! How could that happen?’ Ad and I had a good laugh about it. His last name referred to Burgundy. In the Netherlands, a Burgundian lifestyle denotes enjoyment of life and good food, most often found in the vicinity of Eindhoven. And Ad radiated this lifestyle. He seemed the personification of it. His first name and the region he came from make another peculiar coincidence in light of later developments.

With regard to the work that awaits us

My first assignment was on a project at the Groningen office of Cap Gemini. I became part of a team of six with a few colourful personalities. Our customer had hired us but didn’t come up with work. For months we had nothing to do, but we had a lot of fun. And I had more fun than I ever had during my student years. Our project manager was ambitious. He organised project meetings and demanded progress reports he could present to senior management even though we did nothing. One of us was a graduated linguist, so he used his skills to produce eloquently written progress reports. For instance, he wrote, ‘With regard to the work that awaits us, we can only assume a wait-and-see attitude.’

Another guy was a hippie and had been part of the squatters’ movement. He always wore the same orange sweater. Perhaps, he had two orange sweaters, but I am not sure. He was the type of guy who might wear the same sweater for months. He often made fun of the project leader and his ambitions. At the time, Windows was gradually becoming the standard operating system. It had new features like WAF files for sounds. Some team members played around with these features, so if I started my computer, it sometimes made an unexpected noise. I had so much time on my hands that I familiarised myself with database administration. After a few months, the work came in, so the project manager was busy managing our work. He constantly demanded progress updates.

We soon realised we would miss our deadline at the end of July. Before the project manager went on a holiday, he discussed the situation with our customer and arranged a new deadline date at the end of August. Once he was gone, things suddenly went smoothly, so we met the original deadline date in July, possibly because the project manager stopped managing us. When he returned, the programmes were already running at the customer’s site. His superiors praised him for delivering a month ahead of schedule. He was on his way to a great career. Perhaps he received a bonus too.

There is room for improvement

The next job was restructuring a database at a telecommunications company. I had some database knowledge. And my managers were impressed that I had familiarised myself with database administration. And so, I did get that job. The company doubted the capabilities of their database administrator, so they hired me to reorganise one of their databases. They took this delicate task out of the hands of their own database administrator and gave it to me, a novice with little experience. And so, their database administrator didn’t like me from the start. And I didn’t follow his advice because he was a bungler. After all, that was the reason they hired me. And he was showing off his expertise by using incomprehensible language, so I often had no clue what he was talking about.

It was a highly political environment. The telecommunications company had been a government operation for a long time, but the government had just privatised it and put its shares on the stock market. The board wanted to purge the old-fashioned government bureaucrats from management positions. And the department I worked for was led by a risk-averse bureaucrat fearing for his job. If something went wrong, his head might roll. And the database administrator might have felt that his position was on the line too. He often complained about me to his manager. And the manager passed on these complaints to Cap Gemini. I also had a team leader who knew the situation and gave a more accurate depiction of what I was doing to his manager and my account manager. That is why they didn’t take me off the job.

And I caused a major accident. To reorganise the database, I needed a list of the tables in the production database and their sizes. Production is the database that matters. The data in the production database is precious. For that reason, I had no access to the production database. There are also databases for development and testing. But I needed production data, so I prepared a file named tablelist.sql containing a query that delivered the necessary data. And for once, they allowed me to access the production database using a tool called SQL Plus. I could start the script by typing @tablelist and pressing enter. I started typing @t. The system didn’t respond, so I pressed enter to see if there was any response at all. And then, I saw the system respond with table dropped, table dropped, table dropped. I cancelled it, but it was already too late. Some precious data was already gone. The operators restored a backup of the previous night, so a day’s work was lost. The database administrator had left a file named t.sql in the SQL Plus directory, dropping all the tables. It was an accident waiting to happen. And even though everyone knew that, the incident reflected poorly on me. With the benefit of hindsight, it was odd. How much bad luck can you have?

Because of the fuss, Cap Gemini sent me to a course called Professional Skills. I was not politically sensitive, and that could be a handicap when you work at the site of a customer. I was aware of that as I had a way of formulating things clearly, so I considered it a good idea. And the course taught me something. For instance, positive framing can contribute to a better atmosphere. You can call it political correctness. So if it is a complete mess, you can say, ‘There is room for improvement.’ Even though it is the same mess, it sounds a lot better. After all, a consultant’s primary responsibility is not to solve problems but to make money for Cap Gemini by making the customer happy. I let it all pass by, concentrated on my task and successfully finished the database restructuring job.

My next assignment was at the real estate department of the telecommunications company. They hired me to make database queries in their financial system for management information. Usually, managers or salespeople wanted a report promptly. It was always very important and, of course, very urgent. I called them jokingly life-and-death queries. It took a few hours to write a query, check the validity of the output, and deliver the report. By then, it often wasn’t needed anymore. The availability of the data rather than necessity created a demand for these reports. In other words, the reporting usually wasn’t that important. Over time, I found patterns in their requests, so I made a set of standard queries with parameters and delivered 90% of the reports on the spot. No one had ever thought of that, so they saw me as a genius and hired me for a longer time to work on their systems.

Hit the moving target

Cap Gemini emphasised the concept of employability. You were responsible for your employment by ensuring your skills were in demand. ‘Hit the moving target,’ is what they called it, referring to the constantly changing market for skills. You must be there where the demand for skills is. During a company meeting, they once gave us toy guns to aim at moving targets on a large projection screen in the front of the room.

Times were changing, and I had been working on the obsolete systems of the real estate department for a few years. My manager and I agreed I had to catch up with the latest developments. In 1995 and 1996, two new development tools, Oracle Developer/2000 and Designer/2000, came to the market. And so, they sent me far away from home, to Zeist, where Cap Gemini had started an Oracle Developer/2000 software factory, a marketing term for a group of people working with Oracle Developer/2000. Zeist was far from home, so I stayed in a hotel nearby. The newest tool was Oracle Designer/2000, and Oracle introduced it when I worked at the software factory. It had a promising future. Designer/2000 could generate Developer/2000 programmes, so you didn’t need to write them yourself. I gained experience with Developer/2000 and also Designer/2000. After a year, I hoped for a Designer/2000 assignment near home.

My manager agreed, but there was trouble brewing once again. An account manager came up with a prospective assignment. I knew him. He was a rough guy who only cared about his bonus. People like him might have done well in the Wild West, playing poker, staring down opponents and engaging in brawls in saloons. I told him that I specifically aimed for a Designer/2000 assignment as I had invested much time and effort in Designer/2000. He said, ‘The customer is planning to switch to Designer/2000, and you can play a role in that process.’ He didn’t disclose any additional information. His vagueness put me on high alert, and I presumed he was planning to dupe me. And so, I warned him that I would decline the job if it wasn’t Designer/2000.

I contacted my manager and discussed the situation with him. I had invested much time in Developer/2000 and Designer/2000 and had been away from home for a year. I would rather stay away from home a few months more if needed to get a proper Designer/2000 assignment. Designer/2000 was just released, so work had yet to come in. If you intend to hit a moving target, you must aim just in front of it, considering the direction of the movement. It takes time for the bullet to arrive at the target. By then, the target had already moved a bit further. So, I was already there, where the target would soon be. And there was plenty of work at the software factory. And so, I asked him if I could decline the job if it wasn’t Designer/2000. He said that sales targets were important and we all must do our bit. But I was supposed to be the master of my own destiny. Knowing that my Designer/2000 skills would soon be in high demand, I said I would look for another employer if that would be his stance. He then gave in.

But the account manager pressed on, ready to make the kill. Before the interview with the customer, another department of the telecommunications company, we once more discussed the assignment. And again, he didn’t say much more than, ‘They are planning to switch to Designer/2000, and you can play a role in that process.’ Once more, I warned him in no uncertain terms. And despite his name being Warner, he didn’t appear to understand what a warning was. Still, his name was endowed with a whiff of coincidence. Then came the interview. The department manager told me they planned to use Designer/2000, but their people would do the Designer/2000 work. They needed me to maintain their obsolete systems. And my resume was perfect as I had been looking after the old programmes of their real estate department for a long time. That was the role I could play in the process. And the account manager knew that all along.

Assuming that the account manager was ready to close the deal and seal my fate, I declined and said I wasn’t informed about the nature of the assignment. And so, I humiliated the account manager in front of the customer and made Cap Gemini lose face. The account manager probably had believed he could get away with it. Indeed, I didn’t want to cause a fuss again, but I thought Designer/2000 to be crucial for my future employment. After all, life is a bitch. If you end up with obsolete skills, you end up unemployed. A few weeks later, I did get a Designer/2000 assignment in Groningen, so close to home that I could bike to work again. Later, my manager said that my actions were unprecedented and had raised several eyebrows. On closer inspection, I could have been a model employee, and more than Cap Gemini might have hoped for.

Walking out of Paradise, once again

After moving to Sneek, I looked for a job near home. There was a vacancy for a software designer at FBTO, an insurer in Leeuwarden. It later turned out that the job included being a project leader. The insurer had split the IT department into smaller teams working for a business unit. Every three weeks, we planned our tasks for the coming three weeks, and a business unit representative determined the priorities. It worked well as we had fewer political games, like business units competing for resources. The IT department was well organised compared to what I had seen elsewhere. This way of running IT departments has become commonplace two decades later.

The team knew what they were doing, so I felt redundant as a project leader. There is no point in managing people who know what to do. The atmosphere was friendly. I had grown accustomed to grim conditions, so I felt out of place. I could have gotten used to the friendliness but not the job itself. All those documents, meetings, and priorities were boring. Building information systems was much more fun. I was qualified for Oracle, but FBTO didn’t use Oracle. I decided to try my luck as a freelance Oracle Designer/2000 developer and database administrator. And so, I walked out of Paradise again, but this time out of my own will. After all, Cap Gemini had taught me that I was the master of my own destiny. But an ominous incident would soon suggest that I was not.

Latest revision: 7 January 2023

Featured image: Cap Gemini logo

The future of interest rates

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There is a relationship between the amount of capital in a market economy, wealth inequality, savings, the level of debt, and interest rates. If an economic depression or a world war can be avoided, this relationship may decide the future of interest rates, and interest rates may go negative. If this makes you yawn, you have read the message already, and you can proceed with more exiting ventures like checking out what your friends are doing on Facebook or Instagram.

If instead you are thrilled by the idea of knowing more about this relationship, you may continue reading. Interest rates are the result of supply and demand for money and capital. Money and capital differ from consumer goods like coffee and services like haircuts. Money is a medium of exchange. You use money to buy and sell consumer goods and services. And capital isn’t consumer goods or services either. Capital is used to make these consumer goods and services. Hence supply and demand for money and capital need a separate explanation.

The price of money

A kilogram of coffee might cost € 7 in France and $ 8 in the United States. But what does that mean? Is coffee more expensive in the United States than in France? That entirely depends on the price of the dollar and the euro. If one dollar is worth € 0.80 then $ 8 is € 6.40, which is less than € 7. The price of the euro and the dollar change every day because of changes in supply and demand in the market for euros and dollars. But the price of euros and dollars is not the price of money, at least according to economists.

When economists talk about the price of money, they do not mean the price of dollars and euros. They talk about the interest rate. The supply and demand for money and capital determine the interest rate, hence the interest rate is the price of money. This price has a relation with the returns on capital because investments in capital are an alternative to lending. Money isn’t produced and consumed like coffee. If you borrow money, you may have to return it with interest. Borrowers may pay for the use of money, not for the money itself.

There are people and corporations that have savings as well as people and corporations that need money for consumption or investment. So there is supply and demand for money. But what determines the supply and demand for money and therefore the interest rate? It begins with the choice people have when spending their income. They can choose between consumption and saving. Savings can be used for investments in corporations to make products and services in the future.

Consumption versus investment

Economists sometimes use a simple model consisting of only households and businesses to explain things like consuming and saving. Households consume the stuff businesses make. In order to make that stuff, businesses need investment capital provided by households from their savings. It is important to notice that some households borrow and some businesses save, but on balance households save while businesses borrow to invest.

Households can do two things with their income. They can either use it for buying stuff, which is consumption, or save so that businesses can invest. For example, if you are a plumber and need to buy a new van for your business, which is an investment, you may have to forego a new car for your family, which is consumption, to save money for the van. You could also borrow the money for the van so that you can buy the family car too, but in that case someone else has to save so that you can borrow.

If people spend a lot of money on consumption, businesses sell a lot of stuff and make great profits. Businesses may be willing to invest so that they can sell even more and make even more profits. But if there are only a few savings because people spend a lot of money on consumption, so businesses might fear they can’t borrow and may be willing to pay higher interest rates, so that interest rates go up.

When interest rates go up, some businesses may abort their investment plans as they don’t expect to make enough money to pay for the interest. At the same time, more households may be willing to save. So when interest rates go up, the demand for money goes down and the supply of money goes up.

On the other hand, if households save a lot of money and do not consume, there are a lot of savings, but businesses are not willing to invest because they have trouble selling stuff and making profits. In that case households fearing that they don’t receive interest on their savings are willing to lend at lower interest rates, and interest rates go down. But how do households choose between consuming and saving?

Time preference

Economists believe that your choice between saving and borrowing depends on your time preference as well as the interest rate. Time preference is your willingness to forego your needs or desires in the present in order to fulfil your needs or desires in the future. An example can illustrate this. Assume that you want to buy a new car. You want that new car now but you don’t have the money. You can either wait and save to buy the car later or you can borrow to buy the car now.

Assume the car costs € 10,000. If the interest rate is 10%, you may realise that borrowing money to buy the car will cost you dearly. If you pay back € 1,000 each year, you repay the loan in 10 years. Over that period you pay € 5,500 in interest so the car will cost you € 15,500 instead of € 10,000. The alternative is to wait and save money to buy the car.

If you can manage saving € 1,500 per year and the interest rate on savings is also 10%, you could buy the car after less than six years. But then the car only costs you € 8,250 because you receive € 1,750 in interest. At an interest rate of 10% borrowing money to buy this car costs nearly twice as much as saving.

That may convince you to save and drive your old car for six more years. If the interest rate is lower, you may find borrowing more attractive than saving because you would rather have the new car now. Your time preference tells how strong your desire is to have the car now rather than later. It determines the interest rate you are willing to pay. Not surprisingly, different people have different time preferences.

Time preferences affect interest rates. Suppose that you want to borrow money for a new car. Suppose that you can only borrow the money from John. John has € 10,000 but he wants to buy a car too. Time preferences are going to decide whether or not John is going to lend you this money. If your time preference is 7% and John’s time preference is 5%, he will keep his old car for a while and lend the money to you. He may do this because he expects to buy a bigger car once you have repaid your loan with interest.

The interest rate could be anywhere between 5% and 7% depending on your and John’s negotiating skills. You won’t borrow at interest rates above 7% and John won’t lend at interest rates below 5% but any interest rate between 5% and 7% is acceptable to both you and John. In this way time preferences affect interest rates.

When interest rates go down, more people may borrow and fewer people may save because of their time preferences. If the interest rate is 4%, John may buy that bigger car now and borrow the money to buy it. If the interest rate is 8%, you would save to buy the car. When interest rates rise, more people may opt for saving instead of borrowing. The interest rate may move to where supply equals demand, which depends on the time preferences of lenders and borrowers but also on the demand for investment capital.

Capitalist spirit

Time preference only works for ordinary people. There are other people too. They are called capitalists. You probably have heard about them. Capitalists think differently. They suffer from a condition called capitalist spirit, which is having little or no time preference. Capitalists think that money spent on a frivolous item is money wasted, because when you invest your money, you end up with more money that you can invest again.

Capitalists save regardless of the interest rate. They rather invest in the distant future when they are dead than spoil their money on frivolous items during their lifetimes. Consequently capitalists end up with a lot of money when they die. What’s the point of that? Capitalists invest in businesses that make the frivolous items ordinary people enjoy. Ordinary people wouldn’t have invested their money, but spent it on frivolous items instead so that these items wouldn’t have been produced in the first place.

Perhaps you think that all capitalists are wealthy. But that isn’t true. Anyone who saves as much as he or she can regardless of the interest rate can be called a capitalist. What is important here, is that the capitalists as a group own most capital, and because capitalists own so much money and capital, and keep on saving and investing, there is a surplus of savings. And if there is a surplus of savings at an interest rate of zero, the interest rate should be negative according to the law of supply and demand.

Convenience

When you lend money to someone else you can’t use it yourself. There may be a new mobile phone you want to buy, but alas, you have lent out your money. This is not convenient. But then you remember with a smile on your face that you will be able to buy the phone but also an additional hip phone cover next year because you receive interest on that loan. So, if you don’t receive interest on your money, you may not bother lending it out because you may suddenly need it. Interest rates on long-term loans are higher than interest rates on short-term loans because the longer you can’t use your money, the less convenient it is.

When you deposit money at a bank, you lend it to the bank but you can still use it any time. That is possible because when you make payment, for example for legal advice, this money ends up the account of the lawyer. The bank will then be borrowing this money from the lawyer instead until she uses it to pay someone else. This is convenient so you are willing to lend money to a bank. For that reason interest rates on current accounts and checking accounts are low. Having money in a bank account is more convenient than cash so the bank may even charge you for having an account.

Risk

Lending out money can be risky. There are two types of risk. First the borrower may not pay back the loan. That could make you reluctant to lend. So if someone of questionable integrity wants to borrow money from you, and you fear that she may not pay back, she could offer you a very high interest rate so that you might think, ‘Well, she may not pay back, but the interest rate is very attractive, so I’ll take my chances and do it anyway.’

Second, money may become worth less in the future. This is called inflation. If there’s a lot of inflation then the money that buys a mobile phone today may only buy a phone cover next year. In that case you may spend your money right away on a mobile phone before it is too late. That is unless someone wants to borrow the money from you and offers a very high interest rate, so that your can buy a better model next year.

The business of a bank is to know its customers. For that reason lending money to a bank is less risky than lending out money to an individual or a corporation. And because banks are supposed to be good at managing risk, they can borrow at lower interest rates, meaning that interest rates on bank accounts are lower than those on loans.

And because banks know their customers and lend to many different people, they can manage risk better than you can and lend at lower interest rates than you are willing to because if you lend money to a someone you don’t know, you may desire a higher interest rate because you don’t know whether he or she is going to repay the loan.

Returns on investments

If you have money, you could invest it in corporations or real estate. Corporations pay dividends and real estate pays rent. If the rents and dividends are higher than the interest rate you get by lending out your money, you may prefer investing to lending. But investing is more risky than lending. If sales are sluggish, profits may go down and dividends may be cut, but lenders still get their interest. Nevertheless investments are an alternative to lending, so if investments offer better yields, you may opt for investing.

If someone wants to borrow money from you, the interest rate must be high enough otherwise you may invest this money instead. Other people who have money are in a similar position. Borrowers need to offer attractive interest rates in order to be able to borrow. Similarly, if dividends and rents are low, people with money may prefer lending to investing, so that borrowers can negotiate lower interest rates. In this way the returns on investments affect interest rates on loans.

The type of money used

The properties of money can affect interest rates. Just imagine that apples are money and you are saving to buy a house. If someone wants to borrow 1,000 apples from you, and promises to repay those 1,000 apples after 10 years when you plan to buy your house, you would gladly accept this generous offer. You may even accept an offer of 900 apples because that is better than letting your apples rot. In this case you would settle for a negative interest rate. But you would only do so if there are no alternatives.

If you could make 10% per year in the stock market, you could exchange your apples for Apple stock because their gadgets are in great demand and outrageously expensive. In that case, it doesn’t matter that apples rot and you could demand interest on a loan. But if returns on the stock market are low or when stock prices are fluctuating so wildly that you can’t sleep at night, you may prefer the offer of 900 apples.

If the money had been gold, you would never accept such an offer, even when the stock market is doing terrible. You can always keep your gold in a safe deposit box. Similarly, you wouldn’t accept negative interest rates on euros or dollars because you can take your money from the bank and store the bank notes in a safe deposit box. The problem with this is that if you put money in a safe deposit box, other people can’t use it for buying and selling stuff. And this can cause an economic depression.

Central banks

It is often said that central banks set the interest rate. But how do they do that? Central banks can print money. If central banks believe that the interest rate is too high, they print more money so that there is additional supply and interest rates go down. On the other hand, if central banks believe that the interest rate is too low, they print less money so that interest rates go up. If the central bank says that it sets the interest rate to 3%, this means that it will print precisely enough money to keep the interest rate at 3%.

Why do central banks print money? Money isn’t produced and consumed like coffee. If you borrow money, it has to be returned with interest. Most money is debt so where does the interest come from? Capitalists let their money grow on their bank accounts so the money to pay the interest from must come out of thin air. Individual borrowers may be able to repay their debts with interest but on aggregate borrowers can’t.

More money needs to be borrowed to pay for the interest. That’s why the total amount of debt increases each year. And if people aren’t borrowing enough, the central bank may print more money to prevent a financial crisis.

Sometimes people don’t borrow enough to keep the economy going and sometimes they borrow too much so that the economy is overheating. Central banks adapt their money printing to prevent these things from happening. Central banks raise interest rates and print less money (or stop printing money or even destroy money) when they want people and businesses to borrow less and they lower interest rates and print more money when they want people and businesses to borrow more.

The future of interest rates

Interest rates went down because capitalists acquired more and more capital over the years and kept on saving and investing regardless of the interest rate. In the past returns on capital have mostly been higher than the economic growth rate while most returns were reinvested so that a growing part of total income was for capitalists. As capitalists reinvested most of their capital income, this is not sustainable in the long run.

interestvers
Capital income (red) versus total income with capital income growing faster than total income

The graph above shows how total income and capital returns (in red) develop if the economic growth rate is 2%, the return on capital is 5%, capital income starts out as 10% of total income, and all capital income is reinvested. After 25 years the economic pie has grown faster than interest income and more is available for wages. At some point interest income starts to rise faster than total income, and less becomes available for wages. And after 80 years there’s nothing left for wages.1

This graph explains a lot about what is going on in reality. When wages started lagging, people couldn’t afford to buy all the stuff corporations made. As a consequence business profits, which is capital income, went down. In the short run it was possible to prop up business profits by allowing people go into debt to buy more stuff. But at some point people couldn’t borrow more unless interest rates went down. As capital income went down, capitalists became willing to lend money at lower interest rates, allowing people to borrow more to buy stuff. As interest rates went lower, more and more people went into debt because interest rates moved below their time preferences.

Nowadays most people are borrowing from the capitalists, for instance via mortgages, car loans, and credit cards, but also via governments as governments borrow from the capitalists too. Many people and governments can’t afford to borrow more. Interest rates are already near zero and may need to go negative if the law of supply and demand is going to do its job. In that case capitalists may start handing out money to the rest of us so that we can keep on buying the stuff their corporations make.

Capitalists may only lend at negative interest rates if money is like apples and not like gold.2 When interest rates are negative, people may buy land or real estate so that the prices of these properties may rise. Property taxes are often based on the value so properties may become less attractive at higher prices. Alternatives are gold or bitcoin, but at some point gold or bitcoin may become so expensive that the risk of losing money on these investments could deter people from buying more. Nevertheless, these alternatives put a constraint on how low interest rates can go. Interest rates must remain attractive for investors.

1. The End Of Usury. Bart klein Ikink (2018). Naturalmoney.org. [link]
2. Feasibility Of Interest-free Demurrage Currency. Bart klein Ikink (2018). Naturalmoney.org. [link]

Heaths near Nijverdal

Our invisible friend

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Market economy

Market economies have an invisible friend called the invisible hand. In market economies, goods are distributed without the need for a planning agency. According to Adam Smith, it is as if an invisible hand makes this miracle happen. His critics, for instance, Karl Marx, did not believe in invisible friends. Not surprisingly, Marx also did not believe in God. Smith claimed that if everyone pursues his own interest, the interest of society is often best served. The followers of Marx felt that the state should plan the production and distribution of goods and services.

I’m the invisible man
Incredible how you can
See right through me

– Queen, The Invisible Man

The following story demonstrates how the invisible hand does its magic. Whether or not it is true does not matter. The story goes that the mayor of Moscow once visited London in the 1980s. Back then, Russia did not have a market economy. The mayor received a tour around the city and noticed that no one queued up for bread as everyone did in Moscow. There was an ample supply of bread at affordable prices. Somehow bread was produced in the right quantities for the preferred tastes and supplied at the right places.

The mayor was amazed about this feat, so he said to his hosts, “Back in Moscow our finest minds work day and night on the bread supply and yet there are long queues everywhere. Who is in charge of the supply of bread in London? I want to meet him!” Of course, no one was in charge. That’s the secret of the market economy. Every baker decided how much he was planning to make and sell and at what price. A few years later, Russia switched to a market economy.

The individual decisions of bakers and the businesses in the supply chain, for instance, farmers and flour mills, make this miracle happen. They all decide for themselves. If a baker could sell more than he produced, he would miss out on profits. The same is true when he has to throw away bread. And some people are willing to pay more if the bread tastes better. Hence, each baker tries to make the right amount of bread to the tastes people desire. It is in their best interest.

In Russia, the state planned how much of each item a corporation should produce. Corporations could not decide on prices. They received compensation for their costs but could not make a profit. Employees received a fixed salary. Corporations that produced more or better products and their employees did not benefit. Corporations also could not go bankrupt when they did a terrible job. That resulted in poor-quality products, a shortage of nearly everything and even outright famine from time to time.

It doesn’t always work out well

This miracle has enchanted quite a few people. They believe that everything will turn out fine if only markets can do their job. But there are many instances where a market economy doesn’t produce the best outcome for society. Economists call them market failures. One can think of the following situations:

  • We have more desires than our planet can support. A market economy may fulfil those desires at the expense of our future.
  • Many people cannot make a living in the market economy, for instance, because they lack the skills or have little bargaining power.
  • Corporations use lobbyists and bribe politicians to pass legislation that favours them.
  • A government may be a more efficient producer of products that do not benefit from competition, for instance, roads and the power grid.
  • Corporations may abuse their power and charge higher prices, most notably if they have no competitors.
  • Products can cause harm to people or the environment, but producers may not pay these costs themselves. For example, cigarettes cause health costs.

In most countries, governments interfere with the economy to deal with these market failures. These are situations where pursuing personal interests does not bring the best outcome for society. In many democratic countries, public expenses are about 50% of national income. People in these countries probably believe that a market economy does not always work best. In some areas, markets produce extremely poor outcomes, for instance health care.

An example can demonstrate why. People in the United States live as long as people in Cuba.1 Cuba is poor and does not have a market economy. The United States spends more on health care than any other country in the world. Every possible treatment is available in the United States. Still, in more than 40 countries, people live longer than in the United States.1 Cuba does not spend a lot on health care, only 10% of what the United States spends per person. Healthcare in Cuba appears efficient compared to healthcare in the United States. How can this be?

The available treatments in Cuba are free for everyone. In the United States, you may not receive treatment when you cannot afford it because the United States has a market economy. There may be other causes, for example, differences in diets in Cuba and the United States. There is no fast food in Cuba because Cuba has no market economy. Life in Cuba may be miserable, but healthcare is one of the few things Cuba has organised well.

Successful societies have market economies and governments that organise things that the market fails to do. And a market economy still needs a government to set the rules and enforce them. Governments of successful societies aim at making the market economy work better where it is beneficial for society and constraining it where it does more harm than good.

Capital

Market economy and capitalism are so closely related that many people believe them to be the same. Capitalism is about capital. Capital consists of the buildings and the machines corporations own, but also the knowledge of how to make products and how to bring them to the market. Knowledge of how to make a film entertaining might be capital for a film company. Networks of customers and suppliers can be capital too if they contribute to the success of a business. The same applies to contracts and brands. For instance, the brand Coca-Cola has a lot of value because people are willing to pay more for cola when the logo of Coca-Cola is printed on the bottle.

Building capital can be costly but in a market economy the value of capital doesn’t depend on the cost to build it but on the future income it is expected to produce. This can lead to peculiar situations. When investors have no faith in the future of a corporation because it is expected to make losses, the buildings and the machines on their own may be worth more than the corporation as a whole as those buildings and machines could be used by other corporations for more profitable purposes.

In most cases, more capital means more wealth because capital produces the things people need or desire. Corporations tend to be more profitable if they fulfil those needs and desires better. Therefore, the value of capital in a market economy often depends on how well it can fulfil the desires of consumers. Investors are willing to invest in corporations that fulfil those needs and desires because they expect to make money by doing so.

It is sometimes argued that when investors are free to invest in the corporations of their choosing, the invisible hand channels investment capital to the most useful corporations because they are the most profitable. That’s why the value of corporations is important in a market economy. Businesses ‘create value’ for investors by making consumers happy. Still, the value of a corporation might not reflect the benefits for society as a whole. For instance, if the profitability of a corporation comes from exploiting people or harming life on the planet, a high value could be a bad sign.

And capital can be useful without being profitable, for instance in the public sector. A hospital in the public sector may have no market value because it doesn’t make a profit but it can be useful nonetheless. Capital in the public sector might even be more valuable than in a market economy. For instance, making hospitals private enterprises for profit might not benefit society as a whole. Hospital care may not improve from the competition as it is often best to have one hospital serving a particular area. And patients might receive unnecessary treatments when hospitals can make a profit. Healthcare in the United States may create a lot of value for investors but it doesn’t always benefit the patients.

As there are basically two types of people, capitalists who save and invest and ordinary people who borrow and spend, it is hardly surprising that capitalists tend to be wealthier than ordinary people. Capitalism can create wealth because it is the capitalists who finance the investments in the corporations that make the items ordinary people enjoy, but this wealth is often unevenly distributed. From a moral perspective, it is a problem that poverty still exists when there could be enough for everyone. So the question that still remains is how to make the economy work better for the benefit of all?

Featured image: Our invisible friend photographed in the moorlands near Nijverdal. Jürgen Eissink (2018). Wikimedia Commons. Public Domain.

1. Life expectancy per country 2017. World Population Review. [link]