Making the economy sustainable may require an unprecedented amount of capital in the form of knowledge and outfits like solar panels, sustainable farms and energy-efficient transportation systems. It is hard to imagine that it can be done. And imagining it is still a lot easier than really doing it. It is going to require some economic magic to divert investment capital from destructive activities to the future of humanity. We may need more useful capital and less consumption.
Perhaps the invisible hand can be of some help. It is easier to finance a great endeavour from investments than from taxation because nobody wants to pay taxes but everybody is happy to invest. It is the secret of the success of the European empires that conquered the world after the Middle Ages. England, France, Spain and the Netherlands were much poorer and smaller than China, India or the Ottoman Empire, but they didn’t finance their conquests with taxation, but with the use of investment capital.1
Europe won out because European conquerors took loans from banks and investors to buy ships, cannons, and to pay soldiers. Profits from the new trade routes and colonies enabled them to repay the loans and build trust so they could receive more credit next time.1 The same logic may need to be applied to making the economy sustainable. The challenge is so enormous that it may never be possible to finance it by taxes. Nowadays interest rates are so low because there is plenty of investment capital.
It’s the economy stupid!
It is often argued that the economy is unsustainable because of short-term thinking. The economy must grow in order to have positive returns on investments. And it is believed that returns on investments need to be positive otherwise the economy would collapse. The economic time horizons of individuals are reflected in their time preferences. The time horizon of the economy as a whole is reflected in the interest rate.
The lower the interest rate, the longer the time horizon of the economy could be. The following example from the Strohalm Foundation can illustrate this:
Suppose that a cheap house will last 33 years and costs € 200,000 to build. The yearly cost of the house will be € 6,060 (€ 200,000 divided by 33). A more expensive house costs € 400,000 but will last a hundred years. It will cost only € 4,000 per year. For € 2,060 per year less, you can build a house that lasts three times as long.
After applying for a mortgage the math changes. If the interest rate is 10%, the expensive house will not only cost € 4,000 per year in write-offs, but during the first year there will be an additional interest charge of € 40,000 (10% of € 400,000).
The long-lasting house now costs € 44,000 in the first year. The cheaper house now appears less expensive again. There is a yearly write off of € 6,060 but during the first year there is only € 20,000 in interest charges. Total costs for the first year are only € 26,060. Interest charges make the less durable house cheaper.2
Without interest there is a tendency to select long-term solutions. Interest charges make long-term solutions less economical. Interest promotes a short-term bias in the economy. It may explain why natural resources like rainforests are squandered for short term profits. If interest rates are high, it may be more profitable to cut down a rainforest and to put the proceeds at interest rather than to manage the forest in a sustainable way.
Only, things are not as simple as the example suggests. For example, the building materials of the cheap house might be recycled to build a new house. And technology changes. For example, if cars had been built to last 100 years, most old cars would still be around. This could be a problem as old cars are more polluting and use more fuel. Nevertheless, the example shows that long-term investments can be more attractive when interest rates are lower.
This also applies to investments in renewable energy. For instance, a solar panel that costs € 100, lasts 15 years, and generates € 150 worth in electricity in the course of these 15 years, is feasible at an interest rate of 5% but not at an interest rate of 10%. Many investments in making the economy sustainable may have low returns and are only feasible when interest rates are low. Low and negative interest rates can also deal with low economic growth. That may be needed for living within the limits of the planet.
Living within the limits of the planet
When interest rates are negative, the time horizon of the economy could go to eternity so that it makes sense to invest in making the economy sustainable. A few examples from history can illustrate this. In the Middle Ages some areas in Europe had currencies with a holding fee like Natural Money. As there hardly was economic growth, interest rates were negative. It was the era of Europe’s great cathedrals. These cathedrals were built for eternity. As better investment opportunities were absent, wealthy towns people spent their excess money on cathedrals.3 For similar reasons, the people of Wörgl planted trees as the proceeds of the wood were expected to occur in the distant future.3
A bit of calculus shows why. At an interest rate of 5%, putting € 1 in a bank account turns into € 1,05 after a year, so you would rather have € 1 now than in one year’s time, even when you need the money in one year’s time. That’s because you can put the money on a bank account at interest. At an interest rate of 5%, € 100 in one year’s time is worth € 95.25 now. The distant future has even less value. The same € 100 in one hundred year’s time is worth only € 0.59. And € 100 after 1000 years has no value at all in the present.
At an interest rate of -5%, you would prefer to have the money when you need it, otherwise you would end up with less. At an interest rate of -5%, € 100 in one year’s time would be worth € 105. The same € 100 in one hundred year’s time would be worth € 13,501 now. And € 100 after 1000 years would be worth more than everything there is in the present. Income in the distant future is also very uncertain, so it is unlikely that investors will shift their time horizon to 1,000 years, but this logic may help us to come into terms with the limits our planet poses on human activities.
Living within the limits of the planet may require unprecedented investments in the future. These investments may require low or even negative interest rates as their returns may be low. Only low and negative interest rates can make these investments economical. Everyone who has money to save can help by shifting money from consumption to saving and investing. The more people act like capitalists, the lower interest rates may go, and the more sustainable the economy may become.
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?
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 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.
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:
mortgages and loans
loans to other banks
deposits from other banks
cash, central bank deposits
the bank’s net worth
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:
short-term lending in money markets
insurance and credit lines
the shadow bank’s net worth
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.
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]
The short summary spills the beans already. 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 theme of this post, 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?
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.
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.
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.
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.
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 had serious long-term consequences.
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]
There is a saying, teach a parrot to say ‘supply and demand’ and you have an economist. Economics is about supply and demand. In order to understand how the invisible hand of a market economy operates, you should be familiar with the law of supply and demand. Not surprisingly, this is one of the most important laws in economics. This law states that the price is where supply and demand are equal. An example about the market for coffee can clarify the magic of the invisible hand.
If coffee would be free people might like to drink lots of coffee but producers can’t make coffee for free. Producers go bankrupt if the price is zero because they have costs, for instance employees and equipment. If the price of coffee is low, for instance € 3 per kilogram, that may not cover all the costs. Some producers can produce cheaper than others because they have more efficient production facilities, so when the price is € 5 a few producers might start producing coffee because they can make a profit.
That may not be enough to satisfy all the demand that is out there. The low-cost producers have a limited production capacity so they may be able to come up with 650 kilograms of coffee. Consumers might want to indulge themselves in 1,700 kilograms if the price is only € 5 per kilogram. In that case there would be a shortage of coffee of 1,050 kilograms. Consumers who fear that they are going to be left out of the action might then offer more money so that the price of coffee rises.
When coffee becomes more expensive some consumers might not be able to afford coffee. Others may buy less because they have other expenses like beer and milk. On the other hand, some producers might start making coffee because they can make a profit at these prices. So when the price goes up, supply goes up and demand goes down.
At € 10 per kilogram every producer may be able to make a profit, even those who have high costs, and producers may come up with 2,000 kilograms. However, consumers may only buy 600 kilograms if coffee costs € 10 per kilogram so there may be a surplus of 1,400 kilograms. Producers may then try to sell off their surplus at lower prices before it gets spoiled in order to recover some of their costs. When prices are lower, consumers are willing to buy more, but high-cost producers can’t make a profit and may stop making coffee. So when the price goes down, demand goes up and supply goes down.
The price may settle where supply equals demand. When the price is € 7 producers may make 1,200 kilograms and consumers may gobble up 1,200 kilograms. So € 7 per kilogram could be the price of coffee according to the law supply and demand. Of course, things in reality are a lot more complicated than that, but the law suffices for a basic understanding of markets. A graph can illuminate what has been discussed so far.
The graph above shows the quantities of coffee demanded and supplied at different prices. When the price goes up, demand goes down and supply goes up. The downward sloping black dashed line represents demand. The upward sloping black line represents supply. If the price is low the supplied quantity is low and the demanded quantity is high, leading to a shortage. At a price of € 5 there will be a shortage of 1,050 kilograms as demand is 1,700 kilograms while supply is only 650 kilograms.
If the price is high, demand is low and supply is high, leading to a surplus. If the price is € 10, there will be a surplus of 1,400 kilograms as supply is 2,000 kilograms and demand is only 600 kilograms. The lines of demand and supply cross at 1,200 kilograms and a price of € 7. Supply and demand are both 1,200 kilograms at a price of € 7, which must be the price according to the law of supply and demand.
In reality things often differ a lot from the simple model. There may be different qualities of coffee and each may have its own price. In some markets there is a lot of competition and corporations hardly make a profit. In other markets there is little or no competition and corporations make huge profits. And there hardly ever is an equilibrium as there are many factors that influence supply, demand and price, and they constantly change. Nevertheless, simple examples like this one are useful because they help to explain how a market economy works.
Featured image: Ara Economicus. Beverly Lussier (2004). Wikimedia Commons. Public Domain.
To understand market economies, you need to know about our invisible friend, the invisible hand. Somehow market economies can distribute goods efficiently without anyone planning this. According to the economist Adam Smith it is as if an invisible hand makes this miracle happen. His critics like Karl Marx didn’t believe in invisible friends. Not surprisingly Marx also didn’t believe in God. Smith claimed that if everyone pursues his own personal interest, the interest of society is often best served.
I’m the invisible man Incredible how you can See right through me
– Queen, The Invisible Man
The following tale demonstrates how the invisible hand does its magic. Whether or not it is actually true doesn’t really matter. The story goes that the mayor of Moscow once visited London in the 1980s. Back then Russia didn’t have a market economy. The mayor received a tour around the city and noticed that no one had to queue up for bread like everyone did in Moscow. There was an ample supply of bread at cheap prices while no bread was thrown away. Somehow bread was produced in the right quantities in the preferred tastes and supplied at the right places.
The mayor was truly 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 for himself or herself how much he or she was planning to make and sell and at what price. A few years later Russia switched to a market economy.
It is the individual decisions of bakers and the businesses working in the supply chain, for instance farmers and flour mills, that make this miracle happen. They all decide for themselves. If a baker could sell more than is produced he or she would miss out on profits. The same is true when bread is thrown away. And people are willing to pay more if the bread tastes better. Hence, every individual baker will do his or her best to make exactly the right amount of bread in the tastes people desire. It is in their best interest.
In Russia the state planned how much of every item was produced, where these items were shipped and what prices they were sold. Corporations couldn’t decide about prices. They received a compensation for their costs but they weren’t allowed to make a profit. Employees received a fixed salary. If a corporation produced more or better products, it still didn’t make a profit nor did the employees receive higher wages. Corporations also couldn’t go bankrupt when they did a bad job. This 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
There are instances where a market economy doesn’t produce the best outcome for society as a whole. Economists call them market failures. One can think of the following situations:
People may have far more desires than the planet can support and the market economy may fulfil those desires at the expense of future life on the planet.
Some people are not able to make in 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 to charge higher prices, most notably if it is hard for competitors to enter the market.
Some products cause harm to people or the environment but these costs are not paid for by the producers. For example, cigarettes cause health costs.
In most countries governments interfere with the economy in order to deal with market failures. These are situations where pursuing personal interests doesn’t bring the best outcome for society as a whole. What the best outcome is, is sometimes a matter of taste, but often it is obvious. Government intervention can make things even worse, so decisions about interfering are made after weighing benefits and drawbacks. In many democratic countries public expenses are about 50% of national income. People in these countries probably believe that market economy doesn’t always work best.
An example can demonstrate why. People in the United States live as long as people in Cuba.1 Cuba is a poor country without 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 the United States and Cuba.1 Cuba doesn’t spend a lot on health care, only 10% of what the United States spends per person. Healthcare in Cuba therefore appears extremely 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 people may not receive treatment when they can’t afford it because the United States has a market economy. There may be other causes too, for example differences in the diets in Cuba and the United States. There is no fast food in Cuba because Cuba has no market economy. Still, Cuba isn’t a great country to live in. People have been fleeing Cuba for decades and many Cubans moved to the United States. Cuba is a dictatorship and most Cubans are poor. Healthcare is one of the few things that Cuba has organised well.
The story about the visit of the mayor of Moscow demonstrates that the invisible hand of the market shouldn’t be ignored. Successful societies have market economies. Many public expenses are paid for by taxes on income generated in market economies. A market economy still needs a government to set the rules and to 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.
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 fulfill those needs and desires better. Therefore, the value of capital in a market economy often depends on how good it can fulfill the desires of consumers. Investors are willing to invest in corporations that fulfill 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 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 while 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]