When I was eighteen years or so I once read The Limits of Growth. That’s depressing stuff, most notably if you’re young and expect to live for another sixty years or so. Doom seemed imminent and I would probably live to see it happen. That was the moment when my views about the future turned grim. Before that I hardly had any views about the future at all. A few years later I became an environmentalist and a member of Friends of the Earth in Groningen. Friends of the Earth does research and tries to convince people that they should change their lifestyles. Friends of the Earth also lobbies with politicians and pressures corporations. And sometimes we protested.
One day we blocked the entrance of Groningen Airport to protest against the government subsidies for the airport. The city council felt that Groningen needed an airport but Groningen wasn’t big enough to make it profitable. When we were sitting there, the police came to remove us, and it suddenly became clear to me that activism didn’t help. Politicians will be voted out of office when they are serious about solutions. Businesses will go bankrupt if they take appropriate action unless all other businesses do the same. The required measures are extremely costly and will affect our lifestyles so profoundly that it would never happen in the current political and economic system.
Desperate times require desperate measures. Once being over a cliff, a cartoon character can only clutch at a straw. And only in cartoons the straw might hold. Friends of the Earth in Groningen worked together with the Strohalm Foundation. The meaning of the Dutch word strohalm is straw. According to Strohalm, the economy must grow because of interest, and that’s destroying the planet. It is ‘grow-or-die’ because interest rates need to be positive. Any solution begins with ending interest, they believed, and interest causes a lot of other problems like poverty and financial instability. Strohalm’s idea was banning interest and charging a fee on money as Silvio Gesell had proposed, so that it would be attractive to lend out money without interest.
Economists didn’t take interest-free money seriously. If you can receive interest then why 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 never work, at least so it seemed, and it didn’t take long before I realised that too. Only, that wasn’t satisfactory. Accepting doom is not much unlike committing suicide. If interest is the root of so many social and environmental problems, and may even destroy human civilisation, you can’t ignore that. And perhaps Natural Money could work. During the Great Depression it had been tried in a small Austrian village and it was a stunning success.
For years I didn’t own a car and used public transport as much as possible. At some point I realised that it was pointless. My efforts were thwarted by other people. For instance, more and more people started driving SUV’s. These people didn’t care it seemed. What’s the point in making such a sacrifice if other people don’t. A car makes your life a lot easier. People tend to chose comfort and I am not different or better than most people.
A few years later, in 1998, I became a freelance IT specialist. I made a lot of money so I had some money to invest. My first investments were small and not very successful. That was because I believed that the profits of corporations matter. But investments in loss-making internet startups did very well while profitable corporations did poorly. And so I came to believe that I had to stay informed about the developments in the financial markets. In 2000 I joined the investment message board Iex.nl.
On the message board was a day trader who shared all kinds of conspiracy theories with us. For instance, if the markets were about to collapse, a secret group called Plunge Protection Team would come to the rescue. He was ridiculed, but after the internet bubble popped, the markets often miraculously recovered when they were about to crash. And gold often crashed because of some mysterious overnight selling. The day trader believed this happened because central banks wanted to keep confidence in their currencies and gold was an alternative to central bank currencies. As long as the gold price didn’t rise, he claimed, people would trust central bank currencies. I had no idea about what happened in the financial markets so this was new to me but I already had bought some gold because I didn’t trust financial markets and the people operating them.
In 2001, after the Internet bubble had popped, I felt it was time to pitch the idea of interest-free money on the message board. My lack of knowledge was eclipsed by my zeal so lengthy discussions followed. On the Internet people from different backgrounds and different knowledge can be in one virtual room and participate in the discussion. I was rebutted time after time, but as these discussions went on, my knowledge of the financial system gradually increased, and I became aware of many of the issues that had to be resolved in order to make interest-free money work.
As a gold investor I became familiar with the Austrian School of Economics, which was a group that questioned money creation by banks and the use of central banks. They pointed at the inflation caused by money creation and central banks. At some point all the debt banks created would eventually collapse the financial system and money would be worthless, they believed. They didn’t think that negative interest rates are possible.
And so two opposing fringe ideas, interest-free money with a holding tax and Austrian School, were challenging each other in my mind, which may be how Hegelian dialectic is supposed to work. In 2008 that became the start of the theory on Natural Money as it is both negative interest rates and ending debt expansion. The initial discovery was that the economy can do better without interest so that returns for investors can be higher. As positive interest rates are not allowed, the money may rise in value faster than interest accrues on interest-bearing currencies, so that interest-free money can give better returns. Hence, interest-free money was possible or even inevitable. In the decade that followed I have integrated modern main stream economics into the theory of Natural Money.
After working for Cap Gemini I became a freelance IT specialist. A few years later there weren’t any freelance jobs available. And so I started as a database administrator at a government agency near home. Most people in the Netherlands know about the agency because it processes traffic fines for the police. It didn’t take long before I was seriously tested. Already on the second day one of the main systems crashed, leaving a corrupt database. After two days of research I realised that the exact cause might never be found so I advised to upgrade the database software to see if it solved the issue.
Instead management decided to turn it into a crisis and to set up a multi disciplinary task force to deal with it. They decided that the cause of the crash should be found. Every day at 10 AM there was a meeting of the task force to discuss the state of affair. There was no progress so every day I proposed to upgrade the database software. And every day my proposal was brushed aside. After two weeks of investigating the cause had yet to be found and managers were getting desperate. Upgrading the database software ended the crisis. Knowing the solution matters more than knowing a lot of other things like for instance the cause. This was a harbinger of things to come.
There were some serious issues with access rights in the main systems so in 2005 I built an account administration system named DBB to solve these issues. DBB automated granting and revoking access rights for all the main systems based on job roles. Nobody ordered me to do it but I expected that it would be appreciated. Instead DBB faced opposition and red tape. In 2005 I introduced it in a sneaky way with the help of the people who wanted to use it. After DBB had been installed, there was no way back because DBB solved a pressing business problem while there was no alternative.
The logo of DBB was a drawing made by my wife Ingrid. It features jokers grinning at a set of file folders symbolising bureaucracy. Bureaucrats considered it a rogue system but it worked well. DBB made a joke out of them so the logo became a bit prophetic. For more than ten years they were busy scheming and devising plans to replace DBB. Two projects were started to this aim. The first one was halted prematurely because the complexity of the matter had been underestimated. In 2016 a new project team realised that it was pointless to replace DBB. After eleven years the main systems of 2005 had become of age and it was expected that they would be decommissioned within a few years, so that DBB could retired together with those systems.
DBB was also joking me. In June 2010 someone requested me to drop a user. This was an unusual request as normally DBB took care of that. In fact, this hadn’t happened for several years. The username I had to drop was rather peculiar: ELVELVEN. If you read that aloud, you say eleven elevens in Dutch, a reference to 11:11. Usernames were made up of the first one or characters of the employee’s first name followed by the last name in full. To me 11:11 signals a combination of two related unlikely events that are related. And indeed, the joke had a part two, and it was even more peculiar.
In 2014, when I was testing an improvement to DBB, a test signalled that an illegal account had sneaked into our systems. The username was the first character of the first name followed by the last name of the lady who appeared to be God. If she had been employed with us, this would have been her username. And her name isn’t common like Jane Doe so this is peculiar, even more so it was the only username that popped up. It turned out that a guy with the same last name had been employed with us. His first name began with the same letter as hers. The account wasn’t illegal but I had mixed data from two different dates for the test, which made it appear that way.
In 2005 my manager promised me a promotion. He believed there should be a senior rank for experienced database administrators. He didn’t take a lot of action so I tried to make him put his promise into writing. That took a lot of effort. Just before he left, he wrote it down, only he gave me just a minor wage increase, not the promotion he promised earlier. A few weeks later I was summoned to the human resources department. A bureaucrat had come up with a technicality so I couldn’t even keep the minor wage increase. Having it in writing didn’t help. My manager had left and his temporary replacement didn’t care.
When I arrived at home Ingrid told me that a freelance agency offered me a job. This was the first time this happened after I had stopped working as a freelancer three years earlier. I was angry because I had worked so hard to have the promise in writing, because I didn’t trust the bureaucracy, but that didn’t matter because I was right, so this was a peculiar coincidence. And so I made a rash decision and resigned. It didn’t take long before I started to have second thoughts. There weren’t many jobs for database administrators near home and my physical condition didn’t allow for long travels. There were also issues with my son so working far from home wasn’t an option. There was a new manager who accepted my change of mind. And after a few years of bureaucratic wrangling, the promotion to the senior rank came through.
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 2,000 people applied and 200 of them were selected for a series of tests. At the tests other applicants were telling stories about assessments, tests and job interviews. The economy fared poorly so there weren’t a lot of jobs and many graduates were already searching for a long time. It was discouraging to hear their stories and I expected to remain unemployed for quite a while.
That wasn’t meant to be. The tests went well and I was invited for an interview and some more psychological tests. When I was in the train on my way to the interview, a guy who had lived with me in a dormitory, came sitting on the seat in front of me . 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 put in order for you.” He arranged the tie correctly.
If this event, which appeared mere chance at the time, hadn’t happened, I may not have been hired. The interview and the tests went well. The misfortune during my student years because of not fitting in groups had made me investigating culture and cultural differences, so it wasn’t hard for me to translate the expectations of Cap Gemini with regard to its employees into test answers. The tests made it appear as if I fitted perfectly into the corporate culture of Cap Gemini. And so I was sent to a junior programming class to prepare for my first assignment.
I was afraid to turn up. I felt unfit for the job. My self-confidence was low and I had manipulated the test results to make it appear that I fitted in. During the class we learned about programming. I was often joking about a programme I was planning to write. It was named DoEverything as it was going to do everything. It is a remarkable coincidence that I later fount out that such a programme may already exist.
My classmates were discussing what type of car they were going to drive once they were on the job. I was the only one planning to use public transport. I was not a model employee. One classmate, a cheerful guy coming from the Eindhoven area, expressed his amazement about me having passed all the tests. Remarkably, his name refers to the initials of the lady who appeared to be God. She later moved to the Eindhoven area.
The first assignment was a project at the Groningen office of Cap Gemini. For months we had nothing to do. I often went out late but I also did some additional training. Our project manager was ambitious. He organised project meetings and demanded progress reports he could present to the senior management even though there was nothing to do. After a few months, the computers and the work came in, and the project manager was busy managing our work. He constantly demanded progress updates.
It soon became clear that we were going miss our deadline at the end of July, so before he went on a three-week holiday, the project manager arranged a new deadline date at the end of August. Once he was gone, he didn’t bother us any more. Things suddenly went smoothly so we were able to meet the original deadline date in July with ease. When the project manager returned, all our programmes were already installed, so he was praised by his superiors for delivering a month ahead of schedule.
My next job was a database job at a telecommunications company. The company had difficulty tracking what their database administrator was doing. I was hired to reorganise one of their databases. This important task was taken out of his hands and was given to me, a novice without experience. For that reason he didn’t like me from the start. To make matters worse, I wasn’t following his advice because he was a bungler. That was the reason I was hired in the first place.
There was a fuss because of my disturbed relationship with the database administrator. Cap Gemini sent me to a training called Professional Skills. I was not politically sensitive. I didn’t let political expedience stand in the way of doing what’s right or saying what needs to be said. But framing things positively can contribute to a better atmosphere, they learned me. This is what political correctness is about. Cap Gemini stressed that I was the master of my own destiny. It was one of their company slogans. And I believed it.
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.
Simple examples like this one are used to explain how a market economy works. In reality things often differ in some or more aspects. 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. The amount of competition often depends on how easy it is to enter a market. When you need little capital and expertise to start a business, it is easy to enter the market, but competition is often intense.
Featured image: Ara Economicus. Beverly Lussier (2004). Wikimedia Commons. Public Domain.