loan shark

Why all interest is usury

In the past when borrowers couldn’t pay their debts with interest they became the serfs of money lenders. That’s why interest was often forbidden and called usury. Most people have forgotten about that. But nowadays most money is debt on which interest must be paid. And that is the reason why there are so many problems in the financial system like instability, increasing debt levels, inflation, and central banks having so much power.

Incomes fluctuate but interest payments are fixed. And interest is a reward for risk. So the less a debtor can afford to pay interest, the higher the interest rate will be. The lender is rewarded with a higher interest rate to take that risk. It is therefore not surprising that the financial system is unstable.

Even more importantly, money is loaned into existence and must be repaid with interest. So if the interest rate is 5% and there is € 100 in existence then € 105 must be returned after a year. But where does the extra € 5 come from? There are a few options:

  • Lenders spend some of their balance so borrowers can pay the interest.
  • Some borrowers default so a part of the balance is not returned.
  • Borrowers borrow more.
  • The government borrows more.
  • The central bank creates the shortfall out of thin air.

All these things happen and often at the same time. Lenders on aggregate let their capital grow at interest. A few defaulting borrowers are acceptable but too many defaults can easily cascade into a financial crisis and create an economic crisis. The cost of letting the financial system fail is so big that this option is not acceptable. So if no-one else is willing to borrow then the government or the central bank steps in.

That’s why debts continue to grow. That’s why there is inflation. That’s why we have economic crises. That’s why governments are running deficits. That’s why there are financial crises. That’s why we need central banks to save us. That’s why all fixed positive interest rates on money and debts are usurious, even when they are low. The following example can demonstrate that.

Suppose that Jesus’ mother had put a small gold coin of 3 grammes in Jesus’ retirement account at 4% interest in the year 1 AD. Jesus never retired but he promised to return. Suppose now that the account was kept for this eventuality. How much gold would there be in the account in 2020? The answer is an amount of gold weighing 12 million times the mass of the Earth.

A mere 4% yields an incredible amount of gold after 2020 years. Someone has to pay the interest, in this case the people who borrowed money from the bank. If Jesus doesn’t come back to spend his money, that’s impossible. At some point the debtors can’t pay the interest, let alone repay their debts. They can only borrow more or default. Lowering the interest rate doens’t solve the problem. It only postpones the reckoning.

Ending usury by banning interest was never possible. Lending and borrowing would stop or go underground. The capitalist economy requires lending and borrowing so without interest it would never have been possible to build a modern capitalist economy. But interest rates are poised to go negative so it may soon become possible.

Natural Money is interest free money with a holding fee. The holding fee on money makes it attractive to lend out money at negative interest rates. For example, if the holding fee is 10%, lending out money at an interest rate of -2% will save you 8%. Once most interest rates are negative, positive interest rates can be forbidden. That can end reckless lending without producing a financial or economic crisis.

What does ending usury mean? Interest is everywhere. Interest is hidden in taxes, rents, the price of all the products and services you buy. Most pay more interest than they receive. Ending interest will benefit most people as 90% pays interest on balance while only the to 10% richest people receive interest on balance. But there is more to it. A few consequences:

  • You can’t borrow if your finances are in dire straits. Lending money to people in financial distress shouldn’t be left to the markets.
  • People and businesses will become less leveraged as there is no incentive to that. Risky ventures will be financed with equity.
  • The business for banks does’t change much. Borrowing money at -2% to lend it at 0% is as profitable as borrowing money at 2% to lend it at 4%.
  • Financial engineering will be reduced as financial engineering schemes like LBO’s often involve great leverage.
  • The economy can find support in the negative interest rate so governments don’t need to go into debt to stimulate the economy.
  • The maximum interest rate can curb debt creation for as soon as the economy recovers equity investments become more attractive relative to debt.
  • It can be a blow to political corruption because borrowers need to be trustworthy, and that includes governments, so taxes must cover government expenses.
  • This is not austerity as governments don’t pay interest on their debts but instead receive interest on their borrowings.

Ending interest reduces leverage and this can stabilise the financial system and the economye. The holding fee can ensure that the economy will flourish. Money with a holding fee has brought the economy of the Austrian town of Wörgl back to life in the midst of the Great Depression. Ancient Egypt had a financial system with this money for more than 1,000 years. Usury can end very soon and it may never come back.

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The miracle of Wörgl

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Joseph in Egypt

Ancient Egypt had a money with a holding fee for more than 1,000 years. The Bible that might explain how this money came into existence.

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The future of interest rates

In the long run most capital ends up in the hands of the capitalists. Negative interest rates are the logical consequence.

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Featured image: Loan shark picture circulating on the internet, origin unknown.

 

What is the use of banks?

Turning debt into money

The previous episode about money discussed some imaginary trades between you, a hatter, a lawyer, a barber and a fisherman. It is shown that if people promise to pay this might suffice for payment. So if the fisherman promises you to pay next week for the hat you just made, you could say to the lawyer that you expect the fisherman to pay in a week, and ask her if you can pay in a week too. The lawyer could then ask the same of the barber and the barber could ask the same of the fisherman. If all these debts cancel out then no cash is needed.

In most cases debts cannot be cancelled out so easily. A hat may cost € 50, legal advice € 60, a hairdo € 30, and the fish € 20. If you are the hatter, you could lend € 10 to the barber and the lawyer could lend € 20 to the fisherman. Perhaps the lawyer doesn’t trust the fisherman because he smells fishy. But if the lawyer trusts the barber and the barber trusts the fisherman then the lawyer could lend € 20 to the barber and the barber could lend € 20 to the fisherman.

That could become complicated quite easily. And this is where banks come in. Banks can lend money because they know the financial situation of their customers. The fisherman can borrow money from his bank to make payments because the bank knows that he has an unstable but good income and a vessel that can be sold for cash if needed.

If the fisherman borrows money to pay for the hat you made, this money ends up in your account. You can use it to pay the lawyer. And so the fisherman’s debt becomes the lawyer’s money until she uses it to pay the barber. People that have a deposit lend money to the bank and the bank is lending this money to those who have a loan, in this case the fisherman. Depositors trust the bank even though they do not know the people the bank is lending money to.

Most people think of money as coins and bank notes but more than 90% of the money just exists as bookkeeping entries in banks. When a fisherman borrows money from his bank, he can spend it on a hat. This means that the bank creates money and that this money is debt. Most of our money is debt so the value of money depends on the belief that debtors pay back their debts. This seems scary and it keeps quite a few people awake at night.

Some people argue that debts and banking are a fraud because they are based on a belief. But banks and debts help to boost trade and production by creating money that doesn’t exist to start businesses that don’t yet exist to make products which will be bought by the people those businesses will hire with this newly created money. Banking and debts are at the basis of the capitalist economy.

Banking as bookkeeping

Banking is more or less just bookkeeping and balance sheets. Balance sheets can be used to explain the magic trick banks do, which is creating money. Balance sheets are simple. There are no intimidating formulas, only additions and subtractions. The important thing to remember with balance sheets is that the total of the amounts on the left side must always equal those on the right side.

On the left is the value of your stuff and your money. On the right side is the value of your debts. Your net worth is what remains when you sell all your stuff and pay off your debts. It is on the right side too in order to make it equal to the left side. Your net worth can be a negative value. If that is the case, you might be bankrupt because you can’t repay your debts by selling your assets. The left side is named debit and the right side is called credit. Your balance sheet might look like this:

debit
credit
house
€ 100,000
mortgage
€ 80,000
other stuff
€ 50,000
other loans
€ 30,000
cash, bank deposits
€ 20,000
your net worth
€ 60,000
total
€ 170,000
total
€ 170,000

When you buy a car, you own more stuff, but also another loan or fewer bank deposits as you have to pay for the car. This is because debit always equals credit. When you drive the car, it goes down in value, as does your net worth, because debit always equals credit. If your salary comes in, your bank deposits as well as your net worth rise because debit always equals credit. If you pay down a loan, the amount in your bank account as well as the amount of your loan goes down because debit always equals credit. If debit doesn’t equal credit then you have made a calculation error.

Also for a bank the total of the amounts on the left side must always equal those on the right side, so that debit always equals credit. Your debt is on the debit side of the bank’s balance sheet. You have borrowed this money from your bank. The bank owns this loan. Your bank deposits are on the credit side of the bank’s balance sheet. The loans of the bank are paid for by deposits. Banks lend money to each other. This may happen when you make a payment to someone who has a bank account at another bank. Your bank may borrow this money from the other bank until a payment comes the other way. The balance sheet of a bank may look like this:

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

How banks create money

Banks create money. How do they do that? It is easy if you understand balance sheets. Assume that you, the hatter, the lawyer, the barber, and the fisherman all have € 10 in cash. Together you decide to start a bank. You all bring in the € 10 you own so that you all have a deposit of € 10 and the bank has € 40 in cash. The bank allows everyone to withdraw deposits in cash. This is no problem as long as the total of deposits equal the total amount of cash. After everyone has put in the deposit, the bank’s balance sheet looks as follows:

debit
credit
cash
€ 40
your deposit
€ 10
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 10
total
€ 40
total
€ 40

First, there was only € 40 in cash. Now there are € 40 in bank deposits too. You might think that the bank created money. Only, that isn’t true because the depositors can’t spend the cash unless they take out their deposits. In other words, the depositors don’t have more money at their disposal than before. If you look at the total, there is still € 40. This is bookkeeping. You have to write down the total twice as debit must equal credit.

But now things are going to get a bit wild. The fisherman comes to you and he wants to buy a hat. The hat costs € 50 but the fisherman has only € 10 in his account. To make the sale possible, the bank is going to do its magic. The fisherman calls the bank and asks if he can borrow some money. The bank grants him a loan of € 40 and puts the money in his deposit account so that he can spend it. And look:

debit
credit
cash
€ 40
your deposit
€ 10
loan fisherman
€ 40
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 50
total
€ 80
total
€ 80

Who says that miracles can’t happen? The amount of deposits miraculously increased from € 40 to € 80 so € 40 is created from thin air. There is still only € 40 in cash but the fisherman’s debt created new money. This is how banks create money. And that is only because bank deposits are money. This is all there is to it. So much for the mystery. The fisherman then pays € 50 for the hat. And so it becomes your money:

debit
credit
cash
€ 40
your deposit
€ 60
loan fisherman
€ 40
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 0
total
€ 80
total
€ 80

And now comes the dreadful part that keeps some people fretting. Everyone can take out his or her deposits in cash. There is € 80 in deposits and only € 40 in cash. If you go to the bank and demand your € 60 in cash, the bank would go bankrupt, even when the fisherman pays off his loan the next day. You could bankrupt the bank by buying € 50 in fish with cash. If you go to the bank to get € 50 in cash it would not be there so the bank would go bankrupt before the fisherman can pay off his loan with the same cash.

A bank could get into trouble in this way even when debtors repay their debts. Clever minds already figured out a solution. Central banks can print the needed cash. If the European Central Bank (ECB) prints € 20 on a piece of paper and lends this money to the bank, there would be enough cash to pay out your deposit. Banning the use of cash and only use bank deposits for payments would be another option. So, after the ECB deposited € 20 in cash, the bank’s balance sheet might look like this:

debit
credit
cash
€ 60
your deposit
€ 60
loan fisherman
€ 40
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 0
deposit ECB
€ 20
total
€ 100
total
€ 100

After you pay the fisherman, he can pay off his loan, and the bank will have enough cash to pay out all deposits. The bank can repay the central bank and everything is fine and dandy again. In this case the bank could not meet the demand for cash but the value of cash and loans wasn’t smaller than the deposits (the bank’s debt). After the fisherman pays back his loan and the bank pays back the ECB, the bank’s balance sheet might look like this:

debit
credit
cash
€ 40
your deposit
€ 10
loan fisherman
€ 0
deposit lawyer
€ 10
deposit barber
€ 10
deposit fisherman
€ 10
deposit ECB
€ 0
total
€ 40
total
€ 40

If banks can’t create money, trade would be difficult. If the hat is € 50, the legal advice € 60, the hairdo € 30, and the fish € 20, and you, the lawyer, the barber and the fisherman all have only € 10, nothing can be bought or sold. If the bank lends € 40 to the fisherman, he can buy a hat from you, you can buy legal advice from the lawyer, the lawyer can buy a hairdo and the barber can buy fish. Debt is the basis of the capitalist economy. Nearly all money is debt, and without debt the economy would come to a standstill.

How much money can banks create?

The amount of money a bank can create is limited by the bank’s capital, which is the bank’s net worth. Regulations stipulate that banks should have a minimum amount of capital. This is the capital requirement. If the capital requirement is 10%, and the bank’s capital is € 10,000,000, it can lend € 100,000,000, provided that there are enough deposits. If the bank makes a loan, a new deposit is created. If the deposit leaves the bank, the bank must borrow it back from another bank or cut back its lending. That is because debit must always equal credit.

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

When a deposit leaves the bank, it ends up at another bank. The other bank can use it for lending, provided that it has sufficient capital. There may be a reserve requirement, which is a minimum of cash and central bank deposits the bank must hold. If the reserve requirement is 10%, the bank can lend out as much as ten times the amount of cash and central bank reserves it has available. In the past reserve requirements were important as people often used cash and could go to the bank to demand their deposits in cash. For that reason banks needed to hold a certain amount of cash.

Featured image: Deutsche Bank building CC BY-SA 4.0. Raimond Spekking. Wikimedia Commons. Public Domain.