the plan for the future
7 October 2008 - 5 November 2015
Natural Money is interest-free money with a holding tax. Interest-free means that the maximum interest rate on loans is zero. The holding tax is a tax of 0.5% to 1.0% per month on cash. The holding tax does not apply on bank deposits and loans so that it could be attractive to lend out money at zero or even negative interest rates. The maximum interest rate of zero may curb risky lending to individuals, corporations and governments. Troublesome debtors may not be able to get loans because creditors are only willing to lend at high interest rates, which only makes their predicament worse.
There is a holding tax on cash that may always stimulate the economy as people will be encouraged to use their money for consumption, investment or lending. When the economy is booming, the maximum interest rate of zero could curb lending, because investors expect other investments to have better yields than debts. As there are fewer funds available for loans, the economy may not overheat. This means that economy could do well by itself. Financial and economic crises could be a thing of the past. Governments may not have to stimulate the economy. Central banks may not have to manage interest rates.
Natural Money could improve the efficiency of the economy and provide better real returns on investments including debts. Because the maximum interest rate on loans is zero, and because there are fewer debts, the higher yields on debts may be reflected in a rising value of the Natural Money currency. The value of the Natural Money currency could rise at a higher rate than the interest rates that exist in the market because the average pace of economic growth could increase without interest on money. This may result in a world-wide adoption of Natural Money.
The main assertion is that Natural Money could increase the efficiency of the economy and thus provide higher yields. This is because Natural Money could help to prevent financial and economic crises. As a consequence there could be a capital flight from regular economies to economies that are based on Natural Money as soon as one economy has implemented Natural Money. This will force the entire world to do the same. This document outlines the idea and the prerequisites for success. The financial world is very complex, so this text can only scratch the surface.
A Short History of Money
What is money?
What is the use of banks?
What is the role of governments?
The problem of interest
How banks create money
How the current financial system came to be
The Natural Economic Order
The Austrian School of Economics
The financial System
Banking with Natural Money
Types of services
Properties of the financial system
Wholesale banking system
Governments and central banks
Interest and sustainability
Who benefits from lower interest rates?
Employment and labour income
Government regulation and intervention
Can it work?
Superior efficiency can enforce the change
Maximum interest rate prerequisites
Maximum interest rate
Common ideas about interest
The rationale of having interest on money
Reasons for interest to exist
Time preference versus marginal utility
Effect of a holding tax
Effect of a maximum interest rate
Causes of economic cycles
Expectations and money hoarding
Usury and debt slavery
Fiscal and monetary policies
Diminishing growth perspective
Money has been invented because trade is very complicated without it . For example, if you are a hatter in need of legal advice, then without money, you have to find a lawyer who wants a hat. That is unlikely to happen. Maybe there is a fisherman dreaming of a hat, but he can't give you legal advice. Maybe there is a lawyer in need of a hairdo instead of a hat. With money all these problems disappear like magic. You can buy the services of the lawyer so that the lawyer can go to the barber. The barber can then buy some fish and then the fisherman can buy a hat from you.
Despite these mind blowing advantages, most humans did not need money for a long time because they lived in small bands and villages where everyone depended on each other and everyone helped each other . People within a village exchanged their goods and services for favours and obligations. This meant, for example, that when a fisherman needed a hat, you would give him the hat, in the expectation that if you needed anything, someone else would provide it to you. Villages were largely self-sufficient. Trade with the outside world was very limited so that it could be done with barter instead of money .
As societies became more advanced, and more products and services emerged, favours and obligations did not suffice any more. And so the need emerged for a more formal system for making payments and keeping track of obligations. This formal system is called money. Money at least needs to have the following properties: (1) it could be exchanged for other goods and services, (2) it must be possible to express the value of other items in terms of money and (3) its value had to be relatively constant or predictable over time. Money therefore is a medium of exchange, a unit of account and a store of value.
The value of money comes from the fact that other people are willing to exchange their goods and services for money. And because other people are willing to do this, you are willing to do the same. The value of money is therefore based on a belief . Originally, the value of money may have come from the fact that it was an item that people needed or desired. For this reason, grain, cigarettes and silver have been used as money. Also governments created money, for example by issuing coins, while demanding that these coins should be used for payments and taxes. In this way the authority of the government created the belief.
The authority of governments was limited to the area they controlled so their money had little value outside their borders, unless their coins contained gold or silver. In fact, gold and silver became internationally accepted as money because the value of gold and silver does not depend on the authority of a government. Gold and silver are rare while humans are attracted to shiny stuff. Gold and silver do not deteriorate in quality like other wares such as grain or cigarettes. This makes gold and silver a good store of value. Gold and silver coins could be made of different sizes and purity so they could be used for payment and as a unit of account.
Debts have value so debt can be money too. This may seem strange, but money is just a belief. For example, money is the belief that you can exchange a hat for money and then exchange this money for legal advice. But if the fisherman promises you to pay for the hat you made next week, you could say to the lawyer that you expect the fisherman to pay in a week, and ask him if you can pay in a week too. The lawyer could then do the same with the barber and the barber could do the same with the fisherman. If all those debts are € 50, then you, the lawyer, the barber and the fisherman could decide after a week to cancel these debts.
In most cases debts cannot be cancelled out so easily. The hat may be € 50, the legal advice € 70, the hairdo € 30, and the fish €20. And many people who trade with each other do not know each other. So how can the seller know that the buyer will make good on his or her obligation? This is where banks come in. The business of a bank is to know the financial situation of its customers. Banks can lend money to their customers because they know their incomes and assets. And people can lend money to their bank because they trust their bank even though they do not know the people the bank is lending their money to.
For example, if the fisherman who is buying your hat doesn't have the money to pay for it, he can overdraft his account and still make the payment. In this case the fisherman borrows money from his bank. The bank of the fisherman borrows this money from your bank and your bank borrows this money from you. In fact, the money in your bank account is just money you are lending to your bank. And banks lend money to each other. In this way the fisherman's debt becomes your money and you can use the fisherman's debt to pay your lawyer. And then the fisherman's debt becomes the lawyer's money.
Most people tend to 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 loans money from his bank, he can spend this money on a hat. This means that banks create money and that this money is debt. It has not always been this way. There was very little debt and there were very few banks until Capitalism came along. Banks and debts made it possible to increase trade and production by financing new businesses that were impossible to create otherwise because they require a large amount of capital. Debt is the basis of the modern economy.
Banking is more or less just bookkeeping. In bookkeeping the sum of the left side (debit) always equal those on the right side (credit). On the left (debit) side are the assets, which are the things you own. On the right (credit) side are the liabities, which show how your assets are paid for. Your debt is on the bank's debit side of the balance sheet as it is an asset of the bank while it is on the credit side of your balance sheet as it is your liability. This means that the total value of your house and other stuff and the value of cash and bank deposits always equals the total value of your mortgage and loans and your net worth.
your balance sheet:
your house and other stuff + cash and bank deposits = mortgage and loans + your net worth (debit = credit)
the bank's balance sheet:
mortgages and loans + cash and central bank deposits = bank deposits + the bank's net worth (debit = credit)
For example, when you buy a car, then you will have more stuff, but also more loans or fewer bank deposits as you have to pay for the car. This is because debit always equals credit. If you drive the car, it will go down in value, as will 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 the loan, the amount in your bank account as well as the amount of your loans will go down because debit always equals credit. If debit does not equal credit then you have made a calculation error.
Governments can issue money and demand that it should be used for payments and taxes. This money is called currency. The value of bank deposits, bonds and stocks are expressed in currency, for example euros or dollars. The value of a currency such as the euro or the dollar is based on a belief like all other forms of money. Governments create belief in their currencies by requiring that their currencies should be used for payment and taxes. Governments do much more to promote belief in their currencies. Most notably, they make laws and enforce them, so than people can safely trade and pay.
Currencies are created by the government or the central bank and currencies consist of coins, bank notes and central bank deposits. People believe in a currency because the government has declared that everyone must use it for payment and accept it as payment. This is called legal tender. For the same reason bank debt is also money. The government has declared that bank debt should be used and accepted for payment. This makes the government responsible for the integrity of the currency as well as the bank deposits. For that reason banks have to fulfil all kinds of regulatory requirements.
These regulations limit the amount of loans banks can make and therefore the amount of money that can exist. But everyone can lend to anyone. And so alternative forms of debt financing emerged that circumvent the regulations imposed on banks. These debts are not bank debt so they are not money because they cannot be used for payment. And so human imagination is the only limit on the amount of debt that can exist. Not only is there no limit on the amount of debt that can exist, but lenders often expect that interest will be paid on those debts. And where should the interest come from? A simple example can demonstrate the problem.
Assume that Jesus' mother put a small gold coin weighing 3 grammes in Jesus' retirement account at 4% interest in the year 1 AD. Jesus never retired but he promised to return. Suppose that the account was kept for this eventuality. How much gold would there be in the account in the year 2015? The answer is an amount of gold weighing 10 million times the mass of the Earth. The yearly interest would be an amount of gold weighing 400,000 times the mass of the Earth. There is a small problem. It would be impossible to pay out Jesus' retirement account in gold coin. This is the problem of compounding interest.
Even if a banker could do miracles and create all this gold from thin air like Jesus allegedly produced bread and fish from nothing, there would have been a storage problem, not to mention that the Sun and the Moon would come down because of the gravitational pull coming from the Earth. But we shouldn't worry about these things because bankers cannot create gold but only to promises to pay. An astute banker would have realised that there wasn't enough gold to pay back Jesus when he returns. He would have feared the day of reckoning and prayed that Jesus wouldn't return during his lifetime.
The problem of interest was already known in ancient times. Interest on loans caused suffering and charging interest was called usury. In the past schemes have been devised to curtail or prohibit interest or to cancel debts. Economic growth was practically non-existent and interest rates were high so interest charges pushed many people into poverty. But the schemes to control usury didn't work because nobody was willing to lend out money at an interest rate of zero. There was a considerable risk that loans were not repaid and it was difficult to sell a loan and exchange it for money if the lender suddenly needed the cash.
There is much to do about banks creating money out of thin air. Some money reformers think that banks creating money is an evil invention that causes financial crises. Let's first go into the basics in order to understand the process of creating money out of thin air. Consider a simple scenario in which an snake enters Eden with 20 in cash to start a bank. The bank then has a capital of 20 in cash. Then Eve and Adam come in and both make a deposit of 20.
the snake's bank's balance sheet after Eve and Adam made a deposit:
Everything seems fine until Cain wants to start a business. He goes to the bank and convinces the snake that eating from the forbidden fruit is a bad idea. But there must be food on the table so Cain wants to make a living out of growing fig trees. He takes out a loan of 60 to start his business. In exchange for the loan he receives a deposit of 60, which he can use to set up his business. After this transaction, the bank's balance sheet has changed.
the snake's bank's balance sheet after Cain takes out a loan:
Who says that miracles can't happen? The amount of deposits miraculously increased from 40 to 100. The miracle is that the loan gave rise to a deposit. Because withdrawable bank deposits are money, the bank has created money. It is important to realise that the only reason that the bank has created money is that the government has declared by law that you can use bank deposits for payment. Cain then pays Eve 50 for cultivating the land and planting the trees.
the snake's bank's balance sheet after Eve has been paid:
The problem that the money reformers see is easy to understand. The snake, Eve and Cain have conspired to create a situation in which the deposit of the unsuspecting Adam is at risk. If Eve goes to the bank and demands her deposit of 70 in cash, the bank would go bankrupt because the cash isn't there. This could cause a financial crisis in Eden and a sudden disappearance of the trust in banks and snakes. Of course Eve doesn't do that because she expects that the business of Cain will do well so that he can repay his loan.
If Cain had borrowed the money directly from Adam instead, he would have had a debt of 60 to Adam, and no money would have been created at all. So, if people lend money to each other directly, the problem of banks creating money out of thin air suddenly disappears. But if Adam only has 20 then he would not have been able to lend 60 to Cain and Cain would not have been able to start the business. The bank made the business possible by creating money out of thin air. Eve, Adam and Abel could start a business in the same way too if the snake expects them to repay their loans with future revenues.
In England during the 17th century, many goldsmiths owned a safe where they stored their own gold. Other people preferred store their gold there too because those safes were better guarded. In this way the goldsmiths could make a business out of renting safe storage. People storing their gold did get a receipt that certified the amount of gold they brought in. At first these receipts could only be collected by the original depositor. Later this restriction was lifted so that the holder of the receipt could collect the deposit. People began to use these receipts as money because paper money was more convenient than gold coin .
Consequently, depositors rarely demanded their gold and it remained with the goldsmiths. The goldsmiths then found out that they could lend out this gold at interest. When the depositors found out about this, they demanded interest on their deposits. At this point modern banking started to take off, and paper money became known as bank notes. Borrowers also preferred bank notes to gold coin, so the goldsmiths who had now become bankers, found out that they could lend out more gold than there was in their vaults. This practise is called fractional reserve banking because not all bank notes were backed by gold reserves .
When depositors found out that there were more bank notes circulating than there was gold in the vaults of the goldsmiths, the scheme could run into trouble but mostly it didn't. Depositors received interest which enticed them to keep their deposits in the bank. People trusted their bank as long as debtors had no trouble repaying their loans. If people started to distrust their bank, worried depositors went to the bank to exchange their bank notes for gold. When that happened, the bank could run out of gold and go bankrupt because the gold wasn't there, and the bank's bank notes could become worthless. This is called a bank run.
Because banking was important for economic development, the scheme of the goldsmiths was not banned. Their practise became legalised and regulated instead. Banks needed to have a minimum amount of gold available in order to pay depositors. Central banks were instituted to support banks in trouble by supplying additional gold if too many depositors came in to collect their gold. Central banks could still run out of gold but this problem was solved when the gold backing of currencies was ended. Nowadays it is possible to create additional dollars and euros to cope with any shortfall because money is not backed by gold any more.
Many debts exist outside the banking system because people can lend money to each other directly. For example, corporations can issue bonds and sell them to investors. Those debts are not money but investors can exchange them for money so those debts are very much like money. If governments try to regulate the banking system to curb lending, debts emerge elsewhere because the only limit on debt is human imagination. As long as people imagine that those debts can be repaid, even if they imagine that those debts will be repaid with new debts, there is no problem and those debts can be sold for money if needed.
People and corporations can go bankrupt and their debts may not be repaid. As long as there are few bankruptcies, this is not really a problem because creditors can recover from such losses. Banks make money from demanding a higher interest rate on loans than they pay on deposits and this difference can be used to pay for losses. Serious problems arise when a large number of debtors cannot repay their loans. People may then lose their belief in a financial system that is based on debts. This problem is caused by the total amount of debts rather than by banks creating money, because this money is only a specific type of debt.
When Silvio Gesell finished writing The Natural Economic Order in 1916, his proposal for a holding tax on money marked the beginning of new school of economic thought. Gesell labeled this money free money because he believed that it promoted the free play of economic forces. The most remarkable success of Gesell's ideas was the emergency currency of Wörgl. Famous economists like Irving Fisher and John Maynard Keynes thought that free money had potential. Still, the idea became close to forgotten after the emergency currency was banned and World War II ended the Great Depression.
Silvio Gesell is considered a socialist by some and a free-market proponent by others. He favoured free markets without state intervention, which made him a liberal, but he disliked the privileges of money and capital, which puts him in the camp of the socialists. Silvio Gesell was influenced by the Manchester School of Economics that contended that free trade and free capital markets would push interest rates to zero. The Manchester economists based this prediction on the discovery that in interest rates were the lowest England where money and capital markets were the most competitive and well-developed.
Gesell was also influenced by Proudhon, who thought that the accumulation of more and more capital would push interest rates to zero. Proudhon was a socialist who opposed the general Marxist doctrine that labourers could get the upper hand via class struggle. Instead he suggested that workers should do their jobs and work diligently to produce more and more capital. He thought that building more factories and churning out more products would push down prices while building more houses would push down rents. Proudhon saw that money somehow limited the production of capital. In the words of Gesell :
What Proudhon and Gesell discovered was that interest rates cannot go below a certain minimum level because investments would then stop. Money would go on strike as Gesell put it. The main reason is that low yields make investing and lending out money unattractive because of the risks involved. Money, most notably gold, does not depreciate like goods so it can be stored without a loss, hence there is no incentive to put money at work if interest rates are low.
Keynes called this a liquidity trap, which means that when interest rates are low, people tend to prefer cash to investments. Nowadays bank deposits are considered lower risk than cash so the liquidity trap is at an interest rate near zero. Gesell thought that if money depreciated like other goods, the requirements of money would not block the production of more capital, and interest rates could go to zero. When Gesell lived, the gold standard was still in force. He noted that gold does not decay so that the possessors of gold have an advantage over the posessors of other goods. He came up with the following observation :
Gesell concluded that the owners of money could exploit their advantagous position by charging interest. His observation shows that there is a minimum interest rate that does not depend on the state of the economy. Money will be withdrawn from the economy once this level is reached so that interest rates cannot go lower. This is not because there are fewer savings but because savings are withdrawn from the economy. This causes an economic downturn so that the demand for goods and services drops, which demonstrates that money hoarding could result in an economic recession or even a depression.
On the other hand, Gesell observed that higher interest rates would make more credit available. This is problematic because higher interest rates and more credit do not create more gold or currency, so that interest and credit produce the seeds of economic destruction. At some point credit may need to be repaid with interest in gold or currency, which is more difficult if there is more credit created or interest rates have been higher.
The recent economic crisis is not so different. Banks were hoarding money because they did not see investment opportunities at the prevailing low interest rates. Economic theory suggests that the equilibrium interest rate was negative, and that equilibrium could not be reached because there is a minimum interest rate. In plain English this means that there are too many savings and too few investment opportunities and that interest rates must go even lower to discourage saving or to promote investing. Gesell proposed a tax on money to achieve this. He wrote :
And the consequence Gesell envisioned was that :
There are some issues with the proposal of Gesell. He foresaw the need of a Currency Office that manages the money supply based on inflation numbers. The Currency Office can become subject to political objectives. Gesell also did not think of a method to reign in credit. The economy may boom, interest rates could go positive, and credit could become abundant. At this point the Currency Office, which is more or less a Central Bank, might not be in a good position to curb inflation. Reducing the number of currency units could cripple the booming economy and produce an economic depression.
On the opposite side of Silvio Gesell were adherents of the gold standard and what came to be known as the Austrian School of Economics. The Austrian School of Economics contends that too much credit is an important cause of economic crises. The goldsmiths issued more claims than there was gold in their vaults and in this way they created money out of nothing. This scheme sometimes collapsed. Banks do essentially the same, so that sometimes a bank run occurred when people lost their trust in the banker's scheme. Banks also borrow funds from each other so that one bank's trouble can spread to other banks.
When banks collapsed, credit dried up, and an economic crisis often followed suit. The Austrian School opposes the idea of banks creating money. Instead it proposes a clear distinction between savings and credit. Savings consist of money entrusted to the bank for a specific time and money that cannot be withdrawn on short notice. According to the Austrians, only savings should be used for loans, so that there is always enough gold or money in the vault to pay depositors .
In the view of the Austrian School, bank credit causes interest rates to be lower than they otherwise would have done, so that bad investments are made, creating excess capital. As long as the economy is booming, those investments appear to be profitable, but when the bust sets in this excess capital will be destroyed . Because interest rates cannot go below a certain minimum level, credit will dry up once this level is reached.
Central banks meddle with this process. They can supply credit at a lower interest rate than the mininum interest rate in the market so that the reduction of excess capital during the bust does not have to take place . Many Austrians fear a day of reckoning when all this excess credit cannot be repaid so that the economy enters the most serious economic depression there has ever been. This concern is reflected in the following famous words of Ludwig von Mises:
But the type of money determines the outcome. If all funds are always available for lending and interest rates could go negative, there would always be an equilibrium in the markets for money and capital, as the owners of money would be forced to choose between investing and consuming, so that the economy would not enter a depression. In that case the market could set the interest rate and central bank intervention would be superfluous. And without fractional reserve banking and central banks, interest rates could never have gone so low.
Inspired by the Austrian School, money reformers often criticise fractional reserve banking or the ability of banks to create money. The distinction between savings and credit is not always clear. A simple example can demonstrate this. Assume that banks only lend out money in savings accounts and that only savings yield interest. Imagine that Eve and Adam only do business with each other and that they both have 100 money units that they use for their daily business transactions. They could get rid of cash and give each other credit so that they both could put 100 money units in a savings account.
They accept each other's credit risk because they trust each other. Similar schemes can be devised so that savings can be fabricated out of credit. In fact, when banks create money, they do what Eve and Adam do on a larger scale. They can act as an intermediary between Eve and Adam so that they can give each other credit, even when they do not business with each other or do not trust each other. As a consequence the distinction between savings and credit tends to be ficticious and arbitrary. Banning fractional reserve banking could produce a number of schemes that replace it, rendering such a ban meaningless.
Creating money is just a specific example of the bank's main business. It only means that depositors can take out their deposits at any time regardless the end dates of the loans backing them. Loans and deposits tend to mature on different dates. In order to end all risk of banks not being able to repay deposits because of this issue, deposits and loans should match each other in time, which is impossible. When loans are made out of savings, banks can still go bankrupt when loans are not repaid or when people do not renew their deposits when they are due.
Most economists think that the views of the Austrian School are outdated and do more harm than good because the Austrian School advises governments and central banks not to interfere in the economy so that recessions and depressions last longer and become more severe than needed . Still, the Austrian School stresses the need for an effective mechanism to restrict credit in order to prevent booms and busts from occurring. The Austrian School also stresses that government interventions and cental bank policies may have undesired side-effects because they can distort the markets for money and capital.
Natural Money is based on the idea of Gesell and it provides a mechanism to restrict credit. Governments and central banks do not manage the econonomy via aggregate spending and interest rates. Natural Money is currency with a holding tax, a maximum interest rate of zero and a fixed amount of currency units. The holding tax means that currency in circulation is taxed at a rate of 0.5 to 1% per month. The tax is spent back into circulation by the issuing government.
It is not allowed to charge interest on Natural Money currencies. The holding tax does not apply on investments and loans so it can be attractive to lend out money at a maximum interest rate of zero. The fixed number of currency units, and most notably the maximum interest rate, limit the creation of credit. This does not have to harm the economy as the holding tax could provide a permanent stimulus.
Because banks can lend out money at a maximum rate of zero, deposit accounts will have negative yields that might amount to -2% to -3% annually. Because there is a fixed amount of currency units, there probably is no price inflation, and economic growth may cause the value of the currency to rise. This is because economic growth means that more products and services become available, and when the amount of money remains the same, prices could go down.
Cash seems an obstacle to implementing a holding tax. Eliminating cash alltogether might pose serious difficulties because some people prefer cash for various reasons. Silvio Gesell proposed a monthly stamp on the bank notes , which is very cumbersome indeed. Turning cash and electronic money into separate currencies and making cash depreciate relative to electronic money at the pace of the holding tax is not that much hassle, but people could lose a lot of money by holding on to cash. Another option might be that banks issue bank notes backed by bank credit that give a better rate than currency.
With Natural Money banks operate much like they do nowadays, but there are a few differences. There is a clear distinction between the near risk-free banks and other financial service providers. The maximum interest rate at which banks can lend out funds is zero. Because there is a holding tax on money, depositors are expected to accept negative interest rates on their deposits in order for banks to have a profit margin. There is a central bank that can support banks by lending money to them at an interest rate of zero if they cannot borrow elsewhere. Governments may also choose to guarantee deposits at banks.
Apart from regular banks there might be financial service providers or investment banks. They also cannot make loans at higher rates than zero but they could for example offer lease contracts on cars and houses similar to car loans and mortgages. This implies a shared ownership of a property, and therefore a shared risk taking. The lessee may not only pay rent but may also pay to gradually become the owner of the property. Those financial service providers cannot offer deposit accounts but they can offer shares in a closed-ended or open-ended structure. The value of those shares and their dividend can fluctuate.
There are two types of accounts with regard to risk. Money in a deposit account is part of the bank's capital available for lending. This money is subject to the risk of banking but depositors do not have to pay the holding tax. Money in an administrative account is similar to cash outside the banking system and it is not available for lending. This money is not subject to the risk of banking but a holding tax must be paid on this money. Because banks do not earn revenue from lending against administrative accounts, account holders might pay additional fees for the services associated with administrative accounts.
There are two types of accounts with regard to availability. Money in current accounts is readily available and can be used for payments. Money in savings accounts is not directly available for payment. Depending on the conditions of the savings account, this money can at some point in time be transferred to a current account and then used for payment. Current accounts could be administrative accounts while savings accounts are always deposit accounts.
Inside the core financial system, which consists of the banks and the central bank, fixed or flexible rates on deposits and loans could be agreed as long as they do not exceed zero. Central bank support might be needed to guarantee those agreements as fixed rates and a return of the principle amount are promised. Outside the core financial system there is no central bank support and yields exceeding on investments exceeding zero are possible. The absence of central bank support implies a higher risk for investments in financial service providers relative to bank deposits.
Based on these considerations, the following properties might need to be implemented in the Natural Financial System:
- only banks can offer deposit accounts and other financial service providers can only offer administrative accounts;
- banks should only provide payment, borrowing and lending services;
- banks cannot invest directly in securities, except bonds that yield less than the maximum nominal interest rate of zero;
- financial service providers can make other investments and make loans at a maximum nominal interest rate of zero;
- only banks can receive central bank credit and central banks could discount bonds for banks at an implied interest rate of zero;
- government guarantees may only apply on bank deposits;
- only banks can receive central bank credit.
Fischer Black realised in 1970 that a long term bond could be sold in three separate parts to three different investors. One could supply the money for the bond, one could bear the interest rate risk, and one could bear the risk of default. The last two would not have to put up any capital for the bonds, although they may have to post some sort of collateral . This idea became the basis for the development of wholesale banking and derivatives in recent decades. The wholesale banking system is more commonly known as the shadow banking system.
The emergence of the wholesale banking system and derivatives is often seen as a dangerous development because it is not well understood, and because the regulation systems of the wholesale banking system as well as the derivatives have been immature. Many derivatives could not be traded in transparent liquid markets so that their true value was difficult to establish. On the other hand, the emergence of the wholesale banking system probably helped to spread risk and thus contributed to the drop in interest rates in recent decades. Its main weakness is that it is prone to sudden evaporation of liquidity.
A well-developed wholesale banking system might improve the efficiency of markets. For that to happen the liquidity issue has to be solved. Economic stability and a maximum interest rate of zero could help to reduce risk in the wholesale banking system. Default risk could be reduced with a maximum interest rate of zero. The holding tax on the currency will make it expensive to hold currency so liquidity is less likely to dry up. Combined with adequate regulation that includes solvability and liquidity requirements, as well as transparent liquid markets for derivatives, this could help to develop a mature and stable wholesale banking system.
On the one hand, Natural Money requires more discipline from governments with regard to their budgets. Government borrowing can crowd out private borrowing and can make it difficult or even impossible to keep nominal interest rates below zero. On the other hand, Natural Money may offer more opportunities for governments to enforce budget discipline. There might be no need for deficit spending because the holding tax could stimulate the economy so that budget cuts or tax increases may have fewer adverse effects on the economy.
The role of the central banks with Natural Money is somewhat different. In the current situation central banks can influence the money supply by buying bonds or other assets from banks or selling bonds or other assets to banks in exchange for currency. If central banks buy bonds or other assets in exchange for currency then they are printing currency. This currency can then be used for making new loans. If they sell bonds or other assets, they do the opposite. Central banks can also influence interest rates. They set the short term interest rate and this may also influence longer term interest rates.
With Natural Money, the interest rate is set by the market, and not by the central bank. The lower bound is the holding tax rate and the upper bound is zero. The central bank only gives credit to banks at an interest rate of zero. This is unattractive for banks because they cannot lend out this money at higher interest rates. Banks will therefore not borrow at the central bank unless they have to, for example in case of an emergency. Bank are stricly regulated and have limited investment options because they operate the payment system and therefore have a public role so that they could have a public guarantee.
Apart from banks there might be financial service providers without a public guarantee that offer similar services. They cannot guarantee deposits at face value because they do not have central bank support. They also cannot make loans at interest rates above zero but they can invest in equity. Financial service providers can offer administrative accounts, but deposits are converted into shares that have a price risk attached to them. Those shares can be converted back into money in an administrative account and used for payment. In times of emergency financial service providers may limit withdrawals or opt to become a closed-end fund.
There might be a reserve requirement with Natural Money, which is a ratio between the amount of currency in the banking system and the amount of credit outstanding. Banks pay a holding tax on the currency in their vaults, but they can pass on those costs to account holders via the intermediary fee. It is possible to have fixed reserve requirements based on the type of deposits. A better idea might be to base reserve requirements based on a moving average of the daily transactions between accounts, including transactions within the same bank.
A fixed reserve requirement seems less appropriate as it does not adapt to the velocity of money. A high velocity of money tends to be price inflationary while a low velocity of money tends to be price deflationary. If the reserve requirement changes with the velocity of money, it could counteract price inflation and deflation. In order not do disadvantage small banks, transactions between accounts within the same bank could be included in the reserve requirement calculation.
With Natural Money, banks can receive temporary central bank credit, which can be used as reserves. This may be needed if there are sudden withdrawals from savings accounts in the case of full reserve banking or when there is a sudden surge in the turnover of money in current accounts in the case of a fractional reserve system. The central bank currency is subject to the same holding tax as regular Natural Money currency.
The use of central bank credit with Natural Money is expensive for banks because it is available at a nominal interest rate of zero. The central bank therefore does not subsidise the banking system with cheap credit. Under normal conditions a bank can borrow at better rates from other banks and depositors. Because they cannot make money from central bank credit, banks may have little appetite for central bank credit and curb lending when they are on it.
Natural Money has a few stabilisers. The holding tax could stimulate the economy by making holding money idle expensive so that the economy could recover quickly from a downturn. Governments and central banks may not need to intervene to support the economy. A reduction in debt levels and price deflation probably may not do much harm. There might be no need for more debt and currency to keep the economy afloat. If there is economic growth then prices may go down because there are more goods and services available for the same amount of money.
When savings exceed investments then interest rates could go below zero to discourage saving and promoting investing. A maximum interest rate of zero could curb credit expansion when the economy is doing well because people are less inclined to deposit money at the bank when other investment opportunities provide better returns. The adaptive reserve requirement could have a similar effect. If the economy is doing well, the money is spent more often so that the reserve requirement increases and fewer funds are available for lending.
The maximum interest rate may result in a cap on the risk lenders are willing to take. Consequently risky projects may be financed with equity instead of debt. People and businesses in financial trouble may have to adjust their finances in an earlier stage if nobody is willing to lend them money. Furthermore, their troubles cannot be compounded by interest charges. The stable economy could help to reduce the likelihood of people getting in financial trouble. Natural Money could help to discipline governments as low interest rates require sound government finances.
Interest contributes to financial crises via the mechanism of risk. First of all, interest rates reflect the risks involved in lending money. If the borrower is less likely to repay the loan because of high debt levels or poor and unstable income, he or she has to pay higher interest rates on loans. Borrowing at high interest rates might make those borrowers worse off. They might be better off if they could not borrow at all and had to curb spending.
It works both ways. As interest is a reward for risk, lenders are more willing to take risk if there is a reward in the form of higher interest rates. This risk then enters the financial system, making it more prone to crisis. What is even more troublesome, is the fact that when a borrower is in poor financial shape, paying higher interest rates tends to make his or her predicament even worse. Interest in this way tends to increase risk.
The trouble in the financial system that led to the crisis of 2008 can in this way be related to interest as lending to subprime borrowers could have been interest-induced. The risks were also underestimated because of government policies and guarantees that supported this borrowing. A maximum interest rate could curb the risk lenders are willing to take, but such a measure might be more effective if governments do not distort the market by giving guarantees and subsidies.
When interest on money is charged, money in the future is worth less than money now. This has a major impact on investment choices. Interest promotes short term thinking. If no interest was charged, long-term investments would be more attractive . The following example comes from the book Poor Because Of Money of Strohalm :
The example shows that without interest charges there is a tendency to select long-term solutions, so interest makes long-term solutions less economical. If interest rates are negative, future income would be preferred even more. Interest promotes a short term bias in economic decisions. This must also be true on a larger scale. It may help to explain why natural resources, such as rainforests are squandered for short term profits.
When interest rates are lower then savings yield less, but interest rates on loans and mortgages will also be lower. If interest rates are lower, people have to save much more for retirement. On the other hand, everyone pays interest indirectly via the products they buy, so that lower interest rates tend to lower prices. German research has shown that 90% of the people pay more interest than they receive. Only the top 10% richest people receive interest on balance . While most people could benefit from lower interest rates, the richest people could lose from lower interest rates.
It seems possible that the availability of credit at negative interest rates could push down interest rates further because there might be more room for capital buildup. Credit is unlikely to dry up at interest rates near zero so that more capital could be made available and the return on capital could go lower than it otherwise could have done. This might mean that more products and services could be available at lower prices and that wealth will be distributed more evenly as the return on capital, and most notably the difference between return on capital and economic growth, could be the most important driver of wealth inequality .
Natural Money can help to reduce unemployment as the holding tax can provide a constant stimulus . Not all unemployment can be eliminated because not everybody meets the requirements of potential employers. Often there is a surplus of low skilled labour. But as interest rates go lower, more people might be employed profitably, so that Natural Money could have a positive impact on employment.
Profits tend to reflect the risk of doing business so that reducing the risk of doing business could increase the overall level of wealth as well as wealth equality. If there is sufficiently easy to enter the market, excess profits could lead to increased competition or a higher demand for labour, which could lower the price of products or increases the price of labour. Hence, the reward for labour could increase when the risk of doing business is lower.
Natural money may help to reduce the risk of doing business, and hence reduce the cost of capital. Because the economy could be more stable with Natural Money, the risk of doing business could also be lower. Consequently the reward that capital requires to be employed can be lower so that the portion of national income paid out to labour could rise. An important condition for low business risk is political stability and respect for property rights.
The holding tax on money could help to correct trade imbalances. An exporting country might be more inclined to spend the foreign currencies it received. It is more likely that for each import a matching export will be found. A country that lacks exports may need to replace imports with locally produced goods and services. A holding tax on money may therefore cause international trade to be based on comparative cost advantages. Countries might receive credit but the maximum interest rate could help to limit this credit.
In the past tariffs have been used to defend national industries. There is no magic formula for determining what tariffs on what products are needed or justified, so decisions on tariffs tend to be arbitrary and political. The consequence may be that the advantages of trade between nations diminish, and that people will be paying more for foreign products than needed, and that employment may not improve because higher prices reduce demand for other goods and services. A holding tax on money might do a better job in balancing trade.
Government regulations and interventions are aimed at specific goals that most people appreciate but they could produce undesired side-effects. In many cases there are loopholes and opportunities for profit at the expense of the general public. If the economy could realise the goals intended by government inteventions automatically as a result of market forces, this might be more efficient and it could reduce fraud and misuse of funds.
Natural Money could provide a number of benefits that might reduce the need for government intervention and regulation. First of all, the economy is likely to do well by itself and there might be no need for governments to interfere with the economy. The holding tax on money provides a stimulus so that governments may not have to stimulate the economy. There could be more employment so that there may be less need for employment benefits and assistance.
Low interest rates can make sustainable investment choices rational economic decisions so that the government might have fewer reasons to encourage them. Fewer regulations in the financial system may suffice because a restriction on charging interest on money is likely to reduce risk taking in the financial system so that many of the abuses caused by financial engineering could become unprofitable and disappear.
One of the core elements of economic development is specialisation and division of labour, often based on the economies of scale. In some cases a certain reduction in the division of labour might enhance the efficiency of the economy as there could be diminishing returns on investments in social complexity . Local currencies may have benefits for communities and can produce more local economic activities, but only when the economies of scale are limited.
Local and regional governments could issue Natural Money currencies to support local and regional development. Those currencies could circulate along with the national currency. People will be inclined to spend the local currencies first because they can only be used locally. This might stimulate local trade . A multitude of local currencies could be confusing and reseach has shown that not more than 20% of the currency in circulation could be local.
The Bible contains a story about the Pharaoh having dreams that he could not explain. The Pharaoh dreamt about seven fat cows being eaten by seven lean cows and seven full ears of grain being devoured by seven thin and blasted ears of grain. Joseph was able to explain those dreams to the pharaoh. He told the Pharaoh that seven good years would come and after that seven bad years would follow. Joseph advised the Egyptians to store food in large storehouses. They followed his advice and built storehouses for food. In this way Egypt survived the seven years of scarcity (Gen. 41:1-45).
What is less known, because it is not recorded in The Bible, is that the storing of food resulted in a financial system. The historian Friedrich Preisigke discovered that the Egyptians used grain receipts for money and had built a sophisticated banking system based on this money . Farmers bringing in the food received receipts for grain. Bakers who wanted to make bread, brought in the receipts which could be exchanged for grain. According to the Bible, Joseph took all the money from the Egyptians (Gen. 47:14-15). This may have prompted them to invent an alternative currency.
As a consequence the grain receipts may have been accepted as money. The degradation of the grain and storage cost caused the value of the receipts to decrease steadily over time. This stimulated people to spend the money. There was credit in this banking system, and most likely it was interest free. The grain receipt system lasted for many centuries. The actions of Joseph may have created this system as he allegedly proposed the grain storage and took all the money from the Egyptians. When Joseph came to Egypt, the country had already passed its zenith and the time of the building of the great pyramids was centuries earlier.
A few centuries later, during the reign of Ramesses the Great, Egypt became again a leading power . Some historians suggested that the wealth of Egypt during the reign of Ramesses the Great was built upon the grain financial system . The grain money remained in function in Egypt after the introduction of coined money around 400 BC until it was finally replaced by the Roman currency. The money and banking system were stable and survived for more than a thousand years. It seems therefore possible to have a sophisticated banking system with Natural Money, at least in a stationary economy.
Grain based money existed before. Sumerian barley money probably was the first money ever used around 3000 BC. Fixed amounts of barley grains were used as a universal measurement for evaluating and exchanging all other goods and services . The Sumerian money was not based on storehouses so it did not have a holding tax nor could the Sumerians build a sophisticated banking system based on this money like the Egyptians did. The Egyptian design proved that money with a holding tax and interest free banking could work on a large scale over a long timeframe.
In The Bible once in seven years a Sabbath Year was introduced in which debts were forgiven (Deut. 15:1-18). Once in the fifty years there was a Jubilee (Lev. 25:8-55). In the Jubilee every man could return to his possession while the land had to be redeemed. The Bible also banned interest . The periodic debt forgiveness in The Bible was not unique as Mesopotamian royal edicts cancelled debts, freed debt-servants and restored land to cultivators who had lost it under economic duress .
The freedom advocated by the Covenant Code of Exodus, the septennial year of release in Deuteronomy and the Jubilee Year of Leviticus may have been concrete legal practises freeing rural populations from debt servitude and the land from appropriation by foreclosures . Those concepts may work well today but may not be needed if there is no interest on money. The creation of debt under a system of interest can be seen as fraud because the money to repay the debts with interest is not there unless more debts are created.
Around 500 BC agricultural output in Greece was not able to keep up with increasing population. Because of interest charges, mostly paid to city people, the debt load for farmers had gotten out of hand so that many of them could no longer pay their debts and were forced into slavery. Farms became the property of rich city people who did not understand farm work, while slavery did not contribute to the productivity of agriculture .
Harvests declined and the people in the cities were threatened by famine. Solon realised that a healthy countryside is a countryside without debts. Farmers who understand the business of farming must make their own decisions. The farmer's ambition to improve himself is indispensable for a vital countryside. Solon introduced drastic measures eliminating all existing debts. To avoid the expansion of new debts, a limit was also set to the rate of interest and the accumulation of land .
Solon's reforms were concentrated on the constitution and the economy and his reforms on debt and interest are just one of them . Solon also set a moral example. He identified greed as having negative consequences for society. The modesty and frugality of the rich and powerful men of Athens may have contributed to the city's subsequent golden age. Solon, by being an example and by reforming legislation, may have established a moral precedent .
A number of historians and economist investigated the decline of Rome and consequently a number of theories have been proposed to explain this historic event . In the fifth century the Roman historian Vegetius pleaded for a reform of the weakened army. The Roman Empire, and particularly the military, declined largely as a result of an influx of Germanic mercenaries into the ranks of the legions. This led not only to a deterioration of the standard of drill and overall military preparedness within the Empire, but also to a decline of loyalty to the Roman government in favour of loyalty to commanders.
There was a slump in agriculture and land was withdrawn from cultivation. High taxation on cultivated land was probably to blame. Another factor may have been the debasement of the currency that led to inflation. Apart from an expansion of the state, the debasement could also have been caused by interest on money as usurers may have amassed most of the gold and silver in the Roman Empire. Price control laws resulted in prices that were significantly below their free-market levels. The artificially low prices led to a scarcity of food. Together with increased taxation and oppressive laws, this led to more poverty. In the Decline and Fall of the Roman Empire Edward Gibbon wrote:
Taxation was spurred by the expanding military budget, which was the result of the barbarian invasions and the use of mercenaries. A few centuries later the Eastern Roman Empire managed to survive the invasion of Arabs by introducing local militia that were not paid from the treasury but from local revenues . Over time the ranks of the militia were filled with local people that had an interest in defending their own land.
Roman money was based on gold and silver. Contrary to the Egyptian corn receipts, this money could be hoarded and moved abroad. This meant that when the Roman Empire started to decline, money may have disappeared from circulation. This may have reduced trade and impaired the economy. Because of this, as well as the expansion of government and the barbarian invasions, the government was permanently short of funds, causing a debasement of the currency and a rise of taxes that further burdened the Roman economy. In the end the invading barbarians may have been considered liberators.
After the Roman Empire collapsed, feudalism became the predominant political and economic system in Western Europe. The power in Western Europe became fragmented, so trade diminished and money became less important. Gold disappeared from circulation. Most transactions however were done as barter while taxes were mostly paid in kind. There were metal coins as well as promises . From around 1100, money became increasingly important as both trade and cities grew at a steady pace and gold reappeared in Western Europe.
From the year 300 onwards, the church restricted charging interest. Rates above 1% per month where considered to be usurious and evil. There was no enforcement of the restrictions and charging interest remained common practise in trade . In 784 the Council of Aachen forbade charging interest altogether. In Western Europe this rule was more strictly enforced during the subsequent centuries . In the Byzantine Empire, restrictions on interest remained less strict, possibly because economic life was more developed, which made it more difficult to enforce a full ban on charging interest .
The restrictions on charging interest did not hamper economic development in Western Europe. When the ban on usury was first imposed, Western Europe was backwards compared to the Byzantine Empire and the Arab world, but during the centuries that the ban on charging interest was in force, Western Europe managed to become a dominant power. By the year 1100 when the Crusades started, Western Europe had enough resources to spend on a long war that lasted two centuries. The crusaders maintained long supply lines of thousands of kilometres, while the conquered land was not profitable.
When economic life in Western Europe became more developed, the ban on charging interest became more and more difficult to enforce. In the 14th century partnerships emerged where creditors received a share of the profits from a business venture. As long as the share in the profits was not fixed, this was not considered to be usury . Over time contracts were devised to evade the restrictions on charging interest. Rents on property were allowed so the definitions of rent and property were extended. During the 15th and 16th century, the restrictions on charging interest became untenable and were gradually lifted .
In the second half of the Middle Ages some lords started to issue fiat and scrip money. The fiat money had value because it could be used to pay taxes. Apart from making money legal tender, taxes can give value to money issued by governments. The scrip money was valid for a limited period of time. After that period the the money had to be returned to the ruler who exchanged it for new money that also was valid for a limited period of time. During the exchange a tax was levied. The actual value of the scrip currency decreased slowly during the period it was valid and was the lowest just before the tax was due.
An example of a fiat currency is the tally stick introduced by King Henry the First around 1100. Henry introduced sticks of polished wood, with notches cut along one edge to signify the denominations. The stick was then split full length so each piece still had a record of the notches. The King kept one half for proof against counterfeiting and spent the other half so it could circulate as money. Only tally sticks were accepted by Henry for payment of taxes so there was a demand for them. This gave people confidence to accept tally sticks as money. The tally sticks remained in use until the early nineteenth century .
An example of a scrip currency is the brakteaten. The brakteaten was used in Europe between 1150 and 1350. Brakteaten coins were silver plaques called back by the local authorities from time to time and then reissued with a new image. During reissuing a tax was levied that amounted to a holding tax. At first the currency was only reissued when a new ruler came to power. Later on the silver plaques were called back on a regular basis. Rulers started to abuse the currency and holding taxes reached 6% per month. This burden became so heavy that the brakteaten currencies were abandoned .
On 5 July 1932, in the middle of the Great Depression, the Austrian town of Wörgl introduced a complementary currency. Wörgl was in trouble and was prepared to try anything. Of its population of 4,500, a total of 1,500 people were without a job and 200 families were penniless. The mayor Michael Unterguggenberger had a long list of projects he wanted to accomplish, but there was hardly any money to carry them out. These projects included paving roads, streetlights, extending water distribution across the whole town, and planting trees along the streets .
Rather than spending the 40,000 Austrian schillings in the town’s coffers to start these projects off, he deposited them in a local savings bank as a guarantee to back the issue of a type of complementary currency known as stamp scrip. The Wörgl money required a monthly stamp to be stuck on all the circulating notes for them to remain valid, amounting to 1% of the each note’s value. The money raised was used to run a soup kitchen that fed 220 families .
Nobody wanted to pay the monthly stamps so everyone receiving the notes would spend them as fast as possible. The 40,000 schilling deposit allowed anyone to exchange scrip for 98 per cent of its value in schillings but this offer was rarely taken up. Of all the businesses in town, only the railway station and the post office refused to accept the complementary currency. Over the 13-month period the project ran, the council not only carried out all the intended works projects, but also built new houses, a reservoir, a ski jump and a bridge .
The key to its success was the fast circulation of the scrip money within the local economy, 14 times higher than the Schilling. This in turn increased trade, creating extra employment. At the time of the project, unemployment in Wörgl dropped while it rose in the rest of Austria. Six neighbouring villages copied the system successfully. The French Prime Minister, Édouard Daladier, made a special visit to see the 'miracle of Wörgl' .
In January 1933, the project was replicated in the neighbouring city of Kitzbühel, and in June 1933, Unterguggenberger addressed a meeting with representatives from 170 different towns and villages. Two hundred Austrian townships were interested in adopting the idea. At this point the central bank panicked and decided to assert its monopoly rights by banning complementary currencies .
The Schwanenkirchen WaraIn the town of Schwanenkirchen in Bavaria the owner of a small bankrupt coal mine started to pay his workers in coal instead of Reichsmark. He issued a local script which he called the Wara that was redeemable in coal. The bill was only valid if a stamp for the current month was applied to the back of the note. This demurrage charge prevented hoarding and workers paid for their food and local services with the Wara.
Coal was a necessity and German Marks were in short supply so the currency became widely accepted. The use of this currency was so successful that by 1931 the so-called Freiwirtschaft (free economy) movement had spread through all of Germany. It involved more than 2,000 corporations and a variety of commodities backed the Wara. In November 1931 the German Central bank prohibited the use of the Wara .
The United StatesIn the United States Irving Fisher analysed the miracle of Wörgl. He published various articles about this success. More than 400 cities and thousands of communities all over the US started to issue emergency currencies, and many of them were stamp scrip. There was a movement to issue a stamp scrip currency nationwide. Senator Bankhead from Alabama presented a bill to the Senate on 18 February 1933 and Representative Petenhill from Indiana presented a bill to the House of Representatives on 22 February 1933.
The stamp scrip in the United States often had a high tax rate, sometimes 1 to 2% per week instead of 1% per month like in Wörgl. This undermined the confidence in the stamp scrip currencies. Irving Fisher approached the Undersecretary of the Treasury, Dean Acheson, to obtain support from the Executive branch for issuing stamp scrip. Acheson asked the opinion of one of his Harvard professors, who advised him that the system could work, but that it would imply strongly decentralised decision making. President Roosevelt later prohibited any use of stamp scrip .
In 1956 a few people in Lignières-en-Berry started a revolutionary experiment. They issued vouchers of 100 French francs for 95 French francs. After four months the vouchers could be returned for 98 French francs. A notary saw to it that for each voucher 98 French francs were deposited into a bank account. If the vouchers were not returned, a stamp of 1 franc had to be bought to keep the voucher valid.
The money was attractive because there was three francs of profit to be made by buying vouchers for 95 French francs and returning them for 98 French francs four months later. By spending the vouchers for 100 Francs it was even possible to make a profit of five francs. People tried to spend the vouchers in the shops and the shopkeepers liked the currency because it brought them additional customers, while it never did cost them more than 2% because the vouchers could be returned for 98 French francs. The shopkeepers also preferred to use the vouchers for their own payments.
Many people did not return the vouchers but bought the stamps to keep them valid. From the income of the stamps the cost of buying returned vouchers for 98 French francs could be covered. It did not take long before the currency of Lignières-en-Berry had replaced the French francs. The vouchers spread quickly and the French authorities were alarmed. The vouchers were prohibited .
If the economy is stable and operating at or near the trend growth rate at full employment then the maximum economic potential appears to be achievable. Under those circumstances real interest rates could be near their maximum. It seems that Natural Money helps to realise a stable economy and that Natural Money reduces risk in the financial system. It therefore follows that real interest rates with Natural Money could be higher. This could then be reflected by a strong currency that is rising in value. An interest rate of zero might then be a positive real return.
A simple calculation can be made to support such a view. There is a link between the amount of money and money substitutes (M) in circulation and prices in the equation Money Stock (M) * Velocity (V) = Price (P) * Quantity (Q). Prices are not only determined by the money stock (M) but are also affected by the quantity of economic production (Q) and velocity of money (V). From M*V = P*Q it follows that P = M*V/Q, so that P+ΔP = (M+ΔM)(V+ΔV)/(Q+ΔQ), where ΔP is the change in price level, ΔM is the change in money stock, ΔV is the change in money velocity and ΔQ is the change in quantity of production.
If ΔP, ΔM, ΔV and ΔQ are sufficiently small, it is possible to approximate this equation with %ΔP = %ΔM + %ΔV - %ΔQ, where %ΔP is the percentage change in price level, %ΔM is the percentage change in money stock, %ΔV is the percentage change in money velocity and %ΔQ is the percentage change in the quantity of production. To simplify matters, we assume that the velocity of money (V) is fairly constant over time so that %ΔP = %ΔM - %ΔQ.
Even though the velocity of money (V) for Natural Money might be higher than the velocity of money (V) for interest bearing currency, it is even more likely to remain constant as the economic picture is more likely to remain constant. Now it is possible to make a calculation of the real interest rate (r), which is the the nominal interest rate (i) minus the inflation rate (%ΔP) so that r = i - %ΔM + %ΔQ.
Suppose that for interest-bearing money the long-term average economic growth is 2%, but for Natural Money it might be 3% because the economy is more often performing at its maximum potential. Assume that the long-term average money supply increase for interest-bearing money is 6% per year, but for Natural Money it is 0%. The long-term price inflation rate could then be 4% for interest-bearing money, but for Natural Money there could be a price deflation rate of 3% as the economy grows 3% on a stable money supply. Then the following calculation can be made:
Economic growth is likely to be higher with Natural Money, so real interest rates are likely to be higher. Furthermore, because the design has a number of stabilisers that tend to reduce risk in the financial system, the level of risk is likely to be lower in the Natural Financial System. It seems therefore likely that the risk/reward ratios in the Natural Financial System are better than in the current financial system. This suggests that the design of Natural Money is more efficient so that there might be a capital flight from the interest economy to the interest-free economy as soon as Natural Money is implemented somewhere.
The real interest rate improvement may be higher than the improvement in the economic growth rate as there might a reduction in financial sector profits. Economic and financial stability might imply a reduction in the risks of investing so that investments could be made with less financial sector intermediation. The financial instability and the perceived need for government and central bank interventions in the interest-based financial system may have produced opportunities for politically connected and informed people to enrich themselves at the expense of the general public.
Non-productive activities in the financial sector may have harmed the real economy and may have contributed to a reduction in living standards. It might not be a coincidence that despite economic growth, real wages in the United States have remained stagnant for decades, while the US financial sector comprised only 10% of total non-farm business profits in 1947, but grew to 50% by 2010 . This development seems to have benefited the richest people, most notably those in finance and accounting related sectors. Natural Money might help to reverse this development.
The complementary currency of Wörgl was a stunning succes, but other experiments with free money did not yield similar results. It was a fluke, but it highlighted a hidden potential. At least in theory, it seems possible to have stable economic growth without unemployment, or something close to that. The ideas of Silvio Gesell have fallen out of grace as they seem impractical to work with. To get it right seems to be a major challenge.
The first major obstacle could be the maximum interest rate of zero. How can the market for money and capital operate if there is ceiling on interest rates? This depends on the amount of loans that would require a higher interest rate. If this amount of loans is relatively small, there would be no problem. This may well be the case. If the holding tax is 1% per month, there is a margin of 13% per year to work with. This means that zero percent loans yield 13% per year more than cash.
It seems important that the currency is legal tender and the only payment for taxes the goverment accepts. The existence of competing currencies, such as Bitcoin does not seem to be such a problem, as they often do not have a holding tax. As a consequence the Natural Money currency will be used for transactions. Investing in Natural Money deposits can also be more profitable. It seems that Natural Money can work under the same conditions as existing fiat currencies.
Most people are not familiar with the concept of interest-free money. It requires a new way of thinking. People are used to receiving interest on deposits and may object to paying for having deposits in the bank. The idea that the money may be worth more in the future, may not be very appealing unless they can see that they are better off. It might be important to educate people about Natural Money and it seems a good idea to decide about introducing it via a referendum.
Maximum interest rates have caused trouble in the past. If market interest rates exceed the maximum interest rate then investors will seek alternative investments and banks can become short of funds. In the United States there have been maximum interest rates on bank deposits for decades. The system came under stress because alternatives were offered, such as money market funds. As a consequence, maximum interest rates were phased out in the 1980s .
With Natural Money, banking is separated from other types of business, and only banks are able to guarantee the value of their deposits as there is a central bank to guarantee liquidity and a government to insure deposits. Other financial institutions must issue shares that have a price risk attached to them, but people may find the higher rates they offer more attractive and withdraw deposits from the banking system. This could cause a liquidity crisis in the banking sector.
The question is whether or not market interest rates will exceed the interest rates banks can offer on their deposits. The maximum interest rates in the United States did not cause any trouble when market interest rates were low. The maximum interest rate on Natural Money can be a positive real return. In mature economies with stable political systems and respected property rights, interest rates may remain low enough for Natural Money to succeed.
In Japan near zero interest rates have existed for decades. Japan could be a harbinger of what is to come for the rest of the world. Because of compound interest, debts tend to go to infinity. When debts near infinity, they can only be sustained by zero or negative interest rates. The alternatives to zero or negative interest rates are widespread defaults or high price inflation rates.
Some economists have entertained the idea of negative interest rates to kickstart the economy in times of crises  , but the adverse consequences of compounding interest on money as such is not an issue in mainstream economics. There is little thought on the idea of interest as a promoter of risk taking and moral hazard within the financial sector. Little attention is paid to the effects of interest on money on the stability of the financial system. These are core issues in the theory of Natural Money.
Many theories about interest-free money do not consider arbitrage. If an interest-free currency can be used to buy assets with a yield, there will be free money for those who engage in this trade. An interest-free currency must provide a competitive return in order to be a viable alternative. This means that a number of preconditions must be met in order to have interest-free money. At least in theory, interest-free money could be more efficient, and thus provide better real returns.
Another issue with some ideas about interest-free money is the idea that charging interest is morally wrong. This requires an explanation. It is not wrong to be rewarded for lending out money as there is risk involved and opportunity forgone. Still, it might be a bad idea to desire more and more of something that is in limited supply, such as gold or currency, most notably if other people need that something to survive or to have a meaningful role in society.
A common misconception is that a restriction on charging interest on money is a restriction on business profits. Capital needs a reward to be employed and restricting interest on money does not change that. Others might worry that credit will not be available when charging interest on money is restricted, or they may fear the opposite, that abundant credit will destroy the currency. That does not have to happen.
It may seem strange that a restriction on charging interest on money can result in higher real interest rates. On closer inspection this makes sense. After all, if Natural Money is to improve economic efficiency, then this will somehow affect real interest rates. This is likely to be reflected in a rising value of the currency. This counterintuitive idea is the reason why Natural Money could be a success that might surprise most economists.
Many of the reasons for interest to exist are standard economics, but some are not, so that a more comprehensive view on interest rates might be possible. Those reasons are:
- returns on capital;
- the risks associated with lending out money (default and inflation);
- time preference and marginal utility, where marginal utility counterbalances time preference;
- money itself not depreciating in nominal terms, which puts a floor on interest rates.
Economists see interest as a payment for deferred consumption. By deferring consumption resources can be used for production. This can facilitate future consumption. As a general rule, it is assumed that a certain amount of savings makes a greater amount of future consumption possible. This is the return on capital, which exists independent of money.
In a competitive free market, interest rates on money tend to reflect the productivity of capital. If they did not, and the risk/reward ratio of capital was better or worse, interest rates would adjust until they do reflect the productivity of capital. For example, if interest rates on money are low and the return on capital is high, then more people would be willing to invest in capital directly. Therefore interest rates on money tend to reflect the expected future return on capital.
Interest rates may reflect the expected rate of price inflation and the risks associated with the borrower. Default and price inflation are both risks associated with lending out money. It is often assumed that there is a risk free interest rate, for example on government bonds. Governments may not default outright but they can create money to pay off their debt, thereby lowering the value of the currency.
There is time preference because on average people prefer to have a good or service sooner rather than later. In this way time preference contributes to positive nominal interest rates. Interest may have another cause too. Money does not depreciate like capital or other goods, so nobody accepts negative nominal interest rates as money can be put away in a safe. If there is a holding tax on money, people may be more willing to accept zero or negative nominal interest rates. The law of marginal utility also counteracts time preference.
For example, when there is a choice between 10,000 loaves of bread now or one loaf of bread each day for the next 10,000 days, most people prefer one loaf of bread every day for the next 10,000 days. Most people will even prefer one loaf of bread each day for the next 1,000 days above 10,000 loaves of bread now, which implies a steep negative real interest rate. This is because bread spoils in a short time so no one can use 10,000 loaves of bread. It also applies on durable goods. Most people would prefer to have a new car now and a new car in ten years’ time instead of having two new cars now.
The predominance of time preference for goods and services above the law of marginal utility is therefore questionable, most notably in affluent societies. For affluent people long term security becomes more important than short term needs. The time preference is predominant when you are hungry and have the choice between one loaf of bread now or one tomorrow. Time preference may also be predominant when you can sell the 10,000 loaves of bread and put the money on the bank at interest. In this way interest itself promotes time preference.
The money we currently use evolved from gold. It makes no sense to lend out gold at zero interest because gold does not decay. Money inherited this property from gold. Below a certain threshold there is no incentive to lend out gold because of the risks associated with lending. John Maynard Keynes thought that a liquidity trap can occur, which is a floor under which nominal interest rates cannot fall . Similarly it makes no sense to lend out euros at negative interest rates if you can put euro bank notes in a safe deposit box. This is why interest rates cannot meaningfully drop below zero.
If money depreciates over time like capital and other goods, for example by applying a holding tax, the picture may alter dramatically. People may prefer to have money at the time they need it in the same way they desire a loaf of bread when they need it. Under those conditions they may be willing to lend at zero or negative nominal interest rates. Whether or not that might happen also depends on other conditions such as the return on capital and the level of risk associated with lending out money, as well as the value development of the currency over time. Only strong currencies allow for negative interest rates.
A holding tax might affect real interest rates, but only if risk free interest rates are already near zero. An interest rate near zero might imply that there is no real equilibrium between the supply and demand of money. This equilibrium might be at an interest rate below zero. Central banks try to induce inflation by printing money and lowering interest rates, but until now they had little success. If the experience of Japan is to be a guide, they may not succeed. A holding tax on money could make it possible to achieve this equilibrium without much effort.
Restricting interest on money poses constraints on the funds available for borrowing. If the risk/reward ratio of capital is more favourable, interest rates on money may not be able to adjust upwards and direct investments may be preferred. There may be less borrowing for consumption so the economy may not overheat because of unsustainable accelerated consumption. The value of money may increase as economic output increases and in this way the real interest rate on money can reflect the return on capital. Consequently it may be possible to sustain borrowing and lending at a maximum nominal interest rate of zero.
Questionable borrowers may not be able to borrow at a nominal interest rate of zero. They may be better off because they have to postpone consumption instead of paying high interest rates, so they will end up having more purchasing power. It is likely that financial innovators will try to chisel on any interest restriction. Loan sharks may try to fill in the gap and black markets may emerge. Making interest on money illegal and nullifying loans with interest may help to alleviate this issue as it makes the risk of doing business for loan sharks prohibitively high, so that black market interest rates are prohibitively high for most prospective borrowers.
For centuries usury laws have been enacted to protect the poor from unscrupulous lending practises by setting a maximum interest level. Economists contend that usury laws in the past failed because the interest ceiling was set below the equilibrium market interest rate. The effect of the interest rate ceiling may have been that only wealthy people could borrow money and that the poor had to manage themselves. Insofar the poor could not borrow at all they may have been better off in the end, but many poor may have become victims of loan sharks.
It follows that any feasible maximum interest rate should be near or above the market interest rate. A maximum interest rate of zero might seem a serious obstacle, but it might not be. First of all, real interest rates in developed nations might remain zero bound for the foreseeable future. Second, the risks associated with lending money are reduced when the financial system is more stable because only the best borrowers get a loan. Third, and finally, with Natural Money a nominal interest rate of zero might imply a real interest rate close to the trend growth rate as the interest rate might reflect the level of economic growth.
Interest on money can contribute to economic cycles but interest on money is not the only cause of economic cycles. In general economic cycles are caused by mismatches between supply and demand. Those mismatches can concern the supply and demand of money, capital, labour or consumer products. Interest reflects the market for money and capital. If all markets were perfect, and supply could adapt to demand instantly, then there would be no economic cycles.
Economic cycles occur because mismatches between supply and demand emerge from time to time and are resolved after some time. Fluctuations in demand and supply cause fluctuations in prices, stocks and employment. There are a number of theories and explanations regarding those mismatches, economic cycles and their effects. Some of them identify banking and interest rates as causes. The ideas that are relevant for Natural Money are discussed here.
Expectations are important in economics. If people feel secure and have a good feeling about their future, they could be more willing to spend. A positive or negative feeling about the economy can become a self-fulfilling prophecy. For example, if people expect a bank to collapse then this could happen because there might be a bank run. Therefore many policy makers tend to give a rosy picture of the economy or the state of the banking system.
According to Say's law supply creates its own demand because goods and services are produced to acquire an equal value of other goods and services. This applies to a barter economy. If money is used as a medium of exchange, people can hold on to money and postpone their purchases. In this way producers can be left with overproduction, and a reduction in economic activity could be the result.
Money hoarding can be caused by bleak expectations about the future. Money hoarding can reinforce itself as a decline in economic activity can make people more cautious. They may start to save more and economic activity may decline even more. As a consequence, more people may expect that times get worse and start to save more. This cycle can reinforce itself and become destructive.
During good economic times, businesses and individuals tend to be confident. Credit is often available because future income projections of businesses and individuals are the basis for banks to lend money. Therefore businesses and individuals tend to increase their leverage during good times. When the economy slows down and their incomes reduce, they can get into trouble. People would have more disposable income when they were out of debt and did not have to pay interest. Similarly, businesses can go bankrupt even when they are profitable overall because of interest charges.
For example, a business may expect a return on investment of 8% and can borrow at 6%. It makes sense to use leverage and the business may have liabilities equalling two thirds of total assets. If the return on capital turns out to be 3%, the business operates at a loss because of interest payments. If there was no leverage then the business would still operate at a profit. Leverage can add to economic instability as it fuels the boom as well as the bust.
Often businesses are not liquidated but taken over at a lower price. In that case competitors that are more conservatively financed suffer as the overinvestment has created a new competitor with a lower cost base. Some of those more conservatively financed competitors can go bankrupt as a consequence. Leverage can be an accelerator of economic change as it reduces the value of the capital of the leveraged business as well as the capital of the more conservatively financed businesses.
Leverage also contributes to the overall risk in financial markets. Liquid financial markets make it easier to enter and exit positions, making it appear that it is safe to operate with a leverage. If markets were not liquid then leverage appears more dangerous as it is more difficult to exit a position. In times of crisis liquidity may suddenly disappear. Liquidity makes it possible to take on more risk so the overall level of risk in the financial system might increase as a consequence of liquidity. This may become apparent during a crisis.
Banks create money by issuing bank credit that can be used for payments. From time to time a bank cannot meet the demand for money of its depositors and then the bank goes bankrupt. Such a situation can have different causes, such as reckless lending, unexpected withdrawals, economic cycles or seasonal factors. Because banks hold deposits at other banks, one bank's financial troubles can cascade through the banking system. As a consequence, people can lose their confidence in the banking system and bank runs may ensue.
Banks may stop lending money because they need to meet the demand from depositors for money. This can cause an economic recession or even a depression because a reduction in lending causes a reduction in spending and investments. During a depression business incomes drop in money terms so many businesses and people experience difficulty to repay their debts. This causes more businesses to go bankrupt and more people to become unemployed. More loans will then not be repaid and consequently more banks can get into trouble. In this way a credit cycle can reinforce itself.
Ancient societies observed the adverse consequences of interest. Interest contributed to the concentration of money in the hands of a few people, while on the other hand many people were in debt or had become serfs of the money lenders. For that reason debts were forgiven from time to time . This may have produced economic cycles. The Bible has provisions to forgive debts such as the Jubilee Year. Compound interest is infinite in the long run. This is a problem when the money lenders do not spend the interest on their money but accumulate it.
When money becomes concentrated into the hands of a few, less money remains in circulation and prices may drop. It becomes difficult to repay debts with interest because the debts and interest are fixed in money terms. Interest payments further reduce the available money in the hands of the public. Money lenders can then take possession of the belongings of the borrowers and demand their labour as repayment. In this way many people became serfs of the money lenders. This phenomenon is called debt slavery.
From this one could conclude that any interest rate on debts above the change in the monetary base, which could be currency or gold, contributes to this problem and can henceforth be called usurious. For example, if there is two percent more currency in circulation every year, then an interest rate of two percent on debts does not contribute to the concentration of money into the hands of a few, but higher interest rates do. It also follows that if the monetary base remains stable, interest rates above zero could be called usurious.
Interest on money is a possible cause of economic cycles and the expansion of debts. There is not be enough money in circulation to pay off all debts with interest. If new debts are made at a faster pace than old debts are repaid with interest, the amount of money in circulation increases, which is monetary inflation. Under those conditions the economy tends to perform well and there could be price inflation. If new debts are made at a slower pace than old debts are repaid with interest, then the amount of money in circulation decreases, which is monetary deflation. Under those conditions the economy tends to perform poorly and there could be price deflation. This is why many economists think that there should be some monetary inflation but not too much.
To deal with economic cycles and to deal with economic crises, monetary policies and fiscal policies have been introduced to manage interest rates, money supply and aggregate demand. Those instruments have turned out to be awkward because the best course of action is difficult to know in advance, but also because policy actions can distort markets and favour politically connected people and businesses. Most notably, those policies may foster moral hazard if market participants expect governments and central banks to help them out in times of trouble.
Economists often assume that there is a natural interest rate at which the economy is growing at its trend rate and inflation is stable. The natural interest rate may differ from the actual interest rate in the market because the market is influenced by the creation of bank credit. Deviations from this natural rate of interest could trigger booms and busts. If the market rate of interest is pushed below the natural rate of interest, for example through monetary expansion caused by bank credit during times of optimism, then people might receive a false signal to invest in more interest-sensitive projects. During an economic bust, capital might be destroyed that might have to be rebuilt during the next economic boom.
The market interest rate may therefore differ from the natural interest rate so economists often assume that it must be set by monetary policies. One of the intentions of central bankers is to keep the market interest rate near the natural interest rate. By setting short term interest rates, and in this way indirectly targeting long term interest rates, central banks can influence the creation of bank credit. If they perceive the natural interest rate to be above the market interest rate, they will raise short term interest rates, and if they perceive the natural interest rate to be below the market interest rate, they will lower short term interest rates.
The natural interest rate is a theoretical construct. It cannot be measured or calculated. Economists and central bankers therefore have to rely on estimates. During an economic boom the natural interest rate is above the market interest rate because economic growth is above the trend rate, while during an economic bust the market interest rate is below the natural interest rate because economic growth is below the trend rate. Monetary policies may be too easy during the boom phase as high interest rates could produce a bust while policy makers prefer not to be responsible for economic downturns.
Policy makers therefore tend to extend booms and mitigate busts so money supply as well as debts continue to expand. Often the growth rate of the money supply exceeds nominal interest rates. The scheme of compounding interest contributes to this as it needs new money to pay off the interest on old debts. Debt expansion also seems to require lower interest rates because otherwise people might not have adequate income to service a higher debt level. If no-one is willing to take on more debt, then the last resort of central bankers is printing new currency. This can have unforeseen inflationary consequences in the long run.
Fiscal policies and monetary policies are driven by a fear of economic cycles, most notably economic crises and monetary deflation. When there is price deflation, debts and interest payments grow in real terms, which may become a further drag on economic growth. People may postpone purchases when they expect lower prices and an uncertain future. A holding tax on money could solve this issue as the holding tax makes keeping money idle expensive. It allows for negative interest rates when the equilibrium of intended savings and investments is at a negative interest rate.
Economic growth comes from capital deepening and technological change. Capital deepening is increasing the amount of capital per worker, such as machines, infrastructure and software. At some point adding more capital to a worker starts to yield less because of the law of diminishing returns. Mature economies have large capital bases and adding more capital may lead to lower returns on capital and a downward pressure on interest rates.
In the past technological change helped to overcome this problem as technological change destroys capital and offers opportunities for new capital to grow. Even though technological development seems to continue unabated, new innovations may have less economic value as further improvements in living standards are subject to the law of diminishing marginal utility. This also may put a downward pressure on interest rates.
There might be a global savings glut, often identified as excess savings in Asian economies invested in the United States and the European Union. A global savings glut, if it exists, could push interest rates downwards. An uneven distribution of wealth may also contribute to lower interest rates. Capital not only produces wealth, but it also requires wealth to exist, because supply must equal demand. When the richest people do not have meaningful ways to spend their wealth, they can only invest, which produces a downwards pressure on interest rates.
Many mature economies have a low population growth or their population might even decline. They may enter a steady state where interest rates might remain low. Japan with its advanced economy and ageing population could be a precursor for what will be happening in other mature economies like Europe and the United States. In Japan interest rates have been near zero for more than two decades despite massive monetary and fiscal stimulus.
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