Is interest-free lending inevitable?

Last week I wrote a post which attracted more comment – and much angrier comment – than anything I've written before. (It was entitled “Ban compound interest to save the planet”. If you missed it, you can read it here.)

In writing the piece, I wanted to draw attention to something that increasing numbers of people seem to be saying: that an economic system that depends on constant growth is inherently unsustainable.

It's clear that many people found the post ridiculous. They may be right, though mercifully others recognised some merit in the points I raised.

In the hope that I might do this important subject greater justice, I've interviewed a recognised expert - Richard Douthwaite (pictured), of Feasta, The Foundation for the Economics of Sustainability.

Bearing in mind the response to last week's post, I daresay that many people will disagree with Douthwaite, but I hope that you will find his ideas interesting – not least the suggestion that peak oil and climate change may soon see banks deprived of the right to lend in a way which creates new money, something they do routinely today.

JPF Hello Richard. Why do you think that people reacted so strongly to my post last week?

RD Your post seems to be demanding massive changes in the way the world works. People find that very threatening and react emotionally. But besides being emotional, your contributors were confused because the relationship between rent and interest was not clarified.

JPF That's my fault. Can you explain the difference for me?

RD Rent is the fee you pay for using something. You rent a house because you need somewhere to live. The use of the house has a cost and you are prepared to pay it for the benefits you get in return. That's fine. No-one has any problems with that.

Interest, on the other hand, is the rent one pays for the use of money. But money itself is sterile. It is only the things that you can buy with it that are of use. So charging people for using money is illegitimate whereas charging them for the use of the goods that were bought with the money is OK. This may seem a fine distinction but it is an important one.

JPF It is a fine distinction, but I think I have grasped it. So, returning to compound interest – what's the problem?

RD The distinction goes to the root of the difficulties people were having distinguishing between simple interest and compound interest. Simple interest is paid off quarterly or annually. Just like the rent on a house, it is never allowed to build up. So it's fine for loans which are made for consumption purposes like buying a house or a car. Compound interest involves paying interest on interest and this is generally allowed only on loans made to provide funds for someone to invest. There's no problem with simple interest - people expect to pay that out of their normal income. With compound interest, however, economic growth is required if everyone who has borrowed to invest is to be able to pay the interest on their loans without impoverishing themselves.

So lending money at interest for investment purposes means that economic growth has to happen if it is to be successful. It was easier to recognise this in the days when gold was used as currency. Gold did not increase itself, and very little was being mined - so where, people asked, was the extra bullion to come from to pay the interest when both principal and interest had to be handed over at the end of the loan?

Obviously, the person who had borrowed gold to invest could only obtain the extra gold to pay the interest if someone else had less, so lending gold at interest in a no-growth society meant that either the borrower impoverished himself when he paid over the extra or he impoverished someone else. And neither outcome was socially desirable.

JPF This is why lending at interest was regarded as a sin?

RD Yes. Usury, as all forms of moneylending were called - no matter how low the interest rate - stood morally condemned by both the Roman Catholic Church and by Islam. The Catholics only formally lifted their ban in the 1830s when European economies had begun to grow.

JPF But we don't use gold any more. We can issue as much paper money and electronic money as we like, surely?

RD Even though we now use paper and electronic currencies, the source-of-interest problem has not gone away. Since almost all money in circulation in the world is issued on loan, borrowers can only obtain the money they need to cover interest payments if other borrowers have borrowed sufficiently more.

So, the fact that we create our money supply on the basis of debt, and charge interest on that debt, means that our money supply has to expand year by year at the rate at which interest payments take money out of circulation. If the rate of interest is 10%, and the cost of running the banks is 4%. the money supply has to increase by 10 – 4 = 6% if the average borrower is to be able to find the cash to pay their interest bill because that is the net amount of money that interest payments extract from the circular money flow.

But if the money supply increases by 6% and the real economy only grows by 2% - what then? The answer is that we've got too much money chasing to few goods and services and an inflation results.

So, because we charge interest on the money the banks lend into circulation, we've got to have growth, or inflation, or a bit of both if defaults are not to become a problem, eventually threatening the lenders' solvency. In short, the charging of interest by the banks creates a need for growth, a growth compulsion, which contains the seeds of its own destruction since infinite growth is impossible in a finite world.

JPF A lot of people will not like the idea that you seem to be suggesting – that we must stop growing. I don't think many will even think it's possible.

RD Although our continuing efforts to grow have already done enormous environmental damage without making people any happier, I'm not saying that we must stop growing. I'm saying that we will be stopped.  That, sooner or later, we are bound to reach the limits to growth and our money creation system will break down. Indeed, I believe that with climate change and oil peak, we already have.

JPF Blimey. And what does that mean?

RD If I'm correct, in the next year or two people won't be prepared to borrow enough for investment purposes to keep the money supply increasing because they won't be sufficiently confident of making profits if they do. This means we will have to start putting money into circulation in an entirely different, interest-free way if a serious depression is to be averted. If the reforms are radical enough to solve the problem permanently, banks will lose the right to create money in the way they do at present. Borrowing and lending would still go on, of course, but the basis on which both were done would be closer to the interest-free Islamic model than the one we currently operate.

JPF In a capitalist economy, that's a pretty revolutionary suggestion. Do you really think banks will allow anybody to deprive them of that right?

RD I think they will be in no position to object because their losses will have brought them to the point at which they need rescuing by the government. The government should therefore be planning to turn the developing banking crisis into an opportunity for real reform. It's not just a matter of incentivising bankers in some other way so that they lend more responsibly as some commentators suggest. The entire money creation system needs to be re-built in a different form. 

JPF I'm informed by my correspondents that this “interest-free” model would be more expensive than compound interest. Others laugh at the idea because they think I'm calling for “free money”. Who is right?

RD I'm not sure what they mean by “free money”. Money has to be scarce if it is to have any value. There's no evidence that interest-free banking is any more expensive to provide than the interest-charging kind. The JAK bank in Sweden does not charge interest on its loans but it does impose a service charge to cover its operating costs. This works out at about 3%. The arrangement is that you can have the use of other people's money interest free provided that you repay the loan and then give the other members the use of your money for the same number of kronor-months as you had theirs. It works well and means that, if you use a JAK loan to buy a house, you come away after 25 years with the loan paid off and a lump sum equal to the amount you originally borrowed. As you don't get that from any of the British mortgage lenders, that seems to indicate to me that JAK is cheaper. There's a good article on how the JAK bank works here.

JPF Several people who commented on my post last week said that if I didn't like compound interest I should just stop borrowing. I have a lot of sympathy with them because I hate centrally imposed regulation and would rather see change effected through individual personal decisions. But is their suggestion practicable, at the individual level? And what effect would it have on the economy if a lot of people stopped borrowing?

RD: If you stopped borrowing, it would not mean that you stopped paying interest. You would continue to pay it indirectly because every business borrows and has to make sure that you, its customer, pays a price which is high enough to cover its interest costs. For this reason, if money was issued in a debt-free way, it seems likely that prices would fall.

As for your second point, if everyone stopped borrowing today, the economy would gradually collapse because the money supply would contract as past loans and interest were paid off, making it increasingly hard to do business and for taxes to be collected.

JPF What kind of problems have you had trying to get your ideas heard by mainstream economists?

RD Surprisingly, very few economists are interested in the way that money gets into circulation and the effect that has on the way the economy operates. Some years ago I spoke to a professor at a university in the north of England who was interested in the topic but he told me it had proved a professional dead-end and he was moving to another area.

JPF Many people seem to feel that changing from the system we use currently would effectively mean returning to the Middle Ages, or even the life of a cave man? Are they, in any sense, correct?

RD: I've been developing scenarios for dealing with the climate crisis and peak oil. The most plausible scenario, which we call "enforced localisation", would return countries to a life of poverty in which their people scraped a meager living from the resources of their local areas. That scenario is based on continuing with the systems we have now until they break down as growth becomes impossible.

By contrast, reforming the money creation system promises to enable countries to retain a decent standard of living - provided that other policies, such as a rapid transition to a renewable-energy-only economy, are adopted too.

Comments

[Stephen]

Oh dear

[Abdullah]

A great book on the subject from an Islamic economics perspective

http://adnan-globalissues.blogspot.com/2008/06/new-book-global-credit-crunch.html

[Raf Manji]

Wow. It's amazing to see this subject pop up in a mainstream environment. As a former investment banker and trader I can only affirm what Richard is saying.

The banking system is on the verge of total collapse not just due to a complete binge in the creation of new credit by banks but in the way the system is actually structured.

There are some good pieces of research on my website if people are really interested.

What is important to note is that very few people understand how the money system is put together and more importantly it is not recognised or taught at any level in schools or academia. No wonder that professor gave up exploring this area.

Compound interest is an all devouring beast whose power has been revealed in the last year with the exposure of the lending system.

Did you know that there has been an Early Day Motion in Parliament calling for public interest free money for the last 6 years?

If people are serious about the environment they should learn all they can about the money system. And don't be put off by those who knock you back. They wouldn't last 10 minutes in a serious discussion of the subject.

Start here with this 1965 motion

http://www.monies.cc/forum/actions/precedence.htm

Regards

Raf

[deoxy]

Basic problem I see in lots of doom-saying like this: the assumption of a zero-sum game economy - that is, no value is ever created, it is simply taken from somewhere else.

In the modern world, we create value. Somebody mines ore from the ground - that is taking from a finite supply. But, from there until the final product, nothing else is taken - the metal is refined, making it more valuable; the metal is made into a product, making it more valuable again.

Let's say I borrow enough money to purchase refined metal and make a product (a folding chair, for instance). I sell the product for enough money to cover my cost (INCLUDING the interest) and pay myself for my labor, or I go out of business.

I don't really care what inflation is; that doesn't factor into my equation anywhere, nor does it matter.

The other major flaw in this line of reasoning is that money can quite easily be created WITHOUT any of the problems you mentioned. The stock market has beaten inflation on any 10-year period of time in the last hundred years.

In a system that creates value, you never have to have the problems predicted by this "expert".

[Brad]

Blimey. No. False. Bloody hell. Wrong. Incorrect. Fish and chips.

There are so many logical fallacies in his explanations that it's pointless to try to deconstruct them. He ignores so many of the important characteristics of the lending industry that it seems like he's completely unfamiliar with them. I'll give him the benefit of the doubt and suppose that he's just not very good at "dumbing things down."

The discussion about the JAK bank is absurd and hardly applicable to the general economy. Your website's own description of the system admits that participants have great credit and very rarely default. Of course the system works!

Further, the "reports" on this website are poorly contrived and poorly written, illustrating a poor fact poorly.

I feel stupider having read this.

God save the Queen. Yellow Submarine. Larch.

[Sabine K McNeill]

Dear Critics of Richard Douthwaite's arguments,

1. Please consider that money was invented as a medium of exchange to facilitate trade, not as a product to buy, sell or rent as food and accommodation

2. Please distinguish between the FINANCIAL economy of people transacting money for money and the REAL economy of people getting money for their time, services or products.

Sabine
Organiser, Forum for Stable Currencies
Publisher, Public Credit Petition
See http://tinyurl.com/666rwd

[Brad]

That was mentioned in the article. I've considered, distinguished, and rejected this rubbish.

Are you saying people shouldn't be compensated for sharing their wealth (medium of exchange, illusory power, fairy dust, etc.)?

[Sabine K McNeill]

Raf,

I'm soooooooo grateful for you having reminded me of the document on the historic precedent! I'm now incorporating it in the article that Prof. Prem Sikka has invited me to write about our Public Credit Petition. See http://tinyurl/666rwd.

Your analysis is great and your support is most valuable! Would you consider signing the petition? We're at 65 signatures and 819 page views. Interesting, eh?

By the way: we've kept nine Early Day Motions going since 2002: see http://www.forumforstablecurrencies.org.uk/index.htm

The petition is now the on-line political tool which is hopefully more effective. I'm now referring to this article from John-Paul as well as Ban compound interest to save the planet in its description/history.

Thank god, we're not alone! But making that visible, audible and publicly known seems to be the task of our 'interesting' times...

See you on-line!

Sabine
http://forumnews.wordpress.com/

[Soreofhing]

Mind boggling innocence, and ignorance of the ways of the world. If I lend you money at simple interest and you agree to pay me quarterly but don't, then I don't have the money that I could otherwise have invested, lent out or spent. You must pay me for this lost income, and that is called compound interest. It has nothing to do with ecology, it's sound equitable common sense.
Sorry, this proposition is a lead tennis ball.

[Sean]

money:creation of goods & businesses::medical research:medical advancements and new drugs/treatments

[Alistair McConnachie]

Interesting article. The following expands upon the general area of our privately-created for profit, debt-based money supply:

STOPPING THE DEBT DRIVER: Why Reforming the Way our Money is Created Holds the Key to Halting Unsustainable Growth
by Alistair McConnachie
Prosperity, October 2006
URL: http://www.prosperityuk.com/prosperity/articles/driver.html

The following is a transcript of the lecture, with the above title, given by Alistair McConnachie in the Cultivate Centre, Essex Street West, Dublin on the 3rd October 2006, as part of FEASTA's "Understanding the Economics of Sustainable Development" course. The lecture was delivered with a Powerpoint
presentation based around the 1968 Warner Bros film, "Bullitt", starring Steve McQueen:

Central to our lecture tonight is our concept of the Debt Driver. This is shorthand for the element of debt intrinsic to the economy which impels it, at breakneck speed, on the route towards unsustainable growth. As we will demonstrate, this debt has its base, its source, its point of origin, its genesis, in the very way in which our money is created. (continued at link)

[Wageslave]

Very interesting article. While I disagree with a few points, it has really made me think.

To Deoxy - you don't have to look very far back to find a 10 year period where the stock market hasn't beaten inflation - try looking at the FTSE 100 today as compared with 10 years ago. This is quite difficult, as investment firms will only show you figures for the past five years of recovery from the dotcom+9/11+Iraq war equities bust, and therefore show dazzling returns. However, according to Yahoo Finance, the FTSE100 closed at 5,455 on 14 August 1998, and it closed at 5,448.6 today, 14 August 2008. (http://uk.finance.yahoo.com/q/hp?s=%5EFTSE&a=07&b=14&c=1998&d=07&e=14&f=2008&g=d&z=66&y=2508)

Once inflation is factored in, at whatever rate you think is applicable, investors in the FTSE100 will on the whole have made a real loss. Dividend yields are very unlikely to have compensated for inflation, especially once tax on dividends is deducted.

[hotairmail]

I was told that this was a common misunderstanding. "Because of interest there are more liabilities than money, and therefore the money supply has to grow."

It is said £1 is all that is needed to settle all the debts in the world - as long as that £1 circulates more quickly than interest accumulates.

That means the velocity of money and thereby gdp are important to this discussion re the ability of debtors to settle their debts.

[Jamie Napier]

Simple interest is OK but Compound interest is not? Strange, given that simple interest is mathematically calculated from the compound interest of the component time periods. For example, on a one year loan, 10.5% simple interest payable at the end of the year EQUALS 10% compound interest payable every 6 months!

One answer is provided by Douthwaite himself (see FEASTA 13Aug), it is the PURPOSE of the loan that is important to him. He objects to compound interest because it is typically used for investment loans where "the money is being invested in a project and interest and principal can only be repaid when the project has begun to trade". Unlike consumption loans where the principal and interest are repaid from normal income, investment loans require the project to be successful which implies growth. "So it is borrowing for investment that creates the growth compulsion". Douthwaite objects to growth because it is unsustainable and inequitable. This is, in fact, his starting point. (And leads him to favour consumer loans over investment loans, which is unusual!)

However, leaving aside whether or not growth is good or bad, it is illogical to finger compound interest as INHERENTLY requiring growth. The objections to this logic are many. Not all investment loans are successful and an unsuccessful loan does not create growth. Not all loans with compound interest rates are for investment, a bank may approve a longer term consumption loan (eg to buy a home) with no interest payments for the first 5 years. Not all investment loans are at compound interest, some are at simple interest rates (paid out of normal business operations). And, as shown in my first paragraph, simple interest is mathematically a function of compound interest rates for the component time periods, so it makes no sense to object to one and not the other!

In contrast to Douthwaite who objects to compound interest because of what happens when the loan project is successful (i.e. growth), others object to compound interest because of what happens when the loan project is unsuccessful - the total debt increases exponentially over time. But this is also the case with a simple interest rate loan. If interest and principal remains unpaid at the end of its term and the bank chooses to rollover the loan (instead of defaulting the loan), interest will subsequently be due on the interest owed. It is the bad lending decision that is the problem, not the type of interest per se. Yes, a long term investment loan for a project that is not expected to generate any income for 5 years is riskier than a one year consumer loan to be repaid out of current salary, but this does not mean that compound interest is evil.

[Ian Greenwood]

VERY interesting subject with implications on general well-being. This complements the new Flintoff section on Money as Debt here's the link. A free DVD is also available. For concrete proposals see Sept 08 posting :

http://timesonline.typepad.com/environment/2008/09/limits-to-growt.html?cid=129077216#comment-129077216

In response to WAGESLAVE on interest, you say difficult to get figures beyond 5 years for the stockmarket: I agree, the reason could be that there is a deception process going on to conceal what I call the "saw-tooth" effect.

Big players can force up the price of shares by buying lots of them. Then others join in (or the "biggies" join into a pre-existing trend).

By close monitoring (only really those on the case full time can do this - or those with full time staff) and by gathering evidence, the top of the market can be forecast and a biggie can then sell all at once which forces the price down. Others then join in to take profits or cut their losses (since they are unsure of what caused the bump/decline) which further depresses the price. Yet the biggie can then start to buy again after the bottom has been reached, pocketing a "healthy profit", knowing that they have been the cause, the shares are healthy, and their profit is a simple quick buck. Obviously later those "bitten" will be wary.

Any such big boys behaviour or collusion to sell together should in my opinion be outlawed as it is obviously immoral - but how could you discover or regulate it? or even monitor it? Obviously such a situation would be far from healthy but difficult to prosecute (see recent difficulties of the FSA in bringing insider dealing to book. Also far from healthy considering the vast number gaining their livelihood from these and other exercises creating dependency in the UK and a distorted GDP. There is also another area of false value described in my documents (on imported goods resold).

Going back to the original point, The idea of the stock market at its invention was to cheapen the cost of capital investment at the outset of a company, free them from the tyranny of some banks in the 1800s or eearlier and to allow smaller shareholders to make reasonable amounts of money from the steady growth of a company, spreading the risk of their investments. Yet the most money by large margins is easily picked up by the big players, making it more difficult for the small guy (as usual)

Big bang indeed - the above observation exploded any confidence I might have had in the Stock market. Although the general upness seems to say they are a good investment, I wonder. What do you and others think?

Personally I'd rather stay out and plod on with my real estate, even if borrowing is much more costly because of "free money" - credit etc - see my papers free to you - which results in banks forcing prices/cost/taxes up !!

The question is what is the right and true reward for finance/banking/traders (see my documents available with practical proposals for far-reaching change, stability and justice, gradually re-stabilising the situation globally. Can we bring those costs down and improve stabilty by united action? I am sure that we can!! Please be in touch for charts, cartoons and easy documents, including "Progress.doc".
"Can we do it - YES WE CAN!" If we act together. email for docs: Ian.Greenwood@STEERglobal.org