Index

Interest, Usury and Seigniorage in the Public Interest

Bill Powell, 9/2009

WHAT IS INTEREST?

How words have been changed or twisted in meaning over the years! Classical economics defines ‘Interest’ as the return on ‘Capital’. Capital in turn refers to an asset created by Labour acting on natural or communal resources which are referred to as ‘Land’. Today we use Interest to refer to return on a money loaned under a contract that it be repaid with Interest by a certain date. So now what was once called Usury is now called Interest, and though there are no more debtor’s prisons the courts are still pretty merciless in enforcing these contracts even when things go wrong.

Things can go wrong for a borrower. He very likely borrows to buy an asset on which he expects a real return. That return is in the future which can never be 100% certain. Yet the contract is based on an estimate of what the future holds. The borrower carries all the risk, and the courts see to it that the lender carries none.

The alternative is for the lender to enter a partnership with the borrower, taking an Equity stake in the asset and enterprise. Then they share the risk.

Businesses commonly combine both. A farmer typically sells ‘forward’ half the crop he expects to grow in order to borrow money for the seed he will plant to grow it. His profit will be magnified if he has a bumper harvest, but he will be in trouble if the harvest is poor. His risk is magnified. The Lender’s is not.

WHO DOES IT BELONG TO?

The return on an asset is real. It arises day by day, year on year, not only in monetary form, but also in quality of life. That is why we buy it.

We allocate ownership of a capital asset to its creator to enjoy or hire or sell to someone else. Yet is this right? The natural and communal resources used surely belong to us all.

herefore part of the return on the asset should go to the public. Following Henry George this should be done by making a charge such as a ground rent directly on the asset. Since this is rarely done, there is a public element in the Interest the lender charges the owner of the asset which should go not to the lender but the public.

In a more subtle way there is another element of Interest which should also belong to the public. The use of money instead of barter greatly increases the efficiency of society’s transactions, including lending and borrowing. The benefit from this should go not to the lender or the borrower, but to the community as a whole. A charge made on payments of interest would therefore be analogous to seigniorage, but would arise continuously, not simply when new money is put into circulation.

ASSET PRICE VERSUS INTEREST RATE

There is generally a good idea of the return on an asset, e.g. the crop on a field. The return is real. But what is the price of the field? That depends on how much the return is worth to a buyer in competition with other would be buyers, many of which will be offering borrowed money.

If interest rates are low they will be able to borrow more than if they are high. If interest rates fall the owner of an asset will see its price rise, but if they rise the price of the asset will fall perhaps even below what he owes the lender. It is therefore interest rates that set asset prices and not the other way round.

The BANK RATE set by the Bank of England (BoE) is often used as a guide in contracts which read “x% below or above bank rate”. Some lucky holders of mortgages have seen their interest payments all but vanish as the BoE slashed the bank rate from 5% to 0.5%. And unlucky pensioners have seen the income on their hard earned savings all but vanish. Surely manipulating interest rates can’t be the right way to control the money supply if it leads to such injustice.

On the face of it low interest rates ought to be good. They allow more money to be borrowed to invest in higher quality assets. But LOW INTERES RATES ARE DANGEROUS. They led to the asset bubbles of the Greenspan era, and the property bubble which brought the financial system to its knees.

Consider how much of your income you would have to save over a 35 year period to give you a 20 year pension of half that income. If the (real) interest rate is 6% over the whole period you must save 5.15% of your income p.a. If the interest rate is only 3% you must save 12.3% of it. This huge difference arises because money accumulates faster at 6% and also pays out more during retirement.

Next consider house purchase. The purchaser can afford £6,000 p.a. (i.e. 30% of his income of £20,000 p.a.) Over a 25 year term he can borrow £76,700 if the interest rate is 6%, but if it is only 3% he can borrow £104,479. At first sight the lower interest rate looks better for him. Bear in mind however that some competing buyer will also be offered more. The house price will therefore be higher. He will have to borrow 5.22 x his income if the interest rate is 3% instead of only 3.84 x if it is 6%. His financial risk is magnified. If he is saving up for a down payment the low interest rate makes matters even worse. He has to save up more and his savings accumulate more slowly.

One can only wonder at the madness of setting near zero interest rates when house prices are still far too high. It was low interest rates that caused the bubble and collapse in the first place. Central bankers are prescribing more of the same drug!

Is there a fair, correct or ‘NATURAL INTEREST RATE’? Surely there should be one that is fair to both borrower and lender, and also serves the public interest? Religion perhaps gives a clue. The Jubilee translates in a rough and ready way into 2.5%. The Muslim zakat is also at this level.

It must also be borne in mind that for several hundred years there has been a 2.5% or so growth in the return on assets as we learn new more efficient technologies. Adding the growth to the return gives a total of 5% or so (real) return.

Perhaps better would be to judge where fairness lies. Just how hard should we have to save to provide for our own old age? If we could answer that we could calculate the fair and natural interest rate. I daren’t risk giving a definite answer, but surely the current 0.5% Bank Rate is far too low, just as 10% would be far too high.

INTEREST AND FRACTIONAL RESERVE BANKING

Mr Adams deposits £100 in Mr Lloyd’s safe. Mr Lloyd lends £90 of it to Mrs Baker. Mr Adams buys an asset from Mr Cook for £100. He gives Mr Cook a cheque for £100 in payment. Mr Cook passes the cheque to Mr Lloyd who moves the £100 it is to repay Mr Adams to a promise to pay Mr Cook £100 instead.

Note that Mrs Baker and Mr Adams both apparently have money, £190 in all. The original £100 has been magnified into £190 and this much money circulates until Mrs Baker repays her loan to Mr Lloyd. Mr Lloyd keeps back only a £10 cash ‘reserve’ because he knows that at least nine out of ten transactions will be by cheque, debit card or internet transfer. Only at the tenth one will someone show up at the till and ask for cash. This is ‘Fractional Reserve’ banking.

Note that although the money circulating has nearly doubled there are no more real assets in the community. Suppose they gave a return of 5% before the money nearly doubled. There is now nearly twice as much money so these asset prices will nearly double. It will now cost nearly twice as much to buy the same real return for an asset. This is asset inflation, resulting in a near halving of the real interest that money can earn.

[The process of fractional reserve banking needn’t end there. Mrs Baker will almost certainly give her money to Mr Barclay to look after. He will lend £81 to Ms Davies keeping £9 in reserve, and so on and on until the money circulating increases to £1,000.]

BANKING REFORM

Clearly fractional reserve banking invites unstable interest rates and asset values. It needs reform to stabilise interest rates at the natural level. It should also levy seigniorage just as printed or minted money does, otherwise the seigniorage arising from fractional reserve banking accrues to the bankers instead of the public. There are two approaches.

The first is to outlaw fractional reserve banking by private banks. All money would be issued by the Bank of England (BoE) which would also control all credit creation. High street banks would merely act as agents of the BoE.

An alternative would be to levy a charge on loans issued by banks. There is after all a case for part of the interest going to the public. Such a charge would in effect be the seigniorage arising on the money created by bank lending.

In normal times both methods would recover seigniorage.

In the event of a mania leading to an asset bubble, both methods could remove money circulating so as to restore interest and asset values to normality. In the second reform raising the charge on credit created by banks to the point that it was hardly profitable would discourage lending.

In the event of a depression the first method would enable the bank to simply create money for the government money to spend. In the second the government would borrow from banks as now, but the interest it paid the banks would very nearly all return to it by way of the credit creation charge. It would be nearly ‘free money’ for the government to spend or lend.

QUANTITATIVE EASING AND INTEREST

Quantitative Easing (QE) is very like the first method. The BoE simply creates money out of nothing, but it is money that it knows it will have to take out of circulation again when the recession is over. The issue is what it does with the money.

It has mainly spent it buying existing government stock, i.e. loans made earlier by the government on which we tax payers pay interest. The effect is to drive up the asset price of

overnment stock which in turn means that the rate of interest it yields falls. That has led to a general fall in interest rates. Like the 0.5% Bank Rate this seems to me more of the same drug that led to the property bubble in the first place. Indeed property prices have not fallen anything like what was expected, nor what is needed to make it affordable.

Government stock is paid off out of our taxes, so the BoE knows that QE money it spends in this way will go out of circulation as the stock is redeemed out of our taxes.

This has been of little help to Farmer Giles however. His once friendly bank will no longer advance him money to buy seed. Nor will the BoE. That’s a pity, because farmer Giles track record in repaying his loans is good. It’s also a pity because he may not be able to grow any crops in the coming year. Furthermore it is he, not us taxpayers who repay the loan.

There is one silver lining to spending QE money on government stock. The interest we pay on government loans now goes to the BoE. The BoE in turn remits its profits to the government. The cost of creating the money is therefore nearly nil.

CONCLUSIONS

Clearly the global banking system is in need of far more serious reform than now seems likely. Indeed it looks destined to go back to almost to where it was before the property bubble nearly brought it down.

Part of this reform should be redirection of seigniorage from the banking system to the public and not merely some rules about reserves or bonuses.

The BoE focus on inflation has been inadequate in that it has ignored asset values and used a wrong headed and unjust tool to regulate the economy, namely the Bank Rate.

A better way out of recession would have been to keep interest rates near the natural level which as they were in Britain but use QE to provide money to the likes of Farmer Giles while the banks refuse to lend.

Bill Powell
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