Most people would reflexively answer yes — of course interest helps people save. That’s the whole idea behind saving — you set aside a portion of your earnings and then interest causes that amount to grow — hopefully enough to allow you to live off your savings once you’re too old to work.
The irony of this “conventional wisdom” is that probably 9 out of 10 of the people who defend the existence of interest will pay far more interest than they will receive over the course of their lifetimes — by a large margin.
Think about your own life. Think about all of the different forms in which you pay interest — from credit cards to car loans, from student loans to home mortgages. And now think about the forms in which you receive interest — from interest bearing bank accounts to savings bonds and other fixed income investments. Now ask yourself, have you paid more interest than you have received or vice versa? And would you be better or worse off in a world without interest?
So, why do so many people have a psychological attachment to a phenomenon that has a net negative impact on their financial well-being? Is it simply a matter of being comfortable with the devil we know? Or is it that people don’t have a complete understanding of all the ways in which interest impacts their lives? I hope it is the latter, because if that’s the case there is hope that people’s attitudes can be changed through education.
The reason most people believe that it would be more difficult to save in a world without interest is because they are only considering a small part of the overall picture. They are thinking about the small percentage of their earnings that they are able to set aside after paying for the goods and services that they consume. And, while it is true that if a typical wage-earner is able to scrimp and economize in order to set aside some savings, interest will enable those savings to grow over time. But that is only a small part of the overall impact that interest has on their financial lives. Focusing solely on the interest they earn on their bank accounts ignores the effects of interest on their earnings and on the costs of the goods and services that they consume. And, in the course of a lifetime, these aspects of interest are far more significant in terms of their impact on people’s overall financial well-being than the small amount of income they receive in the form of interest on their savings.
Have you ever considered the notion that interest affects both your likelihood of finding a job as well as the level of your wages? The existence of interest artificially restricts job creation and also reduces wages across the entire labor market. This fact is far more significant in terms of the overall economic well-being of the vast majority of workers than the relatively small amount of interest they earn on their savings. After all, would you prefer to earn $2,000 a month and have the opportunity to earn 5% interest on whatever amount remains after paying your bills, or would you rather earn $4,000 a month but not have the ability to earn interest on your savings?
So, let’s think about the ways interest affects your employment prospects and wages.
Suppose that government bonds are yielding 5%. (At the moment government bonds yield significantly less than this, but we are living in a very unusual interest rate environment. 5% is a reasonable estimate of the historical average of interest rates on high quality government debt.) Now, let’s consider the options which are available to someone who has excess wealth that he/she is looking to invest. Let’s say a new business is seeking capital and is projecting a 5% return on investment. Between buying government bonds or investing in the new business, which option will most people choose?
Clearly, most people would choose to invest in the government bonds because they are less risky. Everyone knows that investing in a new business involves a significant chance of loss. So, if both investments are projected to yield 5%, why would anyone go with the riskier option?
Therefore, in order to attract capital, a new enterprise will need to offer investors a return of significantly more than 5% (to compensate for the additional risk vis-a-vis government bonds). Let’s suppose that in order to persuade investors to accept the additional risk the business needs to offer a projected return of 8%. This means that if it can only offer a 7% return it will not be able to raise the capital it needs. Therefore, that business will never get off the ground, and all of the jobs that it would have created will not exist. And, to reiterate the point, the reason that business won’t receive funding — and those jobs won’t be created — is because investors have the option of earning interest by putting their money in government bonds. If investors didn’t have the option of earning money by lending to the government, all of the money which is currently invested in government bonds would have to find other employments. And much of that money would fund new (or expanding) businesses. Those businesses would in turn create jobs and increase the overall demand for labor, thereby pushing up wages. In other words, the existence of interest draws money away from productive enterprise, thereby restricting job creation and depressing wages.
So, to recap, the fact that investors have the option to earn interest by lending to the government makes it more difficult for businesses to attract capital, and this in turn diminishes the demand for labor and reduces wages.
Now let’s consider another way in which interest impacts the economic well-being of ordinary people — i.e. through its effects on housing costs. Regardless of whether one owns a home or rents, housing is one of the largest expenses for most people. So, would housing costs be greater or less in a world without interest?
In a similar manner to how interest puts a brake on the formation of productive enterprises, it also artificially restricts the supply of housing. Any developer who is considering building new housing will compare the prospective rate of return on that housing with alternative investments, including lending money at interest. If investors can earn 5% by lending money to the government, obviously they won’t build a new house that is projected to yield less than 5%. In fact, similarly to the example above, building new houses entails risk, so in order to attract capital the investment will need to offer a return significantly above that which can be earned by lending to the government. And any prospective investment that does not offer a sufficiently high rate of return will not receive funding.
And what is the impact of fewer houses being built on the overall cost of housing? Obviously if you have the same number of people competing for fewer houses, the price of those houses — whether in the form of purchase prices or in the form of rent — will be higher than if more houses were built. So, virtually everyone in the entire economy pays more for housing than they would in a world without interest. This is yet another way in which the existence of interest negatively impacts people’s financial well-being.
Finally, let’s consider a third way in which the existence of interest affects people’s lives. The vast majority of businesses employ debt in order to fund their activities. Whether it is in the form of bonds, bank loans or lines of credit, interest expense constitutes a significant percentage of the costs of producing goods and services. And who ultimately pays those costs? Obviously those costs are passed along to the consumer in the form of higher prices. So, once again, we see that the existence of interest negatively impacts the economic lives of virtually all consumers.
So, now let’s tally up all of the ways in which interest negatively impacts the financial well-being of the typical wage earner and compare that with the benefit they receive by virtue of earning interest on their savings. An ordinary worker will be less likely to be able to find work, will get paid less if he/she is fortunate enough to have a job, will pay more to secure housing and will pay higher prices for almost all of the goods and services they consume. And on the other side of the scale is the interest they earn on their savings. Look at your last 1099-INT and ask yourself if the amount you earned in interest is enough to compensate for all of the ways in which interest negatively impacts your economic well-being.
Ultimately, the best comparison I can think of for the role that interest on savings plays in most people’s lives is that of a comp meal in a casino. Anyone who has gambled is familiar with the idea of a comp. In order to get people to keep gambling, casinos give their patrons various products and services for “free”. If you lose a thousand dollars, the casino will give you a free meal. If you lost ten thousand, they’ll give you a hotel room and tickets to a show. If you lose hundreds of thousands, they’ll pick you up in a private jet and put you up in a luxury suite. But those meals, hotel rooms and plane tickets — even if you don’t pay for them directly — are anything but free. In fact, they’re probably the most expensive meals, hotel rooms and plane tickets you will ever consume in your entire life. And, for the large majority of people, believing that interest helps them save is as irrational as thinking that casino comps are a good way to provide for one’s food, lodging and transportation needs.
The interest that most small savers receive on their savings is a small rebate they receive for playing a rigged game. They pay a mountain of interest in the form of home loans, car loans, credit card debt, student loans, etc., they earn less money, they pay more for housing, goods and services, and after all of that, they get a small amount back in the form of interest on their savings. But, like a gambler in a casino, they would be far better off if they never played a rigged game in the first place.
Trying this again since I don’t think it worked the first time. It’s very interesting and persuasive what you say about interest. I do wonder empirically whether people do think interest is a net positive thing or realize it has a net negative outcome for most people or if they’ve simply never thought about it at all and have always accepted it as the way things are. I would be in the latter category. You are obviously suggesting that interest has a harmful overall impact and I certainly agree with your case for why we should not feel justified in expecting interest on our savings. But how about from the institutional lender perspective? Are you saying institutions like banks and credit card companies should not charge interest? If not how would it work for them to advance funds/credit?