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?
Thanks for your comment and questions. I agree that most people probably haven't thought about these things and just accept things the way they are. That is one of my main objectives in writing this newsletter -- i.e. to encourage people to think critically about factors that affect their economic well-being but which they have probably never thought about in depth before. Overcoming habitual modes of thought is a steep hill to climb.
To answer your question about institutional lending, it is first necessary to clarify exactly what I mean when I use the word "interest", since my use of the word is narrower than how it is used in common parlance. In reality, when most people use the word "interest", they are lumping together three separate and distinct components. An interest rate on a loan agreement typically consists of three elements. The first is what economists would call risk-free, or "pure" interest. This is the return that money generates when loaned without risk. (This is a theoretical concept, since it could be argued that there is no such thing as a completely risk-free loan. In practice, the yields on US Treasury securities is used as a proxy for the risk-free interest rate.) The second component is a risk premium, which reflects the creditworthiness of the individual borrower. Obviously, lenders need to be compensated for assuming credit risk, or else only the most creditworthy borrowers would be able to access credit. Under the system Gesell proposed, risk premiums would continue to exist and would be determined in the same way they are now -- i.e. by competition in the marketplace. And the third component of "interest" is a measure of anticipated inflation or deflation. Obviously, if the market expects inflation, lenders will need to be offered a higher rate to offset the fact that the purchasing power of the future cash flows they receive will be diminished by devaluation of the currency. And, as with risk premiums, this third component is determined by the market. So, to be clear, it is only the first component -- "pure" interest -- that Gesell's criticism is aimed at. Even if his proposal for a depreciating currency was implemented, risk premiums and expected inflation/deflation would still apply to all lending agreements.
So, in terms of institutional lending, financial intermediaries would still have the same basic function under a depreciating currency system as they do now. They would still provide a valuable service (for which they would be compensated) by matching up people with excess money and those in need of money. The only difference is that the rates applied to lending agreements would no longer include pure interest. (And, to be clear, the disappearance of pure interest wouldn't be something that the government or financial authorities would need to impose by law or regulations. It would be a natural consequence of competition and supply & demand in the marketplace (just as pure interest is now). Pure interest is a naturally occurring phenomenon in a monetary system based on a hoardable currency. But, in my view, that is an unintended consequence of a flaw in the design of money. If that flaw was fixed, pure interest would disappear naturally.)
So under your/Gessell’s system would the individual who puts their money in a bank also expect to receive the third form of interest (basically to keep up with inflation)?
Well, I would reiterate that the market would ultimately determine the answer to these questions. It's not like there would be someone sitting in a government agency or a bank determining the rate of expected inflation and then plugging that into the loan formula. My sense, though, is that the third component of "interest" would probably not be necessary, since there would be no reason to expect inflation. Under our existing monetary system, central bankers around the world explicitly aim for a positive inflation rate, so obviously that needs to factor into lending agreements. But the goal with a depreciating currency would be to maintain a stable price level, so there probably wouldn't be a need for the third component of interest.
Your original comment talked about how most people pay a lot more interest than they make due to student loans, credit card debt, etc. if the pure interest component was eliminated all around, would it still be true that most people are paying a lot more interest? Would it actually change the equation in terms of net interest paid (amount of interest you pay versus receive)? (I understand you are saying eliminating pure interest would have many other positive impacts such as on wages, etc.)
Yes, eliminating the pure interest component would make a big difference. Just to get a sense of the magnitudes involved, let's consider the category of mortgage debt. According to Investopedia, there is currently around $10 trillion of outstanding mortgage debt in the US. If we assume a pure interest rate of 4% (which is not an accurate estimate of current rates but is a reasonable estimate of the historical average), that would translate to around $400 billion annually. And that's just one category of debt. Estimates of total debt in the US economy are somewhere in the neighborhood of $35-40 trillion.
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?
Thanks for your comment and questions. I agree that most people probably haven't thought about these things and just accept things the way they are. That is one of my main objectives in writing this newsletter -- i.e. to encourage people to think critically about factors that affect their economic well-being but which they have probably never thought about in depth before. Overcoming habitual modes of thought is a steep hill to climb.
To answer your question about institutional lending, it is first necessary to clarify exactly what I mean when I use the word "interest", since my use of the word is narrower than how it is used in common parlance. In reality, when most people use the word "interest", they are lumping together three separate and distinct components. An interest rate on a loan agreement typically consists of three elements. The first is what economists would call risk-free, or "pure" interest. This is the return that money generates when loaned without risk. (This is a theoretical concept, since it could be argued that there is no such thing as a completely risk-free loan. In practice, the yields on US Treasury securities is used as a proxy for the risk-free interest rate.) The second component is a risk premium, which reflects the creditworthiness of the individual borrower. Obviously, lenders need to be compensated for assuming credit risk, or else only the most creditworthy borrowers would be able to access credit. Under the system Gesell proposed, risk premiums would continue to exist and would be determined in the same way they are now -- i.e. by competition in the marketplace. And the third component of "interest" is a measure of anticipated inflation or deflation. Obviously, if the market expects inflation, lenders will need to be offered a higher rate to offset the fact that the purchasing power of the future cash flows they receive will be diminished by devaluation of the currency. And, as with risk premiums, this third component is determined by the market. So, to be clear, it is only the first component -- "pure" interest -- that Gesell's criticism is aimed at. Even if his proposal for a depreciating currency was implemented, risk premiums and expected inflation/deflation would still apply to all lending agreements.
So, in terms of institutional lending, financial intermediaries would still have the same basic function under a depreciating currency system as they do now. They would still provide a valuable service (for which they would be compensated) by matching up people with excess money and those in need of money. The only difference is that the rates applied to lending agreements would no longer include pure interest. (And, to be clear, the disappearance of pure interest wouldn't be something that the government or financial authorities would need to impose by law or regulations. It would be a natural consequence of competition and supply & demand in the marketplace (just as pure interest is now). Pure interest is a naturally occurring phenomenon in a monetary system based on a hoardable currency. But, in my view, that is an unintended consequence of a flaw in the design of money. If that flaw was fixed, pure interest would disappear naturally.)
So under your/Gessell’s system would the individual who puts their money in a bank also expect to receive the third form of interest (basically to keep up with inflation)?
Well, I would reiterate that the market would ultimately determine the answer to these questions. It's not like there would be someone sitting in a government agency or a bank determining the rate of expected inflation and then plugging that into the loan formula. My sense, though, is that the third component of "interest" would probably not be necessary, since there would be no reason to expect inflation. Under our existing monetary system, central bankers around the world explicitly aim for a positive inflation rate, so obviously that needs to factor into lending agreements. But the goal with a depreciating currency would be to maintain a stable price level, so there probably wouldn't be a need for the third component of interest.
Your original comment talked about how most people pay a lot more interest than they make due to student loans, credit card debt, etc. if the pure interest component was eliminated all around, would it still be true that most people are paying a lot more interest? Would it actually change the equation in terms of net interest paid (amount of interest you pay versus receive)? (I understand you are saying eliminating pure interest would have many other positive impacts such as on wages, etc.)
Yes, eliminating the pure interest component would make a big difference. Just to get a sense of the magnitudes involved, let's consider the category of mortgage debt. According to Investopedia, there is currently around $10 trillion of outstanding mortgage debt in the US. If we assume a pure interest rate of 4% (which is not an accurate estimate of current rates but is a reasonable estimate of the historical average), that would translate to around $400 billion annually. And that's just one category of debt. Estimates of total debt in the US economy are somewhere in the neighborhood of $35-40 trillion.