The phenomenon of interest is at the heart of Silvio Gesell’s diagnosis of our economic problems, as well as his prescription for their solution. However the word “interest” itself is problematic. As it is typically used, it is somewhat vague and ill-defined. In order for it to be a useful concept for the purposes of understanding how the economy works, we need to take the time to arrive at a more precise, scientific definition of the word. Otherwise we will end up hopelessly lost in analytical confusion that ultimately boil down to semantics.
[Please note: This discussion reflects the views of the writer of this article, not necessarily those of Silvio Gesell. To the best of my knowledge, Gesell never specifically addressed this subject.]
A typical real-world interest rate actually consists of four different components, and each of those components behave according to different dynamic principles. Those components are: 1) “pure” or “risk-free” interest, 2) risk premium, 3) expected inflation/deflation, 4) administrative costs. An interest rate on a mortgage or a car loan lumps these four components together, and the borrower usually doesn’t know what portion of the overall rate corresponds to each one.
The first component, so-called “pure” or “risk-free” interest, is the most important for the purposes of understanding the Gesellian economic perspective. This component represents the power of money to grow without incurring any risk, cost or loss. For example, when a government borrows in a currency which it is also the issuer of, there is zero risk of default because that government can always create additional currency as a last resort in order to meet its obligations. Governments borrowing in their own currencies can never be forced into default. (We will ignore the possibility of voluntary default, which is often used as a negotiating tool by politicians in order to achieve their desired political outcomes — e.g. the recurring debt limit negotiations in the US Congress.)
One might object that the creation of additional currency in order to service government debt creates the possibility of inflation and is therefore not risk-free. While this is true, this is accounted for in the third component of interest (see below).
It is this “pure”, risk-free interest that Silvio Gesell identifies as one of the two primary causes of unearned income. If we wanted to sum up Gesell’s entire perspective in one sentence, it might go like this: “If someone receives income without creating wealth, someone else creates wealth without receiving income.” In other words, the fact that some members of society receive a stream of income without providing any valuable goods or services — in this case, lenders — means that the pool of wealth that is available to compensate the members of society who do provide goods & services is diminished, making it impossible for those members to be fairly compensated for their efforts.
(In this article we will not be examining the question of WHY pure interest exists. That subject is addressed in Gesell’s book, The Natural Economic Order, and is discussed in other installments of this newsletter. The purpose of this article is simply to define the word interest, as it is used in the Gesellian economic perspective.)
The second component of interest is the risk premium. Not all borrowers are equally risky. Extending a $20,000 car loan to someone who earns $300,000 a year is typically less risky than lending the same amount to someone who earns $50,000 a year. A risk premium is a portion of the overall interest rate that reflects the creditworthiness of the specific borrower. This applies to corporate and governmental borrowers as well as to individuals. Companies and nations with better credit ratings pay lower rates of interest than those with lower ratings.
If there were no adjustment to interest rates to reflect the creditworthiness of specific borrowers, only the most creditworthy borrowers would be able to access credit. Therefore, it is logical and reasonable that riskier borrowers should pay higher rates on loans, since there is a greater likelihood that lenders will lose some or all of their investments due to default. So, in terms of the Gesellian economic perspective, the risk premium is NOT part of what Gesell refers to as “unearned income”. Assuming risk is a valuable service and deserves to be remunerated. (After all, that’s the entire reason the insurance industry exists.)
The third component of interest is expected inflation/deflation. Inflation and deflation mean that the purchasing power of money changes over time. If inflation occurs while a debt is outstanding, the money used to repay the loan has less purchasing power than the money originally loaned. Conversely, if prices fall (i.e. deflation), the money that is repaid in the future is worth more than the money that was originally lent. So both borrowers and lenders are impacted by inflation/deflation, and the interest rate of a loan will typically include a component that reflects expected inflation or deflation. (Of course it is impossible to know in advance what prices will do in the future, so this component represents a prediction about the future, not a measure of what inflation/deflation turns out to be.)
To better understand the expected inflation/deflation component, consider the following. In the United States, 20% would be considered a very high interest rate. Inflation in the US might average, say, 2-3% typically (recent history notwithstanding). So if one were to loan money at 20%, inflation would reduce the return on that loan by a couple percent, but the lender would still be receiving a large positive return in real terms. But anyone would be insane to loan money at 20% in Argentina right now, because annual inflation is running at around 100%. If one loaned Argentinian pesos for one year at 20%, the lender would lose 40% in real terms even if the loan gets repaid (assuming that inflation continued at the present rate). In fact, in an even more extreme historical example, at the end of the German hyperinflation, people were able to pay off entire mortgages with a day’s earnings, since one mark at the end of 1923 was worth one-trillionth of what it was worth at the beginning of that same year.
So, similarly to the risk premium, the expected inflation/deflation component of interest is reasonable and necessary. The terms of a loan should reflect expected changes in the purchasing power of money. (There are, of course, other ways to account for inflation/deflation in a loan agreement besides factoring it into the interest rate. An adjustable interest rate is one way. Another way is to use a price index in the loan contract to calculate loan payments so that they reflect changes in the price level. The latter is actually the fairest method in theory, but in practice it is the least commonly used.) So, once again, the Gesellian critique of unearned income does not apply to this component of interest.
The fourth component of interest is administrative costs. It costs money to issue and service a loan. Someone needs to assess the creditworthiness of the borrower, manage the collection and disbursement of loan payments, etc. So this component, like the second and third components, does not fall under the heading of unearned income, since it represents payment for valuable services.
So, to summarize, three of the four components of interest are NOT unearned income. It is only the first component, so called “pure” interest which is unearned. Therefore Gesell’s analysis of how interest causes maldistribution of wealth only applies to a portion of what are typically described as “interest rates”. This is a critical point to keep in mind when considering the Gesellian economic perspective. Without making this distinction explicit, people would justifiably ask questions like, “shouldn’t lenders get compensated for assuming risk?”, and “shouldn’t lenders get paid for providing the service of administering loans?” Yes, they should. That is not interest in the Gesellian sense of the word.
Hello Mr. Sidman,
First of all, I must say that I have huge respect for you, I really admire your work. However, this time I do not share the same opinion with you.
Gesell described interest as a plaguespot of an economy and I think he meant that we need to completely eliminate it.
“Free-Money, that is to say, money free to circulate, money free from the anomaly of interest.” (p. 119)
Your division and explanation open doors to unearned income.
3- expected inflation) In one of your previous articles, you said that inflation is different from demurrage because it is inconsistent and unpredictable. So how borrowers and lenders can precisely decide expected inflation and deflation? The decided rate will always be different from the occurring rate. Therefore usury will be always there.
Also, “The currency office will not be dormant like our present monetary administration which with indolent fatism expects the advantage of swindlers, speculators, and usurers; it will intervene decisively to establish a fixed general level of prices, thereby protecting honest trade and industry” (p. 123)
2- risk premium) Since it is not possible to decide which part of money contains a risk premium and which part contains pure interest, I think it should be illegal to demand all kinds of excesses from the debts. In order to earn risk premium people must seek to invest in real business (e.g. starting their own company or making a partnership etc.). Higher risk must offer higher dividends but not interest. (briefly, the main difference between these two: the company pays dividends if there is a profit but interest must be paid regardless of all scenarios.)
4- Administrative costs) It might be legit to demand this cost however, it should not be a ratio that limitlessly grows with the amount like interest. But it should be a pre-decided fixed rate.
So one might say what would be the point of lending money if it is a 1:1 ratio payment? The lender will avoid the deprecation of his money with demurrage. (Please remember the story of Robinson Crusoe by Silvio Gesell.)