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 Necessary Evil: Not So Necessary

by brendon farrell | 8-Dec-2009 | Comments (5) Tags: interest, monetary policy, social justice, financial crisis  96 ratings. Please log in to rate and comment

If thou lend money to any of My people, even to the poor with thee, thou shalt not be to him as a creditor; neither shall ye lay upon him interest. (Exodus, 22:25) Although the charging of interest is considered sinful by many major religions, its prevalence is considered a fundamental part of a Capitalist Society, facilitating efficient allocation of resources, by restricting borrowing and in turn limiting growth to a sustainable rate. However after the financial crisis the mechanisms of the financial system are in question, resulting in new and progressive concepts such as the one within.

Consider this hypothetical: You require a $500,000 home loan, so you go to the local bank branch and the bank manager offers you two options (A) a 7% interest rate repayable over 10 years and therefore monthly repayments of $5805.45 or (B) a 9% interest rate repayable over 20 years and therefore monthly repayments of $4498.65. You can only allocate $4700 of your income per month to home loan repayments. Even though option (A) has an interest rate that is 2% lower than option (B), your only choice is (B), as you can not meet the liquidity requirements of (A). The situation above highlights one of the most overlooked mechanism of monetary policy; the fact that interest effects repayments and in turn affects an individual's propensity to borrow. This overlooked mechanism has lead me to consider a fresher approach to facilitating monetary policy and the possibility of a banking system that runs effectively without a cash rate.

Today fiat currency is the major type of medium of exchange and is created at a government's discretion. Although it does not represent a commodity, it has a value based on a restricted supply and a demand generated by taxation. Currency enters the money supply when it is printed and expended by a government, with any money entering the system reducing the value of the particular currency due to to an increase in supply. Money exits the money supply when it is taken up via taxes and not re-expended, increasing the currency's purchasing power. Individuals wishing to borrow funds must be willing to pay a rate of interest to attract individuals who have surplus funds to lend to them. This interest rate exists due to the limited supply of funds that are willing to be periodically forgone and the demand for those funds. A government however does not need to be seduced into lending, nor does it have a limited amount of funds, as it can simply print money. If a government does not want interest rates to exist within a financial system it can become the monopoly lender, printing money to fill the demands of borrowers. Many would consider this detrimental, believing that individuals would borrow in masses, in turn flooding the money supply, causing hyperinflation. Such opinions are mainstream and have failed in recognising the liquidity requirements of borrowing as a major factor influencing decisions.

Welcome to the concept of balanced money; a system where all standard commercial banking functions are conducted by a public bank. All surplus funds which exist are balanced by outstanding figures, meaning if all debts are paid back the monetary base would be nonexistent. Money enters circulation via lending and exits via repayments. Individuals borrow from this public bank with no interest expense, but would be required to meet the obligations of repayment which may include a risk premium. Individuals would be deterred from borrowing to varying degrees based on a repayment rate decided by this public bank. Monetary policy is simply conducted by shifting repayment rates, affecting total borrowing and total repayments of the economy, which in turn affects the size of the monetary base and ultimately the activity within an economy.

Consider this hypothetical: A small country operates on a balanced monetary system, the reserve bank currently lends $1,000,000 per day and receive repayments of the same amount. The resultant is no change in the money supply. The reserve bank detects growth is unsustainable within the economy. It is decided that repayment rates are to be increased to counter excessive growth. Upon implementation, lending amounts are reduced by $200,000 per day and repayments increase by $300,000 per day. The monetary base is now contracting $500,000 dollars per day, reducing economic activity and increasing the purchasing power of this country's dollar. Hypothetically this nation or any other nation could conduct similar measures, to effectively control an economy without interest rates.

Ultimately the replacement of fiat money with balanced money would have major effects on the economic landscape and could be implemented in a multitude of ways, each likely to affect an economy differently and have its own supporters and detractors. Although I am restricted in discussing the particulars of such a system, one should not overlook the fact, that in today's world the gap between the rich and poor grows. This can be partially attributed to the differences in cost, that the same undertaking would have for someone who already has the money required, versus the individual who has to borrow. This inequality increases the risks and reduces the returns of the poorer individual. In the end one should agree, that the fiat money system amplifies the merits of the rich and muffles the merits of the poor. If this evil does not need to exist, should me let it remain.

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