During a boom phase interest rates rise. Promises are made that cannot be kept because the pool of money is limited. Borrowing against demand deposits or fractional reserve banking has made it possible to issue loans without the need for savings. In this way interest rates are suppressed when investments exceed savings during the boom phase. This fuels the boom as higher interest rates would have curbed the boom sooner. Because interest rates cannot go negative, they are propped up when savings exceed investments during the bust phase. This extends the bust phase because lower interest rates would have ended the bust sooner.
If banks can only lend against savings and nominal interest rates can be negative then an active management of money supply, interest rates, and aggregate demand by governments and central banks may not be needed. It is likely that in mature economies of stable societies with political freedom and respect for property rights, the natural rate of interest set by the market that matches savings and investments and guides the economy on the maximum sustainable growth path without booms and busts, is in nominal terms at or below the rate of money-supply increase. This can still be a positive real rate when there is economic growth.
To deal with the boom-bust cycle and to deal with bank runs that come from the charging of interest on money, central banks, government guarantees, as well as monetary and fiscal policies, have been introduced to manage interest rates, money supply, and aggregate demand. Those instruments have turned out to be awkward because the best course of action is difficult to know in advance, but also because policy actions distort markets and favour politically connected people and businesses.
Economists often assume that there is a neutral rate of interest that can guide the economy on the maximum sustainable growth path without booms and busts. The neutral rate of interest may differ from the natural rate of interest set by the market so economists often assume that it must be set by monetary policies. The monetary policies appear to be needed because there is a boom-bust cycle caused by interest on money, amplified by fractional-reserve banking.
During a boom phase the neutral rate of interest is above the natural rate of interest because economic growth is above the maximum sustainable growth path, while during a bust phase it is below the natural rate of interest because economic growth is below the maximum sustainable growth path. Monetary policies tend to be too easy during the boom phase as it is difficult to determine the neutral rate of interest. High interest rates will also prompt a bust and policy makers prefer not to be responsible for creating busts.
As a consequence policy makers tend to extend booms and mitigate busts, so overall monetary policies tend to be too easy so money supply as well as debts continue to grow. Mostly money-supply growth exceeds nominal interest rates because the scheme of compound interest cannot be sustained. The continued debt expansion makes interest payments continue to grow, even at lower interest rates. This prompts the need for new debts and money printing that undermines the value of the currency.
The basis of civilisation is specialisation and the division of tasks. Money is the agent that makes this possible. If money becomes worthless then a society can disintegrate. The escalating moral hazard within the financial system may in the end destroy currencies, and may bring down nations and civilisations with it. It is the ultimate consequence of charging interest on money and trying to work around the perverse consequences of interest using government and central-bank interventions.
Monetary and fiscal policies have created a false sense of security and this entailed a moral hazard. It enabled market participants to increase their leverage. The policy instruments do not deal with the underlying issues that create financial instability, which are interest on money and fractio nal-reserve banking. Risks tend to be extended until the point of breaking because there is an incentive to do so in the form of interest. The instruments of policy makers turned out to have done the opposite of what they intended to do. They increased the overall level of risk and offloaded this risk to the public.
Our current monetary system does not allow for negative nominal-interest rates. There is no holding fee on money, so there is no incentive to lend out money at extremely low, zero, or negative nominal-interest rates. Interest on money is an allowance for the risk of default and also reflects the rate of return on capital. Higher interest rates increase the risk of default when the amount of real money (M1) is fixed. With respect to risk, interest on money is a lose/lose proposition. When interest rates could be negative in nominal terms then it is possible to reduce this problem. For this, a holding fee or demurrage on money is needed.
Natural Money is a currency with a holding fee and a ban on charging interest. By putting money in a savings account, savers accept the risks attached to banking and are rewarded with not having to pay the holding fee. As interest is a reward for risk, a ban on charging interest will curb risk-taking in the financial system. Risks will be offloaded to investors so banks will be relatively safe. Savers will also keep a close eye on their bank, making the bank less willing to engage in risky activities. The absence of interest on money mitigates economic cycles, which further reduces the risks of banking. In such a situation government guarantees and central bank support may not be needed, which eliminates the moral hazard.
Natural Money has the following features:
- On the money in circulation a holding fee or demurrage is levied by the issuing government.
- The amount of real money (M1) is fixed.
- Governments must always maintain a balanced budget and there is no government debt.
- A bank can only provide banking services and cannot invest directly in other types of businesses.
- No holding fee needs to be paid on money in a savings account.
- Loans must be made out of savings and only savings are subject to the risk of bank failure.
- Money in current accounts is not part of bank capital. It is not available for lending nor is it subject to the risk of bank failure.
- Banks must keep a reserve against savings that can be withdrawn on short notice.
Whether or not fractional-reserve banking should be allowed is of lesser importance than the acceptance of the risks of banking. As banks have a maturity-transformation function it is difficult to make a clear distinction between fractional-reserve banking and making loans out of savings. It may be possible to have savings accounts with deposits available for immediate withdrawal. In the Natural Money arrangement it is only possible to use money in current accounts for payment. Money in savings accounts has to be withdrawn and deposited into a current account before it can be used for payment.