A ban on charging interest on money poses constraints on the funds available for borrowing. If the risk/reward ratio of capital is more favourable, interest rates cannot adjust upwards and direct investments will be preferred. As a consequence lending and borrowing is restrained and money substitutes (M2) will increase less relative to economic growth. As there will be less borrowing for consumption, the economy will not overheat due to unsustainable accelerated consumption. The value of money will increase as economic output increases and in this way the interest on money will reflect the return on capital. Consequently it will be possible to sustain borrowing and lending at zero percent interest.
Borrowers with a high risk profile cannot borrow at zero percent interest. They may be better off because they have to postpone consumption instead of paying usurious interest rates. They will end up having more purchasing power in the end. It is however likely that there will be schemes devised to chisel on any usury ban. Loan sharks may try to fill in the gap and black markets may emerge. Making charging interest on money illegal and nullifying loans with interest may help to alleviate this issue as it makes the risk of doing business for loan sharks prohibitively high, making black market interest rates prohibitively high for most prospective borrowers.
Mismatches between supply and demand
Economic problems are often seen in terms of anaemic economic growth, unemployment, overinvestment, inflation, tight labour markets, lack of competitiveness, lack of demand or lack of supply. The common denominator of all those problems is that there is a mismatch between supply and demand. If all markets were perfect and supply could adapt to demand instantly, then there would be no economic problems. Those mismatches can exist in the real economy as well as in the financial sector.
Often economic problems manifest themselves in cycles because mismatches occur from time to time and are resolved after some time. This process produces fluctuations in demand, supply, prices, stocks and employment figures. There are a number of theories and explanations regarding those mismatches, economic cycles and their effects. All those theories have merits and limitations. Insofar cycles are caused by monetary issues such as banking and interest, Natural Money may ease them.
Supply time lag
Future demand is not always easy to predict and the current price is often used as a signal guiding future production. If demand for a specific good increases then the price increases. If profits are high this will attract additional investments in production facilities. If profits are low or when there are losses, existing production facilities may be closed down or retooled for other products.
Even when demand is fairly stable supply can fluctuate, creating strong swings in price. This may happen if producers can enter and exit the market easily. An example is the pork cycle. When prices were low, pork producers cut down on production. After some time a shortage of pork emerged and prices rose significantly. At that time, pork production was increased so some time later a surplus emerged and prices dropped. This cycle was repeated over and over again.
When a new technology or resource becomes available it may be profitable to invest in the new technology or resource, and this will result in new investments. The overall cost of living drops when the improvements start to affect market prices or new products will become available, and this will create additional demand. Investment, spending and economic growth will increase. A new technology often produces a wave of investments. If current profits are high then there is a tendency to over invest, as the current price often acts a signal for future production.
For example, faster computers can create a competitive advantage so investing in them can be profitable. Because of investments in computer technology, products can become cheaper or new products can become available. This can create additional demand. It is likely that developments in information technology have contributed to economic growth in recent decades. There was also over investment in information technology. An example is the Internet start up boom around the year 2000. When the boom suddenly ended, a recession started.
According to Say's law supply creates its own demand because goods and services are produced to acquire an equal value of other goods and services. This applies to a barter economy. If money is used as a medium of exchange, people can hold on to money and postpone their purchases. In this way producers can be left with overproduction, and a reduction in economic activity would be the result.
Money hoarding can reinforce itself as a decline in economic activity can make people more cautious. They may start to save more and economic activity may decline even more. As a consequence, more people may expect that times get worse and start to save more. This cycle can reinforce itself and become destructive.
Expectations are important in economics. If people feel secure and have a good feeling about their future, they are more willing to spend. A positive or negative feeling about the economy can become a self fulfilling prophecy. For example, if people expect a bank to collapse then this will happen because there will be a bank run. Therefore many policy makers tend to give a rosy picture of the economy or the state of the banking system.
Stickiness of prices and money illusion
Price adjustments take time. If the costs of a business change, it may take time for those changes to manifest themselves in prices charged. Businesses have fixed costs and are reluctant to adjust prices downwards. Similarly, employees are reluctant to accept lower wages as they also have fixed costs and are accustomed to a specific standard of living. On the other hand, employers may be reluctant to raise wages to attract new employees when there is a shortage of labour. They may accept vacant positions in order not to have to raise wages of existing employees. A market price often lags the supply and demand picture.
Related to the stickiness of prices is money illusion. Money illusion is the mistaken belief that an increase or decrease in price in money units represents an increase or decrease in real price. If the general price level increases or decreases then the value of the money unit changes. It takes time for people to realise that the change in prices is not real. Likewise, when a steady decrease or increase in prices suddenly stops, it takes time for people to realise that this has happened. Stickiness of prices and money illusion cause disequilibriums that will be corrected over time and this contributes to economic cycles.