The coming financial crisis may prove to become a turning point in history. Central banks will be considering negative interest rates because the natural interest rate, which is the interest rate that will bring stable economic growth, is negative. But negative nominal interest rates are an economic singularity, and open an array of new possibilities that may turn out to herald the end of fiscal and monetary policies.
Negative nominal interest rates can steer the economy on a sustainable growth path without booms and busts, and help to achieve maximum economic potential without intervention of governments and central banks. If nominal interest rates are always negative, and cannot exceed zero, then there is no need for additional credit to spur economic growth, so that the economy can grow without more debt. This is possible because interest is a Ponzi-scheme that destabilises the economy.
The Ponzi-scheme of interest
Interest accumulates, and this has serious implications. Lenders may spend the interest and borrowers may default so that it doesn't always happen, but on aggregate the accumulation of interest on loans produces the rationale for fiscal and monetary policies. To pay for the interest on existing debts, new debts are needed. The following example can be used to demonstrate this.
Assume that Jesus' mother put a small gold coin weighing 3 grammes in Jesus' bank account at 4% interest in the year 1 AD. Jesus promised to return. Suppose that the account was kept for this eventuality. How much gold would there be in the account in 2015? The answer might sunrise you. It is an amount of gold weighing 10 million times the mass of the Earth. The yearly interest would be an amount of gold weighing 400,000 times the mass of the Earth.
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Some would argue that increasing economic output can pay for the interest. But even if economic output grows much faster, for example at a rate of 15% per year, that still doesn't make the Ponzi-scheme of interest on loans work, simply because you cannot turn economic output into gold. When the Ponzi-scheme of interest fails, there is a financial crisis. Central banks therefore print currency to keep this scheme from imploding.
Both fiscal and monetary policies are meant to deal with compounding interest:
- to pay for the interest on existing debts, new debts are needed, and if no one is willing to go further into debt, Keynesians think that the government needs to step in;
- central banks manage money supply and interest rates so that debts do not grow too fast or too slowly. When new debts are made too slowly, the Ponzi-scheme of interest runs into trouble, money disappears from circulation, and a financial crisis can be the consequence. If new debts are created too fast, the amount of money in circulation increases, causing an economic boom, and more debts that carry interest, which can cause an even greater economic bust afterwards.
A proposal and its consequences
Interest-free money with a holding tax can solve the coming crisis. Interest-free means that the maximum interest rate on loans is zero. The holding tax is a tax of 0.5% to 1.0% per month on cash and bank reserves held at the central bank. This tax does not apply on bank deposits and loans, so that it can be attractive to lend out money at zero or even negative interest rates. This can only work if interest rates in the market are already low or negative.
Introducing interest-free money with a holding tax can have the following consequences:
- the holding tax can stimulate the economy by allowing interest rates to go further negative when the economy slows down;
- the maximum interest rate of zero can prevent the economy from overheating because interest rates rise when the economy is booming, so that other investments are more attractive than debt and less credit will be available;
- the maximum interest rate can reduce risky lending, so that the balance sheets of people and corporations become more robust;
- the economy will not suffer from compound interest destabilising the financial system.
The case for a maximum interest rate
The safety net of central banks and governments can support the profits of private banks. The rationale for this safety net is that a stable financial system is beneficial to the economy. When things go well, bankers can make huge profits and get big bonuses, but when things go wrong, taxpayers may have to pay for the errors that bankers made. Interest is also a reward for risk so a maximum interest rate limits the risk that bankers are willing to take.
During economic booms there is optimism, new debts are created based upon a rosy picture of the future, and interest rates rise. The greater the optimism, the higher interest rates can go, but also the greater the bust will be when those higher interest rates turn out to be unjustified. A maximum interest rate can curb the creation of these new debts during an economic boom because it makes other investments more attractive, so that the debt-fueled boom fails to materialize, and the subsequent bust does not happen.
Lower interest rates allow people to go further into debt. Lower interest rates also allow corporations to use more leverage. Leverage can make the financial system unstable and this can hurt the economy. Because a maximum interest limits the risk lenders are willing to take, it is likely that a maximum interest rate would cause a reduction in leverage.
The benefits of lower interest rates
Lower interest rates benefit most people because on balance most people pay more interest than they receive. Only the top 10% of richest people benefit from interest, so 90% of the people will benefit from lower interest rates. On the other hand, low interest rates discourage saving and make it possible for people to go deeper into debt.
If interest rates are lower then:
- you receive less on deposits and you may even have to pay for depositing money;
- you have to pay less for mortgages and other debts;
- you have to save more for retirement because investments have lower yields;
- you have to pay less for everything you buy because the interest costs of capital are passed on to the consumer.
It is a misconception that negative interest rates will destroy a currency. Negative interest rates can only coincide with deflation. Only strong currencies like the Swiss Franc allow for negative interest rates. It is a misconception to think that lower interest rates are bad for the economy. Lower interest rates make more capital profitable, so that more products and services can be available at lower prices.
For example, after the Middle Ages more credit became available in Europe at lower interest rates. This helped economic development. In 1694 England started a central bank, which improved the stability of the English banking system so that banks could lend more at lower interest rates. Soon after the central bank was founded, an unprecedented boom of capital buildup started in England. It is called the Industrial Revolution.
Causes of lower interest rates
Low interest rates are a consequence of economic conditions, such as abundant supply of capital, and not the other way around. The idea that central banks force down interest rates, is off the mark. They only allow interest rates to go lower. Central banks provide stability in the banking system by not allowing the Ponzi-scheme of interest on debts to fail, so that interest rates can go lower via the mechanism of capital buildup.
The buildup of capital contributed to lower interest rates in the following way:
- Throughout history returns on investments have mostly been higher than economic growth. This is unsustainable when most capital income is reinvested because this means that at some point capital income will grow at the expense of wages.
- The growth of interest income can become even more problematic when the ownership of capital is not evenly distributed. Most capital is in the hands of a relatively small group of wealthy people that tend to reinvest their capital income instead of spending it.
- As a result other people are not able to buy from their income all the goods and services that this capital produces. This helped to reduce the returns on investments so that interest rates could go down.
Banking, central banking and the deregulation of the financial sector helped to bring down interest rates in the following ways:
- Banks provide convenience by making it possible to call in loans at short notice. Banks also reduce risk by making loans to many different people and corporations. Both developments helped to lower interest rates.
- Central banks also helped to reduce risk. Most loans carry interest, but the money to pay the interest from doesn't exist when the loan is made. This money has to be loaned into existence. Central banks are a backstop when this scheme runs into trouble. This helped to lower interest rates.
- The deregulation of the financial system improved efficiency by increasing convenience and reducing risk. This helped to lower interest rates even further.
Negative interest rates are nothing to be afraid of. On the contrary, negative interest rates could herald the beginning of an era of stable economic growth and greater prosperity. Negative interest rates are the result of capital buildup and efficient financial markets. This means that negative interest rates are likely to become the norm in the future.