Thursday, 24 November 2011

Interest and Sustainability

The remaining major foundation on which the arguments, conclusions and proposed solutions of "Money as Debt" is founded is that the payment of interest requires continuous exponential growth in money. (As we have already seen, the process of creating central bank money and retail bank credit is essentially identical, and for the remainder of this post, I will just refer to money).

The argument runs along the following lines:

  1. All money is created from debt.
  2. Debt must be repaid to the lender with interest.
  3. Since every loan requires the payment of interest in addition to the principal (the original amount lent), the total amount owed to banks must be greater than the total amount of money in existence, since only enough money was created for the principal.
  4. In order for a borrower to repay the interest, he must sell something to someone who takes out a loan for at least as much as the amount of interest outstanding.
  5. While the original borrower can now repay his interest, the second borrower now does not even have enough money to pay the principal. In addition, the amount of interest is continuing to accumulate, and no money is being created with which to pay it.
  6. The situation can only continue without default if an exponentially-increasing amount of money is borrowed in order to repay the principal and interest from earlier loans.
  7. The need to repay the exponentially-increasing loans forces people to create exponentially-increasing amounts of wealth (goods and services), and therefore to exploit natural resources at an exponentially-increasing rate, causing certain environmental catastrophe in a finite world.

This appears quite a compelling and frightening argument. It says that as soon as interest has been charged by a bank, there is now a runaway instability in the system, and stability cannot be restored without universal default and the consequent seizure of all borrowers' wealth by the banks. It took me, as a person with no experience of studying economics, many months to find the flaw in it.

In order to test the film's theory, I attempted to find a scenario in which a loan is made, interest is charged, and the borrower successfully returns both the principal and the interest to the bank, so that we have reverted to the state before the bank lent money. The film implies that this is impossible.

Here is the simplest scenario I found in which a loan is made for a good reason, and it is successfully repaid with interest, and to everyone's benefit. There are three people involved:

  1. Mr Tophat, the banker. He has just set up the Cultural Bank of Somewhereia (CBoS), and currently has no customers. For further simplicity, we will assume that the bank is not required to have any initial capital.
  2. Mr Ploughman, the farmer. He has some farmland, but needs some wheat seeds to plant.
  3. Mr Grain, the seed merchant. He has a bushel of wheat seeds for sale.

In the spring, Mr Ploughman wants to buy some seeds to plant, so that he can grow wheat. He currently has no money. He asks Mr Grain if he can have his bushel of wheat seeds, in return for a share of the harvest in the autumn.

Mr Grain considers this, but realises that Mr Ploughman is not guaranteed to have a successful harvest, so he could end up with nothing. So instead, he insists on payment in money – 100 shillings – allowing him to buy seeds from any farmer in the autumn.

Mr Ploughman has no money, so he goes into CBoS for a loan. CBoS lends him 100 shillings at 10% per year. The money, as always, is newly-created, and CBoS's balance sheet now looks like this:

Table 1 - Balance sheet of CBoS after a loan to Mr Ploughman
Loan (Mr Ploughman)100Deposit (Mr Ploughman)100

Mr Ploughman now buys Mr Grain's bushel of wheat for 100s, and plants the seeds. He looks after the field well, the weather is good, and there is a good harvest. Mr Ploughman now has 10 bushels of wheat seeds. He sells 2 bushels of wheat seeds to Mr Grain for 100s. (Mr Grain must do work to select the best seeds for planting, so unsorted wheat is worth only half of the original seed sown. Mr Grain uses the remaining bushel to make flour for cheese pies).

Mr Ploughman still has 8 bushels of wheat and 100s. As it is now 6 months after borrowing, the interest on the loan means that he owes CBoS 105s. He goes to CBoS and repays the 100s of principal. As we have seen, repaying principal destroys the money, so there is now 5s of interest still to be repaid by Mr Ploughman, but there is no money in existence. How can Mr Ploughman repay his loan? He appears to be stuck.

At this point, let's look at CBoS's accounts before and after the principal is repaid:

Table 2 - Incomplete balance sheet of CBoS after interest charged to Mr Ploughman
Loan (Mr Ploughman)100Deposit (Mr Ploughman)100
Interest due (Mr Ploughman)5???5

A balance sheet must balance, so there must be a new 5s liability to match the new 5s asset of interest owed to CBoS by Mr Ploughman. To whom does CBoS owe this 5s? It is to Mr Tophat, the owner. Banks, like other commercial ventures, are in business to make a profit for their owners, hopefully by providing goods or services of value to their customers. In this case, CBoS provided Mr Ploughman with something of value – a means of buying seeds for sowing. Let's complete the accounts:

Table 3 - Completed balance sheet of CBoS after interest charged to Mr Ploughman
Loan (Mr Ploughman)100Deposit (Mr Ploughman)100
Interest due (Mr Ploughman)5Shareholder equity5

Shareholder equity simply means how much money would be left if the company were liquidated i.e. the assets all sold and the lenders to the company repaid. It is the value of the company to its owners. In this case, the bank has made a profit of 5s, after having started from zero value, so the value of the bank is now 5s.

Now let's look at the situation after Mr Ploughman has repaid the principal:

Table 4 - Completed balance sheet of CBoS after principal repaid by Mr Ploughman
Interest due (Mr Ploughman)5Shareholder equity5

Now Mr Ploughman owes 5s to the bank, and the bank owes 5s to Mr Tophat. Those debts can be resolved simply by Mr Tophat buying 5s of wheat from Mr Ploughman. Since Mr Ploughman has 8 bushels left, and the cost is 50s a bushel for unsorted wheat, he has plenty of surplus to sell to Mr Tophat.

Perhaps the reader could object that in practice people don't buy things by cancelling debts with organisations which they own, even if only because the accounting would be difficult to coordinate between three parties. However, this can be easily overcome as follows:

  1. Mr Tophat instructs his bank to make a 5s interest-free loan to him, thereby creating a new 5s.
  2. Mr Tophat uses this 5s to buy wheat from Mr Ploughman.
  3. Mr Ploughman pays the 5s interest on his loan to the bank, clearing his debt.
  4. The bank pays the 5s to Mr Tophat, clearing its debt to Mr Tophat.
  5. Mr Tophat repays his 5s loan to the bank, clearing his debt to the bank.

Let's look at how much each of the three people has gained or lost:

  1. Mr Tophat has gained 1/10th of a bushel of wheat.
  2. Mr Ploughman has gained almost 8 bushels of wheat.
  3. Mr Grain has lost 1 bushel of wheat suitable for planting, but regained it and also gained 1 bushel of wheat for milling.

So interest has been charged on a loan, and everyone has gained from the arrangement. All the money created has been destroyed again – there is no exponential increase required.

I hope this has been a convincing argument that the charging of interest by banks does not inherently result in unsustainable exponential increases in debt, production, consumption and environmental destruction.