Interest

I wanted to think about interest separate from debt. That is an artificial distinction, of course, but that is true of many of the threads in this section. But it does seem that interest is not monolithic in its effects, so it might be possible to find out something about that if we try to see it in isolation.

In both Christianity in the past, and in islam even now, interest is forbidden. I find that very interesting because these are two very major religions, covering a vast number of people and a big area: and for some reason they actively deplore the charging of interest. It may be that this is just a consequence of their judaic roots, and that there is nothing particularly significant about it. An accident of one small groups's particular taboos, which spread with that group's influence. Perhaps the fact that christians have abandoned the prohibition lends weight to that idea. But so far as I know there is no direct instruction against it in the old testament, though there is a prohibition on a jew charging interest on another jew: so it would appear that the strong aversion does not come from the parent religion.

Christianity, and presumably islam, were also influenced by other cultures, notably Greek and Roman. They, too, had a distaste for the charging of interest, and at the very least the rates which could be charged were regulated by law most of the time. It seems reasonable to conclude that the charging of interest was seen to be an important phenomenon, which was widespread, and which had potentially damaging effects on the society, so that it needed to be discouraged, or at least regulated strongly. Given the very wide acceptance of it now, that is rather strange to modern ears. And yet we do still regulate it. It follows that there is some damage which arises from the practice, which needs to be recognised and addressed.

It seems to me that one of the problems in considering this issue is the many hats that money wears. That is, as BobC pointed up in another thread, a problem in many of these issues; and it is difficult to see through the fog to what function it is serving in any given instance. So the first question is "what is interest for?"

That of course brings us to the question of lending, and therefore of debt, immediately. So from the lender's point of view, what is the point of making a loan? That is another of those questions which look simple, but turn out not to be.

Let us suppose that people are reasonably sensible, and that some people are richer than others. There is a limit to the utility of wealth, for the individual, because money is not valuable in itself. That is recognised in the attitude we have to the archetypal miser: he is a figure of fun because he has a fundamental misunderstanding of the status of money; he sees it as an end in itself. His position is understandable because we all have some element of that in our relationship with money: it is hard to see it as a means to an end, and easy to imagine that "one can never be too rich or too thin". But the miser figure points up the absurdity through exaggeration, and he does indeed make matters plain.

It follows that there is something silly about continuing to amass money beyond the point where you can think of something to do with it: and once again we may turn to Bill Bryson's "At Home" for entertaining examples of people who illustrate that at the extreme. Very rich people who can think of nothing better to do with money than to keep a second house next door for the sole purpose of perpetually redecorating it are entertaining to read about: they are also extremely peculiar. Seen in this way the amassing of money is no more reasonable than the amassing of sofas: when you cannot enter your living room because it is full of sofas, you have lost the plot. The problem in seeing that money is just the same is two fold: we do not actually have to devote whole rooms to storing it, because it is small, and because we can put it in the bank. We do not have to be like dragons and sleep on it: so oversupply does not inconvenience us, as too many sofas do. This was not so true in the past because money was in the form of commodities, and in principle the problem would eventually present itself in exactly the same way: folk lore is full of descriptions of caves or rooms filled to the brim with "treasure": and of course the conversion of the means of exchange into objects has a long tradition: if you are going to store a vast sum of gold then you make it into the sofa: that way it gains a utility and saves space. It is not especially attractive unless you have the miser attitude: and it is not necessarily the best material to make a sofa out of: but it solves a problem, kind of. And it does impress the neighbours.

But a better way of solving the same problem is to give it to someone else: someone who does not have a surplus. If you genuinely have no use for it then you can do that. It is not much different from giving surplus clothes or books away. It is charity, in fact. It is generally held to be a good thing in itself, and we do not expect a return on charity: at least not in money terms. As I understand it, there have in some societies been institutional arrangements for recognising this aspect of the accumulation of wealth. Sometimes called "potlatch" it involves periodic redistribution through the giving of gifts. Effectively this is a solution to the problem which tends to arise in all economic systems, over time: the rich get richer and they run out of ideas. Potlatch recognises that there is a big element of luck in amassing wealth, and that having done so it is likely you will continue to amass it: and it resets the distribution from time to time. That is anathema to a society which has persuaded itself that wealth is accrued through effort and ingenuity: and which sees riches as symptomatic of virtue. But there is nothing objective about that perception and it is obviously not univeral. Potlatch was, I believe, actively suppressed by the colonial powers, and that tells you something about the challenge it represents to our own perceptions of rational behaviour, I think. We always have an agenda and a set of presumptions: often we don't look at them too closely.

Charity or potlatch is a great solution to the problem of concentration of wealth (if you see that as a problem) if you live in a small group: it is not so good when the group is larger, because then what happens is that those who are giving some of their surplus away tend to want to control where it goes, depending on their own particular values. They are apt to see it as "theirs" and so are comfortable if they can control its future use. That is understandable and I think it is probably more common than not: we all have our prejudices and our sympathies and so we wish to help those we see as unfortunate: and avoid helping those we see as feckless or undeserving. That is reinforced where the idea of wealth accumulation as related to virtue takes hold. And the physical and social separation of rich and poor gives another turn to that wheel: it is much harder to other a group you actually mix with than one you only know through hearsay and not as individuals. There are limits to our empathy, after all.

One solution to that is to insert a middle man in the form of the church or state, for example. I think the state is better, because churches are apt to make charity dependent on professions of faith: so you get phenomena like "rice christians" in china in the 19th century: but that is not inevitable, and there are religious groups who adminster charity without conditions. Nonetheless the state is comprised of all citizens and has a duty of care for all: it also has the power to enforce "charity" so that those rich people who have the miser mentality are made to participate in the redistribution despite their personality disorder. (A further advantage is that if a basic standard of living is a right there is less stigma attached to the redistribution: that is one of the reasons why universal benefits are superior to the current fad of "targetting the most needy". But I digress) From this point of view taxation is the modern equivalent of "potlatch" and legal obligation takes the place of social pressure in circumstances of large groups where such pressure can be avoided because of the functional distance between groups who are ostensibly part of one community. At some times the obligation to pay tax for this kind of purpose is widely accepted as just: at other times the misers are in the ascendant and they splutter that such redistribution is theft of wealth they acquired on merit or through their virtue, or whatever. When the misers are a strong narrative force we stop laughing at them, though I cannot for the lfe of me think why: they remain absurd to my eyes, even while they cause untold harm.

So if the purpose of giving away money is redistribution there can be no justification for interest at all. And that is one form of organising a society, with hope and justice for all. It is this kind of conception which I think underpins the traditional disapproval of usury (which originally meant all interest, though it has subsequently come to mean "excessive" interest: a shift which is interesting in its legitimation of the idea of interest: it is instructive to read the rather wriggly approach of the catholic church in this connection: they do seem to struggle with it ).

Time to start a new post I think: subject too big for one: aren't they all

What makes the notion of charity and active redistribution problematic is the determnation of when you actually have surplus money: we are all in pursuit of security to some extent, and the future is uncertain. It follows that we will not characterise our own surplus as surplus until well beyond the point that an objective observer might do that. There is nothing wrong with a "cushion" to meet unexpected financial emergencies, and most people will save for such things if they can. Theoretically that could be unlimited: and so one can justify hanging on to any amount of money. In practice it is not unlimited or we would not see Bryson's misers desperately doing more of the same and doing it bigger, just to get rid of some wealth. But for most people there is no possibility of saving enough to meet all likely calls on wealth, as the huge numbers of bankruptcies through health care costs in America amply demonstrate. Some things are surprisingly and cripplingly expensive: and that is what insurance is for. Insurance is based on the twin notions of risk and hazard: we insure where the risk is small and the hazard is great.

Insurance can be collective, as in any example of a "welfare state": or it can be individual, as when you insure agains theft of your property. Which risks and hazards are to be insured for all is a matter of politics, and it has consequences for our economic behaviour. There is a whole debate to be had about that but it is beyond the scope of this thread. Suffice to say that the particular political decisions made about that have an impact on what we conceive as "surplus" wealth.

This seems to me to be important because if we do not conceive of the wealth we do not use as genuinely suplus it changes our notion of what we can give away. Where that money is held in reserve to meet possible contingencies it is not "surplus": it is valuable to us in a way an extra 10 sofas are not. We are never going to sit on more than one sofa: our guests are not going to sit on more than four, because they can't get into the room if there are 14. Nothing is going to make those sofas useful: but a disaster can make our savings useful and, indeed, necessary. It is curious feature of the miser mentality we have currently that people do have wealth, and they see themselves as prudent if they amass savings: but though they tell themselves that is their protection against a rainy day they feel quite aggrieved if they have to spend it when it is pouring. That is not universally true but it is something I see quite often. Again it arises from the notion that virtue and wealth are synonymous: having to spend it means your virtue is not demonstrable: and so we see increasingly the middle class aggrieved if the capital limits they placed as a condition of state help in times of illness or unemployment are applied to them and "their" money: they are positively schizophrenic about it and this is because they never expected it to rain on them. Another digression

The point is that if the wealth is not seen as surplus then it is not available to give away as charity or redistribution: now it can only be "lent" and it must be repaid. Effectively one can allow someone else the use of it, but it must remain "yours" and available, if and when disaster strikes. So does this necessarily entail a demand for interest? I would suggest that it does not. If the money is in the form of a fixed commodity which is held in the house when not in use, then it does not grow. In fact it is at risk of theft, and so lending it out is safer than keeping it, so long as the sum is repaid. There is no intrinsic justification for charging interest in those circumstances. Suppose that I have £100 which I am keeping in case the roof falls in . Suppose that Mr X needs £100 to buy a car which he will use to get to work in his new job. Without it he cannot take the job and will not have any money coming in: but with it he can repay me at £50 a year. If I lend him my £100 he will give it back to me in two years. If the roof does not fall in in those years I have lost nothing and gained nothing. If the roof does fall in year 2 then I can go to Mr Z and borrow £50 to add to the £50 Mr X repaid last year: and so I can get my roof fixed. When Mr X pays me £50 in year two, I repay Mr Z. We are all back where we started and no need for interest. I have lent money which I was not using: and borrowed money from Mr Z which he was not using, when the need arose. Mr X has less of his wages for his own use in years 1 and 2: so he has brought forward consumption and pays for it later: but if he had not done that he would have had less still, so it is a reasonable thing for him. to do. I have not "given" him the money: but I have helped him out, and I have done so at no cost to myself. I see no justification for charging interest here.

In the real world it is rather different: I do not have commodity money and I do not keep it at home. I keep it in the bank and they give me some small amount of interest on it. Meantime prices go up because of inflation. Therefore if I lend it to Mr X without interest I forego whatever interest the bank will give me. Now it makes sense that I charge Mr X interest on the money I lend him. But that is only true because the bank has made it true. The same considerations apply to the bank as apply to me. But not entirely. The bank has overheads, and so there must be some source of money to meet those wage and property costs etc. And there must also be a source of income to cover the risk that Mr X will not repay the debt. The convenience of a clearing house where I can put my money and Mr X can borrow is also significant: as with barter, direct lending means that we have to find each other and a bank makes that much easier. This is the function of a commerical bank, I suppose. Note that money in this use is not a way of keeping account: it is a commodity, even if it is fiat money. The commodity is my money and that is what is passed about. The bank cannot lend more than I deposit, but it can make that money grow and it can make profit through the difference in the rate it charges Mr X vis a vis the rate it pays me. This is possible because there is a source of money external to the banking system in the form of Mr X's wages. He will reduce his current consumption for longer, but there is no reason why this will not work. The interest is the rent paid on the money borrowed: and it is distributed partly to me and partly to pay for the service the bank offers, and to provide them with profit.

On this scenario there is no need for a bank to lend more than it holds. This is because the profit is achievable directly: and that in turn depends on the fact that Mr X has used the money to maintain/increase his income. It is obvious that if Mr X needs the money to buy food then he will not be able to repay the debt because he has not "invested" it: instead he has consumed it. It is the job of the bank to refuse to lend to him if that is the situation: and his needs must be met from some other process: hopefully the welfare state in some form. It is true that the bank may make a mistake: or that Mr X may fall over his dog and become unable to work, and thus unable to repay his debt. The risk of default is determined by actuaries and it is a statistical exercise. We cannot predict if Mr X will fall over the dog: but we can predict what percentage of the population fall over the dog in a given year. And so we set the interest rate to cover that inevitable rate of default.

The justification for interest in this situation is reasonable. My asset is matched by Mr X's liablity and the money has been invested in productivity so that the sum of wealth in this little system is actually increased: that is what meets the interest payment. Mr X makes an increase in the goods or services produced, through his work, and some part of that increase pays off the debt and the interest. If Mr X cannot work then there is no increase in production and no source of wealth to make repayments from. We have covered that through insurance in the form of the actuarial calculations, and so there is no need for punitive action against Mr X . We may wish to impose sanctions in order to discourage wide boys from abusing this system by wilfull default: but in the case of companies which go bankrupt we give them protection: and so we do with bankrupt individuals (though rather less so, I think): there is nothing wrong with having such a check and the consequent protection, as I see it.

What we have done with Mr X is effectively take a share of his "profit" in the form of wages. And that is just the same as if we combine your money and mine, and lend it to a start up business. We charge interest and look for capital repayment, and that is a share of the profit too. The alternative is to invest directly in the business by buying shares, for example: that is, by buying part of that business. Either way the business gets money at the cost of some of its future profit. If it takes a loan, then in principle the foregone profit is time limited: if it shares ownership, then it is not. But there is no problem so long as the new business increases production: this is economic growth and it is new wealth out of which the repayments can be made.

This is the narrative beloved of the banks and financial institutions: they claim that the process outlined is what is actually happening; the loans are made to those who use it to create wealth, and so the whole system is sustainable. The problem is that this is not what is happening. They trade on the many hats money wears: and on the ambiguity of words such as wealth creation.

If a bank or financial institution lends to Mr X to buy an existing house it is not different from lending to him so he can buy food: there is nothing in the loan which will produce new stuff or new services. Mr X may spend on furniture etc, and that will give work to those who make those things: but it does not add to the sum of stuff produced. But an increase in the sum of stuff produced is one meaning of wealth creation, and that is what we are invited to think about. Another meaning of wealth creation is "banker gets more money for doing nothing much at all": because that banker has indeed created wealth for himself: but he has done it by transfer, not by increasing production. One of the peculiarities of the way we measure economic growth is that such useless transfers are counted. I was struggling with that idea in the economic growth thread, and I still am.

If Mr X borrows to buy a house, he is borrowing to consume. He does not produce any more than he did before, and neither does anyone else. It follows that the repayments come out of existing wealth: he transfers some of his income to the lender. That means he does not buy as much stuff as he did before from other businesses. And his obligation to pay is long term. It would not matter if the lender spent what he gets from Mr X: it would mean that different folk are buying stuff but it is still getting bought. But they don't. In the first place rich people do not spend all their money: they haven't the imagination nor the necessity. So they hoard it. So those who would have jobs because of the money Mr X spent won't have: and thus high unemployment is going to come out of that transfer. And that is indeed what we have seen, since this neoliberal policy has been pursued. High unemployment drives down wages and so in the short term business profits rise: and this is also what we have seen. As wages stagnate or fall people have to borrow to make ends meet: and these debt are also for consumption not investment. Again they will preserve some jobs but they will not produce any new wealth. Secondly, because of the miser mentality, those who receive the money do not invest in productive businesses: because the return on playing with money is higher than the return on making stuff. Playing with money does not produce stuff either: but it still is counted as if it did, because that is how GDP is measured. So we can move towards a "service economy" and on paper it will not matter. But so far as I can see, the increase in debt is not matched by any increase in stuff: and so there is no real economic growth to pay for it. There is only the increase in price for existing things - a bubble, in fact. And all that wealth is transferred to the lenders over time: till they finish up with huge proportion of it. Eventually there has to come a point when the debtors can't pay: really can't. And economic activity goes into free fall.

It seems to me that this is because we have chosen to equate transfer of money for purposes of consumption with transfer of money for investment: that is we have charged interest on what should properly be gifts.

That is not simple to distinguish, I freely admit. But if, for example, you decided that something as basic as a house was the right of all citizens then they would be provided by redistribution of wealth through the welfare state. That is effectively what social housing does and it leaves the housing market to those who have real surplus and choose to pay more for something they see as better than the standard. If social housing is characterised in that way there is no justification for charging interest on it: rent is paid and it is set at a level which allows for maintenance, but not for profit. It may also be set at a level which allows for new build, to keep up with demand, or to improve the stock. What will not happen is a housing bubble of the sort we have seen. And that can only be a good thing. This, to me, distinguishes between consumption and investment and I think it could be applied to many things which we have "privatised": because I now think that much of the will to privatisation is predicated on a wish to pretend that consumption is the same as investment: and the way we count GDP tends to mask the implications of that.

I said before that tax is a way of redistributing wealth in a large group. What we seem to do now is refuse to tax the wealthy to any reasonable extent: we then borrow the money they have accumulated partly through that refusal, and partly through their abuse of finance: and we pay them interest on it. They get a better return than they do from investing in production: and we drown in debt. When people can no longer pay as is inevitable if you lend for consumption (such as unemployment benefit which is a direct cost of this way of doing things) there is a debt crisis and the only solution proposed is to cut the "consumption" so that the debt they have engineered can be paid. And this seems to me to be usury

I wanted to just add a comment on this earlier statement because it is relevant to how islamic banks operate and I think there is something to learn from them. As noted above, islam still prohibits the charging of interest. Yet there are islamic banks and financial institutions.So I had a wee dig about to see how that can work: because in my mindset it is quite hard to see. Apparently the way they do it founds on the notion of "partnership" or perhaps we could call it "joint enterprise"

For businesses it is reasonably simple: the bank buys part of the business and that is not much different from buying shares. As I said, it means that payment to the bank is not time limited any more that the dividend to shareholders is. But what might not be immediately obvious is that it completely avoids the adverse consequences of a loan: because the payment to the bank, like the payment to shareholders, is not fixed. In other words, if the business is in trouble the payment falls: that is not true for loans. One can immediately see why the banks and financial institutions prefer loans. Usury is at its worst when it results in the transfer of the borrowers property to the lender, due to the lender's financial distress. Default on a loan has just that result, and it is one of the mechanisms which leads to concentration of wealth in the hands of the few: the lender imposes a tax on profit, and therefore taxes all those who buy goods or services from the business: but his tax is unrelated to the ability to pay. So long as the asset is not overvalued he can't lose: and when it is overvalued, the taxpayer bails the lender out.

In the case of house purchase the islamic practice is still a form of partnership. The way they do it is also done in this country, though not very commonly, and it is usually called a "shared-ownership" agreement. What happens is that the buyer buys part of the house and the bank (or in the case of the government scheme something like a housing association) buys part of it too. The UK government is pushing this kind of arrangement for first time buyers because they are now very often unable to buy a house, and that is the aim of all right thinkiing people.

I looked at the arrangement offered by the Islamic Bank of Britain. The repayment is different in England and in Scotland (presumably reflecting the different legal systems) but effectively in both cases the buyer pays for the bank's share in installments. The payments are part purchase payments, and part rent for the use of the property until the whole price is repaid.

In the standard product the rent element is variable and it is, rather curiously, tied to the bank base rate with a margin added. The margin can be varied but any increase is capped at 2% above the margin at the start of the arrangement. The bank states that the relation to the bank base rate is to ensure the product is in line with ordinary mortgages in terms of cost: but insists it is not of itself an interest payment. In support of that it is noted that the occupancy element falls as the acquisition payments are made, with the consequence that the quarterly reviews of that element may result in a reduction; no change; or an increase if the base rate rises more than the reduction for purchasing some part of the bank's share of the property every month. The maximum the bank will buy is 80% of the purchase price so the buyer must find 20% of the purchase price in order to buy a house. The buyer can make enhanced purchase payments if he wishes, and can sell the house at any time without penalty, but with an admin charge. The bank also notes that because it is a part owner it is is responsible for part of the maintenance of the property and it shares the "risks of ownership", whatever that might mean.

To some extent this looks very much like an interest arrangement by any other name, and it is likely to be more expensive because rent does tend to go up, in my experience. But what does seem to be significant is the higher deposit demanded, and the tighter rules on income multiple, which seem to be applied. Those are both important because high multiples and low (or even negative) deposits contribute to asset bubbles. Islamic and shared ownership arrangements are not currently big enough parts of the mortgage market to prevent that: but if they were widespread that might change, assuming the same limits were adhered to

www.philstockworld.com/2011/12/10/e...y-to-oligarchy/

A fierce blog post on the same lines but far more detailed than mine. Worth reading, methinks.It is long: will take some time..

Edited by FionaK - 11/12/2011, 16:30