The toxicity of interest

By Mubarak Sooltangos

In the previous issue of Conjoncture, the ineffectiveness of interest to promote savings, to beef up economic activity by supposedly encouraging investments, to discourage borrowing for consumption, to control inflation and to support national currencies were demonstrated. In this present paper, the harmful side of interest will be analysed, namely its toxicity in individual and corporate borrowing, in a national economy, and by extension, in the world economy.

At the base of this toxicity, there are the following potent realities: a) interest gives access to easy money and promotes indebtedness and debt-based economies, b) it kills the incentive to invest productively, and in the equity of businesses, c) it fuels wars, d) it is, at its root, an act of speculation and a gamble on the future, e) it is a vector of inflation.

Access to easy money

Let us examine a simplistic scenario, which, for many people, would seem surprising that they had not seen it before. In the absence of interest, who would be prepared to lend his saved or hoarded money? Nobody would, because who would want to take any lending risk, however small, without due remuneration? But if a holder of capital is offered an attractive rate of interest, he would be prepared to lend. This brings us to another question: who is the keener between the borrower and the lender to introduce interest in the equation? As much as the opponents of interest blame ruthless lenders, the originator of interest-based loans are the borrowers themselves. Starting from a zero-interest situation, it is the borrower who would be the first mover to offer an interest as remuneration.

So, let us not dwell on beaten track reasoning that holders of capital have invented interest. They have reacted to a market situation where there was a demand for their money, and they have become suppliers in this market. What the borrower has created for himself a market which gives him an access to easy money. He generally, and on paper, considers the interest charge to be easily payable by the return he expects from his venture or business, or his access to the immediate use or enjoyment of a product or a service, which, in the absence of available money, he would have had to wait up to the time where he would have constituted his own savings. This access to easy money applies to all classes of borrowers, from households to businesses and governments. It also applies to all situations, whether the money borrowed is to finance a business, a house, a consumer durable, an overseas holiday, a national budget deficit or a situation of extreme difficulty where money is required at all cost. This is how interest creates easy money and debt-based economies.

Killing the incentive to take risk and invest in productive ventures

It would have been ideal if all hoarded money could be directly invested in the equity of productive businesses to create economic growth, wealth and employment. But not all people are risk takers or have business acumen or have the know-how or the desire to open a business and work hard to make it a success. For these people, there is the possibility of investing as a partner with an entrepreneur who has drive and know how. Those who are even less keen on taking risks have the option of investing on the stock exchange, in a selection of good stocks to spread their risk. In a no-interest system, those who prefer not to take any risk and see their liquid money in bank, in front of their eyes would be reduced to seeing it eroding with inflation. But interest in our system perfectly suits the lazy and the totally risk averse who hold capital and can earn a remuneration without any effort, and this is the cancer of the system because it remunerates idleness.

This is how interest kills any incentive to take risks to invest in an active business and drives many holders of capital to choose the interest earning route, which, on top of its no-risk facet, gives them the opportunity to convert back their lent money into liquidity more easily. The absence of interest would not have created a stalemate for them because of the investment possibilities named above.

In many multi-activity companies, easy credit often fuels dubious investments in side businesses.

Whatever the investment scenario, the money would have gone into productive investments and, more importantly, in equity. If the difference between lending on interest and investing in equity does not mean much from a macroeconomic view to those who have capital, it changes the equation drastically for the businesses which benefit from these incoming funds. They capitalize their ventures better, eliminate their interest problem, which is a fixed cost with fixed due dates, and which condemns their businesses to be profitable. If their business is well structured financially, in case of a pressing need of money, they would have a solid balance sheet in hand and a repayment capacity to show to raise money from new equity partners who would want a sell option after a certain number of years.

The side effects of easy access to money

In many multi-activity companies, easy credit often fuels dubious investments in side businesses which often turn into loss-making ventures because their senior management have no time and find no thrill in monitoring these businesses. This is called “empire building”, and is a frequent recipe for catastrophe when the core activity must subsidise loss-making subsidiaries. In other circumstances, easy borrowing gives rise to laxity in stock control and credit collection. It also encourages the acquisition of sumptuous assets which only serve to make a boastful statement for public eyes, and that of idle or under-utilised assets which bring little or no revenue. In business jargon, this is called a “fattening of the system”, where additional costs are recklessly taken on board, and this mostly happens when companies are doing well and they ignore basic rules of prudence. The sad reality of being cash-stretched sets in when there is a sudden down-turn in their businesses for whatever reason, and expensive overheads suddenly become too heavy to shoulder.

For households, easy credit allows them to live beyond their means and to buy luxuries which they would not even have thought of in normal circumstances. Commercial staff in credit institutions are commissioned on the amount of loans that they sell, with the risk of reckless selling that this involves. Isn’t it a paradox that sales people are employed by banks to sell loans, when everybody should be encouraged to save money for future expenses as in the good old days? Is it normal that when every employed person should be happy on payday, a large number of people are distressed as to how to run their households when as much as 30% of their salary has already been committed to paying debts by direct debit from their bank accounts? Isn’t repossession of articles by traders and hire purchase fund providers for payment defaults a traumatic experience for any family which could have been avoided, had credit money been not so easily available because of interest?

The world’s explosive debt situation

China is notorious as a provider of easy money in pursuance of its financial neo-colonialist strategy. A list of 150 countries owes important sums to China. America is sitting on a debt time bomb because it is so easy to pay its trade or budget deficit with treasury bonds in its own currency, and its creditors are happy with holding what they consider to be a safe haven because of the strength of the US dollar. The most powerful country in the world is sitting on a mountain of debt which it will never repay, unless countries which trade in dollars or have national reserves in US dollars change to another monetary standard. But why would these countries destroy the value of their own reserves held in dollars? So, the debt economy is not likely to change for the better.

On the negative side for America, it does not stand any chance of winning a trade war against China, because this country is cash rich, produces at lower cost and it has built a network of captive customers in the form of the 150 countries which are its debtors. It is more than certain that these loans are tied to trade agreements which will bind them for a long time with China.

The fuelling of war

Interest, because it gives access to easy money, has fuelled numerous wars in the world. These conflicts need huge sums of money which governments do not keep in store, and money cannot be set aside year-on-year in time of peace, to finance war, because wars.re rarely premeditated over a long period of time. They are most of time impulsive, and therefore decided in a matter of months. What is provided for in many countries’ annual budget is money allocated for purely defence purposes. This serves to finance sustainable weapon purchase as a means of dissuasion, and payment of salaries of military personnel. However, it does not suffice to have these two military components to actually sustain a war financially. When war is declared, massive additional amounts of money have to be made available for exponentially increased weapon needs and other expenses, namely to cater for important increases in salaries of additional personnel required.

For households, easy credit allows them to live beyond their means.

More money is also needed to finance the side effects of armed conflicts, because an economy in recession, which is a natural consequence of war, needs to be financed. War cannot be imagined without access to borrowing, and this is where interest provides this easy money through government borrowing. This fund-raising exercise through treasury bonds does not end when the war is over, because funds are still needed over a long time period to repay the debts contracted and repair the damages of war. This can go on for a decade, but only by siphoning funds from productive activity to the servicing of war debt.

Concurrently, national budgets of an expansive nature have to be created for the functioning of the state, for investment in infrastructure and spending on welfare. The usual recourse is high budget deficits which also have to be financed through interest bearing borrowings, and this creates inflation as another negative by-product.

The promotion of speculation

At the heart of the interest problem, most business borrowers on interest are in fact speculators without actually realizing it. They take commitments even before they start to produce, in the hope that they will be profitable enough to earn profits after servicing their loans every month. This is a bold and speculative projection into a future which is fraught with uncertainties. If things do not turn out as they are forecasted and they default on certain loan repayments, they become classified as doubtful debtors with their bankers, and they are faced with even higher punitive rates of interest. It is an extreme perversion to claim 5% penalty interest to a borrower who already has to service his debt at standard rate of interest. It has become mandatory in lots of countries to report such cases to central banks, and all financial institutions have access to this consolidated classified list. This wipes out any possibility of future borrowing from any other financial institution and businesses with stretched cash flow situations run the risk of disappearing.

The inflation fuelling effect

As much as it is claimed that interest is a tool to fight inflation, it is in itself an inflationary factor on two distinct counts.

First, interest-bearing funds borrowed for investment or working capital requirements in an undercapitalised business company represents a cost which adds to normal production costs, and on top of this, its rate is fixed in advance. This means that for a start-up enterprise, it is the first cost which has to be taken into account, before any production actually begins. For a borrowing enterprise as a going concern, this has a definite effect on its cost of production. If a higher cost of production of any product and a more expensive selling price can be sustained on its domestic market by protectionism or otherwise, it is evident that interest paid has a negative bearing on the price competitiveness of goods intended for exports in this competitive world. It can be very detrimental if there is a high interest rate differential between the exporter’s country and those of its competitors operating in other countries.

Second, interest-based borrowing of pre-existing savings, as those held by insurance companies, pension and investment funds to finance budget deficits are non-inflationary. But these pre-existing savings are not always available, and if they are, government borrowing shuts out deserving companies from having recourse to this source of funds. Otherwise, the government treasury must rely on bank finance, which is an important cause of inflation, because it adds created money, i.e. virtual means of payment without any substance into the economy and increases liquidity which, though virtual, has a buying power which is a source of inflation for the country.

There can never be a total dichotomy between different actors in any economy. While interest rates are raised by central banks supposedly to combat inflation by making money expensive, it must be borne in mind that this also, and more importantly, affects all existing borrowers who are all of a sudden faced with higher financial expenses. As a paradox, as long as inflation remains high, totally inefficient high rates of interest are likely to be maintained by professionals with a book mentality to the detriment of all sectors of economy which are riding on debt for their survival. This is clearly a case of navigating without visibility and a dangerous trial and error strategy which no responsible central bank can afford.

It is not the role of any government to create employment.

How to combat inflation and redress our balance of payments?

Besides interest, which is a qualitative measure and takes time to produce results, there is an array of quantitative measures which can be taken and which can bring immediate results. Capitalists do not like quantitative measures because these prevent them from exerting their dictatorship of supply in a market economy. The new brand of economists is also against drastic quantitative measures because they have been bred in institutions which only swear by liberalism and deregulation, but facing the realities of a difficult economic situation like the one we are in, demands strong dissuasive measures to curb consumption and fuel production.

Thinking of growth by consumption as a means of creating activity and massive state investments in infrastructure financed by debt to beef up economic activity would be criminal acts in our dire situation. It would be abusive state interventionism without effort and in the wrong direction because money needed by governments are always available provided the return in interest is attractive. It is not the role of any government to create employment. I would rather see the money earmarked for state investments to go into massive tax incentives to private sector businesses to encourage them to invest, and in subsidies for exports to make our export sector price competitive. Neither China, with its currency rate which it deliberately keeps low, nor America and Europe are shy of subsidizing their exporting companies by state intervention, the most blatant ones being their financial support to Boeing and Airbus. Why should we be shy to be a follower?

It could not have been made clearer that not only interest is an ineffective tool in the monetary policy of central banks, but more of a liability than a solution. It is highly toxic because it burdens households, companies and countries when it is at all times included in their economic models, which seems to be the case. This makes interest not a simple financial evil, but an abomination ingrained in our sub conscience by habit, with disastrous effects and which should be shunned at all costs. The cause of the world’s problematic economy today is that it is based on debt, and the primary cause is the easy access to borrowed money because of the existence of interest which serves as a catalyst, but at a hefty cost.