By Mubarak Sooltangos
The world is so deeply entrenched in a monetary system where interest holds a key role, and all economics and finance professionals, worldwide, are so subdued to the paradigm that the doctoring of interest rates can change a national economy for the better that my attempt to prove the contrary may be viewed as an idea coming from outer space. Yet, for those who will read this article dispassionately, without letting preconceived ideas blur their vision, there can be at least the beginning of a debate that maybe there are other ways of looking at an economy with a new pair of eyes and outside the beaten track.
Interest is basically concerned with money. The layman has no other view that money, either in its printed form or lying in a bank account is an asset with a definite purchasing power which can be converted into goods and services at any time. But for economists and financial experts, money needs to have a finer definition, more scientific, and an agreed set of functions to know those which are likely to be influenced by voluntary variations of interest rates. There are four functions of money on which experts agree. Let us try to see the pertinence of interest in harnessing these functions to obtain meaningful results.
Definitions of money
The first definition of money is that it is an accepted standard by which the relative values of different goods and services between them can be compared. For example, if it can be established with objective and rational means that the value of a luxury car is twice the value of a “budget car”, then to buy a luxury car, a purchaser has to tender twice the number of dollars than for a budget car. This is rational reasoning, but it only gives money an administrative and a passive role, as a standard. Can a standard, which has no intrinsic value in itself, be lent against interest? As a standard, however universally accepted, money is not more precious that a measuring tape or a litre bottle.
The second definition is that money is an intermediary of exchange of goods and services. The value of each one is measured as having the worth of so many dollars. This means that when somebody buys a luxury car, he is not compelled to pay for it by giving out two budget cars. He pays with a certain number of dollars which would be enough for anybody to buy two budget cars if he so wishes. In this function, money has again an administrative and an intermediary role. Is it rational to lend a mere intermediary against payment of interest?
The third definition is that money is legal tender to pay any sum of money which is due, or to buy a product or a service. Any creditor or seller is bound by law to accept these paper dollars and liberate the borrower from his debt. Likewise, a citizen can pay his taxes due to the government by means of dollars, which are considered as legal tender. Again, in this schema, dollar money remains a mere tool to be used in certain specific circumstances. Is it right to lend a paper representing only a symbol of value against payment of interest?
The fourth definition seemingly gives professionals a reason to attribute a value to it, as it is considered to be a reserve of purchasing power. As such, the lender demands an interest payment for abstaining from enjoying his money. Thinking rationally, if somebody considers that money is a reserve, a value kept aside for use at any time, he should not give it away, because he may need it at any time. If somebody considers that lent money has an “opportunity cost” and he may lose a more lucrative way of using his money elsewhere, he is better off by keeping his money and using it to take advantage of that opportunity, which is, in actual fact, often unknown. On the same subject of opportunity cost, if a holder of capital already has a good opportunity to commit his money to better use, he is worse off by lending it to others. In actual fact, all these reasons to charge interest are no more than subterfuges to pretend that the money could have been destined to other uses, but, in reality, in full the knowledge that these alternative uses of money would never be availed of or the risks attached to them never be taken.
The immoral nature of interest is that it favours the lazy and the risk averse.
The other pretext is that interest covers the depreciation of money given on loan due to inflation. The simple question that this begs is: How is it that every person suffers depreciation on all the things that he possesses, namely houses, cars, equipment, furniture, without seeking a compensation, but holders of money want a specific compensation, at a rate fixed contractually in advance, to counter balance the depreciation of their money while sitting idle and taking no risk? If money is really an asset, what makes it different from all other assets? If somebody really wants an income out of his financial reserves expressed in money, the rational way should be by putting it to productive use to earn a profit which would cancel and even beat inflation and depreciation. The immoral nature of interest is that it favours the lazy and the risk averse who have no investment ideas and no business acumen, and yet brings them remuneration, at guaranteed rates, whether the borrower of the money makes a profit or a loss in his business.
The utility of interest as viewed by economists
Economists are at a loss to say with certainty why interest exists. So, they limit themselves to forecasting the effects of increasing or lowering interest rates, and even then, they are very often helpless in explaining why variations in rates do not produce any tangible effect on the economy, contrary to what they have been taught. Here are some of their theories.
1) That interest is a crucial incentive for saving money. This is a principle existing in textbooks only and is far from reality. Savings is generated only when there is an excess of income over expenditure. Interest on savings may go up to over 10%, but there will be no savings generated in a household where there is no disposable income left. The reason which prompts savings is not financial return. Savings is money left aside to accumulate because of a known expenditure which will arise in future, for example wedding expenses, projected overseas holidays, acquisition of an asset (house, car) or the tertiary education of children. Besides this, savings is also prompted because of the fear of the uncertainty of the future. Examples of such unpredictable things are: loss of job, death of an important income earner in the family, illnesses requiring expensive treatment like surgery, opening of a business for a child who does not do well at school or topping up retirement pensions.
Savings motivated by the above vectors have nothing to do with interest rates and will exist even when bank savings rate is zero. This is a verifiable fact in countries where it has actually happened, namely in Japan, and America between 2008 and 2015. It is a fact, though, that varying interest rates on savings offered by financial intermediaries and borrowers do cause mobility of funds towards more lucrative placements offering better returns or additional benefits, but they do not generate new savings.
2) That low borrowing rates of interest rates favour investment. The reasoning behind this is that when borrowed money becomes cheaper, it is an incentive for companies to borrow, invest and make their business grow, or open new businesses. This also is a total fallacy. When interest rates go down in our era, we are taking of about 1-2 percentage points. Business people do not invest to have 1-2% returns on investments, they think of something like 20% return on capital employed. In such cases, a 2% increase or decrease in interest rate is academic. On top of this, if the borrowed money is rotated 3 times in a year, its actual cost is only an additional 0.5 % per annum and small costs of this magnitude do not even require any thought by the active and wise businessman.
Interest rate on borrowed money can be as low as 1%, but apart from speculative investments, borrowing for business purposes is not motivated by the low cost of money. The main drivers of investment in productive industries are business opportunities, growth opportunities, existence of a market, availability of raw materials at reasonable prices, availability of skilled labour and its cost, strength of competitors, availability of know-how or its cost when it has to acquired. I have personally been managing a conglomerate of several business units employing 1,500 people. Even in the face of high interest rates, I have made lots of investment decisions by borrowing money at 10% per annum and which have never ended in losses.
Interest only becomes a brake to borrowing for business purposes when it attains punitive rates.
No doubt, a reduction of interest rates is a relief for a heavily indebted business, but I have never seen a seriously ailing business being bailed out of bankruptcy by a reduction in interest rates. If an investor in a new venture bothers himself with a 1-2% variation in interest rate, his place is not in business. Interest only becomes a brake to borrowing for business purposes when it attains punitive rates like 13-14%.
3) That adjusting interest rates is crucial to stabilize the value of the national currency. It is a theoretical reasoning that when a currency’s exchange rate needs to be beefed up, central banks increase interest rates and foreign money from outside comes in. Their conversion into the local currency to benefit from the increased interest rate is supposed to increase the demand for the local currency and to raise its exchange rate.
This is what we can call an exception which confirms the rule and is best explained by a concrete illustration. The interest rate on the South African Rand (ZAR) is currently 3.5%, which is twice that of the US dollar. Is this interest premium in any way increasing the exchange rate of the ZAR? The ZAR exchange rate has fallen continuously with regard to the USD and its depreciation has attained 50% in four years. It should not have been so, if we reason solely on the basis of the interest rate. The only thing that an increased interest rate can do is to avoid, to a certain extent, an outflow of national money converted into foreign currency.
The reality is that raising the interest rate for this purpose is totally without effect on increasing the exchange rate of a currency which is liable to weaken in future because of the weak economic fundamentals of the country. A perfect example is the Mauritian rupee in the present circumstances. Other examples are politically unstable countries or in a quasi-state of war or one product countries. Opportunistic, medium term Investors and speculators do not invest in volatile and illiquid currencies. By the time investors gain 3.5% per annum out of interest, it is likely they would have lost twice as much in currency depreciation.
This reasoning on the effectiveness of interest only applies to strong and stable currencies where there is likely to be appreciation rather than depreciation, and there are only a handful of such currencies in the world, not exceeding 10 out of 180 currencies. Economic fundamentals are also scrutinised by any investor, the only exception to this being the US Dollar. It is a currency so widely in demand for world trade and for constituting central bank reserves that it is unlikely to depreciate to the extent of becoming a weak currency, even with weak economic fundamentals.
4) That interest is crucial when budget deficits have to be financed. Budget deficits, which were considered as taboo in the old days, have today acquired a recurring nature. Economists say that budget deficits have become an economic tool to manage the economy by increasing demand via the injection of money in sectors which generate activity. True, but is it systematic that injection of funds by the government must be through a budget deficit only? What about drawing from the country’s reserves, or by selling public enterprises to the private sector if the funds unlocked are to be directed to better activity-generating investments? Is this not a safer alternative which renders indebtedness and interest useless?
All this theoretical reasoning on borrowing to finance voluntarily created budget deficits is fine, but the real story is that today, most countries have recurrent budget deficits for no strategic reason. Seen through a looking glass, in many countries budget deficits have become a fact of life. They either finance new infrastructure often not needed or they serve to service old debts taken precisely to finance previous budget deficits. In our own beloved country, 80% of budget deficit or some 3% of GDP is used to pay interest on old public borrowing. In these circumstances, in what way is the budget deficit being used as an economic tool? As for repayment of capital of government indebtedness, it is simply done by raising new loans because the national budget cannot afford to set aside an iota of money for the repayment of capital.
Stop creating deficits which do not trigger economic growth.
The lesson to be drawn from this is as follows: Stop creating deficits which do not trigger economic growth, and there will be no need to borrow on interest.
5) That interest rates can be increased to discourage indebtedness to fight inflation. True, raising interest rates may to some extent discourage individuals from borrowing from financial institutions to buy cars or apartments. But even this is debatable because all housing loans and other loans of 3 years and above are granted on a variable interest rate basis. Interest on loans can be expensive today, but it can fall at any time, depending on what rate of interest banks pay their depositors. And this gives households hope when they borrow even at high rates in the expectation that interest will not stay high throughout the duration of their loans, and in the expectation that their salaries will rise from year to year, making their loan repayment instalments less of a burden.
Indebtedness is rarely a function of the cost of interest. When money is needed for meaningful reasons, or emergencies, or to pay other more pressing debts, the cost of money becomes academic. Here is one glaring example. Many banks have adopted the practice of asking only 5% (and above) of the owing balance of credit card as monthly payment. Millions of people are debtors on their credit cards and still agree to pay up to 20% interest per year.
In actual fact, raising the cost of borrowed money to curb inflation-generating consumption addresses only consumption financed by bank credit, but this does not address over-consumption by people who have savings or quasi-cash immediately available. It is a general conception that central banks mopping up excess liquidity held in banks for the account of their customers by the issue of interest-bearing Treasury bonds prevents this excess money from being used to feed consumption. This is also without effect on consumption, and hence inflation because households never buy government securities and their excess money remains available on their bank accounts to allow them to consume whatever they want and whenever they want.
Lastly, inflation due to over consumption beyond the volume of goods in supply, which we call demand-pull inflation, is only part of the inflation headache. There are two other causes of inflation: a) by the rising prices of raw materials going into production, due to shortage of these inputs, whether locally, regionally or worldwide, and b) by the depreciation of the national currency, for whatever reason, which automatically raises the cost of whatever goods and services which are imported from overseas.
Having seen the uselessness of interest in an economy, I will tackle in the next issue of Conjoncture the toxicity of interest which makes it a monumental evil responsible for many disasters and reply to the obvious question of how to raise deposits and how to finance those who are in need of money for productive investment in an interest-free economic system.