While the creation and management of credit was indeed a revolutionary advance for society, perhaps just as important was the impact the greater availability of finance had in lowering of the ‘price’ of money, or the rate of interest. 33
The rate of interest on credit is fundamental to the health and stability of an economy, which is why much attention is paid to it in this book. The level of employment and activity in an economy depends critically on the rate of interest. Too high a rate stifles enterprise, creativity and initiative and
renders debts unpayable. There is also a moral dimension to the relationship between those who own assets, the creditors, and those in need of money or credit, but without assets, the borrowers. This moral dimension has been at the heart of the condemnation of usury – exploitative rates of interest - by faiths, including Islam and Christianity
A low rate is also fundamental I argue, to the health of the ecosystem. Too high a rate demands ever-rising extraction of the earth’s assets, to generate resources for repayment.
Given there is no necessary limit to the volume of credit and debt that can be created by private, commercial banks then credit is essentially a free good – not subject to finitude, or the market forces of supply and demand.
From this it follows, as Keynes argued in his Treatise on Money, that:
“... if the banks can create credit, (why) should they refuse any
reasonable request for it? And why should they charge a fee for what costs them little or nothing?” 34
38 Keynes recognised that once the system of bank money evolved, and credit became more widely available, society no longer needed to rely on existing wealth holders for finance. Barons in the castle – owners of a surplus of capital - were no longer sole providers of loan finance to the rest of the economy. Savings were no longer needed for investment. The powers exercised by the owners of wealth could be subordinated to society’s wider interests. Credit creation by banks could provide borrowers, entrepreneurs and innovators with the finance needed for investment – at affordable rates of interest. Creative artists and designers, entrepreneurs and innovators no longer had to turn to wicked, wealthy ‘robber barons’ for usurious finance.
The ‘price’ of money vs the price of smartphones
The rate of interest on this bank money is determined in ways quite different to the way in which the price of (say) tomatoes or a smartphone or a pair of shoes is fixed. It is different, and cannot be subject to the forces of ‘supply and demand’ because of the very nature of bank money, and of the largely effortless way in which it is created; and because rates are fixed by
committees of men and women.
To manufacture a product such as for example a smartphone requires manufacturers to engage with first the Land – in the broadest sense of the word. Minerals and crucial elements for the phone have to be extracted from the earth, and then transported to manufacturing sites. The extraction, supply and transport of these minerals are subject to both geological and geographical, but also geopolitical, constraints.
Second, the manufacturers of the smartphone have to engage with Labour – in the broadest sense of the word. Labour has to be found and trained;
wages have to be negotiated; and sometimes disputes have to be managed.
The creator of credit faces none of these challenges. The banker engages with neither the Land nor Labour in the creation of his financial product. Sound banking requires good judgment, a conscience, and accounting skills. But
39 the mere act of credit creation is effortless in the way that the manufacture of, say, a mobile phone, no matter how slapdash or obsolete, is not.
Because credit or bank money is created in this way, there is no necessary limit to the volume of credit that can be created. Of course there are
constraints in the management of credit, including the threat of excessive credit leading to inflation; or the contraction of credit leading to deflation.
But unlike smartphones, credit does not rely on finite (mineral and labour) resources for its production. Instead it relies on a potentially infinite supply of that essentially human quality: trust.
Interest extracts wealth from borrowers and assets from the planet
The development of the credit system takes place as a reaction
against usury. This violent fight against usury … on the one hand robs usurer’s capital of its monopoly by concentrating all fallow money reserves and throwing them on the money-market, and on the other hand limits the monopoly of the precious metals themselves by creating credit-money.
Karl Marx35
As Marx notes above, the development of the banking system, and of a
system of credit, arose as a reaction to usury. Rates of interest, in particular usurious rates, extracted excessive wealth from borrowers. Borrowers and wider society eventually reacted against such exploitation, and the banking system began its steady evolution.
The extraction of wealth from borrowers is compounded when payments to the lender, creditor or rentier are delayed or halted, so that the lender can make exponential gains from debtors. As such the practice of exploitative moneylending is widely viewed as parasitical, with humanity and the ecosystem as host.
40
Furthermore money-lending at high rates of interest can help stratify wealth and poverty. The rich effortlessly become richer, and the poor and indebted ever more entrenched in their debt and impoverishment.
Usurious behaviour is repellent, but high real, rates of interest are accepted as normal – the necessary ‘price’ paid for ‘easy money’ - in western society.
There was a time when Christianity’s leaders condemned usury, and
punished usurers with ostracism, denying them the chance to be buried in sacred ground, or married in church. Cosimo de Medici paid for the
restoration of a monastery in return for a papal bull that redeemed him of past sins, in a clear attempt to absolve himself and his heirs of any potential charge of usury by the Church.
Christianity’s prohibition of usury was to be modified by John Calvin (1509 – 1564) and other Christian leaders, a modification as the Financial Times noted on the 400th anniversary of Calvin’s birth, led to:
a huge influx of protestants from France, following in Calvin’s footsteps (who) brought ... skills to Geneva while the lifting of the Catholic Church’s ban on usury paved the way for the city’s pre-eminence in private banking.36
Even while some branches of Islamic finance circumvent the Koranic law, Islam has always upheld the Koran’s prohibition of the taking or giving of interest, or riba – regardless of the purpose of the loan. “Riba” includes the whole notion of effortless profit or earnings that arise without work or value-addition production in commerce. In Islam money can only be used for facilitating trade and commerce – a crucial difference with the acceptance of interest by the world’s major Christian religions. Islamic scholars were fully aware that moneylending can stratify wealth, exacerbate exploitation, and lead to the eventual enslavement of those who do not own assets. Because Arabs were the world’s foremost mathematicians, having imported the
41 decimal system invented by Hindus they fully understood the “magical”
qualities of compound interest, and its ability to multiply and magnify debts.
Usury is today widely accepted as normal in western economies that have been weakened, morally, politically and economically, by the parasitic grasp of finance capital, and immobilised by heavy burdens of debt.
This acceptance blinds society to the way in which usury exacerbates the destructive extraction of assets from the earth. This happens because, as Prof. Frederick Soddy once explained:
“Debts are subject to the laws of mathematics rather than physics.
Unlike wealth which is subject to the laws of thermodynamics, debts do not rot with old age and are not consumed in the process of living ... On the contrary (debts) grow at so much per cent per annum, by the well-known mathematical laws of simple and compound interest ... which leads to infinity … a mathematical not a physical quantity …”
Prof. Frederick Soddy37
The earth and its assets are finite, and subject to the process of decay.
Nature’s curve for growth is almost flat. The rate of interest’s curve is linear.
Compounded interest’s curve is exponential, as the late Margrit Kennedy demonstrated in the chart below.38
42 In order to repay debts that have accumulated exponentially, society is obliged to extract more and more assets from Labour on the one hand, and Land on the other.
This means, in macroeconomic terms, that Labour has to work harder and longer, to repay rising levels of debt. It is no accident that the de-regulation of finance correlated with the de-regulation of working hours, and the abolition of Sunday as a day of rest. ‘24/7’ – meaning shops are open 24 hours a day for 7 days a week, became an acceptable practice as the finance sector’s values took precedence over other considerations.
It is not just workers who are hurt by finance capital’s exploitation of their labour and the extraction of wealth, by way of high rates on debt. Firms, entrepreneurs, inventors and engineers, innovators, artists of all kinds find their efforts thwarted by bankers, ‘private equity investors’ demanding higher rates, and a larger share of the returns on creativity, investment and innovation. As this process snowballs, rents rise.
43 But high rates have implications for the ecosystem too. First, ‘easy credit’
leads to an expansion of consumption. Shopping malls become the temples of the High Street. In order to pay for credit-financed consumption, seas have to be fished out; forests have to be stripped; and the ‘productivity’ of the land intensified – at the same exponential rate as interest rates rise.
High-yield crops, the use of fertilisers and pesticides; the constraining of animals indoors; increases in food production, not just for the world’s
growing population, but to make food production more profitable than debt - all this must be done in order to repay debt. The effects are well known: soil degradation, salination of irrigated areas, over-extraction and pollution of groundwater, resistance to pesticides, erosion of biodiversity, etc.
In other words, the earth’s limited resources have to effectively be cannibalised to repay the world’s creditors.
The high real rates of the neoliberal era
As I have shown above, the supply of money or credit is without limit. Its over-supply, and the tendency of creditors to lend pro-cyclically, should if anything, suppress its price. Not so. Interest rates, in real terms, have risen steadily over the period since Keynesian policies were abandoned. Indeed high rates of interest have punctured credit bubbles with painful regularity since central banks abandoned management of rates, and regulations over credit creation were lifted in the 1970s.
There are very few charts that show the progress of interest rates in real terms – that is in relation to inflation. Because of this I have chosen to highlight the chart below, with acknowledgements to the Financial Times. It shows in nominal terms (i.e. not adjusted for inflation) the official Bank of England Rate between 1914 and 2009. Central bank rates are on the whole lower than commercial bank rates. While this chart does not provide the full picture, note the period between 1933 and1950 when Keynes’s liquidity preference theories were applied by Britain’s authorities. Over this period inflation was subdued. Note also, that as finance was liberalised, and the creation of too much credit chasing too few goods and services led to
44 inflation, the central bank’s rate rose too – both in line with inflation, but also as a symptom of the volatility caused by liberalisation. The central bank rate in turn influenced rises in the full spectrum of interest rates – for short-term and long-short-term loans; safe and risky loans and in real short-terms. These latter rates are not reflected in the chart below.
45
Dr. Geoff Tily in a study published by the Bank for International Settlements provides the following chart of US long-term real interest rates, which shows the rise of rates in real terms after the mid-1970s.39
The de-regulation of credit creation was begun in the UK in 1971 with a process known as ‘Competition and Credit Control’ – often described by economists as “all competition and no control.” Finance capital – the ‘robber barons’ of our day - had regained control over the spectrum of rates applied to borrowers, from long-term rates used for investment by firms, to
mortgages and short term unsecured loans.
As de-regulation freed up private bankers to create credit without oversight, and for speculation, too much credit/money began chasing too few goods – resulting, inevitably, in inflation. Secondly, as private bankers were freed up
46 to fix rates on that ‘easy money’, so interest rates were ratcheted upwards.
High rates periodically bankrupted firms, industries and economies.
Governments reacted to the inflation of the 1970s by introducing policies that suppressed the prices of wages, goods and services. Asset prices, by contrast were not suppressed in the same way.
Today, by controlling the dominant rates of interest in an economy, finance capital once again controls and holds the economy to ransom. It is finance capital, not central bankers or politicians that exercises overbearing, and unaccountable power over society and the ecosystem.
Determining a sustainable rate of interest
Our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our calculations and conventions concerning the future… The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.
J. M. Keynes, 1937 40
Keynes’s liquidity preference theory outlined in The General Theory of
Employment, Interest and Money provided central bankers and governments with not just an understanding of how interest rates are determined but also with policies for managing, and keeping rates of interest low across the full spectrum of lending during World War II, and beyond.41 This was a time when Britain’s government borrowed more than it had ever borrowed before, and public debt peaked at 250% of GDP.
Geoff Tily argues in his book, Keynes Betrayed 42 that:
liquidity preference theory led [Keynes] to conclusions of the most
profound importance. Ultimately, the theory turned classical analysis on its head. The rate of interest was the cause, not the passive
47 consequence, of the level of economic activity and in particular, of the level of employment.
Yet this revolutionary monetary theory is largely ignored by the economics profession, and forgotten by regulators and policy-makers.
Central to Keynes’s theory is an understanding of bank money, not just as a means of exchange but as a store of value. He argued that once a system of bank money evolved, society no longer needed to rely on the holders of wealth, the “robber barons” of old. The existence of bank money means, as explained in earlier chapters, that those fortunate enough to own a surplus of capital are no longer sole providers of loan finance to the rest of the
economy.
Second, under a well-managed banking system (managed in the interests of society as a whole) finance capital need no longer determine the rate of
interest for lending. Instead, within a bank money system, finance capital can be held at bay, and forced to play a more passive role in the economy.
How, you ask?
A lender or creditor’s decision about where to place, and for how long to hold her savings, is determined first by a need for cash, for immediate or near-immediate use in purchasing goods and services. Second, by the
precautionary motive: the desire for security as to the future equivalent of her cash. And third, by the speculative motive: the desire to secure gains by knowing better than the market what the future will bring. Here’s Tily again:
The rate of interest, Keynes concluded is therefore determined by the supply of, and demand for, safe assets into which holdings of (stocks) of wealth can be placed for different motives and for different periods of time – to suit the liquidity preferences of the investors.
By producing and managing a full range of such assets, governments
working with Treasuries and central banks can jointly create and manage a the full range of assets needed by investors, and thereby influence and
48
manage the spectrum of interest rates applied across the economy for loans of different maturities and riskiness
However, central bankers long ago abandoned Keynesian policies for the management of rates to meet investor demands for assets that will satisfy their need for liquidity or cash, for security and for speculation. Instead this asset-creation role, and with it the determination of interest rates, was transferred into the hands of global finance capital.
Today, as this book goes to press, global financial institutions are gravely weakened by the financial crisis. Investors have lost confidence in these institutions and their ‘products’, and there is a serious shortage of assets. As a result savings and surpluses are poured into a small group of assets
regarded as safe by investors: mainly property, gold, jewels, stocks and
shares, government bonds. This has led, predictably, to the inflation of these assets. Central bankers appear helpless to deal with this inflation – only because they have abandoned Keynes’s advice of how central banks and governments can intervene, to manage both the production of a range of assets needed by investors, and the pricing, or the rate of interest on those assets.
How commercial bankers fix interest rates
While central banks have control over the ‘base’, ‘short’ or ‘policy’ rate, they have not since the de-regulation of the 60s and 70s exercised control over the whole spectrum of rates: real, short and long-term; safe or risky rates.
Indeed urged on by commercial and central bankers, politicians and regulators deliberately weakened central bank control over the rates of interest that could be charged by commercial bankers.
The Bank Rate is of very little relevance to producers in the real economy: no entrepreneur that needs to borrow from a commercial bank pays the ‘base’
or central bank rate (currently 0.5% in the UK and 0.225% in the Eurozone) for their overdrafts or loans. Only banks or financial institutions registered with the central bank enjoy the benefit of the policy rate.
49 The rates on loans made to firms and individuals are determined – socially constructed - by those engaged in the ‘production’ of loans: commercial bankers. Bankers make decisions about the rate of interest on a loan based on their assessment of the riskiness of the borrower, and on the rate of
49 The rates on loans made to firms and individuals are determined – socially constructed - by those engaged in the ‘production’ of loans: commercial bankers. Bankers make decisions about the rate of interest on a loan based on their assessment of the riskiness of the borrower, and on the rate of