Proposed Solution to Economic Dilemma

What is interest? I realize that based on your understanding of it that you associate it with money, but the fact is that interest has nothing to do with money, but with the preferences of people, once you deny that preference you destroy all economic functionality.

Now, while I am totally against the current fractional reserve system and the fiat currency that fuels it, I will attempt, once again, to explain to you the fallacies associated, and apparently so engrained, in your thinking.

At this time I will restrict the subject to the current banking system for simplicity sake. You assume that because new money is created when a banker issues a loan that only the amount of that loan is created and, according to your theory, the interest that is associated with the amortization of that loan is not created. Thus, based on your linear logic, the interest must therefore come from somewhere, otherwise the entire system will collapse because there is not enough money in circulation to pay both the increasing amounts of loans and the interest to retire those loans. Thus, your theory assumes that there is an exponential multiplication of debt and interest that consumes the amount of money in circulation eventually leading to a collapse.

Now, to make this simple and show you that interest is essential and not associated with money, but is a time preference that functions within an economy and is necessary for economic health, I will give you the following example to ponder. Interest began prior to the use of money, it began in the barter economy.

Say there was a baker who made bread everyday and because this little story takes place in a society prior to the use of money, the baker barters his bread for other products he may need. One day an apple grower came to the baker and wanted 10 loaves of bread, but the problem was that while the baker was willing to barter 10 loaves of bread today for 6 baskets of apples today, but the apple grower would not have a crop for 6 months. The apple grow said he was willing to “pay” 6 baskets of apples to the baker, but that he wouldn’t have those apples until a point in the future. Why should the baker accept 6 baskets of apples in the future when he could easy barter those 10 loaves of bread today for something he needed today, say like 6 dozen eggs, or some other commodity that was ready today for barter? He has a preference, based on the barter price today, but he is willing to consider his time preference in the future and since the apple grower cannot “pay” him today the baker is willing to barter the 10 loaves today to the apple grower if the apple grower, who needs the bread today, is willing to “pay” 8 baskets of apples in 6 months to the baker for the 10 loaves today. It would not be prudent for the baker to simply turn over 10 loaves of bread to the apple grower today while losing the present value he has to barter that same 10 loaves today to someone else for a product, like 6 dozen eggs which have present preference over waiting for 6 months for the apple grower to barter him 6 baskets of apples for those 10 loaves because it would not be worth it to the baker to lose the ability to “profit” today by waiting for the same number of baskets of apples in the future. It would however, be a potentially good barter, based on time preference, for the baker to barter those 10 loaves today for 8 baskets of apples 6 months into the future.

I will take this further. Money resulted from the uncertainty of human action and preferences. Interest came about based on several preferences found within humans, and it came about in the barter stage of economic development prior to the development of money. The various preferences that brought about the need for interest was not only time preference, which happens to be an essential element of economic exchange based upon uncertainty, but also as a means of determining risk, which is the hinge of a capital economy, as well as a barter economy for that matter. Like the baker, a person must determine risk based upon both present need and availability verses future need and availability. Without this mechanism the potential for exchange cannot exist. Additionally, the baker had to determine if the future price of 10 loaves of bread would indeed still be worth 8 baskets of apples in the future, it might be that his risk of bartering those 10 loaves today to the apple grower will not actually cover his cost of 10 loaves in the future with only 8 baskets of apples. The baker must also be aware that he is also taking risk by giving 10 loaves of bread to the apple grower today and the apple grower loses his entire crop of apples in 6 months; thus he must once again determine the risk associated with his willingness to give over those 10 loaves today for 8 baskets of apples 6 months into the future. Now, had the apple grower had 6 baskets of apples today then there would be no risk and the voluntary exchange for 10 loaves of bread today would have taken place with no questions of risk asked about the transaction.

Likewise, with money, no different that the bread or the apples, both are mediums of exchange in a given economy. Now, with money there are also other factors concerning a persons goals, whether personal or business, and how those goals will be reached. Additionally, there is the risk, with money, like the risk with the bread and apples. Essentially, there must be a consideration which demonstrates a preference for present value over future value. Present goods, or money is always more preferable to future goods, or money. If you can exchange your money today for something you need today then you will do so. If however, you need something today without the ability to pay for it you either must wait until you earn the money or you must intervene on the time preference of someone else, such as a lender. Now, a lender, whether institutional or a personal associate, would rather use their money today if it brings about a fulfillment of present preferences, however if they lead it out and assume the risk associated with that act, then they must also assume the difference in time value. Since taking present money and lending it renders that money void of both exchange and investment, the risk of lending must take into consideration all the preferences between present and future values. Essentially, interest represents the constraints of time preferences, thus a man will exchange a present good, such as money against a future good, such as money loaned, only if he can anticipate that the future amount will be of a greater value to him. Without this time preference function, the economy would not function because there would only be present consumption without regard for any future return, the reason for that is the risk would simply be too great to assume a loss today for a potential future repayment without that risk being accounted for in the equation of a loan.

Now, in a free market, the rate of interest is basically nothing more than the complete sum of all time preferences within a society. Thus the supply of goods or money offered in exchange against future goods and services are determined by market movements as individuals determine their needs, their desires, their goals and whether they are willing and able to pay for those things today or, if not, then are they willing to assume the premium of someone else’s time preference to lend them the money to buy the goods today, but repay over time. Thus the demand for present goods must be capable of yielding future returns, if not then there is no reason for the borrower to borrow and there is no need for the lender to lend since there would be no just exchange between the two time preferences of each person, the borrower and the lender.

I could go deep into interest and savings, the essential conjunction between the two, but that would complicate matters beyond your willingness to consider, that based on my past discussions with you. However, I will say that in a free market, sound money economy, no supply of loanable funds could exist without there being previous savings. What are savings? Basically, it is the excess of current production over current consumption and is based again on time preferences and as well as, other preferences including a person’s present and future needs, desires and goals. Indeed, there would be no demand for loanable funds if a person, judging his time preferences, did not perceive some opportunity to employ those funds in hopes that he would be able to both repay those funds and benefit from the funds he borrowed.

Without interest, which is simply a measure of time preferences in our society, there would be no measure of risk that a person or business would be able to use to determine the degree of his preferences. Without interest we would consume our present goods because there would be no measure to utilize to determine either present value over the risk of future value. What you are asking for would lead to a primitive subsistence existence because no one would lend without the ability to determine risk and protect themselves against any possible risk. Business would not exist, whether it was a money based exchange system or a barter exchange system, no business would extend present goods without the measure of risk associated with future time values. Without interest, there would be no excess production over present consumption, there would not only be no need for it, but no mechanism to bring it about. There is always a price paid for buying time, either in terms of risk, in terms of need or in terms of desire. To think otherwise simply indicates a economic and monetary naiveté that borders on willful ignorance.

Time preferences, as expressed in interest, are also directly associated with employment and income, yet it has nothing to do with money, as I said the money represented by interest is just the medium of exchange for time values between present value and future value. The fact is that interest and money are independent and is not a monetary phenomenon, but a human phenomenon based on numerous preferences found within human beings.

In contrast to money, time preferences expressed and measure by interest, brings about a particular equilibrium within the economy that could not be attained without it even if there were no money used as a medium of exchange.

You see, without interest there would be no ability for the economy to maintain the equilibrium necessary to function properly. In fact, without interest there would be no savings, no investments, no reinvestments because without interest there would be no positive rate or hope of return on risk. As we are now seeing, even in this artificially managed economy, when the rate of interest is lowered to the Zero Bound, capital consumption is resulting and the entire system is being thrown out of equilibrium.

Interest brings and allows a certain degree of certainty over uncertainty, in other words there is a degree of trust associated with interest, both on the part of the lender and the borrower. Interest is the bond of agreement on the value of time, without it there would be, there could be no agreement on time value or the risk associated with that value. All consumption and investments are determined by time preference and time preference is what created interest, whether in a monetary exchange system or a barter exchange system, time preference an essential function for an healthy economy that will produce prosperity, if that economy is allowed to function as it should.

In a real economy, the level of the actual money stock has no effect at all on interest. This is evidence of the fact that money does not determine the rate of interest, time value determines the rate of interest in a free market economy. As I said, money and interest are not associated, but are independent of each other in their functions in an economy. Since interest has nothing to do with money, interest never causes inflation or deflation, only the supply of money causes those or in the case of supply and demand, you will find inflation or deflation being effected, but never interest since it has nothing to do with money, but time preferences. That is why it is so damaging when the Federal Reserve manipulates interest rates, they are actually manipulating time preferences which will always, without exception, cause booms that are always characterized by mal-investments leading to economic dislocation. While it is true that the supply of money can effect time preferences within a society, as we have seen in this latest round of boom/bust cycles, it is not the determinate factor of those preferences. The artificial increase or decrease in the money supply can and does distort the equilibrium within the economy, as we have seen.

It is important to understand that in a free market economy, the rate of interest is completely determined by the market rate of time preferences and that is why the market will always seek that equilibrium, even under the pressure of artificial influences such as the FED.

http://www.1776solution.blogspot.com

"Don't worry, we've thrown out the Weimar Republicans and elected the Zimbabwe Democrats." Billy Joe Allen