the plan for the future
Proposal for Phd research
Bart klein Ikink, MSc
2 September 2016
The future economy may need to rely more on asset spending rather than debt creation. A tax on currency and a ban on charging positive nominal interest rates on loans may be required to bring the global economy back on track. This design, called Natural Money, can provide an economic stimulus while putting a lid on debt expansion. A side-benefit may be a reduction of moral hazard attached to government and central bank interventions.
The economy may perform better than it would have done if positive nominal interest rates were allowed, even after the zero lower bound has been phased out. This means that real interest rates on Natural Money currencies may be better so that these currencies are likely to appreciate in value relative to interest-bearing currencies. If this is indeed the case, Natural Money may become the dominant type of money in the future.
Negative interest rates and interest rate ceilings have long been considered fringe economics, but they may go main stream in the near future. This makes them a promising research field. The initial research could focus on the following questions:
(1) Can this idea help to improve the performance of the economy?
(2) If so, then what are the preconditions for this to happen?
(3) What are the consequences for market participants?
Low interest rates are often seen as a consequence of a global savings glut. Lower interest rates allowed consumers to take on more debt, most notably mortgage debt. In the wake of the financial crisis of 2008 many governments went deeper into debt while central banks implemented unconventional measures to stimulate the economy. During the recovery, interest rates remained low, so that a new recession may require negative interest rates.
Innovations in the financial system with regard to mediation and risk management have lowered carry costs and risk premiums. The globalisation of financial markets caused by the end of capital controls during the 1980s and 1990s made it much easier to invest around the globe. Central banks provided a backstop if things went wrong (Miller, Weller & Zhang, 2002). These developments have contributed to lower interest rates worldwide.
Financial innovations such as the credit derivatives tend to improve the risk management of banks. This allowed banks to offer lower corporate loan spreads. The effect of risk management remained unchanged during the crisis period of 2007-2009. Banks with larger gross positions in credit derivatives cut their lending by less than other banks during the crisis and had consistently lower loan charge-offs (Norden, Silva Buston & Wagner, 2014).
Capital accumulates through interest. Interest rates on capital exceeded the rate of economic growth for most of history (Pikety, 2013). If most of the proceeds of capital are reinvested, then this development cannot continue indefinitely due to compounding, and interest rates will go down. As wealthy people tend to reinvest a larger portion of their income, and own more capital, interest also contributes to wealth inequality (Kennedy, 1995).
Many economies are maturing. Population growth in these maturing economies is often low. Furthermore, mature economies have to deal with a reduced marginal utility of additional wealth. These issues tend to lower the demand for investments, which contributes to lower interest rates. High debt levels put a strain on consumer spending as well, and because this affects demand, it affects the rationale for investment spending.
A basic premise underpinning much of economic thought is scarcity, and by consequence time preference. This reasoning is often used to explain why interest rates need to be positive. In the face of abundance, long-term security can become of a greater concern, so that people may save more for retirement. If interest rates are lower, they may need to save even more. Hence, abundance may lead to lower interest rates.
Economic models suggest that wealth will end up in the hands of the most patient consumers (Ramsey, 1928). It is also argued that consumers value wealth directly in their preferences (Kurz, 1968) because people may see wealth as an end in itself (Zou, 1994) or because of a desire for status (Cole, Mailath & Postlewaite, 1992). This may induce people to acquire more wealth even when interest rates are lower than the rate of time their preference.
The wealthiest people tend to reinvest most of their interest income as they are more likely to be people that see acquiring wealth as an end in itself. They own a disproportionate amount of capital so that their attitude may have a disproportionate effect on interest rates. Lower interest rates allow for more capital to exist as more projects become feasible. Negative interest rates may therefore be a sign of prosperity.
It has been a matter of debate as to what extent monetary policies affect the real economy in the short run. In the long run changes in money supply only tend to affect the price level (Friedman & Schwartz, 1963; McCandless & Weber, 1995). The financial crisis of 2008 demonstrated that central banks have proven to be helpful as lenders of last resort but the effects of their monetary policies in the aftermath of the crisis are not so clear.
One of the main criticisms against monetary policies is that the quantity of money is determined endogenously by the state of the economy rather than the policies of the central bank. It is argued that central bank actions reflect the state of the economy. A consequence of this reasoning is that financial markets without an active central bank may have acted in similar fashion, provided that the central bank assures financial stability.
Interest rates nowadays are not able to adjust to market conditions because of the zero lower bound. One of the main symptoms of this problem is an appetite for cash, more commonly known as the liquidity trap (Keynes, 1936). This is the reason why traditional central bank policy tools have been rendered impotent so that some central banks have been experimenting with quantitative easing and negative interest rates.
Quantitative easing aims at increasing the money supply by exchanging debt for currency. This approach may do very little as market participants keep currency for the same reasons as they previously held these debt instruments. Furthermore, liquid financial markets have blurred the distinction between money and other asset classes such as stocks and bonds because they can be easily exchanged for money at low cost.
Central bank guarantees can promote debt creation and private profits at the expense of the public. This became apparent during the financial crisis of 2008 as it was related to sub-prime lending. To cope with this issue, the body of regulation has been enhanced. An alternative solution is to implement a maximum interest rate on loans as interest is a reward for risk. This could create cap on risk appetite and moral hazard in the financial system.
A maximum interest rate on loans is likely to reduce the leverage of businesses as well as consumers, making their finances more resilient, so that their spending can be more stable. Leverage is one of the reasons why there are business cycles as market participants tend to extend leverage during booms and reduce leverage during recessions. Some market participants default on their debts. These defaults may cascade, which can cause a financial crisis.
Setting a legal maximum interest rate is likely to cause evasive behaviour. In Western Europe interest was forbidden during the Middle Ages. When economic life became more developed, the ban on interest became more difficult to enforce. In the 14th century partnerships emerged where creditors received a share of the profits from a business venture. As long as this share was not fixed, this was not considered to be usury (Kuznets, Lo & Weyl, 2009).
Later on, when usury bans were replaced by interest rate ceilings, creditors and debtors could agree that less money is handed over to the borrower than stated in the actual loan contract so that more interest was paid in practise (Samuelsson, 1955). The experience with Regulation Q in the Unites States suggests that a maximum interest rate is feasible only if it doesn't affect the bulk of borrowing and lending (Gilbert, 1986).
Interest on loans contributes to financial instability as a fixed income is extracted from an unpredictable income. The rationale for monetary policies is based on the idea of natural interest rates. Deviations from this rate can trigger booms and busts. By setting short term interest rates, and in this way influencing long term interest rates, central banks influence credit creation by trying to keep interest rates near the natural interest rate.
There has been a lot of criticism on this idea. The natural interest rate cannot be measured or calculated so that policy makers have to rely on estimates. Fiscal and monetary policies can become subjected to political objectives (Nordhaus, 1975; Cukierman & Webb, 1995). It is therefore argued that a central bank should be independent. Still, central bank decisions affect politics so that there are benefits to limiting their discretion.
Even more importantly, interest rates rise in times of optimism. The consequence may be that interest rates are too high during the boom. When the boom is over, it turns out that there had been a lot of borrowing at interest rates that turned out to be unjustified based on the outcome, leading up to defaults. Lower interest rates would only have prolonged the boom, and the end result would probably have been worse (Mises, 1949).
Keynes already argued that there must be multiple natural rates of interest that and that there is no rate of interest that would maintain capitalist stability. Minsky expanded on this idea in his Financial Instability Hypothesis by arguing that capitalist economies exhibit debt inflations and deflations which have the potential to spin out of control because the economic system has a tendency to amplify these movements (Minsky, 1992).
An important assumption to Natural Money is that future interest rates will remain low, and may go even lower. This may happen under the conditions of (1) peace, prosperity, rule of law and abundance of capital, (2) efficient global financial markets, (3) effective measures to counter risk and moral hazard in the financial system, (4) sound government finances and stable currencies, (5) reduced population growth or even population decline.
Natural interest rates have been trending lower in recent decades and may have gone into negative territory in recent years (Lubik & Matthes, 2015) so that this assumption seems not far-fetched. It is also supported by the arithmetic indicating that returns on capital cannot exceed the rate of economic growth in the long run if most of these returns are reinvested, which is to be expected as wealth is distributed unevenly.
Central banking has been crucial in economic development. The financial stability produced by central banks reduced the risk premium and lowered interest rates. This made more projects feasible. It may not be a coincidence that the Industrial Revolution started in England, just after this country was the first to institute a central bank. In this way more credit became available at lower interest rates via fractional reserve banking.
The proposal of Natural Money consists of (1) a holding tax on currency (cash and central bank deposits) amounting to 0.5% to 1.0% per month to provide a stimulus when needed, (2) a maximum nominal interest rate of zero on loans to curb debt expansion, (3) reducing the need for monetary and fiscal policies by providing stable economic growth, and possibly maximum economic growth given the economic potential.
The name Natural Money refers to the Natural Economic Order of Silvio Gesell. Gesell expected that a free play of economic forces in financial markets will bring down interest rates to zero. He also realised that if interest rates fell below a certain threshold, no money was available for lending (Gesell, 1916). This is known as the liquidity trap (Keynes, 1936). To deal with the liquidity trap Gesell proposed a holding tax on currency (Gesell, 1916).
The government should spend the holding tax back into circulation. The holding tax provides a stimulus by allowing interest rates to go further down when the economy slows down. Under the Natural Money proposal banks pay a holding tax on reserves so that they need to pass down these costs to their customers. As central banks don't set interest rates under the proposal, interest rates on deposits will better the holding tax rate.
Remaining liquid by keeping currency balances is expensive as the cost of keeping currency is 6% to 13% annually. It is less likely that a financial crisis, and consequently an economic crisis, will occur as a consequence of a sudden evaporation of liquidity. Hence, central banks may see fewer reasons to provide liquidity by increasing the amount of currency and governments may see fewer reasons to revert to deficit spending to prop up the economy.
Deposit rates may vary between -5% and -1% and could be around -2% to -3% most of the time. As people keep most of their money in bank accounts, these are the rates they effectively pay. If the currency is inflation free, or even rises in value, these rates may be acceptable to depositors. Real interest rates may even be positive if the economy grows and monetary aggregates as well as money velocity remain fairly constant.
The proposal includes a ceiling on interest rates. Once the bulk of interest rates have gone negative, charging positive nominal interest rates on loans can be forbidden. The proposed enforcement measure is to declare void loans with a positive nominal interest rate. This also applies to bonds at the time of issuance. Bonds may still have positive nominal yields when interest rates go up or if the financial position of the issuer deteriorates.
Interest is also a reward for risk so a maximum interest rate can eliminate risky forms of credit. This can force troublesome debtors to reorganise their finances. The interest rate ceiling may ensure that financial troubles do not escalate because of interest charges. This may enhance the stability of the financial system and the economy, which can have a positive feedback effect as this can make the financial position of debtors more predictable.
An interest rate ceiling can cause market participants to revert to alternative schemes of finance such as lease and hire-purchase. Partnerships between financial institutions and corporations similar to Islamic finance may be introduced on a greater scale to fill in the void that emerges as a consequence of the interest rate ceiling. As investors take more price risk themselves, this development tends to stabilise the financial system.
The proposal affects government finances as they should be kept in check so that government debt levels remain stable or sustainable. For example, if a government can borrow at -3% while government debt is 70% of GDP, then government deficits of 2.1% are sustainable. Central banks should aim at keeping the amount of currency constant so that there is a deflation expectation or at least no inflation expectation.
Interest is to some extent a reward for risk so insurance premiums are to some extent interest, most notably if the insurance is against the risk of default. Examples are the obligation to insure a mortgaged property or a life insurance pledged as collateral for a loan. If there is to be an interest rate ceiling, then a rationale emerges to regulate the use of these types of insurance as collateral.
Natural Money can mitigate the business cycle. If the economy is poised to boom, interest rates rise, and available credit at a maximum nominal interest rate of zero will reduce as investors start to prefer equity investments to debt. This can prevent overheating, most notably as it hinders consumer borrowing. If the economy is poised to weaken, interest rates drop, which will generate a stimulus. This can prevent a recession from happening.
A debt overhang can worsen a recession. If debt creation is curtailed during boom times, then debt will be a lesser problem when the economy softens. Even more so, because there is no interest on debts, spending power of consumers is not suppressed by interest payments. As poor people can often only borrow at high interest rates, they may be unable to borrow under the proposal, so that their spending power can improve.
The envisioned financial and economic stability reduces the rationale for fiscal and monetary policies. The proposal requires budgetary discipline from governments to keep nominal interest rates in negative territory. As there is a stimulus as well as a lid on debt expansion, the need for monetary policies is likely to reduce. The absence of interest may end the need for adding new currency (Kennedy, 1995) so that interest rates can be set by the market.
In the case of economic shocks, there may be need for central bank actions. Central banks can still be a lender of last resort and provide emergency credit, normally at a rate of zero. This rate is unfavourable as it is also the maximum interest rate on loans. In this way central banks shift back to their 19th century role, which is averting panic by lending early and without limit to solvent firms against good collateral at high rates (Bagehot, 1873).
Central bank and government interventions can distort markets as there is a moral hazard attached these actions . The expectation of these interventions can foster the belief with market participants that they are insured against downside risk, causing lower risk premiums and a reduction in risk-aversion (Miller, Weller & Zhang, 2002). These developments may have contributed to sub-prime lending and the financial crisis of 2008.
Cash is an obstacle to implementing negative interest rates because many people still see banks notes as the currency standard. To implement negative interest rates, the electronic currency unit should become the currency standard (Buiter, 2009). This idea was first floated by Robert Eisler (Eisler, 1932). It can be implemented via an exchange rate between cash and the electronic currency unit (Buiter, 2009; Agarwal and Kimball, 2015).
Demurrage currency and negative interest rates are likely to increase the velocity of money. If demurrage currency is to be introduced without additional measures, it could produce price inflation. It may even cause hyperinflation in the wake of quantitative easing because of the excess currency made available in this process. It is therefore advisable to implement measures to counter these inflationary effects.
It stands to reason that most currency currently in circulation needs to be decommissioned. Cash is becoming less attractive because of the holding tax on currency. Banks should be able to get rid of excess reserves. The quantitative easing may need to be undone, quite possibly at a handsome profit to the central banks as interest rates have gone down in the meantime.
The holding tax and the interest rate ceiling may be introduced gradually to let market participants adapt to the new situation. At first, interest rates of above 1% per month could be forbidden. These interest rates sometimes exist on credit card debt and instalment credit. After the initial introduction of the interest ceiling, it could gradually be brought down to zero. This may take several years depending on conditions in the money and capital markets.
Negative interest rates are likely to run into opposition. It should be noted that most people pay more interest than they receive, either directly via loans and rents, and indirectly via the products they buy, so that most people would benefit from lower interest rates (Kennedy, 1995). In general, lower interest rates bring down capital costs. It may be possible to counter the opposition with these arguments.
Liquidity preference results in a demand for money because it is a liquid asset (Keynes, 1936). This preference causes people accept lower interest rates on money relative to other assets. People may therefore accept negative interest rates on money if the risk/reward ratio of other assets are deemed less favourable. The existence of money substitutes such as gold can provide a floor under interest rates.
The maximum interest rate shouldn't affect the bulk of borrowing and lending as that would disrupt the markets for money and capital. There is likely to be some fraud. But as long as the official sector can sufficiently influence the economy, the proposal may have the intended effect. Evasionary actions could also imply that investors will prefer equity over debt, and take price and income risk, which can improve financial and economic stability.
The business of banks doesn't change much under the proposal. Banks have to pay the demurrage on reserves so that they are unlikely to keep excess reserves. They have to pass these costs down to the depositors. This is not much different from a situation where market interest rates are above zero while the interest rate on reserves is zero. Also in this case, keeping reserves comes at a cost to banks that will be passed down to the depositors.
There may be a reserve requirement if there is a desire in society to influence the amount of bank credit, most notably if the state and the central bank guarantee the integrity of the banking system. A reserve requirement may have little effect on credit in general as there are many other sources such as bonds and the shadow banking system, but it can be expected that the maximum interest rate will help to curb credit excesses.
If interest-free demurrage currencies were to coexist with interest bearing currencies then interest-free demurrage currencies may win on two fronts. People will use the demurrage currencies for transactions. This is because "bad" money drives out "good" money (Kennedy, 1995). If interest-free demurrage currencies subsequently provide superior yields, market participants will start to accumulating balances of interest-free demurrage currencies.
In practise the competition of two currencies within one economy is not feasible as there is likely to be one set of real interest rates because of arbitrage. Differences in real interest rates could reflect other factors such as the risks associated to holding balances in those currencies. It stands to reason that interest-free demurrage currencies should be legal tender in order to have the intended effect.
If the economy is running at maximum potential, this as an upward effect on real interest rates. If the maximum nominal interest rate is zero, this can only be reflected in an appreciating value of the currency relative to currencies with positive interest rates. This is possible because monetary aggregates, which are the amount of currency and debt, are unlikely to grow. For mature economies this could lead to better returns on deposits.
The strongest currencies tend to have the lowest interest rates as interest also reflects risk and inflation expectations. Negative interest rates therefore tend to coincide with currency strength because of arbitrage. In the current economic environment this is caused by a demand for currency because of the liquidity trap. With demurrage currencies, currency strength is likely to reflect the strength of the underlying economy.
The proposal is quite radical as it departs from the idea that governments and central banks manage the economy via fiscal and monetary policies, so it may be better to explore the idea qualitatively at first as to whether it is viable, and if it is, under which conditions that may be so. Quantitative models may be the next stage after this research has indicated that the concept is feasible and may bring the some of the expected benefits.
The thesis should be that Natural Money is a design that can to improve the performance of the economy by stabilising the financial system. There may be preconditions for the thesis to hold. The idea for the research is to examine existing literature in more depth, and to explore these preconditions as well as some tentative answers on a number of questions such as those listed below:
(1) Will interest rates remain low enough and what are the preconditions for interest rates to remain low?
(2) Is it true that the proposal can help to keep the economy on the maximum growth path so that real interest rates will be higher than they otherwise would have been?
(3) What would be the consequences of closing down the high risk segment of the fixed income market? Is this feasible under the conditions that have been brought forward?
(4) What are the consequences for the business models for different types of businesses, for example banks, insurers, but also government and businesses in general.
(5) What will be the social consequences of the proposal and how can adverse consequences be mitigated?
(6) Will the design provide stability so that there will be fewer financial and economic crises?
(7) Will the proposal succeed in providing liquidity in moments that would otherwise be crises?
(8) Will there be price deflation so that negative interest rates can be competitive?
(9) Will there a market for alternative forms of finance like Islamic banking?
(10) How does this system react to different kinds of shock?
It has taken several years to formulate the proposal and to explore the feasibility so that the first stage of the research may not take very long, provided that there is support from an economic research department. The idea was first conceived in 2008 (Klein Ikink, 2008). Research started in earnest in 2013 once the concept started to look more promising as the trend towards negative interest rates became more evident (Klein Ikink, 2013).
Aristotle noted that money is barren. Money does not grow on trees. If the number of currency units is fixed, charging interest can cause economic problems because compound interest is infinite. German research has shown that the bottom 80% poorest people pay interest to the top 20% of richest people (Kennedy, 1995; Lietaer, 2001). Interest can therefore be seen as a tax on the poor for the benefit of the rich (Kennedy, 1995).
Most money is created as interest-bearing debt, but the money to pay the interest from doesn't yet exist, so that there is an alleged artificial money scarcity that encourages competition and discourages cooperation (Lietaer, 2001). Central banks often print new currency to mitigate the adverse effects of compound interest. In this vein interest can be seen as a cause of monetary and price inflation (Kennedy, 1995).
To pay for interest, economic growth is needed, which may lead to growth coercion (Lietaer, 2001). High interest rates often coincide with high unemployment rates possibly because fewer projects are feasible when interest rates are high (Kennedy, 1995). Interest promotes a short term bias as investment projects have to be discounted against the prevailing interest rate. This discourages sustainable investments (Lietaer, 2001).
Usury in its original form means charging a usage fee for money. This usage fee is called interest. Usury is condemned both in the Bible and the Quran. The problem with this view is that interest is not only linked to money. Interest rates are determined in markets and are related to business profits, supply and demand of capital, time preference, liquidity preference, the risk of default, and the stability of the currency.
Islam forbids charging interest and excessive uncertainty or gambling. Islamic banks offer interest-free current accounts and profit-sharing investment accounts. Islamic lending consists of leasing, profit-sharing partnerships, and fee based services. As Islamic banks have to compete for funding in international markets where arbitrage exists, one cannot expect them to be interest-free in practise.
Sukuk is the Islamic equivalent of bonds. These are similar to asset backed securities. The principle amount is not guaranteed and the returns on investments are linked to the underlying assets. The essence of Islamic finance is that investors take a price risk on the asset as well as a risk on the income coming from the assets. This contributes to financial stability as no fixed income is extracted from an unpredictable income.
Complementary currencies are also called community or emergency currencies. Most are interest-free and some have a holding tax. The currency of Wörgl during the Great Depression pointed at the potential of demurrage to end an economic depression (Lietaer, 1995). Complementary currencies are not liquid so that large scale interest-free banking in these currencies is not feasible because of the transaction costs and risks involved.
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