Is our money system broken?

December 11, 2008 11:01 AM

[EconomistFilter] Are interest based money systems fundamentally broken?

Here's the logic: You might have heard the thought experiment where we're all on an island using a fixed number of coconuts for money, and if we start lending coconuts at interest, we create imaginary coconuts so it's impossible for all the debts to be repaid. To make the simplest possible example, if there's only one coconut, and I lend it to you on the condition that you pay me back two, we now have two imaginary coconuts and only one real coconut. You can't pay me back two, so instead you pay me back one and become my slave.

So, are interest based money systems fundamentally broken? And how does this idea relate to our economy today (how does it translate into reality)?

posted by symbollocks to law & government (23 answers total)

We have unlimited coconuts
posted by low affect at 11:12 AM on December 11, 2008 [2 favorites]

The set of tokens that represent our economy - whether they're dollars or coconuts - has to expand as the economy grows. If someone really agreed to a 100% interest rate loan, it's presumably because they figured it was worth it and there's corresponding economic growth.
posted by GuyZero at 11:12 AM on December 11, 2008

You're forgetting/ignoring the value input of the borrower's work. He presumably got the one-coconut loan so he could expand his business. He doesn't have to create coconuts to create value, just something that someone else will give him 2 coconuts for. No magic creation of coconuts required.

In the real world, we are constantly creating new wealth, by digging it up out of the ground, turning sunlight (and lots of labor) into crops, by writing that new Britney pop single, etc etc.
posted by nomisxid at 11:13 AM on December 11, 2008

Well you get back the one coconut plus effort, and effort has value.
posted by zeoslap at 11:14 AM on December 11, 2008

It's called the money multiplier, and is directly linked to inflation.

As to your coconuts example, it's impossible for all of the coconuts to be repaid as coconuts, but luckily money is just a fungible substitute for exchange value, so when you lend coconuts and are paid back in slavery, that slavery should have a fixed expiration date, and that time with a slave should allow you to increase the absolute value of the goods you already have (as opposed to the abstract value of your, say, new swimming pool outside your hut as expressed in coconuts).

Without some form of money multiplier or new money available, investment and growth necessarily grind to a halt as the coconuts become too valuable to part with, and some other method of exchange is substituted (deflation of goods relative to money, essentially).

Keep in mind that I'm not an economist, and I've never actually had a macro economics class, so most of this is gleaned from the bizarro-economics of PoliSci.
posted by klangklangston at 11:19 AM on December 11, 2008

There are a couple issues at play here.

1: Money is a secondary good, meaning that money itself is not useful for anything, it is only useful for the purpose of trading it for primary goods (things you can actually use).

2: The concept of interest is based on how it might be used over time. Basically, having money right now is ever so slightly more valuable than having money at some arbitrary time in the future (because you have been given the capability to utilize it sooner and derive pleasure, utility, or sustainance sooner).

Coconuts in your example are being used as a secondary good. In the scenario that person A borrows 1 coconut from person B with the understanding of some arbitrary amount of interest, person A has made the conscious decision that having that coconut sooner is worth whatever sacrifices that person would have to make to pay back the debt (along with whatever interest has accrued). In an economy, different players make different decisions about the "value" of interest. Therefore, at a given interest rate, there are likely to be lenders and borrowers. The borrowers would have to perform other services (or arbitrage) to continue with the deal.

Your example implies that there is no other way to get a coconut other than to borrow it. Other islanders might be willing to pay coconuts for all sorts of services. Chances are, they will pay well for services that they have a hard time doing on their own, and pay best for the jobs they can't do, or the jobs that would-be workers do well.

It all fits in, there are no imaginary coconuts.
posted by milqman at 11:26 AM on December 11, 2008 [1 favorite]

NPR's Planet Money did a weeklong series recently on "What is money?" that, among other things, attempts to answer your question. This segment will be particularly interesting to you.
posted by mkultra at 11:38 AM on December 11, 2008

What everyone said. As long as there's no fractional reserve into play, it's not creating any "imaginary coconut". If there's really one coconut, and the guy has no chance to get another (that is, the guy made a stupid loan, and the bank was stupid for lending a coconut for someone who can't pay), the fact that the guy owes 2 only means that he's upside down, will go bankrupt, and the bank will eventually get stiffed (the bank effectively loses any claim after the guy goes bankrupt, it'll get whatever the guy has at the time (probably even less than 1 coconut, if the borrower spent some), but there's no "becoming slave" part)

Assuming no FR, if there are coconuts enough, unless everyone is making very stupid loans, it is assumed that everyone that is taking a loan can make more money than the interest. So, if everyone is making rational loans, the banker is actually getting less profit than he'd be making in the trades of the borrowers. In practice, there'll be enough stupid loans to make the banker earn about the same as everyone else (but not much more, otherwise more people would lend money and drive the interest down). This can work whether you have positive interest and grow the money pool with economy growth, or whether the money pool is fixed, the money unit value increases with economic growth (deflation), and then interest rates could even be negative.

With fractional reserve it gets more complicated. If you deposit ten coconuts (so you still have 10 coconuts "at the bank"), and I go ahead and lend 9 of those coconuts for interest, the guy who got those coconuts buys a house, the guy who sold the house deposits the 9 coconuts, I go ahead and lend 8 of them, and so forth, I eventually have 60 coconut-certificates out (each guy that deposited the coconuts has certificates redeemable at any time), 10 real coconuts at my safe, and am owed 60 coconuts plus interest, but these are only coming back in about a year. Assuming everyone trusts the bank, the 60 coconut-certificates are as good as money, and then, yes, you have 60 imaginary coconuts circulating for 10 real ones at the bank.

You can see what'll happen if the borrowers start defaulting, or if everyone comes asking for their deposited coconuts before the lending term. this time it's not only the bank that gets stiffed, it's everyone holding a coconut-certificate. However, theoretically, if everyone pays their loans on time and there's no bank run, everyone will eventually get their money.

Some defend that with enough safeguards (FED, FDIC, the occasional bailout) this system can be maintained, while others (in both ends of the spectrum, both Austrians [arguably the most extreme free market capitalists] and Marxists) argue that this is a house of cards doomed to fall. There's a youtube video series called Money as Debt (5 x 10min videos) that explains this point of view. It starts out very instructive, but by the third video it starts to degenerate into "OMG Trilateral Commison! Wake up sheeple!" drivel, so caveat emptor. The wikipedia entry for Fractional Reserve Banking also explains the FR mechanism, and it's more serious, but also more complex.
posted by qvantamon at 12:11 PM on December 11, 2008 [2 favorites]

Your question demonstrates the necessity of fiat currency and the complete ridiculousness of gold-backed or similarly fixed currencies. The government, or whoever it is that sets interest rates, may not have the best idea about how much money the economy "needs," but that's a far better way of doing things than fixing the amount of currency at some arbitrary amount.

There are no "imaginary coconuts," or, more accurately, there are only "imaginary coconuts," because money doesn't stand for anything in particular. This creeps some people out--hence the frequent calls that we return to a gold standard, where a dollar stands for a fixed quantity of something--but it's true. Money is simply a medium of exchange. It isn't stuff, but it's a way of facilitating trading my stuff or labor for your stuff or labor.

Your example fits pretty well with what's happening right now: there isn't enough money to cover the total transactions in the economy. This is why central banks worldwide are slashing interest rates: low interest rates accelerate the rate at which money is created (if you don't understand that, you need to take macro). Part of the recent crisis is related to the fact that asset prices were very high and people acted as if they actually had cash equivalent to those prices, but when those asset prices fell and obligations came due, they didn't have enough money to pay them. More liquidity would solve the problem, because if the banks felt they had sufficient currency to carry on business, they would begin lending again.

At least in theory. There's a real sense in which what's occurring right now is unprecedented, so no one's entirely sure what's going on or how to fix it.
posted by valkyryn at 12:17 PM on December 11, 2008

Well, first of all, remember that coconuts grow on trees, so how can you have a fixed number?

Secondly, when you loan money to someone, there is a chance they won't pay you back, if too many loans are made, then it's true that a lot of loans won't get repaid, and people will lose money they thought they had. That's an asset bubble, and that's what's happening now. That sort of thing happens from time to time, so it's obviously a "flaw."

If you wanted to get rid of interest based loans, you'd have to get rid of banks and replace them with something like a cash storage collective, where everyone chips in to buy a vault, pay for security guards, and ATM machines. It couldn't make loans.

All investment would have to be done with equity shares in companies. To buy a house, an individual would issue stock in a holding company that would own the house, and he would gradually buy those shares back.

I don't think it would be that different, rather then credit crunches, people would see stock value plummeting, and become skittish about investing again. so the same problem would come up.

This is all speculation on my part, of course.
posted by delmoi at 12:29 PM on December 11, 2008

Fundamentally: having something today is worth more than having it tomorrow. Interest reflects this. Any number of financial systems we have may be broken, but interest based money systems are certainly not fundamentally broken.
posted by pompomtom at 12:43 PM on December 11, 2008

If you're interested in problems with, and alternatives to, an interest system, you might enjoy reading this.

The analogy with coconuts doesn't work on the surface, because you can always grow more coconuts, right? But what this does require is that you always grow more and more coconuts, because you're always introducing more putative coconuts into the system. The interest system requires both near-constant inflation and near-constant economic growth, or it starts falling in on itself - cf the current situation.
posted by Acheman at 2:16 PM on December 11, 2008

And since near-constant economic growth requires near-constant growth in population or human activity or both, and since growth in population is unsustainable on a planet of fixed size, and growth in the total activity of a constant or shrinking population will eventually require everybody to be awake and working for 25 hours out of 24: yes, near-constant economic growth is fundamentally broken.
posted by flabdablet at 3:53 PM on December 11, 2008

The real (i.e., inflation-adjusted) interest rate should be thought of as a price for resources (it has no necessary connection to "money") -- the future benefit you have to receive before you're willing to give up present resources. The interest rate can be positive, negative, or zero, all depending on how people see the tradeoff between resources today and in the future. In human experience, it is generally positive because people prefer present resources to future resources, and so only the future projects that have positive returns (i.e., increase wealth) are able to get funded; they do this by offering positive interest rates.

A corollary is that as long as intertemporal trade is allowed (e.g. contracts), interest rates are unavoidable. Even if you abolished money, bartering present as against future goods would reflect an interest rate. It's just a mathematical feature of social intertemporal tradeoffs. The interest rate is enshrined in our current social institutions, but it isn't itself a social institution, it's just an aggregate fact about how people are willing to put their wealth to use.

(If you're wondering what this has to do with poor people getting loans and the "interest system," the answer is: banks and other financial institutions exist as matchmakers between holders of present wealth and people who want it and are willing to trade future wealth. When you put your money in a savings account that accrues interest, your playing the role of a holder of present wealth making your funds available for future projects. When you borrow money, the roles are reversed, although sometimes the word "project" will be a poor fit.)

Your coconut example amounts to a kind of skepticism about whether any projects that use present wealth can result in more future wealth. This is actually reminiscent of another recent AskMe. The short answer, which is given by some other posters here, is that such projects exist, since economics is not a zero-sum game. I took a stab at this in the earlier thread, though I did not discuss the timing part of the problem.
posted by grobstein at 4:07 PM on December 11, 2008 [1 favorite]

Incidentally, you may notice none of this assumes positive economic growth. Positive economic growth is not even a necessary condition for positive real interest rates. Here's a short post (not me) about the conditions that might obtain that could lead to negative real interest rates.
posted by grobstein at 4:09 PM on December 11, 2008

Am I not being polemical and assertive enough? Most people in this thread appear to not understand what interest rates are. This is on par with the medieval thinking that condemned "usury" and vilified its practitioners, as though money-lending was a free way of extracting wealth from the hard-working gentile population. The fact is, lending money (the right to social resources) has a cost, mostly the result of aggregate preference for present as against future resources, and moneylenders can only make up that cost by charging interest.

And -- again -- this has nothing to do with money specifically. Lending out seeds in return for a share of the harvest has a cost too, and the seedlender would have to charge interest for the intervening time.

delmoi's answer is an attempt to imagine what it would be like if it was illegal to lend money for interest. The thing to notice is that there are no fundamental differences between that scenario and the real world. Financing would be much less efficient, but (as he points out) there would still be a market in using present wealth to fund projects to generate future wealth, and there would still be prices in that market. Stock prices would (and in fact do) incorporate what we really ought to call an "interest rate," i.e. a factor that measures how much you have to increase someone's future wealth to get them to give you their present wealth. So even in the absence of what everyone is calling the "interest system" there would still be an interest rate.
posted by grobstein at 4:22 PM on December 11, 2008

Another way to look at it is that interest is what you pay to rent money.

Suppose you have a lawnmower. (supply) Your neighbor wants to borrow it. (demand) That's fine, except that you need the lawnmower to cut your grass tomorrow. So, you and your neighbor need to come up with a transaction that satisfies both of your needs. Your neighbor offers to cut your grass for you this week in return for letting him borrow the lawnmower, and you agree to that. He is renting your lawnmower and "paying" for it with his labor. And you gained an hour or two of free time.

That's interest. It's a way to trade resources. The only difference is that with money, the product and the payment are the same thing. The rate or price is determined by supply and demand. If there were 100 neighbors and 100 lawnmower owners, they'd all go down to the town square and haggle for the deal that best fits their needs.
posted by gjc at 8:16 PM on December 11, 2008

"And since near-constant economic growth requires near-constant growth in population or human activity or both, and since growth in population is unsustainable on a planet of fixed size, and growth in the total activity of a constant or shrinking population will eventually require everybody to be awake and working for 25 hours out of 24: yes, near-constant economic growth is fundamentally broken."

No, Malthus, that's not true. Near-constant economic growth requires (tautologically) near-constant increases in the amount of value added to the system. That does not necessitate population growth, as a constant population can increase their productivity through the use of tools. There may be a fundamental limit, but I'm not aware of anyone who's shown it yet.
posted by klangklangston at 8:44 PM on December 11, 2008

You haven't dealt with the second branch of the argument, which is that in order for what must eventually become a static population to continue indefinitely adding value to an economy, it must continually increase the amount of production that gets done. You have also merely assumed that such an increase can always be achieved by means of tools, rather than necessarily requiring an increase in the amount of labour, which seems far more likely to me.

Look, the whole idea is a fairy tale anyway. Economic growth is generally held to be some kind of universal good - just look at the degree of panic that its present temporary hiccup is causing! - and yet the primary measure of economic activity, Gross Domestic Product, makes no distinction at all between activity that benefits people and activity that harms us. Car crashes, heart attacks and dumping mercury in the Florida woods increase GDP, because they cause more economic activity than they prevent. What we ought to be aiming at is not universal economic growth, but universally sufficient well-being.

This is supposed to the Age of Technology. More and more of the grunt work is being done by machines, so why is time-poverty still almost universal? I was assured that this would be an Age of Leisure, so why am I so tired all the time? And where is my goddam flying car?
posted by flabdablet at 4:26 AM on December 12, 2008

"You haven't dealt with the second branch of the argument, which is that in order for what must eventually become a static population to continue indefinitely adding value to an economy, it must continually increase the amount of production that gets done. You have also merely assumed that such an increase can always be achieved by means of tools, rather than necessarily requiring an increase in the amount of labour, which seems far more likely to me."

Well, first off, it doesn't even have to continually increase the amount of production, but production is a decent stand-in for increasing the value of the economy. But, you're reading the chain incorrectly—what I'm saying is that indefinitely increasing the value of the economy does not necessitate increasing the population or the amount of labor required from individuals, provided an increase in productivity due to tools.

That an increase in labor sounds more likely doesn't mean that you have demonstrated its necessity. You also haven't demonstrated a limit to population growth either (hence the Malthus crack).

"Look, the whole idea is a fairy tale anyway. Economic growth is generally held to be some kind of universal good - just look at the degree of panic that its present temporary hiccup is causing! - and yet the primary measure of economic activity, Gross Domestic Product, makes no distinction at all between activity that benefits people and activity that harms us."

Of course it doesn't. Didn't this come up in a blue FPP already? GDP is a rough measurement of the increase in value of an economy—it is as amoral as money itself. That's like saying that measuring the health of swimming as a sport by noting the amount of swim meets is bad because it doesn't note the number of swimming records being broken. Or that measuring global average temperature is flawed because it doesn't account for unseasonably warm weather in Alaska if it's cool in Tijuana.

This is supposed to the Age of Technology. More and more of the grunt work is being done by machines, so why is time-poverty still almost universal? I was assured that this would be an Age of Leisure, so why am I so tired all the time? And where is my goddam flying car?"

Because money is relative and we don't have slaves?
posted by klangklangston at 9:42 AM on December 12, 2008

The problem with the original poster's thesis is that I, like everyone else writing on here, will use an imaginary coconut just as soon as a real one, and for the same purpose. That is why we have accountants and fractional reserve banking, two concepts without which the analysis of money systems is impossible.
posted by ikkyu2 at 11:28 AM on December 12, 2008

Thanks for the answers everybody. Once I find time to digest all of these I'll probably come back with more economics questions of similar ilk.
posted by symbollocks at 12:52 PM on December 12, 2008

indefinitely increasing the value of the economy does not necessitate increasing the population or the amount of labor required from individuals, provided an increase in productivity due to tools.

That an increase in labor sounds more likely doesn't mean that you have demonstrated its necessity.

What I'm arguing against is the highly prevalent idea that economic growth is a good thing, a necessary thing, and something we ought to be pursuing for its own sake. I'm suggesting that at some point, people are going to look at what's being done in support of endless economic growth and realize it's not worth it.

Let me give you a vastly oversimplified illustration that makes the point. You and I are the main economic actors on an island. Every day, I pay you to dig a hole, and you pay me to fill it in again. I'm not looking for anything in particular in the holes; it's just that I like holes (for me, a hole is an economic good) and you like flat ground (for you, flat ground is an economic good). So by trading what you value for what I value, we both win! It's an economy.

Now, both of us believe that Economic Growth is a good and necessary thing, so we're going to find ways to promote it. There are two ways to increase our island's GDP. Either we can pay each other more for dealing with the same volume of dirt (inflation) or we can increase the amount of dirt we move (increased productivity). Inflation is of course a Bad Thing, and increased productivity is a Good Thing; so clearly we're going to choose to process more dirt.

We can do this either by working harder or longer, or by inventing more effective dirt-moving tools. For example, instead of spending hours scrabbling away at the earth with our hands, we could invest in spades and do the job in a quarter of the time. We might even each aspire to owning a 20 ton excavator. Just imagine how fast we could move dirt with that!

The trouble with having more effective tools is that they pretty much compel us to use them. This is the Technological Imperative: Can = Must. Instead of a five-foot hole based economy, we're pretty much guaranteed to end up with a five-thousand-foot hole based economy, because we can.

Neither of us is actually any better off as a result of this massive productivity increase; our lives are simply more complicated. We need to know more things to function effectively in our updated economy. It used to be that we could get by with a simple knowledge of hand care; now we need to know about hydraulics and diesel engine maintenance as well. Also, the five thousand foot holes we're digging all over our island are progressively destroying the aquifer we rely on for our drinking water. But it's all good, because we have ongoing economic growth, right?

It seems to me that the global arms industry is an almost exact parallel to this idiotic business model. We pay trillions of dollars for highly skilled artisans to use incredibly sophisticated tools and increasingly intricate engineering to assemble wonderfully complicated and expensive machinery which we then blow up. But the military industrial complex is a Good Thing, because it Creates Jobs! Yeah, right.

You also haven't demonstrated a limit to population growth either (hence the Malthus crack).

Lazy sarcastic references to Malthus implicitly assume that the argument that Malthus is best known for is somehow discredited or invalid.

We're living in a world where the human population is higher than it's ever been, where there are greater numbers of people living in conditions of abject poverty and/or civil strife than there have ever been, where the ratio of the wealth of the richest to that of the poorest is higher than it's ever been, and where pressure from human population is causing an unprecedented rate of species extinction. I'd say Malthus is looking sounder than his critics at this point.

GDP is a rough measurement of the increase in value of an economy—it is as amoral as money itself.

This is precisely my point! GDP is a purely amoral measure - a measure that does not and cannot have anything meaningful to say about how good people's lives actually are; and yet we organize our collective efforts toward producing an ongoing increase in this measure as if it did mean something real, and we get panicked and frighened when we fail to achieve this. We do this even though there are far more important issues requiring urgent action, such as working out how to kick our collective addiction to fossil fuels and avert runaway climate change.

I can see no fundamental reason at all why a satisfactory life for as many people as possible needs to be predicated on an ever-increasing GDP.

Because money is relative and we don't have slaves?

You're making my point for me again! How is an industrial robot distinguishable from a slave, in economic terms? I don't think it is. And it seems to me that the point of inventing a good tool ought to be to make a crappy job take less time so we have more time to do other things like lazing about on beaches drinking Pina Coladas, and not so that we can produce four times as much crap.

Take a look at the history of rampant consumerism in the US. I think you'll find that it really cranked itself into high gear right after the Second World War, when the sudden drop in necessary arms production threatened to stop economic growth in its tracks for a while. But don't worry about this stuff. I'm clearly just another misguided hippie greenie crackpot, so you don't need to pay any attention to me. Probably better not to, in fact. Carry on. Have a nice day.
posted by flabdablet at 6:34 PM on December 12, 2008 [1 favorite]