Credit, Debt and Interest

 Today, some might argue for a return to the gold standard of the past and in so doing, abolish the idea of fiat currencies, such that money with intrinsic value might be restored. However, while the collapse of the global economy might one day inflict this situation on us, this ‘solution’ to our current economic woes appears to add nothing to the analysis of cause and effect. For while credit leading to excessive debt is indeed a problem, credit leading to increased growth is not, although the definition of growth possibly needs to be contextualized beyond the myopia of financial gain. Likewise, there is nothing wrong with paper fiat currencies in preference to carrying large and heavy sums of gold coinage, as long as this fiat currency is not over inflated for the wrong reasons, e.g. financial greed. As such, credit and debt, in and of themselves,  are not an explicit problem, if interest is held in check, although history has long held the belief that the charging of interest on a loan amounts to usury . We might use the words of Thomas Aquinas, a 13th century  philosopher and theologian, taken from two extracts from his work entitled the Summa Theologica to outline the historic objections:

To accept usury for the loan of money is in itself unjust; because this is selling what does not exist, and must obviously give rise to inequality, which is contrary to justice. For the better understanding of this point it should be noted that there are some things whose use lies in their consumption: as, for example, wine is consumed when it is used as drink, and wheat is consumed when it is used for food. In such cases the use of the thing and the thing itself cannot be separately taken into account, so that whenever the use of the thing is granted to someone the thing itself is given at the same time. For this reason ownership is transferred by a loan in such cases. If a man were to sell separately both the wine and the use of the wine he would be selling the same thing twice over; that is he would be selling what does not exist: and he would clearly be sinning against justice. For the same reason he commits an injustice who requires two things in return for the loan of wine or wheat, namely the return of an equal quantity of the thing itself and the price of its use. This is what is called usury.

However, Aquinas is really only paraphrasing, by example, the idea that interest and usury are the same thing, which has its roots in religious scriptures going back thousands of years. While the modern financial world might obviously want to refute Aquinas’ arguments, the previous review of the financial dynamics underpinning today’s globalised economy might suggest that debt dynamics only leads to instability, when credit comes to dominate economic growth or, at least, the allusion of it. For economic growth that simply leads to an ever widening inequality of wealth in which only a small percentage of the population prospers is not necessarily sustainable growth, even if we ignore finite planetary resource issues . Therefore, we shall pursue Aquinas’ argument to the next stage:

There are other things whose use does not lie in the consumption of the thing itself; as for instance the use of a house, which lies in the living in it and not in its destruction or consumption. In such cases both the use and the thing itself can be separately granted; as when, for instance, someone passes the ownership of a house to another, but reserves to himself the right to live there for a certain time; or on the other hand when someone grants the use of a house to another, reserving to himself its ownership. For this reason it is permissible for a man to accept a price, i.e. rent, for the use of a house, and in addition to sell the freehold of the house itself, as is clear in the sale and leasing of houses. Now money, according to the philosopher Aristotle is devised mainly to facilitate exchange; and therefore the proper and principal use of money lies in its consumption or expenditure in the business of exchange. For this reason, therefore, it is wrong to accept a price, or money, i.e. interest, for the use of a sum of money which is lent.

While this position has a consistent logic, the idea of usury as a crime has passed into history based primarily on the initial argument that interest is not profit, but rather the avoidance of loss, although we might now question the scale of this ‘loss avoidance’. So, over time, the financial sector has come to occupy a similar position as landlords did in history, where debt interest has replaced land rent. However, unlike rent income that was assumed to be returned to the wider economy via the spending of wealthy landlords in the local economy, the financial sector tends to used their ‘loss avoidance’ to finance new loans, i.e. to proliferate further debt and interest payments on a global scale. This has ultimately led to a huge escalation of the overall debt burden within the economy without necessarily increasing the productivity of output or income for the wider majority. However, it is important to recognise that this system of gain is driven by compound interest and represents a form of exponential inflation of the currency in circulation.

[1]    

In [1], compound interest leads to the exponential sum [A] over the original sum [P], which in financial terms is called the principal, which grows as a function of the interest rate [r] and the exponential of time [t]. Depending on the units of [t], e.g. days, months or years, the compound growth may be calculated at [n] different times, so if t=14 years and [n=1], the exponential sum [A] is calculated once every year for 14 years. By way of an example, used in previous discussions, if debt interest was set at 5%, it would cause a doubling of currency in circulation every 14 years and fuel price inflation.

[2]    

We might contrast the exponential effect of compound interest against the growth of simple interest, where the interest rate [r] added each year is simply multiplied by time [t] and then added to the principal to calculate the accumulated sum [A]:

[3]    

While the format of [3] does not look so different at first glance to the second form in [1] and appears to result in a value of [A] in the same ballpark, i.e. $1 becomes $1.98 versus $1 becoming $1.7, the implication of the exponential [t] on the result can be very dramatic over time. This effect was highlighted by a contemporary of Adam Smith in 1772, when writing:

Money bearing compound interest increases at first slowly. But, the rate of increase being continually accelerated, it becomes in some time so rapid, as to mock all the powers of the imagination. One penny, put out at our saviour’s birth at 5% compound interest would, before this time, have increased to a greater sum than would be obtained in a 150 millions of Earth, all solid gold. But if put out to simple interest, it would, in the same time, have amounted to more than 7 shillings 4½d.

However, we might update the numbers in the previous historic example as follows, [P=$0.01], interest rate [r=0.05] and time [t=2000]. In the case of compound interest governed by [1], the value of [P=$0.01] grows to $2.39*1040, which is almost too big to comprehend, while the simple interest based on [3] results in [P=$0.01] growing to just $1.01. Today, 1 metric tonne of gold is worth about $40 million, where the compound interest total would equate to about 600,000 billion billion billion tonnes of gold. Therefore, we might now begin to realise the full implication of the charging of compound interest on almost all debts, although some were very quick to realise the benefits that might be accrued.

J. P. Morgan and John D. Rockefeller are said to have called the principle of compound interest the eighth wonder of the world. For them it meant concentrating financial fortunes in the hands of an emerging oligarchy indebting the economy to itself at an exponential rate.

In practice, it is almost impossible for most people not to incur private debt on which compound interest is charged, even if they ignore the temptation of credit cards and the need for a student loan, for most people need a home in which to live and raise their families. However, for most, this aspiration will invariably require a mortgage with some level of compound interest charged. So, as has already been suggested, the siphoning off of compound interest diverts revenue away from the currency in circulation within the productive economy in the form of unearned income into the financial sector that not only avoids loss, but greatly profits from the charging of compound interest. However, as a consequence, this financial profit has become an overhead on the wider economy by putting a downward pressure on the productive economy by increasing the breakeven cost of living for individuals and small businesses, which has ultimately led to the  increase in wealth inequality.