The problem isn't interest, it is fractional reserve banking.

Lets say we have the rich guy (A) and the poor guy (B). Now the poor guy lives in an unsafe neighbourhood, so he gives his money to the rich guy (A) to put in his safe. Meanwhile another poor guys (C) needs a loan, so he goes the rich guy (A) and borrows some money. Fractional reserve banking allows the rich guy(A) to lend out the poor guy's (B) money to C, instead of using his own money.

Now normally this works really well for A, because on the off chance that C cant pay up, A can just go and take all of C's stuff and sells it at a ridiculous profit, leaving C with no assets and a huge debt, plus fees and interest. And all the while A is still collecting a fee from B for holding his cash.

The problem is that fractional reserve banking works TOO well. See its actually better for A if C cant pay it back, because he gets all the assets, fees and interest as well as the money he lent out, which wasn't even his.

The crisis we face today came about because A lent out huge ammounts of money to lots of people he knew couldn't pay it back (C), specifically because he wanted to get their assets. BUT the money he lent out wasn't his, so when B came to get their money back off him, it was all lent out.. and when A tried to collect the assets, they weren't worth anything because he had recollected so many that demand had dried up and there were no more C's left to lend to.

We were allways going to reach this point with fractional reserve banking, and this isn't the first time it has happened. Time and time again around the world, something happens, everyone goes to collect their money and finds it isn't there.

What is most ridiculous is this proposed solution.

see in America, A not only lends to the poor suckers, he also lends to all the businesses in town and even the government(D).In fact A has the whole deal so stiched up that he even prints the money and the government has to borrow all its spending money from him.

So the bailout is D borrowing money from A with interest, to give it strait back to A.. without interest.

This of course will imediately result in inflation.

No one in this country is forced to take out any loans. If a person feels a loan offered to him is not a good deal, he should not accept the loan. It's as simple as that.

It is always an option to save up money and purchase the object with cash. The other option is buying it now buy paying a greater price. Effectively, this approach "buys" the cash used to purchase, and the cost of buying the cash is the interest.

If your argument were correct, and loans did not add value to society, people would not take loans. The fact that so many people take out loans disproves your hypothesis -- actually, loans add value.

Last but not least, banks are companies just like any other. If a person feels that today's banks are offering too high of interest rates, that person should be encouraged to start his own bank and offer lower ones. If he is correct, he will take business from the competing banks by undercutting their price.

Our economy is a market. Goods and services are priced according to their value. If you, an individual believe the price is higher than the value, don't purchase the good or service. You should think of loans the same way. When offered a loan, decide if the benefit (having cash now when you otherwise shouldn't) is worth the cost (the interest).

You might decide that having a car now is worth it because it saves you 2 hours per day on your commute compared to the bus. You might decide that this increase in time is worth the price of the car -- and that having this car now rather than in 5 years is worth the price of the interest. If you decide that, it makes perfect sense to take out a loan.

Lending money does create value in society directly and indirectly. It creates value directly the same way that any service does -- a person pays a price to use the service -- and the service is getting cash immediately that one could not otherwise get. What you are trading is expected future income for current liquidity. This has value and risk: risk because future income is not definite, and value because there is an opportunity cost to that money.

Rather than provide you solely with academic and abstract examples, let me provide you with a very concrete one:

Imagine a farmer who earns $100,000 per year tilling his fields by hand. He might know that he could produce $500,000 per year, if only he had an expensive piece of farm machinery. That machine costs $1,000,000, so he might have to save for the next many years in order to purchase it with cash.

In the world you propose, this farmer has no option but to save for years -- even though he could be earning 5x as much right now! Indeed, the economy is best off if a bank can give this farmer a loan for $1,000,000 to buy the farm machinery now. Having the farm machinery, the farmer now earns $500,00 per year; he pays off the loan easily and society is better off because he can produce more food.

This is the underlying concept of loans. In this example, without a loan, the farmer can only produce $100,000 of value. With the loan, he can create $500,000 of value per year. By introducing loans into the economy, this farmer and every other business can immediately produce more value using machines it could not have bought. The whole society is wealthier because this farmer is producing $400,000 more of food. The farmer is better off because his income has gone up 5x.

This is how it works with loans all throughout society. It's harder to see that with housing because the benefits are closer to intangible. Nevertheless, having a house is very important to people, and it would be difficult for them to be productive and happy without them.

Up in your essay you whine that you have to pay rent to a landlord, and "the system" is broken. The system is not broken at all -- it's working just as it should. No one is forcing you to lease an apartment. You could live on the street. But you've decided that the benefit of living in an apartment is worth the price of the lease -- that was your decision to make, and you made it. It's unreasonable for you now to complain that it's somehow unfair.

You certainly are not owed housing buy society; it's your job to provide yourself that from your income. If all landlords went away and stopped offering leases, would you be better off? Would you have purchased your own house and be living in it?

If all banks went away and stopped offering mortgages, would the people you know have saved up cash to buy their homes instead? Would they really be better off?

The alternative to loans is saving up cash to buy products outright. Ask yourself if you would really be better off in a world with no loans. How would you have a car, a house, or business capital equipment? Are you going to save up your money to buy these things in cash?

Wow, good article. Have you heard of Islamic Banking?? http://en.wikipedia.org/wiki/Islamic_banking I believe there is a bank in Sweden or The Netherlands that works in a similar fashion but I can't find it now...

Well, it's nice to have the philosophy subreddit to submit this to - which is full of folks who are interested in outside-the-box thinking about economics. I have the most visitors I've ever had today, coming in from reddit to read this essay of mine.

I hope to hear more about the Islamic banking thing, and the swedish and netherlands' systems.

Cheers.

And as for you first two commenters, I'll get back to you at some point soon. I'm kind of tuckered after a long discussion about this essay of mine over at the reddit thread today.

interest makes sense in a couple of ways.

1 - if you have $100 and choose to loan it out, you no longer have access to that money for your own purposes. you might miss an opportunity to put that $100 to some good or desirous use for yourself.

2 - because there's a risk that you might not get your money back in a timely manner, or at all. the borrower might go bankrupt, or run off to another country, or die, in which case your $100 is gone. interest payments help defray this risk, and indeed that is why interest charged (or earned) is indexed to perceived risk.

"Now as I begin this discussion, let me start by saying that one important idea of mine is that strictly speaking, money is not wealth. Goods and services are wealth. Money is only a way to obtain wealth. The social contract we all adhere to as a society is that people produce goods and services, and in return receive the medium of exchange - cash. The cash allows people to obtain wealth elsewhere."

Hmm, I don't understand how the write wants to distinguish the value between money and other objects. The writer says that since the value of money is a social construction, its value isn't as real as objects like houses and cars that serve some purpose. This is a fallacious reasoning. No value is intrinsic. Even houses and cars are valuable only because we think they are valuable. In this sense, the value of houses and cars are as socially constructed as money. So his whole argument falls apart.

If he wants to save himself here, he would have to assert that making any profit from transaction is wrong because it is charging more than what it is actually worth. But then again, even this isn't going to work.

The value of an object is subject to change depending on our needs. Person A might need an object X more than Person B. Then X is worth more to A than B. So if X is sold to A rather than B, is the seller making a profit?

Good luck sorting these things out, mistyriver. By the way, Marx couldn't do it.

Ok.. we can continue our conversation over here.

In that quote, I was meaning to say that money is pieces of paper or numbers on a computer. It's an abstract thing. Wealth, on the other hand, I insist is concrete things like goods and services - a trip to tahiti, or a vacation in bali, or a new car, or a computer.

Now, I hope that you also understand that my main thrust as I write is to muse; it's how I seek to puzzle things out. Any assertions I may have made can be freely questioned by anyone else - and are certainly being questioned by me, as well. My point in having a conversation as I have had over the last couple of days, is that it helps me to develop my ideas, and to correct them wherever they have gone off track.

Indeed, I think I've reached a set of conclusions which I'm happy with over the course of the discussion the last couple of days at reddit. A short answer to you, and to the folks who wrote the headlines "interest=rent of money" and "No one is forced to take loans" (Should I include a nickname field for commenters? It might be easier that way to talk with folks) would be that I believe that the debtor is actually providing a service, rather than purchasing a service.

My brother was a mortgage broker for a little while, and so I've had some exposure to the ins and outs of the business. Yes, the relationship with the client who is desiring a loan is important. But even more important is to find the bank who is willing buy the right to collect on that homeowner's loan.

If we turn things around, and think of it in this way, then the same rules which tend to correct the rest of the market also can work here. The bank which buys that right to collect the monthly mortgage payment is responsible for deciding on the quality of the service which the mortgage broker (and the home owner) is providing. Banks chose not to do that, because of this odd idea that with more risk comes more reward. What does that translate to in plain english? Well, it means that the banker rubs her or his hands with glee and anticipates a predatory hike in interest rates because of an adjustable rate loan.

who wrote the post with the title "No one is forced to take loans:"

First of all, let me thank you for the time you spent in composing that comment. It's a wonderfully detailed and clear explanation of something which you have obviously studied in detail. As I noted above, I have to insist that I believe that the debtor is providing a service, rather than asking for one. The whole situation becomes a lot clearer if you turn it around like that. The bank is paying a one-time upfront fee in return for thirty years of monthly payments from the debtor. And now that I'm looking at things this way, one thing that jumps out at me right away is that nowhere else in the business world does a customer have the right to alter the terms of an agreement halfway through. The seller or service provider always is given the right to set the terms of the contract. So adjustable rate loans would be at least unusual, and might even be found to be unlawful, if one found a judge who understood all of these concepts.

You say:

In the world you propose, this farmer has no option but to save for years — even though he could be earning 5x as much right now!

Hmmm... I think that easy credit might lead to inflation of the prices of equipment which the farmer is trying to buy. We certainly saw this with housing over the past decade and two, didn't we?

And in conclusion you say:

If all banks went away and stopped offering mortgages, would the people you know have saved up cash to buy their homes instead? Would they really be better off?

I say they would be better off... because the price of homes would fall drastically, and builders would find ways of making homes more inexpensively. And all in all, I have many ideas of how this would be a really good thing for a community, even though it might be painful in the short term for people who actually end up paying for the construction costs of the home they bought, without being able to pass that on to the next buyer.

The biggest conclusion I reached over the last couple of days - which I wrote extensively about in a conversation with folks over at reddit under my nickname "mistyriver" - was embodied with an anachronism "You can't squeeze blood out of a turnip." The reason the investment markets just crashed so spectacularly in 2008, is because the investors were focusing so heavily on home loans... and they were hoping to make a bigger profit than is reasonable to expect when you are being paid with the life's blood - the monthly salary - of a person working a forty hour a week job.

I introduced my essay here with a story about two friends - one who is rich and one who is poor. Is it fair if the rich one helps the poor one buy a house for the first time, in return for the favor of making the rich person richer than he was before?

Another version of the story could go as follows: There are two friends, a rich one and a poor one. The poor man has invented something really astounding, and wants his rich friend to help him set up a factory so he can start a business. Well, in that case, the poor gentleman might easily become as well-monied someday as his aquaintance... and certainly in that case it would be ethical for the money lender to ask for usury on the loan (or even a share in the profits).

As Bill Clinton suggested in this interview, I think that it would have been a lot more profitable for investors to have put their money into green technologies - electric cars, solar thermal power plants, liquid hydrogen powered planes, and into research and development of all kinds of assorted alternative energy technologies. These will be real industries, with real ongoing profits... and in fact, I believe that they will be the next blue chip stocks. In every decade, it is businesses using cutting edge technologies and who have the good business plans, which are the best investments. General Motors was a great stock to own in the latter part of the 1900s. Google's stock does well in this first decade. Why? Well, in a roundabout way, because those companies were and are making real money. If investors had actually turned their interest towards helping the usa produce new and important technologies, that would certainly had helped to even out the trade deficit too.

talking about fractional reserve banking:

Those are some excellent points. And that's a very refreshing perspective. I have heard folks grumble about how the government might simply want to cause inflation to bring down the value of it's debt obligations. I'll have to muse on that one a bit more. My question for you is if you have an alternate proposal. What would an ideal money circulation pattern look like, if you could design it? You seem like you've thought this thing through in detail.

You asked me what I would change.

Talking about the circulation of money is deceptive at best. First we must speak of physics and philosophy.

Consider this:

We humans are only capable of acting on 4 dimensions. Three of which are matter and one of which is time.

Matter is merely energy spinning slowly. So all matter is energy.

That leaves humans with only two types of power in this world, energy and time.

All human endevours are one of these two, and usually both.

Money has no intrinsic value of its own, it is merely a way of expressing power.

And now consider this:

Money = Time multiplied by energy.

So What we are really talking about here is the circulation of energy and time.

If I become rich, I am merely increasing my ability to control other peoples time and energy. There by increasing my total reserves of both.

So now we have established the scope of what we are talking about, we can start to consider what is wrong with the current system, and how it could be improved.

Everyone gets all worked up over the worlds problems, I am as guilty as anyone of this, and it can seem like there are so many problems, it can be hard to know where to start.

Really there are four. Four things which if changed would solve most of the worlds current ills.

1. The Abolition of Fractional Reserve Banking

   I believe I have explained this point, and as long as banks can still collect interest and fees then there will still be banks, they just wont have an unfair advantage over everyone else.

2. The Abolition of the Federal reserve.

   Money exists only to facilitate trade. There should be a limited ammount in cirulation at any one time, too little and it becomes hard to trade, too much and it becomes worthless. The flow of currency should be controlled by the total populace. This means the government, and if we ever move to one global currency, then it would mean we would need to create a global government. The printing and distribution of money is the prime responsibility of government, as the control of this mechanism is the prime driver behind any economy.

3. The Abolition of the wealth bell curve.

   Let us imagine a man, sitting atop a bell curve of wealth. If he takes a few steps backwards he begins a slippery slope into poverty, and for every step he takes toward poverty, the easier the next step becomes. What I mean is that once you are allready poor, then even the slightest financial imposition can dramatically impact upon your circumstances, and this effect is only magnified the poorer you get.

   Conversely, if he takes a step forward toward wealth, things become easier and it becomes progressively easier to obtain more wealth. What i mean is that a man with $10,000 will find it far easier to make $100 than a man with $1. And the greater your wealth, the easier it is to make a hundred dollars.

   However, the average human doesn't sit atop the bell curve as the the name would suggest. They sit halfway down the poor side. And for the average man to make it past the top of the hill takes a huge ammount of perserverance, skill or luck, but once he is beyond the halfway point things become so easy that even if he were lobotomised he would still be capable of generating a sizeable income (if through nothign else than the interest on his assets)

   I put it to you that this curve is an abhoration, that for capitalism to work, it requires each step in the ladder to take more effort than the previous step. rather than the highest steps requiring no effort what so ever.

   Can you imagine a game (lets say WoW), where it is excedingly difficult to reach level 40, where it is easier to go backwards in levels than forwards. And then all fo a sudden, once you have reached level fourty, the game becomes a cakewalk.. with each subsequent level becoming easier and easier, at some point you dont even have to play.. the game just plays itself.. until finally the last level is granted to you so easily that you don't even notice because you ceased playing the game long ago and went off to a spa..

   It wouldn't work. And in the same way our present economic system doesn't work.

4. The education and empowerment of the general populace.

   Democracy (and so for our puposes capitalism) can not succeed without a well educated and well informed populace capable of making rational decissions and able to have those acted upon. There is a general trend globally toward nanny states. But the success of any economy is dependant upon the ability of the people within it to make good decissions. All of the people. Currently there are a few people who are well educated, and they essentially run things by ripping off the poorly educated and calling it a successfull economy. It is not.

   Why are such social issues so important to an economy? As an example: Many people spend large ammounts of time arguing over the relative merits of regulation and self-regulation, when in reality there is only one kind of regulation that works. That is the regulation of the market where every member of the populace is well informed enough to spot a con, and well empowered enough to do something about it. Another example is the environment, if the populace were well informed enough to assign value to nature, and well empowered enough to invest in and protect that wealth, then environmentalism would become the ultimate form of conservatism, as it should be. The only area which requires strict regulation is education and the media, which must be high quality, uncensored and unbiased, or everything else will fall apart.

   The exact measures taken to achieve these goals would require far more time to outline than i have available, but I would make these suggestions.

   a) the distinction between government and the people is an illusion, we should strive allways toward the most direct form of government possible.

   b) all of these measures can be achieved through legislation and taxation, but will only succeed if the general populace is actively involved in the creation and maintenance thereof.

c) the general populace must be well informed and impowered or any solution is doomed to failure.

When it comes time to rework things, and such a time will come, it seems to me that we must remember not to break everything in order to fix it, because there is really not that many things wrong.

-p0ss

For a mere speculation, you sounded too assertive and conclusive already. I treated as such. But anyhow, let's examine your distinction between money and other objects. I understand the division you want to draw between money and other objects, and it is a commonly drawn distinction. However, as I have said, the distinction is flawed. Any value of something is an abstraction. A trip to Tahiti? It has value because you give it a value. New car and computer? Their value is not intrinsic. For a caveman , cars and computers are no use to their way of life. These goods have no value to him, while they have value to us. Money works the same way. Money is extremely easy to carry around, and keep it stored. Money is an accepted mean to get you goods. Of course, the value of money is an abstraction, but so are others.

I have to agree there is a lot of merit in what you are saying about value being what something is worth to someone else.

However, beyond what you're saying, we have to look at money differently than we do other things. Money has no intrinsic value. It cannot gain or lose value based on things inherent in it. You can't break out your toolkit and repair your dollar bill, and make it worth more. And that dollar bill could conceivably lose value abruptly (hyperinflation) because of outside factors that have nothing to do with the quality of paper the dollar is printed on. Money is an abstraction. And as I said, I have found it much easier to look at the situation of a lender and a borrower in terms of the lender being the customer, and the borrower being the provider of a service. The lender makes a one time purchase of a long term of debt service by the borrower. A service is done over a period of time, and a purchase is a one time transfer of funds, right? All the well known market forces then can be seen to be working as they typically do, if you turn it around and look at that situation the other way.

The real problem with abbreviating the notion of value, and saying that value (like beauty ;-)) is only in the eye of the beholder... is that people who think that way will create problems like that which happened in the mortgage markets lately: they seek to obfuscate the intrinsic value of the package of derivatives, and try to keep trading these things around. They use the very reasoning you used in order to justify their lack of transparency, and their swindling.

The ponzi game of speculation on market value of stocks is another absurd gambling game which is justified by the very idea which you proposed. The fact is, that unless you own enough of the company to have some control over it's direction, all you own is a piece of paper and the hope that you can exchange it for more money than you bought it for. That's pretty much wishful thinking, if you ask me.

Wow...

I am really impressed with your insights. You are exactly the kind of person I had hoped to attract to this blog of mine.

After much thought, and hearing more and more about this problem that we've encountered, I see indeed that the fractional reserve banking system is precisely what has caused this problem. As you pointed out, the banks are experiencing a pinch and they can't pay their obligations, because the money is all lent out. And it is true - it is better for the bank that if the debtor cannot pay back the loan, halfway through the term, because then the bank not only has gotten the debt service moneys, but also the hard asset - the house and the real estate.

I definitely agree with points three and four as well.

Musing about this whole problem this morning, my proposal to fix the problem would be this:

As you have suggested... it would be appropriate to forbid banks from lending out money which their customers have given them. Banks should raise their fees to customers significantly, and get all their income from charging a series of fees for the storage and transfer of funds. This would prevent any future meltdown like we see today where the banks simply don't have the money on hand to pay back to their customers.

If people have a good chunk of money, and they don't want to pay the bank fees, but instead, want to give out loans to debtors, then let them do that through mortgage market funds, and through places like Prosper.com, and most of all through venture capitalism.

The usa has fallen behind the curve quite a ways over the past decade and two when it comes to producing goods and services that people in other nations want to buy. Ironically, at the same time, there seem to be a lot more people out there wanting to find those to do them debt-service, than there are people who actually want to be debtors. Those aristocrats have done all they can to pump up housing prices, because they want to create more debtors when there aren't enough willing debtors to be found.

The high tech industries in silicon valley seem to have been the sensible folks. There, they have built a system around Moore's law where they can keep on selling products which are twice as good every three years or so to consumers who are happy to fork over money for them. They have formed a real economy, while their colleagues over in the mortgage markets were going hog wild with trying to sell and resell securities of dubious value.

Paul Graham is a person I very much admire. He finds college students who wish to form companies. He has a summer program for them in Cambridge, Massachusetts... where he mentors them, and funds their projects. If there's that much demand by people with money to find places to invest it, then there needs to be a lot more of this. Well moneyed people should be combing the internet, and looking for people with exciting ideas, and then offering to fund their projects. That would be a much more labor-intensive way to invest, but it would also yield much higher and much more reliable returns.

I would really like to learn how we could level the "wealth bell-curve" which you talked about, and yes, I definitely agree that there needs to be more transparency in regards to all of these financial markets. In fact, I think that congress ought to institute a law requiring end-to-end transparency between those lending money and those borrowing money. People need to be educated about all these things.

Is p0ss your username over at reddit? If so, I'll send you a note over there. Thanks for your gracious and very insightful words here on my blog.

I actually came across your site by the Amish reference. I live in a community with over 1/3 of our population being Amish. It's amazing how they band together to help in times of need. None have insurance. If one gets sick, the community comes together to pay the bills in cash. It's really quite amazing.

Robb (http://onewisemedia.com/donate-real-estate/)

Thanks for chiming in. I appreciate it.