Good point. If interest is outlawed, only outlaws will charge interest. If banks can’t charge interest, Tony Soprano is going to get into the game. Today there are so many legal loansharks out there that they’ve pretty much put the mom and pop loansharks of yesterday out of business, you can max out your credit cards, take equity out of your home, or get a payday loan. Max out your credit cards and you’re only paying 20% annual interest! How can Tony Soprano compete with that?
Those things don’t go away just because you make them illegal, instead they are taken over by organized crime, but the interest payments are much much higher because of the risk the lender is taking. So your average citizen will still be able to get small loans from illegal lenders, what he won’t be able to do is save money for interest. Wealthy sophisticated people with lots of capital will be able to invest the money in equity, but your average guy with a few thousand dollars will just stuff it under his mattress.
Category 1. Equity in the company. Hard to allocate contribution of various assets to the bottom line? Of course, but we have the exact same problem now. Somehow, you gotta decide whether the thing is worth buying. And, no, raising equity to buy new stuff doesn’t really dilute existing equity. Rather, they retain a smaller share of a bigger pie. Happens all the time in the current system. And, of course, companies wouldn’t always have to raise equity to buy stuff; depends on reserves and retained earnings.
Category 2. Disagree on the factual premise. Don’t think it’s easy for mom-and-pops to get loans. But if there are investors willing to take that risk now, I don’t see why they wouldn’t take the same risk for equity.
Economic theory. I think you’re drawing more conclusion that the data supports. We know buyers and sellers are able to come to strike prices because it happens every day. In any event, I didn’t base my position on economic theory. I base it on the proposition that people accumulate wealth and, as between stuffing it in a mattress or investing in equity, I think most of them would choose the latter.
Loan sharks. Yup, it would happen. This is a thought experiment.
Voyager already commented on this, but I’ll just reiterate because you don’t seem to be getting it (no offense). Mom and Pop stores will eventually be driven out of existence because they will not be able to get start-up funding. A loan has a guaranteed rate of return. It’s agreed upon by the parties before the loan is processed. Equity lending puts more cash at risk, and the return may be nothing, especially if that business is a restaurant. Most restaurants don’t see profit for what, 2 years? The lender is going to sit on nothing (free meals eat at the bottom line, pun intended) for that long? No, because he is losing rent on his money. He’s better off buying something (wholesale and redistribution) and hoping for retained value, than sitting on nothing. Stuffing money into a mattress makes just as much sense.
:smack: Though I did mention rum runners, I never thought about loan sharking. You’re absolutely right. Nothing would pump more money into the mob than a ban on interest.
mazinger_z, disagree does not equal stupid. I understand perfectly. I disagree. I base my opinion, in part, on knowing several people with businesses of the kind we’re describing and a relatively well-informed understanding of the credit underwriting criteria of banks and other institutional lenders.
It’s a thought experiment and a policy I’ve made clear I don’t even support. No need to get heavy-handed and condescending.
When you are buying equipment to replace depreciated equipment, the pie does not get bigger. A new factory, maybe, but not a new fab, say, to replace an old one. Internal investment decisions depend on factors, such as future business plans, that few companies would want to share with investors. People buying corporate bonds just want to be sure that the company will be solvent enough to pay it off. This assurance is provided by the ratings companies. They do not have to calculate the expected return on investment, since that is guaranteed upfront. (Neglecting bond price fluctuation, not an issue if you’re not trading the bonds.)
No company I’ve ever worked for tracks the return on internal investment very closely. When we buy lab equipment at a couple of million bucks a pop, finance does not monitor usage. If I were an external investor I’d want a lot more details. Companies would have to be going back to the equity markets all the time, and there is no way that is not going to dilute equity.
Of course the company could guarantee they’d buy back shares at a certain higher value - whoops, we got interest again.
Here is data on venture capital in 2002 (about $7 billion) and 2001 ($40 billion). Compare to Small Business Loans which were $250 billion in 2002. Yes, venture capital was $100 billion in 2000, at the end of the bubble, but that was unsupportable. So today there is a lot more small business money out there than venture capital money. If the benefits of both types of funding were considered to be equal, there should be equal amounts of money invested. An equity only solution might not generate as much cash, and would probably have the venture capitalists taking a greater share of the business to offset the risk. My other objections still hold.
It’s not me. Try to read some stuff by Richard Thaler, etc. In this situation, though,. people would not stuff their money into mattresses. They might put more money in existing equity markets, driving up the prices, and leading to another bubble. In times of high inflation, when the savings rate is close to zero or even negative, people tend to purchase things as a way of maintaining the value of their assets. I’d buy myself some gold before this happened.
Well, we agree on that at least. I’d change my name to Vito, and make a killing in the markets.
On the run at the moment, so will comment later. One quick question. Does the stuff you’re looking at have a number for private, non-institutional investment? In my experience, that’s who’s doing a lot of the mom-and-pops right now. (Personal savings, family, friends, friends-of-family, family-of-friends, etc.) Sometimes as loans, sometimes as equity. And you need a certain amount of the latter before you can get SBA guaranties. Thanks.
The data from the link is from commercial banks and thrifts. I’ve never started a small business, but my understanding is that you are right - much of the money comes from savings or relatives.
Which leads to another loophole - private interest bearing loans. Part of my mortgage is with my father-in-law, since I’m paying above market interest at the moment, and since we’ll get the money anyway since my wife is an only child. We have a legal agreement, and we both report it to the IRS, but we could easily have done it under the counter, where he might reduce the interest rate to make up for him not paying taxes on the interest.
I’d think that this would tend to lock out low income areas from business startups, unless the government had a zero interest investment plan.
Unfortunately, life intrudes and I’m going to be flat out for a few days. Will return when I can. Meanwhile, I’ll confess that you’ve convinced me small businesses would be more difficult to fund than I thought at first. Not so much because capital would avoid them, though. I can think of several models in which equity investment, even without government guaranties, would be attractive. But I have a hard time convincing myself the entrepreneurs would find them acceptable. Still working on it. The other big problem which has come to mind, and I don’t think anyone has mentioned it, is student loans. Short of indentured servitude, I don’t see how one invests in someone else’s education on an equity basis. Maybe the answer is that (except for the rich) higher education becomes a publicly-funded commodity, as are primary and secondary now. But it certainly would be a issue.
Well, this thread has about run out of steam anyway. Anyhow, I agree about student loans. Loans in general are a way of saving in reverse - expenditure before the savings, rather than after. In some case this is due to our propensity of not wanting to put off getting things, but for student loans it is due to the fact that kids can’t save before their education. The only way around this is to play it forward. My father paid for my education, and I had a minimal loan, and I’m paying for my kids education so they’ll come out with no debts. But not everyone can do that.
I know you didn’t start this thread, so this is not addressed to you, but I’m not sure of the moral argument against interest. It’s like alcohol - too much is bad, but the right amount can be very beneficial.
I’m not enough of an economist to really contribute to this thread, but aren’t people sort of changing the question from “Is a society without interest lending possible” to “Is a society like ours without interest lending possible”?
I mean, there’s not much of an interest-lending system among hunter-gatherer tribes or nomadic herders, is there?
A society with barter only probably doesn’t have much interest lending. But an advanced society?
And we can distinguish between a society without legal interest lending (possible if inefficient) and a society without interest lending at all (probably impossible.) We’ve already found that a society without legal alcohol is possible, but not one without any alcohol.
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A society with barter only probably doesn’t have much interest lending.
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They probably don’t have much lending at all.
To clarify the issue, ask yourself this question: Would society be better off if it were not possible to borrow money?
The answer is that it would suck. I wonder if the prohibition against usury isn’t one of the things holding back development of the Middle East.
Interest is simply a way of accounting for the time-value of money. Without interest, there is no reason for anyone to lend their money to anyone else, because $1 today is worth much more than a promise to have $1 in ten years. The $1 you have today can be invested in production that will produce extra money over that period. So unless you have a way to compensate people for lending you their capital, they simply won’t do it.
Yes, there will still be venture capitalism and equity ownership as ways to invest extra money. But think about what that means. The rich then own EVERYTHING. If you have no money but you have a good idea for a million-dollar profit, the only way you can capitalize on it is to cut a rich guy in on the deal. And the end result is you’ll pay him a lot more than you would pay a bank in interest, but an equity partner is absorbing a lot more risk than a lender is, and therefore will expect to be compensated accordingly.
It’s simply critical to the functioning of a modern society that capital be allowed to flow to where it is most effective. Interest is nothing more than a very accurate measure of what money is worth. If you can’t invest the money in something that returns more value than the interest, then you won’t borrow it and the capital will go elsewhere. If you can’t spend it on something that gives you more pleasure than the cost of the interest, you won’t buy the thing you’re interested in, and the capital will flow elsewhere.
Interest is therefore the lubricant that allows the wheels of capitalism to turn. Take it away, and the engine grinds to a halt, or at least chugs along at a snail’s pace as the cost of every capital movement goes up and we lose the informational value that interest provides.
I want to expand on this a bit, because it’s not only an interesting question, but it helps understand a lot about why capitalism works and why it’s a good thing.
Let’s take a simple case. You have $1000, and you are faced with two choices - you can invest it in the market, or put it in the bank. If you put it in the bank, the bank is now borrowing your money with interest. The interest represents the value they believe your money will have to them.
Now consider what happens when the economy starts to look shaky. Hmmn… We might go into a recession, because businesses are overvalued, or we’re over-producing and facing a recession. Hmmn… Your returns on your investment might not be as high as the interest rate. Better put your money in the bank. Millions of people make that choice, and capital flows out of shaky businesses and moves to safer investments. This is a good thing, because it protects us from a meltdown.
Now imagine if there was no way to save your money and earn interest on it. Now suddenly the only choice you have is to put your money under your pillow and watch it get eaten away by inflation, or to invest it in companies. So now when the country over-produces or otherwise mismanages itself and is heading for recession, there’s no place for the capital to go - no feedback loop to put the brakes on. No information loop that investment capital is harder to come by. So the economy operates much less efficiently.
Now imagine two companies competing for the same capital. There’s not enough for both of them to get all the investment money they get, so they bid up the price. Eventually, the price gets to the point where one company’s expected return is no greater, and they drop out. The other company gets the money at a higher interest rate. The person lending the money has now been given information that his money is worth more than it used to be, because there’s a greater need for it because there is under-production. So now the interest rate is driven up, and this entices more people to lend their money. Eventually we hit an equilibrium where the interest rate perfectly models the time-value cost of that money, and businesses know one side of the investment-decision equation perfectly, allowing them to make rational choices about whether to invest in more production or not.
(this assumes no meddling in the market by the government, which certainly isn’t true with interest rates - but the general principle is the same).
With interest in the loop accounting for the time-value of money, we are faced with an easy decision - I won’t invest in X unless X will return more to me than the value of my capital over the time that it’s invested. This is critical information in a market-driven economy. A fundamental principle of economics is that if the cost of two options is perfectly known, we will always make the most efficient choice, because no one pays something for nothing.
So it’s critical to know the exact cost of capital. That’s what interest does for us. Only by knowing that can we make rational choices about what to do with our money. Whenever a business chooses to invest in infrastructure or production, it has to weigh the time-value cost of they money needed for investment against the value that will be created through the results of the investment. If the results aren’t high enough, the money won’t be spent. And that capital will be free to be spent in an area where it does give a greater return.
I have to confess some sympathy for usery laws. In a society without bankruptsy procedures (where default on debt is legal), a meagre or nonexistant public safety net, widespread illiteracy and even innumeracy, lending contracts specifying a fixed rate of return seem like a fast path to debt peonage. Not to mention extra-legal enforcement.
What would happen if interest were made illegal? Sam sketches one scenario. More likely though, I suspect that there would be the rise of pseudo-interest contracts. I’m thinking something like preferred stock. Alternatively, an investor and a homeowner could enter into a “Partnership”, whereby the latter agrees to slowly buy said partnership out. If a default occurs -sorry a dissolution occurs- Moneybucks would be entitled to a share of the sale price of the house.
Of course, I’m merely sketching an interest economy disguised as an equity-only economy. But this pseudo-interest economy contains implicit bankruptsy protections.
------- I mean, there’s not much of an interest-lending system among hunter-gatherer tribes or nomadic herders, is there?
Not sure. IIRC, money lending has occurred in India for thousands of years.
In pre-agrarian societies with low capital accumulation, I understand that there are gift-exchange mechanisms that permit a small degree of insurance against a bad day in the field.
That may be the case, but this is destructive to the functioning of the economy because now the value of the money itself is more hidden by secondary factors like risk, liquidity, and all kinds of other things. It’s like a black market - it’s certainly a compensation for a large gap left by regulation, but it’s not as good as a free market because much of the activity remains hidden and information doesn’t flow as well.
The one critical insight you need to understand capitalism is that it’s all about information. Money is the way in which we communicate information about what we want, what we’re willing to pay for, and what the tradeoffs really are between all the economic decisions in our lives. This causes the economy to constantly adapt to changing wants and needs. A critical piece of that is knowing the real value of your money so you rationally choose what to do with it. Replace that with some pseudo-interest that conflates the value with other factors to hide it, and you destroy that critical piece. Maybe we’d eventually refine another method for archieving the same thing. But then you might as well just call it interest, because that’s all it is.
Of course, I’m merely sketching an interest economy disguised as an equity-only economy. But this pseudo-interest economy contains implicit bankruptsy protections.
------- I mean, there’s not much of an interest-lending system among hunter-gatherer tribes or nomadic herders, is there?
Not sure. IIRC, money lending has occurred in India for thousands of years.
In pre-agrarian societies with low capital accumulation, I understand that there are gift-exchange mechanisms that permit a small degree of insurance against a bad day in the field.
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Hm. I guess I’m assuming crude legislators, harried regulators and financiers who can develop a workaround in an afternoon or less. I’m also assuming (reasonably, I think) massive underlying demand for an interest-type product: that is, a relatively reliable reward for savings as opposed to an uncertain one.
Oh yes, I’m also assuming that the rule of law persists, so that the Utopian party can’t round up wise-guy financiers and have them shot.
------- The one critical insight you need to understand capitalism is that it’s all about information. Money is the way in which we communicate information about what we want, what we’re willing to pay for, and what the tradeoffs really are between all the economic decisions in our lives.
The waters would be muddied minimally (though measurably) I would think. Don’t get me wrong. Banning interest payments in a developed economy would be a dumb idea. Impressively so.
But markets are pretty resilient. Here’s an example. In the early 2000s the Bush admin abruptly announced that it was suspending the auction of 30 year treasury bonds. A 25(+?) year time series stopped. Just like that. Those using the 30yr bond to figure out the long term risk free rate could no longer do so.
But, hey, life goes on. Following our interest-banning decree, I would expect that newspapers would continue to publish interest rates/fruit rates, assuming that free speech protections remained.
Yes, but what would be different about it? What are the bad things about interest that you would do away with? The fact that interest rates float? Critical. The fact that longer term loans carry a higher rate? Critical. The fact that different credit mechanisms are available, at varying interest rates? Critical. So what would change, other than the name? Only by determining that can we discuss what its effect might be.
I opposition to interest comes from two camps: The first are the people that don’t understand the time-value of money, and think that it’s somehow wrong for people to charge you a monthly fee for using their capital. The others are the ones who don’t so much mind interest as a concept, but think that certain types of interest (credit cards, ‘money mart’ lenders) are really a ‘rip-off’.
Let’s consider the second case. How come credit card companies can charge 20% interest? How come ‘rent to own’ places can get away with charging effective interest rates close to 30%?
A big part of the answer is risk, obviously. In general, you’ll find lower interest rates whenever the lender is taking less risk with his money. Loans secured against a house or against other assets. Then loans to people with good credit ratings. Then loans to people who live stable lives and are not likely to cut and vanish. So you’ll find the highest interest rates in venues that people will only go to if they simply can’t get credit any other way.
You see the same thing in capital markets. GM just had their credit rating downgraded, which reduced the value of their bonds because people will demand more compensation to hold debt from a less secure company.
This doesn’t mean credit card debt is smart. Because another problem that comes up with credit cards specifically is asymmetric information. Credit card companies can’t afford to do thorough checks on everyone who applies, so they can’t sort out the good credit risks from the bad. So they charge the same interest rate to everyone. This is a good deal for people who know that if they run their cards up they’ll simply abandon the debt, so it encourages this kind of behaviour. It’s a bad deal for people who could get cheaper credit, but lack the knowledge to make that decision. For instance, if you own a house you can often get a secured line of credit for a fraction of the rate a regular credit card charges.
But in general, getting rid of ‘usury’, defined as particularly high credit, means the most disadvantaged people will not be able to get credit at all. You may think that’s a good thing, but that would be a paternalistic attitude, assuming that poor people can’t ‘handle’ credit. But it also condemns them to not being able to invest in ways that help them get out of poverty, or have a way to cover emergency expenses before payday.
High interest rates are also a good signal that good credit is worth having, and encourages people to do the things that allow them to get credit on better terms, such as being more responsible with money or accumulating valuable assets instead of blowing money on smokes and beer. So it drives respnosible behaviour and punishes irresponsible behaviour.
That’s because market alternatives exist. I’d have to know why the government dropped the 30yr bond before knowing if it was a good idea. There could be good reasons or bad, and the effect of it could have been beneficial or harmful. That’s the fundamental problem with government - because they make rules by fiat, it’s extremely hard for information about the real costs and benefits to be found.
But this is a wholly different class of decision anyway. The removal of a specific debt instrument from a market that has many alternatives may not disrupt the functioning of the market at all. GM’s credit downrating didn’t hurt the overall efficiency of the market. In fact, it was crucual to it. But now imagine if the government said that ALL companies must have their credit ratings lowered or equalized, for ‘fairness’. What do you think that would do to information transmission, and ultimately the efficiency of that market? It would destroy it. Alternatives would eventually arise, but when one path is blocked by fiat, the fact that another is found doesn’t mean it’s the most efficient way to do things. It’s only the most efficient way to do things given that the alternative is removed by force.
This is insidious, because we may think the new way is just as good, but because the decision was made by fiat, we no longer have the information we need to know that. It’s hidden. Perhaps over 20 years the marketplace would change such that the new way of doing things is better than the old, or perhaps it changed such that the old way would be way, way better. And we’ll have no way to know because that information flow was cut off by a governmental wall.
That’s what regulation does. It erects barriers to information flow. It diverts capital in unpredictable ways, and it makes it harder for everyone to know what the most economically efficient decisions really are. This has enormous cost - trillions of dollars a year.
I’m not sure where we disagree in a big sense, Sam. The only point I was making was that even if the government does something phenomenally stupid[sup]1[/sup], the market does a pretty good job of working its way around it. Sure, there are costs.
------ That’s what regulation does. It erects barriers to information flow. It diverts capital in unpredictable ways, and it makes it harder for everyone to know what the most economically efficient decisions really are. This has enormous cost - trillions of dollars a year.
But trillions of dollars a year? From barriers to information flow? Cite? :dubious: I assume you’re alleging gross costs and not net ones. Still.
Unpredictable ways: Hm. Over a 5 year period, maybe. Over a one year period? The National Journal, etc. are pretty good at covering regulatory policy, etc. (Admittedly, the worldwide inflation of the 1970s may have disrupted information flows sufficient to crimp productivity. Though this hypothesis has hardly been established.)
There were good reasons: I wasn’t arguing with the policy per se[sup]2[/sup], merely trying to demonstrate the resiliency of markets: after all the T-Bond plays a fairly central role as the measure of the risk-free rate (though admittedly many analysts prefer the LIBOR, because Treasuries are free of state taxes and therefore susceptible to changes in state tax rates).
“because they make rules by fiat, it’s extremely hard for information about the real costs and benefits to be found.”
Again: :dubious: The difficulty of measuring costs and benefits is rarely due to the government keeping information away from the private sector, national security issues excepted. It’s just that the underlying policy problems can sometimes (not always) be difficult.
[sup]2[/sup]My defense of usury laws relates mostly to pre-welfare state (and typically pre-industrial) societies. I guess I might consider certain predatory lending rules, but only after a careful review of the empirics. The disadvantages (a credit crunch for high risk borrowers) would not be dismissed, but nor would I ignore instances of blatant consumer bamboozlement. Neither phenomena would automatically outweigh the other in my book. (Though smart observers of governmental behavior would note that it’s the readily visible effects that tend to attract political attention.)
[sup]2[/sup]Though at the time, I wondered whether or not more warning should have been given.
